federal and california tax update for businesses and estates/media/event...

Federal and California Tax Update for Businesses and Estates

Annette Nellen, CPA, CGMA, JD Gary McBride, JD, LLM (Taxation), CPA

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Notice to ReadersCalCPA Education Foundation programs and publications are designed to provide CPAs and financial professionals current, accurate information concerning the subject matter covered. However, the CalCPA Education Foundation gives no assurance that such information is comprehensive in its coverage of a subject matter or that it is suitable in dealing with specific client problems or business-related circumstances. Accordingly, information published or provided by the CalCPA Education Foundation should not be relied upon as a substitute for independent research to original sources of authority. The CalCPA Education Foundation does not render any accounting, legal or other professional advice, nor does it have any responsibility for updating or revising any programs or publications which it may present, distribute or sponsor.

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Copyright © 2016 Annette Nellen, CPA, CGMA, JD

Gary McBride, JD, LLM (Taxation), CPA No copyright claimed in U.S. Government materials.

TAXB _________________________________________________________________________________________________________www.calcpa.org (800) 922-5272

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2016 Federal & California Tax Update: Businesses, Trusts, Estates, & Exempt Orgs

Gary McBride & Annette Nellen

California CPA Education Foundation November 2016 – January 2017

The PPT slides that accompany each chapter can be download (chapter by chapter) at: http://mntaxclass.com/files.html

Chapter 1: 2016 Legislation and Code/Regs. First Effective in 2016

Chapter 2: Expiring Provisions

Chapter 3: C Corporations

Chapter 4: S Corporations

Chapter 5: Partnerships and LLCs

Chapter 6: Credits

Chapter 7: State of California and MultiState

Chapter 8: Accounting Methods and Section 199

Chapter 9: International Tax

Chapter 10: Payroll Tax and Worker Classification

Chapter 11: ACA Update

Chapter 12: Estate, Gift, and GST Tax

Chapter 13: Income Taxation of Trusts and Estates

Chapter 14: Tax Exempts

Chapter 15: Looking Forward

©2016. These materials are copyrighted and may not be reproduced or distributed in whole or in part without permission of the authors/CalCPA Education Foundation.

http://mntaxclass.com/files.html

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2016 McBride/Nellen Federal and California Update for Businesses and Estates

Chapter 1: 2016 Legislation and Code/Regs. First Effective in 2016 Page 1-1

Chapter 1 : 2016 Legislation and Code/Regs. First Effective in 2016

Table of Contents Chapter 1 : 2016 Legislation and Code/Regs. First Effective in 2016 .................................. 1-1

2016 Legislation ............................................................................................................. 1-2

P.L. 114-125 (2/24/16), Trade Facilitation and Trade Enforcement Act of 2015 ............. 1-2

Continuing Appropriations Legislation FY2017 – P.L. 114-223 (9/29/16; H.R. 5325) ... 1-3

Prior Law First Effective in 2016 ........................................................................... 1-3

New 2016 Filing Requirements ............................................................................................. 1-3

Due Date for W-2 and 1099-MISC ....................................................................................... 1-4

Truncated SSN on Form W-2 ............................................................................................... 1-4

PATH and Deminimis Errors on Information Returns and Payee Statements ............... 1-4

Permanence and Enhancement of Food Inventory Donations .......................................... 1-5

Expensing for Live Theatrical Productions ......................................................................... 1-6

Research Credit Usable Against AMT for Eligible Small Businesses ............................... 1-6

Research Credit Available Against Payroll Taxes for Start-ups ....................................... 1-7

Work Opportunity Tax Credit Extended to Long-Term Unemployed ............................ 1-8

More Employers Are Eligible for Differential Wage Payment Tax Credit ...................... 1-9

Work Opportunity Tax Credit Extension and Modification ............................................. 1-9

Partnership Interests Created by Gift ................................................................................. 1-9

Loss Transfers Between Tax Indifferent Parties ................................................................ 1-9

Regulations First Effective in 2016 .................................................................... 1-10

Chart of All 2016 Federal Tax Regulations ....................................................................... 1-10

T.D. 9752; Reg. 1.6038D-1, -2, -6 (2/22/2016) -- Final Regulations On Specified Foreign Financial Asset (SFFA) Form 8938 Reporting By Domestic Entities ............................. 1-10

Background ....................................................................................................................... 1-10

2016 Final Regulations ..................................................................................................... 1-12

Effective Date. ................................................................................................................... 1-12

Specified Domestic Entity (SDE). .................................................................................... 1-12

Definition of SDE for Partnerships and Corporations.................................................. 1-12

Domestic Trusts ................................................................................................................ 1-16


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REG-163113-02 (8/4/16) Prop. Regs. 25.2701-2,-8, 25.2704-1, -2, -3, -4; IRS Issues Proposed Regulations on Gift and Estate Tax Valuations ............................................... 1-18

T.D. 9728; Regs. 1.706-1, -4, -5 (Aug. 3, 2015) -- Final Regulations on Varying Interest Rules for Partnership TYB On or After Aug. 3, 2015 ...................................................... 1-19

Variations Subject to Varying Interest Rules ................................................................ 1-19

General Rule of Segments and Proration Periods ......................................................... 1-20

Step-by-Step Approach (Ten Steps) ................................................................................ 1-21

Example of Step-by-Step Approach (Reg. 1.706-4(a)(4) Example (Modified) ............ 1-22

Exceptions (Reg. 1.706-4((b)) ........................................................................................... 1-24

Conventions (Reg. 1.706-4((c)) ........................................................................................ 1-26

Optional Regular Monthly Or Semi-Monthly Interim Closings (Reg. 1.706-4(d)) .... 1-28

Extraordinary Items (Reg. 1.706-4(e) ............................................................................. 1-29

Agreement of the Partners (Full text of Reg. 1.706-4(f)) .............................................. 1-33

Effective Date (Reg. 1.706-4(g)) ....................................................................................... 1-33

Inflation Adjustments ................................................................................................ 1-34

2017 Inflation Adjustments – Rev. Proc. 2016-55 ............................................................. 1-34

2017 Social Security Wage Base is $127,200 ...................................................................... 1-34

2016 Legislation P.L. 114-125 (2/24/16), Trade Facilitation and Trade Enforcement Act of 2015

P.L. 114-125 makes these two tax changes:

a. Increase in FTF Penalty - Increases the §6651(a) penalty for failure to file a return from $135 to $205, effective for returns required to be filed after 2015. The change is the last sentence of §6651(a):

“In the case of a failure to file a return of tax imposed by chapter 1 within 60 days of the date prescribed for filing of such return (determined with regard to any extensions of time for filing), unless it is shown that such failure is due to reasonable cause and not due to willful neglect, the addition to tax under paragraph (1) shall not be less than the lesser of $135 $205 or 100 percent of the amount required to be shown as tax on such return.”

This amount is adjusted annually for inflation.

CBO estimates this change will raise $202 million over ten years (12/10/15 cost estimate on H.R. 644).


https://www.congress.gov/bill/114th-congress/house-bill/644/text

https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/costestimate/hr644conference.pdf

https://www.cbo.gov/sites/default/files/114th-congress-2015-2016/costestimate/hr644conference.pdf

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b. Made the Internet Tax Freedom Act (ITFA) moratorium permanent and, effective after June 30, 2020, removed the grandfather provision (relevant to Hawaii, New Mexico, North Dakota, Ohio, South Dakota, Texas, and Wisconsin). This moratorium was originally enacted in 1998 and renewed a few times. See further discussion in the Multistate Tax portion of the outline.

Continuing Appropriations Legislation FY2017 –

P.L. 114-223 (9/29/16; H.R. 5325) This legislation funds the government through December 9, 2016. Thus, Congress left the full funding activity until after the November elections.

Prior Law First Effective in 2016

New 2016 Filing Requirements

New Return Due Dates - The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (PL 114-41 (7/31/15), changed the due dates of some business returns. This proposal has been floated around for over one year and was also included in Congressman Camp’s tax reform proposal. The purpose of the change is to improve the filing season process. For example, the due date for corporate returns is pushed out 1 month (it doesn’t feed into any individual returns) and the partnership due date is moved up 1 month.

Changes include (assuming calendar year taxpayers, unless otherwise noted):

Return Current due dates New due date Extended due date

1065 April 15/Sept 15 March 15 Sept 15

1120S (no change)

March 15/Sept 15 March 15 Sept 15

1120 (calendar year)

March 15/Sept 15 April 15 Sept 15*

1120 with 6/30 fiscal year

Sept 15/ March 15 Sept 15 April 15**

1120 other than 12/31 or 6/30 year

end

15 day of 3rd month/15th day of

9th month

15 day of 4th month 15th day of 10th month

FBAR June 30 April 15 October 15


https://www.congress.gov/bill/114th-congress/house-bill/5325

https://www.congress.gov/bill/114th-congress/house-bill/3236/all-info

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*After 12/31/2025, C corps using a calendar year will have extended returns due October 15 (rather than September 15).

**The new due dates go into effect for 6/30 C corps for tax years beginning after 12/31/2015.

Conforming amendments were also made to other Code sections as needed, such as §170(a)(2)(B).

Effective dates: Generally, to returns for tax years beginning after 12/31/15. So, for filing 2016 returns (assuming calendar year).

Additional resources:

The AICPA has a nice chart summarizing all of the changes.

Sherr, “Why new tax return due date changes are important,” AICPA CPA Insider, 10/19/15.

JCT, Overview of Selected Provisions Relating To The Financing of Surface Transportation Infrastructure, JCX-97-15 (6/23/15).

Due Date for W-2 and 1099-MISC PATH modifies the filing dates of returns and statements relating to employee wage information and nonemployee compensation to improve compliance; generally, all forms are due to the IRS by January 31 (Sections 6071 and 6402). This change applies to 2016 returns and statements (due January 2017). See AICPA Due Date chart and new IRS instructions for Form 1099-MISC. These measures aim to help reduce identity theft.

Truncated SSN on Form W-2 PATH extends IRS authority to require truncated Social Security numbers on Form W–2 (§6051(a)(2)). IRS authority at §6109(d). Effective 12/18/15. Per the JCT, this change will allow the IRS to issue regulations “requiring or permitting” a truncated SSN on Form W-2 (JCS-1-16, 3/14/16, p. 336). For overview of IRS regulations on truncation, see Nellen, “TTINs and protecting taxpayer identities,” AICPA Tax Insider, 9/11/14. PATH and Deminimis Errors on Information Returns and Payee Statements


https://www.aicpa.org/advocacy/tax/taxlegislationpolicy/downloadabledocuments/due-dates-summary-chart.pdf

http://www.journalofaccountancy.com/newsletters/2015/oct/new-tax-return-due-date-changes.html

https://www.jct.gov/publications.html?func=startdown&id=4796

https://www.aicpa.org/Advocacy/Tax/TaxLegislationPolicy/DownloadableDocuments/Due-Dates-Summary-Chart.pdf

https://www.irs.gov/instructions/i1099msc/ar01.html


https://www.cpa2biz.com/Content/media/PRODUCER_CONTENT/Newsletters/Articles_2014/Tax/TTINs.jsp

https://www.cpa2biz.com/Content/media/PRODUCER_CONTENT/Newsletters/Articles_2014/Tax/TTINs.jsp

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PATH (P.L. 114-113 (12/18/16)) adds a safe harbor provision to §6721 to allow taxpayers to not have to re-issue certain information returns where there is an error of $100 or less. This changes applies to returns required to be filed and payee statements required to be provided after 12/31/16 (thus for 2016 forms).

Per the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 2015 (JCS-1-16; March 2016), page 222:

“In general, a de minimis error of an amount on the information return or statement need not be corrected if the error for any single amount does not exceed $100. A lower threshold of $25 is established for errors with respect to the reporting of an amount of withholding or backup withholding. The provision requires broker reporting to be consistent with amounts reported on uncorrected returns which are eligible for the safe harbor. If any person receiving payee statements requests a corrected statement, the penalty for failure to file a correct information return and the penalty for failure to furnish a correct payee statement would continue to apply in the case of a de minimis error.”

Permanence and Enhancement of Food Inventory Donations

PATH made permanent the enhanced donation deduction for food inventory (§170(e)(3)(C)). Permanence is effective contributions after 12/31/14. The enhancements apply for tax years beginning after 12/31/15. Per the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 2015 (JCS-1-16; March 2016), pages 130-131:

“The provision reinstates and makes permanent the enhanced deduction for contributions of food inventory for contributions made after December 31, 2014.

For taxable years beginning after December 31, 2015, the provision also modifies the enhanced deduction for food inventory contributions by: (1) increasing the charitable percentage limitation for food inventory contributions and clarifying the carryover and coordination rules for these contributions; (2) including a presumption concerning the tax basis of food inventory donated by certain businesses; and (3) including presumptions that may be used when valuing donated food inventory.

First, the ten-percent limitation described above applicable to taxpayers other than C corporations is increased to 15 percent. For C corporations, these contributions are made subject to a limitation of 15 percent of taxable income (as modified). The general ten-percent limitation for a C corporation does not apply to these contributions, but the ten-percent limitation applicable to other contributions is reduced by the amount of these contributions. Qualifying food inventory contributions in excess of these 15-percent limitations may be carried forward and treated as qualifying food inventory contributions in each of the five succeeding taxable years in order of time.

Second, if the taxpayer does not account for inventory under section 471 and is not required to capitalize indirect costs under section 263A, the taxpayer may elect, solely for computing the enhanced deduction for food inventory, to treat the basis of any apparently wholesome food as being equal to 25 percent of the fair market value of such food.




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Third, in the case of any contribution of apparently wholesome food which cannot or will not be sold solely by reason of internal standards of the taxpayer, lack of market, or similar circumstances, or by reason of being produced by the taxpayer exclusively for the purposes of transferring the food to an organization described in section 501(c)(3), the fair market value of such contribution shall be determined (1) without regard to such internal standards, such lack of market or similar circumstances, or such exclusive purpose, and (2) by taking into account the price at which the same or substantially the same food items (as to both type and quality) are sold by the taxpayer at the time of the contributions (or, if not so sold at such time, in the recent past).”

Expensing for Live Theatrical Productions The 2015 PATH Act extends the election to expense qualified film and television production costs for two years, to cover productions commencing in 2015-2016. For productions commencing after 2015, the election is expanded to cover qualified live theatrical productions. Per the JCT Bluebook:

A qualified live theatrical production is defined as a live staged production of a play (with or without music) which is derived from a written book or script and is produced or presented by a commercial entity in any venue which has an audience capacity of not more than 3,000, or a series of venues the majority of which have an audience capacity of not more than 3,000. In addition, qualified live theatrical productions include any live staged production which is produced or presented by a taxable entity no more than 10 weeks annually in any venue which has an audience capacity of not more than 6,500. In general, in the case of multiple live-staged productions, each such live-staged production is treated as a separate production. Similar to the exclusion for sexually explicit productions from the present-law definition of qualified productions, qualified live theatrical productions do not include stage performances that would be excluded by section 2257(h)(1) of title 18 of the U.S. Code, if such provision were extended to live stage performances. …. The modifications for live theatrical productions apply to productions commencing after December 31, 2015. For purposes of this provision, the date on which a qualified live theatrical production commences is the date of the first public performance of such production for a paying audience.

Research Credit Usable Against AMT for Eligible Small Businesses

PL 114-113 (12/18/16) (PATH) modified the credit to allow eligible small businesses to use the research tax credit against AMT effective for credits determined for tyba 12/31/15. Following is an explanation and example from the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 2015 (JCS-1-16; March 2016), pages 136-137.



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“in the case of an eligible small business (as defined in section 38(c)(5)(C), after application of rules similar to the rules of section 38(c)(5)(D)), the research credit determined under section 41 for taxable years beginning after December 31, 2015, is a specified credit. Thus, these research credits of an eligible small business may offset both regular tax and AMT liabilities.”

Example from Footnote 403: “Assume a taxpayer has a regular tax liability of $80,000, a tentative minimum tax of $100,000, and a research credit determined under section 41 of $90,000 for the taxable year (and no other credits). Under present law, the taxpayer’s research credit is limited to the excess of $100,000 over the greater of (1) $100,000 or (2) $13,750 (25% of the excess of $80,000 over $25,000). Accordingly, no research credit may be claimed ($100,000 – $100,000 = $0) for the taxable year and the taxpayer’s net tax liability is $100,000. The $90,000 research credit may be carried back or forward under the rules applicable to the general business credit.”.

Example of law change from Footnote 412: “the limitation would be the excess of $100,000 over the greater of (1) $0 or (2) $13,750. Since $13,750 is greater than $0, the $100,000 would be reduced by $13,750 such that the research credit would be limited to $86,250. Hence, the taxpayer would be able to claim a research credit of $86,250 against its $100,000 net income tax (the sum of $80,000 regular tax liability and $20,000 alternative minimum tax), which would result in $13,750 of total net tax owed ($100,000—$86,250). The remaining $3,750 of its research credit ($90,000—$86,250) may be carried back or forward, as applicable.”

Research Credit Available Against Payroll Taxes for Start-ups

Research Credit and Payroll Taxes – PL 114-113 (12/18/16) (PATH) made the research tax credit permanent and made a few taxpayer favorable modifications. One of the modifications is to allow certain start-up businesses to use the credit against payroll taxes (limited to $250,000) for tax years beginning after 12/31/15. The draft Form 6765 for 2016 has a new Section D for this calculation, which also affects payroll returns (see Form 941 and 2017 draft form). The draft 2017 Form 941 refers to Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, which is attached to Form 941.

Interaction with §280C(c): Per the JCT Bluebook for PATH – “If a taxpayer makes an election under this provision, the amount so elected is treated as a research credit for purposes of section 280C.414

fn414 “Thus, taxpayers are either denied a section 174 deduction in the amount of the credit or may elect a reduced research credit amount. The election is not taken into account for purposes of determining any amount allowable as a payroll tax deduction.”


https://www.irs.gov/uac/about-form-941

https://www.irs.gov/pub/irs-dft/f941--dft.pdf




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JCT explanation of a business eligible for the payroll tax offset: “A qualified small business is defined, with respect to any taxable year, as a corporation (including an S corporation) or partnership (1) with gross receipts of less than $5 million for the taxable year, and (2) that did not have gross receipts for any taxable year before the five taxable year period ending with the taxable year. An individual carrying on one or more trades or businesses also may be considered a qualified small business if the individual meets the conditions set forth in (1) and (2), taking into account its aggregate gross receipts received with respect to all trades or businesses. A qualified small business does not include an organization exempt from income tax under section 501.”

Payroll credit basics from JCT: (pages 138-139)

“The payroll tax credit portion is the least of (1) an amount specified by the taxpayer that does not exceed $250,000, (2) the research credit determined for the taxable year, or (3) in the case of a qualified small business other than a partnership or S corporation, the amount of the business credit carryforward under section 39 from the taxable year (determined before the application of this provision to the taxable year).”

“For purposes of this provision, all members of the same controlled group or group under common control are treated as a single taxpayer. The $250,000 amount is allocated among the members in proportion to each member’s expenses on which the research credit is based. Each member may separately elect the payroll tax credit, but not in excess of its allocated dollar amount.”

“A taxpayer may make an annual election under this section, specifying the amount of its research credit not to exceed $250,000 that may be used as a payroll tax credit, on or before the due date (including extensions) of its originally filed return. A taxpayer may not make an election for a taxable year if it has made such an election for five or more preceding taxable years. An election to apply the research credit against OASDI liability may not be revoked without the consent of the Secretary of the Treasury (‘‘Secretary’’). In the case of a partnership or S corporation, an election to apply the credit against its OASDI liability is made at the entity level.”

Applying the credit against payroll tax (JCT p 139): “The payroll tax portion of the research credit is allowed as a credit against the qualified small business’s OASDI tax liability for the first calendar quarter beginning after the date on which the qualified small business files its income tax or information return for the taxable year. The credit may not exceed the OASDI tax liability for a calendar quarter on the wages paid with respect to all employees of the qualified small business.”

“If the payroll tax portion of the credit exceeds the qualified small business’s OASDI tax liability for a calendar quarter, the excess is allowed as a credit against the OASDI liability for the following calendar quarter.”

Guidance Expected: The IRS is to issue regulations to ensure limitations apply even if there is a successor company, to minimize compliance and recordkeeping burdens and allow a credit recapture if needed.

Work Opportunity Tax Credit Extended to Long-Term Unemployed


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The 2015 PATH Act extended the deadline for employing eligible members of targeted groups for purposes of claiming the Work Opportunity Tax Credit (WOTC), to cover hiring that occurs in 2015-2019 (section 51(c)(4)). After 2015, the PATH Act also modified the WOTC rules to benefit employers that hire qualified long-term unemployed individuals (those who have been unemployed for 27 weeks or more), with the credit amount for those individuals is equal to 40% of the first $6,000 of wages (section 51(d)).

More Employers Are Eligible for Differential Wage Payment Tax Credit The PATH Act made permanent the tax credit for employers that provide differential pay to employees while they serve in the military. The credit equals 20% of differential pay of up to $20,000 paid to each qualifying employee during the applicable year. In addition, beginning in 2016, the PATH Act makes the credit available to employers of any size, rather than just small employers with 50 or fewer workers. The credit applies to differential wage payments to qualifying employees for periods that they are called to active duty with U.S. uniformed services for more than 30 days. (section 45P)

Work Opportunity Tax Credit Extension and Modification PATH extended and modified the WOTC (51(c)(4)) to include “qualified long-term unemployment recipients.” The extension is effective for individuals who starts work after 12/31/14. The modification applies for those who start work after 12/31/15. See Notice 2016-22 and Notice 2016-40 for guidance and transition relief. Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity Credit, has been updated.

Partnership Interests Created by Gift P.L. 114-74 (11/2/15) – Bipartisan Budget Act of 2015 - Modifies §761 for partnership interests created by gift. For partnership TYBA 12/31/15.

Loss Transfers Between Tax Indifferent Parties Section 267(d) was modified by PATH for sales and other dispositions of property acquired after 12/31/15 in a sale or exchange to which §267(a)(1) applied. Per the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 2015 (JCS-1-16; March 2016), page 313:

“The provision provides that the general rule of section 267(d) does not apply to the extent gain or loss with respect to property that has been sold or exchanged is not subject to Federal income


https://www.irs.gov/pub/irs-drop/n-16-22.pdf


https://www.irs.gov/uac/Form-8850,-Pre-Screening-Notice-and-Certification-Request-for-the-Work-Opportunity-Credit

https://www.congress.gov/bill/114th-congress/house-bill/1314/text/pl


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tax in the hands of the transferor immediately before the transfer but any gain or loss with respect to the property is subject to Federal income tax in the hands of the transferee immediately after the transfer. Thus, the basis of the property in the hands of the transferee will be its cost for purposes of determining gain or loss, thereby precluding a loss importation result.”

“The provision applies to sales and other dispositions of property acquired after December 31, 2015, by the taxpayer in a sale or exchange to which section 267(a)(1) applied.”

Regulations First Effective in 2016

Chart of All 2016 Federal Tax Regulations For a complete list of regulations issued by the IRS and Treasury in 2016, see http://www.sjsu.edu/people/annette.nellen/website/2016regs.html. T.D. 9752; Reg. 1.6038D-1, -2, -6 (2/22/2016) -- Final Regulations On Specified

Foreign Financial Asset (SFFA) Form 8938 Reporting By Domestic Entities

Background Section 6038D, enacted as part of The Hiring Incentives to Restore Employment Act in 2010, requires certain individuals and specified domestic entities to report information about specified foreign financial assets (SFFAs). SFFAs are reported, as an attachment to the income tax return, on Form 8938. "Specified foreign financial assets," include financial accounts held at foreign financial institutions, and stocks, securities, financial instruments, contracts, or interests issued or held by a foreign person or entity. Section 6038D(f) extends SFFA reporting, to the extent provided in regulations, to domestic entities such as U.S. partnerships, corporations, and trusts; therefore, the regulations declare that a “specified person” subject to Form 8938 reporting is a “specified individual or a specified domestic entity.” Reg. 1.6038D-1(a)(1). Specified individuals include U.S. citizens and resident aliens of the United States for any portion of the tax year. Regarding specified individuals, the IRS issued temporary regulations on Dec. 19, 2011 (TD 9567) addressing the Form 8938 reporting requirements and those rules were finalized on Dec. 12, 2014 (TD 9706). On Dec. 19, 2011 (REG-130302-10) the IRS published proposed regulations addressing the reporting requirements for specified domestic entities (SDEs); however, the 2014 final regulations covered only SFFA reporting by individuals and reserved coverage of reporting by domestic entities. Notice 2013-10 clarified that reporting by domestic entities of interests in SFFAs would not be required before the date specified by final regulations.


http://www.sjsu.edu/people/annette.nellen/website/2016regs.html

https://s3.amazonaws.com/public-inspection.federalregister.gov/2016-03795.pdf

https://www.irs.gov/irb/2014-53_IRB/ar06.html

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The 2014 final regulations did specify the applicable reporting threshold for SDEs: The section 6038D requirement would only apply to domestic entities if the aggregate value of a domestic entity’s SFFAs exceeds: (1) $50,000 on the last day of the taxable year, or (2) $75,000 at any time during the taxable year. (Reg. 1.6038D-2(a)(1)). With respect to entities, the 2014 final regulations further explain that:

A “specified person is not treated as having an interest in any specified foreign financial assets held by a corporation, partnership, trust, or estate solely as a result of the specified person's status as a shareholder, partner, or beneficiary of such entity.” (Reg. 1.6038D-2(b)(4)(i)) A “specified person that is treated as the owner of a trust or any portion of a trust under sections 671 through 679 [a grantor trust]” with limited exceptions, “is treated as having an interest in any specified foreign financial assets held by the trust or the portion of the trust.” (Reg. 1.6038D-2(b)(4)(ii)) A specified person that owns a foreign or domestic disregarded entity “is treated as having an interest in any specified foreign financial assets held by the disregarded entity.” (Reg. 1.6038D-2(b)(4)(iii))

Specified persons are not required to report an SFFA on Form 8938 if the specified person reports the asset on at least one of the following IRS Forms:

3520, “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts” (“in the case of a specified person that is the beneficiary of a foreign trust”);

5471, “Information Return of U.S. Persons With Respect To Certain Foreign Corporations”;

Form 8621, “Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund”;

Form 8865, “Return of U.S. Persons With Respect To Certain Foreign Partnerships”; For taxable years beginning after March 18, 2010, and ending on or before December 31,

2013, Form 8891, “U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans”

Instead of reporting the SFFA on Form 8938, the specified person reports on Form 8938 the form (above) on which the SFFA was reported. (Reg. 6038D-7(a)(1)(i) and (ii)) A specified person treated as the owner of a foreign trust or any portion of a foreign trust under sections 671 through 679 is not required to report any SFFAs held by the foreign trust on Form 8938, provided—

(i) The specified person reports the trust on a Form 3520 timely filed; (ii) The trust timely files Form 3520-A, “Annual Information Return of Foreign Trust With

a U.S. Owner,”; and (iii) The Form 8938 filed by the specified person reports the filing of the Form 3520 and

Form 3520-A. (Reg. 6038D-7(a)(2))


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Observation: The Form 8938 filing requirement in IRC section 6038D is in addition to the Report of Foreign Bank and Financial Accounts (FBAR) reporting requirement imposed by Title 31 (not the Internal Revenue Code which is Title 26). Per the IRS website:

“The new Form 8938 filing requirement does not replace or otherwise affect a taxpayer’s obligation to file FinCEN Form 114 (Report of Foreign Bank and Financial Accounts). Unlike Form 8938, the FBAR (FinCEN Form 114) is not filed with the IRS. It must be filed directly with the office of Financial Crimes Enforcement Network (FinCEN), a bureau of the Department of the Treasury, separate from the IRS.”

IRS Chart: Comparison of Form 8938 and FBAR Requirements

2016 Final Regulations Effective Date. The final regulations are effective for tax years that begin after Dec. 31, 2015.

Specified Domestic Entity (SDE). “A specified domestic entity is a domestic corporation, a domestic partnership, or a trust described in section 7701(a)(30)(E), if such corporation, partnership, or trust is formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets. Whether a domestic corporation, a domestic partnership, or a trust described in section 7701(a)(30)(E) is a specified domestic entity is determined annually.” (Reg. 1.6038D-6(a))

Definition of SDE for Partnerships and Corporations The 2016 final regulations set forth two objective conditions to establish if a corporation or partnership is “formed or availed of” for the purpose of holding SFFAs thus making the entity a “specified domestic entity” (SDE). To be an SDE:

1) The entity must be closely held. For corporations, closely held means that a specified individual owns directly,

indirectly or constructively, at least 80 percent (by vote or value) of the corporation, on the last day of the corporation’s tax year.

For partnerships, closely held means that a specified individual holds directly, indirectly or constructively, at least 80 percent of the capital or profits interest on the last day of the partnership’s tax year.

Constructive Ownership: “[S]ections 267(c) and (e)(3) apply for the purpose of determining the constructive ownership of a specified individual in a corporation or partnership, except that section 267(c)(4) is applied as if the family of an individual includes the spouses of the individual's family members.” Per section 267(c)(4): “[t]he family of an individual shall include only his brothers and sisters (whether by


https://www.irs.gov/businesses/comparison-of-form-8938-and-fbar-requirements

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the whole or half blood), spouse, ancestors, and lineal descendants.” Therefore, the spouses of ancestors, lineal descendants, and brothers and sisters are also included. (Reg. 1.6038D-6(b)(2)(iii))

2) At least 50% of the entity’s gross income for the tax year must be passive income or at

least 50% of the entity’s assets must produce or be held for the production of passive income. Passive income and assets generally include dividends, interests, rents and royalties

(unless the rents and royalties are “derived in the active conduct of a trade or business conducted, at least in part, by employees of the corporation or partnership), annuities, the excess of gains over losses from the sale or exchange of assets that generate passive income. (See Reg. 1.6038D-6(b)(3))

For purposes of applying the 50% passive income and asset thresholds “all domestic corporations and domestic partnerships that are closely held by the same specified individual … and that are connected through stock or partnership interest ownership with a common parent corporation or partnership are treated as owning the combined assets and receiving the combined income of all members of that group.” (See Reg. 1.6038D-6(b)(3)(iii))

The percentage of passive assets held by a corporation or partnership for a tax year is “the weighted average percentage of passive assets (weighted by total assets and measured quarterly), and the value of assets of a corporation or partnership is the fair market value of the assets or the book value of the assets that is reflected on the corporation's or partnership's balance sheet (as determined under either a U.S. or an international financial accounting standard).” Reg. 1.6038D-6(b)(1).

Observation: The final regulations eliminated the subjective principal purpose test for determining SDE status that was contained in the proposed regulations that included a corporation or partnership in which only 10% of the income or assets are passive where the entity was formed for the principal purpose of avoiding Form 8938 reporting based upon all of the facts and circumstances.

Reporting Threshold Aggregation Rule for SDEs. An SDE is only required to File Form 8938 if it also meets the reporting threshold: SFFAs exceeding either $50,000 on the last day of the taxable year, $75,000 at any time during the taxable year. (Reg. 1.6038D-2(a)(1)). For purposes of determining if an SDE meets the reporting threshold, the following aggregation rule applies:

“The value of any specified foreign financial asset in which a specified domestic entity has an interest and that is excluded from reporting on Form 8938 pursuant to § 1.6038D-7(a) (concerning certain assets reported on another form) is excluded for purposes of determining the aggregate value of specified foreign financial assets. For purposes of determining the aggregate value of specified foreign financial assets, a specified domestic entity that is a corporation or partnership and that has an interest in any specified foreign financial asset is treated as owning all the specified foreign financial assets (excluding specified


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foreign financial assets excluded from reporting on Form 8938 pursuant to § 1.6038D-7(a)) held by all domestic corporations and domestic partnerships that are closely held by the same specified individual as determined under §1.6038D-6(b)(2).” (Reg. 1.6038D-2(a)(6)(ii)) (Emphasis added)

Example. Individual: Facts. L is a specified individual. After considering family attribution, L owns a 90% capital interest in a family limited partnership (FLP). L does not own any other closely held businesses. 50% of FLP’s gross income is passive. The FLP assets include SFFAs with a maximum value of $90,000 during the tax year. Analysis. Because FLP is closely held by a specified individual and 50% of the gross income is passive, FLP is a specified domestic entity (SDE). Conclusion: Because FLP is an SDE with SFFAs exceeding the filing threshold ($75,000 maximum value during the year), FLP must file Form 8938 as an attachment to Form 1065. Observation: The broad aggregation rule applicable to the reporting threshold should not be confused with the narrower aggregation rule applicable to the passive income or assets test. Example (1) in Reg. 1.6038D-6(b)(3)(iii) -- Closely Held and Constructive Ownership. Facts DC1 is a domestic corporation the total value of the stock of which is owned 60% by A, a

specified individual, 30% by B, a member of A's family for purposes of section 267(c)(2) who is not a specified individual, and 10% by FC1, a foreign corporation.

DC1 owns 90% of the total value of the stock of DC2, a domestic corporation. FC2, a foreign corporation, owns 10% of DC2.

Neither A nor B owns, directly, indirectly, or constructively, any stock in FC1 or FC2. Closely held ownership determination A is considered to own 90% and 81% of the total value of DC1 and DC2, respectively, by

application of the rules of section 267(c) and this section. DC1 and DC2 are closely held by A because A, a specified individual, is considered to own

more than 80% of their total value. Example (2) in Reg. 1.6038D-6(b)(3)(iii) (modified)-- Application of Aggregation Rule and Reporting Threshold. Facts L is a specified individual. In Year X, L wholly owns DC1, a domestic corporation, and also owns a 90% capital interest

in DP, a domestic partnership. DC1 owns 80% of the sole class of stock of DC2, a domestic corporation. DC1 has no assets other than its interest in DC2. DC2's only assets are assets that produce passive income, with a maximum value in Year X

of $40,000 on October 12. DC2's assets are comprised in relevant part of SFFAs with a maximum value in Year X of

$15,000 on October 12. DP's only assets are assets that produce passive income and that are SFFAs with a maximum

value of $90,000 in Year X on October 12.


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Specified domestic entity status DC1 and DC2. DC1 and DC2 are closely held by a specified individual. DC1 and DC2 are considered related entities that are connected through stock ownership

with a common parent corporation, because DC1 and DC2 are closely held by L, and DC2 is connected with DC1 through DC1's ownership of stock of DC2 representing at least 80% of the voting power or value of DC2.

As a result, each of DC1 and DC2 is considered as owning the combined assets, and receiving the combined income, of both DC1 and DC2; however, DC1's equity interest in DC2 is disregarded for this purpose.

Therefore, DC1 and DC2 each satisfies the passive asset threshold, because 100 percent of each company's assets is passive.

DC1 and DC2 are specified domestic entities for Year X. DP DP is closely held by a specified individual. DP is not considered a related entity with DC1 and DC2, because DC1 and DP are not owned

by a common parent corporation or partnership. As a result, whether the 50% passive income or passive asset threshold is met with respect to

DP is determined solely by reference to DP's separately earned passive income and separately held passive assets.

DP holds only passive assets during Year X and therefore DP is a specified domestic entity for Year X.

Reporting requirements DC1 Under Sec. 1.6038D-2(a)(6)(ii), DC1 is not treated as owning the SFFAs held by DC2 and

DP for purposes of applying the reporting threshold, because DC1 does not have an interest in any SFFAs.

DC1 is not required to file Form 8938 because DC1 does not satisfy the reporting threshold. DC2 and DP Under Sec. 1.6038D-3, DC2 and DP each has an interest in SFFAs. For purposes of applying the reporting threshold, DC2 is treated as owning in addition to its

own assets the assets of DP, and DP is treated as owning in addition to its own assets the assets of DC2.

As a result, DC2 and DP each satisfies the reporting threshold of Sec. 1.6038D-2(a)(1), because the value of the SFFAs each is considered as owning is $105,000 on October 12, Year X, which exceeds DC2's and DP's $75,000 reporting threshold.

DC2 and DP must each file Form 8938 for Year X to report their respective SFFAs in which they have an interest and disclose their maximum values as provided in Sec. 1.6038D-4 ($15,000 in the case of DC2 and $90,000 in the case of DP).

Example (3) in Reg. 1.6038D-6(b)(3)(iii) (modified) -- Application of Aggregation Rule and Entity with an Active Trade Or Business. Facts The facts are the same as in Example 2 above, except that DC2 also owns an active business. The assets attributable to the business are not passive assets and constitute at least 60% of the

value of DC2's assets at all times during Year X.


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The income from the business is not passive income and constitutes at least 60% of the gross income generated by DC2 in Year X.

Specified domestic entity status. DC1 and DC2 DC1 and DC2 are considered related entities that are connected through stock ownership

with a common parent corporation because DC1 and DC2 are closely held by L, and DC2 is connected with DC1 though DC1's ownership of stock of DC2 representing at least 80% of the voting power or value of DC2.

As a result each of DC1 and DC2 is treated as owning the combined assets, and receiving the combined income, of both DC1 and DC2; however, DC1's equity interest in DC2 is disregarded.

As a result, no more than 40 percent of the value of DC1's and DC2's assets at all times during Year X are passive and no more than 40 percent of DC1's and DC2's gross income for Year X is passive.

DC1 and DC2 do not satisfy the passive income or passive asset threshold for Year X. DC1 and DC2 are not specified domestic entities for Year X.

DP For the reasons described in Example 2 above, DP is a specified domestic entity for Year X.

Reporting requirements DC1 and DC2 DC1 and DC2 are not specified domestic entities for Year X, and are not required to file

Form 8938. DP Under Sec. 1.6038D-3, DP has an interest in SFFAs.

Under Sec. 1.6038D-2(a)(6)(ii), DP is treated as owning in addition to its own assets the assets of DC2.

As a result, DP satisfies the reporting threshold of Sec. 1.6038D-2(a)(1) because the value of the specified foreign financial assets it is considered to own for purposes of Sec. 1.6038D-2(a)(1) is $105,000 on October 12, Year X, which exceeds DP's $75,000 reporting threshold.

DP must file Form 8938 for Year X to report the specified foreign financial assets in which it has an interest and disclose their maximum values as provided in Sec. 1.6038D-4, which is $90,000.

Domestic Trusts As a general rule a trust described in section 7701(a)(30)(E) is formed or availed of for purposes of holding, directly or indirectly, specified foreign financial assets (thus is an SDE) if and only if the trust has one or more specified persons as a current beneficiary. A “current beneficiary” is:

1) “any person who at any time during such taxable year is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the trust (determined without regard to any power of appointment to the extent that such power remains unexercised at the end of the taxable year).”

2) “any holder of a general power of appointment, whether or not exercised, that was exercisable at any time during the taxable year, but does not include any holder of a general power of appointment that is exercisable only on the death of the holder.” Reg. 1.6038D-6(c).


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The determination of whether a domestic trust is an SDE is made annually for each taxable year of the trust. A trust is described in Section 7701(a)(30)(E) as “any trust if--(i) a court within the United States is able to exercise primary supervision over the administration of the trust, and (ii) one or more United States persons have the authority to control all substantial decisions of the trust.” Exception Where Domestic Trust Not Required to File Form 1041. The preamble to the final regulations explains the issue:

Proposed §1.6038D-6(d) excepts certain entities from being treated as a specified domestic entity. A commenter recommended that the final regulations expand proposed §1.6038D-6(d) to also except certain domestic trusts that are not required to file a Form 1041, "U.S. Fiduciary Income Tax Return," or any information returns. The Treasury Department and the IRS do not adopt this comment because the 2014 final regulations already address the commenter's concerns. The 2014 final regulations provide in §1.6038D-2(a)(7) that a specified person, including a specified domestic entity, is not required to file Form 8938, "Statement of Specified Foreign Financial Assets," with respect to a taxable year if the specified person is not required to file an annual return with the IRS with respect to that taxable year. In the case of a specified domestic entity, the term "annual return" means an annual federal income tax return or information return filed with the IRS, including returns required under section 6012. See §1.6038D-1(a)(11). A Form 1041 is an annual return for purposes of §1.6038D-1(a)(11) of the final regulations. (TD 9752)

Excepted Domestic Entities. Grantor Trusts. A domestic trust or any portion of the trust that is treated as owned by one or more specified persons under sections 671 through 678 (the grantor trust rules) and the regulations issued under those sections is not considered to be a specified domestic entity.

Observation: A “specified person that is treated as the owner of a trust or any portion of a trust under sections 671 through 679 [a grantor trust]” with limited exceptions, “is treated as having an interest in any SFFAs held by the trust or the portion of the trust.” (Reg. 1.6038D-2(b)(4)(ii)). Therefore, the grantor, rather than the grantor trust, is subject to Form 8938 reporting of SFFAs owned by the grantor trust.

Other Exceptions:

A domestic entity is not considered to be an SDE if it is described in section 1473(3) and the regulations as excepted from the definition of the term “specified United States person”. This exception does not apply to any trust that is exempt from tax under section 664(c)--a charitable remainder annuity trust and a charitable remainder unitrust.


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A domestic trust is not considered an SDE if the trustee is a bank, financial institution, or domestic corporation that is subject to certain examination, oversight or registration requirements, has supervisory authority over or fiduciary obligations with regard to the trust’s specified foreign financial assets, and files income tax returns and information returns on behalf of the trust.

REG-163113-02 (8/4/16) Prop. Regs. 25.2701-2,-8, 25.2704-1, -2, -3, -4; IRS Issues Proposed Regulations on Gift and Estate Tax Valuations

IRS proposes significant changes to Reg. 25.2701 and 25. 2704-2 and -3.

Per the preamble to the regulations: “these proposed regulations concern the treatment of certain lapsing rights and restrictions on liquidation in determining the value of the transferred interests. These proposed regulations affect certain transferors of interests in corporations and partnerships and are necessary to prevent the undervaluation of such transferred interests.”

Among other things, the proposed rules disregard certain restrictions on the liquidation or redemption of interests if such restrictions may be removed by the transferor or the transferor's family after the transfer. In addition, restrictions that defer the payment of liquidation proceeds for more than six months or permit payment in any manner other than cash or other property will be disregarded. The regulations, if finalized, eliminate valuation discounts (such as due to lack of control) for gift and estate tax purposes on transfers of interests in family entities.

A public hearing is scheduled for 12/1/16. If finalized, a few provisions would not be effective until 30 days afterwards. With the current administration coming to an end, there may be a rush to get the regulations finalized soon after the hearing.

Why issued: Per the White House, “reduces tax avoidance by making it more difficult for the wealthiest Americans to exploit this loophole and avoid contributing their fair share. The tax avoiding activity that this action addresses is quite significant.”

Proposed Effective Date. The regulations are proposed to apply to rights created after 10/8/1990, where the lapse occurs on or after the date the regulations are finalized. In addition, the rules are proposed to apply to property restrictions created after 10/8/1990, where the transfer occurs 30 days or more after the date the regulations are finalized.

Planning: Taxpayers with significant assets to transfer inter-family should consider accelerating setting up appropriate entities and making transfers before the regulations are finalized as well as evaluating timing of transfers in existing entities.

Legislation Introduced to Stop the Proposed Valuation Discount Regulations:

H.R. 6042, To nullify certain proposed regulations relating to restrictions on liquidation of an interest with respect to estate, gift, and generation-skipping transfer taxes – Introduced by Congressman Sensenbrenner (R-WI). See 9/15 press release. The text is as follows:

“Regulations proposed for purposes of section 2704 of the Internal Revenue Code of 1986 relating to restrictions on liquidation of an interest with respect to estate, gift, and generation-skipping transfer taxes, published on August 4, 2016


https://www.gpo.gov/fdsys/pkg/FR-2016-08-04/pdf/2016-18370.pdf

https://www.whitehouse.gov/blog/2016/08/03/closing-estate-tax-loophole-wealthiest-few-what-you-need-know


http://sensenbrenner.house.gov/news/documentsingle.aspx?DocumentID=398045

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(81 Fed. Reg. 51413), and any substantially similar regulations hereafter promulgated, shall have no force or effect.”

Protect Family Farms and Business Act – introduced by Congressman Davidson (D-OH) – see text (no bill number as of 9/23/16) and explanation (9/21 press release). The text of the bill is as follows:

“The proposed regulations under section 2704 of the Internal Revenue Code of 1986 relating to restrictions on liquidation of an interest with respect to estate, gift, and generation-skipping transfer taxes, published on August 4, 2016, in the Federal Register (81 Fed. Reg. 51413) shall have no force or effect. No Federal funds may be used to finalize, implement, administer, or enforce such proposed regulations or any substantially similar regulations.”

Resources:

REG-163113-02 (8/4/16)

AICPA Resources

White House, Closing an Estate Tax Loophole for the Wealthiest Few: What You Need to Know, 8/3/16

Treasury blog post of 8/2/16

“The Controversial Way Wealthy Americans Are Lowering Their Estate Taxes,” Saunders, Wall Street Journal, 8/19/16.

T.D. 9728; Regs. 1.706-1, -4, -5 (Aug. 3, 2015) -- Final Regulations on Varying

Interest Rules for Partnership TYB On or After Aug. 3, 2015 IRS issued final regulations on the determination of a partner's distributive share of partnership items of income, gain, loss, deduction, and credit when a partner's interest varies during a partnership tax year. The final regulations also modify the existing regulation on the required tax year of a partnership.

Variations Subject to Varying Interest Rules A Variation. Reg. 1.706-4 provides rules for determining the partners' distributive shares of partnership items when a partner's interest in a partnership varies during the taxable year as a result of:

the disposition of a partial or entire interest in a partnership as described in reg. 1.706-1(c)(2) (sale, exchange or liquidation of entire interest or death of partner closing the tax year with respect to the partner) and (3) (sale or exchange of less than entire interest which does not close the tax year with respect to the partner) or

with respect to a partner whose interest in a partnership is reduced as described in reg. 1.706-1(c)(3), including by the entry of a new partner (collectively, a "variation").

Note: The above variations may result in a closure of the tax year with respect to the partner, but they do not result in a closure of the partnership tax year for the entire partnership.


https://davidson.house.gov/sites/davidson.house.gov/files/wysiwyg_uploaded/Protect%20Family%20Farms%20and%20Businesses%20Act.pdf

https://davidson.house.gov/media-center/press-releases/rep-davidson-introduces-legislation-stop-irs-s-unilateral-death-tax


https://www.aicpa.org/interestareas/personalfinancialplanning/resources/taxplanning/pages/section-2704.aspx



https://www.treasury.gov/connect/blog/Pages/Treasury-Issues-Proposed-Regulations-to-Close-Estate-and-Gift-Tax-Loophole.aspx

http://www.wsj.com/articles/the-controversial-way-wealthy-americans-are-lowering-their-estate-taxes-1471614809


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The following items, subject to allocation under other rules, are not subject to the rules of Reg. 1.706-4:

special allocation rules for certain items from the discharge or retirement of debt in sections 108(e)(8) and 108(i)

relating to the determination of partners' distributive shares of allocable cash basis items in section 706(d)(2)

relating to the determination of partners' distributive share of any item of an upper tier partnership attributable to a lower tier partnership in section 706(d)(3)

“In all cases, all partnership items for each taxable year must be allocated among the partners, and no partnership items may be duplicated, regardless of the particular provision of section 706 (or other Code section) which applies, and regardless of the method or convention adopted by the partnership.”

General Rule of Segments and Proration Periods The preamble describes the general rule of segments and proration periods as follows:

For purposes of accounting for the partners' varying interests in the partnership, the 2009 proposed regulations required the partnership to maintain, for each partner whose interest changes in the taxable year, segments to account for such changes. Under the 2009 proposed regulations, a segment was a specific portion of a partnership's taxable year created by a variation, regardless of whether the partnership used the interim closing method or the proration method for that variation. The final regulations continue to rely on the concept of segments; however, because the final regulations now permit partnerships to use both the interim closing method and the proration method in the same taxable year, the final regulations also contain a new concept of proration periods. Under the final regulations, segments are specific periods of the partnership's taxable year created by interim closings of the partnership's books, and proration periods are specific portions of a segment created by a variation for which the partnership chooses to apply the proration method. The partnership must divide its year into segments and proration periods, and spread its income among the segments and proration periods according to the rules for the interim closing method and proration method, respectively. Under the final regulations, the first segment commences with the beginning of the taxable year of the partnership and ends at the time of the first interim closing of the partnership's books. Any additional segment shall commence immediately after the closing of the prior segment and ends at the time of the next interim closing. However, the last segment of the partnership's taxable year ends no later than the close of the last day of the partnership's taxable year. If there are no interim closings, the partnership has one segment, which corresponds to its entire taxable year.


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Under the final regulations, the first proration period in each segment begins at the beginning of the segment, and ends at the time of a variation for which the partnership uses the proration method. The next proration period begins immediately after the close of the prior proration period and ends at the time of the next variation for which the partnerships uses the proration method. However, each proration period ends no later than the close of the segment. Thus, segments close proration periods. Therefore, the only items subject to proration are the partnership's items attributable to the segment containing the proration period.

Step-by-Step Approach (Ten Steps) The final regulations provide the following step-by-step approach to determining the distributive share of partnership items (reg. 1.706-4(a)(3)(i) through (x)):

1) Determine whether either of the exceptions in reg. 1.706-4(b) for contemporaneous partners and partnerships for which capital is not a material income-producing factor applies (detail below).

2) Determine which of its items are subject to allocation under the special rules for extraordinary items in reg. 1.706-4(e) and allocate those items accordingly (detail below).

3) Determine with respect to each variation whether it will apply the interim closing method or the proration method. Absent an agreement of the partners (within the meaning of reg. 1.706-4(f)) to use the proration method, the partnership shall use the interim closing method. The partnership may use different methods (interim closing or proration) for different variations within each partnership tax year; however, the IRS “may place restrictions on the ability of partnerships to use different methods during the same taxable year in guidance published in the Internal Revenue Bulletin.”

4) Determine when each variation is deemed to have occurred under the partnership's selected convention (as described in 1.706-4(c), detail below).

5) Determine whether there is an agreement of the partners (within the meaning of 1.706-4(f)) to perform regular monthly or semi-monthly interim closings (as described in 1.706-4(d)). If so, then the partnership will perform an interim closing of its books at the end of each month (in the case of an agreement to perform monthly closings) or at the end and middle of each month (in the case of an agreement to perform semi-monthly closings), regardless of whether any variation occurs. Absent an agreement of the partners to perform regular monthly or semi-monthly interim closings, the only interim closings during the partnership's taxable year will be at the deemed time of the occurrence of variations for which the partnership uses the interim closing method.

6) Determine the partnership's segments, which are specific periods of the partnership's taxable year created by interim closings of the partnership's books. The first segment


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starts with the beginning of the tax year of the partnership and ends at the time of the first interim closing. Any additional segment begins immediately after the closing of the prior segment and ends at the time of the next interim closing. However, the last segment of the partnership's tax year ends no later than the close of the last day of the partnership's tax year. “If there are no interim closings, the partnership has one segment, which corresponds to its entire tax year.”

7) Apportion the partnership's items for the year among its segments. The partnership determines the items of income, gain, loss, deduction, and credit of the partnership for each segment. In general, a partnership treats each segment as though the segment were a separate distributive share period. “For example, a partnership may compute a capital loss for a segment of a taxable year even though the partnership has a net capital gain for the entire taxable year. For purposes of determining allocations to segments, any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership taxable year will be applied based upon the partnership's satisfaction of the limitation or requirement as of the end of the partnership's taxable year. For example, the expenses related to the election to expense a section 179 asset must first be calculated (and limited if applicable) based on the partnership's full taxable year, and then the effect of any limitation must be apportioned among the segments in accordance with the interim closing method or the proration method using any reasonable method.”

8) “[D]etermine the partnership's proration periods, which are specific portions of a segment created by a variation for which the partnership chooses to apply the proration method. The first proration period in each segment begins at the beginning of the segment, and ends at the time of the first variation within the segment for which the partnership selects the proration method. The next proration period begins immediately after the close of the prior proration period and ends at the time of the next variation for which the partnerships selects the proration method. However, each proration period shall end no later than the close of the segment.”

9) “[P]rorate the items of income, gain, loss, deduction, and credit in each segment among the proration periods within the segment.”

10) [D]etermine the partners' distributive shares of partnership items under section 702(a) by taking into account the partners' interests in such items during each segment and proration period.”

Example of Step-by-Step Approach (Reg. 1.706-4(a)(4) Example (Modified)

At the beginning of 2016, PRS, a calendar year partnership, has three equal partners, A, B, and C.

o On April 16, 2016, A sells 50% of its interest in PRS to new partner D. o On August 6, 2016, B sells 50% of its interest in PRS to new partner E.

During 2016, PRS generated: o $75,000 of ordinary income,


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o $33,000 of ordinary deductions, o $12,000 of capital gain in the ordinary course of its business, o <$9,000> of capital loss in the ordinary course of its business.

Within that year, PRS earned $60,000 of ordinary income, incurred $24,000 of ordinary deductions, earned $12,000 of capital gain, and sustained $6,000 of capital loss between January 1, 2016, and July 31, 2016, and

PRS earned $15,000 of gross ordinary income, incurred $9,000 of gross ordinary deductions, and sustained $3,000 of capital loss between August 1, 2016, and December 31, 2016.

None of PRS's items are extraordinary items. Capital is a material income producing factor for PRS. For 2016, PRS determines the distributive shares of A, B, C, D, and E as follows. First, PRS determines that none of the exceptions in paragraph (b) apply because capital

is a material-income producing factor and no variation is the result of a change in allocations among contemporaneous partners.

Second, PRS determines that none of its items are extraordinary items subject to allocation under paragraph (e).

Third, the partners of PRS agree to apply the proration method to the April 16, 2016, variation, and PRS accepts the default application of the interim closing method to the August 6, 2016, variation.

Fourth, PRS determines the deemed date of the variations for purposes of this section based upon PRS's selected convention.

Because PRS applied the proration method to the April 16, 2016, variation, PRS must use the calendar day convention with respect to the April 16, 2016, variation. Therefore, the variation that resulted from A's sale to D on April 16, 2016, is deemed to occur for purposes of this section at the end of the day on April 16, 2016.

Further, the partners of PRS agree to apply the semi-monthly convention to the August 6, 2016, variation.

Therefore, the August 6, 2016, variation is deemed to occur at the end of the day on July 31, 2016.

Fifth, the partners of PRS do not agree to perform regular semi-monthly or monthly closings. Therefore, PRS will have only one interim closing for 2016, occurring at the end of the day on July 31.

Sixth, PRS determines that it has two segments for 2016. The first segment commences January 1, 2016, and ends at the close of the day on July

31, 2016. The second segment commences at the beginning of the day on August 1, 2016, and ends

at the close of the day on December 31, 2016. Seventh, PRS determines that during the first segment of its taxable year (beginning

January 1, 2016, and ending July 31, 2016), it had $60,000 of ordinary income, $24,000 of ordinary deductions, $12,000 of capital gain, and $6,000 of capital loss.

PRS determines that during the second segment of its taxable year (beginning August 1, 2016, and ending December 31, 2016), it had $15,000 of gross ordinary income, $9,000 of gross ordinary deductions, and $3,000 of capital loss.

Eighth, PRS determines that it has two proration periods.


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The first proration period begins January 1, 2016, and ends at the close of the day on April 16, 2016; the second proration period begins April 17, 2016, and ends at the close of the day on July 31, 2016.

Ninth, PRS prorates its income from the first segment of its taxable year among the two proration periods. Because each proration period has 106 days, PRS allocates 50% of its items from the first segment to each proration period. Thus, each proration period contains $30,000 gross ordinary income, $12,000 gross ordinary deductions, $6,000 capital gain, and $3,000 capital loss.

Tenth, PRS calculates each partner's distributive share. Because A, B, and C were equal partners during the first proration period, each is

allocated one-third of the partnership's items attributable to that proration period. Thus, A, B, and C are each allocated $10,000 gross ordinary income, $4,000 gross ordinary deductions, $2,000 capital gain, and $1,000 capital loss for the first proration period.

For the second proration period, A and D each had a one-sixth interest in PRS and B and C each had a one-third interest in PRS. Thus, A and D are each allocated $5,000 gross ordinary income, $2,000 gross ordinary deductions, $1,000 capital gain, and $500 capital loss, and B and C are each allocated $10,000 gross ordinary income, $4,000 gross ordinary deductions, $2,000 capital gain, and $1,000 capital loss for the second proration period.

For the second segment of PRS's taxable year, A, B, D, and E each had a one-sixth interest in PRS and C had a one-third interest in PRS.

Thus, A, B, D, and E are each allocated $2,500 gross ordinary income, $1,500 gross ordinary deductions, and $500 capital loss, and C is allocated $5,000 gross ordinary income, $3,000 gross ordinary deductions, and $1,000 capital loss for the second segment.

Exceptions (Reg. 1.706-4((b))

Permissible changes among contemporaneous partners. The general rule with respect to the varying interests of a partner does not preclude changes in the allocations of the distributive share of items described in section 702(a) among contemporaneous partners for the entire partnership taxable year (or among contemporaneous partners for a segment if the item is entirely attributable to a segment), provided that- Any variation in a partner's interest is not attributable to a contribution of money or

property by a partner to the partnership or a distribution of money or property by the partnership to a partner; and

The allocations resulting from the modification satisfy the provisions of section 704(b) and the regulations promulgated thereunder.

The logic of the contemporaneous partner exception, also included in the 2009 proposed regulations, is described in detail in the preamble to the final regulations:

The 2009 proposed regulations contained a "contemporaneous partner exception" based on the Tax Court's opinion in Lipke v. Commissioner, 81 T.C. 689 (1983),


http://www.leagle.com/decision/198377081aotc689_1730/LIPKE%20v.%20COMMISSIONER

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and the legislative history of section 706. Section 761(c) provides that a partnership agreement includes any modifications of the partnership agreement made prior to, or at, the time prescribed by law for the filing of the partnership return for the taxable year (not including extensions). In Lipke, the Tax Court held that section 706(c)(2)(B) (as in effect prior to 1984) prohibited retroactive allocations of partnership losses when the allocations resulted from additional capital contributions made by both new and existing partners. However, the Tax Court held that the prohibition on retroactive allocations under section 706(c)(2)(B) did not apply to changes in the allocations among partners that were members of the partnership for the entire year (contemporaneous partners) if the changes in the allocations did not result from capital contributions. Congress amended section 706 in 1984, in part to clarify that the varying interests rule applies to any change in a partner's interest, whether in connection with a complete disposition of the partner's interest or otherwise. To that end, Congress replaced the varying interests rule in section 706(c)(2)(B) with the rule that now appears in section 706(d)(1). The legislative history pertaining to this amendment reflects Congress's intention that the new rule of section 706(d)(1) be comparable to the pre-1984 law without overruling the longstanding rule of section 761(c):

‘The committee wishes to make clear that the varying interests rule is not intended to override the longstanding rule of section 761(c) with respect to interest shifts among partners who are members of the partnership for the entire taxable year, provided such shifts are not, in substance, attributable to the influx of new capital from such partners.’ (Citations omitted)

Safe harbor for partnerships for which capital is not a material income producing factor. “With respect to any taxable year in which there is a change in any partner's interest in a partnership for which capital is not a material income-producing factor, the partnership and such partner may choose to determine the partner's distributive share of partnership income, gain, loss, deduction, and credit using any reasonable method to account for the varying interests of the partners in the partnership during the taxable year provided that the allocations satisfy the provisions of section 704(b).” The logic of the service partner exception is explained in the preamble to the final regulations:

The Treasury Department and the IRS intend the safe harbor for service partnerships to be limited to partnerships that derive their income from the provision of services and not from capital because, in general, allocations among individual partners in partnerships for which capital is not a material income-producing factor do not raise concerns that may be present in allocations among partners in capital-intensive partnerships.


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Conventions (Reg. 1.706-4((c)) In general. “Conventions are rules of administrative convenience that determine when each variation is deemed to occur for purposes of this section. Because the timing of each variation is necessary to determine the partnership's segments and proration periods, which are used to determine the partners' distributive shares, the convention used by the partnership with respect to a variation will generally affect the allocation of partnership items.” Permissible Conventions for Each Variation--Rules Applicable To All Partnerships.

“A partnership generally shall use the calendar day convention for each variation; however, for all variations during a taxable year for which the partnership uses the interim closing method, the partnership may instead use the semi-monthly or monthly convention by agreement of the partners. The partnership must use the same convention for all variations for which the partnership uses the interim closing method.” (Citations omitted)

Publicly traded partnerships. A publicly traded partnership (as defined in section 7704(b)) that is treated as a partnership may, by agreement of the partners use any of the calendar day, the semi-monthly, or the monthly conventions with respect to all variations during the taxable year relating to its publicly-traded units, regardless of whether the publicly traded partnership uses the proration method with respect to those variations. A publicly traded partnership must use the same convention for all variations during the taxable year relating to its publicly traded units. A publicly traded partnership must use the calendar day convention with respect to all variations relating to its non-publicly traded units for which the publicly traded partnership uses the proration method.

Partnerships may generally choose from the following three conventions:

Calendar day convention. Under the calendar day convention, each variation is deemed to occur at the end of the day on which the variation occurs.

Semi-monthly convention. Under the semi-monthly convention, each variation is deemed to occur either:

a) In the case of a variation occurring on the 1st through the 15th day of a calendar month,

at the end of the last day of the immediately preceding calendar month; or

b) In the case of a variation occurring on the 16th through the last day of a calendar month, at the end of the 15th calendar day of that month.

Monthly convention. Under the monthly convention, each variation is deemed to occur either:


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a) In the case of a variation occurring on the 1st through the 15th day of a calendar month, at the end of the last day of the immediately preceding calendar month; or

b) In the case of a variation occurring on the 16th through the last day of a calendar month, at the end of the last day of that calendar month.

Exceptions.

“All variations within a taxable year shall be deemed to occur no earlier than the first day of the partnership's taxable year, and no later than the close of the final day of the partnership's taxable year. Thus, in the case of a calendar year partnership applying either the semi-monthly or monthly convention to a variation occurring on January 1st through January 15th, the variation will be deemed to occur for purposes of this section at the beginning of the day on January 1st.”

In the case of a partner who becomes a partner during the partnership's taxable year as a result of a variation, and ceases to be a partner as a result of another variation, if both such variations would be deemed to occur at the same time, then the variations with respect to that partner's interest will instead be treated as occurring on the dates each variation actually occurred. “Thus, the partnership must treat such a partner as a partner for the entire portion of its taxable year during which the partner actually owned an interest.” However, this paragraph does not apply to publicly traded partnerships that are treated as partnerships with respect to holders of publicly traded units.

A publicly traded partnership (as defined in section 7704(b)) that is treated as a partnership may consistently treat all variations occurring during each month as occurring at the end of the last day of that calendar month if the publicly traded partnership uses the monthly convention for those variations.

Examples in Reg. 1.706-4((c)(4)): Example 1.

PRS is a calendar year partnership with four equal partners A, B, C, and D. PRS is not a publicly traded partnership. PRS has the following three variations that occur during its 2016 taxable year:

o on March 11, A sells its entire interest in PRS to new partner E; o on June 12, PRS partially redeems B's interest in PRS with a distribution comprising

a partial return of B's capital; o on October 21, C sells part of C's interest in PRS to new partner E.

These transfers do not result in a termination of PRS under section 708. The partners of PRS agree to use the interim closing method with respect to the variations

occurring on March 11 and October 21 and agree to use the proration method with respect to the variation occurring on June 12.

The partners of PRS may agree to use any of the calendar day, semi-monthly, or monthly conventions with respect to the March 11 and October 21 variations, but must use the same convention for both variations.


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If the partners of PRS agree to use the calendar day convention, the March 11 and October 21 variations will be deemed to occur for purposes of this section at the end of the day on March 11, 2016, and October 21, 2016, respectively.

If the partners of PRS agree to use the semi-monthly convention, the March 11 and October 21 variations will be deemed to occur for purposes of this section at the end of the day on February 28, 2016, and October 15, 2016, respectively.

If the partners of PRS agree to use the monthly convention, the March 11 and October 21 variations will be deemed to occur for purposes of this section at the end of the day on February 28, 2016, and October 31, 2016, respectively.

PRS must use the calendar day convention with respect to the June 12 variation (proration method used); thus, the June 12 variation is deemed to occur for purposes of this section at the end of the day on June 12, 2016.

Example 2.

PRS is a calendar year partnership that uses the interim closing method and monthly convention to account for variations during its taxable year.

PRS is not a publicly traded partnership. On January 20, 2016, new partner A purchases an interest in PRS from one of PRS's

existing partners. On February 14, 2016, A sells its entire interest in PRS. These transfers do not result in a termination of PRS under section 708. The January 20, 2016, variation and the February 14, 2016, variation would both be

deemed to occur at the same time: the end of the day on January 31, 2016. Therefore, under the exception in reg. 1.706-4(c)(2)(ii), the rules of paragraph (c)(1) do

not apply, and instead the January 20, 2016, variation and the February 14 variation are considered to occur on January 20, 2016, and February 14, 2016, respectively.

PRS must perform a closing of the books on both January 20, 2016, and February 14, 2016, and allocate A a share of PRS's items attributable to that segment.

Optional Regular Monthly Or Semi-Monthly Interim Closings (Reg. 1.706-4(d)) A partnership may, by agreement of the partners perform regular monthly or semi-monthly interim closings of its books, regardless of whether any variation occurs. Example. PRS is a calendar year partnership with five equal partners A, B, C, D, and E. PRS has the following two variations that occur during its 2016 taxable year:

o on August 29, A sells its entire interest in PRS to new partner F; o on December 27, PRS completely liquidates B's interest in PRS with a distribution.

These variations do not result in a termination of PRS under section 708. The partners of PRS agree to use the interim closing method and the semi-monthly

convention with respect to the variation occurring on August 29. Thus, the August variation is deemed to occur for purposes of this section at the end of the

day on August 15, 2016.


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The partners of PRS agree to use the proration method with respect to the December 27 variation.

Therefore, PRS must use the calendar day convention with respect to the December variation.

Thus, the December variation is deemed to occur for purposes of this section at the end of the day on December 27, 2016.

The partners of PRS agree to perform regular monthly interim closings. Therefore, PRS will have twelve interim closings for its 2016 taxable year, one at the end of

every month and one at the end of the day on August 15. Therefore, PRS will have thirteen segments for 2016, one corresponding to each month from

January through July, one segment from August 1 through August 15, one segment from August 16 through August 31, and one corresponding to each month from September through December.

PRS must apportion its items among these segments. PRS will have two proration periods for 2016, one from December 1 through December 27,

and one from December 28 through December 31. PRS will prorate the items in its December segment among these two proration periods. Therefore, PRS will apportion 27/31 of all items in its December segment to the proration

period from December 1 through December 27, and 4/31 of all items in its December segment to the proration period from December 28 through December 31.

Pursuant to the Tenth Step (in 1.706-4(a)(3)(x)), PRS determines the partners' distributive shares of partnership items under section 702(a) by taking into account the partners' interests in such items during each of the thirteen segments and two proration periods.

Thus, A, B, C, D, and E will each be allocated one-fifth of all items in the following segments: January, February, March, April, May, June, July, and August 1 through August 15.

B, C, D, E, and F will each be allocated one-fifth of all items in the following segments: August 16 through August 31, September, October, and November. B, C, D, E, and F will each be allocated one-fifth of all items in the proration period from December 1 through December 27.

C, D, E, and F will each be allocated one-quarter of all items in the proration period from December 28 through December 31.

Extraordinary Items (Reg. 1.706-4(e) “Extraordinary items may not be prorated. The partnership must allocate extraordinary items among the partners in proportion to their interests in the partnership item at the time of day on which the extraordinary item occurred, regardless of the method (interim closing or proration method) and convention (daily, semi-monthly, or monthly) otherwise used by the partnership.” “These rules require the allocation of extraordinary items as an exception to the proration method, which would otherwise ratably allocate the extraordinary items across the segment, and the conventions, which could otherwise inappropriately shift extraordinary items between a transferor and transferee.”


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“However, publicly traded partnerships (as defined in section 7704(b)) that are treated as partnerships may, but are not required to, apply their selected convention in determining who held publicly traded units (as described in §1.7704-1(b) or (c)(1)) at the time of the occurrence of an extraordinary item.” “Extraordinary items continue to be subject to any special limitation or requirement relating to the timing or amount of income, gain, loss, deduction, or credit applicable to the entire partnership taxable year (for example, the limitation for section 179 expenses).” An extraordinary item is:

(i) “Any item from the disposition or abandonment (other than in the ordinary course of business) of a capital asset as defined in section 1221 (determined without the application of any other rules of law);

(ii) Any item from the disposition or abandonment (other than in the ordinary course of business) of property used in a trade or business as defined in section 1231(b) (determined without the application of any holding period requirement);

(iii)Any item from the disposition or abandonment of an asset described in section 1221(a)(1), (a)(3), (a)(4), or (a)(5) if substantially all the assets in the same category from the same trade or business are disposed of or abandoned in one transaction (or series of related transactions);

(iv) Any item from assets disposed of in an applicable asset acquisition under section 1060(c);

(v) Any item resulting from any change in accounting method initiated by the filing of the

appropriate form after a variation occurs;

(vi) Any item from the discharge or retirement of indebtedness (except items subject to section 108(e)(8) or 108(i), which are subject to special allocation rules provided in section 108(e)(8) and 108(i));

(vii) Any item from the settlement of a tort or similar third-party liability or payment of a

judgment;

(viii) Any credit, to the extent it arises from activities or items that are not ratably allocated (for example, the rehabilitation credit under section 47, which is based on placement in service);

(ix) For all partnerships, any additional item if, the partners agree (within the meaning of

paragraph (f) of this section) to consistently treat such item as an extraordinary item for that taxable year; however, this rule does not apply if treating that additional item as an extraordinary item would result in a substantial distortion of income in any partner's return; any additional extraordinary items continue to be subject to any special limitation or requirement relating to the timing or amount of income, gain, loss,


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deduction, or credit applicable to the entire partnership taxable year (for example, the limitation for section 179 expenses);

(x) Any item which, in the opinion of the Commissioner, would, if ratably allocated, result

in a substantial distortion of income in any return in which the item is included;

(xi) Any item identified as an additional class of extraordinary item in guidance published in the Internal Revenue Bulletin.”

Small Item Exception. A partnership may treat an item as other than an extraordinary item if:

1) For the partnership's tax year the total of all items in the particular class of extraordinary items, for example, all tort or similar liabilities, but in no event counting an extraordinary item more than once is less than five percent of

a. the partnership's gross income, including tax-exempt income described in section 705(a)(1)(B), in the case of income or gain items, or

b. gross expenses and losses, including section 705(a)(2)(B) expenditures, in the case of losses and expense items; and

2) The “total amount of the extraordinary items from all classes of extraordinary items amounting to less than five percent of the partnership's gross income, including tax-exempt income described in section 705(a)(1)(B), in the case of income or gain items, or gross expenses and losses, including section 705(a)(2)(B) expenditures, in the case of losses and expense items, does not exceed $10 million in the taxable year, determined by treating all such extraordinary items as positive amounts.”

Examples Example 1. PRS, a calendar year partnership, uses the proration method and calendar day convention to

account for varying interests of the partners. At 3:15 p.m. on December 7, 2016, PRS recognizes an extraordinary item. On December 12, 2016, A, a partner in PRS, disposes of its entire interest in PRS. PRS does not experience a termination under section 708 during 2016. PRS has no other extraordinary items for the taxable year, the small item exception does not

apply, the exceptions in reg. 1.706-4((b) do not apply, and PRS is not a publicly traded partnership.

The item of income, gain, loss, deduction, or credit attributable to the extraordinary item will be allocated in accordance with the partners' interests in the extraordinary item at 3:15 p.m. on December 7, 2016.

The remaining partnership items of PRS that are subject to this section must be prorated across the partnership's taxable year in accordance with reg. 1.706-4(a)(3).

Example 2.


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Assume the same facts as in Example 1, except that PRS uses the interim closing method and monthly convention to account for varying interests of the partners.

The December 12 variation is deemed to have occurred at the end of the day on November 30, 2016.

Thus, A will not generally be allocated any items of PRS attributable to the segment between December 1, 2016, and December 31, 2016; however, PRS must allocate the item of income, gain, loss, deduction, or credit attributable to the extraordinary item in accordance with the partners' interests in the extraordinary item at the time of day on which the extraordinary item occurred, regardless of the convention used by PRS.

Thus, because A was a partner in PRS at 3:15 p.m. on December 7, 2016 (ignoring application of PRS's convention), A must be allocated a share of the extraordinary item.

Example 3. Assume the same facts as in Example 2, except that PRS is a publicly traded partnership and

A held a publicly traded unit in PRS. Under PRS's monthly convention, the December 12 variation is deemed to have occurred for

purposes of this section at the end of the day on November 30, 2016. A publicly traded partnership may choose to respect its conventions in determining who held

its publicly traded units at the time of the occurrence of an extraordinary item. Therefore, PRS may choose to treat A as not having been a partner in PRS at the time the

extraordinary item arose, and thus PRS may choose not to allocate A any share of the extraordinary item.

Example 4. A and B each own a 15 percent interest in PRS, a partnership that is not a publicly traded

partnership and for which capital is a material income-producing factor. At 9:00 a.m. on April 25, 2016, A sells its entire interest in PRS to new partner D. At 3:00 p.m. on April 25, 2016, PRS incurs an extraordinary item. At 5:00 p.m. on April 25, 2016, B sells its entire interest in PRS to new partner E. PRS must allocate the extraordinary item in accordance with the partners' interests at 3:00

p.m. on April 25, 2016. Accordingly, a portion of the extraordinary item will be allocated to each of B and D, but no

portion will be allocated to A or E. Example 5. PRS, a calendar year partnership that is not a publicly traded partnership, has a variation in a

partner's interest during 2016 and the exceptions in reg. 1.706-4((b) do not apply. During 2016 PRS has two extraordinary items: PRS recognizes $8 million of gross income

on the sale outside the ordinary course of business of an asset, and PRS also recognizes $12 million of gross income from a tort settlement.

PRS's gross income (including the gross income from the extraordinary items) for the taxable year is $200 million.

The gain from the extraordinary asset sale is less than five percent of PRS's gross income ($8 million gross income from the asset sale divided by $200 million total gross income, or four percent) and all of the extraordinary items of PRS from classes that are less than five percent


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of PRS's gross income ($8 million), in the aggregate, do not exceed $10 million for the taxable year.

Thus, the $8 million gain recognized on the asset sale is considered a small item and is therefore excepted from the extraordinary item rules.

Because the gross income attributable to the tort settlement exceeds five percent of PRS's gross income (six percent), the tort settlement gross income is not considered a small item.

Therefore, the $12 million gross income attributable to the tort settlement must be allocated in accordance with PRS's partners' interests in the item at the time of the day that the tort settlement income arose.

Example 6. Assume the same facts as Example 5, except that during the year, PRS also recognizes two

additional extraordinary items: $2 million of gross income from the sale of a capital asset (outside of the ordinary course of the trade or business), and $1 million of gross income from discharge of debt.

The gain items are each less than five percent of PRS's gross income; however the extraordinary items of PRS from classes that are less than five percent of PRS's gross income totals $11 million, in the aggregate, which exceeds $10 million for the taxable year.

Thus, none of the items are considered a small item. Therefore, the items attributable to the sale of the capital asset, the sale of the trade or

business asset, the discharge of indebtedness income, and the tort settlement must each be allocated in accordance with PRS's partners' interests in the item at the time of the day that the items arose.

Agreement of the Partners (Full text of Reg. 1.706-4(f)) “For purposes of paragraphs (a)(3)(iii) (relating to selection of the proration method), (c)(3) (relating to selection of the semi-monthly or monthly convention), (d) (relating to performance of regular monthly or semi-monthly interim closings), and (e)(2)(ix) (relating to selection of additional extraordinary items) of this section, the term agreement of the partners means either an agreement of all the partners to select the method, convention, or extraordinary item in a dated, written statement maintained with the partnership's books and records, including, for example, a selection that is included in the partnership agreement, or a selection of the method, convention, or extraordinary item made by a person authorized to make that selection, including under a grant of general authority provided for by either state law or in the partnership agreement, if that person's selection is in a dated, written statement maintained with the partnership's books and records. In either case, the dated written agreement must be maintained with the partnership's books and records by the due date, including extension, of the partnership's tax return.”

Effective Date (Reg. 1.706-4(g)) The final regulations under reg. 1.706-4 generally apply for partnership tax years that begin on or after Aug. 3, 2015; however, the rules of reg. 1.706-4(c)(3) (dealing with permissible conventions for each variation) do not apply to existing PTPs (i.e., ones formed prior to Apr. 19, 2009). For purposes of the effective date provision, the termination of a PTP under section


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708(b)(1)(B) due to the sale or exchange of 50% or more of the total interests in partnership capital and profits is disregarded in determining whether the PTP is an existing PTP.

Inflation Adjustments

2017 Inflation Adjustments – Rev. Proc. 2016-55 Rev. Proc. 2016-55 (10/24/16) provides the 2017 inflation adjustment amounts including individual rate brackets, AMT exemption and rate brackets, personal exemptions, standard deduction, various phase-outs and more. Key items:

Foreign earned income exclusion is $102,100, up from $101,300 for tax year 2016. Estate tax exclusion is $5,490,000 (it was $5,450,000 in 2016). The annual exclusion for gifts is $14,000.

Inflation adjustments also include numerous dollar penalty provisions.

2017 Social Security Wage Base is $127,200 In October 2017, the Social Security Administration announced a 0.3% increase in benefits for 2017. Also, starting January 2017, the wage base for Social Security taxes increases to $127,200 from $118,500. SSA estimates that of the roughly 173 million workers who pay these taxes, only about 12 million are affected by this increase in the wage limit. Tax rates remain the same (7.65% for employees and 15.3% for self-employed). [10/18/16 SSA press release]


https://www.irs.gov/pub/irs-drop/rp-16-55.pdf


https://www.ssa.gov/news/press/releases/#/post/10-2016-1

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Chapter 2: Expiring Provisions Page 2-1

Chapter 2 : Expiring Provisions

Table of Contents Chapter 2 : Expiring Tax Provisions ...................................................................................... 2-1

The State of Expiring Provisions and the 2015 PATH Act ................................................ 2-1

Credits Expiring 12/31/16...................................................................................................... 2-1

Depreciation Provisions Expiring 12/31/16 ......................................................................... 2-2

Other Provisions Expiring 12/31/16 ..................................................................................... 2-2

Provisions Expiring 12/31/19 ................................................................................................ 2-3

The State of Expiring Provisions and the 2015 PATH Act Every January, the Joint Committee on Taxation issues a report of expiring tax provisions. This list is extremely helpful for tax planning as it allows the user to see what expires during the current year and next several years. The report released in January 2016, List of Expiring Federal Tax Provisions 2016-2025 (JCX-1-16; 1/8/16), looks much different and is a bit shorter than in past years. This is because, the PATH Act (Protecting Americans from Tax Hikes) (P.L. 114-113; 12/18/15), made several items permanent. Also, several items were extended for more than one year retroactively, to either the end of 2016 or through 2019. The JCT report released in January 2016 lists 36 provisions as expiring at the end of 2016.

Credits Expiring 12/31/16 Per JCT, List of Expiring Federal Tax Provisions 2016-2015 (JCX-1-16; 1/8/16), the following credits expire at the end of 2016:

1) Certain nonbusiness energy property (sec. 25C(g)) 2) Residential energy property (sec. 25D(g)) [12/31/21 for qualifying solar energy property] 3) Qualified fuel cell motor vehicles (sec. 30B(k)(1)) 4) Alternative fuel vehicle refueling property (sec. 30C(g)) 5) Two-wheeled plug-in electric vehicles (sec. 30D(g)(3)(E)(ii) 6) Second generation biofuel producer credit (sec. 40(b)(6)(J)) 7) Biodiesel and renewable diesel (secs. 40A, 6426(c)(6) and 6427(e)(6)(B))






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8) Beginning-of-construction date for nonwind renewable power facilities eligible to claim the electricity production credit or investment credit in lieu of the production credit (secs. 45(d) and 48(a)(5)) [12/31/19 for wind]

9) Production of Indian coal (sec. 45(e)(10)(A)) 10) Indian employment tax credit (sec. 45A(f)) 11) Railroad track maintenance credit (sec. 45G(f)) 12) Construction of new energy efficient homes (sec. 45L(g)) 13) Mine rescue team training credit (sec. 45N 14) Hybrid solar lighting system property (sec. 48(a)(3)(A)(ii)) 15) Geothermal heat pump property, small wind property, and combined heat and power

property (secs. 48(a)(3)(A)(vii), 48(c)(4), and 48(c)(3)(A)(iv)) 16) Qualified fuel cell and stationary microturbine power plant property (secs. 48(c)(1)(D)

and (c)(2)(D)) 17) Qualified zone academy bonds: allocation of bond limitation (sec. 54E(c)(1))

Depreciation Provisions Expiring 12/31/16

Per JCT, List of Expiring Federal Tax Provisions 2016-2015 (JCX-1-16; 1/8/16), the following credits expire at the end of 2016:

Three-year depreciation for race horses two years old or younger (sec. 168(e)(3)(A))

Five-year cost recovery for certain energy property (secs. 168(e)(3)(B)(vi)(I) and 48(a)(3)(A))

Seven-year recovery period for motorsports entertainment complexes (secs. 168(i)(15) and 168(e)(3)(C)(ii))

Accelerated depreciation for business property on an Indian reservation (sec. 168(j)(8))

Special depreciation allowance for second generation biofuel plant property (sec. 168(l))

Other Provisions Expiring 12/31/16 Per JCT, List of Expiring Federal Tax Provisions 2016-2015 (JCX-1-16; 1/8/16), the following credits expire at the end of 2016:

Discharge of indebtedness on principal residence excluded from gross income of individuals (sec. 108(a)(1)(E))

Premiums for mortgage insurance deductible as interest that is qualified residence interest (sec. 163(h)(3))

Energy efficient commercial buildings deduction (sec. 179D(h)) Election to expense advanced mine safety equipment (sec. 179E(g))




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Special expensing rules for certain film, television, and live theatrical productions (sec. 181)

Deduction allowable with respect to income attributable to domestic production activities in Puerto Rico (sec. 199(d)(8))

Medical expense deduction: adjusted gross income (AGI) floor for individuals age 65 and older (and their spouses) remains at 7.5 percent (sec. 213(f))

Deduction for qualified tuition and related expenses (sec. 222(e)) Special rule for sales or dispositions to implement Federal Energy Regulatory

Commission (“FERC”) or State electric restructuring policy (sec. 451(i)) Special rate for qualified timber gains (sec. 1201(b)) Empowerment zone tax incentives (secs. 1391, 1394, 1396, 1397A, 1397B) Incentives for alternative fuel and alternative fuel mixtures (secs. 6426, 6427) Temporary increase in limit on cover over of rum excise tax revenues (from $10.50 to

$13.25 per proof gallon) to Puerto Rico and the Virgin Islands (sec. 7652(f)) American Samoa economic development credit (sec. 119 of Pub. L. No. 109-432 as

amended by sec. 756 of Pub. L. No. 111-312)

Provisions Expiring 12/31/19 Per JCT, List of Expiring Federal Tax Provisions 2016-2015 (JCX-1-16; 1/8/16), the following credits expire at the end of 2019:

1) Specified health insurance policy fee (sec. 4375(e)) [expires 9/30/19] 2) Self-insured health plan fee (sec. 4376(e)) [expires 9/30/19] 3) Credit for health insurance costs of eligible individuals (sec. 35(b)) 4) New markets tax credit (sec. 45D(f)) 5) Work opportunity tax credit (sec. 51(c)(4)) 6) Additional first-year depreciation with respect to qualified property (secs. 168(k)(1) and

(2) and 460(c)(6)(B)) 7) Election to accelerate AMT credits in lieu of additional first-year depreciation (sec.

168(k)(4)) 8) Election of additional depreciation for certain plants bearing fruits and nuts (sec.

168(k)(5)) 9) Beginning-of-construction date for wind renewable power facilities eligible to claim the

electricity production credit or investment credit in lieu of the production credit (secs. 45(d) and 48(a)(5))

10) Look-through treatment of payments between related controlled foreign corporations under the foreign personal holding company rules (sec. 954(c)(6))



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Chapter 3: C Corporations Page 3-1

Chapter 3 : C Corporations

Table of Contents Chapter 3 : C Corporations ..................................................................................................... 3-1

Form 1120 Changes for 2016 ................................................................................................ 3-2

C Corporation Due Dates + Charitable Contributions + Recurring Item Exception ..... 3-2

Compensation Cases.................................................................................................... 3-4

H. W. Johnson, Inc., TC Memo 2016-95 (May 11, 2016) -- Compensation Paid to Sons Of Company's Founder Were Deductible ................................................................................. 3-4

Brinks Gilson & Lione PC, TC Memo 2016-20 (Feb. 10, 2016) -- Penalty for Compensation that Zeroed Out Law Firm Book Income .................................................. 3-6

Qualified Small Business Stock ............................................................................. 3-9

PLR 201636003 (9/2/2016)—LLC electing to be Treated as a C Corp Can Be Qualified Small Business Stock.............................................................................................................. 3-9

Corporate Spinoff News............................................................................................ 3-10

Rev Proc 2016-40 (7/15/2016) -- New Safe Harbors Clarify When Pre-Spinoff Acquisition of “Control” Has Substance ................................................................................................ 3-10

REG-134016; Prop Reg 1.355-2, -9 (7/14/2016) -- Proposed Regs Clarify Device And Business Requirement Under Code Sec. 355 ..................................................................... 3-10

Rev Proc 2016-45 (8/26/2016) – IRS Will Again Rule on the Device and Business Purpose Tests Involving Spinoffs ...................................................................................................... 3-11

Mergers and Acquisitions ........................................................................................ 3-11

Legal Advice Issued by Field Attorneys (LAFA) 20163701F (9/9/2016) -- “Break Fee” Paid With Respect To Cancelled Merger Generates A Capital Loss .............................. 3-11

Merger Termination Fee Treatment to Recipient Corporation - CCA 201642035 (10/14/16) ............................................................................................................................... 3-13

Consolidated Returns ................................................................................................ 3-14

Marvel Entertainment LLC v. Comm., (CA 2 9/7/2016) -- Consolidated Group Must Use “Single Entity” Approach For NOL Reduction ................................................................ 3-14

BEPS and Tax Reform Type Actions .................................................................. 3-16

Anti-Inversion, Earnings Stripping and Debt-Equity Regs Under Section 385 ............ 3-16

JCT Overview of The Tax Treatment Of Corporate Debt And Equity (May 20, 2016)3-19

Other Updates ................................................................................................................ 3-20


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Prop Reg 1.305-1, -3, -7; 1.860G-3; 1.861-3; 1.1441-2 , -3, -7; 1.1461-2; 1.1471-2; 1.1473-1; 1.6045B-1 (04/12/2016) -- Proposed Reliance Regs On Adjustments To Stock Rights . 3-20

GAO Study on Effective Corporation Tax Rates.............................................................. 3-20

Form 1120 Changes for 2016 Per the 9/15/16 draft of the Form 1120 instructions, the IRS notes the following “what’s new” items:

a. Due date changes (see above)

b. Increase in failure to file penalty – “the minimum penalty for failure to file a return that is over 60 days late has increased to the smaller of the tax due or $205.”

c. Form 8938 reporting for some entities – “Beginning in 2016, certain domestic corporations that hold specified foreign financial assets (“specified domestic entities”) must file Form 8938, Statement of Specified Foreign Financial Assets.”

d. Tax on timber gains – “For tax years beginning in 2016, if a corporation has both net capital gain and qualified timber gain (as defined in section 1201(b)(2)), an alternative tax may apply. See the instructions for Schedule J, line 2.”

e. New withholding question – “New Schedule K, question 19, was added for corporations making payments that require the corporation to file Forms 1042 and 1042-S under chapter 3 or 4 of the Internal Revenue Code.”

Draft Form 1120 (7/13/16) – here.

C Corporation Due Dates + Charitable Contributions + Recurring Item Exception

P.L. 114-41 (7/31/15) changed the due dates for several types of tax returns. The due date for Form 1120 was pushed out one month for most C corporations. The due date changes won’t all be finalized until after 2025. For C corporations with a calendar year end or June 30 have different due date or extended due date until after 2025 because of congressional concern of changing dates that are near the country’s fiscal year end of September 30.

Tax Year Current Law original extended

New Law tyba 12/31/15

original extended

New Law tyba 12/31/25

original extended


https://www.irs.gov/pub/irs-dft/i1120--dft.pdf


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Calendar 3/15

9/15

4/15

9/15

4/15

10/15

June 30 y/e 9/15

3/15

9/15

4/15

10/15

4/15

All Others 15th of 3rd month after y/e

15 of 9th month after y/e

15th of 4th month after y/e

15 of 10th month after y/e

Related Change: The due date change also changed the special charitable contribution rule available for C corporations (§170(a)(2)) (emphasis added):

“(2) CORPORATIONS ON ACCRUAL BASIS In the case of a corporation reporting its taxable income on the accrual basis, if—

(A) the board of directors authorizes a charitable contribution during any taxable year, and

(B) payment of such contribution is made after the close of such taxable year and on or before the 15th day of the fourth month following the close of such taxable year,

then the taxpayer may elect to treat such contribution as paid during such taxable year. The election may be made only at the time of the filing of the return for such taxable year, and shall be signified in such manner as the Secretary shall by regulations prescribe.”

Prior to the change, the contribution had to be made by the 15th day of the third month after the prior year end.

No change to RIE: A well-known rule is the recurring item exception to the economic performance requirement for timing of liabilities/expenses for accrual taxpayers. This is also referred to as the 8 ½ month rule. A calendar year, accrual method taxpayer who meets the all events test by year end but not the economic performance requirement can see if the RIE is met (if adopted). The requirements are (461(h)):

“(3) EXCEPTION FOR CERTAIN RECURRING ITEMS

(A) In general Notwithstanding paragraph (1) an item shall be treated as incurred during any taxable year if—

(i) the all events test with respect to such item is met during such taxable year (determined without regard to paragraph (1)),

(ii) economic performance with respect to such item occurs within the shorter of—


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(I) a reasonable period after the close of such taxable year [per Reg. §1.451-5(b), this means the date the return is filed including extensions], or

(II) 8½ months after the close of such taxable year,

(iii) such item is recurring in nature and the taxpayer consistently treats items of such kind as incurred in the taxable year in which the requirements of clause (i) are met, and

(iv) either—

(I) such item is not a material item, or

(II) the accrual of such item in the taxable year in which the requirements of clause (i) are met results in a more proper match against income than accruing such item in the taxable year in which economic performance occurs.”

Prior to the due date change for Form 1120, the 8 ½ month time period noted at §461(h)(3) was the extended due date. This will not always be the case anymore and definitely will not be after 2025. For example:

Corporation’s year end

Normal due date

Extended due date

RIE must be met by

Calendar 4/15 9/15 9/15

March 31 7/15 1/15 12/15

June 30 9/15 4/15 3/15

Calendar (after 2025)

4/15 10/15 9/15

June 30 (after 2025)

10/15 4/15 3/15

Thus, rather than having to meet RIE by the extended due date, the earlier date will be 8 ½ months after year end (one month before the extended due date) (other than for calendar year C corps through 2025).

Rationale: Most likely, the 8 ½ month rule did not get changed because the rule is not only for C corporations. The new C corporation situation is similar to what it has always been for sole proprietors using the accrual method and RIE. They would have to meet RIE by 9/15 even though the extended due date is 10/15.

Compensation Cases

H. W. Johnson, Inc., TC Memo 2016-95 (May 11, 2016) -- Compensation Paid to Sons Of Company's Founder Were Deductible


http://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=10799

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The Tax Court concluded that a company in the concrete contracting business could deduct the $4 million and $7.3 million of compensation it paid to each of the company's founder's sons. This compensation was reasonable, and thus deductible under section 162(a)(1).

The Tax Court applied the “Elliotts factors” set forth by the Ninth Circuit to establish the reasonableness of the compensation:

The Court of Appeals for the Ninth Circuit, to which an appeal in this case would normally lie, applies five factors to determine the reasonableness of compensation, with no factor being determinative: (1) the employee's role in the company; (2) a comparison of compensation paid by similar companies for similar services; (3) the character and condition of the company; (4) potential conflicts of interest; and (5) the internal consistency of compensation arrangements. Elliotts v. Commissioner, 716 F.2d at 1245-1247. In analyzing the fourth factor, the Court of Appeals emphasizes evaluating the reasonableness of compensation payments from the perspective of a hypothetical independent investor, focusing on whether the investor would receive a reasonable return on equity after payment of the compensation. Id. at 1247; see also Metro Leasing Dev. Corp. v. Commissioner, 376 F.3d 1015, 1019 (9th Cir. 2004), aff'g T.C. Memo. 2001-119.

The IRS essentially conceded four of the Elliotts factors leaving the Tax Court to focus on the independent investor test. The Tax Court agreed with the taxpayer that an independent investor would be satisfied with the return on equity:

We agree with petitioner. Respondent cites no authority for the proposition that the required return on equity for purposes of the independent investor test must significantly exceed the industry average when the subject company has been especially successful, and we have found none in the case law. Instead, in applying the independent investor test the courts have typically found that a return on equity of at least 10% tends to indicate that an independent investor would be satisfied and thus payment of compensation that leaves that rate of return for the investor is reasonable. See, e.g., Thousand Oaks Residential Care Home I, Inc. v. Commissioner, T.C. Memo. 2013-10; Multi-Pak Corp. v. Commissioner, T.C. Memo. 2010-139. Indeed, compensation payments that resulted in a return on equity of 2.9% have been found reasonable. Multi-Pak Corp. v. Commissioner, T.C. Memo. 2010-139. It is compensation that results in returns on equity of zero or less than zero that has been found to be unreasonable. See, e.g., Mulcahy, Pauritsch, Salvador & Co., Ltd. v. Commissioner, 680 F.3d 867 (7th Cir. 2012), aff'g T.C. Memo. 2011-74; Multi-Pak Corp. v. Commissioner, T.C. Memo. 2010-139. We consequently find that petitioner's returns on equity of 10.2% and 9% for 2003 and 2004, respectively, tend to show that the compensation paid to Donald and Bruce for those years was reasonable.

Tax Court’s conclusion:


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As a whole, the Elliotts factors support the conclusion that the compensation petitioner paid to Bruce and Donald in 2003 and 2004 was reasonable. The brothers were absolutely integral to petitioner's successful performance, a performance that included remarkable growth in revenues, assets, and gross profit margins during those years, as respondent concedes. The return on equity petitioner generated for each year after payment of Bruce's and Donald's compensation was in line with-indeed closely approximated-the return generated by the companies most comparable to it. We accordingly conclude that an independent investor would have been satisfied with the return. For these reasons, we hold that the $4,025,039 and $7,300,916 petitioner paid as officer compensation in 2003 and 2004, respectively, were reasonable and therefore deductible under section 162(a)(1).

Brinks Gilson & Lione PC, TC Memo 2016-20 (Feb. 10, 2016) -- Penalty for Compensation that Zeroed Out Law Firm Book Income

Reasonable Comp versus Dividends for a PSC – Brinks Gilson & Lione, A Professional Corporation, TC Memo 2016-20 (2/10/16) – The issue of whether year-end bonuses to the attorney-owners of the law firm were compensation or dividends was resolved upon audit. The issue before the court was whether the corporation had substantial authority or reasonable cause to avoid an understatement of tax penalty. The court held that B was liable for the penalty. The case includes a comprehensive discussion of relevant case law on reasonable compensation. It is also a reminder of the need for documentation of bonus plans and consideration of the best entity form to reach the tax planning goals of the owners. For example, if B operated as an S corporation, the shareholders and corporation would have reduced income and payroll tax obligations.

Brinks Gilson & Lione (B), a calendar year, cash basis law firm, operating in the corporate form had about 270 staff and 150 attorneys, 65 of whom were shareholders. A board of directors managed the firm. Generally, the shareholders’ ownership tied to their share of compensation. After the board set the compensation levels, ownership percentage were adjusted via stock redemptions and reissuances. No dividends were paid during the years in issue (2007 and 2008) or the several preceding years.

B’s compensation strategy involved consideration of each shareholder’s billed hours, collections, new business and other work to help the firm. The estimates were shared with all shareholders. During the year, each shareholder received a portion of estimated salary with the expectation of the balance issued as a year-end bonus. The board’s goal was to zero out book income via these bonuses. Generally, the bonuses were paid in the same proportion as the draws during the year.

The board, CFO and outside return preparer firm did not discuss whether the bonuses were properly treated as compensation. All payroll tax and reporting forms were properly prepared. Pertinent figures include:

2007 2008

Year-end bonuses $ 8,986,608 $13,736,331



https://www.ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=10685


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Total income per return $91,742,819 $107,019,812

Taxable income $539,902 $561,075

Tax $188,966 $196,376

Book value of shareholder equity (approximate)

$8,000,000 $9,300,000

IRS examination of B’s 2006 return resulted in a no change. Audit of the 2007 and 2008 returns resulted in disallowance of various deductions. In addition, the year-end bonuses were recharacterized as non-deductible dividends. A settlement was reached resulting in tax due each year of approximately $1 million. The remaining issue litigated was whether B was subject to penalties under §6662. B argued it had substantial authority for its treatment of the shareholder payments as compensation. Alternatively, B argued that it had reasonable cause due to its reliance on its paid preparer. B lost on both issues.

Some of the law cited by Brinks:

Section 83 and regulations - Amounts paid to shareholder-attorneys should be treated as compensation for services.

Law Offices – Richard Ashare, PC, TC Memo 1999-282 – Here, the court allowed a deduction for a year-end bonus to the attorney-shareholder that eliminated book income and exceeded revenue.

The court noted that this firm “did not consistently pay compensation that had the intended effect of eliminating book income.”

Hubbard-Ragsdale Co. v. Dean, 15 F2d 1013 (6th Cri. 1926) and Reg. 1.704-1(e)(1)(iv) - A professional service firm does not generate revenue from capital (but from labor).

Substance over form doctrine - Stock of shareholder-attorneys should be treated as debt with the result that part of the year-end bonuses are deductible interest expense.

The court noted that the stock lacked the characteristics of debt.

Pediatric Surgical Assocs., PC, T.C. Memo. 2001-81 - Shareholder-attorneys should be compensated for generating business and nonbillable hours or service.

The IRS noted that in this case, payments to shareholder employees are not compensation if funded by earnings attributable to either the work of non-shareholder employees or the corporation’s intangible assets or capital.

Cases noted by the court:

Mulcahy, Pauritsch, Salvador & Co., 680 F.3d 867 (7th Cir. 2012) – B argued that this case did not apply because B’s shareholders must sell their shares back at cash book value, thus they are not true equity shareholders. B also argued that this case should not be considered as it was decided after B filed its 2007 and 2008 returns.




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The court noted that this case is “well established in the law and grounded in basic economics: The owners of an enterprise with significant capital are entitled to a return on their investments. Thus, a corporation's consistent payment of salaries to shareholder employees in amounts that leave insufficient funds available to provide an adequate return to the shareholders on their invested capital indicates that a portion of the amounts paid as salaries is actually distributions of earnings.”

Independent Investor Test – This is used by the 7th Circuit and other courts and considers an “independent investor” rather than an employee’s perspective in determining what is reasonable compensation. The court made its view on this perspective clear as it applied to B:

“Ostensible compensation payments made to shareholder employees by a corporation with significant capital that zero out the corporation's income and leave no return on the shareholders' investments fail the independent investor test. As the Court of Appeals for the Ninth Circuit observed in Elliotts, Inc. v. Commissioner, 716 F.2d at 1247: "If the bulk of the corporation's earnings are being paid out in the form of compensation, so that the corporate profits, after payment of the compensation, do not represent a reasonable return on the shareholder's equity in the corporation, then an independent shareholder would probably not approve of the compensation arrangement."”

B’s argument that its attorney-shareholders were not typical shareholders because they acquire the stock at cash book value and must sell it back using the same formula, was not accepted by the court. The court noted this approach was used “to avoid the practical difficulties of more precise valuation.” This doesn’t mean the shareholders don’t own the corporation.

In weighing the authorities, the court concluded they favored a conclusion that compensation was beyond what was reasonable. They also noted that some of B’s authorities were either “materially distinguishable” on the facts or inapplicable to the tax issues at hand.

Neither did the court find reasonable cause for waiving the penalties. B’s “argument that it reasonably relied on McGladrey fails for two reasons. First, the record provides no evidence that McGladrey advised petitioner regarding the deductibility of the yearend bonuses. Second, in characterizing as compensation for services amounts that have been determined to be dividends, petitioner failed to provide McGladrey with accurate information.” The compensation topic had not been discussed between B and its preparer. Yet, B argued “that silence can be a "communication". In that regard, petitioner observes that the regulations do not require advice to take "any particular form."”

The court disagreed finding that any advice had to be an “explicit communication” rather than silence.

Also, use of a CPA is not “carte blanche protection” against penalties. Good faith reliance is also necessary. The court found that B “could not have relied in good faith on McGladrey's preparation of its returns for the years in issue because it provided McGladrey with inaccurate information. The error that led to the claiming of the disallowed deduction was, in the first instance, petitioner's.” There was no evidence that B did what it did based on its CPA’s advice.

“Because petitioner initiated for its own reasons--whatever those reasons might have been--the practice of paying yearend bonuses that eliminated its book income, any culpability of


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McGladrey was secondary, in failing to recognize petitioner's erroneous characterization of part of the yearend bonuses. As a general matter, in the fulfillment of professional responsibilities, an accountant preparing or signing a return is entitled to rely on information furnished by the taxpayer and has only a limited obligation to make inquiries in the case of manifest errors. See 31 C.F.R. sec. 10.34(d) (2008) (duties of return preparers under rules governing practice before Internal Revenue Service, effective for returns filed after September 26, 2007); id. sec. 10.34(c) (same, before amendment by T.D. 9359, 2007-2 C.B. 931); American Institute of Certified Public Accountants, Statement on Standards for Tax Services No. 3, Certain Procedural Aspects of Preparing Returns (2000).”

“McGladrey's failure to bring to petitioner's attention the possible mischaracterization of the yearend bonuses does not absolve petitioner of responsibility because the mischaracterization was petitioner's doing in the first place.”

Finally, the no-change letter for 2006 is not relevant as there is not evidence that the year end bonus was examined.

Qualified Small Business Stock

PLR 201636003 (9/2/2016)—LLC electing to be Treated as a C Corp Can Be Qualified Small Business Stock

PLR 201636003 (9/2/16) – X started as a C corporation on Date 1. On Date 2, X amended its articles of incorporation to change its name. On Date 3, that name was changed to a new name and a late entity classification election [Form 8832] was made to treat that named entity as an association taxed as a C corporation. “On Date 4, a Certificate of Conversion from an LLC to a corporation was filed, changing the name to Corporation and converting X in Name 3 owned by the taxpayers to Y in Corporation representing all the common stock in Corporation after conversion.” Since inception, the owners have not acquired additional shares or had any redeemed.

In Year 5, the owners sold all of the stock of the corporation to an unrelated entity.

The IRS found that the owners met the gain exclusion of §1202 for qualified small business stock, which must be original issue stock of a C corporation. Per the IRS:

“While ownership of a corporation is normally tied to stock ownership, and under state law LLC owners hold a member interest and not formal stock, the term “stock” for federal tax purposes is not restricted to cases where formal stock certificates have been issued. Rather, it has been consistent Service position that for federal tax purposes stock ownership is a matter of economic substance, i.e., the right to which the owner has in management, profits, and ultimate assets of a corporation. The presence or absence of pieces of paper called “stock” representing that ownership is immaterial. See Rev. Rul. 69-591, 1969-2 C.B. 172.

Therefore, based on the facts and representations submitted, we rule that the Corporation stock meets the definition of qualified small business stock under §§§ 1202(c), 1202(f) and 1202(h).”


https://www.irs.gov/pub/irs-wd/201636003.pdf?_ga=1.209466773.681724123.1466546876

https://www.irs.gov/pub/irs-wd/201636003.pdf

https://www.irs.gov/uac/form-8832-entity-classification-election

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Observations: Formal IRS guidance on this topic would be helpful. Here, on Date 4, the entity filed a certificate of conversion from LLC to corporation. Perhaps, being taxed as a corporation per Form 8832 is enough; or is it also important that the entity here started as a corporation under state law? Is an LLC electing to be taxed as a C corporation meet the economic substance for QSBS treatment in all cases?

Corporate Spinoff News

Rev Proc 2016-40 (7/15/2016) -- New Safe Harbors Clarify When Pre-Spinoff Acquisition of “Control” Has Substance

The new revenue procedure contains fact patterns to illustrate situations where the IRS will not assert that a distributing corporation fails to satisfy the “control” requirement for a tax-free distribution of a controlled corporation's stock and securities under Code Sec. 355:

“The Treasury Department and the IRS recognize that determining whether an acquisition of control has substance for federal tax purposes can be difficult and fact-intensive. The Treasury Department and the IRS are concerned that, in some cases, taxpayers may not be able to determine whether such an acquisition has substance with sufficient certainty to proceed with transactions that otherwise satisfy the requirements of §355. To resolve this uncertainty, the Treasury Department and the IRS are describing transactions in which the IRS will not assert that an acquisition of control lacks substance.”

“This revenue procedure applies to transactions in which—

(1) D owns C stock not constituting control of C;

(2) C issues shares of one or more classes of stock to D and/or to other shareholders of C (the issuance), as a result of which D owns C stock possessing at least 80 percent of the total combined voting power of all classes of C stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of C;

(3) D distributes its C stock in a transaction that otherwise qualifies under § 355 (the distribution); and

(4) C subsequently engages in a transaction that, actually or in effect, substantially restores (a) C’s shareholders to the relative interests, direct or indirect, they would have held in C (or a successor to C) had the issuance not occurred; and/or (b) the relative voting rights and value of the C classes of stock that were present prior to the issuance (an unwind).”

Rev. Proc. 2016-40 provides safe harbors under which IRS will not assert that the transaction lacks substance.

REG-134016; Prop Reg 1.355-2, -9 (7/14/2016) -- Proposed Regs Clarify Device And Business Requirement Under Code Sec. 355


https://www.irs.gov/irb/2016-32_IRB/ar05.html?_ga=1.259928266.1950182913.1469837234


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IRS has issued proposed regs that would clarify the application of the device prohibition and the active business requirement under Code Sec. 355. Per the preamble introduction:

“This document contains proposed regulations that would amend 26 CFR part 1 under section 355 of the Code. The proposed regulations would provide additional guidance regarding the device prohibition of section 355(a)(1)(B) and provide a minimum threshold for the assets of one or more active trades or businesses, within the meaning of section 355(a)(1)(C) and (b), of the distributing corporation and each controlled corporation (in each case, within the meaning of section 355(a)(1)(A)).

This Background section of the preamble (1) summarizes the requirements of section 355, (2) discusses the development of current law and IRS practice under section 355 and the regulations thereunder, and (3) explains the reasons for the proposed regulations.”

Rev Proc 2016-45 (8/26/2016) – IRS Will Again Rule on the Device and Business Purpose Tests Involving Spinoffs

In Revenue Procedure 2016-45, the IRS removes two no-rule areas relating to distributions of stock of controlled corporations under section 355. The issues concern the requirements that a transaction not be used principally as a device for the distribution of earnings and profits and that the distribution must be carried out for a corporate business purpose.

Mergers and Acquisitions

Legal Advice Issued by Field Attorneys (LAFA) 20163701F (9/9/2016) -- “Break Fee” Paid With Respect To Cancelled Merger Generates A Capital Loss

Character of Break Fee – FAA 20163701F (9/9/16) – Taxpayer announced to the public that it had entered an agreement with Target to merge. T formed a new company for this purpose and the agreement included what T and Target shareholders would receive. Both entities would become subsidiaries of the new parent corporation which such stock listed on the Exchange. The deal fell through though when the U.S. Treasury Department “issued a notice that adversely affected the expected tax benefits of the proposed merger.” T no longer recommended the merger.

The merger agreement specified that T was to pay a break fee to Target if T changed its merger plan. The parties entered an agreement to terminate the first agreement and stated that break fee




https://www.irs.gov/pub/irs-lafa/20163701f.pdf


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that T would pay to Target and the date. This was “target’s sole and exclusive remedy for the terminated merger.”

The IRS ruled that the payment of the break fee by T resulted in a capital loss under §1234A, Gains or losses from certain terminations. The provision states in its entirety:

“Gain or loss attributable to the cancellation, lapse, expiration, or other termination of—

(1) a right or obligation (other than a securities futures contract, as defined in section 1234B) with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer, or

(2) a section 1256 contract (as defined in section 1256) not described in paragraph (1) which is a capital asset in the hands of the taxpayer,

shall be treated as gain or loss from the sale of a capital asset. The preceding sentence shall not apply to the retirement of any debt instrument (whether or not through a trust or other participation arrangement).”

The IRS found that the stock involved in the merger agreement met the definition of a capital asset under §1221. The 1997 legislative history to §1234A includes this observation: “An example of the second type of property interest that is affected by the committee bill is the forfeiture of a down payment under a contract to purchase stock.”

The IRS concludes: “The break fee relates to a contractual right and obligation concerning a capital asset (the right and obligation to acquire stock). Consistent with the purpose of section 1234A, any gain or loss realized by Taxpayer on the termination of the contract, which provides Taxpayer with rights and obligations with respect to stock, a capital asset, would be capital in nature. Therefore, section 1234A applies and Taxpayer's loss on paying the break fee is a capital loss.”

Observation: Presumably, based upon the logic of the LAFA, the recipient of the break fee would be entitled to capital gain pursuant to section 1234A. Based upon U.S Freight Co. (cited in the legislative history), section 1234(a) does not apply to liquidated damages (not the same as an option because a bilateral contract). Compare, CRI-Leslie, LLC, (2016) 147 TC No. 8 (Sept. 7, 2016), in which the Tax Court denied a partnership capital gain treatment under section 1234A for its right to retain $9.7 million of forfeited deposits from a canceled sale of real property used in its trade or business because the real property was section 1231 property rather than a “capital asset.” If the forfeited deposit in Leslie related to property the was merely held for investment, thus a capital asset, then section 1234A would come to the rescue and allowed for capital gain treatment to the recipient. In Leslie, would the party who forfeited the $9.7 million be entitled to ordinary loss treatment? Yes, based upon U.S. Freight Co (cited in the legislative history to section 1234A) neither section 1234A (per Leslie), nor section 1234(a) applies to convert the transaction to a sale or exchange of a capital asset and thus forcing capital loss treatment. Whether the property were acquired for use in a trade or business or as an investment, the forfeited deposit would be eligible for ordinary loss treatment because the transaction is not a sale or exchange. Is it possible for the seller to get capital gain on the forfeiture while the potential buyer gets ordinary loss treatment? Why not. If the property is investment property to the seller, yet acquired for T or B purposes to buyer. Consider sec 165 investment v. business loss and 2% cut.


http://ustaxcourt.gov/UstcInOp/OpinionViewer.aspx?ID=10921


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[Section 1234A] with no apparent ambiguity, supplies the sale or exchange requirement expressly with respect to transactions involving a privilege or an option; the section makes no reference to transactions involving bilateral contract rights. The legislative history of section 1234, moreover, contains no indication that Congress intended bilateral contracts to be included within the operation of the section. See H. Rep. No. 8300, 83d Cong., 2d Sess., A278-79 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess., 437-38 (1954).

Merger Termination Fee Treatment to Recipient Corporation - CCA 201642035 (10/14/16)

CCA 201642035 (10/14/16 – In Situation 1, Acquiring corporation (A) and Target Corporation (T) enter a bilateral agreement to pursue a merger. There are specified conditions that allow T to terminate the contract with T paying a termination fee of $1 million to A. T gets a better offer from another company and enters that and pays the termination fee to A. At the time, A has incurred $200,000 of costs in investigating the transaction. A capitalized these costs under 1.263(a)-5(e) as costs of facilitating a transaction.

In Situation 2, the facts are the same as for Situation 1 except that A incurs costs of $1.1 million which it capitalizes under 1.263(a)-5(e).

Section 1234A applies to the parties in these situations if the asset was or would be a capital asset in their hands. “Section 1234A(1) provides that gain or loss attributable to the cancellation, lapse, expiration or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer is treated as gain or loss from the sale of a capital asset.”

Section 165 is also applicable in terms of whether the loss (whether capital or ordinary) is allowable. “Section 165(a) provides that there shall be allowed as a deduction any uncompensated loss sustained during the taxable year. Section 165(f) provides that capital losses are subject to the limitations in sections 1211 and 1212.”

If A had acquired T’s stock, it would be a capital asset in its hands. Thus, §1234A is applicable.

The IRS concludes:

“In Situation 1, Acquirer’s amount realized from the receipt of the termination fee ($1,000,000) is reduced by Acquirer’s capitalized facilitative costs ($200,000). Because this gain was attributable to the termination of Acquirer’s right with respect to Target’s stock -- property that would have been a capital asset in Acquirer’s hands -- the gain is treated as a gain from the sale of a capital asset under section 1234A. Accordingly, Acquirer has a capital gain of $800,000 (the termination fee income of $1,000,000 less Acquirer’s capitalized facilitative costs of $200,000).”

“In Situation 2, Acquirer’s amount realized from the receipt of the termination fee ($1,000,000) is reduced by Acquirer’s capitalized facilitative costs ($1,100,000), resulting in a loss of $100,000. Because this loss was attributable to the termination of Acquirer’s right with respect to Target’s stock -- property that would have been a capital asset in Acquirer’s hands -- the loss is treated as a loss from the sale of a capital asset under section 1234A. Accordingly, Acquirer has a capital loss of $100,000 (the termination fee income of $1,000,000 less





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Acquirer’s capitalized facilitative costs of $1,100,000) that Acquirer may deduct under section 165, subject to the limitations on capital losses in sections 1211 and 1212.”

Consolidated Returns Marvel Entertainment LLC v. Comm., (CA 2 9/7/2016) -- Consolidated Group

Must Use “Single Entity” Approach For NOL Reduction The Second Circuit affirmed a 2015 Tax Court decision that applied a "single entity" approach to reduce Marvel Entertainment Group’s (a consolidated group’s) net operating loss (NOL) by its members' previously excluded cancellation of debt (COD) income. The facts involved an interpretation of the pre-2003 consolidated return regulations and “the issue was whether the pre-2003 consolidated return regulations allow for the separate-entity approach” (Tax Court). The current regulations (finalized in 2005), mentioned by the Tax Court, are discussed below in an observation. Tax Court’s Summary (affirmed by Second Circuit):

[Marvel Entertainment Group] MEG was an affiliated group that filed consolidated returns. On Dec. 27, 1996, certain MEG member entities filed for bankruptcy under 11 U.S.C. ch. 11 and subsequently excluded cancellation of indebtedness (COD) income from their respective gross incomes under I.R.C. sec. 108(a)(1)(A) for MEG's short taxable year ending Oct. 1, 1998. Pursuant to I.R.C. sec. 108(b)(2)(A), MEG reduced each member entity's allocable share of consolidated net operating loss (CNOL) by each member entity's previously excluded COD income. MEG carried forward into its successor affiliated group a $47,424,026 CNOL and used this amount to offset income of the successor group for its taxable years ending Dec. 31, 2003 and 2004. [IRS] determined deficiencies for 2003 and 2004, arguing that I.R.C. sec. 108(b)(2)(A) required MEG's 1998 tax attribute reduction to occur at the consolidated level rather than at the individual entity level. P, the successor to MEG and as agent for the members of the affiliated group, timely filed a petition disputing IRS’s determinations. Held: Where a member of a consolidated group has excluded COD income during a consolidated return year before the adoption of sec. 1.1502-28T, Temporary Income Tax Regs., 69 Fed. Reg. 12071 (Mar. 15, 2004), the NOL subject to reduction pursuant to I.R.C. sec. 108(b)(2)(A) is the entire CNOL of the consolidated group. See United Dominion Indus., Inc. v. United States, 532 U.S. 822 [87 AFTR 2d 2001-2377] (2001).


http://law.justia.com/cases/federal/appellate-courts/ca2/15-3335/15-3335-2016-09-07.html


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The Second Circuit, in a three paragraph per curiam opinion, affirmed "for substantially the reasons stated by the Tax Court in its complete and well-reasoned opinion." MEG’s computation of the NOL carryforward appears in the Tax Court’s opinion:

On its consolidated Federal income tax return for the short taxable year ending October 1, 1998, MEG Group reduced the share of CNOL separately attributable to each of MEG, Fleer, Heroes, and Malibu by the lesser of (1) each member's excluded COD income or (2) each member's allocable share of CNOL, as follows:

----------------------------------------------------------------------

Allocated Excluded Reduction of Remaining

CNOL COD income CNOL CNOL

----------------------------------------------------------------------

-

MEG $71,330,567 $2,497,828 $2,497,828

$68,832,739

Fleer 82,656,671 163,680,402 82,656,671 -0-

Heroes 4,058,504 4,930,767 4,058,504 -0-

Malibu 2,707,590 353,466 353,466

2,354,124

----------- ----------- ---------- ----------

Total 160,753,332 171,462,463 89,566,469 71,186,863

---------------------------------------------------------------------

The IRS position--which prevailed--is summarized by the Tax Court as follows:

In the notice of deficiency [IRS] challenged the Marvel Group's computation of the CNOL carryforward and took the position that MEG Group should properly have reduced its $187,154,680 CNOL as of October 1, 1998, by $171,462,463, the total of excluded COD income for MEG, Fleer, Heroes, and Malibu.

The Tax Court framed the issue as follows:

The sole issue for decision is whether the NOL subject to reduction under section 108(b)(2)(A) is the entire CNOL of a consolidated group (single-entity approach) or a portion of a consolidated group's CNOL allocable to each group member (separate-entity approach). [ IRS] argues that the “NOL' that must be reduced under section 108 is the entire CNOL” of a consolidated group. According to [IRS], “the MEG Group should properly have reduced its $187,154,680 CNOL as of October 1, 1998 by $171,462,463, the total of the excluded COD income for each of Fleer, Heroes, MEG and Malibu resulting in a remaining CNOL as of October 2, 1998.

Observation: The Tax Court discussed the fact that the instant case dealt with the pre-2003 consolidated return regulations and explained the current law as follows:


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For COD income discharged after August 29, 2003, section 1.1502-28T, Temporary Income Tax Regs., 68 Fed. Reg. 69025 (Dec. 11, 2003), prescribes a hybrid approach that first reduces the tax attributes of the member entity, then applies a lookthrough rule to reduce attributes of the member entity's subsidiaries, and lastly reduces attributes of the consolidated group. With slight modifications, this temporary regulation was adopted as final and effective for COD income discharged after March 21, 2005. Sec. 1.1502-28(d), Income Tax Regs.

The above quotation citation contained a footnote which reads: These post-United Dominion regulations appear to follow the invitation of the Supreme Court:

Thus, it is true, as the Government has argued, that ‘[t]he Internal Revenue Code vests ample authority in the Treasury to adopt consolidated return regulations to effect a binding resolution of the question presented in this case.’ Brief for United States 19-20. To the extent that the Government has exercised that authority, its actions point to the single-entity approach as the better answer. To the extent the Government disagrees, it may amend its regulations to provide for a different one. United Dominion, 532 U.S. at 838. (footnote 10 of Tax Court opinion)

BEPS and Tax Reform Type Actions

BEPS – Base Erosion and Profit Shifting

Anti-Inversion, Earnings Stripping and Debt-Equity Regs Under Section 385

Corporate Inversions and Related Issues

4/4/16 press release of Treasury Department – The guidance issued in early April is designed to “reduce the benefits of and limit the number of corporate tax inversions.” Per Treasury:

· Limit inversions by disregarding foreign parent stock attributable to recent inversions or acquisitions of U.S. companies. This will prevent a foreign company (including a recent inverter) that acquires multiple American companies in stock-based transactions from using the resulting increase in size to avoid the current inversion thresholds for a subsequent U.S. acquisition.

· Address earnings stripping by: o Targeting transactions that generate large interest deductions by simply

increasing related-party debt without financing new investment in the United States.


https://www.treasury.gov/press-center/press-releases/Pages/jl0405.aspx

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o Allowing the IRS on audit to divide debt instruments into part debt and part equity, rather than the current system that generally treats them as wholly one or the other.

o Facilitating improved due diligence and compliance by requiring certain large corporations to do up-front due diligence and documentation with respect to the characterization of related-party financial instruments as debt. If these requirements are not met, instruments will be treated as equity for tax purposes.

· Formalize Treasury’s two previous actions in September 2014 and November 2015.

Treasury will continue to explore additional ways to address inversions.

IRS LB&I International Practice Service Concept Unit guide released 7/5/16 (53 pages).

See additional information in the International section. §385 Part 1 - Proposed Debt-Equity Regulations Under §385 – On 4/8/16, IRS released proposed regulations (REG–108060–15) under §385 dealing with debt versus equity determinations and relevance. Per the preamble to these regulations:

These “regulations under section 385 that would authorize the Commissioner to treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes, and establish threshold documentation requirements that must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes. The proposed regulations also would treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes. The proposed regulations generally affect corporations that issue purported indebtedness to related corporations or partnerships.”

These regulations have been controversial with commentators finding them overly broad. They were issued along with the regulations on inversions because they attempt to reduce incentives to invert.

The Administration also updated its 2012 Framework For Business Tax Reform (April 2016) to address inversions (see mostly pages 15-16).

Selected comment letters:

AICPA, 7/13/16 – Lack of authority to have the regulations apply to partnerships

AICPA, 7/7/16 – General comments

ABA, 7/13/16 – General comments (177 pages)

Group of industry associations. 6/14/16 – A one-page letter stating that the regulations are of “questionable validity,” and will harm job creation and economic growth.

On 8/22/16, House Republicans from the Ways & Means Committee sent a letter to Secretary Lew calling for a “complete overhaul” of the proposed regulations approach (also see press release of 8/22/16). Per the letter:





https://www.irs.gov/businesses/corporations/international-practice-units

https://www.irs.gov/pub/int_practice_units/isocup_1_10_01.pdf


https://www.treasury.gov/resource-center/tax-policy/Documents/The-Presidents-Framework-for-Business-Tax-Reform-An-Update-04-04-2016.pdf

https://www.aicpa.org/Advocacy/Tax/DownloadableDocuments/AICPA-Expresses-Concern-over-IRS-Authority-to-Apply-Section-385-to-Partnership-Debt-7-13-16.pdf

https://www.aicpa.org/Advocacy/Tax/DownloadableDocuments/AICPA-Comments-Section-385-Prop-Regs-7-7-16.pdf

http://www.americanbar.org/content/dam/aba/administrative/taxation/policy/071316comments.authcheckdam.pdf

http://ofii.org/sites/default/files/Coalition%20Letter%20on%20Sec%20385.pdf

http://waysandmeans.house.gov/wp-content/uploads/2016/08/8.22.16_WM-Reps_Lew_Section-385-Regs.pdf

http://waysandmeans.house.gov/new-wm-gop-letter-treasury-proposed-regs-will-hurt-u-s-economy-stifle-job-creation-home/

http://waysandmeans.house.gov/new-wm-gop-letter-treasury-proposed-regs-will-hurt-u-s-economy-stifle-job-creation-home/

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Senator Hatch of the Senate Finance Committee also sent a letter to Treasury Secretary Lew on 8/22/16, expressing similar concerns (also see 8/22/16 press release). He concludes his letter with:

“I ask you to re-propose the regulations not because I wish for there to not be any section 385 regulations. Rather, I am seekign to ensure that, should the Treasury Department issue regulations under IRC section 385, the Department does so in a thoughtful, prudent, and legal manner.”


http://www.finance.senate.gov/imo/media/doc/8.22.2016%20Co-ordinated%20385%20Letter%20to%20Treasury.pdf

http://www.finance.senate.gov/chairmans-news/hatch-calls-on-treasury-to-re-propose-debt-equity-rules

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§385 Part 2 – Emphasis Mostly on Earnings Stripping – On 10/21/16, the IRS released final, temporary (TD 9790 (10/21/16)) and proposed regulations (Reg-130314-16 (10/21/16)) under §385. Per the preamble: “final and temporary regulations under section 385 that establish threshold documentation requirements that ordinarily must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes, and treat as stock certain related-party interests that otherwise would be treated as indebtedness for federal tax purposes. The final and temporary regulations generally affect corporations, including those that are partners of certain partnerships, when those corporations or partnerships issue purported indebtedness to related corporations or partnerships.”

The regulations are 127 pages in the Federal Register (including the preamble).

The Treasury Department also issued a press release (10/13/16) emphasizing the purpose of the revised regulations based on public input. Per the release:

These regulations “further reduce the benefits of corporate tax inversions, level the playing field between U.S. and non-U.S. businesses, and limit the ability of companies to lower their tax bills through transactions involving debt that do not support new investment in the United States. These regulations also require large corporations claiming interest deductions to document loans to and from their affiliates, just as businesses of all sizes do when they borrow from unrelated lenders. The rules were proposed in April along with temporary anti-inversion regulations.”

“Today’s final regulations are an important step in addressing earnings stripping, a commonly used technique to minimize taxes after an inversion. Throughout our rulemaking process, we sought comments to help narrow the rule and avoid any unintended consequences. We engaged extensively with businesses, tax experts, the public, and lawmakers and carefully considered their comments and recommendations. As a result of this process, the final rule effectively addresses stakeholder concerns by more narrowly focusing the regulations on aggressive tax avoidance tactics and providing certain limited exemptions.”\

Treasury also released a fact sheet (10/13/16).

JCT Overview of The Tax Treatment Of Corporate Debt And Equity (May 20, 2016)

The Joint Committee on Taxation (JCT) provides an overview of Federal income tax rules relating to debt and equity and some of the tax incentives each provides (JCX-45-16). The report was prepared for a hearing by the Senate Committee on Finance scheduled for May 24, 2016, titled “Debt and Equity: Corporate Integration Considerations.”







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Other Updates Prop Reg 1.305-1, -3, -7; 1.860G-3; 1.861-3; 1.1441-2 , -3, -7; 1.1461-2; 1.1471-

2; 1.1473-1; 1.6045B-1 (04/12/2016) -- Proposed Reliance Regs On Adjustments To Stock Rights

The proposed regulations “amend 26 CFR part 1 under sections 305, 860G, 861, 1441, 1461, 1471, 1473, and 6045B … concerning deemed distributions that are or result from adjustments to rights to acquire stock.

IRS has issued proposed reliance regs that cover the amount of taxable income, and the timing of the recognition of taxable income, from deemed distributions that are, or that result from, adjustments to rights to acquire stock. The proposed regs also provide guidance to withholding agents regarding withholding and reporting obligations under Code chapters 3 and 4, and provide guidance regarding other reporting requirements, with respect to these deemed distributions.

GAO Study on Effective Corporation Tax Rates A March 2016 report, Most Large Profitable U.S. Corporations Paid Tax but Effective Tax Rates Differed Significantly from the Statutory Rate, GAO-16-363 found:

“In each year from 2006 to 2012, at least two-thirds of all active corporations had no federal income tax liability. Larger corporations were more likely to owe tax. Among large corporations (generally those with at least $10 million in assets) less than half—42.3 percent—paid no federal income tax in 2012. Of those large corporations whose financial statements reported a profit, 19.5 percent paid no federal income tax that year. Reasons why even profitable corporations may have paid no federal tax in a given year include the use of tax deductions for losses carried forward from prior years and tax incentives, such as depreciation allowances that are more generous in the federal tax code than those allowed for financial accounting purposes. Corporations that did have a federal corporate income tax liability for tax year 2012 owed $267.5 billion.”




http://www.gao.gov/assets/680/675845.pdf

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Chapter 4: S Corporations Page 4-1

Chapter 4 : S Corporations

Table of Contents Chapter 4 : S Corporations ...................................................................................................... 4-1

Scott Singer Installations, Inc., TC Memo 2016-161 (8/24/2016) -- S Corp's Payment of Shareholder Personal Expenses are Loan Repayments Not Wages .................................. 4-1

PLR 201633017 (Aug. 12, 2016) – Erroneous Disproportionate Distributions Did Not Terminate S Corp .................................................................................................................. 4-6

Medley v. Citizen Southern Bancshares, (Bktcy Ct AL 5/17/2016) -- S Corp Income Earned After Bankruptcy Commencement Taxable to Bankruptcy Estate .................... 4-7

Jasperson v. Comm., (CA 11 08/31/2016) -- S Corp Owner Denied Unsubstantiated NOL Carryforwards........................................................................................................................ 4-8

Squeri, TC Memo 2016-116 (Tax Ct.) -- S Corp. Must Report Income Consistently Even if Incorrect .............................................................................................................................. 4-9

Scott Singer Installations, Inc., TC Memo 2016-161 (8/24/2016) -- S Corp's Payment of Shareholder Personal Expenses are Loan Repayments Not Wages The taxpayer started Scott Singer Installations, Inc. (SSI -- an S corporation) in 1981. The business was primarily engaged in servicing, repairing, and modifying recreational vehicles. Taxpayer was the sole shareholder and president of the S corporation and served as its sole corporate officer. Singer funded the S corporation with back to back loans in 2006 through 2008:

In order to fund [SSI’s] growth, Mr. Singer began raising money from various sources. In 2006 Mr. Singer established a $224,000 home equity line of credit. In less than a year Mr. Singer had drawn on the entire line of credit and advanced the funds to [SSI]. In 2006 Mr. Singer also established an $87,443 line of credit by refinancing a home mortgage. He likewise advanced the entire amount to [SSI] within the same year. In 2008 Mr. Singer established a $115,000 general business line of credit and advanced all the funds to [SSI]. Mr. Singer also borrowed $220,000 from his mother and her boyfriend and advanced all the funds to petitioner throughout 2007 and 2008. In sum, Mr. Singer advanced a total of $646,443 to [SSI] between 2006 and 2008. [SSI] reported all of the advances as loans from shareholder on its general ledgers and Forms 1120S, U.S. Income Tax Return for an S Corporation, but there were no promissory notes between Mr. Singer and petitioner, there was no interest charged, and there were no maturity dates imposed.

The back-to-back loans continued in 2009-2011:



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Because Mr. Singer was unable to borrow from commercial banks, he financed petitioner's operations from 2009 through 2011 by borrowing an additional $513,099 from his mother and her boyfriend and advancing the funds to petitioner. Mr. Singer also began charging business expenses to personal credit cards. Petitioner was not profitable during the years at issue [2010 and 2011]. Petitioner reported operating losses of $103,305 for 2010 and $235,542 for 2011. During the same years petitioner paid $181,872.09 of Mr. Singer's personal expenses by making payments from its bank account to the Singers' creditors. These payments made on behalf of the Singers were treated on petitioner's general ledger and Forms 1120S as repayments of shareholder loans. Petitioner did not deduct the payments made on behalf of the Singers as business expenses.

SSI “did not report paying wages to Mr. Singer during 2010 or 2011.” The IRS argued that Singer was an employee of SSI for the years at issue—2010 and 2011--and that the $181,872.09 in payments SSI made on behalf of Singer constituted wages that should have been subject to employment taxes. The Tax Court agreed with the IRS that Singer was an employee for the years at issue; however, the Tax Court ruled in favor of the S corporation primarily because Singer intended his advances to be loans:

Rather than analyze every factor on the debt-equity checklists, we confine our discussion to those points we find most pertinent. In our analysis we look at the relative financial status of petitioner at the time the advances were made; the financial status of petitioner at the time the advances were repaid; the relationship between Mr. Singer and petitioner; the method by which the advances were repaid; the consistency with which the advances were repaid; and the way the advances were accounted for on petitioner's financial statements and tax returns. After looking at all these criteria in the light of the other factors traditionally distinguishing debt from equity, particularly the intent factor, we believe Mr. Singer intended his advances to be loans and we find that his intention was reasonable for a substantial portion of the advances. Consequently, we also find that petitioner's repayments of those loans are valid as such and should not be characterized as wages subject to employment taxes.

The Court held that SSI’s payment of Singer’s personal expenses were repayments of loans made to the S corporation, and not wages. The Tax Court noted that Singer did not have a reasonable expectation of repayment for advances made after 2008 and that such advances were capital contributions. Regardless, the advances from 2006 through 2008 were sufficiently large to justify the repayments in 2010 and 2011.


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While we believe that Mr. Singer had a reasonable expectation of repayment for advances made between 2006 and 2008, we do not find that a similarly reasonable expectation of repayment existed for later advances. When the recession occurred in 2008 and petitioner's business dropped off sharply, Mr. Singer should have known that future advances would not result in consistent repayments. When neither petitioner nor Mr. Singer was able to raise funds from unrelated third parties, Mr. Singer must have recognized that the only hope for recovery of the amounts previously advanced to petitioner was an infusion of capital subject to substantial risk. After 2008 the only source of capital was from Mr. Singer's family and Mr. Singer's personal credit cards. No reasonable creditor would lend to petitioner. Accordingly, we find that advances made in 2008 and earlier were bona fide loans and that advances made after 2008 were more in the nature of capital contributions. We also find that petitioner had a sufficient outstanding loan balance at the time the repayments were made so that loan repayments made during the years at issue are valid as such.

Observation #1: Singer overcame the “heightened scrutiny” that applies to “loans” to a controlling shareholder. Per footnote 9:

“While we recognize that transfers by Mr. Singer as the controlling shareholder (and the corresponding labels attached to such transfers) are subject to heightened scrutiny, we believe Mr. Singer provided enough objective evidence to overcome the higher standard.”

Observation #2: The Tax Court was remarkably generous in ignoring the lack of formalities to support the “loan”. Per footnote 10:

“We recognize that Mr. Singer's advances have some of the characteristics of equity—the lack of a promissory note, the lack of a definitive maturity date, and the lack of a repayment schedule—but we do not believe those factors outweigh the evidence of intent. See Johnson v. Commissioner, T.C. Memo. 1977-436 (finding that advances to corporation were loans even though there was no note, no specific time fixed for repayment, and no interest, because intent of parties to create loan was overwhelming and outweighed other factors).”

Observation #3: Compare Glass Blocks Unlimited, TC Memo 2013-180 (8/7/2013). Facts per the Tax Court in Glass Blocks:

“Following a downturn in the real estate and construction markets after 2005, petitioner's business began to experience financial difficulties, and Mr. Blodgett transferred funds to petitioner in order to cover operating expenses and other costs. In 2007, Mr. Blodgett transferred $30,000 from his family trust to petitioner. Deborah R. Vancleave, Mr. Blodgett's fiance at the time, contributed $15,000 to petitioner in 2007 and an additional $10,000 in 2008. Petitioner did not give any collateral to Mr. Blodgett with respect to the transfers, and no promissory notes reflecting the transfers were issued.”


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“Petitioner did not on its 2007 and 2008 Forms 1120S report paying Mr. Blodgett a salary or wages. It did, however, distribute money to him as cash was available and he asked for it. Petitioner distributed not less than $30,844 to Mr. Blodgett over the course of 2007. During 2008, petitioner made distributions to Mr. Blodgett totaling not less than $31,644.” “On its 2007 Form 1120S, petitioner reported gross receipts of $832,579, total income of $308,516, and net ordinary business income of $877. Petitioner also reported repayment of $29,132 of loans from shareholders. On Schedule L, Balance Sheets Per Books, petitioner reported that the corporation did not have any outstanding loans from shareholders at the beginning of the year and had a balance of $12,868 in loans from shareholders at the end of the year.” On its 2008 Form 1120S, petitioner reported gross receipts of $701,338, total income of $257,638, and net ordinary business income of $8,950. Petitioner reported repayment of $8,391 of loans from shareholders. Petitioner's reported loans from shareholders balance decreased from $12,868 at the beginning of the year to $4,477 at the end of the year. Petitioner also reported dividend distributions totaling $21,078.”

Tax Court’s opinion in Glass Blocks:

“Petitioner contends that certain distributions represented repayment of loans between itself and Mr. Blodgett and, as such, should not be recharacterized as wages. According to petitioner, transfers of funds totaling $45,000 in 2007 and $10,000 in 2008 from Mr. Blodgett (or his fiance, on his behalf) were loans to petitioner and the distributions were merely repayment of those loans. Respondent argues that the funds were contributions to capital and the distributions constitute wages to Mr. Blodgett.” “The proper characterization of the transfers as either loans or capital contributions is made by reference to all the evidence. Petitioner bears the burden of proving that the transfers were loans. Courts have established a nonexclusive list of factors to consider when evaluating the nature of transfers of funds to closely held corporations. Such factors include: (1) the names given to the documents that would be evidence of the purported loans; (2) the presence or absence of a fixed maturity date; (3) the likely source of repayment; (4) the right to enforce payments; (5) participation in management as a result of the advances; (6) subordination of the purported loans to the loans of the corporation's creditors; (7) the intent of the parties; (8) the capitalization of the corporation; (9) the ability of the corporation to obtain financing from outside sources; (10) thinness of capital structure in relation to debt; (11) use to which the funds were put; (12) the failure of the corporation to repay; and (13) the risk involved in making the transfers.” (Citations omitted.) (Emphasis added)


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“The factors are not equally significant, and no single factor is determinative. Ultimately, we must determine whether the transfer, analyzed in terms of economic reality, constitutes risk capital entirely subject to the fortunes of the corporate venture or a strict debtor-creditor relationship. Transfers to closely held corporations by controlling shareholders are subject to heightened scrutiny, however, and the labels attached to such transfers by the controlling shareholder through bookkeeping entries or testimony have limited significance unless these labels are supported by other objective evidence.” (Citations omitted.) Applying the above factors, we find that the transfers in question were capital contributions and not bona fide loans. There were no written agreements or promissory notes supporting Mr. Blodgett's testimony that the transfers were loans. While it is true that a portion of the transfers was reported as loans from shareholders on petitioner's Forms 1120S, that entry is of little value without the support of other objective criteria. Indeed, petitioner did not even report the $10,000 transfer as a shareholder loan on its 2008 return. The absence of notes or other instruments, plus petitioner's failure to treat the $10,000 transfer as a loan at all, indicates that the transfers were not loans. Moreover, there is no evidence that Mr. Blodgett required interest for the use of the funds, that petitioner provided any security for the loan, or that a fixed repayment schedule existed. Mr. Blodgett withdrew funds solely on the basis of petitioner's financial ability to repay. Where the expectation of repayment depends solely on the success of the borrower's business, rather than on an unconditional obligation to repay, the transaction has the appearance of a capital contribution. On the basis of the evidence, we conclude that the funds Mr. Blodgett transferred to petitioner were, in substance, capital contributions and not bona fide loans. Therefore, petitioner's distributions did not represent repayment of shareholder loans.” (Citations omitted)

Tax Court’s opinion on reasonable compensation:

“Reasonableness of compensation is a question determined by all the facts and circumstances of the case. E.g., Joly v. Commissioner, T.C. Memo. 1998-361, aff'd without published opinion, 211 F.3d 1269 (6th Cir. 2000). Factors affecting the reasonableness of compensation include the employee's role in the company, comparisons of the employee's salary to those paid by similar companies for similar services, the character and condition of the company, and potential conflicts of interest. Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1245-1246 (9th Cir. 1983), rev'g T.C. Memo. 1980-282. The evidence in this case does not convince us that the amounts [IRS] recharacterized as wages constitute unreasonable compensation for the services Mr. Blodgett performed.”


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Petitioner directs the Court to statistics concerning the median hourly wages of a shipping clerk, an accounts receivable clerk, and an accounts payable clerk, plus the average annual salary for officers of S corporations in the wholesale durables business. Mr. Blodgett's role in petitioner's business, however, was more substantial than any one of those positions. Rather, he performed all of those roles within the company and, through his efforts, generated all of petitioner's sales and income for the periods at issue. Moreover, we do not accept that Mr. Blodgett worked only 20 hours per week. Mr. Blodgett told his examiner during the audit for petitioner's 2007 and 2008 tax years that he worked over 40 hours per week. Petitioner's own Web site states that petitioner's hours were 8 a.m. to 5 p.m. Monday through Friday during 2007 and 2008. In the absence of other evidence substantiating Mr. Blodgett's later testimony that he worked only 20 hours per week, we give that testimony little weight. Thus, even assuming arguendo that petitioner's proposed finding of $15.25 per hour is a reasonable wage for an employee in Mr. Blodgett's position, such a finding would in fact support the conclusion that $30,844 and $31,644 were reasonable for a full-time employee. Accordingly, petitioner has not carried its burden to show that the amounts respondent determined are unreasonable compensation.”

Note: The compensation cannot exceed the amounts actually paid to the shareholder/employee. Per IRS Fact Sheet FS-2008-25:

“The amount of the compensation will never exceed the amount received by the shareholder either directly or indirectly. However, if cash or property or the right to receive cash and property did go the shareholder, a salary amount must be determined and the level of salary must be reasonable and appropriate.”

Additional Resources:

IRS webpage on “S corporation Employees, Shareholders, and Corporate Officers” IRS webpage on “S Corporation Compensation and Medical Insurance Issues” (updated Aug. 2016) S Corporation Shareholder Compensation: How Much Is Enough? Tony Nitti, The Tax Adviser, July 31, 2011

PLR 201633017 (Aug. 12, 2016) – Erroneous Disproportionate Distributions Did Not Terminate S Corp

Facts (full text):


https://www.irs.gov/uac/wage-compensation-for-s-corporation-officers

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-employees-shareholders-and-corporate-officers?_ga=1.45093604.1950182913.1469837234

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues

http://www.thetaxadviser.com/issues/2011/aug/nitti-aug2011.html

http://www.thetaxadviser.com/issues/2011/aug/nitti-aug2011.html


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“The information submitted states that X was incorporated under the laws of State on D1 and made an election to be treated as an S corporation effective the same day. From Year 1 to Year 2, X made disproportionate distributions to its shareholders due to an error in the ownership percentage information used for calculating shareholder distributions. Also during those same years, X made composite state tax payments on behalf of its shareholders, later determining the precise amount of state tax liability allocable to each shareholder. X treated the state tax payments as interest-free, no-term loans to the shareholders, some of which have not yet been repaid. Near the end of Year 2, X engaged an accounting firm to audit its books. X learned that it was making disproportionate distributions and shortly thereafter made corrective distributions. X also changed its policy regarding the state tax payments such that it no longer treats the payments as loans. X represents that it corrected the disparate distributions due to the erroneous ownership percentage information and the composite state tax payments. X represents that its governing provisions, including its Articles of Incorporation, Bylaws, and Shareholder Agreements, confer identical rights to distribution and liquidation proceeds with respect to X's outstanding shares of stock. X also represents that there was not a principal purpose to circumvent the one class of stock requirement. Finally, X represents that it always intended to be an S corporation since D1.”

Conclusion (full text): “Based solely on the facts submitted and representations made, we conclude that because X's governing provisions provide for identical distribution and liquidation rights and because X represents that it was not a principal purpose to circumvent the one class of stock requirement, the disproportionate and corrective distributions X made to its shareholders and loans for the state tax payments did not create a second class of stock for purposes of § 1361(b)(1)(D). However, such disproportionate and corrective distributions must be given appropriate tax effect. Under these circumstances, we conclude that X's S corporation election did not terminate as a result of the distributions or loans.”

Medley v. Citizen Southern Bancshares, (Bktcy Ct AL 5/17/2016) -- S Corp Income Earned After Bankruptcy Commencement Taxable to Bankruptcy

Estate

Background: In Williams v. Comm’r, 123 TC 144 (7/22/2004), the Tax Cour held that when an individual S corporation shareholder, filed for bankruptcy before the corporation's yearend, operating losses sustained by the corporation during the year in which he filed for bankruptcy were reported by the


https://ecf.almb.uscourts.gov/docpub/016013977823

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bankruptcy estate, not the individual shareholder, because income or loss of an S corporation is determined as of the last day of the corporation's taxable year:

We agree with [IRS]. Section 1398 specifically applies to individuals in bankruptcy and must be considered before applying the rules of section 1377 to S corporation shareholders in bankruptcy. Under section 1398(f)(1), a transfer of an asset from the debtor to the bankruptcy estate when the debtor files for bankruptcy is not a disposition triggering tax consequences, and the estate is treated as the debtor would be treated with respect to that asset. Therefore, the Estate is treated as if it had owned all the shares of [the S corporation] for the entire year and, accordingly, is entitled to the entire loss that [the S corporation] generated during 1990, including the loss …for the period January 1 through December 3, 1990 [prior to the filing for bankruptcy].”

Medley: The Alabama bankruptcy court held that income from an S corporation owned by the debtor, with respect to an S corporation tax year that ended after the commencement of the involuntary bankruptcy, was taxable to the bankruptcy estate and not to the debtor. The fact that the debtor failed to elect under section 1398(d)(2) to split the tax year into two tax years was not relevant to its determination. The Bankruptcy Court explained that the K-1 should have been provided to the Trustee in Bankruptcy:

26 U.S.C. § 1398(e)(1) addresses how income is allocated between an individual debtor and the bankruptcy estate. Under that section of the tax code, the bankruptcy estate is entitled to the individual debtor's income or loss from the bankruptcy commencement date while any items of income or loss received or accrued before the bankruptcy filing remain with the debtor. Williams v. CIR., 123 T.C. 144, 149 (2004). Hence, the bankruptcy estates of these debtors was entitled to any income from the debtors' stock after the debtors were adjudicated bankrupt. Further, the income or loss of an S corporation is determined as of the last day of the corporation's taxable year. Id.; Kumar v. C.I.R., 106 T.C.M. (CCH) 109 (T.C. 2013) (explaining that "an S corporation's items of income, gain, loss, deduction, and credit-whether or not distributed-flow through to the shareholders, who must report their pro rata shares of such items on their individual income tax returns for the shareholder taxable year within which the S corporation's taxable year ends'). Because the debtors filed for bankruptcy before the last day of the S corporation's tax year, gains or losses of the corporation for that year flow through in their entirety to the bankruptcy estate pursuant to 26 U.S.C. § 1366(a)(1) 5 Thus, the K-1's provided to the debtors should have been provided the trustee of their bankruptcy estates.

Jasperson v. Comm., (CA 11 08/31/2016) -- S Corp Owner Denied Unsubstantiated NOL Carryforwards



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The Eleventh Circuit, affirming the Tax Court, held that an S corporation owner could not carry forward net operating losses (NOLs) where he did not prove (1) the existence of the losses, (2) whether he first carried the NOLs back, or (3) whether he elected to not use the carryback period:

Taxpayers are required to maintain adequate records substantiating their claimed net operating losses. See Scharringhausen v. Commissioner, T.C. Memo. 2012-350. Petitioner wished to prove his case by submitting hundreds of accounting records from an electronic database as replacements for source documents. Many of these records were not produced to respondent before the two-week deadline before trial to share documents, and their authenticity could not be verified. They were not allowed in the record. In any case, without any sort of direction as to the contents of these documents, this type of voluminous, unverified, and indiscriminate documentation does not provide adequate substantiation of the items petitioner reported on his tax returns. See Hale v. Commissioner, T.C. Memo. 2010-229; Patterson v. Commissioner, T.C. Memo. 1979-362. Finally, petitioner did not provide his individual tax returns for 2005 and 2006, the years he claimed to have incurred net operating losses. Without these returns, we cannot determine whether any limitations apply to curtail petitioner's claiming the losses or whether he properly carried forward the losses to the years at issue. We also cannot determine whether the returns were timely filed. Without this information, we find that petitioner has failed to establish entitlement to net operating loss carryover deductions for the years at issue. Accordingly, we sustain [IRS’s] determination.

The Eleventh Circuit also upheld the imposition of accuracy-related penalties against the taxpayer.

Squeri, TC Memo 2016-116 (Tax Ct.) -- S Corp. Must Report Income Consistently Even if Incorrect

A cash basis S corporation, PBS, deposited checks each January that had been received in December of the prior year and determined its income based on total deposits made during the calendar year:

“PBS deposited checks that were probably received in 2008 totaling $1,634,720 into its bank account in January 2009. PBS deposited checks that were probably received in 2009 totaling $1,893,851 into its bank account in January 2010. PBS deposited checks that were probably received in 2010 totaling $2,271,175 into its bank account in January 2011. PBS deposited checks that were probably received in 2011 totaling $1,564,602 into its bank account in January 2012.”

On audit, the IRS adjusted gross income as follows, per the court:



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In calculating the adjustment to PBS' gross receipts for each tax year at issue except 2009, [IRS]: (i) included the checks that were received in the year at issue but deposited by PBS in January of the following year and (ii) excluded the checks that were deposited in January of the tax year at issue, but received in the prior year. To illustrate: [IRS] adjusted the 2010 gross receipts by excluding the checks that had been received in 2009 but deposited in January 2010 and by including the checks that had been received in 2010 but deposited in January 2011. For 2009, however, respondent did not do the second adjustment and did not exclude the checks that had been received in the prior year, 2008, but deposited in January 2009.

The taxpayer argued that the checks received in 2008 (closed by the statute of limitations) should be excludible. The Tax Court (interpreting Ninth Circuit law per the Golsen rule) concluded “that the duty of consistency requires that the $1,634,720 in gross receipts that PBS received in 2008 but reported for 2009 be recognized as income for tax year 2009.”

Observation for Cal State East Bay Alumni: The Tax Court specifically noted that the taxpayer, Robert Squeri, “graduated from California State University Hayward with a degree in history and is the chief executive officer of PBS.” The Court did not mention (even in a footnote) that the name of the University is now CSU East Bay.


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Chapter 5: Partnerships and LLCs Page 5-1

Chapter 5 : Partnerships and LLCs

Table of Contents Chapter 5 : Partnerships and LLCs ........................................................................................ 5-1

TD 9787; Regs. 1.707-4, -5, -6, -9; 1.752-3 and TD 9788; Regs. 1.707-5, -9; 1.752-2; 1.707-5T, -9T; 1.752-2T (10/5/2016) – Final and Temp. Regs. on Disguised Sales, Bottom Dollar Guarantees, Etc. ......................................................................................................... 5-3

REG-122855-15 (Oct. 5, 2016)– Re-Proposed Regulations Address When PSP Debt Is Recourse Debt and Deficit Restoration Obligations ........................................................... 5-9

Khoury, California SBE, Case Nos. 867810, 867855, 867874 (9/23/2016) -- Installment Sale Treatment Allowed on Sale to Related PSP .............................................................. 5-14

Refco Public Commodity Pool LP, (Bktcy Ct DE 8/2/2016) -- No $3.5 Mil. Failure-To-File Penalty For Upper Tiered Partnership. ............................................................................. 5-17

Lamas-Richie, TC Memo 2016-63 (April 11, 2016) -- Taxpayer Is A Partner Despite No Distributions Of Income And No Timely K-1 ................................................................... 5-20

Hastings, TC Memo 2016-61 (4/5/2016) – No Basis for Contributed Services Until Taxed................................................................................................................................................ 5-21

Methvin v. Comm., (CA 10 6/24/2016)-- Tenth Circuit Finds Oil And Gas Ventures Were Partnerships Thus Distributive Share is SE Income ........................................................ 5-22

CCA 201640014 (released 9/30/2016) – Franchisee/Operating Manager and LLC member is Not a Limited Partner Says Chief Counsel ..................................................... 5-22

T.D. 9766, Reg. 301.7701-2T; Prop. Reg. 301.7701-2 (05/03/2016) -- Clarification of Employment Tax Rules Where Partnership Owns Disregarded Entity ........................ 5-25

LAFA 20161101F (released 3/11/2016) -- No Partnership Existed For Tax Purposes; No Risk Of Loss Or Chance Of Gain ....................................................................................... 5-27

Costello, LLC, TC Memo 2016-184 (9/29/2016) – SMLLC Filing Form 1120 is Not a Corporation Due to Failure to File Form 8832. ................................................................ 5-27

IRS Updates LLC Publication In June 2016 ..................................................................... 5-28

TD 9771; Reg. 1.108-9 (6/10/2016) -- Final Regulations on COD Exclusion for Disregarded Entities and Partners ..................................................................................... 5-28

Partner’s Outside Basis Reported on Form 8971, Sch. A ................................................ 5-29

AM 2016-001 (April 15, 2016) – Chief Counsel Reverses Tough Stance on “Bad Boy” Loan Guarantees .................................................................................................................. 5-33

Route 231, LLC, (CA 4 1/8/2016) – Fourth Circuit Affirms Tax Court’s Holding of Partnership’s Disguised Sale of State Tax Credits ........................................................... 5-34

TIFD III-E Inc. v. U.S., (CA 2 1/24/2012), the Supreme Court Declined to Review the Second Circuit’s 2012 Decision on January 11, 2016. ...................................................... 5-37


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McNeill v. U.S., (CA 10 9/6/2016) – Reasonable Cause/Good Faith Defense Can Be Pursued at Partner Level .................................................................................................... 5-39

LTR 201608005 (Released 2/19/2016) – Construction Contract Obligations are Section 752 Debt Which Increase a Partner’s Outside Basis ........................................................ 5-40

T.D. 9748, 02/03/2016, Reg. § 1.704-1T and Prop Reg § 1.704-1 -- Temp. Regs. On Partnership's Allocation of Creditable Foreign Tax Expenditures ................................ 5-41

Pitts v. U.S., (CA 9 9/2/2016) -- Ninth Circuit Finds Partner Liable For Partnership's Unpaid Employment Taxes ................................................................................................. 5-42

PLR 201608011 (released 2/19/2016) -- Publicly Traded Partnership's Income From Fluid Management Services Was Qualifying Income....................................................... 5-43

JCT “General Explanation of Tax Legislation Enacted in 2015” Provides New Details on New Partnership Audit Regime (3/14/2016) ...................................................................... 5-43

Joint Committee on Taxation (JCT) Explanation (March 2016) ................................. 5-44

Repeal of TEFRA and electing large partnership rules ............................................... 5-44

In General.......................................................................................................................... 5-44

Determination at partnership level ................................................................................. 5-44

Election out ........................................................................................................................ 5-44

Requirement of consistency with partnership return ................................................... 5-47

Partners bound by actions of partnership; designation of partnership representative .................................................................................................................... 5-47

Partnership Adjustments ................................................................................................. 5-48

Partnership adjustments by the Secretary .................................................................... 5-48

Alternative to payment of imputed underpayment by partnership ........................... 5-52

Administrative adjustment request by partnership ..................................................... 5-54

Interest and penalties ....................................................................................................... 5-57

Judicial review of partnership adjustment .................................................................... 5-57

Period of limitations on making adjustments ................................................................ 5-57

Definitions and Special Rules .......................................................................................... 5-60

Related provisions ............................................................................................................ 5-62

Effective Date .................................................................................................................... 5-63

T.D. 9780, Temp. Reg. 301.9100-22T, Prop. Reg. 301.9100-22 (08/04/2016) -- How to Elect Into The New Partnership Audit Rules .................................................................... 5-64


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TD 9787; Regs. 1.707-4, -5, -6, -9; 1.752-3 and TD 9788; Regs. 1.707-5, -9; 1.752-2; 1.707-5T, -9T; 1.752-2T (10/5/2016) –

Final and Temp. Regs. on Disguised Sales, Bottom Dollar Guarantees, Etc. The final, temporary and proposed regulations address several aspects of the disguised sale rules, target “bottom-dollar” guarantees, and make several other changes, ordering rules, tiered-partnership rules, and a new rules addressing preformation capital expenditure reimbursements. Disguised Sale Debt Share. The temporary and final regulations generally treat all partnership debt as nonrecourse (excess nonrecourse debt under Reg. 1.752-3(a)(3)), for purposes of the disguised sale rules that must be allocated, solely in accordance with the partners’ allocable share of partnership profits. The significant item method, alternative method, and additional method of allocating excess nonrecourse debt do not apply to disguised sales. A partner's share of a partnership debt for disguised sale purposes does not include any amount of the debt for which another partner (i.e., a partner other than the contributing partner), bears the economic risk of loss (EROL) for the partnership debt under Reg. 1.752-2. This change will apply to any transaction in which all transfers occur on or after January 3, 2017. For a partnership that has a single profit allocation ratio throughout the life of the partnership, the application of the new rule will be relatively simple. However, for partnerships with guaranteed payments to partners under section 707(c) (preferred returns), and profit shares that flip or shift, the new rule requires further clarification. The preamble to the reproposed section 752 regulations mention that Treasury recognizes the need for further guidance regarding reasonable methods for determining a partner’s share of partnership profits under Reg. 1.752–3(a)(3) for disguised sale purposes and request comments regarding possible safe harbors and reasonable methods that can be used. The major impact of these new rules is that any disproportionate (relative to profit share) leveraged distribution may trigger gain to the extent the debt is incurred in connection with a property contribution to, or distribution from, a partnership (i.e., a disguised sale). See Reg. 1.707-5T(f) Examples (2) and (3), below, for an illustration.

Observation: Existing Reg. 1.707-3(c)(2) requires a partner (“the transferor of property”) to attach Form 8275, Disclosure Statement, to his or her return if

The partner contributes property to a PSP, the PSP transfers money or other consideration to the partner within 2 years before or

after the contribution, the partner treats the transfers as something other than a sale, and the transfer of money or other consideration is not presumed to be a guaranteed

payment for capital, is not a reasonable preferred return, and is not an operating cash flow distribution.

“If more than one partner transfers property to a partnership pursuant to a plan, the disclosure …may be made by the partnership on behalf of all the transferors rather than by each transferor separately.” (Reg. 1.707-8(c))




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Temp. Reg. Examples of Disguised Sales. Reg. 1.707-5T(f) Example 2 (modified), Partnership's Assumption of Recourse Liability Encumbering Transferred Property. C transfers property Y to a partnership in which C has a 50 percent interest. At the time of its transfer to the partnership, property Y has a fair market value of

$10,000,000 and is subject to an $8,000,000 liability that C incurred and guaranteed, immediately before transferring property Y to the partnership, in order to finance other expenditures.

Upon the transfer of property Y to the partnership the partnership assumed the liability encumbering that property.

Under section 752 and the regulations thereunder, immediately after the partnership's assumption of the liability encumbering property Y, the liability is a recourse liability of the partnership and C's share of that liability is $8,000,000.

Under the facts of this example, the liability encumbering property Y is not a qualified liability.

Accordingly, the partnership's assumption of the liability results in a transfer of consideration to C in connection with C's transfer of property Y to the partnership.

Notwithstanding C's share of the liability for section 752 purposes, for disguised sale purposes, C's share of the liability immediately after the partnership's assumption is $4,000,000 (50 percent of $8,000,000) under paragraph (a)(2) of this section (which determines a partner's share of a liability using the percentage under §1.752-3(a)(3)).

Therefore, the amount of consideration to C is $4,000,000 (the excess of the liability assumed by the partnership ($8,000,000) over C's share of the liability for purposes of §1.707-5(a) immediately after the assumption ($4,000,000)). See §1.707-5(a)(1) and paragraph (a)(2) of this section.

Reg. 1.707-5T(f) Example 3 (modified), Subsequent Reduction of Transferring Partner's Share of Liability. The facts are the same as in Example 2. In addition, property Y is a fully leased office building, the rental income from property Y is

sufficient to meet debt service, and the remaining term of the liability is ten years. It is anticipated that, three years after the partnership's assumption of the liability, C's share

of the liability under paragraph (a)(2) of this section will be reduced to $2,000,000 because of a shift in the allocation of partnership profits pursuant to the terms of the partnership agreement which provide that C's share of the partnership profits will be 25 percent at that time.

Under the partnership agreement, this shift in the allocation of partnership profits is dependent solely on the passage of time.

Under §1.707-5(a)(3), if the reduction in C's share of the liability was anticipated at the time of C's transfer, was not subject to the entrepreneurial risks of partnership operations, and was part of a plan that has as one of its principal purposes minimizing the extent of sale treatment under §1.707-3 (that is, a principal purpose of allocating a larger percentage of profits to C in the first three years when profits were not likely to be realized was to minimize the extent to


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which C's transfer would be treated as part of a sale), C's share of the liability immediately after the partnership's assumption is treated as equal to C's reduced share of $2,000,000.

Therefore, the amount of consideration to C is $6,000,000 (the excess of the liability assumed by the partnership ($8,000,000) over C's share of the liability for purposes of §1.707-5(a) immediately after the assumption ($2,000,000)), taking into account the anticipated reduction in C's share of the liability pursuant to the terms of the partnership agreement. See §1.707-5(a)(1) and (3) and paragraph (a)(2) of this section.

Bottom-Dollar Guarantees. The standard understanding of a “bottom-dollar” guarantee is one in which a partner guarantor is liable to the lender for a portion of the debt only to the extent the lender cannot first collect at least a certain guaranteed amount from the borrower partnership. For example, if ABC LLC/partnership borrows $1,000 from Bank, and partner B guarantees payment of up to $200, but only if the Bank otherwise recovers less than $200, then that is a “bottom dollar” guarantee. Once the bank collects $200 of the $1,000 partnership debt, the bottom dollar guarantee is inapplicable. Treasury believes that “bottom-dollar” guarantees should generally not be recognized as payment obligations because they lack a significant non-tax commercial business purpose. The temporary section 752 regulations “[i]n response to comments, clarify the description of so-called "bottom-dollar guarantees and indemnities" by consolidating these noncommercial obligations under one term: bottom-dollar payment obligations [BDPOs]”:

[T]he term ‘bottom dollar payment obligation’ includes (subject to certain exceptions): (1) any payment obligation other than one in which the partner or related person is or would be liable up to the full amount of such partner's or related person's payment obligation if, and to the extent that (A) any amount of the partnership liability is not otherwise satisfied in the case of an obligation that is a guarantee or other similar arrangement, or (B) any amount of the indemnitee's or benefited party's payment obligation is satisfied in the case of an obligation which is an indemnity or similar arrangement; and (2) an arrangement with respect to a partnership liability that uses tiered partnerships, intermediaries, senior and subordinate liabilities, or similar arrangements to convert what would otherwise be a single liability into multiple liabilities if, based on the facts and circumstances, the liabilities were incurred (A) pursuant to a common plan, as part of a single transaction or arrangement, or as part of a series of related transactions or arrangements, and (B) with a principal purpose of avoiding having at least one of such liabilities or payment obligations with respect to such liabilities being treated as a bottom dollar payment obligation. Any payment obligation under §1.752-2, including an obligation to make a capital contribution and to restore a deficit capital account upon liquidation of the partnership as described in §1.704-1(b)(2)(ii)(b)(3), may be a bottom dollar payment obligation if it meets the requirements set forth above. (Temp. Reg. Preamble)

Anti-Abuse Rule. “The 752 Temporary Regulations also provide an anti-abuse rule in §1.752-2T(j)(2) that the Commissioner may apply to ensure that if a partner actually bears EROL for a partnership liability, partners may not agree


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among themselves to create a bottom dollar payment obligation so that the liability will be treated as nonrecourse.” (Temp. Reg. Preamble)

See Reg. 1.752-2T Examples (10) and (11), below, for an illustration.

Exception for Vertical Slice Guarantees:

The Treasury Department and the IRS agree with the commenters that certain obligations, including a vertical slice of a partnership liability, should not cause a payment obligation to be a bottom dollar payment obligation and, thus, not recognized under §1.752-2(b)(3). In addition, the Treasury Department and the IRS have determined that, as long as a partner or related person is or would be liable for the full amount of a payment obligation, such obligation is not a bottom dollar payment obligation merely because a maximum amount is placed on the partner's or related person's obligation. Accordingly, the 752 Temporary Regulations specifically except certain payment obligations within those parameters, including obligations with joint and several liability, from being treated as bottom dollar payment obligations. (Temp. reg. preamble)

For example, a partnership borrowed $1,000, and a partner guaranteed 25% of every dollar of the loan. If the bank did not recover say $250 of the $1,000 partnership liability, the partner would only be obligated to pay $62.50 (25% of $250) pursuant to the terms of the guarantee. Vertical slice guarantees differ from a pure bottom-dollar guarantee in that the partner must pay at least something for even the first dollar the bank loses. 90% Exception:

The 752 Temporary Regulations provide an exception if a partner or related person has a payment obligation that would be recognized (initial payment obligation) under §1.752-2T(b)(3) [EROL] but for the effect of an indemnity, reimbursement agreement, or similar arrangement. Such bottom dollar payment obligation is recognized under §1.752-2T(b)(3) if, taking into account the indemnity, reimbursement agreement, or similar arrangement, the partner or related person is liable for at least 90 percent of the initial payment obligation. This obligation, like any other payment obligation, must otherwise be recognized under §1.752-2, including under the anti-abuse rules in §1.752-2(j). (Temp. reg. preamble)

Disclosure Requirement on IRS Form 8275:

The 752 Temporary Regulations require the partnership to disclose to the IRS all bottom dollar payment obligations [BDPOs] with respect to a partnership liability on a completed Form 8275, Disclosure Statement, attached to the partnership return for the taxable year in which the bottom


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dollar payment obligation is undertaken or modified. That disclosure must identify the payment obligation with respect to which disclosure is made including the amount of the payment obligation and the parties to the payment obligation. If a bottom dollar payment obligation meets the exception, the partnership must also disclose to the IRS on Form 8275 the facts and circumstances that clearly establish that a partner or related person is liable for up to 90 percent of the partner's or related person's initial payment obligation and, but for an indemnity, reimbursement agreement, or similar arrangement, the partner's or related person's payment obligation would have been recognized. (Temp. Reg. Preamble)

Observation: Because “vertical slice” and “top dollar” guarantees are excluded from the definition of bottom dollar payment obligations, no disclosure is required with respect to such guarantees. Vertical slice guarantees are likely to replace bottom dollar guarantees for LLC member/partners who wish to have debt share outside basis (section 752) and minimize the impact of the partnership defaulting on the debt.

Bottom Dollar Guarantee Examples in Reg. 1.752-2T: Example 10 (Modified). Guarantee of first and last dollars. A, B, and C are equal members of a limited liability company, ABC, that is treated as a

partnership for federal tax purposes. ABC borrows $1,000 from Bank. A guarantees payment of up to $300 of the ABC liability if any amount of the full $1,000

liability is not recovered by Bank [a “top dollar” guarantee]. B guarantees payment of up to $200, but only if the Bank otherwise recovers less than $200

[a “bottom dollar” guarantee]. Both A and B waive their rights of contribution against each other.

Partner A: Because A is obligated to pay up to $300 if, and to the extent that, any amount of the

$1,000 partnership liability is not recovered by Bank, A's guarantee is not a bottom dollar payment obligation.

Therefore, A's payment obligation is recognized. The amount of A's economic risk of loss (EROL) under §1.752-2(b)(1) is $300. Partner B: Because B is obligated to pay up to $200 only if and to the extent that the Bank otherwise

recovers less than $200 of the $1,000 partnership liability, B's guarantee is a bottom dollar payment obligation and, therefore, is not recognized.

Accordingly, B bears no economic risk of loss (EROL) for ABC's liability. Conclusion: In sum, $300 of ABC's liability is allocated to A under §1.752-2(a) [recourse debt], and

the remaining $700 liability is allocated to A, B, and C under §1.752-3 [nonrecourse debt].

Example 11 (Modified). Indemnification of Guarantees.


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The facts are the same as in Example 10, except that, in addition, C agrees to indemnify A up to $100 that A pays with respect to its guarantee and agrees to indemnify B fully with respect to its guarantee.

The determination of whether C's indemnity is recognized is made without regard to whether C's indemnity itself causes A's guarantee not to be recognized.

Because A's obligation would be recognized but for the effect of C's indemnity and C is obligated to pay A up to the full amount of C's indemnity if A pays any amount on its guarantee of ABC's liability, C's indemnity of A's guarantee is not a bottom dollar payment obligation and, therefore, is recognized.

The amount of C's economic risk of loss (EROL) under §1.752-2(b)(1) for its indemnity of A's guarantee is $100.

Because C's indemnity is recognized, A is treated as liable for $200 only to the extent any amount beyond $100 of the partnership liability is not satisfied.

Thus, A is not liable if, and to the extent, any amount of the partnership liability is not otherwise satisfied

As a result, A's guarantee is a bottom dollar payment obligation and is not recognized. Therefore, A bears no economic risk of loss (EROL) under §1.752-2(b)(1) for ABC's

liability. Because B's obligation is not recognized independent of C's indemnity of B's guarantee, C's

indemnity is not recognized. Therefore, C bears no economic risk of loss (EROL) under §1.752-2(b)(1) for its indemnity

of B's guarantee. In sum, $100 of ABC's liability is allocated to C under §1.752-2(a) [recourse debt] and the

remaining $900 liability is allocated to A, B, and C under §1.752-3 [nonrecourse debt]. Final Reg. Effective date: The final regulations are effective for transfers occurring on or after the publication in the Federal Register (October 5, 2016). Temp. Reg. Effective Date. Per the Temp. Reg. Preamble:

With respect to changes under §1.707-5, the 707 Temporary Regulations [disguised sale rules] apply to any transaction with respect to which all transfers occur on or after [January 2, 2017]. In addition, with respect to the changes under §1.752-2, the 752 Temporary Regulations apply to liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken with respect to a partnership liability on or after [October 5, 2016], other than liabilities incurred or assumed by a partnership and payment obligations imposed or undertaken pursuant to a written binding contract in effect prior to that date. The 2014 Proposed Regulations provided for an effective date similar to the one in these final and temporary regulations. A commenter recommended that partnerships be permitted to elect to apply all, but not less than all, of the provisions of the final regulations to all of its liabilities and payment obligations with respect to its liabilities after the effective date of the final regulations. These 752 Temporary Regulations adopt that change; therefore, partnerships may apply all the provisions contained in the 752 Temporary Regulations to all of their


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liabilities as of the beginning of the first taxable year of the partnership ending on or after [October 5, 2016]. Commenters on the 2014 Proposed Regulations also recommended that partnership liabilities or payment obligations that are modified or refinanced continue to be subject to the provisions of the existing regulations to the extent of the amount and duration of the pre-modification (or refinancing) liability or payment obligation. The 752 Temporary Regulations do not adopt this recommendation as the terms of the partnership liabilities and payment obligations could be changed, which would affect the determination of whether or not an obligation is a bottom dollar payment obligation. The 752 Temporary Regulations do, however, provide transition relief for any partner whose allocable share of partnership liabilities under §1.752-2 exceeds its adjusted basis in its partnership interest on the date the temporary regulations are finalized. Under this transitional relief, the partner can continue to apply the existing regulations under §1.752-2 with respect to a partnership liability for a seven-year period to the extent that the partner's allocable share of partnership liabilities exceeds the partner's adjusted basis in its partnership interest on [October 5, 2016]. The amount of partnership liabilities subject to transitional relief will be reduced for certain reductions in the amount of liabilities allocated to that partner under the transition rules and, upon the sale of any partnership property, for any tax gain (including section 704(c) gain) allocated to the partner less that partner's share of amount realized.

REG-122855-15 (Oct. 5, 2016)– Re-Proposed Regulations Address When PSP

Debt Is Recourse Debt and Deficit Restoration Obligations Background: The 2014 Proposed Regulations provided that a partner's or related person's obligation to make a payment with respect to a partnership liability (excluding those imposed by state law) will not be recognized for purposes of section 752 unless all of the following conditions are met: 1) the partner or related person is (A) required to maintain a commercially reasonable

net worth throughout the term of the payment obligation or (B) subject to commercially reasonable contractual restrictions on transfers of assets for inadequate consideration;

2) the partner or related person is required periodically to provide commercially reasonable documentation regarding the partner's or related person's financial condition;

3) the term of the payment obligation does not end prior to the term of the partnership liability;

4) the payment obligation does not require that the primary obligor or any other obligor with respect to the partnership liability directly or indirectly hold money or other liquid assets in an amount that exceeds the reasonable needs of such obligor;



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5) the partner or related person received arm's length consideration for assuming the payment obligation; and

6) the obligation is not a bottom dollar guarantee or indemnity (recognition factors). Proposed Reg. 1.752-2: Commenters expressed concerns with the all-or-nothing approach in the 2014 Proposed Regulations. IRS agreed, and moved the list of exclusive factors to an anti-abuse rule in §1.752-2(j). Under the anti-abuse rule, non-exclusive factors are weighed to determine whether a payment obligation should be respected. “[T]the presence or absence of any particular factor, in itself, is not necessarily indicative of whether or not a payment obligation is recognized under §1.752-2(b). Factors indicating plan to circumvent or avoid an obligation:

(A) The partner or related person is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment, including, for example, restrictions on transfers for inadequate consideration or distributions by the partner or related person to equity owners in the partner or related person. (B) The partner or related person is not required to provide (either at the time the payment obligation is made or periodically) commercially reasonable documentation regarding the partner's or related person's financial condition to the benefited party. (C) The term of the payment obligation ends prior to the term of the partnership liability, or the partner or related person has a right to terminate its payment obligation, if the purpose of limiting the duration of the payment obligation is to terminate such payment obligation prior to the occurrence of an event or events that increase the risk of economic loss to the guarantor or benefited party (for example, termination prior to the due date of a balloon payment or a right to terminate that can be exercised because the value of loan collateral decreases). This factor typically will not be present if the termination of the obligation occurs by reason of an event or events that decrease the risk of economic loss to the guarantor or benefited party (for example, the payment obligation terminates upon the completion of a building construction project, upon the leasing of a building, or when certain income and asset coverage ratios are satisfied for a specified number of quarters). (D) There exists a plan or arrangement in which the primary obligor or any other obligor (or a person related to the obligor) with respect to the partnership liability directly or indirectly holds money or other liquid assets in an amount that exceeds the reasonable foreseeable needs of such obligor. (E) The payment obligation does not permit the creditor to promptly pursue payment following a payment default on the partnership liability, or other


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arrangements with respect to the partnership liability or payment obligation otherwise indicate a plan to delay collection. (F) In the case of a guarantee or similar arrangement, the terms of the partnership liability would be substantially the same had the partner or related person not agreed to provide the guarantee. (G) The creditor or other party benefiting from the obligation did not receive executed documents with respect to the payment obligation from the partner or related person before, or within a commercially reasonable period of time after, the creation of the obligation. (Prop. Reg. 1.752-2(b)(3)(ii))

Deemed plan to circumvent or avoid an obligation:

Evidence of a plan to circumvent or avoid an obligation is deemed to exist if the facts and circumstances indicate that there is not a reasonable expectation that the payment obligor will have the ability to make the required payments if the payment obligation becomes due and payable. For purposes of this section, a payment obligor includes an entity disregarded as an entity separate from its owner…. (Prop. Reg. 1.752-2(b)(3)(iii))

Treasury withdraws §1.752-2 of the 2014 Proposed Regulations:

After consideration of the comments received on the 2014 Proposed Regulations, the Treasury Department and the IRS are reconsidering the rules under section 752 regarding payment obligations that are recognized under §1.752-2(b)(3), the satisfaction presumption under §1.752-2(b)(6), the anti-abuse rule provided in §1.752-2(j), and the net value requirement as provided in §1.752-2(k). Accordingly, the Treasury Department and the IRS are withdrawing §1.752-2 of the 2014 Proposed Regulations and publishing these new proposed regulations that would amend existing regulations under sections 704 and 752. (Preamble)

Examples in Prop. Reg. 1.752-2(b)(4): Example 1. Gratuitous guarantee (modified).

In 2016, A, B, and C form a domestic limited liability company (LLC) that is classified as a partnership for federal tax purposes.

Also in 2016, LLC receives a loan from a bank. A, B, and C do not bear the economic risk of loss with respect to that partnership liability, and, as a result, the liability is treated as nonrecourse under §1.752-1(a)(2) in 2016.

In 2018, A guarantees the entire amount of the liability. The bank did not request the guarantee and the terms of the loan did not change as

a result of the guarantee. A did not provide any executed documents with respect to A's guarantee to the

bank. The bank also did not require any restrictions on asset transfers by A and no such

restrictions exist.


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A's 2018 guarantee (payment obligation) is not recognized if the facts and circumstances evidence a plan to circumvent or avoid the payment obligation.

In this case, the following factors indicate a plan to circumvent or avoid A's payment obligation:

1) the partner is not subject to commercially reasonable contractual restrictions that protect the likelihood of payment, such as restrictions on transfers for inadequate consideration or equity distributions;

2) the partner is not required to provide (either at the time the payment obligation is made or periodically) commercially reasonable documentation regarding the partner's or related person's financial condition to the benefited party;

3) in the case of a guarantee or similar arrangement, the terms of the liability are the same as they would have been without the guarantee; and

4) the creditor did not receive executed documents with respect to the payment obligation from the partner or related person at the time the obligation was created.

Absent the existence of other facts or circumstances that would weigh in favor of respecting A's guarantee, evidence of a plan to circumvent or avoid the obligation exists and, A's guarantee is not recognized.

As a result, LLC's liability continues to be treated as nonrecourse. Example 2. Underfunded disregarded entity payment obligor (modified).

In 2016, A forms a wholly owned domestic limited liability company, LLC, with a contribution of $100,000. A has no liability for LLC's debts, and LLC has no enforceable right to a contribution from A.

LLC is a treated for federal tax purposes as a disregarded entity. Also in 2016, LLC contributes $100,000 to LP, a limited partnership with a

calendar year taxable year, in exchange for a general partnership interest in LP, and B and C each contributes $100,000 to LP in exchange for a limited partnership interest in LP.

The partnership agreement provides that only LLC is required to restore any deficit in its capital account.

On January 1, 2017, LP borrows $300,000 from a bank and uses $600,000 to purchase nondepreciable property.

The $300,000 is secured by the property and is also a general obligation of LP. LP makes payments of only interest on its $300,000 debt during 2017.

LP has a net taxable loss in 2017, and, under §§1.705-1(a) and 1.752-4(d), LP determines its partners' shares of the $300,000 debt at the end of its taxable year, December 31, 2017.

As of that date, LLC holds no assets other than its interest in LP. Because LLC is a disregarded entity, A is treated as the partner in LP for federal

income tax purposes. Only LLC has an obligation to make a payment on account of the $300,000 debt

if LP were to constructively liquidate. Therefore, paragraph (j)(3)(iii) of this section is applied to the LLC and not to A.


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LLC has no assets with which to pay if the payment obligation becomes due and payable.

As such, evidence of a plan to circumvent or avoid the obligation is deemed to exist and, LLC's obligation to restore its deficit capital account is not recognized.

As a result, LP's $300,000 debt is characterized as nonrecourse under §1.752-1(a)(2) and is allocated among A, B, and C under §1.752-3.

Preamble Comments with Respect to DROs:

The 2014 Proposed Regulations applied the list of recognition factors [discussed above] … to all payment obligations under §1.752-2(b), including a DRO, as provided under the section 704(b) regulations. Commenters explained that not all of the recognition factors could be satisfied with respect to a DRO. In addition, commenters suggested that the regulations under section 704(b) be amended to clarify that if a DRO is not given effect under section 752, it should not be given effect under section 704(b). A DRO is an obligation to the partnership that is imposed by the partnership agreement. In contrast, a guarantee or indemnity is a contractual obligation outside the partnership agreement. As a result of this difference and based on the comments on the 2014 Proposed Regulations, the proposed regulations refine the list of factors applicable to DROs and clarify the interaction of section 752 with section 704 regarding DROs. Under §1.704-1(b)(2)(ii)(c)(2) of the existing regulations, a partner's DRO is not respected if the facts and circumstances indicate a plan to circumvent or avoid the partner's DRO. These proposed regulations add a list of factors to §1.704-1(b)(2)(ii)(c) that are similar to the factors in the proposed anti-abuse rule under §1.752-2(j), but specific to DROs, to indicate when a plan to circumvent or avoid an obligation exists. Under the proposed regulations, the following factors indicate a plan to circumvent or avoid an obligation: (1) the partner is not subject to commercially reasonable provisions for enforcement and collection of the obligation; (2) the partner is not required to provide (either at the time the obligation is made or periodically) commercially reasonable documentation regarding the partner's financial condition to the partnership; (3) the obligation ends or could, by its terms, be terminated before the liquidation of the partner's interest in the partnership or when the partner's capital account as provided in §1.704-1(b)(2)(iv) is negative; and (4) the terms of the obligation are not provided to all the partners in the partnership in a timely manner. Notwithstanding the proposed factors, the Treasury Department and the IRS have concerns with whether and to what extent it is appropriate to recognize DROs (and certain partner notes treated as DROs) as meaningful payment obligations. Many DROs are triggered only on the liquidation of a partnership. However, some partnerships are intended to have perpetual life and other partnerships can effectively cease operations but not actually liquidate; therefore, a partner's DRO may never be required to be satisfied. In addition, some DROs can be terminated


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or significantly reduced in a manner that may not be appropriate, and therefore, the DRO similarly may never be triggered. The Treasury Department and the IRS request comments on the extent to which such DROs should be recognized. In addition, certain partner notes are treated as DROs under §1.704-1(b)(2)(ii)(c)(1) and (3) of these proposed regulations. The Treasury Department and the IRS also request comments concerning whether these obligations should continue to be treated as DROs.

Proposed Applicability Dates Per the Preamble: The amendments to §1.704-1 are proposed to apply on or after the date these regulations are published as final regulations in the Federal Register. The amendments to §1.752-2 are proposed to apply to liabilities incurred or assumed by a partnership and to payment obligations imposed or undertaken with respect to a partnership liability on or after the date these regulations are published as final regulations in the Federal Register. Partnerships and their partners may rely on these proposed regulations prior to the date they are published as final regulations in the Federal Register. However, the rules in §1.752-2(k) still apply to disregarded entities until the proposed regulations are published as final regulations in the Federal Register. (Emphasis added) Some commenters were concerned that the 2014 Proposed Regulations "delinked" the regulations under sections 704 and 752 concerning DROs, that is, that a DRO may somehow still be recognized under section 704 despite not meeting the requirements to be recognized as a payment obligation under section 752. DROs are subject to the bottom dollar payment obligation rules in the 752 Temporary Regulations, but the rules in these proposed regulations concerning DROs will not be effective prior to the date they are published as final regulations in the Federal Register. However, these proposed regulations allow partnerships and their partners to rely on the proposed regulations, which should address this concern.

Khoury, California SBE, Case Nos. 867810, 867855, 867874 (9/23/2016) -- Installment Sale Treatment Allowed on Sale to Related PSP

Facts per the SBE: “Appellants Brian Khoury, Jason Khoury, and Noelle Ludwig (Siblings) are the adult children of Tawfiq N. and Richel G. Khoury (Grandparents). Grandparents are the founders of the Pacific Scene Family of Companies (Pacific Scene), a group of family-owned real estate companies.” “In summary, in the transaction at issue, NBJ Associates L.P. (NBJ) sold its limited partnership interest in RSD Group L.P. (RSD) to Sundance-K, LP (Sundance-K) in return for $10,000 in cash and a $14,750,000 note (RSD Interest Sale).”


http://www.boe.ca.gov/meetings/pdf/hearingsummaries/2016/B_Khoury_Brian_N_867810_et_al_Sect40_Sum_071416.pdf

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“The Siblings each owned a 33-percent interest in NBJ. An S corporation that was wholly owned by the Siblings served as NBJ’s general partner and held the remaining 1-percent interest in NBJ. Until the RSD Interest Sale, the Siblings held an interest in RSD through NBJ. The Siblings also held indirect interests in RSD through its other partners. The Khoury Family 1999 Irrevocable Trust, which was formed to benefit appellants’ children, owned an 80-percent limited partnership interest in Sundance-K. The Siblings owned the general partner of Sundance-K, which owned the remaining interest in Sundance-K. The Siblings’ interests were held through disregarded grantor trusts.” “Shortly after [the sale of RSD to Sundance-K], RSD sold the Club Pacifica Apartments in El Cajon, California (RSD Property) to an unrelated third party (RSD Property Sale).” “To provide more background, on or about December 6, 2005, RSD contracted to sell the Club Pacifica Apartments. On or about January 3, 2006, NBJ sold its interest in RSD to Sundance-K in return or a $14,750,000 installment note issued by Sundance-K and $10,000 in cash. Of the $14,750,000 amount due on the note, $490,000 was due on February 1, 2006, and was paid on or about that date. The remaining $14,260,000 was due in thirty years, on January 3, 2036, with monthly interest-only payments of $60,000 (a five-percent rate) due and paid beginning March 1, 2006. Pursuant to an Internal Revenue Code (IRC) section 754 election, Sundance-K’s share of the partnership’s basis in the property was increased by $17,529,480. On February 7, 2006, the RSD Property Sale closed. The gain and sale proceeds were allocated and subsequently distributed to the partners of RSD. As a result of the IRC section 754 election, Sundance-K, which now held the partnership interest that had formerly been held by NBJ, had $223,558 of allocated net gain. On February 28, 2006, RSD distributed $14,504,490 in proceeds from the RSD Property Sale to Sundance-K and, on July 7, 2006, it distributed an additional $351,698 to Sundance-K. Sundance-K then used substantially all of the proceeds to extend interest-bearing loans to other entities. On and following March 1, 2006, Sundance-K paid the $60,000 monthly interest-only payments which were due on the installment note, which NBJ reported as taxable income.” (Emphasis added) Issue #1: “Whether appellants’ installment sale transaction should be disallowed under the economic substance doctrine or other judicial standards.” “Appellants recognized taxable gain through their interest in NBJ when it received the initial principal payment in the installment note, and also recognized a share of the gain realized on the sale of the RSD Property through their interests in other entities investing in RSD. The Grandparents also recognized taxable gain due to their interest in another entity investing in RSD. Instead of seeking to avoid tax, appellants agreed to a transaction in which they and their parents incurred significant tax in the year at issue and would pay tax in the future as payments were made.” “Through the transaction, proceeds from the RSD Property Sale that would have been received by an entity in which the Siblings owned a 99-percent interest (i.e., NBJ) were, instead, distributed to a limited partnership (Sundance-K) in which an irrevocable family trust held an 80-percent economic interest. The trust had been established years prior to the transaction at issue to ensure a legacy for the children of the Siblings (i.e., TNK’s grandchildren), and had an


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independent bank trustee. Through the use of the installment note, the transaction effectively placed the Siblings on an allowance and ensured that the sale proceeds attributable to the RSD Interest were invested for the benefit of the next generation. Thus, the structure of the transaction evidences the stated estate-planning motivation of setting aside funds for the next generation” “Rather than constituting a tax-motivated sale to an alter ego of NBJ or appellants, the installment sale of the RSD Interest constituted a sale to a separate economic entity that was managed for the benefit of an irrevocable trust with an independent trustee. “ The SBE concluded that “we do not find a sufficient basis to disallow installment sale treatment based on judicial doctrines such as the economic substance doctrine or cases such as Rushing and Roberts [discussed in the holding]. Issue #2. “Whether IRC section 453(e) applies to disallow installment sale treatment.” In pertinent part, IRC section 453(e)(1), provides as follows: If –

(A) any person disposes of property to a related person [as defined in IRC section 453(f)(1)] (hereinafter in this subsection referred to as the “first disposition”), and

(B) before the person making the first disposition receives all payments with respect to such disposition, the related person disposes of the property (hereinafter in this subsection referred to as the ‘second disposition’), then, for purposes of this section, the amount realized with respect to such second disposition shall be treated as received at the time of the second disposition by the person making the first disposition.

Per the SBE: “Thus, IRC section 453(e)(1) generally disallows installment sale treatment where there is a disposition of property (‘first disposition’) and, before all payments have been made for the property, the property is sold to a related party (“second disposition”). However, pursuant to IRC section 453(e)(7), the provision ‘shall not apply to a second disposition . . . if it is established to the satisfaction of the Secretary that neither the first disposition nor the second disposition had as one of its principal purposes the avoidance of Federal income tax.’ Also, pursuant to IRC section 453(e)(2)(A), and subject to exceptions that are not relevant here, installment sale treatment is not disallowed if the second disposition is “not more than 2 years after the date of the first disposition.” “Respondent argued that, for purposes IRC section 453(e), there was an initial disposition of the RSD Interest by NBJ that was followed, within two years, by a second disposition of the RSD Interest to Sundance-K, which respondent contended was a related party. Respondent argued that the second disposition occurred when Sundance-K received distributions from RSD of its share of proceeds from the RSD Property Sale. Specifically, respondent asserted that, while the distributions from RSD were not called a liquidation of the RSD Interest, they constituted a disposition of the RSD Interest for purposes of IRC section 453(e) because they effectively


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allowed NBJ and Sundance-K to a “cash out” of appreciation that had occurred in the RSD Interest.” “Even if we accepted all of the above arguments, and we do not, IRC section 453(e) does not apply if appellants did not have as one of their principal purposes the avoidance of tax. Based on the findings of fact and analysis outlined in our discussion of business purpose under Legal Issue 2, we find that appellants did not have as one of their principal purposes the avoidance of tax. Consequently, IRC section 453(e) is not applicable, and we need not discuss further the issues of whether Sundance-K and NBJ were related or whether there was a second disposition of the RSD Interest for purposes of IRC section 453(e).” Issue #3: “Whether the partnership anti-abuse rule applies to appellants’ transaction.” Per the SBE: “Based on the findings of fact and analysis outlined in our discussion of business purpose under [issue #1 above], we find that the avoidance of tax was not a principal purpose of the sale of the RSD Interest. Accordingly, as the anti-abuse rule requires a principal purpose of tax avoidance, it is not applicable here.” In a parenthetical, the SBE also referred to Reg. 1.701-2(d), example 9 which states that ‘Congress clearly recognized that if the section 754 election were not made, basis distortions may result.’ Observation: Subject to concerns that a sale lacks economic substance or fails the anti-abuse rules (both are issues discussed in Khoury), the installment sale of a partnership interest (vs. installment sale of the underlying assets of the partnership) to a related party, seems to duck all of the normal statutory related party hurdles. Assume the underlying asset of the partnership is depreciable property. The transaction appears to conveniently avoid:

1) Section 453(e)(1), the two year resale prohibition at issue in Khoury 2) Section 453(g) which prohibits installment sales of depreciable property between

controlled related entities, including partnerships (a PSP interest is not depreciable property) if tax avoidance is a principal purpose.

3) Section 707(b)(2)(A) which forces ordinary income treatment on the sale of an asset to a controlled PSP if the property is "other than a capital asset" (a PSP interest is a capital asset).

4) Section 1239 which forces ordinary income when the property is sole to a controlled entity if it is depreciable in the hands of the transferee (a PSP interest is not depreciable in the hands of the transferee).

Refco Public Commodity Pool LP, (Bktcy Ct DE 8/2/2016) -- No $3.5 Mil.

Failure-To-File Penalty For Upper Tiered Partnership. Bankruptcy Court summary:


http://www.deb.uscourts.gov/sites/default/files/opinions/judge-brendan-l.shannon/refco-tax-opinion-and-order.pdf

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“[Refco] asks this Court to disallow the amended proof of claim (the "Claim") filed by the Internal Revenue Service (the "IRS") and determine that [Refco] owes no tax or penalty under applicable tax law and Bankruptcy Code .... It is undisputed that that [Refco] failed to file its tax returns for the years 2006 to 2008; and that for such failure, [Refco] incurred penalties totaling $3,662,000. The question before the Court is whether these penalties should be waived under Internal Revenue Code ("IRC") sections 6724(a) and 6698(a)(1) because [Refco’s] failure to file was due to reasonable cause and not willful neglect. For the reasons set forth below, the Court holds that the penalties should be excused and will disallow the Claim.

Key Facts: Refco was formed in 2003 as a partnership to track the performance of the Standard & Poor's Managed Futures Index. Refco invested nearly all of its assets in SMFF, a Cayman Islands partnership (lower tiered partnership) that was part of the SPhinX Group. In June 2006, the SPhinX Group, including SMFF, voluntarily placed itself into liquidation in the Grand Court of the Cayman Islands (the Grand Court). Two individuals were appointed as liquidators (Liquidators). The Grand Court ordered the winding up of each of the funds in the SPhinX Group. The SPhinX Group also filed for U.S. bankruptcy and was “absolved from having to file Partnership Returns”:

“After 2005, SPhinX Group did not file Form 1065 with the IRS, or provide its investors with a Schedule K-1 (together, the "Partnership Returns"). In July 2011, the Liquidators filed a motion under Bankruptcy Code section 505 in its Chapter 15 proceeding seeking a determination that the SPhinX Group owed no penalties for not filing Partnership Returns for the years 2005 to 2007. In a declaration submitted with the motion, Mr. Krys noted that the Liquidators would not be filing Partnership Returns for any year after 2005. He explained that to prepare these returns would cost between $5 and $7 million because an accounting firm would have to reconstruct thousands of records. 4 The IRS and the Liquidators settled the matter and SPhinX Group was absolved from having to file Partnership Returns for the years 2005 to 2007.”

On May 13, 2014, Refco filed a voluntary Chapter 11 petition with the Bankruptcy Court. Refco’s “only material non-cash asset was its investment in SMFF”. The only issue before the Bankruptcy Court was whether Refco (the Debtor) had “reasonable cause” for failing to file its 2006-2008 partnership returns. The Bankruptcy Court articulated the “reasonable cause” test as follows:

“Although ‘reasonable cause’ is not defined under the IRC, the Treasury Regulations sets forth what a taxpayer must show to establish reasonable cause: a filer must prove that either (1) the failure was due to impediments that were beyond the filer's control, or (2) there were significant mitigating factors with respect to the failure to file. Treas. Reg. § 301.6724-1(a)(2)(i)-(ii). In addition to


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satisfying one of these prongs, a filer must also establish that it acted in a responsible manner both before and after the failure to file occurred. Id. § 301.6724-1(a). Case law teaches that the threshold inquiry is whether, based on all the facts and circumstances, the taxpayer exercised ordinary business care and prudence, but was still unable to file a return within the prescribed time. See, e.g., Estate of Thouron v. United States, 752 F.3d 311, 314 [113 AFTR 2d 2014-2082] (3d Cir. 2014); Sanderling, Inc. v. C.I.R., 571 F.2d 174, 179 [41 AFTR 2d 78-831] (3rd Cir. 1978).”

Bankruptcy Court reasoning with respect to Refco’s control over the failure to file:

“Here, the record reflects that events transpired outside of the Debtor's control such that it could not prepare reasonably accurate returns. As discussed in greater detail below, the Debtor was largely left at the whim of SMFF and its liquidation proceeding in the Cayman Islands. The Debtor invested nearly all of its money in SMFF and therefore relied on SMFF to provide it with a Schedule K-1. SMFF's Schedule K-1 provided essential information to the Debtor because it detailed the Debtor's share of income, deductions, and credits in SMFF. But after 2005, SMFF stopped supplying the Debtor with a Schedule K-1. The reasons SMFF failed to supply such information arose from events unrelated to the Debtor; namely, SMFF entering liquidation proceedings and the Liquidators uncovering material inaccuracies in SPhinX Group's accounting records.”

SPhinX Group's books and records were in “disarray”:

“In submissions with the Grand Court, the Liquidators noted that SPhinX Group's records could not be relied upon due to, inter alia, co-mingling of funds, misstatements of cash and receivables, improper allocation of shares, failure to account for the Preference Settlement, and the failure to process redemptions.”

The Bankruptcy Court viewed the situation as “entirely out of [Refco’s] control”:

“As an accrual method taxpayer, [Refco] cannot recognize income until "all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy." , Treas. Reg. §§ 1.451-1(a), (c)(1)(ii). With SMFF not providing Partnership Returns after 2005, the above-noted events prevented [Refco] from determining whether it had a fixed right to receive income from SMFF. The documents available from SMFF were the NAVINC Files and the Summary Financial Data, but this information was fraught with errors; and with respect to the Summary Financial Data in particular, entirely unhelpful because it only provided information on "receipts" and "proceeds" received, not "income." Thus, the Court concludes that [Refco’s] failure to file its Partnership Returns arose from events beyond its control.”

The Court also concluded that Refco fit within the mitigating factors contemplated by Treas. Reg. 301.6724-1(a)(2)(i):


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“The Debtor has an established history, albeit brief, of timely filing its Partnership Returns and has not been penalized before due to not complying with the IRC. Id. § 301.6724-1(b)(2). The Treasury Regulations explicitly list such circumstances as mitigating factors. Id . Furthermore, the first time the Debtor did not file its returns coincided with the first year the SPhinX Group stopped sending investors Schedule K-1s and filed for liquidation-the very events this Court found qualify as impediments. Based on the totality of the circumstances, the Court holds that there are significant mitigating factors with respect to the Debtor's failure to file. See IRM 20.1.1.3.2 (Nov. 25, 2011) (‘Reasonable cause is based on all the facts and circumstances in each situation and allows the IRS to provide relief from a penalty that would otherwise be assessed.’).”

The Bankruptcy Court also determined that Refco “acted in a responsible manner by making concerted efforts to obtain the information necessary to prepare its Partnership Returns”:

“Ultimately, the inquiry under the responsible manner standard is not whether the Debtor undertook, or even considered, every conceivable option; rather, it is whether the Debtor exercised reasonable care under the circumstances. 15 Based on the evidence presented, the Debtor proved that it carefully considered its filing obligations and undertook appropriate steps in an effort to avoid the failure. Accordingly, the Court holds that the Debtor acted in a responsible manner both before and after the failure to file occurred.”

Finally, the Bankruptcy Court agreed with both parties “that this is not a case of a taxpayer failing to file a return due to willful neglect”:

Nothing in the record shows that the Debtor's failure to file resulted from carelessness or recklessness. The Debtor was fully aware of its filing obligations and took steps to comply with the tax laws. … [T]he Debtor reasonably declined to rely on the NAVINC Files and the Summary Financial Data. And the Debtor made repeated efforts to obtain the necessary information from the Liquidators to file its Partnership Returns. The Court therefore concludes that the Debtor has shown that the failure to file its Partnership Returns was not the result of willful neglect.

Lamas-Richie, TC Memo 2016-63 (April 11, 2016) -- Taxpayer Is A Partner Despite No Distributions Of Income And No Timely K-1

The taxpayer, a gossip blogger, was liable for income tax on his 41% distributive share of partnership income ($25,417) despite his testimony that he was not aware of the partnership income until the year at issue (2011) was later audited by the IRS:



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[Taxpayer] did not receive a copy of this Schedule K-1 and was not aware of the contents of [the partnership’s] Form 1065 until the IRS began its examination of his 2011 return. [Taxpayer] credibly testified that [the partnership] had never previously reported any net profit. The Schedule K-1 for 2011 shows no distributions to him.

Regardless, he has taxable on his distributive share of partnership income:

[Taxpayer] conceded at trial that he held a 41% limited partnership interest in [the partnership] during 2011, and his Schedule K-1 shows 41% as his distributive share of the partnership's profits. [The partnership] filed a Form 1065 reporting for 2011 ordinary business income of $61,992. This return was signed by … the controlling partner, and [taxpayer] has provided no reason to believe that this figure was incorrect. [Taxpayer] must report his 41% distributive share of [the partnership’s] profits, or $25,417, even though no distributions were made to him during 2011. See Chama v. Commissioner, T.C. Memo. 2001-253; Johnston v. Commissioner, T.C. Memo. 1984-374 (holding that each partner is taxed on his distributive share of partnership income without regard to whether the amount is actually distributed to him).

The Tax Court declined to impose accuracy-related penalties because the taxpayer believed himself to be an employee of the partnership and acted in good faith.

Hastings, TC Memo 2016-61 (4/5/2016) – No Basis for Contributed Services Until Taxed

The taxpayer formed a partnership but did not contribute any capital. Taxpayer agreed to forgo any salary until the LLC had sufficient cash flow. On his 2008 tax return, the taxpayer deducted his share of the LLC's losses ($39,142). On audit, the IRS disallowed the loss citing lack of sufficient outside basis. The Tax Court agreed, holding that tax basis does not include the value of services unless such services have been subject to tax. Per the Tax Court:

Generally, a partner's basis consists of contributions and transfers and may be increased by taxable income and reduced by distributions and losses of the partnership. Sec. 705. Although a partner's basis in a partnership may include the adjusted basis of property, basis does not include the value of services performed unless and until the value of those services has been subjected to taxation. Haff v. Commissioner, T.C. Memo. 2015-138, slip op. at *5 (citing Hutcheson v. Commissioner, 17 T.C. 14, 19 (1951)). Accordingly, petitioners have not shown they had any basis in [the partnership] and are not entitled to a deduction for the $39,142 partnership loss for 2008.



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Methvin v. Comm., (CA 10 6/24/2016)-- Tenth Circuit Finds Oil And Gas Ventures Were Partnerships Thus Distributive Share is SE Income

Circuit Court summary:

This appeal involves characterization of Mr. David H. Methvin's participation in certain oil and gas ventures. If Mr. Methvin's participation in those ventures constituted a partnership, he would have to pay a self-employment tax on the income he received from the ventures.See I.R.C. § 1402(a); Treas. Reg. § 1.1402(a)-2(d). The Tax Court determined that Mr. Methvin's participation in the ventures qualified as a partnership. As a consequence, the Tax Court concluded that Mr. Methvin owed the Internal Revenue Service $690 for self-employment tax based on his 2011 income. Mr. Methvin appeals, and we affirm. Mr. Methvin owns working interests of 2-3% in various oil and gas ventures. For these ventures, Mr. Methvin entered into both a purchase agreement and an operating agreement with the operator. For the 2011 tax year, the operator designated Mr. Methvin's income as nonemployee compensation and did not send a Schedule K-1 (for partner income) to Mr. Methvin. Mr. Methvin paid federal income taxes on his 2011 income, but he did not pay a self-employment tax on his income from the oil and gas ventures. The Tax Court determined that Mr. Methvin's arrangement with the operator constituted a partnership under the Internal Revenue Code. On that basis, the Tax Court concluded that Mr. Methvin should have paid a self-employment tax based on his income from the oil and gas ventures.

The Tenth Circuit upheld the Tax Court's finding that the arrangement constituted a partnership.

CCA 201640014 (released 9/30/2016) – Franchisee/Operating Manager and LLC member is Not a Limited Partner Says Chief Counsel

Issue, per the IRS:

Whether Franchisee, the Operating Manager, President, and Chief Executive Officer of Partnership, a partnership which operates restaurants, is a ‘limited partner’ exempt from self-employment tax under Internal Revenue Code § 1402(a)(13) on his distributive share of Partnership's income.

Key facts per IRS:

Partnership [state law LLC] treated Franchisee as a limited partner for purposes of §1402(a)(13), and included only the guaranteed payments in Franchisee's net earnings from self-employment, not his full distributive share. Partnership's position is that Franchisee's income from Partnership should be bifurcated for


https://www.ca10.uscourts.gov/opinions/15/15-9005.pdf


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self-employment tax purposes between Franchisee's (1) income attributable to capital invested or the efforts of others, which is not subject to self-employment tax, and (2) compensation for services rendered, which is subject to self-employment tax. Partnership asserts that, as a retail operation, Partnership requires capital investment for buildings, equipment, working capital and employees, and states that, in the years at issue, it spent approximately $N in fixed asset additions. Partnership notes that Franchisee and Partnership have made significant capital outlays to acquire and maintain the restaurants, and argues that Partnership derives its income from the preparation and sale of food products by its J employees, not the personal services of Franchisee. Partnership asserts that the Franchisee has a reasonable expectation for a return on his investment beyond his compensation from Partnership. Partnership argues that Franchisee's guaranteed payments represent "reasonable compensation" for his services, and that Franchisee's earnings beyond his guaranteed payments were earnings which were basically of an investment nature. Partnership cites to Brinks Gilson & Lione a Professional Corporation v. Commissioner, T.C. Memo 2016-20 , a case involving a corporation's deduction for compensation paid to employees who were also shareholders, for the propositions that Partnership's guaranteed payments to Franchisee are reasonable compensation for Franchisee's services, and that Franchisee's distributive share represents a reasonable return on the capital investments. Therefore, Partnership concludes that Franchisee is a limited partner for purposes of § 1402(a)(13) with respect to his distributive share.

IRS analysis:

Individual partners who are not limited partners are subject to self-employment tax regardless of their participation in the partnership's business or the capital-intensive nature of the partnership's business. The Tax Court decisions in Cokes v. Commissioner, 91 T.C. 222 (1988), Methvin v. Commissioner, T.C. Memo. 2015-81, and Perry v. Commissioner, T.C. Memo. 1994-215, all involved individuals who owned working interests in oil and gas joint ventures, but did not participate in the business operations. In each case, the Tax Court found that the joint ventures constituted partnerships for federal tax purposes and the petitioners were subject to self-employment tax on their earnings from the joint venture, notwithstanding the petitioners' lack of participation. In Renkemeyer, Campbell, and Weaver LLP v. Commissioner, 136 T.C. 137 (2011), the Tax Court ruled that practicing lawyers in a law firm organized as a Kansas limited liability partnership (LLP) were not limited partners within the meaning of §1402(a)(13) and thus were subject to self-employment taxes. The court discussed Kansas state law under which an LLP is considered a general partnership. The court discussed the ordinary meaning of the term "limited partnership." The court stated:

A limited partnership has two fundamental classes of partners, general and limited. General partners typically have management power and unlimited personal liability. On the other hand, limited partners lack management powers but enjoy immunity from


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liability for debts of the partnership.1 Bromberg & Ribstein, Partnership, sec. 1.01(b)(3) (2002-2 Supp.). Indeed, it is generally understood that a limited partner could lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the interest of a limited partner in a limited partnership is generally akin to that of a passive investor. See 3 Bromberg & Ribstein, supra sec. 12.01(a) (1988).

The IRS concludes that Franchisee is not a limited partner:

Franchisee is not a limited partner for purposes of § 1402(a)(13). As discussed above, the Renkemeyer Court reviewed the legislative history of §1402(a)(13) and concluded that § 1402(a)(13) was intended to apply to those who "merely invested" rather than those who "actively participated" and "performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons)." Renkemeyer, 136 TC at 150. The Renkemeyer Court explained that "the interest of a limited partner in a limited partnership is generally akin to that of a passive investor." Id. at 147, 148. And as the Riether Court stated, limited partners are those who "lack management powers but enjoy immunity from liability for debts of the partnership." Riether, 919 F.Supp.2d 1140, at 1159, 1160. Here, Franchisee has sole authority over Partnership, and is the majority owner, Operating Manager, President, and Chief Executive Officer with ultimate authority over every employee and each aspect of the business. Even though Partnership has many employees, including several executive-level employees, Franchisee is the only partner of Partnership involved with the business and is not a mere investor, but rather actively participates in the partnership's operations and performs extensive executive and operational management services for Partnership in his capacity as a partner (i.e., acting in the manner of a self-employed person). Therefore, the income Franchisee earns through Partnership is not income of a mere passive investor that Congress sought to exclude from self-employment tax when it enacted the predecessor to § 1402(a)(13).

Chief Counsel’s interpretation of Renkemeyer and other case law:

Although the Renkemeyer Court noted the partners' small capital contributions and service-generated income as factors influencing its decision that the partners in that case were not limited partners, Renkemeyer does not stand for the proposition that a capital-intensive partnership should be treated like a corporation for employment tax purposes. Instead, as the Tax Court has repeatedly held, partners who are not limited partners are subject to self-employment tax, even in cases involving capital-intensive oil and gas joint ventures where all of the work was performed by other parties. See Cokes, Methvin, and Perry. Under the Renkemeyer Court's interpretation of the legislative history, and consistent with the Court's holding in Riether, Franchisee is not a limited partner in Partnership within the meaning of § 1402(a)(13) and is subject to self-employment tax on his full distributive shares of Partnership's income described in § 702(a)(8).


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Observation: The CCA was originally written in 2014, but not published until 9/30/2016. A likely reason for the delay in publication was that Methvin was on appeal to the 10th Circuit (decided in June 2016 and discussed above) and the IRS relied upon Methvin, and much earlier cases, for its position that “the Tax Court has repeatedly held, partners who are not limited partners are subject to self-employment tax, even in cases involving capital-intensive oil and gas joint ventures where all of the work was performed by other parties.”

T.D. 9766, Reg. 301.7701-2T; Prop. Reg. 301.7701-2 (05/03/2016) -- Clarification of Employment Tax Rules Where Partnership Owns

Disregarded Entity Background. Reg. 301.7701-2(c)(2)(i) states that, except as otherwise provided, a business entity that has a single owner and is not a corporation is a disregarded entity. However, current reg. 301.7701-2(c)(2)(iv)(B) provides that a disregarded entity is treated as a corporation for purposes of employment taxes on the employees of the entity. As a result, the entity rather than the owner, is the employer subject to employment tax on the entity's employees. That said, the regulations make it clear that an individual owner of a single-member LLC (disregarded entity) is subject to tax on self-employment income.

Per the preamble to the temporary regulations:

It has come to the attention of the Treasury Department and the IRS that even though the regulations set forth a general rule that an entity is disregarded as a separate entity from the owner for self-employment tax purposes, some taxpayers may have read the current regulations to permit the treatment of individual partners in a partnership that owns a disregarded entity as employees of the disregarded entity because the regulations did not include a specific example applying the general rule in the partnership context. Under this reading, which was not intended, some taxpayers have permitted partners to participate in certain tax-favored employee benefit plans. (Preamble)

Treasury explains the current regulations and reiterates its view the partners are not employees of a partnership:

The Treasury Department and the IRS note that the regulations did not create a distinction between a disregarded entity owned by an individual (that is, a sole proprietorship) and a disregarded entity owned by a partnership in the application of the self-employment tax rule. Rather, §301.7701-2(c)(2)(iv)(C)(2) provides that the general rule of §301.7701-2(c)(2)(i) applies for self-employment tax purposes for any owner of a disregarded entity without carving out an exception regarding a partnership that owns such a disregarded entity. In addition, the Treasury Department and the IRS do not believe that the regulations alter the holding of Rev. Rul. 69-184, 1969-1 CB 256, which provides that: (1) bona fide members of a partnership are not employees of the partnership within the meaning of the Federal Insurance Contributions Act, the Federal Unemployment Tax Act, and the Collection of Income Tax at Source on Wages (chapters 21, 23, and 24,




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respectively, subtitle C, Internal Revenue Code of 1954), and (2) such a partner who devotes time and energy in the conduct of the trade or business of the partnership, or in providing services to the partnership as an independent contractor, is, in either event, a self-employed individual rather than an individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee. (Preamble)

Temporary (and Proposed) Regulations

The temporary regulations clarify:

[T]hat the rule that a disregarded entity is treated as a corporation for employment tax purposes does not apply to the self-employment tax treatment of any individuals who are partners in a partnership that owns a disregarded entity. The rule that the entity is disregarded for self-employment tax purposes applies to partners in the same way that it applies to a sole proprietor owner. Accordingly, the partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.

Prospective Effective Date

The regulations agree the new regulations prospectively:

In order to allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, these temporary regulations will apply on the later of: (1) August 1, 2016, or (2) the first day of the latest-starting plan year following May 4, 2016, of an affected plan (based on the plans adopted before, and the plan years in effect as of, May 4, 2016) sponsored by an entity that is disregarded as an entity separate from its owner for any purpose under §301.7701-2. For these purposes, an affected plan includes any qualified plan, health plan, or section 125 cafeteria plan if the plan benefits participants whose employment status is affected by these regulations. For rules that apply before the applicability date of these regulations, see 26 CFR part 301 revised as of April 1, 2016. (Preamble)

Treasury requests comments on when it may be appropriate to treat partners as employees:

The Treasury Department and the IRS request comments on the appropriate application of the principles of Rev. Rul. 69-184 to tiered partnership situations, the circumstances in which it may be appropriate to permit partners to also be employees of the partnership, and the impact on employee benefit plans (including, but not limited to, qualified retirement plans, health and welfare plans, and fringe benefit plans) and on employment taxes if Rev. Rul. 69-184 were to be modified to permit partners to also be employees in certain circumstances.


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LAFA 20161101F (released 3/11/2016) -- No Partnership Existed For Tax Purposes; No Risk Of Loss Or Chance Of Gain

In a heavily redacted Legal Advice Issued by Field Attorneys (LAFA), IRS concludes that a taxpayer's investment in an arrangement which was to provide the investor with section 45 refined coal production tax credits is not a bona fide partner/partnership relationship. The purported partner did not engage in a joint undertaking to operate a profitable refined coal facility because the partner's investment lacked “significant downside risk and any “significant upside potential”. Costello, LLC, TC Memo 2016-184 (9/29/2016) – SMLLC Filing Form 1120 is

Not a Corporation Due to Failure to File Form 8832. Background. A domestic LLC with a single owner that does not file an election on Form 8832 to be taxed as a corporation is disregarded as an entity separate from its owner. An election is necessary only when the LLC chooses to be classified initially as something other than its default classification or when the LLC chooses to changes its classification. To avoid penalties, an LLC that is required to file a Federal tax or information return for the taxable year in which an election is made must attach a copy of Form 8832 to its return for that year. Facts. Mr. Costello was the sole owner of a Louisiana C corporation (HECI), inherited from his father. On December 31, 2003, Mr. Costello formed an LLC in the Louisiana. He is its sole member. The LLC never filed Form 8832, Entity Classification Election. HECI and LLC merged on December 31, 2003, and HECI thereafter ceased to exist. Following the merger, LLC filed Forms 1120 (and IRS accepted them) using HECI's employer identification number. Issue. The taxpayer sought to avoid disregarded entity status to avoid personal liability for unpaid Form 941 employment tax (FICA and FUTA). Trust fund liability and the 100% penalty is not discussed in the case. Tax Court’s holding. Per the Tax Court “[u]nder these rules, LLC is disregarded as a separate entity from petitioner, its owner, because it is a single-member LLC that has never filed Form 8832.” The taxpayer made three arguments:

First, petitioner argues that the merger of HECI and LLC was a valid reorganization under section 368(a)(1)(F), and as a result, LLC should be treated as a corporation for Federal tax purposes. Second, petitioner argues that the filing of Forms 1120 for the first year after the merger of HECI and LLC constituted a valid election for LLC to be taxed as a corporation.




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Third, petitioner argues that the doctrine of equitable estoppel prevents respondent from contending that LLC is not a corporation because of his ‘tacit acquiescence’ to the filings of Forms 1120 for the year of the merger and subsequent years.

The Tax Court rejected all three of the taxpayers arguments stressing the need for the taxpayer to file Form 8832: “an eligible entity may not elect its entity classification by filing any particular tax return it wishes; it must do so by filing Form 8832 and following the instructions within section 301.7701-3(c)(1)(i), .... Thus, LLC could not elect to be treated as a corporation merely by filing corporate income tax returns. The Tax Court concluded that that the taxpayer, Mr. Costello, was liable for the LLC's unpaid employment tax arising during the tax periods and tax years at issue.

Observation: A corporation electing “S” status by filing a timely Form 2553 need not file Form 8832 in order to be classified as a corporation. Per the Form 8832 instructions:

An eligible entity that timely files Form 2553 to elect classification as an S corporation and meets all other requirements to qualify as an S corporation is deemed to have made an election under Regulations section 301.7701-3(c)(v) to be classified as an association taxable as a corporation. (Emphasis added)

IRS Updates LLC Publication In June 2016

The IRS updated its Pub 3402, Taxation of Limited Liability Companies. Topics covered in this 6-page pub:

a. What is an LLC? b. Classification of an LLC c. LLCs classified as partnerships d. LLCs classified as disregarded entities e. LLC classified as corporations f. Subsequent elections g. Community property.

TD 9771; Reg. 1.108-9 (6/10/2016) -- Final Regulations on COD Exclusion for

Disregarded Entities and Partners The IRS has issued final regulations clarifying that for purposes of applying the bankruptcy and insolvency exclusions, the term taxpayer refers to the owner of a disregarded entity or grantor trust and not the entity or trust itself. The “regulations clarify that the owner of the grantor trust or disregarded entity must itself be under the jurisdiction of the court in a title 11 case as the title 11 debtor to qualify for the bankruptcy exclusion.” The preamble to the regulations addresses the “Gracia Cases” and the application of the bankruptcy exclusion at the partner level”


https://www.irs.gov/pub/irs-pdf/p3402.pdf

https://www.federalregister.gov/documents/2016/06/10/2016-13779/guidance-under-section-108a-concerning-the-exclusion-of-section-61a12-discharge-of-indebtedness

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A commenter noted uncertainty under existing law as to whether the holding in certain case law would be followed by the IRS. See Gracia v. Commissioner, T.C. Memo. 2004-147; Mirarchi v. Commissioner, T.C. Memo. 2004-148; Price v. Commissioner, T.C. Memo. 2004-149; Estate of Martinez v. Commissioner, T.C. Memo. 2004-150 (collectively, the Gracia Cases). Because the bankruptcy court had asserted jurisdiction over non-debtor partners for certain matters, the Tax Court in the Gracia Cases upheld the application of the bankruptcy exclusion to the partners of a partnership that was a title 11 debtor, despite the fact that the partners were not title 11 debtors. The IRS's position is that the Gracia Cases failed to interpret correctly the limited scope of section 108(a)(1)(A), which applies only to partners that are also title 11 debtors. See Action on Decision 2015-01 (2015-6 IRB 579) (nonacquiescence in the Gracia Cases). These regulations provide that, in the case of a partnership that holds an interest in a grantor trust or a disregarded entity, the owner rules apply at the level of the partners to whom the income is allocable. These regulations provide that the owner must be under the jurisdiction of the court in a title 11 case as the title 11 debtor to qualify for the bankruptcy exclusion. Accordingly, when the owner of the grantor trust or disregarded entity is a partnership, the partner to whom the income is allocable must be under the jurisdiction of the court in a title 11 case of that partner as the title 11 debtor to qualify for the bankruptcy exclusion.

The regulations, which make no substantive changes to the 2011 proposed regulations, are effective for COD income occurring on or after 6/10/16 (the date of publication of the final regulations).

Partner’s Outside Basis Reported on Form 8971, Sch. A Background

The beginning outside basis (O.B.) of an inherited partnership interest is

(1) The fair market value of the partnership interest at the date of the decedent’s death or the alternate valuation date, plus

(2) The estate's or other successor's share of partnership liabilities, if any, on that date, minus (3) Value attributable to items (if any) constituting income in respect of a decedent under

section 691. Reg. 1.742-1. The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, enacted July 31, 2015 added sections 1014(f), 6035, 6662(b)(8), 6662(k), 6724(d)(1)(D), and 6724(d)(2)(II). Section 1014(f)(1) provides that the basis of property acquired from a decedent cannot exceed that property's final Federal estate tax value, or, if the final value has not been determined, the value reported on a statement by the decedent’s estate required by section 6035(a). Section 1014(f)(2) provides that section 1014(f)(1) only applies to property the


https://www.law.cornell.edu/cfr/text/26/1.742-1

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inclusion of which in the decedent's gross estate increased the estate's Federal estate tax liability (reduced by credits allowable). T.D. 9757 and REG-127923-15 (03/02/2016) -- Temporary and Proposed Regs. On Inherited Property Basis Consistency Rules Prop. Reg. 1.1014-10(a)(1) provides that “[t]he taxpayer's initial basis in property …may not exceed the property's final value within the meaning of paragraph (c) of this section.”

Prop. Reg. 1.1014-10(a)(2) provides as follows:

Subsequent basis adjustments. The final value within the meaning of paragraph (c) of this section is the taxpayer's initial basis in the property. In computing at any time after the decedent's date of death the taxpayer's basis in property acquired from the decedent or as a result of the decedent's death, the taxpayer's initial basis in that property may be adjusted due to the operation of other provisions of the Internal Revenue Code (Code) governing basis without violating paragraph (a)(1) of this section. Such adjustments may include, for example, gain recognized by the decedent's estate or trust upon distribution of the property, post-death capital improvements and depreciation, and post-death adjustments to the basis of an interest in a partnership or S corporation. The existence of recourse or non-recourse debt secured by property at the time of the decedent's death does not affect the property's basis, whether the gross value of the property and the outstanding debt are reported separately on the estate tax return or the net value of the property is reported. Therefore, post-death payments on such debt do not result in an adjustment to the property's basis.

Reg. Example

The 2016 proposed and temporary regulations contain an example of how to determine the correct outside basis for a beneficiary/partner when the value of the partnership interest is reported to the beneficiary on Form 8971 Schedule A. The example assumes that the partnership nonrecourse debt allocable to the beneficiary/partner under section 752 is 50% of the debt.

Prop. Reg. 1.1014-10(e), Example (1) (Modified to show inside and outside basis) At D's death, D owned 50% of P, an LLC taxed as a partnership, which owned a rental

building with a fair market value of $10 million subject to nonrecourse debt of $2 million. The regulation example does not consider either the LLC/partnership’s basis in partnership

assets (inside basis) or the deceased partner’s outside basis on the date of death, so to make a point, the author has provided an assumed inside and outside basis of zero due to consistent net losses attributable entirely to the depreciation. Assume that the building is on leased land and that it was originally purchased by the partnership for $8,000,000 and depreciated (straight-line) so that the DOD adjusted basis of the building is zero on the date of D’s death.

In Thousands Assets Tax

Basis FMV Outside

Basis




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Building 0 10,000

Total Assets 0 10,000 NR Debt 2,000 2,000 Capital:

Ann (25%) <500> 2,000 0 Bo (25%) <500> 2000 0 D (50%) <1,000> 4,000 0 Debt + Capital 0 10,000

D's sole beneficiary is C, D's child. P is valued at $8 million. D's interest in P is reported by the Estate on [IRS Form 8971 Schedule A] at $4 million (the

example assumes no discount). Statute of Limitations on Form 706 Expires The IRS accepts the estate tax return as filed and the time for assessing the estate tax under

chapter 11 expires. Under these facts, the final value of D's interest is $4 million: the value reported on Form

706 given that the statute of limitations expired without “that value having been timely adjusted or contested by the IRS” (Prop. Reg. 1.1014-10(c)(1)(i).

C sells the interest to Bill for $6 million in cash shortly thereafter. Balance sheet prior to C’s sale to Bill:

In Thousands Assets Tax

Basis FMV Outside

Basis

Building 0 14,000

Total Assets 0 14,000 NR Debt 2,000 2,000 Capital:

Ann <500> 3,000 0 Bo <500> 3,000 0 C <1,000> 6,000 5,000 Debt + Capital 0 14,000

Under section 742 and reg. 1.742-1, C's basis in the interest in P at the time of its sale is $5 million (the final value of D's interest ($4 million) on the date of death plus 50% of the $2 million nonrecourse debt).

C’s amount realized on the sale is $7,000,000 ($6,000,000 (cash received) plus $1,000,000 (debt share allocated to buyer per reg. 1.752-1(h)); therefore, C’s realized gain is $2,000,000:

7,000,000 (amount realized ($6,000,000 (cash) + $1,000,000 (debt relief)) - 5,000,000 (outside basis) = 2,000,000 Gain Realized


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Following the sale of the interest, C reports taxable section 1250 capital gain of $2 million. See Reg. 1.1(h)-1. o C’s realized gain without the section 1250 gain is $2,000,000 (max. rate 25%) C’s share

of section 1250 gain is $4,000,000 (50% x $8,000,000) and C’s residual capital loss is <$2,000,000> ($2,000,000 (realized gain ignoring section 1250 gain look-thru rule) minus $4,000,000 (section 1250 capital gain)). Assuming that C has no other capital gains or losses from other sources, the section 1250 capital gain of $4,000,000 is reduced to $2,000,000 by the <$2,000,000> residual capital loss.

Per the IRS example, C has complied with the consistency requirement of [prop. reg. 1.1014-10(a)(1) which declares that the “taxpayer’s initial basis in property … may not exceed the property’s final value” reported on Form 706].

Observation #1: Assuming no change in the tax basis of the partnership assets between the date of death and the sale to Bill (note: the value of the building increased from $10 mil. to $14 mil. between DOD and sale), if the partnership made a section 754 election in the year D died, then C would be eligible for a $5,000,000 section 743(b) adjustment ($5 million (O.B.) minus $0 (share of inside basis)) and it would all be allocated to the building (and depreciated over the MACRS life of a new building) per section 755. Upon selling to Bill, C’s section 743(b) adjustment disappears and Bill is entitled to a $7,000,000 ($7,000,000 (O.B). minus $0 (I.B.)) section 743(b) adjustment. The adjustment is reported as depreciation on Bill’s K-1 and is not a common balance sheet asset.

Observation #2: Alternatively, assume that instead of C selling to Bill, the LLC/partnership liquidated C for $6 million cash, plus $1,000,000 deemed cash from the debt relief (total distribution $7,000,000). Again, assume that the partnership makes a section 754 election. The LLC obtains the $6 million of cash by borrowing the money and then distributing it to C. To prevent any of the $6 million of new debt from being allocated to C, Ann and Bo could co-guarantee the LLC debt. C would have section 731(a)(1) capital gain of $2,000,000 (max. rate 20%), instead of section 1250 capital gain (max. rate 25%). The reg. 1.1(h)-1 recapture rule for section 1250 capital gains does not apply to redemptions (so the 1250 capital gain shifts to the other partners). In addition, because the partnership has a section 754 election in effect, C’s unused section 743(b) adjustment of $5,000,000 would be pushed to the common balance sheet and be allocated to the building allowing Ann and Bo to benefit from the depreciation (See reg. 1.734-2(b)). In addition, because C recognizes $2,000,000 of section 731(a) capital gain, the partnership is entitled to a $2,000,000 upward section 734(b) adjustment to the common balance sheet basis of the building (depreciable). Accounting entries for the liquidation of C: Debits: $7,000,000 Building (Depreciable basis) Credits: $1,000,000 C’s capital $6,000,000 Recourse Debt

Balance sheet following the liquidation of C: In Thousands


http://www.ecfr.gov/cgi-bin/text-idx?c=ecfr&SID=907799a01916a7138c07aad407e7339b&rgn=div8&view=text&node=26:1.0.1.1.1.0.1.5&idno=26

http://www.ecfr.gov/cgi-bin/text-idx?c=ecfr&SID=e3a7bbf9c73be34007fff9cd6794f3e8&rgn=div8&view=text&node=26:8.0.1.1.1.0.16.266&idno=26

http://www.ecfr.gov/cgi-bin/text-idx?c=ecfr&SID=e3a7bbf9c73be34007fff9cd6794f3e8&rgn=div8&view=text&node=26:8.0.1.1.1.0.16.266&idno=26

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Assets Tax Basis

FMV Outside Basis

Building 7,000 14,000

Total Assets 7,000 14,000 NR Debt 2,000 2,000 Recourse Debt 6,000 6,000 Capital:

Ann <500> 3,000 3,500 Bo <500> 3,000 3,500 Debt + Capital 7,000 14,000

Observation #3: If the $10 million asset on the date of death were zero basis accounts receivable (or a zero basis installment note), then the asset is income in respect of a decedent and thus is not eligible for a basis increase at death. C’s outside basis would be $1,000,000, and it is all attributed to the debt share ($4,000,000 (DOD FMV of partnership interest) plus $1,000,000 (debt share) minus $4,000,000 (value of partnership interest attributable to IRD)).

Variation -- IRS Audits Form 706 and Adjusts the Property Value Assume in the above example, that the IRS adjusts the value of the interest in P to $4.5

million, and that value is not contested by the estate before the expiration of the time for assessing the estate tax.

The final value of D's interest in P is $4.5 million. Under section 742 and reg. 1.742-1, C claims an outside basis of $5.5 million at the time of

sale and reports gain on the sale of $1,500,000 ($7,000,000 (amount realize) - $5,500,000 (OB)).

C has complied with the consistency requirement.

AM 2016-001 (April 15, 2016) – Chief Counsel Reverses Tough Stance on “Bad Boy” Loan Guarantees

Reversing CCA 201606027 (Released 2/5/2016), IRS Chief Counsel concludes in AM 2016-001 that if a partner's guarantee of a partnership's nonrecourse obligation is conditioned on the occurrence of certain so-called “bad boy” nonrecourse carve-out events, the guarantee will not cause the obligation to fail to qualify as a nonrecourse liability of the partnership, or as qualified nonrecourse financing for purposes section 465(b)(6), until such time as one of those events actually occur and cause the guarantor to become personally liable for the partnership debt under local law. IRS rationale:

We understand that including some form of one or more of these “nonrecourse carve-out” provisions in loan agreements is a fairly common practice throughout the


https://www.irs.gov/pub/lanoa/am2016-001.pdf


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commercial real estate finance industry and has been for many years. By including these provisions, the lender seeks to protect itself from the risk that the borrower or a guarantor in charge of the borrower will undertake ‘bad acts’ that will diminish or impair the value of the property securing the loan, that might disrupt the cash flow from the property, or that could delay, complicate or prevent the lender’s repossession of the property in the event of a default. An important aspect of these nonrecourse carve-outs is that the bad acts that they seek to prevent are within the control of the borrower or guarantor—the borrower or a guarantor in control of the borrower can prevent them from occurring by, for example, obtaining the lender’s consent before seeking subordinate financing, or not acquiescing in an involuntary petition for bankruptcy. Because it is in the economic self-interest of borrowers and guarantors to avoid committing those bad acts and subjecting themselves to liability, they are very unlikely to voluntarily commit such acts.

Route 231, LLC, (CA 4 1/8/2016) – Fourth Circuit Affirms Tax Court’s

Holding of Partnership’s Disguised Sale of State Tax Credits Background (Per Tax Court)

“During 2005 and 2006 Virginia provided an income tax credit to encourage the preservation and sustainability of its unique natural resources, wildlife habitats, open spaces, and forested areas. For 2005 this Virginia tax credit was equal to 50% of the ‘fair market value’ of any land or interest in land in Virginia donated to a public or private conservation agency eligible to hold such land and interests therein for conservation or preservation purposes. The credit was available to individuals and corporations for use on their Virginia income tax returns. A partner in a passthrough entity that held Virginia tax credits could use the credits on his or her own Virginia income tax returns either in proportion to his or her interest in the entity or as set forth in the partnership agreement. Any taxpayer holding Virginia tax credits could transfer or sell unused but otherwise allowable credits to another taxpayer for use on his or her Virginia income tax return. A Virginia tax credit, however, could be claimed by only one taxpayer on his or her Virginia income tax return. **** Virginia Conservation is a Virginia limited liability limited partnership that was interested in acquiring Virginia tax credits. Virginia Conservation acquired Virginia tax credits via partnership arrangements with landowners [here Route 231] who placed conservation easements on property in Virginia. When dealing with other partnership arrangements with landowners, Virginia Conservation generally contributed $0.53 for each dollar of Virginia tax credits that the landowner partnerships would allocate to it. Once Virginia Conservation received these Virginia tax credits, it would allocate them to individual investors or to Chesterfield Conservancy, Inc. (Chesterfield Conservancy), a nonstock corporation that owned an interest in Virginia Conservation. Chesterfield Conservancy would then sell the credits to other individuals or entities interested in claiming Virginia tax credits on their Virginia income tax returns.” (Route 231, LLC v. Comm’r, TC Memo 2014-30).

Route 231, a Virginia limited liability company, was a real estate development company. On December 9, 2005, Route 231, in anticipation of making charitable contributions,


http://www.ca4.uscourts.gov/Opinions/Published/141983.P.pdf

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obtained an appraisal report valuing two conservation easements on property it had recently purchased: one property was valued at $8,849,240, and the other property at $5,225,249. A fee interest in one of the properties (subject to the easement) was valued at $2,072,880. Effective December 30, 2005, Route 231 contributed one of the easements to the Nature Conservancy and the other to the Albemarle County Public Recreational Facilities Authority. The fee interest was also gifted to the Nature Conservancy. Fourth Circuit The Fourth Circuit, affirming the Tax Court, determined that the section 707 disguised sale rules applied to the contribution of cash to Route 231 by Virginia Conservation, followed by an allocation to Virginia Conservation of the Virginia tax credits earned by the Route 231 partnership. The Fourth Circuit also agreed with the Tax Court's determination of the year the credits were sold. Fourth Circuit’s summary:

Route 231, LLC, a Virginia limited liability company, (‘Route 231’) reported capital contributions of $8,416,000 on its 2005 federal tax return. This number reflected, in relevant part, $3,816,000 it received from one of its members, Virginia Conservation Tax Credit FD LLLP (‘Virginia Conservation’). Upon audit, the [IRS determined] that Route 231 should have reported the $3,816,000 received as gross income and not a capital contribution. Route 231challenged the FPAA by petition to the United States Tax Court. …the Tax Court determined that the transaction was a ‘sale; and reportable as gross income in 2005. Route 231 [on appeal asserted] that the Tax Court erred in finding the transfer was not a capital contribution or, alternatively, that any income was not reportable until 2006. [The Fourth Circuit] disagree with Route 231 and [affirmed] the decision of the Tax Court.

Virginia Conservation (VC) became a member of Route 231 with a 1% membership interest. VC agreed to make an initial capital contribution of $500 plus an additional sum “in an amount equal to the product of $0.53 for each $1.00 of [the tax credits] allocated to" it.” The agreement anticipated that Route 231 would earn Virginia tax credits "in the range of $6,700,000 to 7,700,000". Ultimately, VC contributed $3,816,000 and was allocated Virginia tax credits (as a partner in Route 231) of $7,200,000.

The Fourth Circuit essentially agreed with the reasoning of the Tax Court which it summarized as follows:

At the outset of its opinion, the Tax Court described our decision in Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 [107 AFTR 2d 2011-1523] (4th Cir. 2011), as ‘squarely on point’ with the case before it. Following much of the same analysis we applied in Virginia Historic, the Tax Court first concluded that Route 231's Virginia tax credits were ‘property’ so their transfer would fall within the scope of I.R.C. § 707. Next, the Tax Court determined that under the applicable tax regulations of § 707, the transaction was a ‘disguised sale’ because the record demonstrated that (1) Route 231 would not have transferred the Virginia tax credits to Virginia Conservation “but for” the fact that Virginia Conservation transferred $3, 816, 000 to it, and (2) Route 231's


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transfer of the Virginia tax credits was not dependent on the ongoing entrepreneurial risks of Route 231's operations. In examining the totality of the facts and circumstances relevant to this inquiry, the Tax Court observed that the amended operating agreements set out the timing and amount of the exchange with ‘reasonable certainty’; they established Virginia Conservation's binding contractual right to the Virginia tax credits; and they secured Virginia Conservation's rights by an indemnification clause. In addition, the Tax Court observed that Virginia Conservation's share of the Virginia tax credits was disproportionately large in comparison to its membership interest and that it had no obligation to return the credits to Route 231. As such, the Tax Court held that the transfer between Route 231 and Virginia Conservation was a disguised sale and that the $3,816,000 received was thus gross income.

The Fourth Circuit agreed with the Tax Court that the money Route 231 received from Virginia Conservation was ‘income’ for federal tax purposes.

The Fourth Circuit also agreed with the Tax Court’s rationale that the sale occurred in 2005:

…[T]he Tax Court rejected Route 231's argument that the transfer occurred for tax purposes in 2006, instead of 2005, for three separate and independent reasons. First, for purposes of federal tax law, the factual circumstances indicate the sale occurred in 2005; second, because Route 231 used the accrual method of accounting, it had to report the transfer as income in 2005 regardless of when it received Virginia Conservation's payment; and, third, Route 231's statements in its 2005 tax return constituted binding admissions that the transfer of money (however characterized) occurred in 2005.

Observation #1: Rev Proc 2014-12 provides a safe harbor under which IRS will not challenge partnership allocations of section 47 rehabilitation credits by a partnership to its partners; however, the revenue procedure is limited to federal section 47 credit (not state tax credits).

Observation #2: Both Route 231 and Rev Proc 2014-12 should be distinguished from the issue in Historic Boardwalk Hall, LLC. v. Commissioner, 694 F.3d 425 (3d Cir. 2012), which hinged on the investor’s status as a bona fide partner (not the disguised sale rules of section 707). As explained by the IRS in Rev Proc 2014-12:

The Third Circuit [in Historic Boardwalk Hall] considered whether an investor's interest in the success or failure of a partnership that incurred qualifying rehabilitation expenditures was sufficiently meaningful for the investor to qualify as a partner in that partnership. The agreements governing the Historic Boardwalk Hall transaction ensured that the investor would receive the § 47 rehabilitation credits (or their cash equivalent) and a preferred return, with only a remote opportunity for additional sharing in profit. Both the § 47 rehabilitation credits and the preferred return were guaranteed as part of the transaction. The preferred return guarantee was funded. The Third Circuit determined that the investor's return from the partnership was effectively fixed, and that the investor also had no meaningful downside risk because its investment was guaranteed. The Third Circuit agreed with the Commissioner's reallocation of all of the partnership's claimed losses and tax credits from the investor to the principal, holding that “


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because [the investor] lacked a meaningful stake in either the success or failure of [the partnership], it was not a bona fide partner.” Id. at 463.

TIFD III-E Inc. v. U.S., (CA 2 1/24/2012), the Supreme Court Declined to Review the Second Circuit’s 2012 Decision on January 11, 2016.

Observation: 2015 Bipartisan Budget Act eliminated prior law section 704(e)(1) (effective for tax years beginning after 12/31/2015) which stated that: “A person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person.” This change clarified that the section 704(e) family partnership rules were not intended to provide an alternative test for whether a person is a partner in a partnership. The taxpayer’s argument in TIFD decision (AKA Castle Harbor) was the likely cause for the law change.

The Supreme Court declined to review the 2012 Second Circuit decision (Castle Harbor) which reversed the district court and held that an alleged partnership interest under section 704(e)(1) was overwhelmingly in the nature of debt and that the government was entitled to a substantial understatement penalty. The Second Circuit held that the bank's risks were minimal and and not real risk.

Second Circuit summary of the facts:

In the early 1990s, [General Electric Capital Corp.] GECC, which had long been in the business of leasing commercial aircraft, found itself in the position of owning a fleet of aircraft that had been fully depreciated for tax purposes. The aircraft could thus no longer serve as the basis for depreciation deductions, which had substantially sheltered GECC's income from federal tax. GECC solicited proposals for alternative methods of financing its ownership of these aircraft. In accordance with one of these proposals, GECC caused the formation of an eight-year partnership, later named Castle Harbour. The taxpayer and another GECC subsidiary transferred to Castle Harbour assets worth a total of $590 million, including a fleet of fully depreciated aircraft under lease to airlines. The two Dutch banks, neither subject to tax by the United States, contributed $117.5 million in cash.

A maze of contractual provisions in the partnership agreement dictated how the revenues, losses, and assets of Castle Harbour would be allocated among its ostensible partners — the two GECC subsidiaries and the two Dutch banks. At bottom, however, the partnership agreement was designed essentially to guarantee the reimbursement (according to a previously agreed eight-year schedule) of the banks' initial investment of $117.5 million plus an annual rate of return of 9.03587% (or in some circumstances 8.53587%), referred to in the agreement as the “Applicable Rate.”


http://www.justice.gov/sites/default/files/tax/legacy/2012/01/25/Castle%20Harbour%20opinion.PDF

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The partnership agreement did not expressly guarantee that the banks would receive a return at the Applicable Rate. Some of its provisions, examined in isolation, were designed to give the appearance of creating the potential for a greater or lesser return in the case of unexpected profits or losses. A web of other provisions, however, together functioned to ensure that there was effectively no practical likelihood that the banks' return would deviate more than trivially from the Applicable Rate.

Second Circuit description of the division of assets, revenues, and losses:

Using complex definitions, the partnership agreement allocated 98% of what the parties and the district court referred to as the "Operating Income" of the partnership to the banks. See TIFD III-E , 342 F. Supp. 2d at 101. Operating Income was a flexible classification. It included most of the partnership's taxable income, while allowing the taxpayer when it so desired to reclassify an income stream, taking it out of Operating Income and designating it instead as a "Disposition Gain." Disposition Gains were allocated (after a threshold amount) almost entirely to the taxpayer. For tax purposes, the allocation of 98% of the partnership's Operating Income to the tax-exempt Dutch banks meant that only a tiny portion of the income of the partnership would be subject to tax. [pg. 2012-635]

The partnership's Operating Income was reduced by expenses, the largest of which was the aggressive depreciation of the aircraft. Because the aircraft had already been fully depreciated for tax purposes, however, this depreciation did not serve to reduce the partnership's taxable income. As a result, the 98% allocation of Operating Income to the banks created an enormous discrepancy between the banks' share of the partnership's taxable income and their share of its book value. When it came to the actual division of the assets, revenues, and losses, the partnership did not credit the banks' capital accounts with the same 98% of the taxable Operating Income described above, but rather with 98% of a much smaller figure, drastically reduced by depreciation charged against the already fully depreciated aircraft.

In footnote 8, the Second Circuit distinguished the Culbertson test from section 704(e)(1):

The taxpayer argues that the banks' interest may qualify as a capital interest under §704(e)(1) despite failing to qualify as bona fide equity participation under Culbertson's totality-of-the-circumstances test because the Culbertson test is ultimately focused on the parties' intent, while the § 704(e)(1) inquiry is limited to an assessment of the objective nature of the interest. See Culbertson , 337 U.S. at 742 ("The question is ... whether, considering all of the facts - the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent - the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.").


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Even assuming, however, that there may be circumstances in which the application of Culbertson and § 704(e)(1) yields different results as to whether the purported holder of a partnership interest qualifies as a partner, we see no reason why the results should differ in this case. In our prior opinion, we ruled that the objective facts of the structure that the parties had created (and intended to create) indicated that the banks' interest was "overwhelmingly in the nature of a secured lender's interest," and therefore required that the banks' interest be treated as debt for tax purpose, regardless of the parties' desire to have it treated as equity. TIFD III-E, 459 F.3d at 231; see id. at 232 ("Th[e] [Culbertson] test turns on the fair, objective characterization of the interest in question upon consideration of all the circumstances."); id. at 238-39 (finding the taxpayer's characterization of the banks' interest as equity and the banks' own characterization of their interest as debt to be at best an "equivocal" factor in determining the proper tax classification of the interest). Applying Culbertson, we thus found that the taxpayer's claimed subjective intent was insufficient to defeat the plain objective facts. And we rely on largely the same objective factors in concluding that the banks' interest is not a "capital interest" for the purpose of § 704(e)(1). Accordingly, even if the taxpayer is correct that the tests of partner status under Culbertson and § 704(e)(1) conceivably yield different results in some circumstances, that possibility has no bearing on this case.

McNeill v. U.S., (CA 10 9/6/2016) – Reasonable Cause/Good Faith Defense Can Be Pursued at Partner Level

The Tenth Circuit, reversing and remanding a district court decision, found that a managing partner could pursue a reasonable cause/good faith defense under section 6664(c)(1) at the partner level:

What the language of the controlling statute suggests the surrounding statutory environment and the government's own implementing regulations confirm. In TEFRA Congress indicated that "partnership item[s]" are those that the Secretary of the Treasury has deemed "more appropriately determined at the partnership level than at the partner level." Id. § 6231(a)(3). And the Secretary's relevant regulations expressly indicate that § 6664(c)(1)'s reasonable cause/good faith defense is not a "partnership item" but something more appropriately determined at the partner level.

The Court observed that the matter before it would soon become moot by virtue of the new partnership audit rules:

It is not only a narrow question but one of receding importance too, for Congress has recently revamped the process for auditing partnerships in order to permit the IRS, beginning in 2018, to recoup taxes from the partnership itself rather than the partners individually. See Bipartisan Budget Act of 2015, Pub. L. No. 114-74, 129 Stat. 584, 625 (to be codified at 26 U.S.C. § 6221). And perhaps that new law will go a long way toward meeting the government's efficiency concerns in future



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cases. But however that may be, it is not within our charter to apply that new law retroactively to cases like this one, though it does seem a bit like that's what we're effectively being asked to do.

The district court judgment was reversed and the case was remanded for further proceedings consistent with the Tenth Circuit opinion.

One Judge lodged a dissenting opinion.

LTR 201608005 (Released 2/19/2016) – Construction Contract Obligations are Section 752 Debt Which Increase a Partner’s Outside Basis

“Two construction companies, X and Y, formed a partnership P to enter into long-term construction contracts to engineer, design, and construct certain industrial facilities for the owner, O.”

The issue in the PLR involved “Notice to Proceed” payments from O. [“O]ver the term of the construction period, progress payments, generally, are tied to the completion of certain work. However, there are certain payments (the “Notice to Proceed payments”) to be made to P before the completion of the work and before incurring costs in performing the work, at the time O issues P certain notices to proceed with the next phase of construction.

For federal income tax purposes, the partnership is reporting income from the contract on the percentage of completion method under section 460. Under section 460, the partnership reports income based on a comparison of contract costs incurred to estimated total contract costs. Notice to proceed payments are different because they are not linked to contract performance and precede P's reporting of the related income for federal income tax purposes.

The PLR describes additional terms of the construction contract and the partnership’s obligation:

Before P is entitled to receive payments under the contracts and, explicitly, to receive the Notice to Proceed payments, P is required to provide certain guarantees and also to deliver to O irrevocable standby letters of credit. The letters of credit secure P’s obligations to perform under the contracts and cover O’s damages in the event of non-performance or default by P. The amount of the letters of credit securing P’s obligations roughly corresponds to the amount of the Notice to Proceed payments.

The contracts provide that if P fails to prosecute the work in a diligent and efficient manner, or if P abandons the project or repudiates any of its obligations, a default occurs. In that event, O is entitled to several remedies, including seeking specific performance (that is, obtaining judicial enforcement requiring P to make good on its obligation to perform the work) and recovery from P of costs, damages, losses, and expenses (that is, requiring P to make good on its obligation to cover O’s damages in the event of nonperformance). Specifically, the contracts



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allow O to draw-down directly against the letters of credit in the event of a default by P.

Because the partnership would have a Reg. 1.752-7 liability for failing to perform the work it had been paid for, the IRS allowed the notice to proceed payments to be treated as section 752 liabilities to the extent not yet included in income:

[W]e conclude that P's obligations under the contracts to proceed with performing work and to incur costs in performing the work, and the corresponding obligations to satisfy O's remedies in the event P were to default or suspend work, constitute liabilities under section 752 upon and to the extent P receives the Notice to Proceed payments but has not yet reported the related income.

Reg. §1.752-1(a)(4)(ii) defines obligation as follows:

For purposes of this paragraph and § 1.752-7, an obligation is any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account for purposes of the Internal Revenue Code. Obligations include, but are not limited to, debt obligations, environmental obligations, tort obligations, contract obligations, pension obligations, obligations under a short sale, and obligations under derivative financial instruments such as options, forward contracts, futures contracts, and swaps.

Additional Resources on Reg. 1.752-7 Liabilities:

Working with the Section 752 Partnership Liability Allocation Rules (Outline), page 56, 2014 William and Mary School of Law Conference Paper, by Jennifer H. Alexander and Andrea M. Whiteway.

Careful Analysis Required for Potential Regs. Sec. 1.752-7 Liabilities, The Tax Adviser, by Lawrence Hirsh.

Obligations, Liabilities, and Construction Partnerships: Regs. Clear Away a Trap, Partnerships, S corporations, and LLCs Journal of Taxation (WG&L) May 2007 by Gerald Thomas II and Andrew Immerman.

T.D. 9748, 02/03/2016, Reg. § 1.704-1T and Prop Reg § 1.704-1 -- Temp. Regs. On Partnership's Allocation of Creditable Foreign Tax Expenditures

Background: Allocations of creditable foreign tax expenditures (“CFTEs”) do not have substantial economic effect, and accordingly a CFTE must be allocated in accordance with the partners’ interests in the partnership. See § 1.704–1(b)(4)(viii). Section 1.704–1(b)(4)(viii) provides a safe harbor under which CFTE allocations are deemed to be in accordance with the partners’ interests in the partnership. In general, the purpose of the safe harbor is to match allocations of CFTEs with the income to which the CFTEs relate.


http://scholarship.law.wm.edu/cgi/viewcontent.cgi?article=1724&context=tax

http://scholarship.law.wm.edu/cgi/viewcontent.cgi?article=1724&context=tax

http://www.thetaxadviser.com/issues/2010/apr/carefulanalysisrequiredforpotentialregssec1752-7liabilities.html

http://www.alston.com/Files/Publication/a3e1c1c5-3083-4a4f-a884-373696882f76/Presentation/PublicationAttachment/83092d09-7e5c-4cc4-968f-136bcf644ab6/JournalofTaxation5-07ThomasImmerman.pdf


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In order to apply the safe harbor, a partnership must (1) determine the partnership’s “CFTE categories,” (2) determine the partnership’s net income in each CFTE category, and (3) allocate the partnership’s CFTEs to each category. Section 1.704–1(b)(4)(viii)(c)(2) requires a partnership to assign its income to activities and provides for the grouping of a partnership’s activities into one or more CFTE categories based generally on whether net income from the activities is allocated to partners in the same sharing ratios. Section 1.704–1(b)(4)(viii)(c)(3) provides rules for determining the partnership’s net income (for U.S. federal income tax purposes) in a CFTE category, including rules for allocating and apportioning expenses, losses, and other deductions to gross income. Section 1.704–1(b)(4)(viii)(d) assigns CFTEs to the CFTE category that includes the related income under the principles of § 1.904–6, with certain modifications. In order to satisfy the safe harbor, partnership allocations of CFTEs in a CFTE category must be in proportion to the allocations of the partnership’s net income in the CFTE category. (Premable to Temp. Regs.)

The Temporary Regulations

The effect of Section 743(b) adjustments. Special rules for deductible allocations and nondeductible guaranteed payments. Inter-branch payments. The regulations also “make certain organizational and other non-substantive

changes that clarify how items of income under U.S. federal income tax law are assigned to an activity and how a partnership’s net income in a CFTE category is determined.”

Effective Date The “temporary regulations apply for partnership taxable years that both begin on or after January 1, 2016, and end after February 4, 2016.”

Pitts v. U.S., (CA 9 9/2/2016) -- Ninth Circuit Finds Partner Liable For Partnership's Unpaid Employment Taxes

The Ninth Circuit summary of facts, issue and conclusion:

Pitts was a general partner in DIR Waterproofing, and the United States liened Pitts's personal property after DIR failed to pay trust fund and employment taxes assessed against DIR. Pitts concedes that, as a general partner, she is liable for the partnership's debts under state law. She argues, however, that the United States may not use administrative enforcement procedures against her - instead, because her liability arises from state partnership law, the United States is confined to remedies under state law. We disagree.

Ninth Circuit reasoning:


http://cdn.ca9.uscourts.gov/datastore/memoranda/2016/09/02/14-56502.pdf

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First, the Ninth Circuit determined that “pursuant to the plain language of 26 U.S.C. §6321, the taxpayer is a "person liable to pay any tax," and a lien in favor of the government arises by operation of federal law.”

Second, Court held that “the United States may utilize administrative enforcement procedures to collect the debt from Pitts, because she is secondarily liable for DIR's assessed debt.”

Third, the Court found that “[t]he United States is not subject to a state statute of limitations when it attempts to enforce a claim created by federal statute and proceeds in its sovereign capacity to enforce that claim.”

Finally, the Ninth Circuit, rejected the taxpayer’s argument “that the taxes are dischargeable in her chapter 7 bankruptcy proceeding, and that the United States's continuing lien violates the discharge injunction contained in 11 U.S.C. § 524(a)(2).

PLR 201608011 (released 2/19/2016) -- Publicly Traded Partnership's Income From Fluid Management Services Was Qualifying Income

Background A publicly traded partnership (PTP) is generally treated as a corporation for federal tax purposes (section 7704(a)). A PTP includes any partnership the interests of which are either traded on an "established securities market," or readily tradable on a secondary market or the substantial equivalent thereof (section 7704(b)).

A PTP is not treated as a corporation if at least 90% of its gross income for the tax year is specified passive-type income ("qualifying income"), and certain other requirements are met (section 7704(c)).

Section 7704(d)(E) describes one (of several) types of income that is “qualifying income”:

income and gains derived from the exploration, development, mining or production, processing, refining, transportation (including pipelines transporting gas, oil, or products thereof), or the marketing of any mineral or natural resource (including fertilizer, geothermal energy, and timber), industrial source carbon dioxide, or the transportation or storage of any fuel described in subsection (b), (c), (d), or (e) of section 6426, or any alcohol fuel defined in section 6426(b)(4)(A) or any biodiesel fuel as defined in section 40A(d)(1,

PLR 201608011 The PLR involved a partnership that intended to earn income by providing fluid management and disposal services to customers engaged in the exploration for, and the development and production of, oil and natural gas. IRS concluded that the gross income would constitute qualifying income within the meaning of section 7704(d)(1)(E).

JCT “General Explanation of Tax Legislation Enacted in 2015” Provides New Details on New Partnership Audit Regime (3/14/2016)




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Joint Committee on Taxation (JCT) Explanation (March 2016) Following is the JCT explanation of the new partnership audit regime (skipping the JCT’s detailed review of present law). New IRC sections 6221–6241.

Repeal of TEFRA and electing large partnership rules Generally for returns filed for partnership taxable years beginning after 2017, the provision repeals the tax reporting provisions and voluntary centralized audit procedures for electing large partnerships, as well as the TEFRA partnership audit and adjustment rules. In place of the repealed procedures, a centralized system for audit, adjustment, assessment, and collection of tax applies to all partnerships, except those eligible partnerships that have filed a valid election out. Electing out of the centralized system leaves applicable the present-law rules for deficiency proceedings. The centralized system is located in subchapter C of chapter 63 of the Code.

In General

Determination at partnership level Under the centralized system, the audit of a partnership takes place at the partnership level. Any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year, and any partner’s distributive share thereof, generally are determined at the partnership level.187 Any tax attributable to these items generally is assessed and collected at the partnership level. The applicability of any penalty, addition to tax, or additional amount that relates to an adjustment of any item of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year or to any partner’s distributive share thereof is determined at the partnership level. Unlike prior law, distinctions between partnership items and affected items are no longer made. An underpayment of tax determined as a result of an examination of a taxable year is imputed to the year during which the adjustment is finally determined, and generally is assessed against and collected from the partnership with respect to that year rather than the reviewed year.

187 Sec. 6221(a).

Under the centralized system, a partnership may seek modification of the imputed underpayment amount by providing the Secretary with specified information about the tax status of partners and about the nature and amount of items of income or gain, by means of reviewed-year partners filing amended returns with payment, or on the basis of other factors in regulations or guidance. A partnership may elect an alternative to partnership payment of the imputed underpayment in which each reviewed-year partner is furnished a statement of the partner’s share of the adjustments (similar to Schedule K–1) and each such reviewed-year partner increases its tax for the year the statement is furnished. A partnership may file an administrative adjustment request. Rules are provided relating to statutes of limitation and other applicable time periods, interest and penalties, judicial review, and other aspects of the centralized system under the provision.

Election out The centralized system is applicable to any partnership unless it meets eligibility requirements and has made a valid election out for a taxable year.188

100 or fewer statements A partnership may elect out of the centralized system (and it and its partners are governed by the present-law deficiency proceedings) for a partnership taxable year


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if it meets eligibility requirements. One of the eligibility requirements is that for the taxable year, the partnership is required to furnish 100 or fewer statements under section 6031(b) (Schedules K–1) with respect to its partners. A further eligibility requirement for a partnership to make the election is that each of its partners is an individual, a deceased partner’s estate, a C corporation, a foreign entity that would be required to be treated as a C corporation if it were a domestic entity, or an S corporation (provided special rules are met). A partnership with a foreign entity as a partner can meet this eligibility requirement if, under the rules of section 7701, the foreign entity would be taxable as a C corporation if it were domestic; that is, the foreign entity has elected to be, or is, treated as a per se corporation under the check-the-box regulatory rules under section 7701.189 A C corporation partner that is a regulated investment company (‘‘RIC’’) or a real estate investment trust (‘‘REIT’’) does not prevent the partnership from being able to elect out, provided the applicable requirements are met.

Example For example, a partnership is formed to conduct a joint venture between two corporations, X and Y. X’s domestic C corporation subsidiary, W, owns a 50-percent interest in the partnership, and Y’s domestic C corporation subsidiary, Z, owns a 50-percent interest in the partnership. The partnership is required to furnish two statements (Schedules K–1), one to W and one to Z. The partnership is

188 Sec. 6221(b). 189 See Treas. Reg. sec. 301.7701–2 and –3.

eligible to elect out of the centralized system for the taxable year, provided that the partnership meets the requirements (described below) as to the time and manner of electing out, including (among other requirements) disclosing to the Secretary the names and employer identification numbers of W and Z.

Time and manner of election out The election is to be made with a timely-filed return of the partnership taxable year to which the election relates; the election is valid only for that year. The election must include the name and taxpayer identification number of each partner of the partnership in the manner prescribed by the Secretary. The partnership must notify each of its partners of the election in the manner prescribed by the Secretary.

S corporation partners For a partnership with a partner that is an S corporation to elect out, the partnership is required to include with its election (in the manner prescribed by the Secretary) a disclosure of the name and taxpayer identification number of each person with respect to whom the S corporation must furnish a statement under section 6037(b) for the S corporation’s taxable year ending with or within the partnership’s taxable year for which the election is made. This requirement is met if the partnership discloses the name and taxpayer identification number of each S corporation shareholder with respect to which a statement (Schedule K–1) is required to be furnished under section 6037(b). These statements required to be furnished by the S corporation are treated as statements required to be furnished by the partnership for purposes of the 100-or-fewerstatements criterion for the partnership’s eligibility to elect out.

Example

For example, if a partnership has 50 partners, 49 of which are individuals and one of which is an S corporation with 30 shareholders all of whom are individuals, the partnership is treated as being required to furnish 80 statements. This is the sum of 49 statements for individual partners, one statement for the S corporation partner, and 30 statements for individuals with respect to whom the S corporation must furnish statements. The partnership meets the 100-or-fewer-statements criterion for the partnership’s eligibility to elect out.


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Foreign partners The Secretary may provide for an alternative form of identification of any foreign partners (for example, if the foreign partners do not have U.S. taxpayer identification numbers) for purposes of the requirement of disclosure of the name and taxpayer identification number of each partner by the partnership.

Other persons as partners The Secretary may by regulation or other guidance identify other types of partners to whom rules similar to the special rules in the case of a partner that is an S corporation can apply. This guidance shall take into account, for purposes of applying the 100-or-fewer-

statements criterion,190 each direct and indirect interest in the partnership of any person to which a statement (comparable to the partner statement under section 6031(b)) is required to be furnished by any person. Such guidance may also take into account any person with respect to which a comparable statement is not required to be furnished but which has an interest (direct or indirect) in the partnership. Further, such guidance shall require the partnership to disclose to the Secretary the name and taxpayer identification number of each person with respect to which a statement (comparable to the partner statement under section 6031(b)) is required to be furnished and of other persons with an interest (direct or indirect) in the partnership.

Examples

For example, assume that a partner of a partnership is a disregarded entity such as a State-law limited liability company (‘‘LLC’’) with only one member, a domestic corporation. Such guidance may provide that the partnership can make the election if the partnership includes (in the manner prescribed by the Secretary) a disclosure of the name and taxpayer identification number of each of the disregarded entity and the corporation that is its sole member, and each of them is taken into account as if each were a statement recipient in determining whether the 100-or-fewer statements criterion is met. As another example, such guidance may provide that a partnership with a trust as a partner can make the election if the partnership includes (in the manner prescribed by the Secretary) a disclosure of the name and taxpayer identification number of the trustee, each person who is or is deemed to be an owner of the trust, and any other person that the Secretary determines to be necessary and appropriate, and each one of such persons is taken into account as if each were a statement recipient in determining whether the 100-or-fewer-statements criterion is met. Similar guidance may be provided with respect to a partnership with a partner that is a grantor trust, a former grantor trust that continues in existence for the two-year period following the death of the deemed owner, or a trust receiving property from a decedent’s estate for a two-year period. As a further example, to the extent that such rules are consistent with prompt and efficient collection of tax attributable to the income of partnerships and partners, such guidance may provide rules permitting election out in the case of a partnership (the first partnership) with one or more direct or indirect partners which are themselves partnerships. Under any such guidance with respect to tiered partnerships, the sum of all direct and indirect partners (including each partnership and its partners) may not exceed 100 persons with respect to which a section 6031(b) statement must be furnished, and each partner must be identified. That is, eligibility of the first partnership to make the election requires the first partnership to include (in the manner prescribed by the Secretary) a disclosure of the name and taxpayer identification number of each direct partner of the first partnership and each indirect partner (in-

190 Sec. 6221(b)(1)(B).

cluding each partnership and its partners) in every tier, and requires that each is taken into account in determining whether the 100-or-fewer-statements criterion is met.


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Requirement of consistency with partnership return The centralized system imposes a consistency requirement. A partner on its return must treat each item of income, gain, loss, deduction or credit attributable to a partnership in a manner that is consistent with the treatment of such income, gain, loss, deduction, or credit on the partnership return.191 An underpayment that results from a failure of a partner to conform to the partnership reporting of an item is treated as a math error on the partner’s return and cannot be abated under section 6213(b)(2).192 The underpayment may be subject to additions to tax.

Notice of inconsistent position

If the partnership has filed a return but the partner’s treatment on the partner’s return is (or may be) inconsistent with the partnership’s return, or if the partnership has not filed a return, the math error treatment and nonabatement treatment do not apply if the partner files a statement identifying the inconsistent position.193 Further, a partner is treated as having complied with the obligation to file a statement identifying the inconsistent position in the circumstance in which the partner demonstrates to the satisfaction of the Secretary that the treatment of the item on the partner’s return is consistent with the treatment of the item on the statement furnished to the partner by the partnership, and the partner elects the application of this rule. A final decision in an administrative or judicial proceeding with respect to a partnership under the centralized system is binding on the partnership and all partners of the partnership.194 In contrast, a final determination in an administrative or judicial proceeding with respect to a partner’s identified inconsistent position is not binding on the partnership if the partnership is not a party to the proceeding.195 No inference is intended that the partnership is bound by any other proceeding to which it is not a party, such as an administrative or judicial proceeding with respect to a partner’s unidentified inconsistent position.

Partners bound by actions of partnership; designation of partnership representative

For purposes of the centralized system, the partnership acts through its partnership representative. The partnership representative has the sole authority to act on behalf of the partnership under the centralized system.196 Under the centralized system, the partnership and all partners of the partnership are bound by actions taken by the partnership.197 Thus, for example, partners may not participate in or contest results of an examination of a partner-

191 Sec. 6222(a). 192 Sec. 6222(b). 193 Sec. 6222(c). 194 Sec. 6223(b). 195 Sec. 6222(d). 196 Sec. 6223(a). 197 Sec. 6223(b).

ship by the Secretary. A partnership and all partners of the partnership are also bound by any final decision in a proceeding with respect to the partnership brought under the centralized system of subchapter C. Thus, for example, a settlement agreement entered into by the partnership, a notice of final partnership adjustment with respect to the partnership that is not contested, or the final decision of the court with respect to the partnership if the notice of final partnership adjustment is contested, bind the partnership and all partners of the partnership. Each partnership is required to designate a partner (or other person) with a substantial presence in the United States as the partnership representative. A substantial presence in the United States enables the partnership representative to meet with the Secretary in the United States as is necessary or appropriate, and facilitates communication during the audit process and during any other proceedings in which the partnership is involved. In any case in which such a designation by the partnership is not in effect, the Secretary may select any person as the partnership representative.


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Partnership Adjustments

Partnership adjustments by the Secretary The centralized system provides that any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year, and any partner’s distributive share thereof, are determined at the partnership level. Any tax attributable to these items is assessed and generally is collected at the partnership level as an imputed underpayment paid by the partnership.

Reviewed year and adjustment year For purposes of the centralized system, the reviewed year means the partnership taxable year to which the item being adjusted relates. For example, in an examination by the Secretary of a partnership’s taxable year 2018, 2018 is the reviewed year.198

The adjustment year means (1) in the case of an adjustment pursuant to the decision of a court (under the centralized system’s judicial review provisions), the partnership taxable year in which the decision becomes final; (2) in the case of an administrative adjustment request, the partnership taxable year in which the administrative adjustment request is made; or (3) in any other case, the partnership taxable year in which the notice of final partnership adjustment is mailed.199 For example, in the case of adjustments with respect to partnership taxable year 2018 resulting in an imputed underpayment assessed in 2020 that the partnership then litigates in Tax Court, the decision of which is not appealed and becomes final in 2021, the adjustment year is 2021.

Payment of imputed underpayment by the partnership Any adjustment to items of income, gain, loss, deduction, or credit of a partnership for a partnership taxable year, and any partner’s distributive share thereof, are determined at the partnership level. In the event of any adjustment by the Secretary in the

198 Sec. 6225(d)(1). 199 Sec. 6225(d)(2).

amount of any item of income, gain, loss, deduction, or credit of a partnership, or any partner’s distributive share, that results in an imputed underpayment, the partnership is required to pay the imputed underpayment in the adjustment year.200

Interest at partnership level Interest due is determined at the partnership level and accrues at the rate applicable to underpayments.201

Adjustment that does not result in imputed underpayment Any adjustment by the Secretary in the amount of any item of income, gain, loss, deduction, or credit of a partnership, or any partner’s distributive share, that does not result in an imputed underpayment is taken into account by the partnership in the adjustment year. The amount of the adjustment is treated as a reduction in non-separately stated income or an increase in non-separately stated loss (whichever is appropriate). It may also be appropriate to treat the amount of an adjustment as a reduction (or increase) in a separately stated amount of income, gain, loss, or deduction. The amount of an adjustment in a credit is taken into account as a separately stated item.202

Determination of imputed underpayment amount An imputed underpayment of tax with respect to a partnership adjustment for any reviewed year is determined by netting all adjustments of items of income, gain, loss, or deduction and multiplying the net amount by the highest rate of Federal income tax applicable either to individuals or to corporations that is in effect for the reviewed year.203 Any adjustments to items of credit are taken into account as


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an increase or decrease, as the case may be, in the figure resulting from this multiplication. Any net increase or decrease in loss is treated as a decrease or increase, respectively, in income. Netting is done taking into account applicable limitations, restrictions, and special rules under present law.

Examples

Example.—Assume that a partnership reports the following items on its return for taxable year 2018 (dollar amounts in thousands):

rental income of $100 depreciation deduction of <$70> interest expense deduction of <$20> deduction for compensation paid of <$50>

In an examination of the partnership’s taxable year 2018, the Secretary determines that depreciation was <$80>, not <$70>, for the year. (Assume that this change does not affect depreciation in other taxable years.) The Secretary also finds that $5 of rental in-

200 Sec. 6225(a)(1). 201 Sec. 6621(a)(2). Rules relating to interest, penalties, and additions to tax are further described below. 202 Sec. 6225(a)(2). 203 Sec. 6225(b)(1). The rule for determining the imputed underpayment applies except as provided in subsection 6225(c), which provides that the Secretary shall establish procedures under which the imputed underpayment amount may be modified consistent with requirements imposed thereunder.

come was omitted, for total rental income of $105, not $100, for the year. The adjustment reflecting an increase of $5 of rental income is netted with the adjustment reflecting the <$10> change in the depreciation (both ordinary in character and not subject to differing limitations or restrictions). The resulting adjustment is a net increase in loss of <$5>. There is no imputed underpayment. For the adjustment year (not 2018, the reviewed year), the partnership has an increase in non-separately stated loss of <$5> (or a reduction in non-separately income of <$5>). Example.—As another example, assume a partnership reports the following items on its return for taxable year 2019 (dollar amounts in thousands):

ordinary income of $300 long-term capital gain (from asset sales) of $125, long-term

capital loss (from asset sales) of <$75>, for a net long-term capital gain of $50 depreciation deduction of <$100> tax credit of $5

In an examination of the partnership’s taxable year 2019, the Secretary adjusts these items as follows and finds:

ordinary income of $500 (a $200 adjustment) long-term capital gain of $200 (a $75 adjustment) and long-term

capital loss of <$25> (a <$50> adjustment), for a net long-term capital gain of $175 (a $125 adjustment) depreciation deduction of <$70> (a <$30> adjustment) tax credit of $3 (a <$2> credit adjustment)

These are netted under the provision as follows. The adjustments to ordinary income and to the ordinary depreciation deduction are netted: $200 minus <$30> yields $230. The adjustments to long-term capital gain and loss are netted: $75 minus <$50> yields $125. The adjustments total $355. Assume that the highest rate of Federal income tax applicable to individuals or corporations in 2019 is 39.6 percent. The product of $355 and 39.6 percent is $140.58. The credit adjustment of <$2> increases that figure, yielding an imputed underpayment of $142.58 (not taking into account possible modifications further described below). The partnership pays the imputed underpayment in the adjustment year.

Determining imputed underpayment amount: adjustments to distributive shares In determining an imputed underpayment, any adjustment that reallocates the distributive share of any item from one partner to another is taken into account by disregarding any decrease in any item of income or gain and disregarding any increase in any item of deduction, loss, or credit.204


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Example

For example, assume that a partnership has two partners, L and M. Under the partnership agreement, $100 of rental income is allocated to L and $70 of depreciation and interest deductions are allocated to M for the taxable year. The Secretary notifies the partnership and the partnership representative of an administrative pro-

204 Sec. 6225(b)(2).

ceeding initiated at the partnership level with respect to the partnership’s return for 2024. Assume that the Secretary determines that the $70 distributive share of depreciation and interest deductions should be reallocated from M to L. The imputed underpayment of the partnership is determined without decreasing the $100 of rental income by the $70 of depreciation and interest deductions. The adjustment is a $70 increase in income. Assume that the highest rate of Federal income tax applicable to individuals or corporations in 2024 is 39.6 percent. The product of $70 and 39.6 percent is $27.72, the amount of the imputed underpayment. However, the partnership may implement procedures for modifying the imputed underpayment as so determined.

Modification of imputed underpayment amount When an audit of a partnership is commenced, the Secretary notifies the partnership and the partnership representative of the administrative proceeding initiated at the partnership level. The Secretary also notifies the partnership and the partnership representative of any proposed partnership adjustment developed during the proceeding.205 The Secretary must establish procedures for modification of the amount of an imputed underpayment.206 One or more modification procedures may be implemented by the partnership after the initiation of the administrative proceeding, including before any notice of proposed adjustment. These procedures include the filing of amended returns by reviewed year partners, determination of the imputed underpayment without regard to the portion of it allocable to a tax-exempt partner, and modification of the applicable highest tax rates, including determining the portion of an imputed underpayment to which a lower rate applies.207 In addition, the Secretary may by regulations or guidance provide for additional procedures to modify imputed underpayment amounts on the basis of factors that the Secretary determines are necessary or appropriate to carry out the function of the modification provisions, that is, to determine the amount of tax due as closely as possible to the tax due if the partnership and partners had correctly reported and paid while at the same time to implement the most

205 Sec. 6231(a)(1) and (2). 206 Sec. 6225(c). 207 See section 411 of the Protecting Americans from Tax Hikes Act of 2015 (Division Q of Pub. L. No. 114–113). Under the provision, certain section 469(k) passive activity losses can reduce the imputed underpayment of a publicly traded partnership under the centralized system. The imputed underpayment can be determined without regard to the portion of the underpayment that the partnership demonstrates is attributable to (i.e., would be offset by) specified passive activity losses attributable to a specified partner. The amount of the specified passive activity loss is concomitantly decreased, and the partnership takes the net decrease into account as an adjustment in the adjustment year with respect to the specified partners to which the net decrease relates. A specified passive activity loss for any specified partner of a publicly traded partnership means the lesser of the section 469(k) passive activity loss of that partner which is separately determined with respect to the partnership (1) for the partner’s taxable year in which or with which the reviewed year of the partnership ends, or (2) for the partner’s taxable year in which or with which the adjustment year of the partnership ends. A specified partner is a person who continuously meets each of three requirements for the period starting with the partner’s taxable year in which or with which the partnership reviewed year ends through the partner’s taxable year in which or with which the partnership adjustment year ends. These three requirements are that the person is a partner of the publicly traded partnership; the person is an individual, estate, trust, closely held C corporation, or personal service corporation; and the person has a specified passive activity loss with respect to the publicly traded partnership.

efficient and prompt assessment and collection of tax attributable to the income of the partnership and partners. Anything required to be submitted pursuant to the modification of the amount of an imputed underpayment must be submitted to the Secretary not later than the close of the 270-day period beginning on the date the notice of a proposed partnership adjustment is mailed, unless the 270-day period is extended with the consent of the Secretary.


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Any modification of the amount of an imputed underpayment is made only upon approval of the modification by the Secretary.

Modification procedures: amended returns of reviewed year partners Payments made by reviewed year partners with amended returns can reduce the amount of an imputed underpayment.208 Procedures for modification provide that the amount of an imputed underpayment is determined without regard to the portion of the underpayment taken into account by payment of tax included with amended returns of the reviewed year partners. The amended return relates to the taxable year of the partner that includes the end of the reviewed year of the partnership. The amended return is to take into account all adjustments in the amount of any item of income, gain, loss, deduction, or credit of the partnership (or any partner’s distributive share) properly allocable to each partner, along with changes for any other taxable year with respect to which any tax attribute is affected by reason of the adjustments. Payment of any tax due is to be included with the amended return. In the case of an adjustment that reallocates the distributive share of any item from one partner to another, this modification procedure is only available if amended returns for the reviewed year are filed by all partners affected by the adjustment.

Modification procedures: tax-exempt partners Procedures for modification provide for determining the amount of the imputed underpayment without regard to the portion of it that the partnership demonstrates is allocable to a partner that would not owe tax by reason of its status as a tax-exempt entity for the reviewed year.209 For this purpose, a tax-exempt entity means (1) the United States, any State or political subdivision thereof, any possession of the United States, or any agency or instrumentality of any of these, (2) an organization (other than a cooperative) that is exempt from Federal income tax, (3) any foreign person or entity, and (4) any Indian tribal government determined by the Secretary in consultation with the Secretary of the Interior to exercise governmental functions. Under this procedure for modification, the partnership demonstrates the amounts of adjustments that are allocable to the tax-exempt partner and the resulting portion of the imputed underpayment allocable to that partner.210

208 Sec. 6225(c)(2). 209 Sec. 6225(c)(3). 210 Secs. 6225(c)(3) and 168(h)(2)(A).

Modification procedures: modification of applicable highest tax rates Procedures for modification provide for taking into account a rate of tax lower than the highest rate of Federal income tax applicable either to individuals or to corporations that is in effect for the reviewed year, for certain types of taxpayers or types of income.211 The partnership may demonstrate that a portion of an imputed underpayment is allocable to a partner that is a C corporation, and for that C corporation partner, the highest marginal rate of Federal income tax (35 percent in 2016, for example) for ordinary income and capital gain 212 for the reviewed year is lower than the highest marginal rate of Federal income tax for individuals (39.6 percent in 2016, for example). For a C corporation, the highest marginal rate of Federal income tax is the highest rate of tax specified in section 11(b). Similarly, the partnership may demonstrate that a portion of an imputed underpayment relates to an item of long-term capital gain or qualified dividend income that is allocable to a partner who is an individual, and that the highest rate of tax with respect to that item of long-term capital gain or qualified dividend income for the reviewed year (20 percent for 2016, for example) is lower than the highest rate of Federal income tax applicable to individuals for the reviewed year (39.6 percent in 2016, for example). The highest rate for the type of income and type of taxpayer applies under the modification. An S corporation is treated as an individual for this purpose.


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In general, the portion of the imputed underpayment to which the lower rate applies with respect to a partner is determined by reference to the partner’s distributive share of items of income, gain, loss, deduction, and credit to which the imputed underpayment relates. However, if the partner’s distributive share differs among items, then the portion of the imputed underpayment to which the lower rate applies is determined by reference to the amount of the partner’s distributive share of net gain or loss if the partnership had sold all of its assets at their fair market value as of the close of the reviewed year. For example, adjustments are made to a partnership’s rental income from property A and its depreciation deductions with respect to property B. A corporate partner has a 20 percent distributive share of rental income from property A, a 15 percent distributive share of depreciation deductions from property B, and a 20 percent distributive share of any gain in the reviewed year. However, if the partnership had sold its assets at fair market value as of the close of the reviewed year, the gain would have been $100, and based on its capital account, the corporate partner’s distributive share would have been $20. Thus, the portion of the imputed underpayment to which the lower rate applies with respect to the corporate partner is 20 percent.

211 Sec. 6225(c)(4). 212 The Secretary has regulatory authority under the provision, including authority to acknowledge or identify the types of income, gain, deduction, and loss to which the lower rate applies. See also section 411 of the Protecting Americans from Tax Hikes Act of 2015 (Division Q of Pub. L. No. 114–113). A lower rate of tax may be taken into account in the case of either capital gain or ordinary income of a partner that is a C corporation.

Modification procedures: additional procedures Additional procedures to modify the amount of an imputed underpayment may be provided by the Secretary on the basis of factors the Secretary determines are necessary or appropriate to carry out the purposes of the provision. These procedures allow partnerships to demonstrate tax attributes or information with respect to the reviewed year and with respect to reviewed year partners that could permit modification of the imputed underpayment to more closely approximate the amount of tax due with respect to the reviewed year if the partnership and partners had correctly reported and paid the tax due. In the absence of regulations or guidance specifically addressing the manner in which these modifications or calculations are made, it is anticipated that partnerships will furnish to the Secretary the necessary documentation, data, and calculations to determine the amount of the reduction of the imputed underpayment with a reasonably high degree of accuracy.

Alternative to payment of imputed underpayment by partnership As an alternative to partnership payment of the imputed underpayment in the adjustment year, the audited partnership may elect to furnish to the Secretary and to each partner of the partnership for the reviewed year a statement of the partner’s share of any adjustments to income, gain, loss, deduction and credit as determined in the notice of final partnership adjustment.213 In this case, each such partner takes these adjustments into account and pays the tax as provided under the provision.214

Payment by reviewed year partners in year that includes date of the statement

The reviewed year partner’s tax is increased for the partner’s taxable year that includes the date of the statement.

Amount of the reviewed year partner’s adjustment The reviewed year partner’s tax is increased by an amount equal to the aggregate of the adjustment amounts as determined under the provision. This includes the amount by which the partner’s tax would increase if the partner’s distributive share of the adjustment amounts were included for the partner’s taxable year that includes the end of the reviewed year, plus the amount by which the tax would increase by reason of adjustment to tax attributes in years after that year of the partner and before the year of the date of the statement. Tax attributes in any subsequent taxable year are required to be appropriately adjusted.


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Penalties, additions to tax, additional amounts Penalties, additions to tax, and additional amounts are determined at the partnership level; 215 each reviewed year partner is

213 Sec. 6226(a). 214 Sec. 6226(b). 215 Secs. 6221 and 6226(c).

liable for its share of the penalty, addition to tax, and additional amount.216

Interest at partner level from reviewed year, with adjustments In the case of an imputed underpayment for which the election under this provision is made, interest is determined at the partner level.217 Interest is determined from the due date of the partner’s return for the taxable year to which the increase is attributable. Interest is determined taking into account any increases attributable to a change in tax attributes for an intervening tax year. The rate of interest determined at the partner level is the underpayment rate as modified under the provision, that is, the rate is the sum of the Federal short-term rate (determined monthly) plus 5 percentage points.

Time and manner of making election The partnership may make this election not later than 45 days after the notice of final partnership adjustment.218 The election is revocable only with the consent of the Secretary. The election may be made whether or not the partnership files a petition for judicial review of the notice of final partnership adjustment.219

The partnership may make the election within 45 days from the notice of final partnership adjustment, and within 90 days from the notice of final partnership adjustment may file a petition for readjustment with the Tax Court, district court, or Court of Federal Claims.220 Upon the final court decision, dismissal of the case, or settlement, the partnership is to implement the election by furnishing statements (at the time and manner prescribed by the Secretary) to the reviewed year partners showing each partner’s share of the adjustments as finally determined. As part of any settlement, for example, it is contemplated that the Secretary may permit revocation of a previously made election, and the partnership may pay at the partnership level.

Time and manner of furnishing statement The statement is to be furnished to the Secretary and to partners within such time and in such manner as is prescribed by the Secretary. In the absence of such guidance, the statements are to be furnished to the Secretary and to all partners within a reasonable period following the last day on which to make the election under this provision. The date the statement is furnished (as well as the date of the statement) is the date the statement is mailed, for this purpose.

Information furnished on statement to the Secretary and to partners The statement furnished to the Secretary and to partners is to include the amounts of and tax attributes of the adjustments allocable to the recipient partner. Under regulatory authority, the Sec-

216 Sec. 6226(c). 217 Sec. 6226(c)(2). 218 Sec. 6226(a)(1). 219 Sec. 6226(d). See section 411 of the Protecting Americans from Tax Hikes Act of 2015 (Division Q of Pub. L. No. 114–113). 220 Sec. 6234.

retary may require the statement to show the amount of the imputed underpayment allocable to the recipient partner. In addition, the statement is to include the name and taxpayer identification number of the recipient partner. The Secretary may require that the statement include such additional information as is necessary or appropriate to carry out the purposes of the provision, such as the address of the recipient partner and the date the statement is mailed.


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Treatment of tiered partnerships and other tiered entities Tiered partnerships.—In the case of tiered partnerships, a partnership that receives a statement from the audited partnership is treated similarly to an individual 221

who receives a statement from the audited partnership. That is, the recipient partnership takes into account the aggregate of the adjustment amounts determined for the partner’s taxable year including the end of the reviewed year, plus the adjustments to tax attributes in the following taxable years of the recipient partnership. The recipient partnership pays the tax attributable to adjustments with respect to the reviewed year and the intervening years, calculated as if it were an individual (consistently with section 703), for the taxable year that includes the date of the statement. The recipient partnership, its partners in the taxable year that is the reviewed year of the audited partnership, and its partners in the year that includes the date of the statement, may have entered into indemnification agreements under the partnership agreement with respect to the risk of tax liability of reviewed year partners being borne economically by partners in the year that includes the date of the statement. Because the payment of tax by a partnership under the centralized system is nondeductible, payments under an indemnification or similar agreement with respect to the tax are nondeductible. Deficiency dividends.—A recipient partner that is a RIC or REIT and that receives a statement from an audited partnership including adjustments for a prior (reviewed) year may wish to make a deficiency dividend 222 with respect to the reviewed year. Guidance coordinating the receipt of a statement from an audited partnership by a RIC or REIT with the deficiency dividend procedures is expected to be issued by the Secretary.

Administrative adjustment request by partnership A partnership may file a request for an administrative adjustment in the amount of one or more items of income, gain, loss, deduction, or credit of the partnership for a partnership taxable year.223 Following the filing of the administrative adjustment request, the partnership may apply most of the procedures for modification 224 in a manner similar to modification of an imputed underpayment under new section 6225(c). Like the partnership audit, tax resulting from the adjustment may be paid by the partners in

221 See section 703, which states, ‘‘the taxable income of a partnership shall be computed in the same manner as in the case of an individual . . .’’. 222 Sec. 860. 223 Sec. 6227. 224 Not including the modifications pursuant to filing of amended returns of reviewed year partners in new section 6225(c)(2).

the manner in which a partnership pays an imputed underpayment in the adjustment year under new section 6225. Alternatively, the adjustment may be taken into account by the partnership and partners, and the tax paid by reviewed year partners upon receipt of statements showing the adjustments, similar to new section 6226.225 However, in the case of an adjustment (pursuant to a partnership’s administrative adjustment request) that would not result in an imputed underpayment, any refund is not paid to the partnership; rather, procedures similar to the procedure for furnishing reviewed year partners with statements reflecting the requested adjustment apply, with appropriate adjustments.

Time for making administrative adjustment request A partnership may not file an administrative adjustment request more than three years after the later of (1) the date on which the partnership return for the year in question is filed, or (2) the last day for filing the partnership return for that year (without extensions). In no event may a partnership file an administrative adjustment request after a notice of an administrative proceeding with respect to the taxable year is mailed.

Tiered partnerships In the case of tiered partnerships, a partnership’s partners that are themselves partnerships may choose to file an administrative adjustment request with respect to their distributive shares of an adjustment. The partners and indirect partners


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that are themselves partnerships may choose to coordinate the filing of administrative adjustment requests as a group to the extent permitted by the Secretary.

In general 226

Procedural Rules The new centralized system provides rules governing notices, time limitations, restrictions on assessment and the imposition of interest and penalties in the context of a partnership adjustment.227 The provisions include specific grants of regulatory authority to address the identification of foreign partners, the manner of notifying partners of an election out of centralized procedures, the manner in which a partnership representative is selected, and the extent to which the new centralized system may be applied before the generally applicable effective date.

Notice of proceedings and adjustments The centralized system contemplates three types of principal notifications by the Secretary to the partnership and the partnership representative in the course of an administrative proceeding with respect to that partnership. The notifications also apply to any proceeding with respect to an administrative adjustment request filed

225 Sec. 6227(b)(2); interest is computed at the underpayment rate (sec. 6621(a)(2)) without substituting ‘‘5 percentage points’’ for ‘‘3 percentage points’’ as under section 6226(c)(2)(C). 226 Secs. 6231 through 6235. 227 Secs. 6231–6235.

by a partnership.228 These notices are (1) notice of any administrative proceeding initiated at the partnership level; (2) notice of a proposed partnership adjustment resulting from the proceeding; and (3) notice of any final partnership adjustment resulting from the proceeding. Such notices are sufficient if mailed to the last known address of the partnership representative or the partnership, even if the partnership has terminated its existence. A notice of proposed adjustments informs the partnership of any adjustments tentatively determined by the Secretary and the amount of any imputed underpayment resulting from such adjustments. The issuance of a notice of proposed partnership adjustment begins the running of a period of 270 days in which to supply all information required by the Secretary in support of a request for modification. During that same period, the Secretary may not issue a notice of final partnership adjustment.229 The Secretary is required to establish procedures and timeframes for the modification process in published guidance, which may include conditions under which extensions of time in which to submit final documentation of a modification request may be permitted by the Secretary.230

With the issuance of a notice of final partnership adjustment to the partnership, a 90-day period begins during which the partnership may seek judicial review of the partnership adjustment. The issuance of a notice of final partnership adjustment also marks the beginning of the 45-day period in which the partnership may elect the alternative payment procedures.231 Further notices of adjustment or assessments of tax against the partnership with respect to the partnership taxable year that is the subject of the notice of final partnership adjustment are prohibited during the period in which judicial review may be sought or during which a judicial proceeding is pending (absent a showing of fraud, malfeasance, or misrepresentation of a material fact).232

Any notice of partnership adjustment may be rescinded by the Secretary, if the partnership consents. If the notice is rescinded, it is a nullity, and does not confer a right to seek judicial review, nor does it bar issuance of further notices.

Assessment, collection and payment An imputed underpayment is assessed and collected in the same manner as if it were a tax imposed for the adjustment year under the Federal income tax.233 The general provisions for assessment, collection and payment under subtitle F of the Code apply unless superseded by rules of the new centralized system. As a result, an imputed underpayment may be assessed against a partnership if the partnership agrees with the results of the examination, following the expiration of the


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90th day after issuance of a notice of final partnership adjustment without initiation of judicial proceedings, or in the case of timely judicial proceedings, following the entry of final decision of such proceedings. If no court proceeding is initiated within the 90-day period, the amount that may be as-

228 Secs. 6231(a) and 6227. 229 Sec. 6231(a). 230 Sec. 6225(c)(7). 231 Sec. 6226. 232 Sec. 6231(b). 233 Sec. 6232.

sessed against the partnership is limited to the imputed underpayment shown in the notice.234

In the case of an administrative adjustment request for which the adjustment is determined and taken into account by the partnership in the partnership taxable year in which the request is made,235 the imputed underpayment is required to be paid when the request is filed, and is assessed at that time. If the administrative adjustment request is subsequently audited and results in an imputed underpayment greater than that reported and paid with the originally filed request, the additional amount of the imputed underpayment may be assessed in the same manner and subject to same restrictions as any other imputed underpayment determined after examination.

Restrictions on assessment, levy, and collection The centralized system provides a limitation on the time for assessment of a deficiency as well as levy and court proceedings for collection. Except as otherwise provided, no assessment of a deficiency may be made, and no levy or court proceeding for collection of any amount resulting from an adjustment may be made, begun, or prosecuted with respect to the partnership taxable year in issue before the close of the 90th day after the day that a notice of final partnership adjustment was mailed. If a petition for judicial review is filed,236 no such assessment may be made and no such levy or court proceeding may be made, begun, or prosecuted before the decision of the court has become final.237

A premature action (i.e., one that violates the limitation on the time of assessment, levy, and court proceeding for collection) may be enjoined in the proper court, including the Tax Court.238 This rule applies notwithstanding the general rule prohibiting suits for the purpose of restraining the assessment or collection of any tax.239 The Tax Court has no jurisdiction to enjoin any such premature action unless a timely petition for judicial review has been filed,240 and then only in respect of the adjustments that are the subject of the petition. Several exceptions to the restrictions on assessment are provided.241 First, rules similar to the math error authority under section 6213(b) are permitted as exceptions to the restrictions on assessment described above. The exceptions apply to instances in which a partnership is notified that adjustments to its return are necessary to correct errors arising from mathematical or clerical errors and in the case of a tiered partnership that fails to prepare its partnership return consistently with that of the partnership in which it is a partner. In the case of an inconsistent return position, the rules similar to those in section 6213(b) (providing for subsequent abatement of any resulting assessments if challenged within

234 Sec. 6232(e). 235 Secs. 6232(a) and 6227(b)(1). 236 Sec. 6234. 237 Sec. 6232(b). 238 Sec. 6232(c). 239 Sec. 7421(a). 240 Sec. 6234. 241 Sec. 6232(d).

60 days) are not applicable. Finally, a partnership may waive the restrictions on the making of any partnership adjustment.


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Interest and penalties

Interest In general, interest due is determined at the partnership level and accrues at the rate applicable to underpayments.242 Two periods are relevant in computing the total interest due: the period in which the imputed underpayment of income tax exists, and the period attributable only to late payment of any imputed underpayment after notice and demand. For an imputed underpayment, interest accrues for the period from the due date of the return for the reviewed year until the due date of the adjustment year return, or, if earlier, payment of the imputed tax. If the imputed underpayment is not timely paid with the return for the adjustment year, interest is computed from the return due date for the adjustment year until payment. If the partnership elects the alternative payment method under section 6226, under which the underpayment is determined at the partner level, the interest due is computed at the partner level. The underpayment interest begins to accrue from the due date of the return for the taxable year to which the increase is attributable, at a rate two percentage points higher than the rate otherwise applicable to underpayments.

Penalties Generally, the partnership is liable for any penalty, addition to tax, or additional amount.243 These amounts are determined at the partnership level as if the partnership were an individual who was subject to Federal income tax for the reviewed year, and the imputed underpayment were an actual underpayment or understatement for the reviewed year. A penalty, addition to tax, or additional amount may apply with respect to an adjustment year return of a partnership in the event of late payment of an imputed underpayment, or, in the case of an election by the partnership under section 6226, with respect to the adjustment year return of a partner. In such cases, the penalty for failure to pay applies.244 For purposes of accuracy-related and fraud penalties, the determination is made by treating the imputed underpayment as an underpayment of tax.245

Judicial review of partnership adjustment A partnership may seek judicial review of a notice of final partnership adjustment within 90 days after the notice is mailed. Judicial review is available in the U.S. Tax Court, the Court of Federal Claims or a U.S. district court for the district in which the partnership has its principal place of business. With respect to judicial review in either the Court of Federal Claims or a U.S. district court, jurisdiction is contingent on the

242 Sec. 6621(a)(2). 243 Sec. 6233(a)(1)(B). 244 Secs. 6233(b)(3)(A) and 6651(a)(2). 245 Secs. 6662, 6662A, 6663, and 6664.

partnership depositing with the Secretary, on or before the date of the petition, an amount equal to the full imputed underpayment. The deposit is not treated as a payment of tax other than for purposes of determining whether interest on any underpayment as ultimately determined would be due. The proceeding under this provision is a de novo proceeding, and determinations made pursuant to the proceeding are subject to review to the same extent as any other decision, decree or judgment of the court in question. Once a proceeding is initiated, a decision to dismiss the proceeding (other than a dismissal because the notice of final partnership adjustment was rescinded under section 6231(c)), is a judgment on the merits upholding the final partnership adjustments.

Period of limitations on making adjustments In general, the Secretary may adjust an item on a partnership return at any time within three years of the date a return is filed (or the return due date, if the return is not filed) or an administrative adjustment request is made. The time within which


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the adjustment is made by the Secretary may be later if a notice of proposed adjustment 246 is issued, because the issuance of a notice of proposed partnership adjustment begins the running of a period of 270 days in which the partnership may seek a modification of the imputed underpayment. Although the partnership generally is limited to 270 days from the issuance of that notice to seek a modification of the imputed underpayment, extensions may be permitted by the IRS. During the 270-day period, the Secretary may not issue a notice of final partnership adjustment. After the timely issuance of a notice of proposed adjustment resulting in an imputed underpayment, the notice of final partnership adjustment may be issued no later than either the date which is 270 days after the partnership has completed its response seeking a revision of an imputed underpayment, or, if the partnership provides an incomplete or no response, no later than 330 days after the date of a notice of proposed adjustment.247

The partnership may consent to an extension of time within which a partnership adjustment may be made. In addition, the provision contemplates that the Secretary may agree to extend the period of time in which the request for modification is submitted, under procedures to be established for submitting and reviewing requests for modification. If an extension of the time within which to seek a modification is granted, a similar period is added to the time within which the Secretary may issue a notice of final partnership adjustment. The procedures for modifications of imputed underpayments are required to provide rules that exclude from any

246 Sec. 6231. 247 See section 411 of the Protecting Americans from Tax Hikes Act of 2015 (Division Q of Pub. L. No. 114–113), which rectifies the unintended conflict between section 6231 (barring the Secretary from issuing the notice of final partnership adjustment earlier than the expiration of the 270 days after the notice of a proposed adjustment) and section 6235 (requiring that a notice of final partnership adjustment be filed no later than 270 days after the notice of proposed adjustment in the case of a partnership that does not seek modification of the imputed underpayment). As amended, section 6235 provides that a notice of final partnership adjustment to a partnership that does not seek modification of an underpayment in response to a notice of proposed adjustment may be issued up to 330 days (plus any additional number of days that were agreed upon as an extension of time for taxpayer response) after the notice of proposed adjustment.

underpayment of tax the portion of adjustments that may have already been taken into consideration on amended returns filed by partners and for which the allocable underpayment of tax was paid. Several exceptions similar to those generally applicable outside the context of partnerships are provided to the limitations period. In the case of a fraudulent return or failure to file a return, a partnership adjustment may be made at any time. If a partnership files a return on which it makes a substantial omission of income within the meaning of section 6501(e)(1)(A), the Secretary may make adjustments to the return within six years of the date the return was filed. In addition, if a notice of final partnership adjustment described in section 6231 is mailed, the limitations period is suspended for the period during which judicial remedies under section 6234 may be pursued or are pursued and for one year thereafter. Where a partnership elects to apply section 6226, this provision operates to ensure that the period in which the Secretary may assess the resulting underpayment due from each partner is open for at least one year after proceedings at the partnership level have concluded. The partner who is responsible for paying an underpayment arising from the partnership reviewed year must compute such tax with respect to his taxable year in which or with which the partnership reviewed year ends, and pay the additional tax with the return for the year in which the partnership mails the statements to partners under section 6226. Because the additional tax arises from an adjustment at the partnership level that is binding on the partner, the partner may neither contest the merits of the partnership adjustment, nor may the partner claim the Secretary is time-barred with respect to such adjustment.

Examples

The interaction of the notice requirements of new section 6231 and the limitations period with regard to adjustments to partnership returns that result in imputed underpayments under new section 6235 is illustrated in this example regarding a partnership’s taxable year 2018. On March 15, 2019, it files a timely income tax return for the taxable year 2018. Absent any other activity by the Secretary or the partnership, the general three-


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year limitations period in which any item on the return may be adjusted expires in three years, on March 15, 2022. On December 15, 2020, the Secretary notifies the partnership that it intends to initiate an administrative proceeding with respect to the 2018 partnership return. That notice neither shortens nor extends the period in which partnership adjustments may be made by the Secretary, but it ends the period in which the partnership may submit an administrative adjustment request with respect to that taxable year. On September 15, 2021, the Secretary issues a notice of proposed adjustments that result in an imputed underpayment. Issuance of this notice triggers a period of 270 days during which the Secretary may not issue a notice of final partnership adjustment and within which the partnership must submit all required documentation in support of a request for modification of the imputed underpayment. This 270-day periods ends on June 15, 2022, which is later than the expiration of the otherwise applicable limitations period. The deadline for issuance of a notice of final partnership adjustment will depend upon whether and how the partnership responds to the proposed notice of adjustments. If nothing further is received from the partnership, the Secretary may issue a notice of final partnership adjustment no later than 330 days after the notice of proposed adjustments (i.e., within 60 days after the expiration of the 270-day period in which partnership was permitted to respond). Because the 330th day after September 15, 2021, falls on Sunday, August 14, 2022, the final date on which the Secretary may issue a notice of final partnership adjustment is Monday, August 15, 2022.248

The partnership may instead respond to the notice with a timely request for modification of the imputed underpayment but ask for additional time to complete its submission in support of the request for modification. For example, the Secretary may grant a timely request for 45 additional days, allowing the partnership until Monday, August 1, 2022, to submit its complete response.

If the partnership fails to provide the required information by August 1, 2022 and no further extension is granted, then the Secretary may issue a notice of final partnership adjustment no later than September 30, which is 60 days after August 1, 2022 (the end of the 270-day period plus the additional time that was granted to the taxpayer to provide its complete response). If the partnership instead provides its complete response on

August 1, a notice of final partnership adjustment may be issued up to 270 days after the date on which the information required by the Secretary was submitted, or April 28, 2023. During this 270-day period ending with April 28, 2023, the Secretary is expected to review the information that was submitted and revise the adjustments that were proposed if appropriate.

In the alternative, consider a variation of the above facts in which the partnership submits an administrative adjustment request on June 1, 2020 that corrects several errors on its timelyfiled 2018 return. The administrative adjustment request results in an imputed underpayment of tax, which the partnership pays in full, with interest from March 15, 2019 (the filing date of the return) when it submits the administrative adjustment request. On December 15, 2020, the Secretary notifies the partnership that he will initiate an administrative proceeding with regard to taxable year 2018. On September 15, 2021, the Secretary issues a notice of proposed adjustments to the partnership 2018 return. As a result of submitting an administrative adjustment request, the period in which partnership adjustments to the taxable year 2018 may be made is extended to June 1, 2023, the date that is three years from the date the administrative adjustment request is submitted. Because that date is later than all of the extensions described in the preceding scenarios, the Secretary may issue a notice

248 See section 7503.


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of final partnership adjustments on or before June 1, 2023, provided that such notice is issued after expiration of the 270-day period within which the partnership must respond to the notice of proposed adjustments issued September 15, 2021. The issuance of a notice of proposed adjustments cannot shorten the limitations period for making an adjustment to the partnership return. Issues raised by the partnership in its administrative adjustment request may be the subject of inquiry by the Secretary in several ways. If the original partnership return may be the subject of an examination, the administrative adjustment request is likely to be reviewed as part of that process. Alternatively, the administrative adjustment request may be subject to examination on its own. Interest on an imputed underpayment accrues from March 15, 2019, the unextended due date of the 2018 timely return until payment, whether the examination was prompted by the return or solely by the administrative adjustment request. However, full payment of the reported underpayment reported on the administrative adjustment request, plus interest calculated through the date of the administrative adjustment requests, ends accrual of additional interest with respect to that portion of the underpayment ultimately determined that was reported on the administrative adjustment request. If an increase in the imputed underpayment reported by the partnership results from the relevant examination, the additional tax that should have been reported and paid with the administrative adjustment request submitted during 2020 will incur interest from March 15, 2019, unextended due date of the 2018 return, to the date the amount is paid. In addition, the issues presented in the administrative adjustment request may be relevant to determining the correct treatment of items reported by the partnership on returns for other periods. For example, the year in which the request is filed may be subject to examination for issues related to the items that were the subject of the administrative adjustment request. In that case, information from taxable year 2018 is relevant, regardless of whether an examination of 2018 is opened. However, no imputed underpayment for 2018 may be determined without initiating an administrative proceeding with respect to that year.

Definitions and Special Rules

(footnote 249)

Partnership The term partnership means any partnership required to file a return under section 6031(a). This includes any partnership described in section 761 that is required to file a return.

Partnership adjustment The term partnership adjustment means any adjustment in the amount of any item of income, gain, loss, deduction, or credit of a partnership, or any partner’s distributed share thereof.

249 Sec. 6241.

Return due date The term return due date means, with respect to the taxable year, the date prescribed for filing the partnership return for such taxable year (determined without regard to extensions).

Payments nondeductible No deduction is allowed under the Federal income tax for any payment required to be made by a partnership under the centralized system of partnership audit, assessment, and collection. Under the centralized system, the flowthrough nature of the partnership under subchapter K of the Code is unchanged, but the partnership is treated as a point of collection of underpayments that would otherwise be the responsibility of


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partners. The return filed by the partnership, though it is an information return, is treated as if it were a tax return where necessary to implement examination, assessment, and collection of the tax due and any penalties, additions to tax, and interest. A basis adjustment (reduction) to a partner’s basis in its partnership interest is made to reflect the nondeductible payment by the partnership of the tax. Specifically, present-law section 705(a)(2)(B) applies, providing that the adjusted basis of a partner’s interest in a partnership is the basis of the interest determined under applicable rules relating to contributions and transfers, and decreased (but not below zero) by expenditures of the partnership that are not deductible in computing its taxable income and not properly chargeable to capital account. Concomitantly, the partnership’s total adjusted basis in its assets is reduced by the cash payment of the tax. Thus, parallel basis reductions are made to outside and inside basis to reflect the partnership’s payment of the tax. Partners, former partners, and the partnership may have entered into indemnification agreements under the partnership agreement with respect to the risk of tax liability of former or new partners being borne economically by new or former partners, respectively. Because the payment of tax by a partnership under the centralized system is nondeductible, payments under an indemnification or similar agreement with respect to or arising from the tax are nondeductible.

Partnerships having principal place of business outside the United States For purposes of judicial review following a notice of final partnership adjustment, a principal place of business located outside the United States is treated as located in the District of Columbia.

Suspension of period of limitations on making adjustment, assessment or collection The provision includes a rule similar to the present-law rule 250 to conform the automatic stay of the Bankruptcy Code (Title 11) with the limitations period applicable under the centralized system for partnership adjustments. Any statute of limitations period provided under the centralized system on making a partnership adjustment, or on assessment or collection of an imputed under-

250 Sec. 6213(f).

payment, is suspended during the period the Secretary is prohibited by reason of the Title 11 case from making the adjustment, assessment, or collection. For adjustment or assessment, the relevant statute of limitations is extended for 60 days thereafter. For collection, the relevant statute of limitations is extended for six months thereafter. In a case under Title 11, the 90-day period to petition for judicial review after the mailing of the notice of final partnership adjustment 251 is suspended during the period the partnership is prohibited by reason of the Title 11 case from filing such a petition for judicial review, and for 60 days thereafter.

Treatment where partnership ceases to exist

If a partnership ceases to exist before a partnership adjustment under the centralized system is made, the adjustment is taken into account by the former partners of the partnership, under regulations provided by the Secretary. Whether a partnership ceases to exist for this purpose is determined without regard to whether there is a technical termination of the partnership within the meaning of section 708(b)(1)(B). The successor partnership in a technical termination succeeds to the adjustment or imputed underpayment, absent regulations to the contrary. A partnership that terminates within the meaning of section 708(b)(1)(A) is treated as ceasing to exist. In addition, a partnership also may be treated as ceasing to exist in other circumstances or based on other factors, under regulations provided by the Secretary. For example, for the purpose of whether a partnership ceases to exist under new section 6241(7), a partnership that has no significant income, revenue, assets, or activities at the time the partnership adjustment takes effect may be treated as having ceased to exist.


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Extension to entities filing partnership return If a partnership return (Form 1065) is filed by an entity for a taxable year but it is determined that the entity is not a partnership (or that there is no entity) for the year, then, to the extent provided in regulations, the provisions of this subchapter are extended in respect of that year to the entity and its items of income, gain, loss, deduction, and credit, and to persons holding an interest in the entity. For example, assume two taxpayers purport to create a partnership for taxable year 2018, and a Form 1065 is filed for that year. The partnership is the subject of an audit under the centralized system for 2018, and pursuant to the provisions for judicial review, the partnership is determined by a court not to exist as partnership. Nevertheless, the rules of the centralized system apply to the items of income, gain, loss, deduction and credit, and to the two taxpayers, in respect of 2018. An imputed underpayment may be collected from the purported partnership in the adjustment year pursuant to new section 6225. Alternatively, the purported partnership representative may elect (at the time and in the manner prescribed by the Secretary) under new section 6226 to issue statements to the two taxpayers, which purported to hold partnership

251 Sec. 6234.

interests for the reviewed year. To the extent of the adjustments, each of the two taxpayer’s tax may be increased for the taxpayer’s taxable year that includes the date of the statement. In this situation, the amount of the increase for each of them is amount by which the taxpayer’s tax would increase if the taxpayer’s share of the adjustment amounts were included for the taxpayer’s taxable year that includes the end of the reviewed year, plus the amount by which the tax would increase by reason of adjustment to tax attributes in years after that year of the taxpayer and before the year of the date of the statement.

Related provisions

Binding nature of partnership adjustment proceedings The provision clarifies that the merits of an issue that is the subject of a final determination in a proceeding brought under the centralized system 252 is among the issues that are precluded from being raised at a collection due process hearing (in connection with the right to, and opportunity for, such a hearing prior to a levy on any property or right to any property under present law).253 The provision does not restrict the authority of the Secretary to permit an opportunity for administrative review, similar to the Collection Appeals Program,254 nor does it limit a partner’s right to seek review of the conduct of collection measures, such as whether notices of Federal tax lien or notice of intent to levy were timely issued. For example, assume that a partnership is audited with respect to taxable year 2018. One of the adjustments reflects the partnership’s omission of income of $1,000 in calculating partnership taxable income. Following receipt of the notice of final partnership adjustment, the partnership decides not to litigate. The partnership elects to issue statements to reviewed year partners, whose tax is increased for the partner’s taxable year that includes the date of the statement, 2021. Reviewed year partner A’s adjustment is $100, resulting in an increase in tax of $35, but partner A does not pay the increased amount of tax. The time for the partnership to litigate the adjustments has elapsed and the notice of final partnership adjustment is a final determination. Prior to any levy on any property or right to any property of partner A in connection with collection of the $35 tax, partner A has the right to and is afforded the opportunity for a hearing (the collection due process hearing). At the hearing, partner A may not raise the issue of whether the $1,000 (or A’s $100 share of it) was properly includable in determining partnership taxable income, because a final determination

252 That is, a proceeding brought under subchapter C of chapter 63 of the Code. 253 Section 6330 establishes the requirement that the IRS provide notice of potential collection action and offer an opportunity for a hearing before an impartial officer, and identifies which issues may be raised at such hearing and which are precluded. Issues permitted to be raised include the underlying liability only if the taxpayer did not receive a


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notice of deficiency or otherwise have an opportunity to contest the liability. Prior to amendment, the issues that were precluded listed those that were the subject of any previous administrative or judicial proceeding. Treas. Reg. 301–6330. The Secretary’s power to levy is set forth in present-law section 6331. 254 For example, under TEFRA, the IRS permits partners to raise computational issues, interest abatement questions and other collection due process rights in administrative appeals in order to assure consistency in the handling of the cases, even though the partners are precluded from questioning the substance of the partnership adjustment. See Internal Revenue Manual, paragraph 8.22.8.19, TEFRA Partnerships.

with respect to the issue was made in a proceeding brought under the centralized system. The result is the same if the partnership had decided to seek judicial review and the final determination of the court is that the $1,000 is includable in determining partnership taxable income.

Restriction on authority to amend partner information statements The provision provides that partner information returns (currently Schedules K–1) required to be furnished by the partnership 255 may not be amended after the due date of the partnership return to which the partner information returns relate. The due date takes into account the permitted extension period. For example, the Schedules K–1 furnished by a partnership with respect to its taxable year 2020 may not be amended after the due date for the partnership 2020 return. If the partnership has a calendar taxable year, the due date for its partnership 2020 return is September 15, 2021 (taking into account the permitted 6-month extension following the due date of March 15, 2021), after which date the Schedules K–1 for 2020 may no longer be amended.256 The partnership may, however, file an administrative adjustment request pursuant to new section 6227, and the partnership may pay any resulting imputed underpayment at the partnership level.

Example

For example, assume that a partnership files its Form 1065 for taxable year 2020 on March 15, 2021. On November 3, 2021, the partnership discovers an omission from income for 2020. The partnership may not issue amended Schedules K–1 to its partners for 2020. However, the partnership may file an administrative adjustment request and pay the underpayment consistently with new section 6227(b)(1) for the partnership taxable year in which the administrative adjustment request is made. In this situation, the partnership does not furnish amended Schedules K–1 to the partners and the partners do not file amended Federal and State income tax returns with respect to the omitted income.257

Effective Date The provision applies to returns filed for partnership taxable years beginning after December 31, 2017. The provision relating to administrative adjustment requests applies to requests with respect to returns filed for partnership taxable years beginning after December 31, 2017. The provision relating to the election of a partnership to furnish statements to partners (section 6226) applies to

255 The requirement of furnishing partner information returns is imposed by section 6031(b). See section 411 of the Protecting Americans from Tax Hikes Act of 2015 (Division Q of Pub. L. No. 114–113), correcting a conforming amendment to strike the last sentence of section 6031(b) under prior law, which sentence related to repealed provisions on electing large partnerships. 256 This rule does not, however, preclude the filing of amended returns of reviewed-year partners pursuant to the procedure for modification of an imputed underpayment in section 6225(c)(2). 257 The partnership that files the administrative adjustment request is not precluded from furnishing under section 6227(b)(2) an adjusted statement (similar to a Schedule K–1) to each reviewed-year partner, who is then required to pay tax attributable to the partnership adjustment (as provided under guidance provided by the Secretary).

elections with respect to returns filed for partnership taxable years beginning after December 31, 2017. A partnership may elect for the provisions of the centralized system (other than the election out under section 6221(b)) to apply to any return of the partnership filed for partnership taxable years beginning after the date of enactment and before January 1, 2018. This election is made at such time and in such form and manner as the Secretary of the Treasury may prescribe. A partnership may not elect out of the centralized system under section 6221(b) in combination with this election. A partnership may choose to make this election, for example, to be eligible before 2018 to pay at the partnership level, to obviate the need to furnish amended Schedules K–1 to correct a partnership-level error, or to obviate the need for


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partners receiving amended Schedules K–1 to file amended Federal and State income tax returns. A partnership may not elect out of the centralized system under section 6221(b) in combination with this election.

Temporary regs set out how to elect new partnership uniform audit rules Additional resources: Potential Financial Reporting Implications of Changes to Partnership Examinations, by Summer, LeBlanc, Corum, KPMG Washington National Tax T.D. 9780, Temp. Reg. 301.9100-22T, Prop. Reg. 301.9100-22 (08/04/2016) --

How to Elect Into The New Partnership Audit Rules The Bipartisan Budget Act of 2015, Public Law 114-74 (BBA) enacted November 2, 2015 and clarified by the PATH Act on December 18, 2015, created the new partnership audit regime effective for partnership taxable years beginning after December 31, 2017 (details discussed above). The BBA provides that a partnership may elect “(at such time and in such form and manner as the Secretary may prescribe)” to apply the new audit regime to tax years beginning after November 2, 2015 and before January 1, 2018 (Preamble). The temporary regulations “provide the time, form, and manner for a partnership to make an election to apply the new partnership audit regime to returns filed for a tax year beginning after Nov. 2, 2015 and before January 1, 2018. “[A] partnership that elects to apply the new partnership audit regime to a partnership return filed for an eligible taxable year may not elect out of the new rules under the small partnership exception under section 6221(b) as added by BBA, with respect to that return” (Preamble). Temp. Reg. 301.9100-22T(a) “further provides that an election made not in accordance with [the] temporary regulations is not valid, and an election, once made, may only be revoked with consent of the IRS” (Preamble). General Rule. The preamble explains the manner of making the election under the “general rule” as follows:

“Under the general rule in §301.9100-22T(b), an election to have the new partnership audit regime apply must be made when the IRS first notifies the partnership in writing that a partnership return for an eligible taxable year has been selected for examination (a "notice of selection for examination"). Section 301.9100-22T(b)(1) provides that a partnership that wishes to make an election must do so within 30 days of the date of the notice of selection for examination. The notice of selection for examination referred to in §301.9100-22T(b) is a notice that precedes the notice of an administrative proceeding required under section 6231(a) as amended by the BBA. Section 301.9100-22T(b) provides that the IRS will not issue a notice of an administrative proceeding, which cuts off the partnership's time for filing an AAR


https://home.kpmg.com/content/dam/kpmg/pdf/2016/01/tnf-wnit-jan6-2015.pdf

https://home.kpmg.com/content/dam/kpmg/pdf/2016/01/tnf-wnit-jan6-2015.pdf

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under section 6227 as amended by the BBA, for at least 30 days after it receives a valid election filed in accordance with §301.9100-22T(b). During the period of at least 30 days after the IRS receives a valid election and before the IRS mails the notice of an administrative proceeding, the partnership may file an AAR under section 6227 as amended by the BBA. Section 301.9100-22T(b)(2) provides that an election must be in writing and include a statement that the partnership is electing to have the partnership audit regime enacted by the BBA apply to the partnership return identified in the IRS notification of selection for examination. The partnership must write "Election under Section 1101(g)(4)" at the top of the statement. The statement must be provided to the individual identified in the notice of selection for examination as the IRS contact for the examination. In addition, the statement must be dated and signed by the tax matters partner, as defined under section 6231(a)(7) of the TEFRA partnership procedures and the applicable regulations, or an individual who has the authority to sign the partnership return for the taxable year under examination under section 6063 of the Code, the regulations thereunder, and applicable forms and instructions. The statement must include the name, taxpayer identification number, address, and telephone number of the individual who signs the statement, as well as the partnership's name, taxpayer identification number, and tax year to which the statement applies. The statement must include representations that the partnership is not insolvent and does not reasonably anticipate becoming insolvent, the partnership is not currently and does not reasonably anticipate becoming subject to a bankruptcy petition under title 11 of the United States Code, and the partnership has sufficient assets, and reasonably anticipates having sufficient assets, to pay the potential imputed underpayment that may be determined during the partnership examination. The statement must also include a representation, signed under penalties of perjury, that the individual signing the statement is duly authorized to make the election under §301.9100-22T(b) and that, to the best of the individual's knowledge and belief, the statement is true, correct, and complete.

Exception to the General Rule. Per the preamble:

“Section 301.9100-22T(c) provides an exception to the general rule in §301.9100-22T(b) that a partnership may only elect into the new partnership audit regime after first receiving a notice of selection for examination. This exception provides that a partnership that has not received a notice of selection for examination described in §301.9100-22T(b) may make an election to have the new partnership audit regime apply to a partnership return for an eligible taxable year if the partnership wishes to file an AAR under section 6227 as amended by the BBA. Once an election is made under §301.9100-22T(c), all aspects of the new partnership audit regime, except section 6221(b) as added by the BBA, apply to the return filed for the eligible taxable year subject to the election. As with an election under §301.9100-22T(b), an election under §301.9100-22T(c) may not be revoked without consent of the IRS.


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An election under §301.9100-22T(c) must be made only in the manner prescribed by the IRS in accordance with the forms and instructions and other guidance issued by the IRS. In no case may an election under §301.9100-22T(c) be made earlier than January 1, 2018. Consequently, an AAR under section 6227 as amended by the BBA may not be filed before January 1, 2018 (except by partnerships that have been issued a notice of selection for examination pursuant to the procedures discussed above). An AAR filed before that date (other than an AAR filed by a partnership that made a valid election under §301.9100-22T(b)) will be treated as an AAR by the partnership under section 6227 of the TEFRA partnership procedures, or as an amended return of partnership income for partnerships not subject to the TEFRA partnership procedures, and will prevent the partnership taxable year for which the request, or return, is filed from being an eligible taxable year. See §301.9100-22T(d)(2). The Treasury Department and the IRS intend to issue guidance regarding AARs under section 6227 as amended by the BBA before January 1, 2018.”

The text of the temporary regulations also serves as the text of accompanying proposed regulations.

Additional Resources:

Links to New York State Bar Tax Section Letter and Report on the new partnership audit rules: I just spoke with the chair of the NY State Bar Tax Section about a bar process item and he happened to

note that the comments they sent to IRS on the p/s audit rules includes ways that taxpayers might try to

get around the rules. In case you haven’t seen the extensive letter:

Letter- http://www.nysba.org/Sections/Tax/Tax_Section_Reports/Tax_Reports_2016/Tax_Section_Letter_13

47.html

Report- http://www.nysba.org/Sections/Tax/Tax_Section_Reports/Tax_Reports_2016/Tax_Section_Report_1

347.html


http://www.nysba.org/Sections/Tax/Tax_Section_Reports/Tax_Reports_2016/Tax_Section_Letter_1347.html

http://www.nysba.org/Sections/Tax/Tax_Section_Reports/Tax_Reports_2016/Tax_Section_Letter_1347.html

http://www.nysba.org/Sections/Tax/Tax_Section_Reports/Tax_Reports_2016/Tax_Section_Report_1347.html

http://www.nysba.org/Sections/Tax/Tax_Section_Reports/Tax_Reports_2016/Tax_Section_Report_1347.html

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Chapter 6: Credits Page 6-1

Chapter 6 : Credits

Table of Contents Chapter 6 : Credits ................................................................................................................... 6-1

Research Credit Statutory Changes Made in 2015 ............................................................. 6-1

Research Tax Credit Made Permanent ............................................................................... 6-1

Final Research Credit Regulations on the Internal Use Software Exception (§1.41-4) .. 6-2

MTC and Sequestration ........................................................................................................ 6-3

§45B and Carryback Correction – PLR 201548006 (11/27/15) ......................................... 6-4

Work Opportunity Tax Credit Transitional Relief – Notice 2016-22 ............................... 6-4

Empowerment Zones – Notice 2016-28 ................................................................................ 6-5

Section 45 and 48 Energy Credits – Notice 2016-31 ........................................................... 6-5

Income Inclusion When Lessee Treated as Having Acquired Investment Credit Property.................................................................................................................................................. 6-5

Fuel Excise Tax Credits – Notice 2016-05 ............................................................................ 6-5

Electricity and Coal Credits 2016 Figures – Notice 2016-34 .............................................. 6-6

Low-Income Housing Credit (§42) – Rev. Proc. 2016-15 ................................................... 6-6

§30D – Notice 2016-51 (9/12/16)............................................................................................ 6-6

§45K – Notice 2016-43 (7/18/16) ........................................................................................... 6-6

§43 – Notice 2016-44 (7/18/16) .............................................................................................. 6-6

§45Q - Credit for Carbon Dioxide Sequestration – Notice 2016-39 .................................. 6-6

§48 Rehabilitation Credit – CCA 201641022 (10/7/16) ...................................................... 6-6

Research Credit Statutory Changes Made in 2015 For changes effective for tax years beginning after 12/31/15 to allow certain businesses to use the credit against AMT or against payroll taxes, see Chapter B1.

Research Tax Credit Made Permanent PL 114-113 (12/18/16) (PATH) made the research tax credit permanent. This had been a temporary provision since first enacted in 1981 – the longest running temporary provision in the IRC! This change is effective from its expiration date of 12/31/14. There was some confusion as to whether this change reinstated the alternative incremental version repealed a few years back. Per footnote 411 of the JCT Bluebook, this was not the intent.



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“In making the present law research credit permanent, Congress did not intend to reinstate the previously terminated alternative incremental research credit. See letter dated January 27, 2016, reprinted in Tax Notes Today (Doc 2016–2887, 2016 Tax Notes Today 27–38), from Chairmen Brady and Hatch and Ranking Members Levin and Wyden to Secretary of the Treasury Lew and Commissioner of Internal Revenue Service Koskinen so stating and announcing their intention to introduce technical correction legislation to strike the alternative incremental research credit from the Code, effective as if included in the PATH Act.”

Final Research Credit Regulations on the Internal Use Software Exception (§1.41-4)

TD 9786 (10/4/16) contains the long awaited (after a few proposed regulation attempts) regulations explaining the exception to the credit for internal use software. The regulations define this term and also explain the exception to the exception where certain internal use software will qualify for the credit.

Key to understanding “internal use software” in the final regulations is that “(1) software is not developed primarily for the taxpayer’s internal use if it is not developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer’s trade or business; and (2) software that is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties and software that is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer’s system are examples of software that is not developed primarily for the taxpayer’s internal use.”

Look at the function of the software, note the type of software.

The classification must be performed at the start of the project as that ties best to the purpose of the research credit. “Congress intended that the credit for increasing research activities would provide an incentive for greater private activity in research. That incentive nature of section 41 is promoted by taking into account a taxpayer’s intent at the beginning of the software development; allowing any change in a taxpayer’s intent throughout the development to support treatment as qualifying research of expenses incurred prior to that change would frustrate the purpose of the credit. Furthermore, allowing a taxpayer to redetermine the overall project’s credit eligibility throughout the development which could span multiple years would provide uncertain and inconsistent treatment and impose an undue burden on both taxpayers and the IRS.”

Guidance is also provided on the exception to the exception where “certain internal use software is eligible for the research credit if the software satisfies the high threshold of innovation test, the three parts of which are (1) software is innovative in that the software would result in a reduction in cost or improvement in speed or other measurable improvement, that is substantial and economically significant, if the development is or would have been successful; (2) software development involves significant economic risk in that the taxpayer commits substantial resources to the development and there is a substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period; and (3) software is not commercially available for use by the taxpayer in that the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.” These terms are defined in the regulations.



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Two examples from the regulations:

“Example 4. Internal use software; support services—(i) Facts. X, a restaurant, develops software for a Web site that provides information, such as items served, price, location, phone number, and hours of operation for purposes of advertising. At the beginning of the development, X does not intend to develop the Web site software for commercial sale, lease, license, or to be otherwise marketed to third parties or to enable X to interact with third parties or to allow third parties to initiate functions or review data on X’s system. X intends to use the software for marketing by allowing third parties to review general information on X’s Web site.

(ii) Conclusion. The software is developed for use in a general and administrative function because the software was developed to be used by X for marketing which is a support services function under paragraph (c)(6)(iii)(B)(3) of this section. Accordingly, the software is internal use software because it is developed for use in a general and administrative function.”

“Example 9. Not internal use software; commercially sold, leased, licensed, or otherwise marketed—(i) Facts. X is a provider of cloud-based software. X develops enterprise application software (including customer relationship management, sales automation, and accounting software) to be accessed online and used by X’s customers. At the beginning of development, X intended to develop the software for commercial sale, lease, license, or to be otherwise marketed to third parties.

(ii) Conclusion. The software is not developed primarily for internal use because it is not developed for use in a general and administrative function. X developed the software to be commercially sold, leased, licensed, or otherwise marketed to third parties under paragraph (c)(6)(iv)(A) of this section.”

MTC and Sequestration FAA 20163601F (9/2/16) – In a heavily redacted memo, the IRS concludes:

“nothing in section 53 provides for a reduction of the allowable MTC by the Sequestration amount, or otherwise amends the MTC calculation to account for Sequestration. The amount of MTC allowable in -------- has not changed.”

FAA or LAFA = Legal Advice Issued by Field Attorneys

The IRS updated its website on 10/4/16 to provide the following:

“Pursuant to the requirements of the Balanced Budget and Emergency Deficit Control Act of 1985, as amended, refund payments issued, as well as credit elect and refund offset transactions, for corporations claiming refundable prior year minimum tax liability, are subject to sequestration. This means that refund payments processed on or after Oct. 1, 2016, and on or before Sept. 30, 2017, as well as credit elect and refund offset transactions processed on or after Jan. 1, 2017 and on or before Sept. 30, 2017, will be reduced by the fiscal year 2017 sequestration rate of 6.9 percent, irrespective of when the original or amended tax return was received by the Service. The sequestration reduction rate will be applied unless and until a law is enacted that cancels or otherwise impacts the sequester, at which time the sequestration reduction rate is subject to change.



https://www.irs.gov/uac/legal-advice-issued-by-field-attorneys

https://www.irs.gov/businesses/effect-of-sequestration-on-the-alternative-minimum-tax-credit-for-corporations

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A corporation that can claim an additional first-year depreciation deduction under section 168(k) can choose instead to accelerate the use of its prior year minimum tax credits, treating the accelerated credits as refundable credits. Corporations making this section 168(k)(4) election and claiming a refund of prior year minimum tax credits should complete Form 8827. These corporations will be notified that a portion of their requested refund was subject to the sequester reduction.

Corporations making the section 168(k)(4) election but not claiming a refund of prior year minimum tax credits are not subject to this reduction.”

§45B and Carryback Correction – PLR 201548006 (11/27/15) PLR 201548006 (11/27/15) – The IRS concludes with respect to the taxpayer’s credit carryover under §45B, Credit for portion of employer social security taxes paid with respect to employee cash tips:

“it is clear that a general business credit originating from closed years and being carried into open years in arriving at tax due can be adjusted to correct errors under the applicable provisions of the law by both the Service and Taxpayer. Although none of the precedents cited above specifically involve partnerships, S corporations, or section 45B credits, it is reasonable to apply the same analysis in Rev. Rul. 82-49 to recalculating the section 38 general business credits and the section 39 carryforward of unused section 45B credits that Taxpayer failed to claim on his original returns from the flow-through entities. For this purpose the Service should treat the carryforward of the investment credit and the section 45B credit the same. Even though Taxpayer’s tax years before 2010 are closed, the Service may examine the correctness of the partnership’s and S corporation’s recomputation of the section 45B credit. In determining the proper amount of the carryforward for the 2014 tax year Taxpayer needs to apply the provisions of Rev. Rul. 82-49. Meaning, that to the extent the additional credits would have been used to reduce Taxpayer’s liability in a closed year, including taking into account increased taxable income for those years due to reduced deductions, Taxpayer would not be entitled to a claim of refund, but would rather be entitled to determine the amount of the carryforward in the open year by an amount equal to the excess of the corrected credit over the amount that would have been allowed as a credit in the closed years including any carrybacks.”

Work Opportunity Tax Credit Transitional Relief – Notice 2016-22 Notice 2016-22 (3/7/16) provides guidance and transitional relief regarding changes to the WOTC (§51 and §3111(e)) by P.L. 114-113 (12/18/15) (PATH). PATH extended the WTOC through the end of 2019 and expanded the eligible employee list to include “qualified long-term unemployment recipients” (§51(d)(15)).

Additional transitional relief is provided by Notice 2016-40 (6/17/16). Per the IRS:

Notice 2016-40 “provides additional transition relief for employers claiming the Work Opportunity Tax Credit (WOTC) under §§ 51 and 3111(e) of the Internal Revenue Code (Code), as extended and amended by the Protecting Americans from Tax Hikes Act of 2015, Pub. L. No. 114-113, div. Q (the PATH Act). Specifically, this notice expands and extends by three months the transition relief provided in Notice 2016-22 (2016-13 IRB 488) for meeting the 28-day








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deadline in § 51(d)(13)(A)(ii) of the Code. This notice applies to employers that (1) hire members of targeted groups (other than qualified long-term unemployment recipients) on or after January 1, 2015, and on or before August 31, 2016, or (2) hire members of the new targeted group of qualified long-term unemployment recipients on or after January 1, 2016, and on or before August 31, 2016. This notice does not otherwise modify or add to the guidance provided under Notice 2016-22.”

Empowerment Zones – Notice 2016-28 Per the IRS (3/25/16): “Notice 2016-28 provides a simplified procedure under the PATH Act for a State or local government to amend an empowerment zone nomination, extending the designation of the empowerment zone remaining in effect through December 31, 2016.” Also see IR-2016-91 (6/21/16) on the designations continuing through the end of 2016.

Section 45 and 48 Energy Credits – Notice 2016-31 Per the IRS (5/5/16) – “Notice 2016-31 updates prior IRS guidance to reflect the PATH Act extension and modification of the date by which facilities must begin construction. Notice 2016-31 also extends the date by which taxpayers must place a facility in service to satisfy the Continuity Safe Harbor.

Income Inclusion When Lessee Treated as Having Acquired Investment Credit Property

On 7/22/16, the IRS released final (TD 9776), temporary and proposed regulations (REG-102516-15) under §50(d)(5) for the treatment of a credit recapture when property is sold. Per an example from the regulations:

“Example 1. X, a calendar year C corporation, leases nonresidential real property from Y. The property is placed in service on July 1, 2016. Y elects under § 1.48–4 to treat X as having acquired the property. X’s investment credit determined under section 46 for 2016 with respect to such property is $9,750. The shortest recovery period that could be available to the property under section 168 is 39 years. Because Y has elected to treat X as having acquired the property, Y does not reduce its basis in the property under section 50(c). Instead, X, the lessee of the property, must include ratably in gross income over 39 years an amount equal to the credit determined under section 46 with respect to such property. Under paragraph (b)(2) of this section, X’s increase in gross income for each of the 39 years beginning with 2016 is $250 ($9,750/39 year recovery period).”

Fuel Excise Tax Credits – Notice 2016-05 Per IRS (1/14/16): “Notice 2016-05 provides rules for claimants to make one-time claims for the 2015 biodiesel mixture and alternative fuel excise tax credits that were retroactively extended by the Protecting Americans from Tax Hikes Act of 2015 (PATH Act), Pub. L. 114-113 Div. Q. It also provides guidance for claimants to claim the other retroactively extended credits for 2015, including the alternative fuel mixture excise tax credit.”




https://www.irs.gov/uac/empowerment-zone-designations-continue-through-the-end-of-2016






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Electricity and Coal Credits 2016 Figures – Notice 2016-34 Per the IRS 2/20/16: “Notice 2016-34 publishes calendar year 2016 inflation adjustment factors and reference prices for the renewable electricity production credit, the refined coal production credit and the Indian coal credit under § 45. “

Low-Income Housing Credit (§42) – Rev. Proc. 2016-15 Rev. Proc. 2016-15 (2/23/16) “sets forth, for purposes of § 1.42-5T(c)(2)(iii)(B) of the Income Tax Regulations, the minimum number of low-income units in a low-income housing project for which a State or local housing credit agency (Agency) must conduct physical inspections and low-income certification reviews. This revenue procedure also permits the physical inspection protocol established by the Department of Housing and Urban Development (HUD) Real Estate Assessment Center (the REAC protocol) to satisfy the physical inspection requirements of § 1.42-5(d) and § 1.42-5T(c)(2)(ii) and (iii).”

§30D – Notice 2016-51 (9/12/16) Notice 2016-51 (9/12/16) “modifies Notice 2009–89, 2009–48 I.R.B. 714, as modified by Notice 2012–54, 2012–52 I.R.B. 773, and Notice 2013–67, 2013–45 I.R.B. 470, by providing a new address to which a vehicle manufacturer (or, in the case of a foreign vehicle manufacturer, its domestic distributor) must send vehicle certifications and quarterly reports. This notice also obsoletes Notice 2012–54.”

§45K – Notice 2016-43 (7/18/16) Notice 2016-43 (7/18/16) – “This notice publishes the reference price under § 45K(d)(2)(C) of the Internal Revenue Code for calendar year 2015. The credit period for the nonconventional source production credit under § 45K ended on December 31, 2013, for facilities producing coke or coke gas (other than from petroleum based products). However, the reference price continues to apply in determining the amount of the enhanced oil recovery credit under § 43, the marginal well production credit under § 45I, and the percentage depletion in case of oil and natural gas produced from marginal properties under § 613A.”

§43 – Notice 2016-44 (7/18/16) Notice 2016-44 (7/18/16) provides inflation adjustments for the enhanced oil recovery credit.

§45Q - Credit for Carbon Dioxide Sequestration – Notice 2016-39 Notice 2016-39 (9/26/16) provides the inflation adjustment factor for this credit for 2016.

§48 Rehabilitation Credit – CCA 201641022 (10/7/16)


https://www.irs.gov/pub/irs-drop/n_16_34.pdf










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CCA 201641022 (10/7/16) – For purposes of a passthrough entity passing a rehabilitation credit through to another entity, the IRS concluded:

1. “For purposes of the rehabilitation credit, if a passthrough entity is not an owner of a qualified rehabilitated building and certified historic structure, but is merely a conduit passing through the QREs of another entity, the IRS may require the passthrough entity to file Form 3468.”

2. “For purposes of the rehabilitation credit, if a lessor of a new § 38 property makes an election under § 50(d)(5) of the Internal Revenue Code to treat the lessee of as having acquired the property, the IRS may require the lessor to provide the lessee with the NPS project number assigned by, and the date of the final certification of completed work received from, the Secretary of the Interior.”

Also see Reg. 1.48-4 and -12(d).



https://www.irs.gov/uac/form-3468-investment-credit-2

https://www.irs.gov/uac/form-3468-investment-credit-2

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Chapter 7: State of California and MultiState Page 7-1

Chapter 7 : State of California and MultiState

Table of Contents Chapter 7 : State of California and MultiState ...................................................................... 7-1

California Conformity ................................................................................................... 7-2

FTB Annual Conformity Report .......................................................................................... 7-2

Due Date Conformity ............................................................................................................. 7-2

California – Income Tax - Businesses ................................................................. 7-5

Large Corporate Understatement Penalty – New Exceptions ........................................... 7-5

FTB Ruling on Doing Business ............................................................................................. 7-5

FTB Report on the New Employment Credit...................................................................... 7-5

California Minimum Wage and New Employment Credit ................................................ 7-6

LLC Fee – Real Property Dealers ........................................................................................ 7-7

Treatment of Existing Water’s-edge Elections After Addition of R&T 23101(b) Results in Unitary Foreign Affiliate Becoming Subject to Tax in California ................................ 7-7

FTB Wins Gillette Decision + FTB Notice 2016-01 (2/23/16) ............................................. 7-8

FTB Rulings for 2016............................................................................................................. 7-8

EDD and Employment Matters ................................................................................ 7-9

New E-File and E-Pay Requirements ................................................................................... 7-9

Treatment of Labor Code 203 Waiting Time Penalty ........................................................ 7-9

Communicating with EDD – SIDES .................................................................................. 7-10

California Sales Tax.................................................................................................... 7-10

Sales Tax Exclusion.............................................................................................................. 7-10

Storage and Use Exclusion .................................................................................................. 7-10

Internet Sales ........................................................................................................................ 7-10

Point of Sale Systems ........................................................................................................... 7-11

Expensed Equipment and the Sales Tax Exemptions ....................................................... 7-11

Lucent Technologies case and Technology Transfer Agreements (TTA) ....................... 7-12

Craft Distillers ...................................................................................................................... 7-13

BOE Sales Tax Guide for Winemakers ............................................................................. 7-13

E-File For Direct Sellers of Prepaid Wireless Products and Services ............................. 7-14

Prepaid Mobile Telephony Services Surcharge ................................................................ 7-14

Limit on Sales Tax Increases .............................................................................................. 7-14


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BOE Tax Practitioner Portal .............................................................................................. 7-14

Multistate Sales and Use Tax ............................................................................... 7-15

State Challenges to Quill ..................................................................................................... 7-15

Litigation Testing State Actions to Overturn Quill .......................................................... 7-17

Marketplace Fairness Approaches ..................................................................................... 7-18

Fantasy Sports Not Subject to Sales Tax in New Jersey .................................................. 7-20

Multistate - Income Tax & Nexus - Businesses ........................................... 7-20

Colorado and LLC/S Corp – GIL-16-001 (1/4/16) ............................................................ 7-20

TEI State and Local Tax Policy Statement Regarding Retroactive Legislation ............ 7-21

Multistate - Other Taxes .......................................................................................... 7-21

Fantasy Sports Tax .............................................................................................................. 7-21

Multistate Matters and Congress ........................................................................ 7-22

Internet Tax Freedom Act (ITFA) Made Permanent ....................................................... 7-22

California Conformity

FTB Annual Conformity Report In early 2016, the FTB issued a 435 page report that examines all 2015 federal legislation and addresses whether California conforms to that change. In many instances, California does not conform because the current conformity date to the IRC is for the IRC as of January 1, 2015. For example, California does not conform to the three changes made to Section 529 plans because the state only conforms to this provision as of 1/1/15. In some instances, the 2015 changes are ones that California has never conformed to such as bonus depreciation and higher expensing amounts under §179.

See the 2015 federal legislative table for the conformity provision (posted at http://mntaxclass.com).

Due Date Conformity On 9/14/16, Governor Brown signed AB 1775 (Chapter 348) which mostly conforms to the federal due date changes made in 2015, effective starting with 2016 returns. Summary per the FTB Taxpayers’ Rights Advocate’s Office:

“Original due dates for filing and payment On September 14, Governor Brown signed AB 1775, which generally conforms due dates for California business entity tax returns to the changes to federal due dates for the 2016 tax year. For 2016 returns due in 2017, partnership returns will be due the 15th day of the


https://www.ftb.ca.gov/law/legis/15FedTax.pdf

https://www.ftb.ca.gov/law/legis/15FedTax.pdf

http://mntaxclass.com/

https://leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=201520160AB1775

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third month following the close of the taxable year (March 15, 2017 for calendar year partnerships). C Corporation tax returns will be due the 15th day of the fourth month (April 15, 2017 for calendar year corporations, extended to April 18th due to the 15th falling on a Saturday.) Due dates for Limited Liability Company (LLC) returns classified as partnerships will be the same as the partnership due date, LLC returns classified as corporations will be due on the corporation due date.

Extensions Revenue and Taxation Code section 18604 allows FTB to set filing extension periods for corporations. FTB plans to issue a formal FTB Notice soon generally keeping the extended due date for C Corporation returns as the 15th day of the 10th month after the tax year (October 15th for calendar year corporations, reducing the current seven month extension to six months due to the later original due date). The extended filing due date for S Corporations will be the 15th day of the 9th month after the tax year (September 15th for calendar year S Corporations, reducing the current seven month extension to six months to match the federal extended due date). The extended filing due date for Exempt Corporations will be the 15th day of the 11th month after the tax year (November 15th for calendar year Exempt Corporations, reducing the current seven month extension to six months to match the federal extended due date).

Revenue and Taxation Code section 18567 limits filing extensions for partnerships to six months after the original due date. As AB 1775 changes the partnership original due date from the 15th day of the 4th month to the 15th day of the third month (April 15 to March 15 for calendar year partnerships), FTB plans to allow the maximum 6-month extension permitted under the statute, which will move the current October 15th extended filing due date to September 15, 2017 for 2016 calendar year partnership returns. For LLCs electing to be taxed as corporations, the corporation extension dates will apply. For LLCs electing to be taxed as partnership, the partnership extension dates will apply. Note that if the 15th falls on a weekend or holiday, returns may be filed the next business day.”

Also see FTB Analysis of AB 1775.

FTB and Original Due Dates – Per the October 2016 FTB Newsletter, the following applies for single-member LLCs:

“For Single-Member LLCs (SMLLCs) owned by pass-through entities (S corporations, partnerships, and LLCs classified as partnerships), the original due date of the return is the 15 day of the 3rd month following the close of the taxable year. For all other SMLLCs, the original due date of the return is the 15th day of the 4th month following the close of the taxable year of the owner.”

FTB and Extended Due Dates – Per the October 2016 FTB Newsletter,

“Revenue and Taxation Code Section 18604 allows us to set filing extension periods for corporations. We plan to issue a formal FTB Notice soon generally keeping the extended due date for C Corporation returns as the 15th day of the 10th month after the tax year (October 15 for calendar year corporations, reducing the current seven month extension to six months due to the later original due date). The extended filing due date for S Corporations will be the 15th day of the 9th month after the tax year (September 15 for calendar year S Corporations, reducing the current seven month extension to six months to


https://www.ftb.ca.gov/law/legis/15_16bills/AB1775_Final.pdf

https://www.ftb.ca.gov/professionals/taxnews/Editions/October-2016.shtml

https://www.ftb.ca.gov/professionals/taxnews/Editions/October-2016.shtml

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match the federal extended due date). The extended filing due date for Exempt Corporations will be the 15th day of the 11th month after the tax year (November 15th for calendar year Exempt Corporations, reducing the current seven month extension to six months to match the federal extended due date).

Revenue and Taxation Code Section 18567 limits filing extensions for partnerships to six months after the original due date. As AB 1775 changes the partnership original due date from the 15th day of the 4th month to the 15th day of the third month (April 15 to March 15 for calendar year partnerships), We plan to allow the maximum six-month extension permitted under the statute, which will move the current October 15 extended filing due date to September 15, 2017, for 2016 calendar year partnership returns. For LLCs electing to be taxed as corporations, the corporation extension dates will apply. For LLCs electing to be taxed as partnership, the partnership extension dates will apply. Note that if the 15th falls on a weekend or holiday, returns may be filed the next business day.”

Thus, the California due date appear to be:

Entity Original due date Extended due date

C corp

(FTB Notice expected)

15th of 4th month 15th of 10th month

S Corp 15th of 3rd month (no change)

15th of 9th month

Exempt Corp 15th of 5th month

(no change)

15th of 11th month

Partnerships 15th of 3rd month 15th of 9th month

LLC taxed as corp


LLC taxed as partnership

15th of 3rd month 15th of 9th month

SMLLC owned by passthrough

15th of 3rd month 15th of 9th month

All other SMLLCs



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California – Income Tax - Businesses

Large Corporate Understatement Penalty – New Exceptions Per the FTB (Jan. 2016), two more exceptions were added to this penalty:

“Federal Accounting Method Change: A change to the taxpayer's federal accounting method under IRC Section 446 where the original due date of the return for the taxable year of the understatement occurs before the IRS consents to the change.

Section 25137: The imposition of an alternative apportionment or allocation method by the Franchise Tax Board under the authority of Revenue and Taxation Code Section 25137.

The federal accounting method change exception applies to taxable years beginning on or after January 1, 2015, and the Section 25137 exception is applicable to understatements for any taxable year for which the statute of limitations on assessments had not expired as of September 30, 2015.”

FTB Ruling on Doing Business

Chief Counsel Ruling 2016-03 (7/5/16) – FTB holdings:

a) “Taxpayer must aggregate the proceeds from sales of TPP with royalties received to determine whether it met California's "doing business" standard under Section 23101(b)(2).

b) Taxpayer should not throw back to its California sales factor numerator the sales of TPP from the States where it has met the "doing business" standard under Section 23101(b)(2) and Taxpayer's activities exceed the protections under P.L 86-272. Taxpayer is taxable in those States under Section 25122.”

Under California law, if sales exceed $500,000 (adjusted for inflation), the doing business standard is met. Also, gross receipts include sales and from use of property including royalties (R&T 25120(f)), which for this taxpayer includes those from TPP and intangibles. The FTB also found that PL 86-272 did not help in that the sales of the intangibles was significant creating substantial economic nexus and could not be ignored to find that the taxpayer only sold TPP.

FTB Report on the New Employment Credit Part of the law enacting the new employment credit starting for 2014 is that the FTB is to issue an annual report that provides the dollar amount of credit claimed, a comparison to the estimated cost, and suggestions for increasing usage of the credit should the estimated cost exceed actual cost.

The FTB issued its first annual report in March 2016. Findings include:

$3.9 million of credit was claimed for the 2014 tax year, well below the estimated $15 million reserved for 2014.


https://www.ftb.ca.gov/law/ccr/2016/03.pdf

https://www.ftb.ca.gov/online/New_Employment_Credit_Reservation/NECReportMarch2016.pdf

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Low usage for 2014 may be attributable to the learning curve of a new credit and use of other credits such as the enterprise zone credits that are phasing out.

Some taxpayers claimed the credit even though they did not reserve it in advance which is one of the requirements for the credit.

Expand usage of the credit by expanding the geographic limitations that are part of the eligibility factors, expand the qualifying wage requirement, drop the reservation requirement, expand the types of businesses that qualify for the credit, increase the credit percentage to make it more attractive and engage in greater education and outreach about the credit.

California Minimum Wage and New Employment Credit The credit requires payment of “qualified wages” which must exceed 150% of minimum wage, but not more than 350% of minimum wage. For a “Designated Pilot Area,” the wages must exceed $10/hour but not 350% of minimum wage. As part of earlier legislation (AB 10, 2013), the minimum wage in California rose to $10/hour starting 1/1/16. (Dept. of Industrial Relations website)

SB 3 (Chapter 4, 4/4/16) will increase the state minimum wage to $10.50/hour starting 1/1/17 for any employer with 26 or more employees. Increases are scheduled as follows:

Starting date Employers with 26 or more employees

Employers with 25 or fewer employees

1/1/17 $10.50 Stays at $10

1/1/18 $11 $10.50

1/1/19 $12 $11

1/1/20 $13 $12

1/1/21 $14 $13

1/1/22 $15 until adjusted for inflation*

$14

1/1/23 $15 until adjusted for inflation*

*Per §1182.12(c) of the Labor Code, the Director of Finance is to calculate an adjusted minimum wage based on the lesser of 3.5% and a BLS Consumer Price index, rounded to the nearest ten cents ($0.10). Each adjusted minimum wage increase takes effect the following January 1.

Starting on or before 7/28/17 and every July 28 afterwards until minimum wage reaches $15/hour, various conditions must be met “to ensure that economic conditions can support a minimum wage increase.” These measures include employment rates and retail sales and use tax cash receipts. See Labor Code §1182.12 for specifics.


https://www.ftb.ca.gov/online/New_Employment_Credit_Reservation/

https://www.gov.ca.gov/news.php?id=18224

http://www.dir.ca.gov/dlse/faq_minimumwage.htm

http://leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=201520160SB3

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Per Governor Brown’s 4/4/16 press release in signing the bill: “The legislation increases the minimum wage over time, consistent with economic expansion, while providing safety valves - known as "off-ramps" - to pause wage hikes if negative economic or budgetary conditions emerge. The Governor can act by September 1 of each year to pause the next year's wage increase for one year if there is a forecasted budget deficit (of more than one percent of annual revenue) or poor economic conditions (negative job growth and retail sales).”

Also see Fact Sheet from Governor’s Office. It notes that for 2016, a full-time minimum wage worker will earn $20,800 while by 2022 ($15/hour), the worker will earn $31,200 which moves the worker ab out the 2016 Federal Poverty Level of $24,300 for a family of 4.

LLC Fee – Real Property Dealers On 7/14/16, the FTB issued Legal Ruling 2016-01, Calculation of the Limited Liability Company Fee -- Real Property Held for Sale to Customers in the Ordinary Course of Business. For real property held for sale to customers in the ordinary course of business, the adjusted basis of the property is added back to gross income in calculating the LLC fee under R&T §17942. If instead, the property is not held for sale to customers but instead held as investment property, its adjusted basis is not added back to gross income in calculating the LLC fee.

The issue relates to the federal income tax treatment of real estate held by a dealer as not being “inventory.” But the FTB noted that it is still in effect, has “cost of sales” from the disposition. Per the FTB: “the term “cost of goods sold” as used by RTC section 17942, subdivision (b)(1)(A), includes real property held for sale to customers in the ordinary course of a trade or business. Therefore, LLCs that are dealers in real property must add the cost of goods sold (based on real property) back to gross income in calculating the LLC fee.”

Review of the fee calculation from the ruling: “RTC section 17942 imposes a fee on LLCs based on "total income from all sources derived from or attributable to this state". Total income for purposes of calculating the LLC fee is defined in RTC section 17942, subdivision (b)(1)(A), as "gross income, as defined in Section 24271, plus the cost of goods sold that are paid or incurred in connection with the trade or business of the taxpayer." Therefore, the cost of goods sold is added back to gross income so that the LLC fee for such amounts is essentially calculated based on net gross receipts.”

Treatment of Existing Water’s-edge Elections After Addition of R&T 23101(b) Results in Unitary Foreign Affiliate Becoming Subject to Tax in

California FTB Notice 2016-02 (9/9/16) addresses the following issue:

“How will the Franchise Tax Board ("FTB") treat an otherwise-valid water's-edge election when a unitary foreign affiliate of the water's-edge combined reporting group becomes a taxpayer because it is doing business in California due to the addition of Revenue and Taxation Code Section 23101, subdivision (b)?”


https://www.gov.ca.gov/news.php?id=19368

https://www.gov.ca.gov/docs/Fact_Sheet_Boosting_Californias_Minimum_Wage.pdf

https://www.ftb.ca.gov/law/rulings/active/2016/01_07142016.pdf

https://www.ftb.ca.gov/law/notices/2016/2016-02.pdf

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R&T §23101(b) is the new “doing business” rule applicable to tax years beginning on or after 1/1/11. The issue arises in that after the change in the “doing business” rule, a foreign affiliate may have become subject to tax in California but was part of a unitary group. Per the FTB:

“This Notice addresses the treatments the FTB will apply in situations where a unitary foreign affiliate of a water's-edge combined reporting group could not make an election at the time of a water's-edge election because the affiliate was not subject to tax in California; but after the addition of section 23101, subdivision (b), the affiliate would have been required to make a water's-edge election for the election to remain effective.”

If four conditions laid out in Notice 2016-02 are met, “the FTB will not seek to terminate the water's-edge election of the water's-edge combined reporting group that is unitary with the foreign affiliate that is now a taxpayer, but will apply the treatments outlined in” in the notice.

FTB Wins Gillette Decision + FTB Notice 2016-01 (2/23/16) The Gillette Company v FTB, S206587 (S Ct CA, 12/31/15), involved whether G was able to use the Multistate Compact apportionment formula of equally weighted factors (sales, property and payroll) rather than double-weighting the sale factor as called for under CA law. G’s rationale was the California is part of the Multistate Tax Compact and thus must follow what it provides rather than unilaterally changing it. Per the court:

“Member state adoption of different formulae, coupled with the Compact’s express grant of authority to join or leave the Compact at will, confirms that the Compact did not prohibit unilateral state action. The freedom of members to engage in such unilateral conduct is inconsistent with the type of binding agreement contemplated by Northeast Bancorp.”

Additional resources:

History of actions from California Courts

FTB Notice 2016-01 (2/23/16) – explains the next steps for the FTB in light of the fact that Gillette is likely to appeal to the U.S. Supreme Court. Regarding claims for refund, the FTB states it “will take no action at this time on claims for refund that have been made to avoid the bar of refunds by the statute of limitations.” It will wait to take action on these claims when it knows whether the US Supreme Court will take the case. The notice also explains the FTB’s audit position and more.

Gillette filed a writ of certiorari with the US Supreme Court on 5/27/16. On 10/11/16, the USSC denied cert. The FTB is working on guidance for taxpayers affected by this final outcome.

There is similar litigation completed and pending in other states including Michigan and Texas. See PwC, Multistate Tax Compact website.

FTB Rulings for 2016



http://www.courts.ca.gov/opinions/archive/S206587.PDF

http://appellatecases.courtinfo.ca.gov/search/case/dockets.cfm?dist=0&doc_id=2030100&doc_no=S206587


https://www.supremecourt.gov/Search.aspx?FileName=/docketfiles/15-1442.htm

http://www.pwc.com/us/en/state-local-tax/multistate-tax-compact.html

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Chief Counsel Ruling 2016-05 - Guidance pertaining to the treatment of the disposition of insurance company stock for California tax purposes in the context of an IRC section 338(h)(10) election.

Chief Counsel Ruling 2016-04 - Whether a non-California credit union and its non-California single member LLC have California filing requirements and an obligation to pay all applicable taxes and fees.

Chief Counsel Ruling 2016-03 - Guidance with respect to the operation of Revenue and Taxation Code sections 23101and 25122; California Code of Regulations, title 18, section 25136-2; and Public Law 86-272.

Chief Counsel Ruling 2016-02 - Whether a Regulated Investment Company (RIC) organized as a business trust is properly treated as a corporation for purposes of the minimum franchise tax imposed under Revenue and Taxation Code section 23153.

Chief Counsel Ruling 2016-01 - Whether a Regulated Investment Company (RIC) organized as a business trust is properly treated as a corporation for purposes of the minimum franchise tax imposed under Revenue and Taxation Code section 23153.

EDD and Employment Matters

New E-File and E-Pay Requirements The EDD reminds employers that per AB 1245 (Chapter 222; 8/17/15), starting 1/1/17, “employers with 10 or more employees will be required to electronically submit employment tax returns, wage reports, and payroll tax deposits to the Employment Development Department (EDD). All remaining employers will be subject to this requirement beginning January 1, 2018. Any employer required under existing law to electronically submit wage reports and/or electronic funds transfer to the EDD will remain subject to those requirements. For more information, visit FAQs – E-file and E-pay Mandate for Employers” and EDD page on e-file and e-pay mandate.

EDD also notes that employers may use “e-Services for Business” for filing and payment purposes. Penalties apply for failure to e-file or e-pay. For example, the penalty for not filing a quarterly DE 9C form electronically is $20 per wage item.

AB 1245 includes a limited waiver provision. Per the EDD website, it will start accepting waivers from employers in July 2016 using Form DE 1245W, E-file and E-pay Mandate Waiver Request. The EDD must approve any waiver (application is not enough).

Treatment of Labor Code 203 Waiting Time Penalty IRS Information Letter 2016-0026 (3/25/16) – This labor law provision imposes a penalty upon an employer who delays paying a terminated employee. The penalty is paid to the former employee. While the amount received by the employee is taxable income, it is not subject to







http://www.edd.ca.gov/payroll_taxes/e-Services_for_Business.htm


http://www.leginfo.ca.gov/pub/15-16/bill/asm/ab_1201-1250/ab_1245_bill_20150817_chaptered.pdf

http://www.edd.ca.gov/payroll_taxes/FAQ_-_E-file_and_E-pay_Mandate_for_Employers.htm

http://www.edd.ca.gov/payroll_taxes/E-file_and_E-pay_Mandate_for_Employers.htm


http://www.edd.ca.gov/payroll_taxes/E-file_and_E-pay_Mandate_for_Employers.htm

http://www.edd.ca.gov/pdf_pub_ctr/de1245w.pdf

https://www.irs.gov/pub/irs-wd/16-0026.pdf

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payroll tax because it is a penalty upon the employer rather than payment for services rendered by the former employee.

The Info Letter also states that the penalty payment should be reported on Form 1099-MISC (box 3) rather than on Form W-2.

Communicating with EDD – SIDES Per the EDD’s Third Quarter 2016 newsletter:

“The State Information Data Exchange System (SIDES) changes the way we communicate and allows a quick, secure, and timely way for employers and third-party administrators (TPAs) to receive and respond electronically to the Notice of Unemployment Insurance Claim Filed, DE 1101CZ, from the” EDD. “By providing accurate and timely information to the EDD, employers can keep UI rates low and prevent payments to former workers who don’t meet eligibility requirements.”

Employers can participate in SIDES using e-response (for those with a low volume of UI claims) or SIDES Web Service.

For more, visit the SIDES website.

California Sales Tax

Sales Tax Exclusion The state level exemption for manufacturing and R&D equipment purchased by a “qualified person” continues (through 6/30/22), as does the California Alternative Energy and Advanced Transportation Financing Authority exemption (CAEATFA). Unlike the exemption, a taxpayer must apply for the CAEATFA exemption with applies to both the state and local tax.

Storage and Use Exclusion The BOE has a new website explaining the “he limited circumstances in which use tax may not be due when items or goods are temporarily stored in California, or incorporated into other property, and then transported outside California for use solely outside the state.”

Internet Sales Updated BOE Pub 109 – In October, the BOE updated its Publication 109, Internet Sales. Information added includes how sales tax applies to use of fulfillment centers. For example, this publication provides the following as to when an out-of-state taxpayer is using an in-state fulfillment center to sell taxable items:


http://www.edd.ca.gov/Payroll_Taxes/pdf/caemp2016_3.pdf

http://www.edd.ca.gov/unemployment/SIDES.htm

https://www.boe.ca.gov/sutax/manufacturing_exemptions.htm

http://treasurer.ca.gov/caeatfa/ste/index.asp

https://www.boe.ca.gov/sutax/storage_and_use_exclusion.htm

https://www.boe.ca.gov/formspubs/pub109/

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“Offering tangible personal property for sale on an online marketplace will generally not,y itself, cause an out-of-state retailer to be engaged in business in California, even if the marketplace operator is located in California. Generally, the use by an out-of-state retailer of a website hosted on servers located in California will not cause the retailer to be engaged in business in California. However, an out-of-state retailer that stores tangible personal property in California, including at a fulfillment center owned and operated by a third-party is engaged in business in California.”

Additional information is provided to help sellers determine if they are required to collect sales tax or if the marketplace/fulfillment house is the responsible party. The terms of the arrangement are relevant. Also, if the fulfillment center is selling the materials without having to notify the goods provider, the original seller likely should have obtained a resale certificate when selling to the fulfillment center. Drop shipping is also mentioned in case that is truly the sales arrangement.

Point of Sale Systems The BOE reported in its March 2016 Tax Information Bulletin (Pub 388) that a new service was available to retailers.

“New Service Available to Retailers

Through the California State Board of Equalization’s (BOE) Geographic Information System (GIS), a new service allows retailers with Point of Sale systems (or other related systems) to accurately determine the sales and use tax rates. This new feature provides the sales and use tax rate based upon the address or coordinates submitted. To access this service, visit the BOE’s Open BOE webpage at www.boe.ca.gov/DataPortal/.”

Expensed Equipment and the Sales Tax Exemptions The BOE modified Reg. 1525.4 on the exemption for manufacturing and R&D Equipment in January 2016. Eligible equipment must have a useful life of one or more years. However, per the modified regulations, certain property is deemed to have a useful life of less than one year if treated as such for income or franchise tax purposes. The added exceptions will treat eligible tangible personal property has having a life over one year if covered by a maintenance or warranty contract that lasts one year or more, or is normally replaced at intervals of one or more years per industry or business practices. Per Example 2 added to the regulations, if the property is warranted by the manufacturer or other third party to last one year or more, it meets the useful life requirement. The changes are effective back to the start of the exemption (1/1/14).

Opposition: There was opposition from the Department of Finance as to whether the BOE had authority for the modification. On 3/24/16, the Office of Administrative Law issued a memo officially stating “On January 4, 2016, the Board submitted the above-referenced regulatory action to the Office of Administrative Law (OAL) for review. On February 17, 2016, OAL notified the Board that OAL disapproved the proposed regulations.” This 248-page memo and attachments lays out the reasons and history of actions. Also see 2/26/16 decision of disapproval.

The current version of Reg. 1525.4 does not include the exception for otherwise eligible property not treated as having a life over one year for income or franchise tax purposes. However, the BOE website on the exemption provides the following regarding the useful life requirement:


http://www.boe.ca.gov/news/pdf/mar16tib.pdf

http://www.boe.ca.gov/DataPortal/

https://www.boe.ca.gov/regs/pdf/Reg1525_4_Updated_Informative_Digest_2015.pdf

https://www.boe.ca.gov/regs/pdf/Regulation_1525_4_Rulemaking_File_2016.pdf

https://www.boe.ca.gov/regs/pdf/Reg1525_4_OAL_Rejection_2016.pdf

https://www.boe.ca.gov/lawguides/business/current/btlg/vol1/sutr/1525-4.html

https://www.boe.ca.gov/sutax/manufacturing_exemptions.htm#Examples

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Lucent Technologies case and Technology Transfer Agreements (TTA) In Special Notice L-468 (August 2016), the BOE acknowledged that it may have to amend SUT Reg 1507 on TTAs and Reg. 1502 on computers, software and data processing in light of the decision in Lucent Technologies, Inc. v. BOE, 241 Cal.App.4th 19 (10/8/15). See the Notice for a summary of the Lucent case. The decision may result in refund opportunities for some taxpayers. Per the Notice:

“Filing A Claim For Refund A retailer may file a claim for refund directly with the BOE for tax the retailer paid on the sale of non-custom software transferred on storage media as part of an agreement that the retailer believes is a TTA. If the retailer collected the amount being claimed as a refund from a purchaser as sales tax reimbursement, the retailer must return any refunded sales tax reimbursement to the purchaser.

A consumer who paid use tax (typically use tax applies when you purchase from an out-of-state vendor) on the purchase of non-custom software transferred on storage media as part of an agreement the consumer believes is a TTA may also file a claim for refund directly with the BOE. However, a consumer who paid sales tax reimbursement (typically sales tax applies when you purchase from a California vendor) on such a transaction must obtain a refund of any excess tax reimbursement directly from the vendor.

For information on filing a claim for refund, including filing deadlines, see publication 117, Filing a Claim for Refund, at www.boe.ca.gov/formspubs/pub117/.”


http://www.boe.ca.gov/pdf/L468.pdf

http://caselaw.findlaw.com/ca-court-of-appeal/1715352.html

http://www.boe.ca.gov/formspubs/pub117/

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In January 2016, the BOE’s petition for review of the case was denied by the California Supreme Court. In describing its next actions, the BOE explains (3/18/16 BOE memo from BOE Chief Counsel):

“Read together, the Nortel and Lucent opinions primarily hold that:

The TTA statutes apply when the holder of the copyright to non-custom copyrighted software transfers a copy of the software on tangible storage media, the right to reproduce or copy the copyrighted software, and the right to make and sell "products" that the buyer could not legally make without using a copy of the copyrighted software;

The TT A statues also apply when the holder of a patent that is embodied, implemented, and enabled by non-custom software transfers a copy of the software on tangible storage media with the right to make and sell a product that is subject to the patent or to use a patented process that is embodied, implemented, and enabled by the software; and

When there is a software TT A ( as described above), the measure of tax is limited to the amount charged for the storage media used to transfer the non-custom software as determined under the TT A statutes and does not include charges for the licenses to copy and use the software; under the TT A statutes, the storage media is deemed to be blank for purposes of the Sales and Use Tax Law, notwithstanding the physical alterations to the storage media caused by placing the software on the storage media.

The corollary of this holding is that, when software on storage media is sold by a non-holder-retailer, the transaction is not a software TTA and the full retail selling price is subject to tax. The typical off-the-shelf retail sale of canned, mass-marketed software does not constitute a software TT A because the typical retailer can only sell tangible storage media and does not hold any intangible copyright or patent interests in the software to transfer with the storage media.”

Craft Distillers Special Notice L-452 (March 2016) explains AB 1295 (Chap 3, 10/8/15) for craft distillers. Starting 1/1/16, this legislation permits the “Department of Alcoholic Beverage Control (ABC) to issue a new craft distiller’s license to a person who has facilities and equipment for the purposes of, and is engaged in, the commercial manufacture of distilled spirits. ABC has designated this new license as a Type 74. ABC has issued an Industry Advisory and Frequently Asked Questions regarding the new Act, which are available on ABC’s website at www.abc.ca.gov.”

BOE Sales Tax Guide for Winemakers In September the BOE released a new guide on sales tax for winemakers. It covers available exemptions, recordkeeping and application of sales tax to wine production and tasting events including treatment of barrels and shipping wine. [Special Notice L-455]


http://appellatecases.courtinfo.ca.gov/search/case/mainCaseScreen.cfm?dist=0&doc_id=2125887&doc_no=S230657

https://www.boe.ca.gov/meetings/pdf/2016/032916_M1_Lucent_Technologies_Inc.pdf

https://leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=201520160AB1295

http://www.abc.ca.gov/

http://www.boe.ca.gov/industry/sales-tax-guide-for-winemakers.html

http://www.boe.ca.gov/pdf/l455.pdf

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E-File For Direct Sellers of Prepaid Wireless Products and Services This requirement starts 11/1/16.

Prepaid Mobile Telephony Services Surcharge Modifications were made to this surcharge that began 1/1/16 (SB 84, chapter 25,6/24/15). Starting 1/1/17, some small sellers no longer have to register and some changes were made to the determination of the rate. For additional information, see BOE website. Rate determination per the BOE:

“If you are making sales of prepaid MTS products/services from your business location, you should generally charge and collect the correct prepaid MTS rate for the city and/or county where your business is located.

However, even if you do not make the sale at your business location (for example, when you sell prepaid MTS online), the sale of prepaid MTS occurs in California and the prepaid MTS surcharge applies when:

1. The item is shipped to, or picked up by, your customer at a California location, or

2. Your records show that the customer's address is located in California, or

3. Your customer provides you an address in California during the sales transaction (for example, a billing address).

When you make online sales or over the phone sales and do not know your customer's address, the sale of prepaid MTS occurs in California and the prepaid MTS surcharge applies if your customer has a mobile telephone number that is associated with a location in California.

For purposes of determining the correct prepaid MTS rate to charge, when you do not sell prepaid MTS to the customer at your business location, but one of the above scenarios applies, you should charge the prepaid MTS rate that applies to the above known California location or address of your customer, in the order listed above.

Note: Prior to January 1, 2017, if a customer's mobile phone number was associated with a California location, the surcharge applied to the retail sale of prepaid MTS, regardless of the customer's address. Beginning January 1, 2017, sellers who make sales and know their customer's address should no longer use their customer's mobile phone number to determine if the surcharge applies.”

Limit on Sales Tax Increases BOE Notice L-465 (August 2016) reminds people that the combined rate of local sales taxes (imposed by cities, counties and special purpose entities) cannot exceed 2% unless there is special statutory authorization by the state legislature. It appears the notice may have been issued due to dueling ballot initiative in some jurisdictions. Per the Notice:

“If both a city and countywide tax are proposed on the same ballot, which together will cause the combined tax rate in the city to exceed 2.00%, the BOE will be unable to administer the new taxes and would seek an opinion from the Office of the Attorney General to determine which tax to implement.”

BOE Tax Practitioner Portal - BOE Tax Practitioner Portal - http://www.boe.ca.gov/industry/tax-practitioners.html


http://www.boe.ca.gov/pdf/l473.pdf

http://www.leginfo.ca.gov/pub/15-16/bill/sen/sb_0051-0100/sb_84_bill_20150624_chaptered.pdf

https://www.boe.ca.gov/industry/prepaid_mts_surcharge.html

http://www.boe.ca.gov/pdf/L465.pdf

http://www.boe.ca.gov/industry/tax-practitioners.html

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- Subscribe to BOE Updates - http://www.boe.ca.gov/boeupdates_subscribe.htm.

Multistate Sales and Use Tax

State Challenges to Quill States have been waiting since the 1992 Quill decision for Congress to exercise its power under the Commerce Clause to provide relief to enable states to collect use tax from non-present vendors. In the meantime, some states joined the Streamlined Sales and Use Tax Project. Various versions of the Mainstreet Fairness Act have been introduced in Congress since at least 1994 and a few hearings have been held. In May 2013, the full Senate passed S. 743 (113rd Congress).

In Direct Marketing Association v. Brohl, Exec. Dir, Colorado Dept. of Revenue, No. 13-1-32 (3/3/15), Justice Kennedy made a statement in his concurring opinion that basically suggests that states start trying to collect from remote vendors to try to get a case to the Supreme Court. Justice Kennedy stated that perhaps given “changes in technology and consumer sophistication,” it is time to revisit the court’s 1992 decision in Quill. He also noted that Quill was a case “questionable even when decided, [that] now harms States to a degree far greater than could have been anticipated earlier.”

State actions to test Quill include:

Alabama – in 2015, the Department of Revenue issued new regulations 810-6-2-.90.03 stating that certain out-of-state sellers with a “substantial economic presence” in the state must collect sales tax. Part of the definition of this presence is that the seller have retail sales in the state in excess of $250,000 per year based on the prior calendar year’s sales. The provision is effective 1/1/16. The Department of Revenue also offers an incentive to any vendor who voluntarily collects and remits use tax. They may keep 2% of the use tax properly collected (see application form). Oklahoma – Oklahoma is considering legislation to broaden the definition of “maintaining a place of business in this state” to reach some remote sellers. See HB 2531 which passed in the Senate on 3/10/16. This proposal is more of an affiliate nexus one.

Tennessee – Rule 1320-05-01-.129 issued in June 2016 states that out-of-state dealers engaging in “regular or systematic solicitation of consumers in this state through any means and make sales that exceed $500,000 to consumers in this state during any calendar year” have substantial nexus. They must register with the state by January 1, 2017 and acknowledge that they will begin to collect and remit sales and use taxes by July 1, 2017. A hearing is scheduled for August 8, 2016.

South Dakota – On 3/29/16, Governor Daugaard signed SB 106. This legislation requires certain remote sellers to collect sales tax if the seller sells tangible personal property into the state,


http://www.boe.ca.gov/boeupdates_subscribe.htm

https://www.law.cornell.edu/supct/html/91-0194.ZO.html

http://21stcenturytaxation.blogspot.com/2013/05/more-on-marketplace-fairness-act-s-743.html

http://www.supremecourt.gov/opinions/14pdf/13-1032_8759.pdf

https://revenue.alabama.gov/rules/810-6-2-.90.03.pdf

http://revenue.alabama.gov/news/09042015.pdf

http://revenue.alabama.gov/salestax/pdf/SSUT-Application_%289-15%29.pdf

http://www.oklegislature.gov/BillInfo.aspx?Bill=HB%202531

http://share.tn.gov/sos/rules_filings/06-12-16.pdf

http://sdlegislature.gov/legislative_session/bills/Bill.aspx?Bill=106&Session=2016

http://sdlegislature.gov/docs/legsession/2016/Bills/SB106ENR.pdf

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electronically delivers products or delivers services into the state and meets one of the following criteria for the prior calendar year or the current calendar year:

1) Gross revenues into the state exceeds $100,000.

2) There were 200 or more separate transactions.

The new law also provides that the state may bring action against any vendor who appears to be subject to the collection requirement even prior to audit or collection procedure.

Among the eleven reasons for enacting SB 106, the legislature declares (#11):

“It is the intent of the Legislature to apply South Dakota's sales and use tax obligations to the limit of federal and state constitutional doctrines, and to thereby clarify that South Dakota law permits the state to immediately argue in any litigation that such constitutional doctrine should be changed to permit the collection obligations of this Act.”

The state brought action in its Sixth Judicial Circuit against four vendors in March 2016. The vendors: Wayfair, Inc., Systemax, Inc., Overstock.com, Inc. and Newegg Inc. The petition includes letters sent by the Department of Revenue to the vendors in March 2016 indicating the state believed they met the threshold requirement to collect use tax. Excerpts follow:


http://www.insidesalt.com/files/2016/04/APP-APPLICATION-1.pdf

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Action has also been brought against the state. For example, the American Catalog Mailers Association and Netchoice filed suit in the Sixth Judicial Circuit in April 2016 challenging the state’s new law.

Litigation Testing State Actions to Overturn Quill Litigation is underway by some merchants opposed to actions by Alabama and South Dakota to change the physical presence nexus requirement to an economic presence one. The Alabama Department of Revenue issued a press release on 6/15/16 in response to Newegg Inc.’s challenge to its regulations. Per the ADOR, it “believes that the actions it has taken to require remote sellers to collect and remit Alabama tax will provide a proper case to the U.S. Supreme Court to consider the significant changes in the retail economy and in technology and to grant relief to the states from Quill's harsh effects.”

"The effects of Quill have been detrimental to the states’ revenues, have forced in-state retailers to operate at an unfair competitive disadvantage for decades, and have allowed online retailers who are clearly doing business in our state to evade collection responsibility," said Alabama


http://netchoice.org/wp-content/uploads/2016-4-28-ACMA-NetChoice-Complaint-3.pdf

http://revenue.alabama.gov/news/06152016.pdf

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Revenue Commissioner Julie Magee. "Until Congress acts, we will continue to lead the charge to overturn Quill."

Marketplace Fairness Approaches Since soon after the US Supreme Court’s decision in Quill (504 US 298 (1992)), Congress has introduced bills to allow states to collect sales/use tax from remote sellers. Typically a de minimis seller provision is included. These bills often get hearings in the House Judiciary Committee, but don’t get much farther. States tend to like the bills that might increase their sales tax collections and vendors do not like them.

In summer 2016, Congressman Goodlatte, chair of the House Judiciary Committee introduced a new approach - the Online Sales Simplification Act of 2016 to address use tax collection on remote sales. As of 10/21/16, no bill number has been assigned. The general rule provides that a state may impose sales and use tax on a seller only if

“(1) the State is the origin State for the remote sale;

(2) the tax is applied using the origin State’s tax base applicable to non-remote sales; and

(3) the State participates in the State tax clearinghouse.”

The tax rate is the destination state rate if that state participates in the clearing house. In that case, the origin state rate is used. The proposal also explains how tax is distributed among the clearinghouse states.

The National Retail Federation indicated support for the idea (8/25/16 press release).

Also introduced in the 114th Congress:

a) Federal Legislation to Preserve Quill – In July 2016, Congressman Sensenbrenner introduced the No Regulation Without Representation Act of 2016 (H.R. 5893) to make a legislative enactment that a state may only collect sales tax from a vendor if the vendor has a physical presence in the state. Per the section-by-section analysis:

“A State may not obligate a person to (1) collect a sales, use or similar tax; (2) report the sale; or (3) assess a tax on a person; or (4) treat the person as doing business in a state for purposes of such tax, unless the person is physically present in that state during the relevant taxing period.”

Among other possibilities, “presence for less than 15 days in a taxable year” is not considered physical presence. Disputes would be resolved in U.S. District Court. The bill is proposed to be effective 1/1/17.

Also see Congressman Sensenbrenner’s press release of 7/14/16.

b) S. 698, Marketplace Fairness Act – Per CRS summary: “Authorizes each member state under the Streamlined Sales and Use Tax Agreement (the multistate agreement for the administration and collection of sales and use taxes adopted on November 12, 2002) to require all sellers not qualifying for a small-seller exception (applicable to sellers with annual gross receipts in total U.S. remote sales not exceeding $1 million) to collect and remit sales and use taxes with


https://www.law.cornell.edu/supct/html/91-0194.ZO.html

http://src.bna.com/h2J

https://nrf.com/media/press-releases/retailers-welcome-release-of-goodlatte-online-sales-tax-bill


http://sensenbrenner.house.gov/uploadedfiles/no_reulation_without_representation_act_of_2016_section_by_section_.pdf

http://sensenbrenner.house.gov/uploadedfiles/no_reulation_without_representation_act_of_2016_section_by_section_.pdf

http://sensenbrenner.house.gov/news/documentsingle.aspx?DocumentID=398028

https://www.congress.gov/bill/114th-congress/senate-bill/698

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respect to remote sales under provisions of the Agreement, but only if such Agreement includes minimum simplification requirements relating to the administration of the tax, audits, and streamlined filing. Defines "remote sale" as a sale of goods or services into a state in which the seller would not legally be required to pay, collect, or remit state or local sales and use taxes unless provided by this Act. Prohibits states from beginning the exercise of the authority granted by this Act for a specified period after enactment.”

c) H.R. 2775, Remote Transactions Parity Act – Per CRS summary: “This bill authorizes both member states under the Streamlined Sales and Use Tax Agreement and states that have not adopted the Agreement (the multistate agreement for the administration and collection of sales and use taxes adopted on November 12, 2002) to require remote sellers (i.e., sellers who make remote sales in a state without a physical presence) to collect and remit sales and use taxes with respect to remote sales sourced to such states.

States that have not adopted the Agreement must show that they have adopted and implemented minimum simplification requirements for the administration of sales and use taxes in order to collect such taxes. Such requirements include: (1) the designation of a single state entity responsible for all state and local sales and tax administration, return processing, and audits of remote sales; (2) a single audit of a remote seller for all taxing jurisdictions in the state; (3) direct contact with a certified software provider utilized by the remote seller in conducting an audit; (4) a single sales and use tax return for use by remote sellers that is filed with a single entity responsible for tax administration; (5) a uniform sales and use tax base; and (6) sourcing of all remote sales in compliance with criteria established by this Act.

This bill expressly prohibits a state from requiring a remote seller to file sales and use tax returns any more frequently than is required for nonremote sellers. Additionally, remote sellers whose gross annual receipts are less than $5 million are exempt from audits unless there is a reasonable suspicion of intentional misrepresentation or fraud.

For the first three years after the effective date of this Act, the requirement for remote sellers to collect and remit sales and use taxes is limited to remote sellers whose gross annual receipts exceed a certain level (i.e., $10 million in the first year, $5 million in the second year, and $1 million in the third year) and who utilize an electronic marketplace for making sales to the public. After the third year after the effective date of this Act, there is no exemption for remote sellers to collect and remit such taxes.

The bill specifies limitations on the applicability of this Act, including by providing that nothing in this Act shall be construed as: (1) subjecting a remote seller to any type of tax other than sales and use taxes, or (2) enlarging or reducing the authority of a state to impose such taxes. The bill suspends the authority of a state to collect sales and use taxes in the first year after the effective date of this Act and between October 1 and December 31 of such first year.

The bill also prohibits a state from exercising any authority under this Act unless it: (1) provides certification procedures for persons to be approved as certified software providers, (2) refrains from denying or revoking certification to a software provider without a reasonable basis, (3) has certified multiple national certified software providers



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and such certifications are in effect, and (4) provides compensation for certified software providers.”

Fantasy Sports Not Subject to Sales Tax in New Jersey The Division of Taxation issued LR: 2016-2-SUT (10/5/16) holding:

“The charge by Taxpayer is not for the information it provides to its contestants but for the entry fee to online daily fantasy sports contests. As such, the service provided is not an enumerated service, and therefore is not subject to New Jersey sales and use tax.”

Multistate - Income Tax & Nexus - Businesses

Colorado and LLC/S Corp – GIL-16-001 (1/4/16) GIL-16-001 (1/4/16) – C is an LLC that made an S election. C has not shareholders or business activities in Colorado. Sales of C’s products (technical surveillance items sold to law enforcement and the military) are finalized via phone or email from C’s headquarters outside of Colorado. One of C’s several sales reps lives in Colorado. Because of this employee, C established payroll and sales tax accounts in Colorado. Sales reps do not finalize sales; they only find customers through product pitches. The Colorado employee performs 90% of his work outside of the state.

C asked if it was subject to income tax in Colorado. The Department of Revenue noted that the state does not tax S corporations, but the shareholders may be subject to income tax if the S corporation is doing business in the state and has substantial nexus. Per the DOR:

“Substantial nexus is established when a business entity organized outside of Colorado has property, payroll or sales that exceed any of the following thresholds in the tax period:

(i) A dollar amount of $50,000 of property; or

(ii) A dollar amount of $50,000 of payroll; or

(iii)A dollar amount of $500,000 of sales; or

(iv) Twenty-five percent of total property, total payroll or total sales.

… If Company does not satisfy any of these criteria, then it has no obligation to file a Colorado income tax return.”

The DOR also noted that even if it meets one of the thresholds, it might not have any income tax obligations in the state if it is protected by P.L. 86-272. There was not enough information from C for the DOR to make a determination. The DOR did not that “if the employee is doing more than soliciting sales or activities closely related to solicitations of orders, Company exceeds the protection of P.L. 86-272. For example, a company, whose employee regularly accepts returns on behalf of a company or regularly handles warranty claims, will likely be viewed a having engaged in activities that exceed those protected by P.L. 86-272.”


http://www.state.nj.us/treasury/taxation/pdf/pubs/letter_rulings/LR-2016-2-SUT.pdf

https://www.colorado.gov/pacific/sites/default/files/LLC%20Employee%20in%20Colorado%20General%20Information%20Letter%20GIL%2016-001.pdf

https://www.colorado.gov/pacific/sites/default/files/LLC%20Employee%20in%20Colorado%20General%20Information%20Letter%20GIL%2016-001.pdf

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TEI State and Local Tax Policy Statement Regarding Retroactive Legislation In September 2016, TEI (Tax Executives Institute) issued another tax policy statement laying out the problems faced when legislatures enact legislation with a retroactive effective date. Per the statement, “even when governments possess the authority to change tax laws retroactively, legislatures should exercise that power sparingly and within narrow limits.” When such power is used to override a court decision, it results in less incentive for taxpayers “to seek judicial redress” and “undermines the division of power among the three branches of government, and the checks and balances the judiciary confers.” TEI also notes the issues that arise under ASC 740 for financial statements.

TEI Policy Statements were also issued in 2016 on:

a. Alternative Apportionment

b. State Tax Haven Laws

Five statements were issued in 2015: (1) Reporting Federal Income Tax Changes, (2) Audit Procedures, (3) Corporate Tax Return Due Dates, (4) State and Local-Imposed Audit Fees, and (5) Interest Rates.

Multistate - Other Taxes

Fantasy Sports Tax Some states make this legal (if it isn’t already) and may tax it. For example, Tennessee started imposing a fantasy sports tax at 6% on the “adjusted revenues” from contests, paid by the operators of the games. Details and form at https://www.tn.gov/revenue/topic/fantasy-sports-tax.

New York also enacted a law that includes a tax on fantasy sports (S. 8153; Chapter 237; 8/3/16). This legislation provides “for the registration, regulation, and taxation of interactive fantasy sports contests in New York State.” It also “imposes a 15% State tax on each registrant's interactive fantasy sports gross revenue for the privilege of conducting interactive fantasy sports contests in New York State, as well as an additional 0.5% tax that is not to exceed $50,000 annually.”

In addition to a stated consumer protection purpose, this new law also generates tax revenue. Per the bill summary: “By taxing interactive fantasy sports contests, and directing such funds to the State Lottery Fund, this bill will also bring about a new and abundant source of revenue for education in New York State.”

Other states considered fantasy sport regulation and taxation, such as HB4323 in Illinois, and AB 1437 in California. AB 1437 would also require operators to work with FTB to help ensure players pay income taxes on winnings. Also see information from Assemblymember Gray (10/6/16).


http://www.tei.org/Documents/TEI-Policy-Statement-on-Retroactivity-9-20-2016.pdf

http://www.tei.org/Documents/TEI-Policy-Statement-on-Alternative-Apportionment-6-15-2016.pdf

http://www.tei.org/Documents/TEI-Policy-Statement-on-State-Tax-Haven-Laws-6-15-2016.pdf

http://www.tei.org/news/Pages/TEI-Issues-Five-State-and-Local-Tax-Policy-Statements-.aspx

http://www.tei.org/Documents/2015-11-17-SALT-Policy-Reporting-Federal-Changes-and-Template-FINAL.pdf

http://www.tei.org/Documents/2015-11-17-SALT-Policy-Audit-Procedures-FINAL.pdf

http://www.tei.org/Documents/2015-11-17-SALT-Policy-Audit-Procedures-FINAL.pdf

http://www.tei.org/Documents/2015-11-18-SALT-Policy-Corporate-Tax-Return-Due-Dates-FINAL.pdf

http://www.tei.org/Documents/2015-11-17-SALT-Policy-State-and-Local-Imposed-Audit-Fees-FINAL.pdf

http://www.tei.org/Documents/2015-11-17-SALT-Policy-Interest%20Rates-FINAL.pdf

https://www.tn.gov/revenue/topic/fantasy-sports-tax

https://www.nysenate.gov/legislation/bills/2015/S8153

http://www.ilga.gov/legislation/billstatus.asp?DocNum=4323&GAID=13&GA=99&DocTypeID=HB&LegID=92715&SessionID=88

http://www.leginfo.ca.gov/pub/15-16/bill/asm/ab_1401-1450/ab_1437_bill_20160621_amended_sen_v96.pdf

http://www.leginfo.ca.gov/pub/15-16/bill/asm/ab_1401-1450/ab_1437_bill_20160621_amended_sen_v96.pdf

http://asmdc.org/members/a21/news-room/press-releases/assemblymember-gray-takes-lead-on-protecting-fantasy-sports-consumers

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Multistate Matters and Congress

Internet Tax Freedom Act (ITFA) Made Permanent P.L. 114-125 (2/24/16) – The only tax item left open from 2015 was the ITFA set to expire October 1, 2016. Congress took quick action on this item in early 2016. P.L. 114-125 (2/24/16), Trade Facilitation and Trade Enforcement Act of 2015, made the ITFA moratorium permanent and, effective after June 30, 2020, removed the grandfather provision (relevant to Hawaii, New Mexico, North Dakota, Ohio, South Dakota, Texas, and Wisconsin).

The ITFA dates back to 1998 (P.L. 105-277) and has expired and been renewed a few times. Its main tax effect is to prohibit state and local governments from imposing taxes on Internet access fees and multiple and discriminatory taxes on e-commerce. Its original purpose was to help the Internet grow. The ITFA also established the Advisory Commission on E-Commerce (ACEC) to study issues regarding the Internet and e-commerce. The report was issued to Congress in April 2000.

The Congressional Budget Office (CBO) issued its required report on the unfunded mandate aspect of this legislation. Per the CBO:

“Beginning in July 2020, the grandfathered states would lose their ability to collect such taxes, and CBO estimates that the cost of the mandate (falling primarily on those states) would then increase significantly and probably would total more than $100 million in the final three months of fiscal year 2020 (July through September). The cost of the mandate would total more than several hundred million dollars annually thereafter, CBO estimates. (The threshold established in UMRA for intergovernmental mandates is $77 million in 2016 and would total $84 million in 2020, with adjustments for inflation.)” [“Mandates analysis of section 922 of the conference report for H,R. 644,” 1/29/16.]

For additional information on the ITFA, see Jeffrey M. Stupak, The Internet Tax Freedom Act: In Brief, Congressional Research Service, 4/13/16.




http://govinfo.library.unt.edu/ecommerce/about.htm

http://govinfo.library.unt.edu/ecommerce/report.htm

https://www.cbo.gov/publication/51178

https://www.cbo.gov/publication/51178

https://www.fas.org/sgp/crs/misc/R43772.pdf


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Chapter 8: Accounting Methods and Section 199 Page 8-1

Chapter 8 : Accounting Methods and Section 199

Table of Contents Chapter 8 : Accounting Methods and Section 199 ................................................................. 8-1

Accounting Methods ..................................................................................................... 8-1

New Form 3115 ...................................................................................................................... 8-1

New Filing Location for Automatic Method Changes ........................................................ 8-2

New Automatic Method Change Guidance – Rev. Proc. 2016-29 (5/5/16) ....................... 8-2

TPR Changes and Audit Protection – CCA 201614037 (4/1/16) ....................................... 8-2

Improper Method Change – Mills, TC Memo 2016-180 (9/27/16) .................................... 8-2

Improper Method Change – Nebeker, TC Memo 2016-155 (8/16/16) .............................. 8-3

Gift Cards and Deferral under §1.451-5 – CCA 201610017 (3/4/16) ................................ 8-4

Fixed and Medicare Payments – CCA 201607026 (2/12/16) .............................................. 8-5

All Events Test Issue – Giant Eagle, Inc., No. 14-3961 (3rd Cir., 5/6/16) .......................... 8-5

IRS NonAcq. In Giant Eagle - AOD 2016-03 (10/3/16) ...................................................... 8-7

Rev. Proc. 2004-34 and Taxable Stock Acquisition – CCA 201619009 (3/11/16) ............. 8-7

Duty of Consistency and Cash Method Reporting of Income – Squeri, et al, TC Memo 2016-116 (6/15/16) .................................................................................................................. 8-8

Completed Contract Method – Shea Homes, Inc. and Subs., No. 14-72161 (9th Cir., 7/24/16) .................................................................................................................................... 8-9

Installment Sale and Related Parties - Vest, TC Memo 2016-187 (10/6/16) ..................... 8-9

MMF and Net Asset Value (NAV) Method of Accounting – Rev. Proc. 2016-39 .......... 8-11

§199 Rulings ................................................................................................................... 8-11

Print Media - CCA 201626024 (6/24/16) ........................................................................... 8-11

Construction - TAM 201638022 (9/16/16) ......................................................................... 8-12

COS - CCA 201642033 (10/14/16) ...................................................................................... 8-12

Accounting Methods

New Form 3115 Announcement 2016-14 (3/24/16) states that the December 2015 version of Form 3115, Application for Change in Accounting Method, and its instructions is the new form to replace the 2009 version. Through 4/19/16, the IRS will accept either version of the form unless otherwise stated.


https://www.irs.gov/pub/irs-drop/a-16-14.pdf

https://www.irs.gov/uac/About-Form-3115

https://www.irs.gov/uac/About-Form-3115

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New Filing Location for Automatic Method Changes Announcement 2016-14 (3/24/16) states that starting in January 2016, the duplicate copy of Form 3115 for automatic method changes is to be filed with the IRS in Covington, Kentucky (rather than Ogden, Utah):

Internal Revenue Service 201 West Rivercenter Blvd. PIN Team Mail Stop 97 Covington, KY 41011-1424

New Automatic Method Change Guidance – Rev. Proc. 2016-29 (5/5/16) Rev. Proc. 2016-29 (5/5/16) updates Rev. Proc. 2015-14 on the list of automatic method changes.

“EFFECT ON OTHER DOCUMENTS .01 This revenue procedure amplifies and modifies Rev. Proc. 2015-14, 2015-5 I.R.B. 450, as modified by Rev. Proc. 2015-20, 2015-9 I.R.B. 694. Rev. Proc. 2015-14, as amplified and modified is superseded in part. The third sentence in the subsection 330 .01 under the EFFECT ON OTHER DOCUMENTS section of Rev. Proc. 2015-14 remains in effect. All other sections of Rev. Proc. 2015-14 are superseded.”

TPR Changes and Audit Protection – CCA 201614037 (4/1/16) CCA 201614037 (4/1/16) – The IRS stated that audit protection applies to certain 481(a) adjustments and method changes related to the tangible property regulations. Per the IRS:

“if a taxpayer made an automatic change in method of accounting to utilize the final tangible regulations pursuant to section 10.11 of Rev. Proc. 2015-14, 2015-5 I.R.B. 450, and that change was made with the limited § 481(a) adjustment required under section 10.11(6)(b) of that revenue procedure, this taxpayer cannot request a subsequent or additional method change for the same item, but only for costs paid or incurred prior to taxable years beginning prior to 1-1-14. For these purposes, we believe the taxpayer would have already made the appropriate method change for all costs paid or incurred for these items, and the taxpayer would have taken into account the appropriate § 481(a) adjustment for these items, regardless of the taxable year in which such costs were incurred. As with any change in method of accounting under the final tangible property regulations, a taxpayer that desires to change its method of accounting for any item that it previously changed under section 10.11 of Rev. Proc. 2015-14 or for any item that it has not yet changed under section 10.11, must change to a method under the final tangible property regulations using the procedures under Rev. Proc. 2015-13 and Rev. Proc. 2015-14 (but only if the taxpayer meets the eligibility requirements for an automatic change), and the taxpayer must include a § 481(a) adjustment as appropriate under the final tangible property regulations.”

Improper Method Change – Mills, TC Memo 2016-180 (9/27/16)


https://www.irs.gov/pub/irs-drop/a-16-14.pdf






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Mills, TC Memo 2016-180 (9/27/16) – In 2005, M formed Diversified Mining Ventures, L.L.C. under Alaska law (where M lived) to mine minerals. Business income was reported on M’s Schedule C using the cash method. M’s 2011 return was filed 2/3/12. He filed an amended return which was processed by the IRS around 5/28/12. The original 2011 return used the cash method and the amended one noted that the cash method was used other than for legal fees of $12,007 included on the original return. On the amended return, M reported legal fees of $77,823 that was billed to him in 2011 but not all paid in 2011. Per the court, M cited a “tax software error for the reported use of the cash method.”

M had no accounting records for 2011. Gross receipts for that year were only $1,525 from renting out equipment. M stated that he was told by the IRS to change his method to the accrual method.

In September 2013, the IRS sent M a notice of deficiency disallowing the legal fees for 2011. The IRS later agreed that M was entitled to a deduction in 2011 of $12,007 for legal fees.

Per §446(e), a taxpayer must obtain IRS consent before changing an accounting method. Per the court: “If the taxpayer changes the accounting method used in computing taxable income without first obtaining consent, the Commissioner can assert section 446(e) and require the taxpayer to abandon the new method of accounting and to report taxable income using the old method. … If the change constitutes a change of accounting method that is subject to section 446(e), then the taxpayer is foreclosed from making the change by section 446(e) and the regulations promulgated thereunder without regard to whether the new method would be proper.”

To obtain consent, a taxpayer must file Form 3115 or other procedure provided by the IRS. M did not file such a form. M’s statement that the IRS instructed him to change his method is not proper.

“Neither Rev. Proc. 2011-14, nor Rev. Proc. 97-27, provides that oral instructions from an agent are sufficient to confer the Commissioner’s consent.” [These are the procedures in effect for 2011.]

Thus, M did not change his method and per §446(e), the IRS can require M to use his original method.

Improper Method Change – Nebeker, TC Memo 2016-155 (8/16/16) Nebeker, TC Memo 2016-155 (8/16/16) – Since 1995, N operated a successful aerospace and defense project management business as a sole proprietor. For the years at issue, 2016 and 2009, N reimbursed his contractors for their work and expenses before N’s clients paid their invoices. N used Microsoft Money software for training business income and expenses. N had a separate bank account for his Schedule C. N’s business activity required keeping track of expenses per job and sometimes his records were audited due to the government contracts of his clients.

N deducted subcontractor expenses as “outside services” in the year the client paid the related invoice. This was true even if the expense had been paid in a prior year (often clients paid invoices two to six months after work was complete). The CPA who prepared N’s returns approved of this approach.

In 2004, the CPA noticed that N had little income and inquired as to why he stayed in the business. Based on these discussions, N started deferring deductions until the associated income





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was received (even if paid in a prior year). N’s returns continued to check “cash” as the method of accounting.

The IRS argued that N was not properly using the cash method and had changed it method without getting permission from the IRS. The court agreed:

“Following Connors, Inc., [71 TC 913 (1979)] we conclude that [N’s] method of deferring his deduction is a method of accounting that he consistently used. Thus, respondent’s adjustment in the notice of deficiency to that material item for tax years 2006 and 2009 constitutes a change in his accounting method, which triggers the application of section 481. “If there has been a change in method of accounting, then section 481 comes into operation and adjustments necessary to prevent an omission of taxable income must be made.” Primo Pants Co. v. Commissioner, 78 T.C. 705, 720 (1982).”

The court agreed that the method change occurred in 2006. The court deferred the 481(a) calculation to the determination of tax owed upon conclusion of the case.

Gift Cards and Deferral under §1.451-5 – CCA 201610017 (3/4/16) CCA 201610017 (3/4/16) – The IRS ruled that income from the sale of unredeemed gift cards can be deferred under §1.451-5 “to the extent Company can make an appropriate estimate of the amounts that are deferrable under §1.451-5 using an allocation similar to that found in §1.451-5(a)(3).” The facts of the ruling are heavily redacted but appears to involve a large retailer of tangible goods with both in-store and e-commerce sales. Services such as delivery, installation and repair are also provided. Services and goods can be acquired separately even if the goods or services were not also purchased from Company. The vendor also sells extended warranty and service contracts, on behalf of a third party. Company sells gift cards with no expiration date. The cards can be used for any combination of goods and services. Company tracks card usage which might take at least five years.

A challenge that exists with using the deferral technique of §1.451-5 (compared to that of Rev. Proc. 2004-34) is that §1.451-5 is for advance payments for sales of goods. However, allocation is possible.

“Section 1.451-5(a)(3) provides that if an agreement for the sale of goods in a future taxable year also obligates the taxpayer to perform services that are not to be performed as an integral part of the sale of goods, then the amount received will only be treated as an “advance payment” to the extent such amount is properly allocable to the obligation to sell goods. The portion of the amount not so allocable will not be considered an “advance payment” to which § 1.451-5 applies.”

“Section § 1.451-5(a)(3) further provides that if the amount not so allocable is less than 5 percent of the total contract price, such amount will be treated as so allocable to the extent that such treatment does not result in delaying the time at which the taxpayer would otherwise accrue the amounts.”

Under 1.451-5, if goods are not specifically identified under the contract, the year the advance payment is received is the year the taxpayer has received “substantial advance payments.” This tells us the triggering point for reporting the advance - “all advance payments received with respect to such agreement by the last day of the second tax year following the year in which such





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substantial advance payments are received, and not previously included in income in accordance with the taxpayer’s accrual method of accounting, must be included in income in such second tax year.” However, if any amounts are included in book income prior to this point, the same must be done for tax purposes (a taxpayer gets no greater deferral for tax than they take for books).

Finding that the gift cards represent “an agreement” with payment “applied against” the agreement and that it is for the sale of goods, the IRS found 1.451-5 applicable. If the services and goods elements can be separated, 1.451-5 can apply to the advance payment for the sale of goods.

The IRS noted: “Company in its submission did not propose an estimation “methodology”, and offered to work with the field to derive an acceptable method of estimation that is both administrable and auditable. Whether Company's particular methods of estimating is appropriate is a question of fact to be determined by the field. No opinion is expressed on the issue of how this estimation is made or on any other issue not directly addressed above.”

Fixed and Medicare Payments – CCA 201607026 (2/12/16) CCA 201607026 (2/12/16) – Per the IRS:

“ISSUE Whether the amount of income the Taxpayer will receive from Medicare pursuant to the Medicare Shared Savings Program regulations is fixed prior to the year of notification of shared savings.

CONCLUSION Due to programmatic factors, the amount of income that the Taxpayer will receive from Medicare pursuant to the Medicare Shared Savings Program regulations is not fixed at the end of the taxable year in which patient services are provided. These factors are resolved and the amount of income is fixed and determinable with reasonable accuracy when the taxpayer is notified of shared savings, which is approximately seven to ten months after the close of the taxable year in which patient services are provided.”

All Events Test Issue – Giant Eagle, Inc., No. 14-3961 (3rd Cir., 5/6/16) In Giant Eagle, Inc., a divided opinion, the court overturned a 2014 Tax Court decision. The issue involved is a reminder that the “fixed” part of the §461 all events test for accrual method taxpayers can be a subjective determination.

Giant Eagle, Inc., TC Memo. 2014-146 (7/23/14) operated grocery stores (“Giant Eagle”) and gas stations (“GetGo”). GE’s customer loyalty program allowed customers of Giant Eagle to earn “fuelperks!” for discounts at GetGo stations. Customers received one fuelperk! for every $50 spent in the store. Each fuelperk! resulted in a ten cent reduction in fuel cost per gallon up to30 gallons. Customers used their loyalty card at the gas station to obtain the discount (and track their fuelperks!). The system allowed for the most optimal use for customers and could result in free gasoline. Excess fuelperks! Remained on the card, but expired three months after the end of the month in which earned. The fuelperks! Were not redeemable for cash.

For the years at issue, GE “deducted the estimated costs of redeeming a certain portion of the issued fuelperks! that were unexpired and unredeemed at the end of each year.” For 2006 and 2007, these amounts were $6,160,855 and $1,130,630, respectively. The IRS denied on the basis




http://www2.ca3.uscourts.gov/opinarch/143961p.pdf


http://ustaxcourt.gov/InOpHistoric/GiantEagleMemo.Haines.TCM.WPD.pdf

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that the all events test was not met for the deduction. Alternatively, GE argued that if a deduction were not allowed, it should be allowed a sales revenue offset under Reg. §1.451-4.

The timing issue focused on the all events test of §461. GE argued that this test was met when fuelperks! are earned. The IRS and court held that the all events test is met when they are redeemed. GE supported its position with the argument that it has a unilateral contract which legally binds it to redeem the perks. Thus, it is liable once the perks are given to customers. The IRS argument which the court agreed with is that the perks are a discount program for the purchase of gas. There is no liability to GE until they are redeemed. The purchase of gas is a condition precedent to the liability.

The court noted with respect to the issue that the perks could reduce the price of gas to zero: “the redemption of fuelperks! could conceivably discount the purchase price to zero. But even so, the right to redeem fuelperks! without paying to purchase gas (i.e., for a free tank of gas) would be contingent on the setting of the retail price of gas immediately before the purchase. Accordingly, whether a customer paid something for the purchase of gas or nothing, petitioner’s obligation to redeem fuelperks! was subject to a condition precedent that could be satisfied only after the close of petitioner’s tax year.”

GE also lost on its §1.451-4 argument. This regulation allows for a revenue offset for certain trading stamps. It applies where the stamp or coupon is redeemable for “merchandise, cash, or other property.” GE’s perks were not so redeemable per the IRS and court. The court referred to Rev. Rul. 78-212, noting:

“Revenue rulings are not substantive authority; however, we may respect the ruling in accordance with its power to persuade. See PSB Holdings, Inc. v. Commissioner, 129 T.C. 131,142 (2007).”

The coupons in the ruling “were not “redeemable in merchandise, cash, or other property” because the redemption of the coupons was conditioned on an additional purchase of the retailer’s product by the consumer” (that is, they could only be used against a future purchase). When the coupon can only be redeemed if there is a future purchase, the matching principle is not met (as it is when the coupon is valid upon issuance due to a current purchase).

The appeals court found that coupons (with an expiration date) given to grocery store customers to obtain a discount at the taxpayer’s gas station represented a fixed liability prior to the purchase of the gasoline. The Tax Court held that using the coupons to buy gasoline was a prerequisite to GE having a fixed or definite liability. The appeals court noted that GE tracked monthly redemption rates to help prove the “absolute liability and a near-certainty that the liability would soon be discharged by payment.” The appeals court also noted that Pennsylvania law relevant to these unilateral contracts indicated that GE had a liability because customers know of the offer and had the power to accept, thus making GE liable when issued. The dissenting judge noted though, that this liability was not absolute.

The dissenting judge noted that the expiration date on the coupons indicated that they might not be redeemed such that a contingency existed preventing the liability from being fixed prior to use of the coupons. This judge also noted that cases cited by the majority, such as Hughes Properties, 476 U.S. 593 (1986) (involving a casino’s liability for the growing jackpot on a progressive slot machine), did not have the same facts. In these cases, the liabilities had “to remain on their books


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until discharged by payment.” Here, GE’s liability is temporary due to the coupon’s expiration date. Per this judge, there was no absolute liability upon issuance of the coupon; GE was not liable until a customer redeemed a coupon.

Observation: This ruling raises issues regarding the application of the “fixed” part of the §461 all events test in similar contexts. That is, when may an accrual method taxpayer treat a liability as fixed even though a third party must still take an action (such as redeem a coupon or return a broken product sold under warranty) for the taxpayer to actually incur a cost?

IRS NonAcq. In Giant Eagle - AOD 2016-03 (10/3/16) The IRS does not agree with the Third Circuit’s opinion in Giant Eagle, Inc., No. 14-3961 (3rd Cir., 5/6/16) (discussed above). Per the IRS:

“The Service’s position is that Taxpayer’s liability for its unredeemed discount coupons is not fixed before the customer purchases fuel. This case is controlled by the Supreme Court’s opinion in United States v. General Dynamics Corp., 481 U.S. 239 (1987), holding that a taxpayer may not “deduct an estimate of an anticipated expense, no matter how statistically certain, if it is based on events that have not occurred by the close of the taxable year.” Id. at 243-44. Although a customer’s purchase of $50 worth of groceries obligated Taxpayer to provide a ten-cent-per-gallon discount on a future purchase of gasoline, the discount itself was not absolute until the customer actually purchased gasoline.”

The IRS also argues that the court misconstrued cases such as Hughes Properties, 476 US 539 (1986) on progressive slot machine payout that involved a liability that is “unconditionally fixed at a point prior to payment.” In such situation, the only uncertainty is the name of the payee. “In contrast, the Pennsylvania law relied upon by the Third Circuit did not fix the amount to be paid by Taxpayer; it only created the contractual obligation to pay in the event the discount coupons were redeemed with the purchase of fuel.”

The IRS will only follow the decision in the Third Circuit, but will check to see if the taxpayer’s facts can be “meaningfully distinguished.”

Rev. Proc. 2004-34 and Taxable Stock Acquisition – CCA 201619009 (3/11/16) CCA 201619009 (3/11/16) – The IRS held that the revenue deferred per the advance payment method of Rev. Proc. 2004-34 must include the balance of the deferred revenue as it normally would even though as part of the company’s taxable acquisition it writes down the deferred revenue to fair value on its Applicable Financial Statement. The conclusion per the CCA:

“A taxpayer that (1) has deferred recognizing revenue into income under Rev. Proc. 2004-34 and (2) subsequently has all of its stock acquired by an unrelated corporation that, for financial accounting purposes, writes down the associated deferred revenue liability to its fair value as of the date of the acquisition, must include the advance payment in its gross income for federal income tax purposes in the year of receipt to the extent the payment is recognized in revenues in its Applicable Financial Statement (“AFS”) for that taxable year, and must include the remaining amount of the advance payment in its gross income in the next succeeding taxable year, irrespective of any write-down of the deferred revenue liability for financial accounting purposes.”


https://www.irs.gov/pub/irs-aod/aod-2016-03.pdf

https://www.irs.gov/pub/irs-aod/aod-2016-03.pdf




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Duty of Consistency and Cash Method Reporting of Income – Squeri, et al, TC Memo 2016-116 (6/15/16)

Squeri, et al, TC Memo 2016-116 (6/15/16) – PBS is a California corporation operating as an S corporation. It provided janitorial services and used the cash method of accounting. Stock was owned by four shareholders who also worked for the company. One shareholder owned 51% of the stock. PBS calculated its gross income based on deposits made to its bank accounts. However, there were funds received in December not deposited until the next January. Under the cash method, such amounts were taxable in December rather than January.

Gross receipts reported were as follows:

2009 $7,217.362

2010 $7,934,376

2011 $8,716,194

The December amounts not deposited until the following January were as follows:

December 2008 $1,634,720

December 2009 $1,893,851

December 2010 $2,271,175 Thus, 2009 income should have included $1,893,851, but not $1,634,720. However, just for 2009, the IRS did not make the adjustment to remove the December 2008 amounts deposited in January 2009 that really belonged in 2008. The statute of limitations for 2008 was closed for the taxpayers. The IRS based its position on the duty of consistency.

Per the court: “The duty of consistency, or quasi-estoppel, is an equitable doctrine which prevents a taxpayer from benefiting in a later year from an error or omission in an earlier year which cannot be corrected because the limitations period for the earlier year has expired.” The court also analyzed the duty of consistency using three requirements laid out by the 9th Circuit:

1) a representation or report by the taxpayer – here, PBS was consistent in reporting income based on bank deposits and the IRS is holding them to that approach. “In the instant cases petitioners made a clear representation on the 2009 Form 1120S for PBS when they represented that PBS had received the $1,634,720 of gross receipts in 2009. This element of the duty of consistency has been met.” It does not matter that this treatment was incorrect.

2) reliance by the Commissioner – IRS had relied because it accepted the 2008 returns and allowed the statute of limitations to expire.

3) an attempt by the taxpayer after the statute of limitations has run to change the previous representation or to recharacterize the situation in such a way as to harm the Commissioner – If PBS were allowed to remove the December 2008 receipts from its 2009 income, the $1,634,720 would never be reported.

“If all those elements are present, the Commissioner may act as if the previous representation, on which he relied, continues to be true, even if it is not. The taxpayer is estopped to assert the




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contrary. … The duty of consistency is an affirmative defense. … Therefore, the party asserting the duty of consistency bears the burden of proving that it applies; thus [IRS] bears the burden.”

Thus, per the duty of consistency, the IRS was permitted to not remove the 2008 receipts from 2009 that were mistakenly reported in 2009 that belonged in 2008. Due to the statute of limitations, the income would never be reported otherwise.

Completed Contract Method – Shea Homes, Inc. and Subs., No. 14-72161 (9th Cir., 7/24/16)

Shea Homes, Inc. and Subs., No. 14-72161 (9th Cir., 7/24/16), aff’g 142 TC No. 3 (2/12/14) – The 9th Circuit agreed with the Tax Court that Shea was eligible to use the completed contract method for sale of homes and common improvements. On appeal, the IRS also questioned how Shea applied the 95% test of Reg. 1.460-1(c)(3)(A). The court did not agree with the IRS. Per the court’s conclusion:

“We affirm the Tax Court’s decision that on the record before it, the Taxpayers “used a permissible method of accounting” and “that method of accounting clearly reflect[ed] [their] income.” Shea Homes, 42 T.C. at 106. In short, they were “permitted to report income and loss from the sales of homes in their planned developments using the completed contract method of accounting” in the manner “consistent with [its] Opinion.” Perhaps the Commissioner wishes that he had approached the proceeding before the Tax Court in a different way. In any event, he asks for relief. We have none to offer; he must thole the result. Nevertheless, we would be remiss if we did not close this opinion with the Tax Court’s admonition: “We are cognizant that our Opinion today could lead taxpayers to believe that large developments may qualify for extremely long, almost unlimited deferral periods. We would caution those taxpayers a determination of the subject matter of the contract is based on all the facts and circumstances.””

Installment Sale and Related Parties - Vest, TC Memo 2016-187 (10/6/16) Vest, TC Memo 2016-187 (10/6/16) – In 2003, V created Truebeginnings, LLC (TB), an accrual method entity, owned 85% by V and his wife. The business activity of TB was a dating website. TB owned 100% of two partnerships: (1) H.D. Vest Advanced Systems (VAS) and (2) Metric, LLC (M). TB created technology for optimizing the delivery of ads on the Internet. In 2008, TB sold computer equipment worth $454,825 and $412,000, respectively, to VAS and M. TB also sold intangible assets to VAS with a value of about $2.8 million. These assets had zero basis to TB so the entire sales price generated gain to TB. VAS and M used promissory notes for the purchase with a stated interest rate of 10%. All interest and principal was due January 2018. TB’s 2008 return included Form 6252 showing deferral of gain of $338,683 for the tangible assets and about $2.8 million for the intangibles. Form 4797 indicated about $30,000 of gain, likely due to depreciation recapture on the equipment that does not benefit from instalment sale treatment.

VAS and M claimed depreciation/amortization on the stepped up bases of the assets purchased.

In 2012, V filed for bankruptcy causing his share of partnership items of TB and another partnership to be converted to nonpartnership items.


https://cdn.ca9.uscourts.gov/datastore/opinions/2016/08/24/14-72161.pdf

https://cdn.ca9.uscourts.gov/datastore/opinions/2016/08/24/14-72161.pdf

http://www.ustaxcourt.gov/InOpHistoric/SheaHomesDiv.Wherry.TC.WPD.pdf



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After disallowing losses treated as a hobby (see discussion of this issue in the loss section of the outline) and disallowing installment sale treatment and accounting for NOLs of V, the IRS found AMT owed for 2008 -2010, the years under audit.

The IRS disallowed installment sale treatment and the court agreed. The relevant rule here is §453(g).* As described by the court:

“Installment sale treatment allows an accrual-basis taxpayer (such as TB) to defer the reporting of gain during the period of the installment note--here, ten years--thus minimizing current tax. However, section 453(g)(1) provides that this treatment generally is not available “[i]n the case of an installment sale of depreciable property between related persons.” In the case of a related-party sale of depreciable property, installment sale treatment is available only “if it is established to the satisfaction of the Secretary that the disposition did not have as one of its principal purposes the avoidance of Federal income tax.” Sec. 453(g)(2).”

The IRS declared the three entities as “clearly” related as V controlled each entity. Also, the tangible property sold to VAS and M was depreciable property. Thus, to be able to use the installment method, V must show tax avoidance was not a principle purpose for the asset sale. Per the IRS, this burden is a “heavy one.”

“In ascertaining the true purpose of the transaction, we accord more weight to objective facts than to the taxpayer’s “mere denial of tax motivation.” Id. at 60. We also consider the enhanced depreciation deductions available to the related buyer in deciding whether the seller had a principal purpose of avoiding tax.”

The IRS found a principal purpose of tax avoidance due to:

V retained control over the assets and ad-optimization business.

Use of 453 enabled TB to defer the $3.2 million gain for ten years and for VAS and M to gain advantage of stepped-up basis and depreciation deductions. This advantage was particularly great with respect to the intangible assets.

V’s argument of a valid business purpose of moving assets into three separate partnerships in anticipation of sale was insufficient. A valid business purpose “does not negate the conclusion that ‘one of its principal purposes’ was the avoidance of tax.”

V’s NOLs don’t overcome the tax avoidance concern because despite the NOLs, he still had significant AMT liability. The installment sale and stepped-up basis in the transferred assets reduced his AMT liability.

Note: This case also involved a business v hobby issue.

*453(g) SALE OF DEPRECIABLE PROPERTY TO CONTROLLED ENTITY

(1) In General In the case of an installment sale of depreciable property between related persons—

(A) subsection (a) shall not apply,

(B)for purposes of this title—


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(i) except as provided in clause (ii), all payments to be received shall be treated as received in the year of the disposition, and

(ii) in the case of any payments which are contingent as to the amount but with respect to which the fair market value may not be reasonably ascertained, the basis shall be recovered ratably, and

(C) the purchaser may not increase the basis of any property acquired in such sale by any amount before the time such amount is includible in the gross income of the seller.

(2) Exception Where Tax Avoidance Not a Principal Purpose Paragraph (1) shall not apply if it is established to the satisfaction of the Secretary that the disposition did not have as one of its principal purposes the avoidance of Federal income tax.

(3) Related Persons For purposes of this subsection, the term “related persons” has the meaning given to such term by section 1239(b), except that such term shall include 2 or more partnerships having a relationship to each other described in section 707(b)(1)(B).

MMF and Net Asset Value (NAV) Method of Accounting – Rev. Proc. 2016-39 Per the IRS (7/7/16): “Revenue Procedure 2016-39 provides the procedures by which a taxpayer may obtain the automatic consent of the Commissioner to change to or from the net asset value (NAV) method of accounting provided in §1.446-7 for gain or loss on shares in a money market fund (MMF). This revenue procedure modifies Rev. Proc. 2016-29.”

In addition, the IRS released final regulations (TD 9774) under §1.446-7 and §1.6045-1 on “Method of Accounting for Gains and Losses on Shares in Money Market Funds: Broker Returns with Respect to Sales of Shares in Money Market Funds.”

§199 Rulings

Print Media - CCA 201626024 (6/24/16) CCA 201626024 (6/24/16) – T manufactured clothes outside of the U.S. Print media to promote the products are produced by third parties in the U.S. T claims to have the benefits and burdens of ownership during the production of this print media. None of this print media is sold. T claimed a §199 deduction on the basis that the advertising is a component of the clothing and accessories it sells.






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T “believes that its advertising revenues generated from the disposition of its manufactured printed media which is included in the sales price of its goods sold in its stores and online is qualified under § 1.199-3(i)(5).” T also claims that its prices include a “component for the printed media produced.” Also, “Taxpayer claims that its printed media campaign is responsible for driving a portion of its sales. Taxpayer claims it is able to identify 92-95% of its incremental sales associated with its catalogs, mailers, and other printed media.”

The IRS disagreed finding it “inappropriate” to treat any portion of T’s gross receipts as derived from sales of products related to advertising (the print media). Per the IRS, “The fact that advertising your products increases your sales is of no consequence when applying § 1.199-3(i)(5)(ii)(A). For this rule to be relevant, Taxpayer’s customers have to pay to advertise in Taxpayer’s print media. That is not happening when they buy a product. Taxpayer’s argument is a misapplication of the rules in § 1.199-3(i)(5). Taxpayer’s products are MPGE outside of the United States, and the gross receipts from their sale are non-DPGR.”

Construction - TAM 201638022 (9/16/16) TAM 201638022 (9/16/16) – T’s NAICS code involved construction. Its projects involve “substantial renovation, construction, or erection of xxx, xxx, and xxx in the” U.S. [xxx means redacted] The IRS found that T’s projects qualified as construction of real property such that the gross receipts qualified as DPGR. The facts are heavily redacted though.

COS - CCA 201642033 (10/14/16) CCA 201642033 (10/14/16) – Per the IRS:

“ISSUE Whether a loss on the sale of Equipment A purchased by a taxpayer to produce qualifying production property (QPP) reduces the taxpayer’s qualified production activities income (QPAI)?

CONCLUSION Under Treas. Reg. §1.199-4(b)(1), the adjusted basis of purchased equipment used to produce qualifying production property is considered cost of goods sold (CGS) when that equipment is sold. Under the facts and circumstances, that CGS will be allocated solely to the taxpayer’s non-domestic production gross receipts (non-DPGR) received on the sale of Equipment A and therefore the loss will not reduce the taxpayer’s QPAI.”






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Chapter 9: International Tax Page 9-1

Chapter 9 : International Tax

Table of Contents Chapter 9 : International ......................................................................................................... 9-1

T.D. 9752; Reg. 1.6038D-1, -2, -6 (2/22/2016) -- Final Regulations On Specified Foreign Financial Asset (SFFA) Form 8938 Reporting By Domestic Entities ............................... 9-1

Prop Reg 1.6038A-1, -2, Prop Reg 301.7701-2 (05/06/2016)-- Prop Regs Would Impose Information Reporting On Foreign-Owned Domestic Disregarded Entities ................... 9-1

TD 9761 and REG-135734-14 (April 29, 2016) – Temp. and Prop. Regs. on Corporate Inversions ................................................................................................................................ 9-2

T.D. 9759; Reg. § 1.332-6, -7; 1.334-1; 1.337-1; 1.351-3; 1.358-6; 1.362-3, -4, Reg. § 1.368-3 (03/25/2016) -- Final Regs Cover Nonrecognition Transfers Of Loss Property To Corporations ........................................................................................................................... 9-3

Notice 2016-52 -- Section 909 and Foreign-Initiated Adjustments .................................... 9-4

IRS International Practice Units Training Aids ................................................................. 9-4

T.D. 9752; Reg. 1.6038D-1, -2, -6 (2/22/2016) -- Final Regulations On Specified

Foreign Financial Asset (SFFA) Form 8938 Reporting By Domestic Entities These regulations are effective in 2016 and are discussed in detail in Chapter 1. Prop Reg 1.6038A-1, -2, Prop Reg 301.7701-2 (05/06/2016)-- Prop Regs Would

Impose Information Reporting On Foreign-Owned Domestic Disregarded Entities

Per the Premable to the Proposed Regs.:

These proposed regulations would amend section 301.7701-2(c) to treat a domestic disregarded entity that is wholly owned by one foreign person as a domestic corporation separate from its owner for the limited purposes of the reporting and record maintenance requirements (including the associated procedural compliance requirements) under section 6038A [a 25% foreign-owned domestic corporation]. As with the existing special rules with respect to employment and excise taxes, these proposed regulations would not alter the framework of the existing entity classification regulations, including the treatment of certain entities as disregarded. These regulations are intended to provide the IRS with improved access to information that it needs to satisfy its obligations under U.S. tax treaties, tax information exchange agreements and similar



https://www.irs.gov/irb/2016-21_IRB/ar19.html#d0e16473

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international agreements, as well as to strengthen the enforcement of U.S. tax laws.

TD 9761 and REG-135734-14 (April 29, 2016) – Temp. and Prop. Regs. on

Corporate Inversions

Treasury Action – In April 2016, Treasury issued temporary and proposed regulations aimed at reducing corporate inversions where a U.S. company in effect becomes a foreign corporation. Treasury notes that such actions can have useful business reasons, but are often driven by a desire for lower taxes. Per a 4/4/16 press release:

“Genuine cross-border mergers make the U.S. economy stronger by enabling U.S. companies to invest overseas and encouraging foreign investment to flow into the United States. But these transactions should be driven by genuine business strategies and economic efficiencies, not a desire to shift the tax residence of a parent entity to a low-tax jurisdiction simply to avoid U.S. taxes.”

“Today, Treasury is taking action to: · Limit inversions by disregarding foreign parent stock attributable to recent inversions

or acquisitions of U.S. companies. This will prevent a foreign company (including a recent inverter) that acquires multiple American companies in stock-based transactions from using the resulting increase in size to avoid the current inversion thresholds for a subsequent U.S. acquisition.

· Address earnings stripping by: o Targeting transactions that generate large interest deductions by simply

increasing related-party debt without financing new investment in the United States.

o Allowing the IRS on audit to divide debt instruments into part debt and part equity, rather than the current system that generally treats them as wholly one or the other.

o Facilitating improved due diligence and compliance by requiring certain large corporations to do up-front due diligence and documentation with respect to the characterization of related-party financial instruments as debt. If these requirements are not met, instruments will be treated as equity for tax purposes.

· Formalize Treasury’s two previous actions in September 2014 and November 2015. Treasury will continue to explore additional ways to address inversions.”

Additional information on inversions, the tax concerns and the Treasury regulations:

Treasury 4/4/16 press release.

Treasury Fact sheet (4/4/16).

Updated business tax reform framework from President Obama (see pages 15-16).

President Obama speech and infographic about inversions and the economy (4/5/16).

Letter from 18 former treasury officials opposing the regulations – 4/18/16.








https://www.treasury.gov/resource-center/tax-policy/Documents/The-Presidents-Framework-for-Business-Tax-Reform-An-Update-04-04-2016.pdf

https://www.whitehouse.gov/blog/2016/04/05/why-you-should-care-new-actions-corporate-inversions

http://static.politico.com/3b/27/d56bbea24c2ebc84dbf023e847dc/letterseclewfinalj-2.pdf

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LB&I information for examiners – IRS LB&I International Practice Service Concept Unit guide released 7/5/16 (53 pages).

Legislative Activity and Related Information

Stop Tax Haven Abuse Act (S. 174 / H.R. 297) Oxfam information – website “Stop Tax Dodging” and report, “Broken at the

top.”

Delphi becomes UK corporation

a. Jeff Bennett, “Delphi Wins IRS Appeal on Tax Status, Sets Bullish Outlook,” Wall Street Journal, 4/13/16.

b. Delphi’s 8-K filing about the IRS settlement (4/8/16).

T.D. 9759; Reg. § 1.332-6, -7; 1.334-1; 1.337-1; 1.351-3; 1.358-6; 1.362-3, -4, Reg. § 1.368-3 (03/25/2016) -- Final Regs Cover Nonrecognition Transfers Of

Loss Property To Corporations

IRS has issued final regulations under sections 334(b)(1)(B) and 362(e)(1) applicable to nonrecognition transfers of loss property to corporations. The regulations also amend final regulations under sections 332 and 351 to reflect certain statutory changes. “The regulations affect certain corporations that transfer assets to, or receive assets from, their shareholders in exchange for the corporation’s stock.”

Basic Example (Reg. 1.334-1(b)(3)(iv) Example 1):

Unless the facts indicate otherwise, the [example] use the following nomenclature and assumptions: USP is a domestic corporation that has not elected to be an S corporation within the meaning of section 1361(a)(1); FC, CFC1, and CFC2 are controlled foreign corporations within the meaning of section 957(a), which are not engaged in a U.S. trade or business, have no U.S. real property interests, and have no other relationships, activities, or interests that would cause their property to be subject to any tax imposed under subtitle A of the Code (federal income tax); there is no applicable income tax treaty; and all persons and transactions are unrelated. All other relevant facts are set forth in the examples:

Distribution of importation property in a loss importation transaction.

(A) Facts. USP owns the sole outstanding share of FC stock. FC owns three assets, A1 (basis $40, value $50), A2 (basis $120, value $30), and A3 (basis $140, value $20). On Date 1, FC distributes A1, A2, and A3 to USP in a complete liquidation that qualifies under section 332.

(B) Importation property. Under § 1.362–3(d)(2), the fact that any gain or loss recognized by a CFC may affect an income inclusion under section 951(a) does not alone cause gain or loss recognized by the CFC to be treated as taken into account in determining a federal income tax liability for purposes of this section. Thus, if FC had sold either A1, A2, or A3 immediately before the transaction, no


https://www.irs.gov/businesses/corporations/international-practice-units

https://www.irs.gov/pub/int_practice_units/isocup_1_10_01.pdf


https://www.congress.gov/bill/114th-congress/house-bill/297/

https://action.oxfamamerica.org/stoptaxdodging/

https://www.oxfamamerica.org/explore/research-publications/broken-at-the-top/

https://www.oxfamamerica.org/explore/research-publications/broken-at-the-top/

http://www.wsj.com/articles/delphi-wins-irs-appeal-on-tax-status-1460551781

https://www.sec.gov/Archives/edgar/data/1521332/000152133216000090/a8-kxapril132016.htm



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gain or loss recognized on the sale would have been taken into account in determining a federal income tax liability. Further, if USP had sold A1, A2, or A3 immediately after the transaction, USP would take into account any gain or loss recognized on the sale in determining its federal income tax liability. Therefore, A1, A2, and A3 are all importation properties. See paragraph (b)(3)(iii)(A) of this section and § 1.362–3(c)(2).

(C) Loss importation transaction. Immediately after the distribution, USP’s aggregate basis in the importation properties, A1, A2, and A3, would, but for section 334(b)(1)(B) and this section, be $300 ($40 + $120 + $140) and the properties’ aggregate value would be $100 ($50 + $30 + $20). Therefore, the importation properties’ aggregate basis would exceed their aggregate value and the distribution is a loss importation transaction. See paragraph (b)(3)(iii)(A) of this section and § 1.362–3(c)(3).

(D) Basis of importation property distributed in loss importation transaction. Because the importation properties, A1, A2, and A3, were transferred in a loss importation transaction, the basis in each of the importation properties received is equal to its value immediately after FC distributes the property. Accordingly, USP’s basis in A1 is $50; USP’s basis in A2 is $30; and USP’s basis in A3 is $20.

Notice 2016-52 -- Section 909 and Foreign-Initiated Adjustments

Per the IRS (9/15/16): “Notice 2016-52 provides guidance relating to certain transactions, undertaken in anticipation of foreign-initiated income tax adjustments, which will be considered foreign tax credit splitter arrangements under section 909.”

IRS International Practice Units Training Aids

The IRS posts some of its “job aids” and training documents dealing with international tax issues on a website. Several new items were added in 2015 including on sourcing of fringe benefits, ECI, and the bona fide residence test.

For example:

09-10-2015 Inbound Liquidation of a Foreign Corporation into a U.S. Corporate Shareholder

(PDF, 421KB)

09-09-2015 Accounting for Intangibles and Services Associated with the Sale of Tangible Property - Outbound

(PDF, 371KB)

08-28-2015 Foreign-To-Foreign Transactions – IRC 367(b) Overview (PDF, 457KB) 08-28-2015 Overview of IRC 482 (PDF, 485KB) 08-21-2015 Short Term Loan Exclusion from United States Property (PDF, 350KB)




http://www.irs.gov/Businesses/Corporations/International-Practice-Units

http://www.irs.gov/Businesses/Corporations/International-Practice-Units

http://www.irs.gov/pub/int_practice_units/ISO9411_08_02.pdf


http://www.irs.gov/pub/irs-utl/ISO9411_02_04.pdf

http://www.irs.gov/pub/irs-utl/ISO9411_02_04.pdf



http://www.irs.gov/pub/int_practice_units/RPA9414_01_01.pdf

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Chapter 10: Payroll Tax and Worker Classification Page 10-1

Chapter 10 : Payroll Tax and Worker Classification

Table of Contents Chapter 10 : Payroll Tax and Worker Classification .......................................................... 10-1

Payroll Tax Matters ..................................................................................................... 10-2

2017 Social Security Wage Base is $127,200 ...................................................................... 10-2

Substitute Form 941 Procedures ........................................................................................ 10-2

Payroll Record Retention Requirements ........................................................................... 10-2

Treatment of Certain Persons as Employers with respect to Motion Picture Projects 10-2

Employment Tax Tip Examination Initial Contact by Mail ............................................ 10-3

Responsibility for Payroll Taxes of Single Member LLC – Costello, LLC, et al, TC Memo 2016-184 (9/29/16) .................................................................................................... 10-4

“Short-Week” Benefits – CCA 201634023 (8/19/16)......................................................... 10-5

New IRS Pub on Employment Tax Return Audits ........................................................... 10-5

Employment-Related Identity Theft Issues – TIGTA Report ......................................... 10-6

Employer Liability for Penalties Where Third Party Payroll Service Embezzled Funds – Kimdun ................................................................................................................................. 10-7

100% Penalty - IRC §6672 Trust Fund Tax Penalty Cases .................... 10-8

Schiffman, (1st Cir. 2016) – 100% Penalty Imposed Upon Fired CFO and CEO ......... 10-8

Willful? Gann, No. 10-359T (Fed Cls, 9/16/16) ................................................................. 10-9

Certified Professional Employer Organizations (PEO) ........................... 10-12

2014 Legislative Enactment .............................................................................................. 10-12

Regulations ......................................................................................................................... 10-12

Self-Employment Tax ............................................................................................... 10-13

Self-Employment Tax Treatment of Partners in a Partnership That Owns a Disregarded Entity ................................................................................................................................... 10-13

LLC Member Fails in Making Brinks Argument to Limit SE Tax – CCA 201640014 (9/30/16) ............................................................................................................................... 10-13

SE Tax and Trade or Business – Ryther, TC Memo 2016-56 (3/28/16) ........................ 10-16

Blogger’s Ad Revenue Subject to SE Tax ........................................................................ 10-17

Real Estate Agent Owes Self-Employment Tax – Wang, TC Memo 2016-123 ............ 10-17

Self-Employment Tax and Deferred Compensation – Peterson, Nos. 14-15773, 14-15774 (11th Cir., 5/24/16) .............................................................................................................. 10-18


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Self-Employment Tax Owed on Working Interests - Methvin, No. 15-9005 (10th Cir., 6/24/16) ................................................................................................................................ 10-20

Puerto Rico Income Subject to SE Tax – Curet, TC Memo 2016-138 (7/25/16) .......... 10-21

SE Tax Owed by Individual, Not Bankruptcy Estate – Sisson, TC Memo 2016-143 (8/1/16) ................................................................................................................................. 10-21

Worker Classification ............................................................................................... 10-22

IRS Pub 15-A – Summary Worker Classification Rules ................................................ 10-22

Litigation and IRC §7436 – CC-2016-002 (12/17/15)...................................................... 10-22

IRC §7436 and IRS Procedure When Taxpayer Raises Classification or Section 530 .. 10-23

SS-8 and Examination Status – BG Painting, Inc., TC Memo 2016-62 (4/5/16............ 10-23

Set Builder Found to Be Independent Contractor – Quintanilla, TC Memo 2016-5 (1/7/16) ................................................................................................................................. 10-24

Companion Sitter – CCA 201633034 (8/12/16) ............................................................... 10-24

Joint Employer Status ....................................................................................................... 10-25

Gig Economy ................................................................................................................. 10-26

Payroll Tax Matters

2017 Social Security Wage Base is $127,200 In October 2017, the Social Security Administration announced a 0.3% increase in benefits for 2017. Also, starting January 2017, the wage base for Social Security taxes increases to $127,200 from $118,500. SSA estimates that of the roughly 173 million workers who pay these taxes, only about 12 million are affected by this increase in the wage limit. Tax rates remain the same (7.65% for employees and 15.3% for self-employed). [10/18/16 SSA press release]

Substitute Form 941 Procedures

See Rev. Proc. 2016-16 (2/23/16).

Payroll Record Retention Requirements The SSA/IRS Reporter newsletter for spring 2016 includes a detailed article on this topic. Generally, payroll records should be retained for at least four years after the due date of the employee’s income tax return. See the article for more details.

Treatment of Certain Persons as Employers with respect to Motion Picture Projects


https://www.ssa.gov/news/press/releases/#/post/10-2016-1


https://www.irs.gov/pub/irs-utl/ssa_irs_reporter_spring.pdf

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PATH added new IRS 3512 for remuneration paid after 12/31/15. This provision allows for more employer favorable treatment than resulted in Cencast Services, 729 F.3d 1352 (Fed. Cir. 2013), if wages are paid by “motion picture project employer” to a “motion picture project worker.”

Per the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in 2015 (JCS-1-16; March 2016), page 315:

“Under the provision, for purposes of the OASDI and FUTA wage bases, remuneration paid by a ‘‘motion picture project employer’’ during a calendar year to a ‘‘motion picture project worker’’ is treated as remuneration paid with respect to employment of the motion picture project worker by the motion picture project employer. As a result, all remuneration paid by the motion picture project employer to a motion picture project worker during a calendar year is subject to a single OASDI wage base and a single FUTA wage base, without regard to the worker’s status as a common law employee of multiple clients of the motion picture project employer during the year.

A person must meet several criteria to be treated as a motion picture project employer. The person (directly or through an affiliate) must (1) be a party to a written contract covering the services of motion picture project workers with respect to motion picture projects in the course of the trade or business of a client of the motion picture project employer, (2) be contractually obligated to pay remuneration to the motion picture project workers without regard to payment or reimbursement by any other person, (3) control the payment (within the meaning of the Code) of remuneration to the motion picture project workers and pay the remuneration from its own account or accounts, (4) be a signatory to one or more collective bargaining agreements with a labor organization that represents motion picture project workers, and (5) have treated substantially all motion picture project workers whom the person pays as employees (and not as independent contractors) during the calendar year for purposes of determining FICA, FUTA and other employment taxes. In addition, at least 80 percent of all FICA remuneration paid by the person in the calendar year must be paid to motion picture project workers. A motion picture project worker means any individual who provides services on motion picture projects for clients of a motion picture project employer that are not affiliated with the motion picture project employer.”

Employment Tax Tip Examination Initial Contact by Mail SBSE-04-0816-0031 – On 8/1/16, the IRS issued a memo to employees involved with employment tax examinations that going forward, all initial contact regarding employment tax on tip income would be by mail rather than phone.

“Examiners will use an appropriate initial contact letter following the requirements in 4.23.7, Employment Tax on Tip Income, to notify the taxpayer that they were selected for examination, and will not make initial contact by telephone. When a valid Form 2848, Power of Attorney and Declaration of Representative, or Form 8821, Tax Information Authorization, is on file for the taxpayer, the appropriate initial contact letter will be mailed to the taxpayer and a copy of the letter will be mailed to the representative with Letter 937, Transmittal Letter for Power of Attorney. After mailing the contact letter, and sufficient time has lapsed for the taxpayer to respond (allow 14 calendar days from mailing the letter), employees can then initial contact by telephone with the taxpayer as needed. We are evaluating our other contacts with taxpayers,


http://www.cafc.uscourts.gov/sites/default/files/opinions-orders/12-5142.Opinion.9-6-2013.1.PDF


https://www.irs.gov/pub/foia/ig/spder/sbse-04-0816-0031.pdf


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outside of the examination context, to determine whether they present risks with respect to phone scams and other such threats.”

Responsibility for Payroll Taxes of Single Member LLC – Costello, LLC, et al, TC Memo 2016-184 (9/29/16)

Costello, LLC, et al, TC Memo 2016-184 (9/29/16) – The IRS assessed payroll taxes on the LLC for six quarters of just over $400,000. The payroll returns were all filed but not completely paid. The issue before the court was whether Mr. Costello was responsible as the owner of a single member LLC or whether the LLC was taxable as a corporation and responsible for the taxes.

The originating entity was a corporation created by C’s father in 1989. The father was the sole owner. Upon his death, C became the sole owner, before 2004. On 12/31/03, C formed an LLC and was the sole member. This LLC never filed Form 8832. C merged his father’s corporation and his LLC with the corporation ceasing to exist. The LLC filed Forms 1120 and used the EIN of the father’s corporation.

C attempted to obtain an offer-in-compromise or an installment agreement although the IRS says it never received the OIC. A Collection Due Process hearing was held where C argued that the taxes were the liability of the LLC, not of him.

C’s problem was that no Form 8832 was ever filed. Thus, the default classification applies which for a single member LLC is a sole proprietorship. Per the court: “An entity whose classification is determined under the default classification retains that classification until the entity makes an election to change it by filing Form 8832, Entity Classification Election.”

C raised three other arguments:

1) The merger of the corporation and LLC was a valid F reorg making the entity a corporation. The court said this did not matter because the LLC never filed Form 8832.

2) LLC filed Form 1120 in the first year after the corporation-LLC merger and that should constitute a valid election to be taxed as a corporation. Per the court, this is not the appropriate method for making the election. “An eligible entity may not elect its entity classification by filing any particular tax return it wishes; it must do so by filing Form 8832 and following the instructions within section 301.7701-3(c)(1)(i).”

3) The IRS is prevented under the doctrine of equitable estoppel from arguing that the LLC is not taxed as a corporation when it accepted its Forms 1120. The court ruled that the four elements required for this doctrine were not met. These requirements: “The elements of estoppel are: “(1) * * * a false representation or wrongful misleading silence; (2) the error must be in a statement of fact and not in an opinion or a statement of law; (3) the person claiming the benefits of estoppel must be ignorant of the true facts; and (4) he must be adversely affected by the acts or statements of the person against whom an estoppel is claimed.”” The court noted that it was not relevant that the IRS did not reject LLC’s Forms 1120 was of consequence.

Thus, the court found that C was personally liable for the entity’s payroll taxes.




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“Short-Week” Benefits – CCA 201634023 (8/19/16) CCA 201634023 (8/19/16) – The IRS stated that “short-week” benefits are considered wages for both FICA and FUTA purposes. The full text follows:

“You asked whether “short-week” benefits paid to workers who work less than 36 hours in a week or who could not work due to weather are excluded from wages for purposes of FICA tax as supplemental unemployment benefits described in Revenue Ruling 90- 72. You stated that under state law, an applicant for state unemployment compensation benefits must be “unemployed, able, available for, and actively seeking suitable full-time work.” Recipients of short-week benefits do not qualify for state unemployment compensation. Thus, these short-week benefits are not “linked to the receipt of state unemployment compensation” as required by Revenue Ruling 90-72. We agree with your conclusion that these” short-week “payments are not excluded from wages for purposes of FICA tax because they do not satisfy the narrow exception set forth in Rev. Rul. 90-72. Your conclusion is also consistent with PLRs 200322012 and 9734035, which stated Automatic Short Week Benefits are wages for FICA and FUTA purposes, unless the benefits are made to individuals who otherwise qualify for excludable Regular Benefits (i.e., if the Automatic Short Week Benefits immediately precede or follow a week in which an employee receives Regular Benefits).”

New IRS Pub on Employment Tax Return Audits In September 2015, the IRS released a new publication – Pub 5146, Employment Tax Returns: Examinations and Appeal Rights. Topics covered:

An Overview of Employment Taxes

What Should You Know if the IRS Is Going to Examine Your Return?

How the IRS Selects Returns to Examine

Once Your Return Is Selected for an Examination, What You Can Expect

What Happens During the Examination?

What the Results of the Examination May Be

What Should You Do After You Receive the Examination Results?

If You Agree with the Results of the Examination

If You Disagree with the Results of the Examination

How Do You Appeal an IRS Decision?

How the Appeal System Works

Special Procedures for Worker Classification Issues

Section 530 of the Revenue Act of 1978 May Provide Relief

You May Be Eligible for the Classification Settlement Program




https://www.irs.gov/pub/irs-pdf/p5146.pdf

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Section 3509 Provides Reduced Rates

We May Send You a Notice of Determination of Worker Classification

Tip Examinations

What Should You Do When You Receive a Bill for Your Balance Due?

Trust Fund Recovery Penalty

About Trust Fund Taxes

Correcting Employment Tax Errors Not Covered in an Examination

Employment-Related Identity Theft Issues – TIGTA Report TIGTA released a report in August 2016 – Processes Are Not Sufficient to Assist Victims of Employment-Related Identity Theft. Per TIGTA:

“Employment-related identity theft occurs when an identity thief uses the identity of an innocent taxpayer to gain employment. Taxpayers may first realize they are a victim of employment-related identity theft when they receive an IRS notice of a discrepancy in the income they reported on their tax return. The identification of the discrepancy is from the IRS’s Automated Underreporter (AUR) Program match of taxpayer income reported on third-party information returns (e.g., Forms W-2, Wage and Income Statement) to amounts reported by taxpayers on their individual income tax returns.” The thief may file a return with an ITIN but attach a W-2 with the SSN used to gain employment.

As further explained by TIGTA:


https://www.treasury.gov/tigta/auditreports/2016reports/201640065fr.pdf

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As the title of the report indicates, TIGTA found that taxpayers are not told when they have been a victim of employment-related identity theft. From February 2011 to December 2015, 1.1 million taxpayers were found by the IRS to be victims of this type of theft. TIGTA made recommendations to the IRS on how to create procedures to notify victims. Also see TIGTA press release of 8/30/16.

Employer Liability for Penalties Where Third Party Payroll Service Embezzled Funds – Kimdun

Kimdun, Inc., 2:16-cv-01500-CAS (CD CA, 8/15/16) (four consolidated cases involving McDonald’s franchises) – The business owner tried to get penalties waived when the payroll taxes were not paid due to embezzlement by the payroll processing company.

“As is relevant here, a corporation, like plaintiff Kimdun, “may establish reasonable cause and avoid late penalty fees under I.R.C. §§ 6651(a) and 6656(a) if it can show that it was disabled from complying timely.” Conklin, 986 F.2d at 318 (citing Boyle, 469 U.S. at 248 n.6) (emphasis in original). Accordingly, plaintiff here alleges that it was “disabled . . . from timely paying its FTDs for the Subject Periods” because it “reasonably relied upon [an] outside payroll service and [a] clearinghouse bank to discharge their duties to remit [p]laintiff’s withheld employment taxes to the IRS,” and these entities “felonious[ly]” embezzled the funds rather then remit them to the IRS. Complaint at ¶ 7 (emphasis added).” There was some dispute though over the relevant law among the circuits.

Ultimately, the court followed the Boyle case and its strict standard for finding reasonable cause if the tax obligation missed is not that is not delegable. Per the court:


https://www.treasury.gov/tigta/press/press_tigta-2016-21.htm

https://www.treasury.gov/tigta/press/press_tigta-2016-21.htm

http://rothcpa.com/wp/wp-content/uploads/2016/08/Kimdun.pdf

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“Plaintiff here appears to suggest that its supervision of Copac and Cachet [the payroll processors] was similarly “not possible.” In plaintiff’s view, it “strains credulity that a taxpayer who entrusts the payroll tax depositary function to a hitherto-reputable payroll service should be required to secondguess the company or anticipate that funds will be stolen from it.” Opp’n at 8. Plaintiff also contrasts the situation in Conklin, where the taxpayer’s employee was responsible for the culpable conduct giving rise to the delinquency, with the instant case, where “no employment relationship existed between plaintiff and Copac,” such that plaintiff had no control over the disposition of its funds after Copac made EFTs from plaintiff’s payroll bank account to pay plaintiff’s FTDs.”

“Thus, at the heart of this action is plaintiff’s contention that its good faith delegation––to a third-party agent––of the responsibility to pay taxes in a timely manner may constitute “reasonable cause” under IRC section 6651(a) 6656(a). The Court concludes, however––as the government argues––that the Supreme Court’s decision in Boyle and its progeny make clear that “a taxpayer may not avoid the adverse consequences of the failure of its agent to perform the taxpayer’s responsibility to timely file and pay federal taxes.”” …

“Simply put, because “[i]t requires no special training or effort to ascertain a deadline and make sure that it is met,” the “failure to make a timely filing of a tax return is not excused by the taxpayer’s reliance on an agent, and such reliance is not ‘reasonable cause’ for a late filing under § 6651(a)(1).” Boyle, 469 U.S. at 252 (emphasis added). Here, although plaintiff “submits that it has established reasonable cause for its failure to file timely file its returns and to pay its FTDs,” plaintiff cites no authority in support of the proposition that reliance upon a third-party agent––even a payroll service that engages in fraud, unbeknownst to the taxpayer––may constitute reasonable cause” for failure timely to meet the requirements of IRC sections 6651(a) and 6656(a). Indeed, as the government rightly notes, numerous district courts have relied upon Boyle in finding plaintiff’s argument regarding “reasonable cause” to be foreclosed as a matter of law.”

100% Penalty - IRC §6672 Trust Fund Tax Penalty Cases

IRC §6672 Trust Fund Tax Penalty Cases - Every year there are usually a few cases involving whether a “responsible person” has been found so that the 100% payroll tax penalty can be assessed where an employer failed to remit payroll taxes. Cases decided in 2016 include the following.

Schiffman, (1st Cir. 2016) – 100% Penalty Imposed Upon Fired CFO and CEO

Facts per the First Circuit:

The raw facts are largely undisputed. ICOA is a Rhode Island corporation, whose subsidiaries provide wireless internet services in public spaces (such as airports and marinas). 2 As far back as 2002, ICOA began struggling to stay current on federal trust fund tax obligations.


https://www.law.cornell.edu/uscode/text/26/6672



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Schiffmann became ICOA's president in October of 2004 and retained that title after becoming its chief executive officer (CEO) in April of 2005. Cummings (previously a consultant to the company) became ICOA's chief financial officer (CFO) in October of 2005. At the latest, the appellants discovered the full extent of ICOA's outstanding trust fund tax liabilities shortly after Cummings became CFO. They nonetheless signed checks to pay other creditors, but did not pay the government. The funds backing these checks came primarily from cash infusions raised by Schiffmann and ICOA's board chairman, George Strouthopoulos (Schiffmann's predecessor as CEO). On November 18, 2005, the ICOA board of directors (which then consisted of at least four members) met to discuss, among other things, the outstanding trust fund tax liabilities. By resolution, the board granted check-signing authority to ICOA's officers on a schedule depending on debt amount and officer rank. Schiffmann, as CEO, was given singular signing authority for checks up to $100,000; Cummings, as CFO, was given singular signing authority for checks up to $75,000. Matters went downhill from there: the trust fund tax arrearage was not paid, new trust fund taxes accumulated, the company's financial decline continued, and the board fired Schiffmann and Cummings in June of 2006.

The appellate court agreed with the IRS that both the CFO and CEO were responsible persons:

There is no question but that Schiffmann's status as CEO and the wide range of his functions afforded him the kind of significant suzerainty over ICOA's affairs to avoid defaulting on taxes. See Stuart, 337 F.3d at 36; Godfrey v. United States, 748 F.2d 1568, 1575 [55 AFTR 2d 85-409] (Fed. Cir. 1984). To cinch the matter, Schiffmann's deep-seated involvement in the financial affairs of the company, including his power over ICOA's bank accounts and payroll, and his check-signing authority, gave him ‘effective power’ to pay the taxes." Vinick II, 205 F.3d at 8 (quoting Barnett v. IRS, 988 F.2d 1449, 1454 [71 AFTR 2d 93-1614] (5th Cir. 1993)). After all, he had funds at his disposal and the power to allocate them. He was, therefore, a ‘responsible person’ within the purview of section 6672(a). [pg. 2016-575]

The undisputed facts likewise dictate a finding of wilfulness on Schiffmann's part. Schiffmann acted wilfully because - after becoming aware that the trust fund taxes were not being paid - he did not lift a finger to pay them. Instead, he allowed the company to use unencumbered funds to pay other creditors. Given Schiffmann's position and authority, no more was exigible to undergird a finding of wilfullness. (Citations omitted)

Willful? Gann, No. 10-359T (Fed Cls, 9/16/16) Gann, No. 10-359T (Fed Cls, 9/16/16) - The court confirmed its earlier ruling upholding the 6672 penalty against Gann. Per the court: Gann “was grossly negligent in disregarding an obvious and known risk of failure to pay over the withheld funds, the penalty was proper as to the fourth quarter of 2005 and forward.” The penalty was calculated on trust fund taxes of


https://scholar.google.com/scholar_case?case=16768196313431094431&q=gann+2016&hl=en&as_sdt=2003


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employees of Humanity Capital, Inc. for quarters ended 6/30/05 through 9/30/07. This totaled almost $700,000 plus interest. Per the court’s brief review of the penalty provision:

“In order to collect such a penalty, the penalized individual must have been (1) responsible for having collected and paid the tax, and (2) must have willfully failed to collect and pay it over to the IRS. Godfrey v. United States, 748 F.2d 1568, 1574 (Fed. Cir. 1984). IRC section 6671 defines a responsible person as referred to in 6672 as "an officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee, or member is under a duty to perform the act in respect of which the violation occurs." 26 U.S.C. § 6671(b). There can be more than one responsible person in a corporation or other business entity.”

In 2015, the court found that G met requirement #1 (responsible) but there was a factual dispute as to whether #2 (willfulness) was met. That was the issue before the court in this 2016 ruling.

G’s background was in investment banking. He was convinced by a golf buddy to start buying staffing firms and make a public offering of a combined entity. He incorporated Humanity Capital in 2005. Working with someone experienced in this industry and with leads (R), H soon had nine office staff and about 400 temporary employees to contract out for staffing. R became the CEO. Tabatha IV, Inc. was set up as a public company and H became its 100% owned subsidiary. G had all of T’s common stock. T was renamed Human Capital Holding Corporation and G was elected Chairman of the Board. R and D (a CPA with staffing industry experience) were also officers.

The companies (HCI) struggled and G loaned HCI $700,000 and was never repaid, other than $13,000. The companies never turned a profit.

HCI did not remit payroll taxes to the IRS although payroll returns were filed. R alerted G to this issue and G and D contacted the IRS to discuss the issue. The parties entered an installment agreement to pay the back taxes. D and G thought HCI was becoming current on its taxes, but it was not. In February 2007, the IRS notified G in person that the IRS would file a lien against HCI.

The IRS officer had G answer various question about the taxes and loans. In his answers he noted that R was also involved with payroll. At trial, G disputed his answers.

G continued efforts to take HCI public, but it didn’t happen. They also pursued sale of the company. HCI ceased operations in September 2007. When the IRS officer visited HCI offices in November 2007, they were abandoned.

Five people testified at trial: G, D, Huff (CPA hired by HCI for audit work although no financial statements were prepared), R and the IRS officer.

G’s testimony included his efforts to work with the IRS and HCI bookkeeper to get current on payroll taxes. He also sought funding for HCI that would cover the taxes.

D testified that he was unaware of the tax problem.

Huff noted that HCI statements noted unpaid payroll taxes. The audit report for FY2005 included a going concern statement.

“As to the audit for the fiscal year ended on June 30, 2006, Mr. Huff recalled that it was not completed by his firm. He could not recall precisely why, other than a general recall that the client either stopped providing requested information or



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decided that it no longer required an audit. The last point in time that he recalled performing work on the 2006 audit was November 2006.”

R said her title with HCI was “illusory” and G and D ran HCI. “she told the court, that Mr. Gann forced her to sign a statement to the effect that she was the CEO and had fiscal responsibility for HCI.”

IRS officer noted that he had conversations with G, D and R about the tax liabilities. He said he gave them time to sell HCI but denied he ever told CHI not to stay current with its payroll taxes.

What is “willfulness”? Per the court:

“Willfulness under the statute is "a deliberate choice voluntarily, consciously, and intentionally made to pay other creditors instead of paying the Government." … The Second Circuit summed up the willfulness test by stating that the person must have known "of the company's obligation to pay withholding taxes" and known "that the company funds were being used for other purposes instead." …In the context of an unpaid prior-incurred liability for trust fund taxes, this court has written that "a responsible person. . . who becomes aware that taxes went unpaid in past quarters . . . is under a duty to use all unencumbered funds available to the corporation to pay those back taxes," … Failure to do so is willful. The willfulness requirement, though not satisfied by mere negligence, can be met with a showing of "reckless disregard of an `obvious and known risk' that taxes might not be remitted."“

In addition, as to the taxpayer’s role:

“The burden is on plaintiff to show that he neither 1) made a deliberate choice to pay other of HCI's obligations instead of the owed taxes, nor 2) became aware of unpaid back taxes and then failed to use all available unencumbered funds to pay them, nor 3) recklessly disregarded an obvious and known risk of non-payment. … This is because IRS tax assessments, including trust fund tax penalties, are presumed to be correct. … It is also the taxpayer's burden to prove that the amount of the assessment is erroneous.”

As in any situation where the stakes are high to find the wrongdoer, there is finger pointing. Per the court, “We were reminded of the adage that success has many fathers; failure, none.” G argued that R ran the business while he was the “virtual absentee chairman”. The IRS argued that R was a salesperson with an “inflated title” with no control over HCI finances.

The court found G responsible even if not aware of the amounts owed as he should have inquired about the matter and prevented problems.

The court found:

G and R were involved in the regular, daily operations.

G signed many checks. G also signed documents including a workers comp insurance policy.

R’s role does not minimize G’s role.

D (CPA) was more involved in operations than he led on as he regularly prepared financial reports.


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G was “grossly negligent of a known risk.” He knew of the unpaid taxes and that it was a continuing problem. G had an office at HCI and was often there.

The court found G to be willful other than for the second and third quarters of 2005 because he did see that checks were delivered to the IRS and G thought the liability for them was met by early 2006.

Certified Professional Employer Organizations (PEO)

2014 Legislative Enactment In 2014, IRC §7705 was added by P.L. 113-295 (12/19/14).

JCT, General Explanation of Tax Legislation Enacted in the 113th Congress, March 2015, JCS-1-15, pages 227 – 237. Per this report:

“if certain requirements are met, for purposes of employment taxes and other obligations under the employment tax rules, a certified professional employer organization is treated as the employer of any work site employee performing services for any customer of the certified professional employer organization, but only with respect to remuneration remitted to the work site employee by the certified professional employer organization. In addition, no other person is treated as the employer for employment tax purposes with respect to remuneration remitted by the certified professional employer organization to a work site employee.”

Regulations In May 2016, final, temporary (TD 9768 (5/6/16)) and proposed regulations (REG-127561-15 (5/6/16)) were issued. Per the preamble to the final/temp regs: “These final and temporary regulations contain the requirements a person must satisfy in order to become and remain a CPEO. The final and temporary regulations will affect persons that apply to be CPEOs and are certified by the IRS as meeting the applicable requirements.”

AICPA comment letter of 8/16/16 regarding reference to CPA in the regulations. Applications:

Per the IRS website (11/18/15), it plans to start accepting applications for PEO certification starting 7/1/16. In November 2015, the IRS announced that it was seeking information on PEO practices to assist with its issuance of guidance. Comments were due 1/8/16.

Rev. Proc. 2016-33 (6/3/16) – provides the detailed guidance on how to submit an electronic application to be a certified PEO. Only online applications are accepted and start 7/1/16. The filing fee is $1,000. Also see IR-2016-83 (6/3/16).






http://www.aicpa.org/Advocacy/Tax/DownloadableDocuments/CPEOs%20Final.pdf

https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Voluntary-Certification-Program-for-Professional-Employer-Organizations

https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Request-for-Information-on-PEO-Industry-Practices


https://www.irs.gov/uac/irs-explains-application-process-for-new-certified-professional-employer-organization-program

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Notice 2016-49 (8/5/16) – “interim guidance on certain requirements for persons seeking certification as Certified Professional Employer Organizations (CPEOs), as defined in §301.7705-1T(b)(1).”

Self-Employment Tax

Self-Employment Tax Treatment of Partners in a Partnership That Owns a Disregarded Entity

In May 2016, the IRS issued final and temporary regulations (TD 9766 (5/4/16)) and proposed regulations (REG-114307-15 (5/4/16)) to address a situation where some partners were being treated as employees. Per the preamble to the final regulations, these regulations “clarify the employment tax treatment of partners in a partnership that owns a disregarded entity. These regulations affect partners in a partnership that owns a disregarded entity.”

The fact pattern that led the IRS to issue these regulations is a partnership that forms an LLC that is a disregarded entity. For employment tax purposes, the entity is treated as a corporation. Thus, these partnerships and LLCs believed they could enable “partners to participate in certain tax-favored employee benefit plans” by treating them as employees of the LLC. Such plans might include a qualified plan, any health plan, or a section 125 cafeteria plan. The IRS continues to follow Rev. Rul. 69-184 which states that partners are not employees.

Per the preamble to the final and temporary regulations under 301.7701-2T, “To address this issue, the Treasury Department and the IRS clarify in these temporary regulations that the rule that a disregarded entity is treated as a corporation for employment tax purposes does not apply to the self-employment tax treatment of any individuals who are partners in a partnership that owns a disregarded entity. The rule that the entity is disregarded for self-employment tax purposes applies to partners in the same way that it applies to a sole proprietor owner. Accordingly, the partners are subject to the same self-employment tax rules as partners in a partnership that does not own a disregarded entity.”

Effective date: The IRS is providing time for affected partnerships and LLCs to adjust their payroll tax and benefit plans. Thus, the regulations apply on the later of (1) 8/1/16, or (2) the first day of the latest-starting plan year after 5/4/16 of an affected plan sponsored by the disregarded entity.

LLC Member Fails in Making Brinks Argument to Limit SE Tax – CCA 201640014 (9/30/16)

CCA 201640014 (9/30/16) – LLC owned several franchised restaurants. F is the franchisee and the restaurants are operated through the LLC. The LLC is owned by F, wife and wife’s irrevocable trust. W and T are not involved in operations while F, majority owner of the LLC, is required per the franchise agreements “to personally devote full time and best efforts work on the operation of the restaurants.” F is the LLC’s operating manage, president and CEO and handles the day-to-day operations including decision making, contracts, loans, hiring and firing








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employees, creating pension plans, hiring advisers and holding meetings of the management team and staff. The LLC has an executive management team who are not owners.

LLC made guaranteed payments to F. LLC treated F as a limited partner for §1402(a)(13) purposes. Thus, only the guaranteed payments were subject to SE tax, not F’s distributive share. Per the CCA, the LLC’s position is that F’s income “should be bifurcated for self-employment tax purposes between Franchisee’s (1) income attributable to capital invested or the efforts of others, which is not subject to self-employment tax, and (2) compensation for services rendered, which is subject to self-employment tax. Partnership asserts that, as a retail operation, Partnership requires capital investment for buildings, equipment, working capital and employees, and states that, in the years at issue, it spent approximately $N in fixed asset additions. Partnership notes that Franchisee and Partnership have made significant capital outlays to acquire and maintain the restaurants, and argues that Partnership derives its income from the preparation and sale of food products by its J employees, not the personal services of Franchisee. Partnership asserts that the Franchisee has a reasonable expectation for a return on his investment beyond his compensation from Partnership. Partnership argues that Franchisee’s guaranteed payments represent “reasonable compensation” for his services, and that Franchisee’s earnings beyond his guaranteed payments were earnings which were basically of an investment nature. Partnership cites to Brinks Gilson & Lione a Professional Corporation v. Commissioner, T.C. Memo 2016-20, a case involving a corporation’s deduction for compensation paid to employees who were also shareholders, for the propositions that Partnership’s guaranteed payments to Franchisee are reasonable compensation for Franchisee’s services, and that Franchisee’s distributive share represents a reasonable return on the capital investments. Therefore, Partnership concludes that Franchisee is a limited partner for purposes of § 1402(a)(13) with respect to his distributive share.”

In examining possible exceptions to treating F’s distributive share of LLC income as subject to SE tax, it considered §1402(a)(3) for sale of capital assets and other property, but notes that sale of inventory doesn’t meet this exception.

The other possible exception is §1402(a)(13) regarding income of a limited partner, noting that it was enacted in 1977 before LLCs were widely used. The Code section does not define “limited partner.” The IRS cites to the 1977 House Report 95-702 (Part 1) which explains:

“Under present law each partner's share of partnership income is includable in his net earnings from self-employment for social security purposes, irrespective of the nature of his membership in the partnership. The bill would exclude from social security coverage, the distributive share of income or loss received by a limited partner from the trade or business of a limited partnership. This is to exclude for coverage purposes certain earnings which are basically of an investment nature. However, the exclusion from coverage would not extend to guaranteed payments (as described in 707(c) of the Internal Revenue Code), such as salary and professional fees, received for services actually performed by the limited partner for the partnership.”

A partner who is not a limited partner is subject to SE tax on any guaranteed payment for services and his distributive share of partnership income. The IRS cited Renkemeyer, Campbell, and Weaver LLP, 136 T.C. 137 (2011), in support of its position that F, with management power, is subject to SE tax as a general partner. The IRS also cited the district court’s argument in Riether, 919 F.Supp.2d 1140 (D. N.M. 2012) regarding LLC owners who paid themselves wages



https://www.ustaxcourt.gov/InOpHistoric/Renkemeyer.TC.WPD.pdf


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in an effort to distinguish earnings from labor versus capital, but to no avail. Per the court: “whether Plaintiffs were active or passive in the production of the LLC’s earnings, those earnings were self-employment income.”

The IRS further emphasized the Renkemeyer decision:

“the Renkemeyer Court reviewed the legislative history of §1402(a)(13) and concluded that §1402(a)(13) was intended to apply to those who “merely invested” rather than those who “actively participated” and “performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons).” Renkemeyer, 136 TC at 150.”

The IRS stressed that Renkemeyer “does not stand for the proposition that a capital-intensive partnership should be treated like a corporation for employment tax purposes. Instead, as the Tax Court has repeatedly held, partners who are not limited partners are subject to self-employment tax, even in cases involving capital-intensive oil and gas joint ventures where all of the work was performed by other parties.”

Here, F was the only owner involved in the LLC’s operations. Thus, the IRS found that F was “not a mere investor, but rather actively participates in the partnership’s operations and performs extensive executive and operational management services for Partnership in his capacity as a partner (i.e., acting in the manner of a self-employed person). Therefore, the income [F] earns through Partnership is not income of a mere passive investor that Congress sought to exclude from self-employment tax when it enacted the predecessor to § 1402(a)(13).”

With respect to F’s and the LLC’s argument tied to the Brinks case and that shareholders can have income tied to capital income that is not subject to SE or payroll tax, the IRS found this inappropriate. Per the IRS:

“Partnership’s arguments inappropriately conflate the separate statutory self-employment tax rules for partners and the statutory employment tax rules for corporate shareholder employees. Section 1402(a)(13) provides an exclusion for limited partners, not for a reasonable return on capital, and does not indicate that a partner’s status as a limited partner depends on the presence of a guaranteed payment or the capital-intensive nature of the partnership’s business.”

“Following the Court’s analysis in Riether, Partnership cannot change the character of [F’s] distributive shares by paying [F] guaranteed payments. Partnership is not a corporation and the “wage” and “reasonable compensation” rules which are applicable to corporations and were at issue in the Brinks case do not apply.”

History Lesson: In footnote 1 to the CCA, the IRS reminds us of at least one reason why we don’t have better guidance on how §1402(a)(13) applies to LLC members:

“In 1997, the Treasury Department and the IRS promulgated proposed regulations defining “limited partner” for § 1402(a)(13) purposes. They generally provide that an individual is treated as a limited partner unless the individual: (1) has personal liability for the debts of or claims against the partnership by reason of being a partner; (2) has authority to contract on behalf of the partnership; or (3) participates in the partnership's trade or business for more than 500 hours. The 1997 proposed regulations also provide exceptions for certain holders of classes of interest that are identical to those held by limited partners. Additionally, the 1997 proposed regulations provide that service





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providers in service partnerships (e.g., law firms, accounting firms, and medical practices) may not be limited partners. The 1997 proposed regulations applied to all partnerships (including LLCs). Congress imposed a temporary moratorium on finalizing the 1997 proposed regulations, which expired in 1998; however, the 1997 proposed regulations have not been finalized.”

Observations: When will regulations under §1402(a)(13) be finalized? The CCA highlights that tax differences between partnerships and corporations include the application of payroll and SE taxes. A partner is unable to have income not subject to SE tax other than by creating some type of investment income, such as by loaning money to the partnership. In contrast, shareholders in a C corporation must have reasonable compensation if they also work for the corporation and must properly classify any other payments from the corporation as dividends (if from E&P) or as interest or rents if other viable arrangements exist (loans and rental agreements). While the shareholder can avoid SE or payroll tax on all distributions, dividends are not deductible to the corporation and are taxed at a 15% or 20% rate to the shareholder (without any SE or payroll tax). If the individual’s income is high enough, the dividend income is subject to the 3.8% NIIT. These tax considerations should be considered along with income taxes in selecting an entity form for a business.

Query: What is the treatment for the wife’s distributive share? She appears to not be subject to SE tax as she is a passive owner. Her distributive share of the income is not passive activity income though because it is from a trade or business in which her husband materially participates and she may treat that participation as her own.

SE Tax and Trade or Business – Ryther, TC Memo 2016-56 (3/28/16) Ryther, TC Memo 2016-56 (3/28/16) involved the question of whether R’s occasional sale of scrap steel to pay his bills produced income subject to self-employment tax under §1401. R formed Knight Steel as a corporation in 1997 and was the sole owner and officer. KS fabricated steel frames for contractors. KS fell into financial difficulties in 2000 and in 2004 a bankruptcy trustee took over the company and engaged in a liquidation. The trustee did not do anything with a few assets viewed as worthless, including a “large pile of scrap steel.” Some of this scrap was up to 40 feet long weighing hundreds of pounds.

R formed a new business, Mission Steel to attempt to continue the operations of KS, but business was weak. To generate income to pay bills, R sold the scrap metal leftover from KS. From 2004 through 2010, the sales aggregated about $317,000. He filed returns for these years late and reported the scrap sales as miscellaneous income. In 2013, the IRS sent a notice seeking SE tax on the income.

To resolve the issue, the court looked at the limited guidance on “trade or business” as used at sections 1402 and 162. This includes the Groetzinger case (480 US 23 (1987)) which found a full-time gambler to be engaged in a trade or business. The cases note that the determination is one of fact. Also relevant here is that sales of property are exempt from SE tax unless they constitute inventory or “property held for sale in the ordinary course of a trade or business.” The court referred to Williford, TC Memo 1992-450 (1992) involving the sale of art by someone selling it part-time. The court used following factors to help determine if the property was



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inventory or property held for sale in the ordinary course of a trade or business. These factors and how the court applied them to Ryther follow.

1) Frequency and regularity of sales – sales average once or twice per month. NO SE

2) Substantiality of sales – sales over $300,000 were substantial to R and constituted 100% of his income. Yet, little effort was involved in the sales and R did not have to produce the scrap. NEUTRAL

3) Length of time the property was held – depends on the item because not all inventory or items held for sale take the same amount of time to sell. For example, classic cars likely take longer than new cars. Here, scrap steel has a published market price and should be easy to sell. The fact that R took seven years to sell it all indicates it was not held primarily for sale to customers. NO SE

4) Segregation of property from business property – Unlike an art dealer, R did not have scrap steel for personal purposes and other scrap steel for business purposes. NEUTRAL

5) Purpose of acquisition – the court said this factor was not clear per the facts. NEUTRAL

6) Sales and advertising effort – Little effort is needed to sell the scrap or determine the price. NEUTRAL

7) Time and effort spent on sales – While the court found that R was active in selling his scrap steel, buyers did not come to him as would customers at a store. NEUTRAL

8) How the proceeds of the sales were used – R did not use the proceeds to replenish his supply of scrap to sell. NO SE

Based on the analysis of these eight factors, the court held that R did not hold the scrap steel for sale in the ordinary course of a trade or business. Thus, no SE tax was owed.

Blogger’s Ad Revenue Subject to SE Tax In Clark, Jr., Docket No. 4131-15 (5/12/16), a bench opinion, Clark was a full-time video blogger in 2012. He had an agreement with Google to allow for ads to be placed on his blog website. For 2012, ad revenue was just over $20,000 and Google issued Clark a 1099-MISC for this amount. Clark reported this as other income on his Form 1040. After an examination, the IRS imposed self-employment tax on Clark.

The court found Clark to be engaged in a trade or business as his intent was to make a profit and worked 6 – 8 hours per day seven days a week, making this a regular and continuous activity.

Clark’s argument that the revenue constituted royalty payments not subject to self-employment tax failed. Per the court, per §1402, “royalty payments received from a trade or business are subject to self-employment tax.”

Real Estate Agent Owes Self-Employment Tax – Wang, TC Memo 2016-123 In Wang, TC Memo 2016-123 (6/21/16), a real estate agent working for Century 21, earned one commission in 2012 of about $20,000. The commission was reported as receipts on Schedule C


https://www.ustaxcourt.gov/InternetOrders/DocumentViewer.aspx?IndexSearchableOrdersID=199512



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along with expenses resulting in net income of over $13,000. No self-employment tax was paid and no Schedule SE was included with Mr. Wang’s return, prepared by a paid return preparer.

W objected that earlier notice sent by the IRS did not indicate that he owed self-employment tax and if they had, he would have paid it. The court noted that so far as the matter before it, Mr. Wang had the burden to prove he did not owe self-employment tax which he was unable to do. Per the court, his Schedule C earnings were subject to self-employment tax.

The court disagreed with the IRS assessment of a substantial understatement of tax penalty under §6662(b) because the amount owed did not rise to the level of a substantial understatement. The IRS also lost on its effort to impose the negligence penalty under §6662 because it had to burden to show that it applied, but did not offer any arguments to support imposition of this penalty.

Query: Did the IRS assess a §6694 preparer penalty on W’s return preparer? This is a private matter we can only speculate about.

Self-Employment Tax and Deferred Compensation – Peterson, Nos. 14-15773, 14-15774 (11th Cir., 5/24/16)

Peterson, Nos. 14-15773, 14-15774 (11th Cir., 5/24/16), is an 87-page opinion involving a retired Mary Kay salesperson and distributor. The SE tax issue centers upon the proper classification of payments received under a “post-retirement, deferred-compensation program.” The Mary Kay sales system allows sellers (independent contractors) to progress from Beauty Consultant (entry level seller) to National Sales Director (NSD). Advancement and new titles comes from recruiting more sellers. Sellers earn commissions from sales of the people they recruit, as well as from some of the sellers recruited by those recruits.

NSDs are appointed by Mary Kay and must sign an agreement regarding their relationship and compensation. This includes a noncompete agreement that lasts for two years after leaving Mary Kay. NSDs no longer recruit. Instead they train, direct, motivate and hold meetings and workshops. NSDs continue as independent contractors. Among a sales force of about 2.7 million individuals throughout the world, only 200 are NSDs and about 155 are retired NSDs.

NSDs are eligible for two “post retirement, deferred-compensation programs” (the Family Program and the Futures Program). Under these programs, an NSD who signs up must sever her NSD agreement with Mary Kay at age 65 at which time the programs become effective.

The plans allowed for continued payments of amounts tied to past commission levels. This incentivized the NSDs to train their sellers well. At trial, it was explained that these programs were non-qualified plans because they were for contractors rather than employees. Mary Kay’s tax director described the programs “as deferred compensation based on past services.”

Peterson started selling for Mary Kay in 1982. She became an NSD in 1991. She moved a few times in order to continue to build her network in large cities. Peterson entered the Family Program in 1992 and the Futures Program in 2005. She retired in 2009. “The year before her retirement in 2009, she had an international network of approximately 23,000 individuals and received commissions on wholesale purchases in excess of $15,000,000.” The documents Peterson received at the time included FAQs. One FAQ stated that the plans complied with §409A and noted that the payments under the plans were gross income to the recipient when received.


http://media.ca11.uscourts.gov/opinions/pub/files/201415773.pdf

http://media.ca11.uscourts.gov/opinions/pub/files/201415773.pdf

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In her first retirement year (2009), Peterson received about $408,000 under the Family Program and almost $13,000 from the Futures Program. These were reported on Form 1099. Following retirement, Peterson became involved with a company selling health products. Upon learning of some derogatory comments Peterson made about Mary Kay, she lost out on a cruise opportunity, but was not further penalized despite the non-compete agreement.

In 2000, Peterson created a defined benefit plan and in 2002 a limited partnership (NSD Interests). Peterson was unable to assign her commissions or NDS interests prior to retirement because Mary Kay would not consent. Commissions were reported on Schedule C but also expensed and reported on the NSD Interests tax return with deductions for retirement contributions. This reporting continued with the post-retirement payments in 2009.

The IRS assessed self-employment tax for these years. Two issues were taken to Tax Court: “(1) whether retirement-plan contributions made by NSD Interests for 2006, 2007 and 2008 were deductible under IRS Code section 404(a), and (2) whether distributions received by the Petersons during 2009 under the Family Program and the Futures Program were subject to self-employment tax.” The court held that the retirement plan contributions were not deductible because NSD Interests was not engaged in a trade or business, although Peterson was entitled to deductions. The court also hold that the 2009 distributions were subject to self-employment tax because they were deferred compensation. Peterson appealed the ruling on the 2009 distributions.

The 11th Circuit Court agreed with the Tax Court that the income from the programs was subject to self-employment tax. Statements supporting this conclusion include:

“income “must arise from some actual (whether present, past, or future) income-producing activity of the taxpayer before such income becomes subject to . . . self-employment taxes.” Id. (emphasis added). “The self-employment tax provisions are broadly construed to favor treatment of income as earnings from self-employment.” Bot v. Comm’r, 353 F.3d 595, 599 (8th Cir. 2003).”

Peterson agreed to the 2008 program amendments under Section 409A which “expressly characterized[d] them as ‘deferred compensation.” She may not later unilateraly change her position. “Under the “Danielson rule,” that characterization is controlling for tax purposes. Comm’r v. Danielson, 378 F.2d 771, 775 (3d Cir. 1967) (en banc); Spector v. Comm’r, 641 F.2d 376, 384-86 (5th Cir. Unit A Apr. 1981) (adopting the Danielson rule).”

The court also rejected Peterson’s argument that the payments were consideration for sale of her Mary Kay businesses and consent not to compete with Mary Kay. The court held that there were no records indicating a sale by Peterson. The court also noted that Peterson broke the non-compete agreement, but continued to receive payments from Mary Kay. The court distinguished cases raised by Peterson that involved “insurance salesman’s after-termination-of-employment payments.” For example, the insurance salespersons earn commissions for single sales while the Mary Kay NSDs earn commissions for sales by others based on their training and leadership efforts. Such arrangements “meet the requirement under a nonqualified plan for deferred compensation, derived from previous work as an independent contractor.”

A dissenting judge argued that the Danielson rule did not apply. Per this judge, Mary Kay unilaterally characterized the payments as deferred compensation after they were originally


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drafted. “The Danielson rule has never been applied on facts like these. Nor should it be.” … “Peterson, the taxpayer, made no attempt to alter the express terms of the transaction that she and Mary Kay agreed to at formation; she merely seeks review and enforcement of the terms of the Programs themselves. Only Mary Kay has arguably attempted to alter the tax consequences flowing from the substantive terms of the Programs to which the parties agreed.”

The dissenting judge then looked for any “nexus” between the payments received by Peterson and her business activities. The judge found a connection between the payments and the Family Program, but not the Futures Program. The judge noted that NSDs receive compensation for commissions, not directly for their leadership and training activities. Thus, she found that the payments were not “deferred compensation,” but noted that such conclusion does not end the question of whether self-employment tax is owed, because they were derived from a trade or business.

The judge found that the Family Program payments were “directly tied to the quality of her Mary Kay labor.” In contrast, the payments under the Futures Program were not tied to her work quality. The judge believed these payments were more closely tied to the non-compete element and income from a non-compete agreement is not subject to self-employment tax. She did not believe the nature of these payments changed based on the fact that Mary Kay did not pursue action when the agreement was broken by Peterson, or perhaps Mary Kay did not believe a breach occurred.

Self-Employment Tax Owed on Working Interests - Methvin, No. 15-9005 (10th Cir., 6/24/16)

In Methvin, No. 15-9005 (10th Cir., 6/24/16), aff’g TC Memo 2015-81 (4/27/15), that M was involved in a partnership and owed $690 of self-employment tax. M owned 2% to 3% interests in various working interests in oil and gas ventures. Per agreement, another party managed the interests. An election to be excluded from Subchapter K was filed, and M received Form 1099-MISC reporting his share of revenues. M reported the revenue less his share of expenses as “other income” on his form 1040. No self-employment tax was paid, but the IRS assessed this tax ($690).

M argued that the working interests were investments rather than business operations. He also noted that he was not actively involved in the wells and lacked knowledge as to their operation. However, as noted by the court:

“a taxpayer who is not personally active in the management or operation of a trade or business may be liable for self-employment tax if the trade or business is carried out on his behalf through his agents or employees or constitutes his distributive share of income from a partnership in which he was a member. Sec. 1402(a); Cokes v. Commissioner, 91 T.C. 222 (1988).”

M argued that his situation varied from Cokes because he owned a much smaller share in the working interests (Cokes owned 42%) and that Cokes had greater rights and involvement in the operation of the wells.

The Tax Court argued though that despite electing out of Subchapter K, the venture was still a partnership regardless of the low level of ownership. Also, per the court: “We have held that




http://ustaxcourt.gov/InOpHistoric/MethvinMemo.Kerrigan.TCM.WPD.pdf

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making this election “‘does not operate to change the nature of the entity. A partnership remains a partnership; the exclusion simply prevents the application of subchapter K.” M’s interest created a pool or joint venture constituting a partnership under §7701(a)(2) with the owner subject to self-employment tax on the net income from the working interests.

In June 2016, the 10th Circuit Court upheld the Tax Court decision, finding that M was involved in a partnership and did indeed owe $690 of self-employment tax for 2011 as assessed by the IRS. Per the circuit court, whether a partnership exists is a factual matter and not finding any error by the Tax Court, its decision holds.

Puerto Rico Income Subject to SE Tax – Curet, TC Memo 2016-138 (7/25/16) Curet, TC Memo 2016-138 (7/25/16) – C lived in Puerto Rico where he worked as a consulting engineer. He filed an income tax form with the Commonwealth of Puerto Rico (PR) for 2010. That return included self-employment income. C did not file Form 1040-SS, U.S. Self-Employment Tax Return with the U.S. in 2010. The IRS assessed SE tax and the court upheld that determination.

A bona fide resident of PR for an entire tax year is not subject to US tax on income sourced within PR (unless received for services as an employee of the US government). However, this §933(1) exemption does not apply to SE tax (per §1402(a)(6) and §1.1402(a)-9). C was also held liable for the failure to file and pay timely penalty of §6651(a). The court found no reasonable cause for waiving the penalties. While C stated he consulted with a tax adviser in PR, that adviser did not testify before the court and C was unable to show “that (1) the adviser was a competent professional who had sufficient expertise to justify reliance; (2) he provided necessary and accurate information to the adviser; and (3) he actually relied in good faith on the adviser’s judgment.” Finding that C’s “explanations do not suffice to demonstrate the ordinary business care and prudence the regulations require” the court upheld the penalty assessments.

Note: §1402(a)(6) provides “a resident of Puerto Rico shall compute his net earnings from self-employment in the same manner as a citizen of the United States but without regard to section 933.”

SE Tax Owed by Individual, Not Bankruptcy Estate – Sisson, TC Memo 2016-143 (8/1/16)

Sisson, TC Memo 2016-143 (8/1/16) – Mr. S (S), a U.S. citizen, worked for the International Monetary Fund (IMF) in 2006 earning over $200,000. The IMF grossed up his pay by about $8,000 to cover S’s SE tax. Under the tax law, earnings from the IMF are not considered wages (per the court, this is per §3121(b), §7701(a)(18), and Exec. Order No. 9751, 11 Fed. Reg. 7713 (July 13, 1946)). S filed for Chapter 11 bankruptcy in June 2006 and the process continued into 2007. S paid his earnings to the bankruptcy estate which covered S’s living expenses through 2008 when S retired from the IMF.

On his 2007 return, S reported Schedule C losses from consulting and farming activities. He did not include SE tax on the IMF earnings. These earnings were reported on his bankruptcy estate return per §1398. The issue before the court was whether S or the estate was liable for the SE tax on the IMF earnings.




http://www.ustaxcourt.gov/ustcinop/opinionviewer.aspx?ID=10858

http://www.ustaxcourt.gov/ustcinop/opinionviewer.aspx?ID=10858

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The court analyzed the history of §1398 and §1399 and concluded that the bankruptcy estate is only liable for section 1 taxes (regular tax) and not SE taxes under §1402. Section 1398(c)(2) makes specific reference to section 1 only. Thus, although the IMF income was reportable by the estate, the SE tax was still a liability of S individually (on his Form 1040).

Worker Classification

IRS Pub 15-A – Summary Worker Classification Rules IRS Pub 15-A, Employer’s Supplemental Tax Guide, includes a summary of the rules used by the IRS to distinguish employees and independent contractors (pages 7 – 10).

Litigation and IRC §7436 – CC-2016-002 (12/17/15) In CC-2016-002 (12/17/15), the IRS explains its change in litigation position regarding IRC §7436, Proceedings for determination of employment status. This notice supersedes Notice 2002-5. “Until further guidance is published, Counsel attorneys are instructed to:

(1) no longer argue that a NDWC [Letter 3523, Notice of Determination of Worker Classification] is a prerequisite to Tax Court jurisdiction when the four requirements discussed below are met;

(2) continue to defend on the merits that Section 530 of the Revenue Act of 1978 (Section 530) and I.R.C. section 3509 do not apply if the Service has not reclassified the workers at issue from nonemployee to employee status with regard to services rendered;

(3) coordinate with the Office of the Associate Chief Counsel (Tax Exempt and Government Entities) (TEGE) regarding Section 530 or section 3509 on issues not covered by paragraphs 4 and 5, below;

(4) coordinate with the Office of the Tax Exempt and Government Entities Division Counsel (TEGEDC) any case-specific matter in litigation that references SECC, American Airlines, or other language implicating section 7436 (TEGEDC will further coordinate such issues with TEGE); and

(5) coordinate with TEGEDC any case-specific Examination or Collection issue relating to the application of section 7436 or the possible issuance of a NDWC (TEGEDC will further coordinate such issues with TEGE).”

The four requirements to be met:

“(1) an examination in connection with the audit of any person;

(2) a determination by the Secretary that –

one or more individuals performing services for such person are employees of such person for purposes of subtitle C, OR

such person is not entitled to the treatment under Section 530(a) with respect to such an individual;


https://www.irs.gov/pub/irs-pdf/p15a.pdf

https://www.irs.gov/pub/irs-pdf/p15a.pdf

https://www.irs.gov/pub/irs-ccdm/cc%202016%20002.pdf



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(3) an “actual controversy” involving the determination as part of an examination; and

(4) the filing of an appropriate pleading in the Tax Court.”

IRC §7436 and IRS Procedure When Taxpayer Raises Classification or Section 530

In a 9/8/16 memo from the SB/SE Division, the acting director lays out procedures for when a taxpayer raises a worker classification or Section 530 arguments regarding “an employment tax issue that would ordinarily be treated as a wage issue.” The memo also explains the existing procedures in light of IRC §7436. The interim process:

“If during consideration of a wage issue, a taxpayer makes an argument regarding worker classification or relief under section 530, the examiner must, as soon as possible, contact TEGEDC (in the special manner described below) for guidance regarding how to proceed in the case. For traditional worker classification issues, examiners should continue to follow normal examination procedures in IRM 4.23.10, Report Writing Guide for Employment Tax Examinations, and do not need to contact TEGEDC [TEGE Division Counsel] for guidance.

This interim guidance is effective immediately and was issued under emergency procedures. More complete guidance is being developed and will be issued in the future.”

SBSE-04-0916-0050 (9/8/16), relates to RIM 4.23.10.

SS-8 and Examination Status – BG Painting, Inc., TC Memo 2016-62 (4/5/16 In BG Painting, Inc., TC Memo 2016-62 (4/5/16), the Tax Court held that issuance of Letter 4991-A to an employer following an IRS review of Form SS-8 filed by a worker is not considered a “determination” such as to give jurisdiction to the Tax Court under §7436, Proceedings for Determination of Employment Status.

BG treated its workers as contractors and issued them Form 1099-MISC. In 2013, one of the workers Guillermo Gaytan, filed a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS for a determination of his employment status. The IRS requested more information from Gaytan and notified BG and requested an SS-8 from BG. The IRS received this information. The information from Blas Gaytan, an officer of BG, also noted that Guillermo is his father.

In May 2015, the IRS sent Letter 4991 to GG indicating the IRS found him to be an employee and explaining his tax obligations. The IRS also sent Letter 4991-A to BG stating they found that GG was an employee and instructing BG to file or amend employment tax returns. Per the court, attached to these letters was Form 14430, SS-8 Determination Analysis. Letter 4991-A includes the term “determination.”

BG filed a petition in Tax Court and the IRS argued it was not appropriate as no determination of employment tax liability had been made. So, in September 2015, the IRS filed a motion to dismiss for lack of jurisdiction.








https://www.irs.gov/uac/about-form-ss8

https://www.irs.gov/uac/about-form-ss8

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Per the Tax Court: “the Form SS-8 process does not constitute an “audit” or “examination”, but rather arises when a firm or worker voluntarily provides information to obtain a determination regarding the employment status of a worker. After considering the information voluntarily provided by the parties, the IRS provides a ruling to the taxpayer and related parties. The process exists so that taxpayers can come into compliance with their employment tax obligation, but specific tax liabilities are not determined and tax assessments are not made. The Form SS-8 process is an entirely voluntary compliance initiative, and a Form SS-8 determination does not involve an “examination” in connection with an “audit” relating to any person, as clearly required in the Court’s Am. Airlines Opinion.”

The court also stated that it “has uniformly found that voluntary participation in connection with tax administration by a taxpayer, even if the taxpayer produces books and records for review by the IRS, does not constitute an “examination” or an “audit”.”

Thus, the court finding that the SS-8 resolution was not an examination, dismissed the case.

Observations: Why does the IRS use the word “determination” in the SS-8 response letter? Why not tell the employer what it should do if it disagrees with the IRS finding regarding the review of SS-8?

In footnote 2 of the case, the court observes that IRS Chief Counsel issued CC-2016-002 (12/17/15) regarding a changed litigation approach for worker classification cases. Per the court, the “IRS is no longer arguing that a notice of determination of worker classification is a necessary prerequisite to Tax Court jurisdiction when the jurisdictional requirements set forth in two recent Tax Court cases, Am. Airlines, Inc. v. Commissioner, 144 T.C. 24 (2015), and SECC v. Commissioner, 142 T.C. 225 (2014), are met.” The court also noted that the IRS “filed a memorandum on January 26, 2016, articulating that Chief Counsel Notice CC- 2016-002 does not affect [IRS’s] position in this case.”

The SS-8 filer was the father of an officer of the employer. Don’t think a family member won’t report a real or perceived tax violation!

Set Builder Found to Be Independent Contractor – Quintanilla, TC Memo 2016-5 (1/7/16)

Quintanilla, TC Memo 2016-5 (1/7/16) – Q had sought-after skills as a set designer for various productions including commercials. He also had a corporation that was a C in 2009 and an S in 2010. Studies hired Q at times and sometimes his company. Typically, he was just told what the director wanted or might be given a sketch. He had a great deal of latitude in constructing the set. Q reported his income and expenses on Schedule C and the IRS argued he was an employee and they should be reported on Schedule A. Q was sometimes paid by W-2 and he was a member of the union, but often was able to set his own pay rates. Q stated that being in the union was for health insurance and to appear on call boards. Most of Q’s jobs were short-term.

The court found that Q was an independent contractor.

Companion Sitter – CCA 201633034 (8/12/16)


https://www.irs.gov/pub/irs-ccdm/cc%202016%20002.pdf

http://www.ustaxcourt.gov/InOpHistoric/americanairlinesdivision.paris.TC.WPD.pdf

https://www.ustaxcourt.gov/InOpHistoric/SECCCorp.Div.Colvin.TC.WPD.pdf

https://www.ustaxcourt.gov/InOpHistoric/SECCCorp.Div.Colvin.TC.WPD.pdf

http://www.ustaxcourt.gov/USTCInOP/OpinionViewer.aspx?ID=10659



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CCA 201633034 (8/12/16) appears to be guidance for the drafter of IRS training materials. The issue addressed is whether a companion sitter for elderly or disabled individuals who is not affiliated with a placement service is a contractor or employee. Basically, the conclusion is it depends. A few interesting points:

a) If there is a service that connects sitters to customers and that service does not receive funds from the customer or pay the sitter is not the employer of the sitters. The CCA refers to Example 3 of Reg. 31.3506-1(e) where a neighborhood association maintains a list of people available to be a babysitter with the list available to members of the neighborhood. Details of hours and pay are addressed between the parent and sitter only. If the sitter “follows specific instructions given by” the parent, the sitter is the employee of the parent and not of the neighborhood association.

b) A sitter may be self-employed if not an employee of a placement service and if the service-recipient does not have the right to direct and control the sitter.

Observations: This situation is a good example of the challenge of applying worker classification rules. A parent or other responsible person hiring someone to watch and care for their child or elderly or disabled relative is arguably in control of what the sitter can and can’t do. For example, the responsible person may tell the sitter not to take the person for a walk or drive them a certain distance or feed them certain foods. The sitter though is responsible for taking care of all immediate needs and likely has the experience and ability to care for the person. Is the direction from the parent to the sitter considered having the right to control the manner and means of how the sitter does their work or is more like a property owner telling a plumber what work they want done and when?

This CCA is also a reminder that in the network platform setting (such as Uber and TaskRabbit), rather than considering if the platform company is the employer, the service-recipient may be the employer. While the platform company handles the payment processing and charges the worker a fee, would that be enough to make them the employer – the placement agency? Perhaps, particularly if the platform company directs and controls the workers, such as via training, how to interact with the customers, hours, etc.

Joint Employer Status Another reminder of the various legal issues of having workers is the issue of who is the employer or employers. In May 2016, the New York Attorney General brought an action for wage theft against a few Domino’s Pizza franchisees and Domino’s Pizza franchisor. Per the compliant, “Domino’s exercised significant authority and control over employee relations in its franchise stores, and at the Three Franchisees in particular.” Also, per the complaint:

“Along with the Franchisee Respondents, Domino’s is liable as a joint employer because it exercised a high level of control over employee conditions at its franchise stores and because of its role in causing the wage violations at issue. Among other things, Domino’s played a significant role in key aspects of hiring, employee terminations and discipline, wage payments, and oversight and supervision of work operations. In addition, Domino’s itself caused many of the wage violations because Domino’s encouraged franchisees to use a “Payroll Report” function in the software system Domino’s required franchisees to install and use in their stores (known as “PULSE”), even though Domino’s knew since at least 2007 — yet failed to disclose to




https://www.ag.ny.gov/sites/default/files/domino_petition.pdf

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franchisees — that PULSE’s “Payroll Report” systematically under-calculated the gross wages owed to workers. As a direct result of Domino’s conduct, the Franchisee Respondents underpaid hundreds of workers by many thousands of dollars.”

The AG describes the joint employer test as follows:

“The four-factor joint-employer test to establish formal control considers whether an employer: (1) had the power to hire and fire the employees, (2) supervised and controlled employee work schedules or conditions of employment, (3) determined the rate and method of payment, and (4) maintained employment records.”

In an unrelated matter, in January 2016, the Dept. of Labor issued Administrator’s Interpretation No. 2016-1, Joint employment under the Fair Labor Standards Act and Migrant and Seasonal Agricultural Worker Protection Act (1/20/16). Among various topics, it explains both vertical and horizontal arrangements that can result in joint employment arrangements where both employers can be responsible for compliance with various laws. Also see U.S. DOL blog post of 1/20/16 – Are You a Joint Employer. It notes that findings of joint employment are increasing. Per the DOL:

“Economic forces and technological advancements have been changing the nature of work for a long time. As a result, more and more businesses are changing their organizational and staffing models by, for instance, sharing employees or using third-party management companies, independent contractors, staffing agencies or other labor providers. We often see these kinds of arrangements in the construction, agricultural, janitorial, distribution and logistics, staffing, and hospitality industries. The growing variety and number of business models and labor arrangements have made joint employment more common and our need to address it more pressing.

“Last summer, for example, a federal court in Seattle sided with the department in ruling that DirecTV was a joint employer of the installers hired by its contractor, resulting in DirecTV paying $395,000 in back wages and damages for minimum wage and overtime violations. And in October, we announced that J&J Snack Foods Corp. would pay $2.1 million in back wages and damages to temporary production line workers hired by two staffing firms that J&J contracted with to provide labor.”

Observation: The above is a reminder that advising clients on worker classification or tax rules related to hiring and paying workers goes beyond tax consequences and the clients should be advised to see a labor law attorney. There are numerous laws involved in these processes including overtime pay, sick pay, timing of pay, expense reimbursement requirements, information required to be included on a pay stub, and more.

Gig Economy Labor law litigation will likely continue on whether various types of “gig” or network platform workers, such as Uber drivers, are employees or contractors (self-employed). Perhaps we’ll see federal and/or state legislation.

1. CRS report - What Does the Gig Economy Mean for Workers?, February 5, 2016.


https://www.dol.gov/whd/flsa/Joint_Employment_AI.htm

https://www.dol.gov/whd/flsa/Joint_Employment_AI.htm

https://blog.dol.gov/2016/01/20/are-you-a-joint-employer/

http://www.dol.gov/opa/media/press/whd/WHD20152036.htm

http://www.dol.gov/opa/media/press/whd/WHD20151976.htm


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2. Organizing Proposal for Web Platform Freelancers – California AB 1727 would require hosting platforms (such as Uber, Taskrabbit) to negotiate with eligible groups of contractors using the platform.


http://www.leginfo.ca.gov/pub/15-16/bill/asm/ab_1701-1750/ab_1727_bill_20160413_amended_asm_v97.pdf

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Chapter 11: ACA Update Page 11-1

Chapter 11 : ACA Update

Table of Contents Chapter 11 : ACA Update ...................................................................................................... 11-1

Employer Payment Plans and Penalties Related to Market Reforms – Form 8928 ........................................................................................................................ 11-2

Notice 2015-87 and 2% S Shareholders – Info Letter 2016-0021 .................................... 11-2

Notice 2015-87 Overview – Info Letter 2016-0019 ............................................................ 11-2

IRS Penalty Waiver ............................................................................................................. 11-3

Small Business Health Care Tax Credit ........................................................... 11-3

IRS Small Business Health Premium Credit Estimator – ................................................ 11-3

“Applicable Large Employers” - Employer Shared Responsibility Payment (§4980H) ....................................................................................................... 11-3

Indexed Amounts ................................................................................................................. 11-3

Indexed Dollar Amount of the ALE Penalty ..................................................................... 11-4

Reminder of 2015 Law Change Regarding Employees with Veterans Coverage .......... 11-4

Part-Time vs. Full-Time Employee – Info Letter 2016-0030 ........................................... 11-4

Assessment of the §4980H Penalty ..................................................................................... 11-5

IRS ESRP Estimator Tool ................................................................................................. 11-10

IRS Website on the ESRP ................................................................................................. 11-10

13/26 Rehiring Rule – Infor Letter 2016-52 .................................................................... 11-10

Forms 1095-B and 1095-C ...................................................................................... 11-11

Automatic Extension of Time to File 2015 Forms 1095 and 1094 with Employees and IRS – Notice 2016-4 ................................................................................................................... 11-11

Updated Forms for 2016 .................................................................................................... 11-12

Data on Number of Forms Expected to be Filed ............................................................. 11-13

Proposed Regulations Under §6055 and §6724 ............................................................... 11-13

Late Filing Penalty Falls Upon Issuer – Info Letter 2016-53 ......................................... 11-14

Other Health Care Items ........................................................................................ 11-14

Health Insurance Providers Fee and Expatriate Health Plans – Notice 2016-14 ........ 11-14

Medical Device Excise Tax and Lease – PMTA 2016-14 (8/17/16) ................................ 11-14


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Employer Payment Plans and Penalties Related to Market Reforms – Form 8928

Notice 2015-87 and 2% S Shareholders – Info Letter 2016-0021 In Information Letter 2016-0021 (3/25/16), the IRS states that until guidance is provided, 2% shareholder-employees of S corporations can continue to rely on the transition relief in Notice 2015-17. This relief pertains to the $100/day/employee penalty of 4980D that can potentially apply if an employer’s health reimbursement arrangement violates the market reforms.

Per the Information Letter:

“For 2-percent S corporation shareholder-employees, the notice says that no excise tax under section 4980D will be asserted for any failure to satisfy the market reforms by a 2-percent shareholder health care arrangement until other guidance is issued. The notice defines a 2-percent shareholder health care arrangement as the payment by the S corporation of premiums for individual health insurance coverage covering the 2-percent shareholder that is included in the income of the shareholder and deducted under section 162(l) if all other eligibility criteria for deductibility are satisfied. To date, the IRS has not issued any other guidance, so, as stated in Question and Answer 5, taxpayers may continue to rely on Notice 2008-1, 2008-2 IRB 1, for the tax treatment of the health coverage provided to a 2-percent shareholder-employee.”

Notice 2015-87 Overview – Info Letter 2016-0019 Information Letter 2016-0019 (3/25/16) provides an overview to some of the reasons why health reimbursement arrangements (HRAs) can cause market reform violations and possible imposition of the $100/day/employee penalty of 4980D. For example, per the Info Letter:

“One of the Departments’ requirements for group health plans is they cannot impose an annual or lifetime dollar limit on essential health benefits under section 2711 of the Public Health Service Act. An agreement by the employer to reimburse medical expenses up to a fixed amount is a group health plan under which there is an annual CONEX-105560-16 2 limit on essential health benefits. Therefore, it fails to comply with the prohibition on annual limits under section 2711.”

“one option for an employer who does not want to offer coverage under a group health plan to its employees is to provide additional compensation to the employee that the employee may use for any purpose, including the purchase of an individual health policy. That amount would be taxable and the employer would not have a group health plan that fails to satisfy the market reforms.”

Per Notice 2015-17, other than for 2% shareholder-employees of S corporations, the IRS deferral of the penalty expired 6/30/15.

For further information on this penalty, see:

Notice 2013-54

Notice 2015-17









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IRS website

IRS Penalty Waiver At least two waivers to Form 8928 penalties have been granted by the IRS. See CCA 201637014 (9/9/16) and CCA 201637015 (9/9/16). The language in the CCA is scant so we don’t know the amount of the penalty or why the IRS agreed to grant a waiver. Per the CCAs:

“As we discussed during our phone call on June 3, 2016 concerning --------------, we agree with granting the waiver of the excise tax under Part II of the Form 8928.

The Form 8928 instructions (page 4) provide that the Secretary may waive part or all of the excise tax under Part II, to the extent that payment of the tax would be excessive relative to the failure involved. This only applies to failures due to reasonable cause and not due to willful neglect. We believe the waiver is appropriate under the circumstances involved in this matter.” [full text]

Part II of the form deals with the ACA group health plan problem such as offering one that does not meet the market reforms (see §4980D, Failure to meet certain group health plan requirements).

Form 8928, Return of Certain Excise Taxes Under Chapter 43 of the Internal Revenue Code, has a few purposes including to be filed by:

“Any employer or group health plan liable for the tax under section 4980D for failure to meet portability, access, renewability, and market reform requirements for group health plans under sections 9801, 9802, 9803, 9811, 9812, 9813, and 9815.”

Query: A $100/day/employee penalty is excessive relative to the failure for all employers. So, why doesn’t Congress change the law or the IRS provide a blanket waiver (perhaps unless due to willful neglect). There are two bills that would provide relief and within specified guidelines allow employers with less than 50 employees to offer a health reimbursement arrangement. See H.R. 2911, Small Business Healthcare Relief Act and S. 1697 (both summarized in the Looking Forward section of the outline).

Small Business Health Care Tax Credit

IRS Small Business Health Premium Credit Estimator – An estimating tool is provided by the National Taxpayer Advocate – here.

“Applicable Large Employers” - Employer Shared Responsibility Payment (§4980H)

Indexed Amounts


https://www.irs.gov/Affordable-Care-Act/Employer-Health-Care-Arrangements



https://www.irs.gov/uac/form-8928-return-of-certain-excise-taxes-under-chapter-43-of-the-internal-revenue-code

https://www.irs.gov/affordable-care-act/employer-health-care-arrangements

https://www.law.cornell.edu/uscode/text/26/4980D

https://www.irs.gov/uac/form-8928-return-of-certain-excise-taxes-under-chapter-43-of-the-internal-revenue-code



https://taxpayeradvocate.irs.gov/get-help/health-care-premium-tax-credit

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While §4980H is not mentioned in Rev Proc 2016-24 which provides indexed ACA figures for 2017, per Q&A 12 of Notice 2015-87, the affordability factor of §36B which is required to be indexed annually, is the same affordability factor an applicable large employer uses if using the affordability safe harbors of the §4980H regulations (§54.4980H-5(e)).

The affordabiltiy factors for 2017 and prior years:

2014 – 9.5% (statute – §36B(c)(2)(C)(i))

2015 – 9.56% (Rev. Proc. 2014-37)

2016 - 9.66% (Rev. Proc. 2014-62)

2017– 9.69% (Rev Proc 2016-24)

Indexed Dollar Amount of the ALE Penalty The penalty amounts are adjusted annually based on an insurance factor published by HHS. See the chart below for the 2015 and 2016 amounts (per Q&A13 of Notice 2015-87). The amounts shown are the annual amounts. These amounts are prorated for the months where the employer had a violation that triggers the §4980H penalty.

2015 2016

§4980H(a) penalty – did not offer coverage and at least one FT employee claimed PTC

$2,080 per FT employee

$2,160 per FT employee

§4980H(b) penalty – did offer coverage, but either was not minimum value or affordable

$3,120 per FT employee who claimed PTC

$3,240 per FT employee who claimed PTC

Reminder of 2015 Law Change Regarding Employees with Veterans Coverage P.L. 114-41 (7/31/15) added §4980H(c)(2)(F) to provide that employees who are veterans enrolled in health coverage from the Veteran’s Administration or TRICARE are not counted in determining if the employer is an “applicable large employer.” Apparently this provision is to help encourage small to medium size employers to hire veterans (if the employer already is an ALE, the provision has not effect regarding that status). This change applies retroactively to months beginning after 12/31/13

Part-Time vs. Full-Time Employee – Info Letter 2016-0030 In Information Letter 2016-0030 (6/24/16), the IRS addressed a question from an employee regarding his employer’s work policy of not allowing part-time and seasonal employees to work more than 29 hours per week. The IRS noted the key rule defining full-time employee for §4980H purposes: “An employee is a “full-time employee” for this purpose if the employee averages at least 30 hours of service per week during a given month.”








https://www.congress.gov/bill/114th-congress/house-bill/3236/text/pl


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The worker asked what could happen to the employer if employees worked more than 29 hours per week. This worker indicated that he is on Medicare. Per the IRS, assuming the employer is an “applicable large employer” (ALE), “an employee who works an average of 30 or more hours of service per week during any given month could potentially trigger (or increase the amount of) employer liability for an assessable payment under section 4980H(a) for that month. Note that all full-time employees are counted for purposes of determining the amount of the assessable payment under section 4980H(a), whether or not the employee is covered by Medicare or another source of coverage.”

The IRS also noted that the employee working an average of 30 or more hours per month might not trigger a penalty for the employer because that employee might not have purchased coverage on the Exchange or otherwise be eligible for a PTC. However, if it turns out that the ALE is liable for the §4980H(a) penalty, having one more full-time employee in a month will increase the §4980H(a) (for not offering coverage to at least 95% of full-time employees and their dependents up to age 26). The §4980H(a) penalty is based on the number of full-time employees per month.

Note: The worker who is actually a full-time worker and is not eligible for the PTC would not increase an ALE’s §4980H(b) penalty because that one is based on how many full-time employees claimed a PTC. In contrast, if subject to the §4980H(a) penalty, it is based on the number of full-time employees, even in only one claimed the PTC.

Assessment of the §4980H Penalty The penalty first applies for 2015 but can’t be assessed until summer 2016 at the earliest because of information IRS needs to get on 2015 returns. Below is a multi-part update on this assessment process. The IRS has said little about the process, but the HHS has some information (but IRS assesses the penalty not HHS).

Brief Review of the §4980H Penalty - Beginning in 2015, applicable large employers (ALEs) are subject to the ESRP of §4980H.1 An ALE is an employer who in the prior year (base year) employed at least 50 full-time or full-time equivalent employees. For 2015 only, ALEs with fewer than 100 full-time and full-time equivalent employees are not subject to the ESRP (see IRS Q&A 34).

The two ESRP penalties are (only one can potentially apply for the year, not both):

a) The §4980H(a) penalty: The ALE does not offer health coverage or does not offer coverage to at least 95% of its full-time employees and the dependents of these employees, and at least one of the full-time employees receives a premium tax credit (PTC).

b) The §4980H(b) penalty: The ALE offers health coverage to at least 95% of its full-time employees, but the coverage either is not “minimum value” or affordable, and at least one full-time employee receives a PTC.

1 This penalty has several names including employer mandate, employer shared responsibility payment (ESRP),

§4980H penalty, and assessable payment.


https://www.irs.gov/affordable-care-act/employers/questions-and-answers-on-employer-shared-responsibility-provisions-under-the-affordable-care-act#Transition

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Note that only full-time employees, not part-time employees, potentially subject the ALE to the ESRP. Part-time equivalent employees are only relevant in determining if an employer meets the definition of an ALE.

A full employee offered coverage by the ALE may qualify for the PTC (assuming they purchased coverage in the Marketplace) because either (a) the coverage offered was not affordable; or (b) the coverage did not provide minimum value. Given that both ESRP penalties rely on a full-time employee claiming the PTC, the IRS needs to see the Forms 8962 to know which individuals claimed a PTC.

The IRS also needs to have Form 1095-C from ALEs to know who are full-time employees. This is the group of employees who potentially trigger a §4980H(a) or (b) penalty for the ALE. If the ALE did everything they were supposed to do to avoid the penalty, including using the affordability safe harbors of the regulations, it will not owe the penalty even if a full-time employee claimed a PTC. It is possible, for example, that the employee’s household income (modified AGI) was low enough (such as due to an NOL carryover) that the employee qualified for a PTC despite the employer’s offer of coverage that was affordable under the employer safe harbors. The affordability safe harbors must be well understood. See IRS Q&A 19 and Reg. 54.4980H-5 which describe the three safe harbors. With the help of the safe harbors, it is entirely possible that the employee who purchases coverage on the Marketplace is entitled to the PTC (because the employer coverage was unaffordable for PTC purposes, despite providing minimum value), while the ALE is not subject to the penalty (because the affordability safe harbors protect the employer).

The Venn diagram below (produced by the author, not the IRS or HHS), shows a likely method the IRS will use to find ALEs potentially subject to the ESRP. Basically, the IRS first identifies from Form 8962 filed with Form 1040 all of the individuals who claimed a PTC. It then finds out which of these employees received a Form 1095-C indicating they are a full-time employee of an ALE. Then the IRS knows which employers (in red below) are potentially subject to the penalty. The penalty can only be assessed by the IRS; employers do not self-assess it.


https://www.irs.gov/affordable-care-act/employers/questions-and-answers-on-employer-shared-responsibility-provisions-under-the-affordable-care-act#Liability

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Observations: From the IRS’s perspective, it will take a fair amount of computing and human labor to find all ALEs potentially subject to the §4980H penalty. Also, it is important for the IRS to be sure any individual who claimed an advance PTC files a return with Form 8962 to reconcile to their true PTC (which might be zero). The IRS must also be sure all ALEs file Form 1095-C (and transmittal form 1094-C) to help identify which full-time employees claimed a PTC.

HHS Employer Notice Program: Per the Department of Health and Human Services (HHS), in 2016, the federal Marketplace will start notifying certain employers if they have an employee who was determined eligible for an advance PTC (APTC) for at least one month in 2016, assuming the Marketplace has the employer’s address.

With respect to 2015, HHS has also stated in its FAQs:

“Q. Will employers be liable for the employer shared responsibility payment for 2015 if a full-time employee receives a premium tax credit for coverage received through a Marketplace in that year? Yes. The IRS will independently determine any liability for the employer shared responsibility payment without regard to whether the Marketplace issued a notice or the employer engaged in any appeals process. More information on the IRS process can be found at www.irs.gov.”

The FAQs also state that if the Marketplace doesn’t issue a notice to an employer it doesn’t mean the employer is not subject to the §4980H penalty because the IRS will independently determine any liability for this penalty.

Sample Notice: HHS has a sample notice dated July 16, 2014 (even though their FAQs state that the federal marketplace won’t issue notices until 2016). This sample notice follows the requirements of Sec. 1411 of the ACA (see ACA text provided by HHS, starting at page 123) and HHS Reg. 45 CFR 155.310(h).

The sample notice includes the following statement about what the recipient should do next [typo and emphasis in the original]:

“You may file an appeal to the Marketplace if you believe there's been a mistake regarding the employee's eligibility for APTC or CSRs. If you believe your employee was incorrectly determined eligible for APTC or CSRs because you offered the employee affordable, minimum value health coverage, filing an appeal could help reduce the employee's potential tax liability. Filing an appeal could also eliminate reports from the Marketplace to the IRS that your employee received APTC or CSRs following an appeal decision in your favor. However, filing an appeal won't necessarily affect whether you have to pay an employer shared responsibility payment to the IRS, because the IRS will determine independantly whether you have to pay.”

Observations about the Notice: Based on the HHS FAQs, regulation and sample HHS notice, the following issues exist:

The notice might be issued to employers who are not even ALEs and thus are not subject to the §4980H penalty. Yet, these employers logically should still file an appeal to try to avoid further actions by the HHS and IRS. While a non-ALE won’t be subject to the penalty, further notices will be time-consuming to deal with.


https://www.cms.gov/CCIIO/Resources/Fact-Sheets-and-FAQs/Downloads/Employer-Notice-FAQ-9-18-15.pdf

http://www.irs.gov/

https://www.cms.gov/CCIIO/Programs-and-Initiatives/Employer-Initiatives/Downloads/Final-Notice-for-Posting-05_10_2016.pdf

https://www.cms.gov/CCIIO/Resources/Fact-Sheets-and-FAQs/Downloads/Employer-Notice-FAQ-9-18-15.pdf

http://www.hhs.gov/sites/default/files/ppacacon.pdf

https://www.law.cornell.edu/cfr/text/45/155.310

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The employee named on the notice might not be a full-time employee to whom an ALE had to offer coverage to avoid a §4980H penalty. Again, it seems wise to file the appeal noting the employee was not a full-time employee for the year involved in order to try to avoid future notices from HHS and/or the IRS. Recall that per §4980H(c)(4) and Reg. 54.4980H(a)(21), “’full-time employee’ means, with respect to any month, an employee who is employed on average at least 30 hours of service per week.”

The employee listed on the notice may have been offered affordable, minimum value insurance, but rejected it.

HHS notices might get sent to various employer locations. For example, if the employee works at a retail outlet of their employer, the employee likely gave the Marketplace that address. If that is not the corporate headquarters of the employer, the notice might get lost. Employers need to implement some type of program to alert their locations that they need to immediately forward any HHS notice to X department at X address, fax or email address. [Thanks to PwC for making this observation in its 4/20/16 “insights” on the Marketplace employer notice program.]

An ALE might not receive a notice even though one of its full-time employees claimed an APTC because the employee might not have provided an employer address or it just doesn’t get sent. Not receiving an HHS notice should not signal to any ALE that the IRS won’t contact them about penalty exposure (see the Venn diagram above for a possible process the IRS can use to find employers who possibly owe the penalty).

The Notice process seems to be a poorly designed one but apparently HHS is interpreting the law as requiring the notice. This program requires a lot of work by HHS and employers, often for no purpose, as noted above. As noted in the Venn diagram above, IRS is the one that has the best information to identify any ALEs potentially subject to the penalty.

Appeals Process: HHS also has information on how an employer can file an appeal if it received a notice that it may owe the penalty, but believes it is not subject to it. HHS also notes that it doesn’t assess the ESRP, the IRS does. This process applies to the federal Marketplace (Exchange) as well as to the state exchanges in California, Colorado, DC, Kentucky, Maryland, Massachusetts, New York and Vermont (per the appeals form). Watch for information from other states with exchanges as to their notice process.

Appeals have to be filed within 90 days of the date on the Notice. The appeals form must be mailed or faxed (no electronic filing option is noted on the notice letter or appeals form).

The Employer Appeal Request Form is available at https://www.healthcare.gov/downloads/marketplace-employer-appeal-form.pdf. An excerpt of this 4-page form follows:


https://www.pwc.com/us/en/hr-management/newsletters/hrs-insights/assets/pwc-aca-marketplace-employer-notice-program-to-start-soon.pdf

https://www.healthcare.gov/marketplace-appeals/employer-appeals/

https://www.healthcare.gov/downloads/marketplace-employer-appeal-form.pdf

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IRS FAQs on Making an Employer Shared Responsibility Payment: Per the IRS ESRP FAQs:

27. How will an employer know that it owes an Employer Shared Responsibility payment? The IRS will adopt procedures that ensure employers receive certification that one or more employees have received a premium tax credit. The IRS will contact employers to


https://www.irs.gov/affordable-care-act/employers/questions-and-answers-on-employer-shared-responsibility-provisions-under-the-affordable-care-act#Making

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inform them of their potential liability and provide them an opportunity to respond before any liability is assessed or notice and demand for payment is made. The contact for a given calendar year will not occur until after the due date for employees to file individual tax returns for that year claiming premium tax credits and after the due date for applicable large employers to file the information returns identifying their full-time employees and describing the coverage that was offered (if any).

28. How will an employer make an Employer Shared Responsibility payment? If it is determined that an employer is liable for an Employer Shared Responsibility payment after the employer has responded to the initial IRS contact, the IRS will send a notice and demand for payment. That notice will instruct the employer on how to make the payment. Employers will not be required to include the Employer Shared Responsibility payment on any tax return that they file.

Bottom Line: It seems prudent for any employer receiving a Marketplace notice who believes it is not subject to the penalty to timely respond to the notice to try to avoid future notices from HHS or IRS. It is not a perfect process, but the one that exists as of July 2016.

IRS ESRP Estimator Tool This tool is new for 2016 and includes this reminder:

IRS Website on the ESRP https://www.irs.gov/affordable-care-act/employers/employer-shared-responsibility-provisions

13/26 Rehiring Rule – Infor Letter 2016-52


https://taxpayeradvocate.irs.gov/estimator/esrp/

https://www.irs.gov/affordable-care-act/employers/employer-shared-responsibility-provisions

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Information Letter 2016-52 (9/30/16) – An individual wrote to President Obama to express his concern that the 13/26 rule required him to take a 6-month break in service after retirement before he is eligible to return to work part-time for his employer. The IRS assured the individual that this was not true.

Per the IRS, the 13/26 rule is one of the rule to help employers identify their full-time employees for purposes of the ESRP. This rule “tells employers how to treat employees rehired after termination of employment or resuming service after other absence.” (Reg. §54.4980H-3(c)(4)). “We see no reason why the rules in the employer shared responsibility regulations would require you to have a 6-month break in service after retirement before working as a part-time employee at the Northern Virginia Community College.”

“Under the employer shared responsibility regulations, the 13/26 rule treats an employee as a continuing employee of an educational institution unless the employee has a period of 26 weeks without an hour of service. See Treasury Regulation section 54.4980H- 3(c)(4)(ii). In this case, the rule treats the employee as terminated from employment and rehired. The rule is 13 weeks without an hour of service for employers that are not educational institutions. See Treasury Regulation section 54.4980H-3(c)(4)(i). Therefore, this 13 week rule does not apply in your case because of your employer.”

“If your employer has told you that a break-in-service is required after retirement, the reason may be due to the terms of your retirement plan instead of any ACA requirement. Some retirement plans restrict distributions to employees who transfer to a part-time position with the same employer before incurring some minimum break-inservice. If you have questions about the terms of your retirement plan, you should contact your employer or plan administrator.”

Forms 1095-B and 1095-C

Automatic Extension of Time to File 2015 Forms 1095 and 1094 with Employees and IRS – Notice 2016-4

Due Dates – Notice 2016-4 - Per the IRS (12/28/15): “Notice 2016-4 extends the due dates for the 2015 information reporting requirements, both furnishing to individuals and filing with the Internal Revenue Service (Service), for insurers, self-insuring employers, and certain other providers of minimum essential coverage under I.R.C. § 6055, and the information reporting requirements for applicable large employers under I.R.C. § 6056. This Notice also provides guidance to individuals who, as a result of these extensions, might not receive a Form 1095-B or Form 1095-C by the time they file their 2015 tax returns.”

In the notice, the IRS says it is ready to accept the forms in January 2016 and encourages those who can file timely to do so. The time extension is offered because the IRS has “determined that some employers, insurers, and other providers of minimum essential coverage need additional time to adapt and implement systems and procedures to gather, analyze, and report this information.”




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Updated Forms for 2016 Review the 2016 forms and instructions for clarifications as well as changes required by the new regulations.

Per the IRS – What’s New for Forms 1094-B and 1095-B:

Per the IRS – What’s New for Forms 1094-C and 1095-C:


https://www.irs.gov/uac/about-form-1095-b

https://www.irs.gov/uac/about-form-1095-c

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Data on Number of Forms Expected to be Filed The NTA’s 2015 report to Congress released in January 2016 indicates the following:

Proposed Regulations Under §6055 and §6724 REG-103058-16 (8/2/16) address a few open items regarding filing of 1095-B and 1094-B by those who provide minimum essential coverage to individuals. Items addressed in these proposed regulations include:


http://taxpayeradvocate.irs.gov/Media/Default/Documents/2015ARC/ARC15_Volume1_MSP_14_ACA-Business.pdf


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Catastrophic Plans – Issuers of these plans are required to report on Form 1095-B, starting for 2016. To provide sufficient time to get ready, the regulations make this optional for 2016, but recommended, and required for 2017 forms.

Truncated EIN – Issuers may truncate the EIN of the employer sponsoring the health plan.

TIN Solicitation – A penalty under 6721 and 6722 can apply for an incomplete Form 1095-B, such as due to a missing TIN. Reasonable cause for waiver can be shown if specified TIN solicitation rules are followed. See Reg. §1.6055-1(h)(3) and §301.6724-1.

Late Filing Penalty Falls Upon Issuer – Info Letter 2016-53 Information Letter 2016-53 (9/30/16) – The IRS addressed an issue raised by a constituent of Senator Gillibrand about a late filed Form 1095-C. Per the constituent, the employer may have failed to file for over one third of the employees. The employees are concerned as to whether this failure might subject the employees to penalties.

The IRS noted that an applicable large employer is not required to file Form 1095-C for all employees, but only for full-time employees.

The IRS assures the senator that “-employees would not be subject to tax penalties in connection with any failure to file Form 1095-C. If penalties for non-filing are applicable, the employer with filing responsibility under section 6056 would owe the penalty, not the individual employee. Also, while an employee may owe a payment if he or she fails to maintain minimum essential coverage or does not qualify for an exemption as required under the individual shared responsibility provisions of Code section 5000A, the filing (or non-filing) of Form 1095-C does not affect this payment.”

Other Health Care Items

Health Insurance Providers Fee and Expatriate Health Plans – Notice 2016-14 Per the IRS (1/29/16): “Notice 2016-14 provides guidance for the 2016 fee year on how the definition of expatriate health plans under the Expatriate Health Coverage Clarification Act of 2014 applies for purposes of the health insurance provider’s fee imposed by § 9010 of the Affordable Care Act.”

Medical Device Excise Tax and Lease – PMTA 2016-14 (8/17/16) Per the IRS:

“ISSUE: Whether a manufacturer’s temporary provision of a surgical instrument that is a taxable medical device to a medical device purchaser, at no additional charge, is a lease under sections




https://www.irs.gov/pub/lanoa/pmta-2016-14.pdf

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4216 and 4217 of the Internal Revenue Code.

CONCLUSION: A manufacturer’s temporary provision of a surgical instrument that is a taxable medical device to a medical device purchaser, at no additional charge, is a lease under sections 4216 and 4217. The portion of the sale price of the taxable medical device that is attributable to the manufacturer’s provision of the surgical instrument to the device purchaser is a lease payment and is taxed as a sale at the rate of tax in effect as of the date of payment.” [PMTA 2016-14]




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Chapter 12: Estate, Gift, and GST Tax Page 12-1

Chapter 12 : Estate, Gift, and GST Tax

Table of Contents Chapter 12 : Estate, Gift, and GST Tax ............................................................................... 12-1

2016 Gift, Estate, and GSTT Tax Rates and Exemptions ................................................ 12-2

2017 Inflation-adjusted Estate, Gift, GST Thresholds Projected by Thompson Reuters Checkpoint ............................................................................................................................ 12-3

What's New - Estate and Gift Tax – IRS Webpage .......................................................... 12-4

IRS Website on Viewing Transcripts in Lieu of Estate Tax Closing Letters (June 2016 update) .................................................................................................................................. 12-6

California Revocable “Transfer Upon Death” (TOD) Deed ............................................ 12-6

REG-163113-02 (8/4/16) Prop. Regs. 25.2701-2,-8, 25.2704-1, -2, -3, -4; IRS Issues Proposed Regulations on Gift and Estate Tax Valuations ............................................... 12-7

Rev Proc 2016-49 (Sept. 27, 2016) -- Rev. Proc. Grants Relief for QTIP Election When Estate Elects Portability ...................................................................................................... 12-7

T.D. 9757 and REG-127923-15 (03/02/2016) -- Temporary and Proposed Regs. On Basis Consistency Rules and Estate Reporting ........................................................................... 12-9

Background ....................................................................................................................... 12-9

Proposed Regulations ..................................................................................................... 12-13

Estate of Sarah D. Holliday, TC Memo 2016-51 (March 17, 2016) -- Assets Decedent Transferred To Limited Partnership Were Pulled Into Gross Estate .......................... 12-21

Estate of Edward G. Beyer, TC Memo 2016-183 (9/29/2016) – Beyer’s Remorse: A Doomed Estate Tax Plan ................................................................................................... 12-22

Estate of James Heller, 147 TC No. 11 (9/26/2016) -- Estate Allowed To Deduct Madoff Ponzi Scheme Losses Through Partnership .................................................................... 12-23

Estate of Dieringer, 146 T.C. No. 8 (3/30/2016) – Estate Denied Full Charitable Deduction ............................................................................................................................ 12-24

Redstone, T.C. Memo 2015-237 (December 9, 2015) – Donor Liable for Gift Tax 40 Years After the Gift ...................................................................................................................... 12-26

CCA 201643020 (released 10/21/2016) -- Statute of Limitations Not Extended When Prior Year Gifts are Omitted from Form 709 ................................................................. 12-26

Specht v. U.S., (CA 6 9/22/2016) -- Malpractice by Return Preparer Insufficient Defense To Estate's Late Filing ....................................................................................................... 12-27

Estate of La Sala, TC Memo 2016-42 (3/8/2016) -- Gift Tax Return Filed As Part Of Estate Tax Settlement Cannot Escape Interest ............................................................... 12-29

PLR 201626016 (March 15, 2016) -- Trust Termination Did Not Triger GST tax .... 12-29


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U.S. v. McNicol, (CA 1 7/15/2016) -- Executrix Personally Liable For Unpaid Estate Taxes.................................................................................................................................... 12-31

U.S. v. Spoor, (CA 11 10/04/2016) -- Executor's Commissions Did Not Have Priority Over Estate Tax Lien ......................................................................................................... 12-31

Singer, TC Memo 2016-48 (3/16/2016) – Executor Escapes Fiduciary Liability for Unpaid Estate Tax ........................................................................................................................... 12-34

(CCA) 201621014 (May 20, 2016) – Who Can Receive Estate Tax Information from the IRS? ..................................................................................................................................... 12-35

2016 Gift, Estate, and GSTT Tax Rates and Exemptions Per the Joint Committee on Taxation’s Bluebook: JCX-43-16 (May 10, 2016) The United States generally imposes a gift tax on any transfer of property by gift made by a U.S. citizen or resident, whether made directly or indirectly and whether made in trust or otherwise. Nonresident aliens are subject to the gift tax with respect to transfers of tangible real or personal property where the property is located in the United States at the time of the gift. The gift tax is imposed on the donor and is based on the fair market value of the property transferred. Deductions are allowed for certain gifts to spouses and to charities. Annual gifts of $14,000 (for 2016) or less per donor and per donee generally are not subject to tax. An estate tax also is imposed on the taxable estate of any person who was a citizen or resident of the United States at the time of death, and on certain property belonging to a nonresident of the United States that is located in the United States at the time of death. The estate tax is imposed on the estate of the decedent and generally is based on the fair market value of the property passing at death.31 The taxable estate generally equals the worldwide gross estate less certain allowable deductions, including a marital deduction for certain bequests to the surviving spouse of the decedent and a deduction for certain bequests to charities. The gift and estate taxes are unified such that a single graduated rate schedule and effective exemption amount apply to an individual’s cumulative taxable gifts and bequests. The unified estate and gift tax rates begin at 18 percent on the first $10,000 in cumulative taxable transfers and reach 40 percent on cumulative taxable transfers over $1,000,000. A unified credit of $2,125,800 (for 2016) is available with respect to taxable transfers by gift or at death. This credit effectively exempts a total of $5.45 million (for 2016)32 in cumulative taxable transfers from the gift tax or the estate tax. The unified credit thus generally also has the effect of rendering the marginal rates below 40 percent inapplicable. Unused exemption as of the death of a spouse generally is available for use by the surviving spouse; this feature of the law sometimes is referred to as exemption portability. A separate transfer tax is imposed on generation-skipping transfers in addition to any estate or gift tax that is normally imposed on such transfers. This tax generally is imposed on transfers, either directly or through a trust or similar arrangement, to a beneficiary in more than one


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generation below that of the transferor. For 2016, the generation-skipping transfer tax is imposed at a flat rate of 40 percent on generation-skipping transfers in excess of $5.45 million.

31 In addition to interests in property owned by the decedent at the time of death, the Federal estate tax also is imposed on (1) life insurance that was either payable to the decedent’s estate or in which the decedent had an incident of ownership at death, (2) property over which the decedent had a general power of appointment at death, (3) annuities purchased by the decedent or his employer that were payable to the decedent before death, (4) property held by the decedents as joint tenants, (5) property transferred by the decedent before death in which the decedent retained a life estate or over which the decedent had the power to designate who will possess or enjoy the property, (6) property revocably transferred by the decedent before death, and (7) certain transfers taking effect at the death of the decedent. 32 The $5 million exemption amount set forth in section 2010(c)(3)(A) is indexed for inflation for years after 2011. Sec. 2010(c)(3)(B). 2017 Inflation-adjusted Estate, Gift, GST Thresholds Projected by Thompson

Reuters Checkpoint Based on the Consumer Price Index for the 12-month period ending August 31, 2016, Thompson Reuters Checkpoint projects:

The unified estate and gift tax exclusion amount (gift and estate tax exemptions) for gifts made and decedents dying in 2017 will be $5,490,000 (up from $5,450,000 in 2016).

The generation-skipping transfer (GST) tax exemption for transfers made in 2017 will be $5,490,000 (up from $5,450,000 in 2016).

The gift tax annual exclusion amount for gifts made in 2017 will be $14,000 (the same amount for gifts made in 2016, 2015, 2014 and 2013).

The annual exclusion for gifts to noncitizen spouses in 2017 will be $149,000 (up from $148,000 in 2016).

The special use valuation reduction limit for estate of decedents dying in 2017 will be $1,120,000 (up from $1,110,000 in 2016).

The portion of the estate tax that may be deferred on farm or closely-held businesses at an interest rate of 2% per year, after the applicable exclusion amount is applied, will be $1,490,000 (up from $1,480,000 for 2016).

The foreign gift reporting threshold for gifts from a nonresident alien or foreign estate to a U.S. person (other than an exempt section 501(c) organization) will be $100,000; the foreign gift reporting threshold for gifts from foreign corporations and foreign partnerships to a U.S. person (other than an exempt section 501(c) organization) will be $15,797 in 2017 (up from $15,671 in 2016).


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What's New - Estate and Gift Tax – IRS Webpage Following is the October 3, 2016 version of the IRS webpage: Consistent Basis Reporting Between Estate and Person Acquiring Property from Decedent

On March 23, 2016, the IRS issued Notice 2016-27, which provides that statements required under section 6035, regarding the basis of property distributed from the estate of a decedent, need not be filed or furnished until June 30, 2016. Other notices had previously delayed the filing of such statements. See Notice 2016-19 (PDF), Notice 2015-57 (PDF), and temporary regulations, T.D. 9757.

In addition, proposed regulations, REG-127923-15, provide guidance regarding the requirement that a recipient's basis in certain property acquired from a decedent be consistent with the value of the property as finally determined for Federal estate tax purposes.

The statements noted above are required by H.R. 3236, the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, which was signed into law on July 31, 2015.

The law created Section 6035, which requires the executor of an estate required to file an estate tax return to also provide certain statements to the IRS and to beneficiaries receiving inherited property. This also applies to 6018(b) filers.

The law also adds Section 1014(f), which requires consistent basis reporting between an estate and the beneficiary receiving certain property from a decedent.

These changes apply to any estate tax return filed, and to property with respect to which an estate tax return is filed, after July 31, 2015.

Form 706 Changes

The basic exclusion amount (or applicable exclusion amount in years prior to 2011) is $1,500,000 (2004-2005), $2,000,000 (2006-2008), $3,500,000 (2009), $5,000,000 (2010-2011), $5,120,000 (2012), $5,250,000 (2013), $5,340,000 (2014), $5,430,000 (2015), and $5,450,000 (2016).

For Estate Tax returns after 12/31/1976, Line 4 of Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, (PDF) lists the cumulative amount of adjusted taxable gifts within the meaning of IRC section 2503. The computation of gift tax payable (Line 7 of Form 706) uses the IRC section 2001(c) rate schedule in effect as of the date of the decedent's death, rather than the actual amount of gift taxes paid with respect to the gifts.


https://www.irs.gov/businesses/small-businesses-self-employed/transfer-certificate-filing-requirements-for-us-citizens





https://www.irs.gov/pub/irs-pdf/f706.pdf


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With the top bracket tax rates decreasing from 55 percent (in 2001) to 35 percent (in 2010), and then increasing to 40 percent (in 2013), the IRS has encountered situations where gift taxes paid were greater than the tax calculated using the rate in effect at the date of death.

It appears that some Form 706 software used by practitioners require a manual input of the gift tax payable line. Some preparers are reporting gift taxes actually paid rather than calculating the gift tax payable under date of death rates. These errors result in underpayment of estate tax due. Cases with this issue will involve estates where large gifts were made during life and at a time when tax rates were higher than at date of death. (Posted 6-5-06)

Beginning January 1, 2011, estates of decedents survived by a spouse may elect to pass any of the decedent’s unused exclusion to the surviving spouse. This election is made on a timely filed estate tax return for the decedent with a surviving spouse. Note that simplified valuation provisions apply for those estates without a filing requirement absent the portability election. See the Instructions to Form 706 for additional information.

Exclusions The annual exclusion for gifts is $11,000 (2004-2005), $12,000 (2006-2008), $13,000

(2009-2012) and $14,000 (2013-2016). The basic exclusion amount (or applicable exclusion amount in years prior to 2011) for

gifts is $1,000,000 (2010), $5,000,000 (2011), $5,120,000 (2012), $5,250,000 (2013), $5,340,000 (2014), $5,430,000 (2015), and $5,450,000 (2016).

Federal Transfer Certificates (International) For more information about securing a transfer certificate, please see:

Transfer Certificate Requirements for U.S. Citizens Transfer Certificates for Non-U.S. Citizens

Form 706 Filing Instructions The instructions (which include rate schedules) may be found on the Forms and Publications - Estate and Gift Tax.

There are few significant changes to Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. The one change that will impact all filers is the elimination of the allowable State Death Tax Credit; for decedents dying in 2005 and later years, it is a deduction.

If you are filing a request for an extension of time to file an estate or gift tax return, remember that the request must go to the Cincinnati Service Center, even if you file your income or other tax returns elsewhere.

The instructions to Form 706 contain detailed guidance on completing the form and the required documentation to include with estate tax returns being filed solely to elect portability.


https://www.irs.gov/businesses/small-businesses-self-employed/transfer-certificate-filing-requirements-for-us-citizens

https://www.irs.gov/businesses/small-businesses-self-employed/transfer-certificate-filing-requirements-for-non-u-s-citizens

https://www.irs.gov/businesses/small-businesses-self-employed/forms-and-publications-estate-and-gift-tax

https://www.irs.gov/businesses/small-businesses-self-employed/forms-and-publications-estate-and-gift-tax

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IRS Website on Viewing Transcripts in Lieu of Estate Tax Closing Letters (June 2016 update)

This IRS website describes how registered tax professionals, can view IRS “account transcripts” that reflect the acceptance of Form 706. The IRS notes that “[t]he decision to audit a Form 706 is typically made four to six months after the filing date.” The IRS recommends that the estate “wait four to six months after filing Form 706 before submitting a request for an account transcript.”

California Revocable “Transfer Upon Death” (TOD) Deed On September 21, 2015, the Governor signed Assembly Bill 139. Per the author of AB 139:

The most common form of real property transfer upon death, a will, must pass through probate, a lengthy legal process… The process is often grueling, can take up to a year, and often results in statutory probate fees in the thousands of dollars. Similarly, establishment of a revocable trust can cost upwards of $2,000. For seniors and individuals whose estate consists primarily of the home, the money to establish a trust is out of the question. [The] revocable transfer on death deed (revocable TOD deed) is the most simple and inexpensive transfer mechanism on the market today. Furthermore, it may be the only tool available to unmarried homeowners who wish to leave their property to a lifelong partner, family member, friend, or loved one upon death, but who cannot afford to set up a trust.

Link to California Legislature Committee Analysis: http://leginfo.legislature.ca.gov/faces/billAnalysisClient.xhtml?bill_id=201520160AB139 Articles: California's New Estate Planning Tool: The Revocable Transfer on Death (TOD) Deed (January 21, 2016), by Christopher Engh and Rebecca Sem: http://www.sjcbar.org/across-the-bar/california-s-new-estate-planning-tool-the-revocable-transfer-on-death-tod-deed.html Is California's New Transfer-on-Death Deed a House of Cards? By Mike Hackard of Hackard Law posted in Probate & Estate Administration on March 11, 2016: http://www.hackardlaw.com/blog/2016/03/is-california-transfer-on-death-deed-a-house-of-cards.shtml Effect of revocable TOD deed upon property tax per California SBE (January 20, 2016): https://www.boe.ca.gov/proptaxes/pdf/lta16006.pdf


https://www.irs.gov/irspup/businesses/small-businesses-self-employed/transcripts-in-lieu-of-estate-tax-closing-letters

https://www.irs.gov/irspup/businesses/small-businesses-self-employed/transcripts-in-lieu-of-estate-tax-closing-letters

http://leginfo.legislature.ca.gov/faces/billAnalysisClient.xhtml?bill_id=201520160AB139

http://www.sjcbar.org/across-the-bar/california-s-new-estate-planning-tool-the-revocable-transfer-on-death-tod-deed.html

http://www.sjcbar.org/across-the-bar/california-s-new-estate-planning-tool-the-revocable-transfer-on-death-tod-deed.html

http://www.hackardlaw.com/blog/2016/03/is-california-transfer-on-death-deed-a-house-of-cards.shtml



https://www.boe.ca.gov/proptaxes/pdf/lta16006.pdf

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REG-163113-02 (8/4/16) Prop. Regs. 25.2701-2,-8, 25.2704-1, -2, -3, -4; IRS Issues Proposed Regulations on Gift and Estate Tax Valuations

IRS proposes significant changes to Reg. 25.2701 and 25. 2704-2 and -3. See Chapter 1 for a detailed discussion.

Rev Proc 2016-49 (Sept. 27, 2016) -- Rev. Proc. Grants Relief for QTIP Election When Estate Elects Portability

Rev. Proc. 2016-49 “modifies and supersedes Rev. Proc. 2001-38” and prevents a QTIP election from being treated as null and void where the QTIP election was not necessary to reduce the estate tax liability to zero and the decedent’s estate elected portability. The new Rev. Proc. also provides a procedure to treat QTIP elections as void in specified circumstances where the decedent does not elect portability. The “revenue procedure is effective September 27, 2016 and applies to QTIP elections within the scope of this revenue procedure.” Background IRS Explanation of Rev Proc. 2001-38:

Rev. Proc. 2001-38, 2001-24 I.R.B. 1335, provides a procedure by which the IRS will disregard and treat as a nullity for federal estate, gift, and generation-skipping transfer tax purposes a QTIP election made in cases where the election was not necessary to reduce the estate tax liability to zero. Rev. Proc. 2001-38, when issued, provided relief to the surviving spouse of a decedent whose estate received no benefit from the unnecessary QTIP election. With the availability of portability elections, however, the procedure to void and nullify QTIP elections in Rev. Proc. 2001-38 may bring into question the ability of a decedent's estate to make an otherwise unnecessary QTIP election to maximize the available unused exclusion amount.

IRS Explanation of QTIP Planning After Portability was Enacted in 2010:

1) Rev. Proc. 2001-38 was premised on the belief that an executor would never purposefully elect QTIP treatment for property if the election was not necessary to reduce the decedent's estate tax liability.

2) With the [2010] amendment of §§2010(c) and 2505(a) to provide for portability elections, an executor of a deceased spouse's estate may wish to elect QTIP treatment for property even where the election is not necessary to reduce the estate tax liability. A QTIP election would reduce the amount of the taxable estate and the tax imposed by §2001(a) (if any), resulting in less use of the




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decedent's applicable credit amount and producing a greater DSUE amount than would exist if no QTIP election was made for the property. An increased DSUE amount available to the surviving spouse increases the applicable credit amount available to the surviving spouse to wholly or partially offset the surviving spouse's gift or estate tax liability that is attributable to the QTIP or any other property.

3) In view of the foregoing, the Treasury Department and the IRS have determined that it is appropriate to continue to provide procedures by which the IRS will disregard an unnecessary QTIP election and treat such election as null and void, but only for estates in which the executor neither made nor was considered to have made the portability election. In estates in which the executor made the portability election, QTIP elections will not be treated as void. (Emphasis added)

Relief in Rev Proc 3.02. “This revenue procedure does not treat as void QTIP elections made to treat property as QTIP in cases where”:

1) A partial QTIP election was required with respect to a trust to reduce the estate tax liability and the executor made the election with respect to more trust property than was necessary to reduce the estate tax liability to zero;

2) A QTIP election was stated in terms of a formula designed to reduce the estate tax to zero. See, for example, §20.2056(b)-7(h), Examples 7 and 8;

3) The QTIP election was a protective election under § 20.2056(b)-7(c); 4) The executor of the estate made a portability election in accordance with §

2010(c)(5)(A) and the regulations thereunder, even if the decedent's DSUE amount was zero based on values as finally determined for federal estate tax purposes; or

5) The requirements of section 4.02 of this revenue procedure [procedural requirements for relief to treat QTIP election as void] are not satisfied.”

Section 3.01: “This revenue procedure treats as void QTIP elections made in cases where all of the following requirements are satisfied”:

1) The estate's federal estate tax liability was zero, regardless of the QTIP election, based on values as finally determined for federal estate tax purposes, thus making the QTIP election unnecessary to reduce the federal estate tax liability;

2) The executor of the estate neither made nor was considered to have made the portability election as provided in § 2010(c)(5)(A) and the regulations thereunder; and

3) The requirements of section 4.02 of this revenue procedure are satisfied.


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T.D. 9757 and REG-127923-15 (03/02/2016) -- Temporary and Proposed Regs. On Basis Consistency Rules and Estate Reporting

The Latest: In mid-October of 2016, the IRS released revised Instructions for Form 8971. New form instructions - https://www.irs.gov/pub/irs-pdf/i8971.pdf?_ga=1.188496936.1053688344.1470948058 Incorporating an AICPA suggestion, the IRS removed the “No Attachments” mandate which appeared in the draft released earlier. The revised instructions state:

“Listing of bulk assets may be attached to Schedule A in lieu of a detailed description of each item that has been acquired (or is expected to be acquired) by a beneficiary. The listing should consist of a (sic) related property (for example, stocks held in a single brokerage account) and only include information relevant to basis reporting such as name/description of the property, value, and valuation date. Do not attach property appraisals to Schedule A.”

Background Prior-law consistency rule. Per TAM 199933001 (8/23/1999):

“Although section 1.1014-3(a) provides that the appraised value of property for federal estate tax purposes is deemed to be the fair market value of such property for purposes of section 1014, where the taxpayer is not estopped by his previous actions or statements, this rule merely establishes a rebuttable presumption and may not be conclusive in the face of clear and convincing evidence to the contrary. Rev. Rul. 54-97.”

In Janis, 461 F.3d 1080, (9th Cir., 8/21/2006), the Ninth Circuit determined that the taxpayer failed the duty of consistency:

o After the taxpayer’s father’s death “the estate hired Sotheby's to value [his] art collection. … the estate calculated a discount-known as a blockage discount--that accounted for [factors such as] a consequence of putting such a large number of works on the market.” The discounted value determined by the estate was $12,403,207.

o In 1990, 91, and 92, the children (taxpayers) filed Forms 1041 using the $12,403,207 discounted value as basis in calculating gain on the sale of the artwork.

o The taxpayers--children of decedent--were co-executors and the sole beneficiaries of his estate.

o In January 1994, the taxpayers consented to the IRS's reduction of the discount so that the estate tax value, per IRS, was $14.5 million rather than 12.5 million. IRS also agreed that the undiscounted value was $36.5 million.




https://urldefense.proofpoint.com/v2/url?u=https-3A__www.irs.gov_pub_irs-2Dpdf_i8971.pdf-3F-5Fga-3D1.188496936.1053688344.1470948058&d=DQMAaQ&c=hLjr57FTI_Vn-XOzslWArQ&r=b8ZJgEkrH7vNm0SQLFvMOrAZ5HL6dJAntr4LqgeYlAM&m=jmLkC2FnyeeX3pKMUjQKMZu8gro1R8JdCpSMKo4rrrw&s=qmbYS861UJqwn8a7y-Qn9_xdYJwwGbs24057lFMXWgA&e=

http://openjurist.org/461/f3d/1080/janis-v-commissioner-of-internal-revenue

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o “[The taxpayers agreed to the estate tax adjustment] signed Form 890, Waiver of Restrictions on Assessment and Collection of Deficiency and Acceptance of Overassessment.”

o After the statute of limitations expired on the estate tax return, the taxpayers amended the 1041s and claimed an income tax basis of $36.5 million (the undiscounted value) generating larger NOLs.

o Holding for the IRS, the Ninth Circuit relied upon the Estate of Ashman v. Comm'r, 231 F.3d 541, 544 (9th Cir. 2000) which spells out the elements for application of the judicially created duty of consistency:

“1) A representation or report by the taxpayer; (2) on which the Commission[er] has relied; and (3) an attempt by the taxpayer after the statute of limitations has run to change the previous representation or to recharacterize the situation in such a way as to harm the Commissioner. If this test is met, the Commissioner may act as if the previous representation, on which he relied, continued to be true, even if it is not. The taxpayer is estopped to assert the contrary.” (Ashman)

Janis concludes that the taxpayer violated the duty of consistency and the “tax gamesmanship” involved in the case was “exactly what the duty of consistency [was] designed to prevent”.

New Statutory Consistency Requirement. The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, enacted July 31, 2015 (Public Law 114-41) added sections 1014(f), 6035, 6662(b)(8), 6662(k), 6724(d)(1)(D), and 6724(d)(2)(II). Section 1014(f)(1) provides that the basis of property acquired from a decedent cannot

exceed that property's final Federal estate tax value, or, if the final value has not been determined, the value reported on a statement by the decedent’s estate required by section 6035(a).

A new accuracy-related penalty applies to underpayments attributable to an inconsistent estate basis (see section 6662(b)(8)).

Section 1014(f)(2) provides that section 1014(f)(1) only applies to property the inclusion of which in the decedent's gross estate increased the estate's Federal estate tax liability (reduced by credits allowable).

Section 6035 requires reporting, both to the IRS and the beneficiary, of the value of property included on a required Federal estate tax return if Form 706 filing is required (even if zero estate tax).

IRS Form 8971 Schedule A is used by the estate to report the value of the inherited property to the beneficiary, and Form 8971 (including all Schedule(s) A) is filed with the IRS. See Form 8971 Instructions.

Observation: Frequently, Form 706 is required to be filed because the gross estate (plus prior taxable gifts) exceeds the basic exclusion amount (for deaths in 2016 the basic exclusion amount is $5,450,000 or $60,000, for property situated in the U.S. if the decedent was a noncitizen nonresident), but the taxable estate is zero (thus no estate tax) due to deductions such as the marital deduction or charitable deduction. In such instances (zero taxable estate), the executor will be


https://casetext.com/case/estate-of-ashman-v-cir#p544

https://casetext.com/case/estate-of-ashman-v-cir#p544


https://www.irs.gov/pub/irs-pdf/i8971.pdf

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required to file Form 8971 with the IRS, and Schedule(s) A with each beneficiary; however, the beneficiary is not subject to the new section 1014(f) penalty because the property did not increase the estate’s Federal estate tax liability. Per IRS statistics for 2014, of the 11,931 Form 706s filed in 2014, only 5,158, were taxable. Schedule A of Form 8971 contains a column for indicating, yes or no, whether the property increased the estate tax liability.

Section 6035(a)(3)(A) provides that this statement is due no later than the earlier of (i.) 30 days after the due date of the return under section 6018 (including extensions,

if any) or (ii.) 30 days after the date the return is filed.

Observation: The due date for an estate tax return is nine months after the date of death (Sec. 6075(a)), with an automatic six-month extension available.

If there is an adjustment to the information required to be included on this statement, section 6035(a)(3)(B) requires the executor (or other person required to file the statement) to provide a supplemental statement to the IRS and to each affected beneficiary no later than 30 days after the adjustment is made.

AICPA Proposal to Change Due Date of Form 8971 (Aug. 31, 2016). Per the AICPA: “Congress should revise the section 6035(a)(3) due date for providing statements to beneficiaries and the IRS to February 15 following the end of a calendar year in which the property is distributed to the beneficiaries in order to streamline the process and make the reporting more accurate and useful to the beneficiaries and the IRS.”

Statements under section 6035 are included in the list of information returns and payee

statements subject to the penalties under section 6721 and section 6722, respectively. The Form 8971 instructions describe the penalty exposure for failure to timely file Form 8971 (including Schedule(s) A) with the IRS:

“Failure to file correct Forms 8971 by the due date (section 6721). If the executor of an estate or other person required to file Form 8971 fails to file a correct Form 8971 and/or Schedule A with the IRS by the due date and reasonable cause is not shown, a penalty may be imposed. The penalty applies if there is a failure to file timely, a failure to include all information required to be shown on the form or schedule, a failure to include correct information on the form or schedule, or a failure to file a correct supplemental Form 8971 and/or Schedule A by the due date. A complete Form 8971 includes all Schedule(s) A. Only one penalty will apply for all failures relating to a single filing of a single Form 8971 and the Schedule(s) A required to be filed along with it. Each filing of a Form 8971 with Schedule(s) A is a separate filing, regardless as to whether the filing is of the initial Form 8971 and Schedule(s) A or a supplemental Form 8971 and Schedule(s) A. The amount of the penalty depends on when the correct Form 8971 with Schedule(s) A is filed. The penalty is as follows.


http://www.aicpa.org/Advocacy/Tax/DownloadableDocuments/AICPA-Legis-Proposal-Estate-Basis-215-8-31-16.pdf

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$50 per Form 8971 (including all Schedule(s) A) if it is filed within 30 days after the due date. The maximum penalty is $532,000 per year (or $186,000 if the taxpayer qualifies for lower maximum penalties, as described below).

$260 per Form 8971 (including all Schedule(s) A) if it is filed more than 30 days after the due date or if it is not filed. The maximum penalty is $3,193,000 per year ($1,064,000 if the taxpayer qualifies for lower maximum penalties, as described below).

All penalty amounts shown are subject to adjustment for inflation. Lower maximum penalties. You qualify for lower maximum penalties if your average annual gross receipts for the 3 most recent tax years (or for the period you were in existence, if shorter) ending before the calendar year in which the information returns were due are $5 million or less. Intentional disregard of filing requirements. If any failure to file a correct Form 8971 or Schedule A is due to intentional disregard of the requirements to file a correct Form 8971 and Schedule(s) A, the minimum penalty is at least $530 per Form 8971 and the Schedule(s) A required to be filed with it, with no maximum penalty. Inconsequential error or omission. An inconsequential error or omission is not considered a failure to include correct information. An inconsequential error or omission does not prevent or hinder the IRS from processing the Form 8971 and the Schedule(s) A required to be filed along with it. Errors and omissions that are never inconsequential are those related to a TIN, a beneficiary's surname, and the value of the asset the beneficiary is receiving from the estate.”

The Form 8971 instructions also, separately, describe the potential penalties for failing to report timely and correctly Schedules A to the beneficiaries:

“Failure to furnish correct Schedules A to beneficiaries by the due date (section 6722). If the executor of an estate or other person required to file Form 8971 fails to provide a correct Schedule A to a beneficiary and does not show reasonable cause, a penalty may be imposed. The penalty applies if there is a failure to provide the Schedule A by the due date, a failure to include all information required to be shown on the schedule, a failure to include correct information on the schedule, or a failure to provide a correct supplemental Schedule A by the due date. The penalty applies for each Schedule A required to be provided. The amount of the penalty depends on when a correct Schedule A is provided. The penalty is as follows. $50 per Schedule A if it is provided within 30 days after the due date. The

maximum penalty is $532,000 per year (or $186,000 if the taxpayer qualifies for lower maximum penalties, as described below).

$260 per Schedule A if it is provided more than 30 days after the due date or if it is not provided. The maximum penalty is $3,193,000 per year ($1,064,000 if the taxpayer qualifies for lower maximum penalties, as described below).

All penalty amounts shown are subject to adjustment for inflation. Lower maximum penalties. You qualify for lower maximum penalties if your average annual gross receipts for the 3 most recent tax years (or for the period you


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were in existence, if shorter) ending before the calendar year in which the information returns were due are $5 million or less. Intentional disregard of filing requirements. If any failure to provide a correct Schedule A is due to intentional disregard of the requirements to provide correct Schedules A, the penalty is at least $530 per Schedule A with no maximum penalty. Inconsequential error or omission. An inconsequential error or omission is not considered a failure to include correct information. An inconsequential error or omission cannot reasonably be expected to prevent or hinder the beneficiary from timely receiving correct information and using the information to report basis on the beneficiary’s own return. Errors and omissions that are never inconsequential are those related to (a) the value of the asset the beneficiary is receiving from the estate, and (b) a significant item in a beneficiary's address. Reasonable cause exception to the penalties for failing to file Forms 8971 and Schedules A and for failing to provide Schedules A to beneficiaries. The penalties for failing to file correct Form 8971 and Schedules A with the IRS and for failing to provide correct Schedules A to beneficiaries will not apply to any failure that is shown to be due to reasonable cause and not to willful neglect. In general, it must be shown that the failure was due to an event beyond the taxpayer’s control or due to significant mitigating factors. It must also be shown that the executor or other person required to file acted in a responsible manner and took steps to avoid the failure. Penalties for Inconsistent Filing. Beneficiaries who report basis in property that is inconsistent with the amount on the Schedule A may be liable for a 20% accuracy-related penalty under section 6662.”

Effective Date and Extension Effective Date. The statutory Form 8971 filing deadline in sections 6035(a)(3)(A) (the earlier of 30 days after Form 706 is required to be filed (including extensions, if any) or 30 days after Form 706 is filed) applies to a Form 706 filed after July 31, 2015. Extension of Form 8971 Filing Deadline. The filing deadline for Form 8971 (and Schedule A) has been delayed three times: o Notice 2015-57 extended the original filing deadline to February 29, 2016 o Notice 2016-19 extended the deadline to March 31, 2016. o Notice 2016-27 (3/24/2016) – Extends the Form 8971 (and Schedule A) filing deadline

until June 30, 2016.

Proposed Regulations Effective Date and Reliance on Proposed Regulations:

Upon the publication of the Treasury Decision adopting these [proposed] rules as final in the Federal Register, this section will apply to property acquired from a decedent or by reason of the death of a decedent whose Form 706 is filed after July 31, 2015. Persons may rely upon these rules before the date of publication of the Treasury Decision adopting these rules as final in the Federal Register. (Reg. Preamble)




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The proposed regulations clarify that if Form 706 was required to be filed on or before July 31, 2015, but is filed after July 31, 2015, then Form 8971 and Schedule(s) A, “are due on or before the date that is 30 days after the date on which the estate tax return is filed [but subject to the Form 8971 deadline extension to June 30, 2016 in Notice 2016-27 (discussed above). Filing Relief if Form 706 is Not Required to Be Filed Form 8971 need not be filed where a Form 706 is filed but not required under Sec. 6018, for example:

o to elect spousal portability election with respect to an unused exclusion amount, o to make a generation-skipping transfer tax exemption allocation or election o "protective" returns filed solely to protect against a later-discovered filing

requirement (Prop. Reg. 1.6035-1(a)(2)). General Rule for Beneficiary. Prop. Reg. 1.1014-10(a)(1) provides that a taxpayer’s initial basis in certain property acquired from a decedent may not exceed the final value of the property “reported on [Form 706] as finally determined for purposes of the tax imposed by chapter 11.” (Reg. 1.1014-10(c) (emphasis added). Final Value. The final value of property determined for Federal estate tax purposes is

(A) the value reported on a Form 706 filed with the IRS that is not contested by the IRS before the period of limitation on assessment expires;

(B) the value specified by the IRS that is not timely contested by the executor of the estate; or

(C) the value is determined by a court or pursuant to a settlement agreement with the IRS. (Reg. 1.1014-10(c))

Example 1 in Reg. 1.1014-10(e) (full text):

“At D's death, D owned 50% of Partnership P, which owned a rental building with a fair market value of $10 million subject to nonrecourse debt of $2 million.

D's sole beneficiary is C, D's child. P is valued at $8 million. D's interest in P is reported on the return required by section 6018(a) at $4

million. The IRS accepts the return as filed and the time for assessing the tax under

chapter 11 expires. C sells the interest for $6 million in cash shortly thereafter. Under these facts, the final value of D's interest is $4 million under paragraph

(c)(1)(i) of this section. Under section 742 and §1.742-1, C's basis in the interest in P at the time of its sale

is $5 million (the final value of D's interest ($4 million) plus 50% of the $2 million nonrecourse debt).

Following the sale of the interest, C reports taxable gain of $1 million. C has complied with the consistency requirement of paragraph (a)(1) of this section.”


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Observation #1: The IRS example erroneously states that C’s taxable gain is $1,000,000. C’s taxable gain is actually $2,000,000 (Amount realized $7,000,000 ($6,000,000 (cash received) + $1,000,000 debt allocated to buyer (see reg. 1.752-1(h)) minus $5,000,000 (C’s O.B.))

Variation “(iii) Assume instead that the IRS adjusts the value of the interest in P to $4.5

million, and that value is not contested before the expiration of the time for assessing the tax under chapter 11.

The final value of D's interest in P is $4.5 million under paragraph (c)(1)(ii) of this section.

Under section 742 and §1.742-1, C claims a basis of $5.5 million at the time of sale and reports gain on the sale of $500,000.

C has complied with the consistency requirement of paragraph (a)(1) of this section.”

Observation #2: For the same reason as that discussed in observation #1 above, the correct gain is $1,500,000 (not $500,000). Debt allocated to the buyer must be included in C’s amount realized.

Example 4 in Reg. 1.1014-10(e) (full text): At D's death, D's gross estate includes a residence valued at $300,000 encumbered by

nonrecourse debt in the amount of $100,000. Title to the residence is held jointly by D and C (D's daughter) with rights of

survivorship. D provided all the consideration for the residence and the entire value of the residence

was included in D's gross estate. The executor reports the value of the residence as $200,000 on the return required by

section 6018 filed with the IRS for D's estate and claims no other deduction for the debt.

The statement required by section 6035 reports the value of the residence as $300,000.

C sells the residence before the final value is determined under paragraph (c)(1) of this section for $375,000 and claims a gain of $75,000 on C's Federal income tax return.

(ii) A court subsequently determines that the value of the residence was $290,000 and the time for contesting this value in any court expires before the expiration of the period for assessing C's income tax for the year of C's sale of the property.

The final value of the residence is $290,000 pursuant to paragraphs (c)(1)(iv) and (c)(2) of this section.

Because C claimed a basis in the residence that exceeds the final value, C may have a deficiency and underpayment.

If ANY Estate Tax is Owed, All Nonexempt Property Increases Federal Estate Tax The preamble to the proposed regulations clarifies that “if any Federal estate tax liability is incurred, all of the property in the gross estate (other than [exempted marital deduction property, charitable deduction property, or tangible personal property for which no


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appraisal is required]) is deemed to increase the Federal estate tax liability and is subject to the consistency requirement of section 1014(f).” Zero Basis Rule If property is discovered after the Form 706 is filed or is otherwise omitted from the return, then provided the statute of limitations is open and executor reports the after-discovered or omitted property, then the final value is determined under the above rules in Reg. 1.1014-10(c). Conversely, if the after-discovered or omitted property is not reported before the period of limitation on assessment expires, then the final value of the after-discovered or omitted property is zero. (Prop. Reg. 1.1014-10(c)(3)(i)(B)) If no initial or corrected estate tax return is filed, then “the final value of that unreported property is zero.” See Example 3 of paragraph (e) of this section. Example 2 in Reg. 1.1014-10(e) (full text): “At D's death, D owned (among other assets) a private residence that was not

encumbered. D's sole beneficiary is C. D's executor reports the value of the residence on the return required by section

6018(a) as $600,000 and pays the tax liability under chapter 11. The IRS timely contests the reported value and determines that the value of the

residence is $725,000. The parties enter into a settlement agreement that provides that the value of the

residence for purposes of the tax imposed by chapter 11 is $650,000. Pursuant to paragraph (c)(1)(iii) of this section, the final value of the residence is

$650,000. (ii) Several years later, C adds a master suite to the residence at a cost of $45,000.

Pursuant to section 1016(a), C's basis in the residence is increased by $45,000 to $695,000.

Subsequently, C sells the residence to an unrelated third party for $900,000. C claims a basis in the residence of $695,000 and reports a gain of $205,000 ($900,000-$695,000).

Conclusion: C has complied with the consistency requirement of paragraph (a)(1) of this section.” Example 3 in Reg. 1.1014-10(e) (full text): The facts are the same as in Example 2 but, after the expiration of the period for

assessing the tax imposed by chapter 11, the executor discovers property that had not been reported on the return required by section 6018(a) but which, if reported, would have generated additional chapter 11 tax on the entire value of the newly discovered property.


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Pursuant to paragraph (c)(3)(i)(B) of this section, C's basis in the residence of $695,000 does not change, but the final value of the additional unreported property is zero.

(ii) Alternatively, assume that no return was required to be filed under section 6018 before discovering the additional property (and none in fact was filed) but, after the application of the applicable credit amount, D's taxable estate including the unreported property would have been $200,000.

Pursuant to paragraph (c)(3)(ii) of this section, the final value of all property included in D's gross estate that is described in paragraph (b) of this section is zero until the executor files an estate tax return with the IRS pursuant to section 6018 or the IRS determines a value for the property.

In either of those events, the final value of property described in paragraph (b) of this section reported on the return is determined in accordance with paragraph (c)(1) or (c)(2) of this section.

Penalty Exclusions. The regulations reiterate that the penalty on the beneficiary for overstating basis (section 1014(f)(1)) only applies to property included in the gross estate that increased the estate's liability for the Federal estate tax reduced by credits allowable against the tax. The proposed regs. also specifically exclude from the section 1014(f) penalty on the beneficiary: all property reported on Form 706 that qualifies for a charitable or marital deduction

under sections 2055, 2056, or 2056A because this property does not increase the estate tax liability.

The prop. regs. also exclude from the penalty tangible personal property with a total value of $3,000 or less (property for which no appraisal is required). Reg. 1.1014-10(b)(2).

Form 8971 Reporting and Exceptions Prop. Reg 1.6035-1(b)(1) mandates reporting on Form 8971 for "all property reported or required to be reported on [Form 706]" as well as any new property the basis of which is determined by reference to property reported on the estate return, such as in like-kind exchanges or involuntary conversions. Exceptions. Specifically exempted from reporting are:

Cash (other than coin collections or other currency with numismatic value); Income in respect of a decedent; Tangible personal property for which an appraisal is not required--household and

personal effects articles having marked artistic or intrinsic value of a total value of $3,000 or less;

“Property sold, exchanged, or otherwise disposed of (and therefore not distributed to a beneficiary) by the estate in a transaction in which capital gain or loss is recognized.”


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Reg. 1.6035-1(b)(2) Example (1) (full text): Included in D's gross estate are the contents of his residence. Pursuant to §20.2031-6(a), the executor attaches to the return required by section 6018

filed for D's estate a room by room itemization of household and personal effects. All articles are named specifically. In each room a number of articles, none of which has a value in excess of $100, are

grouped. A value is provided for each named article. Included in the household and personal effects are a painting, a rug, and a clock, each of

which has a value in excess of $3,000. Pursuant to §20.2031-6(b), the executor obtains an appraisal from a disinterested,

competent appraiser(s) of recognized standing and ability, or a disinterested dealer(s) in the class of personalty involved for the painting, rug, and clock.

The executor attaches these appraisals to the estate tax return for D's estate. Pursuant to paragraph (b)(1)(iii) of this section, the reporting requirements of paragraph

(a)(1) of this section apply only to the painting, rug, and clock. Reg. 1.6035-1(b)(2) Example 2.

Included in D's estate are shares in C, a publicly traded company. Shortly after D's death but prior to the filing of the estate tax return for D's estate, C is

acquired by T, also a publicly traded company. For the shares in C includible in D's estate, the estate receives new shares in T and cash in

a fully taxable transaction. Pursuant to paragraph (b)(1)(iv) of this section, the reporting requirements of paragraph

(a)(1) of this section do not apply to the new shares in T or the cash. Supplemental Reporting Prop. Regs 1.6035-1(e)(2) requires broad supplemental reporting rules. Full text of Reg. 1.6035-1(e) Duty to supplement: 1) In general. In the event of any adjustment to the information required to be reported on the

Information Return or any Statement as described in paragraph (e)(2) of this section, the executor must file a supplemental Information Return with the IRS including all supplemental Statements and furnish a corresponding supplemental Statement to each affected beneficiary by the due date described in paragraph (e)(4) of this section.

2) Adjustments requiring supplement. Except as provided in paragraph (e)(3) of this section, an adjustment to which the duty to supplement applies is any change to the information required to be reported on the Information Return or Statement that causes the information as reported to be incorrect or incomplete. Such changes include, for example, the discovery of property that should have been (but was not) reported on an estate tax return described in section 6018, a change in the value of property pursuant to an examination or litigation, or a change in the identity of the beneficiary to whom the property is to be distributed (pursuant to a death, disclaimer, bankruptcy, or otherwise). Such changes also include the executor's disposition of property acquired from the decedent or as a result of the death of the decedent


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in a transaction in which the basis of new property received by the estate is determined in whole or in part by reference to the property acquired from the decedent or as a result of the death of the decedent (for example as the result of a like-kind exchange or involuntary conversion). Changes requiring supplement pursuant to this paragraph (e)(2) are not inconsequential errors or omissions within the meaning of §301.6722-1(b) of this chapter.

3) Adjustments not requiring supplement

(i.) In general. A supplemental Information Return and Statement may but they are not required to be filed or furnished (A) To correct an inconsequential error or omission within the meaning of §301.6722-

1(b) of this chapter, or (B) To specify the actual distribution of property previously reported as being available

to satisfy the interests of multiple beneficiaries in the situation described in paragraph (c)(3) of this section.

Reg. 1.6035-1(e)(3)(ii) Example (1):

D's Will provided for D's residuary estate to be distributed to D's three children (E, F, and G).

D's residuary estate included stock in a publicly traded company (X), a personal residence, and three paintings.

On the due date of the Information Return and Statement required by paragraph (a)(1) of this section, D's executor had not yet determined which property each child would receive from D's residuary estate in satisfaction of that child's bequest.

In accordance with paragraph (c)(3) of this section, D's executor reported on the Information Return filed with the IRS and on each child's own Statement that E, F, and G each might receive an interest in the stock in X, the personal residence, and the three paintings.

Several months later, the executor determined that E would receive the stock in X, F would receive the residence, and G would receive the paintings.

Paragraph (e)(3)(i)(B) of this section provides that the executor may but is not required to file a supplemental Information Return with the IRS and furnish supplemental Statements to E, F, and G to accurately report which beneficiary received what property.

Reg. 1.6035-1(e)(3)(ii) Example (2):

D's Will provided that D's jewelry and household effects (personalty) are to be distributed among D's three children (E, F, and G) as determined by E, F, and G.

In accordance with paragraph (c)(3) of this section, D's executor reports on the Information Return filed with the IRS and on each child's own Statement each item of personalty other than items described in paragraph (b)(1)(iii) of this section.

Several months later, E, F, and G determine who is to receive each item of personalty. Paragraph (e)(3)(i)(B) of this section provides that the executor may but is not required to

file a supplemental Information Return with the IRS and furnish supplemental Statements to E, F, and G to accurately report which beneficiary received which item(s) of personalty.


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Timing of Supplemental Reporting Full Text of Reg. 1.6035-1(e)(4)Due date of supplemental reporting- (i) In general. Except as provided in paragraph (e)(4)(ii) of this section, the

supplemental Information Return must be filed and each supplemental Statement must be furnished on or before 30 days after- (A) The final value within the meaning of §1.1014-10(c)(1) is determined; (B) The executor discovers that the information reported on the Information Return

or Statement is otherwise incorrect or incomplete, except to the extent described in paragraph (e)(3)(i) of this section; or

(C) A supplemental estate tax return under section 6018 is filed reporting property not reported on a previously filed estate tax return pursuant to §1.1014- 10(c)(3)(i). In this case, a copy of the supplemental Statement provided to each beneficiary of an interest in this property must be attached to the supplemental Information Return.

(ii) Probate property or property from decedent's revocable trust. With respect to

property in the probate estate or held by a revocable trust at the decedent's death, if an event described in paragraph (e)(4)(i)(A), (B), or (C) of this section occurs after the decedent's date of death but before or on the date the property is distributed to the beneficiary, the due date for the supplemental Information Return and corresponding supplemental Statement is the date that is 30 days after the date the property is distributed to the beneficiary. If the executor chooses to furnish to the beneficiary on the Statement information regarding any changes to the basis of the reported property as described in §1.1014-10(a)(2) that occurred after the date of death but before or on the date of distribution, that basis adjustment information (which is not part of the requirement under section 6035) must be shown separately from the final value required to be reported on that Statement.

Subsequent Transfers Additional reporting is required where a recipient of property that was previously reported or required to be reported on Form 8971 and Schedule(s) A, then distributes or otherwise transfers (such as by gift) property to a related transferee, where the related tranferee's basis is determined wholly or partly based upon the recipient/transferor's basis. The recipient/transferor (instead of the executor) must file a supplemental statement with the IRS and furnish a copy of the supplemental statement no later than 30 days from the transfer by the recipient/transferor. There is no apparent time limit on this proposed rule.

Related Transferee. “For purposes of this provision, a related transferee means any member of the transferor's family as defined in section 2704(c)(2), any controlled entity (a corporation or any other entity in which the transferor and members of the transferor's family (as defined in section 2704(c)(2)), whether directly or indirectly,


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have control within the meaning of section 2701(b)(2)(A) or (B)), and any trust of which the transferor is a deemed owner for income tax purposes.”

Reg. 1.6035-1(i) Effective/applicability date “Upon the publication of the Treasury Decision adopting these rules as final in the Federal Register, this section will apply to property acquired from a decedent or by reason of the death of a decedent whose return required by section 6018 is filed after July 31, 2015. Persons may rely upon these rules before the date of publication of the Treasury Decision adopting these rules as final in the Federal Register.” Additional Resources: Link to AICPA comments on proposed regs:

http://www.aicpa.org/Advocacy/Tax/DownloadableDocuments/Aicpa-comments-on-prop-regs-estate-

tax-basis-consistency-6-1-16.pdf

Estate of Sarah D. Holliday, TC Memo 2016-51 (March 17, 2016) -- Assets

Decedent Transferred To Limited Partnership Were Pulled Into Gross Estate Shortly before she died, the decedent transferred her marketable securities (worth about $6 million) to a partnership, Oak Capital in exchange for a 99.9% partnership interest. She gifted 10% of her partnership interest before she died. She died in 2009 when the partnership assets were worth about $4 million. The estate valued the 89.9% partnership interest at about $2.4 million. The IRS determined an estate tax deficiency of $785,019. Tax Court’s conclusion:

Taking all of the facts and circumstances surrounding Oak Capital's formation into account, we find that decedent did not have a legitimate and significant nontax reason for transferring assets to Oak Capital. We also observe that Oak Capital held marketable securities that were not actively managed and were traded only on limited occasions. Despite the purported nontax reasons for Oak Capital's formation, on the record before the Court, the estate has failed to show that there were significant legitimate reasons. Because we have found and hold that there was not a bona fide sale, there remains no reason to address whether decedent received adequate compensation. On the basis of the foregoing, we hold that the value of the assets decedent transferred to Oak Capital should be included in the value of decedent's gross estate pursuant to section 2036(a)(1). (citations omitted)


http://www.aicpa.org/Advocacy/Tax/DownloadableDocuments/Aicpa-comments-on-prop-regs-estate-tax-basis-consistency-6-1-16.pdf

http://www.aicpa.org/Advocacy/Tax/DownloadableDocuments/Aicpa-comments-on-prop-regs-estate-tax-basis-consistency-6-1-16.pdf


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Estate of Edward G. Beyer, TC Memo 2016-183 (9/29/2016) – Beyer’s Remorse: A Doomed Estate Tax Plan

Judge Chiechi’s summary of the 119 page opinion:

[IRS] determined a deficiency of $19,066,532 in Federal estate tax (estate tax) with respect to the Estate of Edward G. Beyer (decedent's estate). [IRS] also determined a deficiency in, and additions under section 6651(a)(1) and (2) 1 to, Edward G. Beyer's Federal gift tax (gift tax) for his taxable year 2002 of $174,300, $43,575, and $39,217, respectively. [IRS] further determined a deficiency in, and an accuracy-related penalty under section 6662(a) on, Edward G. Beyer's gift tax for his taxable year 2005 of $3,933,948 and $786,790, respectively. The issues remaining for decision are: 1. Is the value of assets that Edward G. Beyer transferred to a certain limited

partnership includible in the value of his gross estate under section 2036(a)? We hold that it is.

2. Is decedent's estate entitled to discount the value on the alternate valuation date of assets of a certain limited partnership, which the parties stipulated, that we have held is includible in the value of his gross estate under section 2036(a) in order to determine the value of those assets on that date that is so includible? We hold that it is not.

3. Are the $55,000 that Edward G. Beyer contributed in 2002 to each of ten so-called section 529 accounts and the $55,000 that he contributed in 2005 to each of eight section 529 accounts taxable gifts that he made during his taxable years 2002 and 2005, respectively? We hold that all of those contributions are.

4. Is Edward G. Beyer liable for an addition to gift tax under section 6651(a)(1) for his taxable year 2002? We hold that he is.

5. Is Edward G. Beyer liable for an addition to gift tax under section 6651(a)(2) for his taxable year 2002? We hold that he is.

6. Is Edward G. Beyer liable for the accuracy-related penalty under section 6662(a) for his taxable year 2005 on the portion of the underpayment in gift tax for that year that is attributable to the $55,000 that he contributed to each of eight section 529 accounts in that year? We hold that he is.



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Estate of James Heller, 147 TC No. 11 (9/26/2016) -- Estate Allowed To Deduct Madoff Ponzi Scheme Losses Through Partnership

The Tax Court, in a case of first impression, upheld an estate's theft loss deduction under section 2054 for losses incurred by a limited liability company (LLC) in which it held a 99% interest. The LLC's sole asset was an account that became worthless as a result of Bernie Madoff's Ponzi scheme. Background. Section 2054 Losses states: “For purposes of the tax imposed by section 2001, the value of the taxable estate shall be determined by deducting from the value of the gross estate losses incurred during the settlement of estates arising from fires, storms, shipwrecks, or other casualties, or from theft, when such losses are not compensated for by insurance or otherwise.” Summary per the Tax Court:

[Estate] E held a 99% interest in [James Heller Family LLC (JHF)], which held an account with [Madoff Securities] MS as its only asset. [JHF] distributed to E a portion of the funds from the MS account, and E used those funds to pay estate taxes and administrative expenses. Before E could distribute its remaining assets to [Decedent’s] D's beneficiaries, MS' chairman [Bernie Madoff] was arrested on, and pleaded guilty to, charges relating to a Ponzi scheme. As a result of the Ponzi scheme, the MS account became worthless, and E, on its Federal estate tax return, deducted a theft loss relating to its interest in [JHF]. [The Estate’s Form 706 included JHF, valued at $16,560,990, and the Estate’s theft loss deduction was $5,175,990 reflecting the difference between the value of the Estate’s interest in JHF reported on Form 706 and the estate's share of the amounts withdrawn from the Madoff account with JHF ]. In a notice of deficiency issued to E, R determined that E was not entitled to an I.R.C. sec. 2054 theft loss deduction. E challenged the determination and moved for summary judgment. R objected, contended that [JHF] owned the MS account, and moved for partial summary judgment. Held: E, pursuant to I.R.C. sec. 2054, is entitled to a deduction relating to its interest in [JHF].

Tax Court’s reasoning:

The estate tax is imposed on the value of property transferred to beneficiaries. See secs. 2001, 2031(a), 2051. In that context, a loss refers to a reduction of the value of property held by an estate. See Black's Law Dictionary 1087 (10th ed. 2014) (defining a loss as “the disappearance or diminution of value”). While JHF lost its sole asset as a result of the Ponzi scheme, the estate, during its settlement, also incurred a loss because the value of its interest in JHF decreased from $5,175,990 to zero.



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[IRS] concedes that Madoff Securities defrauded JHF but contends that the estate is not entitled to a section 2054 deduction because JHF incurred the loss. In support of this contention, respondent emphasizes that pursuant to New York law, JHF, not the estate, was the theft victim. Section 2054, however, allows for a broader nexus (i.e., between the theft and the incurred loss) than does respondent's narrow interpretation. “Arise” is generally defined as “to originate from a source”. See Merriam-Webster's Collegiate Dictionary 62 (10th ed. 2001). Pursuant to the phrase “arising from” in section 2054, the estate is entitled to a deduction if there is a sufficient nexus between the theft and the estate's loss. See White v. Commissioner, 48 T.C. 430, 435 (1967) (finding a similarity between losses caused by direct and proximate damage of a section 165(c)(3) “other casualty” and those arising from the specifically enumerated section 165(c)(3) causes). It is sufficient indeed. The nexus between the theft and the value of the estate's JHF interest is direct and indisputable. The loss suffered by the estate relates directly to its JHF interest, the worthlessness of which arose from the theft. Thus, the estate is entitled to a section 2054 deduction relating to its JHF interest. We need not address whether a mere tangential or more circuitous relationship would suffice.

Estate of Dieringer, 146 T.C. No. 8 (3/30/2016) – Estate Denied Full Charitable

Deduction Tax Court’s Summary:

Decedent (D) and some family members owned DPI, a closely held real property management corporation. D was a majority shareholder in DPI, owning 425 out of 525 voting shares and 7,736.5 out of 9,920.5 nonvoting shares. During her life D established Trust (T) and Foundation (F). Her son G was sole trustee of T and F. D's will left her entire estate to T. Pursuant to the terms of the trust agreement, $600,000 went to various charitable organizations and D's children received minor amounts of her personal effects. The remainder of her estate, consisting primarily of DPI stock, would be distributed to the acting trustee of F to be administered in accordance with the terms of the trust agreement. An appraisal for purposes of determining the date-of-death fair market value (FMV) of D's property valued D's DPI nonvoting and voting shares at $14,182,471. The appraisal valued the voting stock at $1,824 per share with no applicable discount. The nonvoting stock was valued at $1,733 per share, including a 5% discount to reflect the lack of voting power at shareholder meetings. Numerous events occurred after D's death but before D's bequeathed property was transferred to F. Seven months after D's death DPI elected S corporation status. DPI also agreed to redeem all of D's bequeathed shares from T. DPI and T amended and modified the redemption agreement, with DPI agreeing to redeem



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all 425 of the voting shares but only 5,600.5 of the nonvoting shares. In exchange for the redemption, T received a short-term promissory note for $2,250,000 and a long-term promissory note for $2,968,462 (as amended). At the same time as the redemption, pursuant to subscription agreements, three of D's sons, including G, purchased additional shares in DPI. F later reported that it had received three noncash contributions consisting of the short-term and long-term promissory notes (as amended) plus nonvoting DPI shares. An appraisal of D's DPI stock for purposes of the redemption and subscription agreements determined that D's DPI voting shares had a FMV of $916 per share and the nonvoting shares, of $870 per share. The appraisal of the voting stock included discounts of 15% for lack of control and 35% for lack of marketability. The appraisal of the nonvoting stock included the lack of control and marketability discounts plus an additional 5% discount for the lack of voting power at stockholder meetings. The parties dispute the amount of the charitable contribution. The estate (E) argues that the charitable contribution should not depend upon or be measured by the value received by F. Respondent (R) argues that the amount of the charitable contribution should be determined by postdeath events. Because R found that the value of E's charitable contribution was lower than reported on its Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, R determined that additional estate tax is due. R also determined that E is liable for an accuracy-related penalty under I.R.C. sec. 6662(a) for an underpayment attributable to negligence or disregard of rules or regulations within the meaning of I.R.C. sec. 6662(b)(1). Held: E's charitable contribution is less than the date-of-death fair market value of the bequeathed property because numerous events occurred after D's death that changed the nature and reduced the value of the property that was actually transferred to F. Held, further, R properly allocated the proportionate share of additional estate tax due to each of the specific bequests and reduced the charitable contribution deduction attributable to those bequests respectively. Held, further, E is liable for an accuracy-related penalty under I.R.C. sec. 6662(a) for an underpayment attributable to negligence.

Tax Court comment about DPI drop in value:

Even though there were valid business reasons for the redemption and subscription transactions, the record does not support a substantial decline in DPI's per share value. Eugene testified that the precipitous drop in the value of the DPI shares was the result of a poor business climate. The evidence does not


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support a significant decline in the economy that resulted in a large decrease in value in only seven months. The adjusted net asset value of DPI was only $1,618,459 higher in the April appraisal. The reported decline in per share value was primarily due to the specific instruction to value decedent's majority interest as a minority interest with a 50% discount.

Redstone, T.C. Memo 2015-237 (December 9, 2015) – Donor Liable for Gift Tax 40 Years After the Gift

Tax Court Summary (modified): IRS determined against taxpayer a gift tax deficiency of $737,625 for the calendar quarter ending September 30, 1972. IRS also determined an addition to tax of $368,813 under section 6653(b) for fraud and (alternatively) an addition to tax of $36,881 under section 6653(a) for negligence and an addition to tax of $184,406 under section 6651(a)(1) for failure to file a timely gift tax return. The focus of the parties’ dispute is whether taxpayer’s 1972 transfer of stock to his children was a “gift” for Federal gift tax purposes or was (as petitioner contends) a transfer for an “adequate and full consideration in money or money’s worth.” See sec. 2512(b). The Tax Court found that this transfer was a taxable gift and determined its value on the transfer date. The Court concluded that the taxpayer was not liable for any penalties. CCA 201643020 (released 10/21/2016) -- Statute of Limitations Not Extended

When Prior Year Gifts are Omitted from Form 709 Background in CCA:

Section 6501(a) provides that, generally, tax must be assessed within three years of when the return was filed. There is a limited exception to this general limitation period for unreported gifts. Section 6501(c)(9) states:

If any gift of property the value of which . . . is required to be shown on a return of tax imposed by chapter 12 (without regard to section 2503(b)), and is not shown on such return, any tax imposed by chapter 12 on such gift may be assessed, or a proceeding in court for the collection of such tax may be begun without assessment, at any time. The preceding sentence shall not apply to any item which is disclosed in such return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature of such item.

Issue per Chief Counsel:




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Where a taxpayer filed a gift tax return that reported a gift for the calendar year in which the gift was made but did not report prior years' gifts on the return as required, causing an under assessment of tax on the reported gift, whether section 6501(c)(9) of the Internal Revenue Code provides an extended period of limitation for assessing the additional tax due on the reported gift.

Conclusion per Chief Counsel:

No. Section 6501(c)(9) only applies to gifts that were not reported on a gift tax return. Because the gift was reported on the gift tax return, the extended period of limitation for assessing additional tax due on the reported gift in section 6501(c)(9) does not apply to the reported gift, even though prior years' gifts were not reported on the return.

Specht v. U.S., (CA 6 9/22/2016) -- Malpractice by Return Preparer

Insufficient Defense To Estate's Late Filing The IRS assessed penalties and interest on the penalties totaling $1,189,261.38 against the estate of Virginia L. Escher (Estate) for its failure to timely file its tax return and pay its tax liability. Finding that the Estate showed neither reasonable cause nor an absence of willful neglect to excuse the late filing and payment, the district court granted the government's motion for summary judgment. The Sixth Circuit affirmed the district court’s holding. The attorney for the estate failed to perform numerous duties with respect to the estate, including timely filing the estate tax return, but the estate did not meet the reasonable cause standard for avoiding late filing and late payment penalties where the executor had evidence that the attorney was lying. Sixth Circuits reasoning:

Although the Tax Code does not define ‘reasonable cause,’ ‘the relevant Treasury Regulation calls on the taxpayer to demonstrate that [s]he exercised 'ordinary business care and prudence' but nevertheless was 'unable to file the return within the prescribed time.'’ Boyle, 469 U.S. at 245 (citing 26 CFR § 301.6651–1(c)(1)) (emphasis added). In Boyle, the leading case interpreting the Tax Code's ‘reasonable cause’ exception1 , the Supreme Court declared that ‘[t]he time has come for a rule with as 'bright' a line as can be drawn ... Congress has placed the burden of prompt filing on the executor, not on some agent or employee of the executor.... Congress intended to place upon the taxpayer an obligation to ascertain the statutory deadline and then to meet that deadline, except in a very narrow range of situations.’ Id. at 249–50. The Court explained that ‘tax returns imply deadlines. Reliance by a lay person on a lawyer is of course common; but that reliance cannot function as a substitute for compliance with an unambiguous statute.’ Id. at 251. The Court therefore concluded that ‘Congress has charged the executor with an unambiguous, precisely defined duty to file the return within nine months ... That the attorney, as the executor's agent, was expected to attend to the matter does not relieve the principal of his duty to comply with the statute.’ Id. at 250.


http://www.opn.ca6.uscourts.gov/opinions.pdf/16a0545n-06.pdf

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The Estate attempts to distinguish Boyle on the basis that Specht was unqualified to be an executor, and her reliance on [attorney] Backsman was thus more reasonable than the reliance in Boyle and our cases following Boyle. To be sure, the Boyle Court left open the possibility that an executor's qualifications might impact the reasonableness analysis, id. at 248 n.6, and Justice Brennan's concurrence includes taxpayers suffering from “senility, mental retardation or other causes' as examples of the ‘exceptional cases' that might render an individual unable to comply with the statutory deadlines. Id. at 255 (Brennan, J., concurring). But even Justice Brennan observed that the “overwhelming majority” of individuals are capable of complying with the deadlines. Id. **** Finally, our recent unpublished decision in Vaughn v. United States, 635 F. App'x 216 [116 AFTR 2d 2015-7022] (6th Cir. 2015), confirms Boyle's bright-line rule. There, Mo Vaughn, a former Major League Baseball player, hired a wealth-management firm and a tax accountant to manage his finances, prepare and file his tax returns, and make payments. Vaughn, 635 F. App'x at 218. Rather than pay Vaughn's taxes, Vaughn's financial manager embezzled millions of dollars from him. Id. Though we expressed sympathy for Vaughn, we affirmed the district court's grant of summary judgment to the government, concluding that “Vaughn's statutory duty is non-delegable and is not excused because of the felonious actions of his financial agents.” Id. at 217. ‘Taxpayers are ... expected to know that they must file a return and pay their taxes.... [Vaughn] is facing penalties because he relied on [his agents] to complete and file his tax returns.’ Id. at 220. Finally, we reiterated our interpretation of reasonable cause to mean ‘something that is beyond the taxpayer's possible control and oversight, not something that occurs under his authorization and subject to his control.’ Id. at 221. **** We acknowledge that Specht was the victim of staggeringly inadequate legal counsel and there is no evidence of purposeful delay. However, although the circumstances are unfortunate, Boyle, Valen, andVaughn make it clear that the duties to file a tax return and pay taxes are non-delegable and mere good-faith reliance does not constitute reasonable cause. Specht signed forms undertaking fiduciary obligations as the executor of the estate, and, despite knowing that her responsibilities were important, asked no questions about what her job entailed. Further, Specht knew the initial filing deadline was September 30, 2009, and understood that there would be consequences for a failure to timely file. She received multiple warnings regarding Backsman's deficient performance but took no steps to replace her until more than a year after the IRS deadline passed, instead relying solely on Backsman's assurances that an extension had been obtained. Although Backsman's representation was certainly an obstacle, Specht was notunable to file the return or pay the liability on behalf of the Estate. Specht could have more seriously considered the numerous warning signs of Backsman's incompetence and replaced her at any time; she has not shown reasonable cause to excuse the Estate's late filing and payment.


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Because we affirm the grant of summary judgment on the basis that the Estate has not met its heavy burden of showing reasonable cause for its failure to file its tax return and pay its tax liability by the applicable deadline, we need not reach the question whether Specht willfully neglected her duty to do so.

Estate of La Sala, TC Memo 2016-42 (3/8/2016) -- Gift Tax Return Filed As Part Of Estate Tax Settlement Cannot Escape Interest

The Tax Court has held that an estate's agreement to file a 2003 gift tax return and pay the gift tax due of $235,207, as part of a November 2010 settlement with IRS that reduced the estate tax deficiency, did not prevent statutory interest of $137,752 from accruing with respect to the gift tax:

The estate's explicit concession that [Decedent] made a taxable gift in 2003 established a gift tax liability for that year. That concession was binding even though no gift tax liability was determined in the notice of deficiency commencing the estate tax case. The estate owes interest on this gift tax liability, just as it would owe interest on any other tax liability not paid at the prescribed time. Sec. 6601; see Gen. Dynamics Corp. v. United States, 562 F.2d 1201 [40 AFTR 2d 77-5161] (Ct. Cl. 1977).

The Tax Court further noted that the estate missed the deduction for the interest:

The estate contends that upholding its liability for interest on the 2003 gift tax would be inequitable because it is now prevented by the statute of limitations from claiming a deduction for that interest against the estate tax. Although we have some sympathy for the estate's position, the responsibility for claiming deductions lies with the taxpayer. The estate's failure to claim a timely deduction for interest does not justify setting aside the statutory interest to which the Government is entitled. See Carlson v. United States (In re Carlson), 126 F.3d 915, 920 [80 AFTR 2d 97-6558] [*16] (7th Cir. 1997) (noting that a court may not use its equitable powers to circumvent the statute's mandatory imposition of interest).

PLR 201626016 (March 15, 2016) -- Trust Termination Did Not Triger GST

tax Background: In the facts of the PLR, the Trust was irrevocable on September 25, 1985, and no additions, actual or constructive, were made to Trust after that date. Such pre-1986 trusts are exempt from the GSTT. IRS explanation of GSTT exemption:



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Under § 1433 of the Tax Reform Act of 1986 (the Act), GST tax is generally applicable to generation-skipping transfers made after October 22, 1986. However, under § 1433(b)(2)(A) of the Act and § 26.2601-1(b)(1)(i) of the Generation-Skipping Transfer Tax Regulations, the tax does not apply to a transfer under a trust that was irrevocable on September 25, 1985, except to the extent the transfer is made out of corpus added to the trust by an actual or constructive addition after September 25, 1985.

Section 26.2601-1(b)(4)(i)(D) provides that a modification of the governing instrument of an exempt trust … by judicial reformation, or nonjudicial reformation that is valid under applicable state law will not cause an exempt trust to be subject to the provisions of chapter 13, if the modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation (as defined in § 2651) than the person or persons who held the beneficial interest prior to the modification, and the modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust. A modification of an exempt trust will result in a shift in beneficial interest to a lower generation beneficiary if the modification can result in either an increase in the amount of a generation-skipping transfer or the creation of a new generation-skipping transfer.

IRS Ruling. IRS ruled that the termination of a trust pursuant to a court-approved nonjudicial settlement agreement—by making distributions to existing beneficiaries who were grandchildren and great-grandchildren to the exclusion of future beneficiaries—did not cause the trust to become subject to generation-skipping transfer (GST) tax under chapter 13. Per the PLR:

Based upon the facts submitted and the representations made, we conclude that the proposed termination of Trust pursuant to the Court-approved Nonjudicial Settlement Agreement will not cause a beneficial interest to be shifted to a beneficiary who occupies a generation lower than the beneficiaries who held the interests prior to the termination, or extend the time for vesting of any beneficial interest in Trust beyond the period provided for in the original Trust. Accordingly, we rule that the proposed termination of Trust will not cause Trust to become subject to GST tax under chapter 13, and that no termination distribution made pursuant to Order will be a direct skip, a taxable distribution or a taxable termination within the meaning of § 2612.

The IRS also concluded that no such distribution would be a direct skip, a taxable distribution, or a taxable termination under Code Sec. 2612.


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U.S. v. McNicol, (CA 1 7/15/2016) -- Executrix Personally Liable For Unpaid Estate Taxes

The First Circuit, affirming a district court, found that a surviving spouse who served as executrix of her deceased husband's estate was personally liable for the estate's unpaid tax in an amount equal to the value of the assets that she transferred to herself instead of using to pay the estate tax:

“In this case, the district court concluded that all three requirements for section 3713(b) liability were satisfied. This conclusion finds solid footing in the record. The acknowledged facts unambiguously demonstrate that the appellant effected asset transfers by distributing virtually all of the assets of [the estate] to herself; that the estate was insolvent at the time of these transfers because its unpaid federal income tax liabilities far exceeded the value of the estate's assets; and that the appellant was aware of the unpaid tax liabilities when she effected the transfers. No more is exigible for a finding of section 3713(b) liability.”

U.S. v. Spoor, (CA 11 10/04/2016) -- Executor's Commissions Did Not Have Priority Over Estate Tax Lien

Eleventh Circuit summary:

In this tax case, the United States appeals the district court's determination that [$1,086,265 of] commissions claimed by Defendant F. Gordon Spoor as personal representative of the Louise P. Gallagher Estate and as trustee of the Louise Paxton Gallagher Revocable Trust have priority over a special deferred estate tax lien on property designated by agreement under I.R.C. § 6324A. Our review, aided by oral argument, of the text and structure of §6324A leads us to the opposite conclusion. We agree with the United States that special estate tax liens on property designated by §6324A, unlike estate tax liens on the gross estate pursuant to §6324, are not subject to an executor's claims for administrative expenses. We also hold that Spoor's administrative expenses do not take priority over income tax liens imposed pursuant to §6321.

Observation: Because, at the time of summary judgment, the executor had paid himself $600,000 of his $1,086,265 commission claim, presumably he will need to pay the $600,000 back to either the estate or the IRS.

Undisputed facts per the court:

On October 17, 1989, Louise Paxton Gallagher created the Louise P. Gallagher Revocable Trust ("Trust"). When Gallagher died on July 5, 2004, the Trust contained 3,970 membership units (later redenominated as 39,700 units) in Paxton Media Group, LLC ("Paxton"), a privately held and family-owned newspaper


http://media.ca1.uscourts.gov/pdf.opinions/15-2214P-01A.pdf


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publishing company. Defendant F. Gordon Spoor is the personal representative of Gallagher's estate as well as the trustee of the Trust. On September 30, 2005, Spoor filed a Form 706 federal estate tax return on behalf of the Estate. The tax return valued the Estate at $36,624,546, of which $34,936,000 reflected the Paxton membership units held in the Trust. The return reported a federal estate tax liability of $15,524,223. Spoor claimed a $1,086,265 deduction for his personal representative fee for administering the Estate. The IRS challenged the valuation of the Paxton units, and the Estate filed a petition in Tax Court to contest the deficiency determination. The Tax Court valued the Paxton units at $35,761,760, and assessed an additional estate tax liability and failure to pay penalties totaling $401,743.89. On its estate tax return the Estate elected to defer and pay its estate tax liability in ten equal installments, pursuant to I.R.C. §6166. The Estate made tax payments totaling $3,007,364.83 in 2005, and a payment of $687.70 in March 2006. The Estate made additional payments of between $1.7 million and $1.8 million each in April of 2006, 2007, and 2008. In August 2010, the Estate agreed to the creation of a special deferred estate tax lien on the Paxton units pursuant to §6324A. The IRS recorded notice of the lien in the public records of McCracken County, Kentucky, on September 3, 2010. By 2012 the value of the Paxton units had become less than the unpaid portion of the deferred tax and interest, and the IRS demanded additional collateral from the Estate. When the Estate was unable to provide additional collateral within 90 days, the IRS accelerated the remaining deferred tax obligations. As of September 10, 2013, the remaining estate tax, penalties, and interest totaled $10,483,006.47. Because the Estate also failed to pay its reported income taxes, as of September 2013 the Estate owed an additional $551,106.39 in income tax, penalties, and interest. Pursuant to §6321, the failure to pay income tax liabilities resulted in federal tax liens attaching to the Estate beginning on September 20, 2010.

On September 17, 2013, the United States filed a complaint … against the Estate and Trust to foreclose the designated property lien under §6324A and the income tax liens. Spoor did not dispute the validity or amount of the IRS liens, and on September 26, 2014, the district court granted summary judgment in favor of the United States on its right to foreclose its tax liens on the Paxton units. Spoor filed a cross-motion for summary judgment, asserting that his claim to administrative expenses took priority over the government's liens. At the time of summary judgment, Spoor had paid himself $600,000 of his $1,086,265 claim, leaving $486,265 yet to be paid. According to Spoor, the value of Paxton units owned by the Estate had fallen to approximately $2 million. Because the estate taxes take priority over the unpaid income taxes, and the Estate's assets are insufficient to cover both the estate taxes and Spoor's commissions, the key question is whether estate taxes take priority over Spoor's commissions.


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The district court entered summary judgment in favor of Spoor. The court held that §6324A is "silent as to the priority of claims which arise prior to a federal tax lien." To resolve the question, the court relied on the common-law principle that "the first in time is the first in right." Because Spoor's administrative expense claim, as filed with the Form 706 tax return in 2005, arose prior to the tax liens that were recorded and assessed in September 2010, the [district] court concluded that Spoor's claim had priority.

Eleventh Circuit’s discussion of the relevant tax lien statutes:

Generally, when a taxpayer fails to pay a tax, that amount, plus interest and penalties, becomes a lien in favor of the United States upon all property belonging to the taxpayer. § 6321. The lien arises at the time the tax assessment is made. §6322. Until the lien is recorded, it does not have priority against any purchaser, holder of a security interest, mechanic's lienor, or judgment lien creditor. §6323(a). Once the lien is recorded, it may still be primed by various other claims enumerated in §6323(b), such as by certain purchasers who do not have actual notice or knowledge of the lien. §6323(b)(1)(A). Liens for estate taxes operate slightly differently. Under §6324, the estate tax lien arises automatically from the date of death, and attaches to the gross estate, "except that such part of the gross estate as is used for the payment of charges against the estate and expenses of its administration ... shall be divested of such lien." §6324(a)(1). The estate tax lien is not valid against a mechanic's lien or or any of the interests that prime general tax liens listed in §6323(b). §6324(c)(1). An alternative to this gross estate tax lien is available if more than 35 percent of the value of the adjusted gross estate is attributable to an interest in a closely held business. §6166(a)(1). Then, the executor may elect to pay the tax in up to ten equal installments, with the first payment due up to five years from the payment due date that would otherwise apply. Id.; §6166(a)(3). The deferred amount of estate tax, plus any interest, penalties, and costs, becomes a lien in favor of the United States. §6324A(a). As collateral, the executor may identify " section 6166 lien property" in lieu of the §6324 gross estate lien after receiving written consent from each person having an interest in the designated property. §6324A(a), (c), (d)(4). The maximum value of the property which the United States may require as §6166 lien property shall not be greater than the deferred amount and required interest, taking into account any encumbrance on the property such as a lien on farm property. §6324A(b)(2). Until the special lien is recorded, it is not valid against any purchaser, holder of a security interest, mechanic's lien, or judgment lien creditor. § 6324A(d)(1). Even after the special lien is recorded, it is not valid against certain other interests including real property tax and special assessment liens. § 6324A(d)(3). If the value of the property designated by the agreement ever becomes less than the unpaid portion of the deferred tax and interest amount, the government may


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require that additional property be added to the agreement, although in no case may the value of the designated property exceed the unpaid portion of the tax liability. § 6324A(d)(5). If property is not provided within 90 days to satisfy the liability, such failure accelerates payment obligations of the deferred portion. Id.

The Eleventh Circuit reasoned that “unlike the general §6324 estate tax lien on the gross estate, Congress did not except property from the lien to pay personal commissions”. The appellate court also rejected the executor’s argument that the common law “first in time is the first in right” applies because, said the court, “Spoor's claim is not a lien. The Eleventh Circuit agreed that the first-in-time principle applies when a federal tax lien competes for priority with other liens “and Congress has not allocated priority”. The appellate court declined to “grant priority to other interests, such as an executor's commissions.” Eleventh Circuit conclusion:

Here, the IRS has chosen to assert the priority of its federal tax lien over the administrative expenses of the estate. As we see it, Congress has permitted it to do so. Accordingly, we reverse the order below and remand for proceedings not inconsistent with this opinion.

Singer, TC Memo 2016-48 (3/16/2016) – Executor Escapes Fiduciary Liability

for Unpaid Estate Tax Background. Per the Singer Tax Court:

[T]he executor of an estate is personally liable for the unpaid claims of the United States to the extent of a distribution from the estate when (1) the executor distributed assets of the estate; (2) the estate was insolvent at the time of the distribution or the distribution rendered the estate insolvent; and (3) the executor had notice of the Government's claim. See 31 U.S.C. sec. 3713(b); see, e.g., United States v. Coppola, 85 F.3d 1015, 1020 [77 AFTR 2d 96-2477] (2d Cir. 1996); Want v. Commissioner, 280 F.2d 777, 783 [6 AFTR 2d 6101] (2d Cir. 1960) rev'g in part [*11] 29 T.C. 1223 (1958); Leigh v. Commissioner, 72 T.C. 1105, 1109 (1979). Federal estate and income tax liabilities constitute a debt owed to the United States. See, e.g., United States v. Moore, 423 U.S. 77 (1975).

The estate filed Form 706 but did not pay the estate tax. The IRS issued a notice of fiduciary liability to the executor, saying that he was liable under section 6901 for the $422,694 (total) distributed to the state (for state estate tax) and a beneficiary. The Tax Court rejected all of the IRS arguments and determined that when nonprobate assets were considered, the estate was clearly solvent at the time of the distribution:

If we use April 15, 1999, the date of the distribution at issue, as the date for measuring the estate's solvency, the evidence does not show that the estate was



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insolvent within the meaning of 31 U.S.C. sec. 3713(a)(1)(B). Regarding probate assets, respondent argues that the estate tax liability of $1,842,592 exceeded probate assets that were valued at approximately $600,000 at the time of Mr. Sacks' death. Regarding probate and nonprobate assets, respondent argues that the estate and income tax liabilities of Mr. Sacks exceeded $7 million at the time of Mr. Sacks' death, which greatly exceeded the taxable estate of $3,208,103 as reported on the Form 706. Neither argument is persuasive for the following reasons. First, the solvency of the estate at Mr. Sacks' death is not relevant; the appropriate date for measuring the assets and liabilities of the estate is the date of distribution. Respondent has offered no evidence or calculations in this regard despite more than eight years' elapsing between Mr. Sacks' death and the distribution at issue. Second, as illustrated by In re Ollag Constr. Equip. Corp., 578 F.2d at 908, we take into consideration the nonprobate assets when calculating the estate's solvency. Third, at the time of the distribution, petitioner had already settled Mr. Sacks' unpaid Federal income tax liabilities for $1 million. In fact it appears that the only tax due to the Government at the time of the distribution was the unpaid estate tax. Accordingly, respondent's cited figures regarding the assets and liabilities of the probate and nonprobate estate are unpersuasive because: (1) we must value nonprobate assets, including contribution rights [from beneficiaries], in calculating the total assets and (2) any liability attributable to overdue income tax is incorrect, considering that Mr. Sacks' income tax liabilities had been settled for $1 million before the distribution at issue.

The Tax Court found that the taxpayer was “not liable as a fiduciary for the distribution from the estate of $422,694.” (CCA) 201621014 (May 20, 2016) – Who Can Receive Estate Tax Information

from the IRS? The IRS explains in the one paragraph, remarkably informal, CCA that:

the only people other than the administrator, executor, or trustee of an estate who can request the return information [from the IRS] are heirs at law, next of kin, beneficiaries under the will, and only in the case of decedents (not the estate), donees of property. For all these categories, in order to be entitled to the return information, the person must establish that they have a material interest that will be affected by the information requested. A material interest is an important information that is often, but not required to be, financial in nature. [The IRS] can withhold things if disclosure would seriously impair federal tax administration.



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Chapter 13: Income Taxation of Trusts and Estates Page 13-1

Chapter 13 : Income Taxation of Trusts and Estates

Table of Contents Chapter 13 : Income Taxation of Trusts and Estates .......................................................... 13-1

PLR 201628010 (released July 8, 2016) -- IRS Rules On Grantor Retained Powers and Gift Tax Consequences ........................................................................................................ 13-1

PMTA 2016-007 (released in 2016) -- IRS Clarifies Which Penalties Apply to Form 1041 K-1 with Incorrect TIN ....................................................................................................... 13-3

Rev. Proc. 2016-42 (8/9/2016) – CRATs ............................................................................ 13-4

PLR 201628010 (released July 8, 2016) -- IRS Rules On Grantor Retained Powers and Gift Tax Consequences

Facts (full text): The information and representations submitted are as follows. On Date, Grantor created Trust, an irrevocable trust. Trust is a domestic trust administered in State 1 and, pursuant to the Trust agreement, is governed by the laws of State 1. A corporate trustee (Trustee) is the sole trustee of Trust.

Grantor transferred certain property to Trust. The Trust agreement defines “beneficiaries” as the Grantor and the Grantor's children and all of his children's lineal descendants. The Grantor's children are defined as Child 1 and Child 2.

During Grantor's lifetime, the Trustee shall make distributions of income and principal to or for the benefit of the beneficiaries, as follows (1) At any time, Trustee, pursuant to the direction of a majority of the Distribution Committee members, with the written consent of Grantor, is expressly authorized to distribute to Grantor or Grantor's descendants such amounts of the net income or principal as directed by the Distribution Committee (Grantor's Consent Power); (2) at any time, Trustee, pursuant to the direction of all of the Distribution Committee members, other than Grantor, is expressly authorized to distribute to Grantor or Grantor's descendants such amounts of the net income or principal as directed by the Distribution Committee, other than Grantor (Unanimous Member Power); and (3) at any time, Trustee shall distribute such portion of the principal to any one or more of Grantor's descendants as the Grantor directs, acting in a non-fiduciary capacity, in such amount as Grantor deems advisable to provide for the health, maintenance, support, or education of Grantor's descendants (Grantor's Sole Power). The Distribution Committee and/or Grantor, as applicable, may direct that distributions be made equally or unequally and to or for the benefit of any one or more of the beneficiaries of Trust to the exclusion of others. Any net



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income not distributed by Trustee will be accumulated and added to principal. Other than as provided above, income and principal of Trust may not be distributed to Grantor.

The Distribution Committee is initially composed of Grantor, Child 1, Child 2, and an unrelated third party. Trust provides that at all times at least two “Eligible Individuals” must be members of the Distribution Committee. An “Eligible Individual” means a member of the class consisting of adult descendants of Grantor, the parent of a minor descendant, and the legal guardian of a minor descendant of Grantor, or such other person or person who qualifies as an adverse party to the Grantor under § 672(a) of the Internal Revenue Code. If at any time fewer than two Eligible Individuals are members of the Distribution Committee, the Distribution Committee shall cease to function and no distributions requiring consent of the Distribution Committee may be made unless and until a sufficient number of “Eligible Individuals” are appointed to the Distribution Committee. Upon the death of the Grantor, the Distribution Committee is disbanded and terminated, and, thereafter, distribution decisions are to be made by the Trustee.

Upon Grantor's death, the remaining balance of Trust shall be distributed to or for the benefit of any person or persons or entity, other than Grantor's estate, Grantor's creditors, or the creditors of Grantor's estate, as Grantor may appoint by will (Grantor's Testamentary Power). In default of the exercise of Grantor's Testamentary Power, the balance of Trust will be distributed to a marital trust for Grantor's surviving spouse, if such spouse survives Grantor, or if not, then in further trust for the benefit of Grantor's descendants.

Taxpayer Ruling Requests:

1) During the period the Distribution Committee is serving, and at any other time during the Grantor's lifetime, no portion of the items of income, deductions, and credits against tax of Trust will be included in computing the taxable income, deductions, and credits of Grantor under § 671;

2) The contribution of any property to Trust by Grantor will be an incomplete gift, not subject to federal gift tax;

3) Any distribution of property to Grantor from Trust which is approved and directed by the members of the Distribution Committee will not be a completed gift by any member of the Distribution Committee to Grantor, and no member of the Distribution Committee will be subject to any federal gift tax by reason of such directed distribution from Trust; and

4) Any distribution of property from Trust to any beneficiary of Trust other than Grantor which is approved and directed by the members of the Distribution Committee will not be a completed gift by any member of the Distribution Committee to any such beneficiary of Trust, and no member of the Distribution Committee will be subject to any federal gift tax by reason of such directed distribution from Trust.

IRS Conclusions (quoted): 1) Based solely on the facts and representations submitted, we conclude an examination

of Trust reveals none of the circumstances that would cause Grantor to be treated as


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the owner of any portion of Trust under §§ 673, 674, 676, or 677 as long as the Distribution Committee remains in existence. We further conclude that an examination of Trust reveals none of the circumstances that would cause administrative controls to be considered exercisable primarily for the benefit of Grantor under § 675. Thus, the circumstances attendant on the operation of Trust will determine whether Grantor will be treated as the owner of any portion of Trust under § 675. This is a question of fact, the determination of which must be deferred until the federal income tax returns of the parties involved have been examined by the office with responsibility for such examination.

2) and 3): [B]ased on the facts submitted and the representations made, we conclude that the contribution of property to Trust by Grantor is not a completed gift subject to federal gift tax. Any distribution from Trust to Grantor is merely a return of Grantor's property. Therefore, we conclude that any distribution of property by the Distribution Committee from Trust to Grantor will not be a completed gift subject to federal gift tax by any member of the Distribution Committee. Further, upon Grantor's death, the fair market value of the property in Trust is includible in Grantor's gross estate for federal estate tax purposes.

4) Based upon the facts submitted and representations made, we conclude that any distribution of property by the Distribution Committee from Trust to any beneficiary of Trust, other than Grantor, will not be a completed gift subject to federal gift tax, by any member of the Distribution Committee. Further, we conclude that any distribution of property from Trust to a beneficiary, other than Grantor, will be a completed gift by Grantor.

PMTA 2016-007 (released in 2016) -- IRS Clarifies Which Penalties Apply to Form 1041 K-1 with Incorrect TIN

IRS Office of Chief Counsel clarified which penalties apply when a Form 1041 K-1 is filed with the IRS and furnished to a beneficiary with an incorrect Taxpayer Identification Number (TIN). The section 6723 penalty applies to the K-1 filed with the IRS, and is not subject to an inflation adjustment:

“Section 806 of the 2015 TPEA amended I.R.C. §6721 and 6722, but not section 6723. That penalty remains at $50 for each failure, not to exceed $100,000”

On the other hand, the section 6722 penalty, which covers failures to furnish correct payee statements, applies to the form furnished to the beneficiary and is subject to an inflation adjustment:

[2015] TPEA Section 806 increased the penalties under section 6722 from $100 to $250 per return or statement, and the annual cap or limit on penalties per calendar year under this section was increased from $1,500,000 to $3,000,000.



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Additionally, if the failure to furnish correct payee statements is a result of intentional disregard, the Legislation increases the penalties under section 6722 from $250 per return or statement to $500 per statement; or, if greater, 10% of the aggregate amount required to be reported correctly. The penalty is adjusted for inflation under section 6722(f). Accordingly, for returns required to be filed after Dec. 31, 2014, the $250 and $500 amount is increased to $260 and $520 as a result of inflation adjustments.

Rev. Proc. 2016-42 (8/9/2016) – CRATs

Per the IRS (8/9/16): “Revenue Procedure 2016-42 states that a charitable remainder annuity trust (CRAT) containing the sample provision found in Rev. Proc. 2016-41 will not be subject to the probability of exhaustion test set forth in Rev. Rul. 70-452, 1970-2 C.B. 199, and applied in Rev. Rul. 77-374, 1977-2 C.B. 329.” Background. Per the IRS

Low interest rates in recent years have greatly limited use of a CRAT as an effective charitable-giving vehicle. For example, in May of 2016, the § 7520 rate was 1.8 percent. At this interest rate, the sole life beneficiary of a CRAT that provides for the payment of the minimum allowable annuity (equal to 5 percent of the initial FMV of the trust assets) must be at least 72 years old at the creation of the trust for the trust to satisfy the probability of exhaustion test. The § 7520 rate has not exceeded the minimum 5 percent annuity payout rate since December of 2007, which has necessitated testing for the probability of exhaustion for every CRAT created since that time.

Relief in Rev. Proc. 2016-42, per the IRS:

The sample provision provides an alternative to satisfying the probability of exhaustion test for those CRATs to which this revenue procedure applies. The sample provision causes the early termination of the CRAT, followed by an immediate distribution of the remaining trust assets to the charitable remainder beneficiary. Specifically, this provision provides for early termination of the trust (and thus the end of the ability to make any more annuity payments) on the date immediately before the date on which any annuity payment would be made, if the payment of that annuity amount would result in the value of the trust corpus, when multiplied by a specified discount factor, being less than 10 percent of the value of the initial trust corpus.

The sample provision is designed to ensure that the benefit from the creation of the CRAT will be available only where there is a significant benefit to charity. This provision also is designed to ensure that the charitable remainder beneficiary will receive an amount that accords with the charitable deduction allowed to the donor on creation of the trust. Finally, this provision is designed to expose the




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charitable remainderman to some, but not all, of the investment performance risk of the CRAT assets. (Citations omitted)

Effective Date: The revenue procedure “is effective August 8, 2016 and applies to trusts created on or after that date.”


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Chapter 14: Tax Exempts Page 14-1

Chapter 14 : Tax Exempts

Table of Contents Chapter 14 : Tax Exempts ..................................................................................................... 14-1

Section 506 Notification Requirement for New and Certain Existing Section 501(c)(4) Organizations – Notice 2016-9 ............................................................................................ 14-1

Requirement to Notify of Intent to Operate as a §501(c)(4) Organization – Rev. Proc. 2016-41 .................................................................................................................................. 14-2

Redacting SSN on Determination Letters.......................................................................... 14-2

Qualified Zone Academy Bonds – Notice 2016-20 ............................................................ 14-2

Data for Qualified Mortgage Bonds - Rev. Proc. 2016-25 ................................................ 14-2

Determination Letters – Rev. Proc. 2016-10 ..................................................................... 14-2

Reduced User Fee for 1023-EZ – Rev. Proc. 2016-32 ....................................................... 14-2

New Format for Electronically Filed Form 990 Data ....................................................... 14-3

Senate Investigation of Tax-Exempt Private Museums ................................................... 14-3

Private Activity Bond and Management Contracts – Rev. Proc. 2016-44 ...................... 14-3

Selected Adverse Determination Letters ........................................................................... 14-4

Section 506 Notification Requirement for New and Certain Existing Section 501(c)(4) Organizations – Notice 2016-9

Per the IRS (1/19/16): “Notice 2016-09 extends the date by which social welfare organizations must notify the Internal Revenue Service of intent to operate under section 501(c)(4), as required by new section 506, added by the Protecting Americans from Tax Hikes Act of 2015. With respect to the separate process by which an organization may, at its option, request a determination that it qualifies for section 501(c)(4) tax-exempt status, the Notice states that organizations seeking IRS recognition of section 501(c)(4) status should continue using Form 1024, “Application for Recognition of Exemption Under Section 501(a),” until further guidance is issued and clarifies that the filing of Form 1024 will not relieve an organization of the requirement to submit the section 506 notification.”

This interim guidance was modified by final, temporary and proposed regulations issued 7/12/16 (TD 9775 and REG-101689-16 at §1.506-1T). The PATH Act added §506 and amended §6033 and §6652. The changes apply to entities organized after 12/18/15.

See Sec. 405 of P.L. 114-113 for application to certain existing entities.

See Form 8976, Notice of Intent to Operate Under Section 501(c)(4), which is filed electronically, with $50 filing fee.





https://www.congress.gov/114/bills/hr2029/BILLS-114hr2029enr.pdf

https://www.irs.gov/charities-non-profits/electronically-submit-your-form-8976-notice-of-intent-to-operate-under-section-501c4

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Requirement to Notify of Intent to Operate as a §501(c)(4) Organization – Rev. Proc. 2016-41

Per the IRS (7/8/16): “Revenue Procedure 2016-41 sets forth the procedure for an organization to notify the Internal Revenue Service (IRS), consistent with section 506, that it is operating as an organization described in section 501(c)(4) (a section 501(c)(4) organization).”

Redacting SSN on Determination Letters An IRS memo of 7/19/16 (TE/GE-07-0716-0018) provides “guidance on redacting social security numbers when processing Exempt Organizations (EO) determination letter requests, particularly requests subject to public disclosure under Internal Revenue Code (IRC) Section 6104. These procedures apply to EO Rulings and Agreements determination cases closed on or after the date of this memorandum. Purpose: This guidance serves to protect the personal privacy of individuals affiliated with exempt organizations where sensitive personal information is included in a determination letter request that is otherwise subject to public disclosure.”

Qualified Zone Academy Bonds – Notice 2016-20 Per the IRS (2/12/16): “Notice 2016-20 provides for the allocation of the national limitation for qualified zone academy bonds among the States, the District of Columbia, and the possessions of the United States.”

Data for Qualified Mortgage Bonds - Rev. Proc. 2016-25 Per the IRS (4/15/16): “Revenue Procedure 2016-25 provides issuers of qualified mortgage bonds, as defined in section 143(a) of the Internal Revenue Code, and issuers of mortgage credit certificates, as defined in section 25(c), with (1) nationwide average purchase prices for residences located in the United States, and (2) average area purchase price safe harbors for residences located in statistical areas in each state, the District of Columbia, Puerto Rico, the Northern Mariana Islands, American Samoa, the Virgin Islands, and Guam.”

Determination Letters – Rev. Proc. 2016-10 Rev. Proc. 2016-10 (1/11/16) provides updated procedures for issuing determination letters regarding §509(a) private foundation status, as well as operating foundation status under §4942(j) and exempt operating foundation status under §4940(d).

Reduced User Fee for 1023-EZ – Rev. Proc. 2016-32 In Rev. Proc. 2016-32 (5/31/16) the IRS reduces the user fee for Form 1023–EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. The fee is reduced from $400 to $275. The fee schedule of Rev. Proc. 2016-8 is modified. This change is effective July 1, 2016. Form 1023-EZ is only filed electronically.



https://www.irs.gov/pub/foia/ig/spder/tege-07-0716-0018.pdf





https://www.irs.gov/uac/about-form-1023ez

https://www.irs.gov/pub/irs-pdf/f1023ez.pdf

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New Format for Electronically Filed Form 990 Data In IR-2016-87 (6/16/16), the IRS “announced that the publicly available data on electronically filed Forms 990 will now be available for the first time in a machine-readable format through Amazon Web Services (AWS). The publicly available data does not include donor information or other personally identifiable information. Today’s launch of this effort marks an important step forward in access to this important public data. Previously, this Form 990 data was only available in image files. This data, which includes filings from 2011 to the present, will now be available as an XML file that is downloadable from the web via AWS.”

Senate Investigation of Tax-Exempt Private Museums On 6/2/16, the Senate Finance Committee issued a press release about Senator Hatch’s findings into his 7-month review of “private, non-profit museums that enjoy tax-exempt status.” Per the press release:

“The review, launched in November 2015, sought answers from 11 private foundations designed to assess whether the public interest was being met and whether operations of the foundations merited the substantial tax benefits afforded to their collector-founders through the tax code.

In the letter, Hatch noted that some of the private museums welcome up to half a million guests per year at no charge, but others are not readily available to the public, including many that require advanced reservations and hold short public hours. Hatch went on to detail how many of the responses showed that founding donors continue to play an active role in management of the museum, and some of the museums occupy property owned by donors, including, in some cases, their own private residence.

“These factors alone are not cause for revoking tax-exempt status or imposing tax on self-dealing, but they do raise questions about the nature of the relationship between the donor and museum that perhaps merit further scrutiny,” Hatch said. “Despite the good work that is being done by many private museums, I remain concerned that this area of our tax code is ripe for exploitation.”

The arrangement of tax-exempt private museums opened by individual collectors creates a unique opportunity for such persons to simultaneously enjoy two generous tax advantages. Under section 501 of the Internal Revenue Code, certain charitable organizations are exempt from federal tax on operations related to their tax-exempt purpose. Separately, under section 170 of the code, donors may receive a deduction for contributions made to such 501(c)(3) organizations.”

The SFC press release includes Senator Hatch’s letter to IRS Commissioner Koskinen. That letter provides a summary of the findings from the 11 entities Senator Hatch pursued and asks the commissioner to respond with “detail the IRS’s views on private museums and the agency’s efforts to ensure that private museums have sufficient guidance to conduct their operations.”

Also see Larry Kaplan, “Senate Finance Committee to Look at Tax Exemptions for Vanity Art Museums,” Nonprofit Quarterly, 12/2/15.

Private Activity Bond and Management Contracts – Rev. Proc. 2016-44


https://www.irs.gov/uac/newsroom/irs-makes-electronically-filed-form-990-data-available-in-new-format

https://aws.amazon.com/public-data-sets/irs-990/

http://www.finance.senate.gov/chairmans-news/hatch-concludes-review-into-tax-exempt-private-museums-notes-concerning-findings

https://nonprofitquarterly.org/2015/12/02/senate-finance-committee-to-look-at-tax-exemptions-for-vanity-art-museums/

https://nonprofitquarterly.org/2015/12/02/senate-finance-committee-to-look-at-tax-exemptions-for-vanity-art-museums/


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Per the IRS (8/22/16): “Revenue Procedure 2016-44 provides safe harbor conditions under which a management contract does not result in private business use of property financed with governmental tax-exempt bonds under § 141(b) of the Internal Revenue Code or cause the modified private business use test for property financed with qualified 501(c)(3) bonds under § 145(a)(2)(B) to be met.”

Selected Adverse Determination Letters

Release 201615018 (4/8/16) – Mission was to “provide a way for your members to collectively and cooperatively cultivate and distribute medical marijuana for medical purposes to qualified patients and primary caregivers who come together to collectively and cooperatively cultivate physician-recommended marijuana.” The IRS found that the entity was “not organized and operated exclusively for exempt purposes.” The purpose of distributing marijuana “not only violates federal law, but also furthers a substantial nonexempt purpose.” Also, primarily benefits members rather than the public.

Release 201623013 (6/3/16) – The entity “was formed to maintain a private road that is the common driveway to four homes.” The town did not maintain the road. Membership is open to the homeowners only and there are only four on this road. Revenue is derived from fees assessed on the homeowners.

Release 201635006 (8/26/16) – Organization operations substantially involved selling cars for a fee. Did not have sufficient records to prove there was any program of charitable purpose. The IRS found that the entity did not meet the qualification for 501(c)(4) status because it was “not organized and operated exclusively for the promotion of social welfare.”

Release 201639016 (9/23/16) – Organization created to operate a farmer’s market (food and crafts). The IRS found this entity did not operate as a business league per §501(c)(6). “Your operations provide specific services to members and allow a convenience and private economic benefit. You do not improve business conditions along one or more lines of business or of a certain area but instead provide services for the convenience of your members.”







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Chapter 15: Looking Forward Page 15-1

Chapter 15 : Looking Forward

Table of Contents Chapter 15 : Looking Forward .............................................................................................. 15-1

IRS Future State ........................................................................................................... 15-1

Treasury-IRS Priority Guidance Plan ................................................................. 15-1

Sampling of Congressional Tax Proposals (114th Congress) ................ 15-2

Federal Tax Reform .................................................................................................... 15-2

NOTE: A longer “Looking Forward” outline can be read at http://mntaxclass.com.

IRS Future State 1. The IRS Future State initiative has been underway for a few years. Per the IRS website

on this project:

“The IRS needs to take advantage of the latest technology to move the entire taxpayer experience to a new level. And it needs to be done in a way that meets the needs of taxpayers and the tax community in an efficient and effective manner while respecting taxpayer rights. All of these efforts touch many different parts of the agency, and they have been described as the IRS Future State initiative.”

2. Online Accounts – A key part of the Future State is better use of information technology. Taxpayers would have online accounts to which they could also let their preparer access. E-filing would be done through the account and communications would also be done through the account. A description of the future state of an individual dealing with the Small Business/Self-Employed Division notes that the filer would be notified that he is at risk of exam due to an increase in his business expenses. The exam would be conducted virtually by an agent “across the country” and all resolved virtually.

3. Describing the Future Experience – the IRS future state website includes a description of what a taxpayer’s experience would be in each IRS Division. See the diagrams for the specifics.

Treasury-IRS Priority Guidance Plan Like past years, there are over 250 projects on the Treasury-IRS Priority Guidance Plan.


http://mntaxclass.com/

https://www.irs.gov/uac/newsroom/irs-future-state

https://www.irs.gov/uac/newsroom/future-state-initiative

https://www.irs.gov/PUP/newsroom/IRS%20-%20Small%20Business%20Vignette%20-%20Version%20A.pdf

https://www.irs.gov/uac/newsroom/future-state-initiative

https://www.irs.gov/uac/Priority-Guidance-Plan

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Sampling of Congressional Tax Proposals (114th Congress) As is common in any session of Congress, there were hundreds of tax bills introduced in the 114th Congress. General categories of changes include:

Technical corrections Address corporate inversions Encourage firms to insource jobs Encouraging employee stock ownership Addressing identity theft IRS reforms Carbon tax

Federal Tax Reform 1. Hearings – Several congressional committees held hearings in 2016 on various aspects of

tax reform. See list and links at http://www.sjsu.edu/people/annette.nellen/website/114th-hearings.htm.

2. Corporate Integration – Senator Hatch announced work on a corporate integration study, likely to be released in summer 2016. [Senate Finance Committee, “Hatch Offers Keynote Address at Bloomberg BNA Tax Policy Event,” 2/24/16.] This topic has been discussed and analyzed for decades. For example, the Treasury has reports on the topic in January 1992 and December 1992. It was also a key topic in the Senate Finance Committee Republican staff tax reform report released in December 2014 (“Comprehensive Tax Reform for 2015 and Beyond”).

The Senate Finance Committee also held hearings on the topic prior to the anticipated release of Senator Hatch’s report – May 17, 2016 and May 24, 2016. The Joint Committee on Taxation released a report on corporate integration for the hearings (JCX-44-16; 5/8/16).

Congressional Research Service report, Corporate Integration and Tax Reform, Sept. 16, 2016.

3. Congressman Renacci’s Simplifying America’s Tax System (SATS) Plan – His plan, not yet in legislative language, is to repeal the corporate income tax and replace it with a national consumption tax. The individual income tax would be simplified with a broader base. Per Rep. Renacci’s two-page summary, the consumption tax would be a 7% “Business Activity Tax.” An example describing the tax indicates it is a credit invoice VAT, used by a majority of countries today.

Also, he states that his plan would create 1.9 million new jobs. Some of the revenue raised would be directed to the Highway Trust Fund. A few more details are included in his 12-page white paper. One point in this paper is the reminder that the corporate tax doesn’t fall on corporations, but instead on individuals. The paper does note that his tax would impact state and local governments that impose a sales tax. He suggests that these jurisdictions might want to conform their sales tax and corporate income tax to the federal tax. The paper also notes the challenge of transition rules including the effect on


http://www.sjsu.edu/people/annette.nellen/website/114th-hearings.htm

http://www.sjsu.edu/people/annette.nellen/website/114th-hearings.htm

http://www.finance.senate.gov/chairmans-news/hatch-offers-keynote-address-at-bloomberg-bna-tax-policy-event

http://www.finance.senate.gov/chairmans-news/hatch-offers-keynote-address-at-bloomberg-bna-tax-policy-event

https://www.treasury.gov/resource-center/tax-policy/Pages/reports_main.aspx

http://www.finance.senate.gov/imo/media/doc/Comprehensive%20Tax%20Reform%20for%202015%20and%20Beyond%20(C).pdf

http://www.finance.senate.gov/hearings/integrating-the-corporate-and-individual-tax-systems-the-dividends-paid-deduction-considered

http://www.finance.senate.gov/hearings/debt-versus-equity-corporate-integration-considerations



http://www.fas.org/sgp/crs/misc/R44638.pdf

http://renacci.house.gov/index.cfm/simplifying-americas-tax-system

http://renacci.house.gov/_cache/files/ad754ad5-9aef-4eff-b3a1-c843284c061b/sats-two-pager.pdf

http://renacci.house.gov/_cache/files/7eeb81fe-f245-42c0-8de4-055ebf4c12e9/sats-white-paper.pdf

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older individuals (who are spending their saved income and in essence having that income taxed again when spent under the federal consumption tax).

4. House Republican Tax Reform Blueprint – As part of its “A Better Way” campaign in summer 2016, House Republicans included a 35-page description of its tax reform “blueprint.”

Key elements: See Nellen, “House Republicans Offer ‘A Better Way’ for Taxes,” AICPA Tax Insider, 7/28/16).


http://abetterway.speaker.gov/

http://abetterway.speaker.gov/_assets/pdf/ABetterWay-Tax-PolicyPaper.pdf

http://abetterway.speaker.gov/_assets/pdf/ABetterWay-Tax-PolicyPaper.pdf

http://www.thetaxadviser.com/newsletters/2016/jul/house-republican-tax-reform-plan.html

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For more information, contact:Marie Ebersbacher, Forensic Services Section Chair [email protected] Ku, Forensic Services Section Manager [email protected]

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