FLORIDA TAX INSTITUTE(http://www.floridataxinstitute.org/)

April 22-24, 2015Tampa, Florida

SUMMARIES OF PRESENTATIONS

Wednesday, April 22nd

I. Recent Developments in Federal Income Taxation (McGovern / McMahon).....................2

II. Protecting the Spirit of the Law (Luke / Solomon)...............................................................7

III. Current Issues in Tax Administration (Wilkins)..............................................................10

IV. Debt v. Equity for U.S. Federal Tax Purposes (Shashy / Friel).......................................12

V. Residency, Domicile, and Foreign Trust Considerations for Inbound Nonresident Aliens (Kasner)........................................................................................................................................17

VI. Dealer v. Investor Revisited (Genz)....................................................................................19

Thursday, April 23rd

VII. Taxing Bets on the Future: Partnership Options and Carried Interests (Burke / Sowell)...........................................................................................................................................21

VIII. Defending Conservation Easements in an Adverse Tax Environment (Levitt)..........24

IX. Defending Against the IRS rubbing Salt in the Wound (Aughtry).................................26

X. Review” of an Individual Judge’s Opinion by the Full Tax Court (Gustafson)..............27

XI. The Examination and Appeals Process (Kay)...................................................................28

XII. Foreign Investments in U.S. Real Property (Sherman)...................................................30

XIII. It Still Takes a Village: Balancing Professionalism, Privilege, and Advocacy in Tax Controversies (Campagna).........................................................................................................32

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Wednesday, April 22nd

I. Recent Developments in Federal Income Taxation (McGovern / McMahon)

Martin H. McMahon, Jr., the James J. Freeland Eminent Scholar in Taxation and Professor of Law at the University of Florida, and Bruce A. McGovern, Vice President and Associate Dean and Professor of Law at South Texas College of Law, discussed recent cases that touch upon various income tax issues.

The following is a summary of some of the cases discussed during the presentation:

1. Accounting Methods

In Howard Hughes Company v. Commissioner, 142 T.C. No. 20 (2014), the taxpayers, who were in the residential land development business, sold land as follows: (1) through bulk sales, in which they developed raw land into villages and sold the entire village to a builder; (2) through pad sales, in which they developed villages into parcels and sold the parcels to a builder; (3) through finished lot sales, in which they developed parcels into lots and sold whole parcels of finished lots to builders; and (4) through custom lot sales, in which they sold individual lots to individual purchasers or custom home builders. The taxpayers never constructed any residential dwelling units on the land that they sold.

The taxpayers reported the income from each of these contracts under the completed contract accounting method under § 460(e).1 The Service argued that none of the taxpayers’ contracts qualified under the completed contract accounting method because the contracts were not “home construction contracts” within the meaning of § 460(e)(6). In addition, the Service argued that the bulk sale and custom lot contracts were not eligible for the percentage of completion method of accounting under § 460 because they were not long-term construction contracts.

After considering the facts, the Tax Court held that none of the taxpayers' contracts were “home construction contracts” within the meaning of § 460(e); thus, the taxpayers could not report these contracts under the completed contract accounting method. However, the Tax Court held that because the taxpayers' custom lot contracts and bulk sale contracts were long-term contracts within the meaning of § 460(f)(1), the taxpayers could report gain or loss from those contracts on the appropriate long-term contract method of accounting, provided that those contracts were entered into in a year prior to their completion.

In the opinion, the Tax Court ruled:

1 Unless otherwise indicated, each statutory reference is to the Internal Revenue Code of 1986, as amended.

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“Our Opinion today draws a bright line. A taxpayer's contract can qualify as a home construction contract only if the taxpayer builds, constructs, reconstructs, rehabilitates, or installs integral components to dwelling units or real property improvements directly related to and located on the site of such dwelling units. It is not enough for the taxpayer to merely pave the road leading to the home, though that may be necessary to the ultimate sale and use of a home. If we allow taxpayers who have construction costs that merely benefit a home that may or may not be built, to use the completed contract method of accounting, then there is no telling how attenuated the costs may be and how long deferral of income may last. . . We think it consistent with congressional intent that a line should be drawn here so as to exclude petitioners' contracts, when we cannot conclude that qualifying dwelling units will ever be built.”

2. Gross Income

In Maines v. Commissioner, 144 T.C. No. 8 (March 11, 2015), the Tax Court considered whether taxpayers, who received income tax credits (the EZ Investment Credit, the EZ Wage Credit, and the QEZE Real Property Tax Credit) from the State of New York for investing in targeted areas within the state, were required to report the income tax credits as gross income.

With respect to the EZ Investment Credit and the EZ Wage Credit, the Tax Court held that any portion of the credit that only reduced the taxpayers’ state-tax liabilities was excludable from gross income. However, the Tax Court held that the refundable portion of the credits was required to be included in gross income in the year of receipt (regardless of whether the taxpayers carried over the credits to the next year).

With respect to the QEZE Real Property Tax Credit, which was limited to past income taxes actually paid, the Tax Court held that any portion of the credit that only reduced the taxpayers’ state-tax liabilities was excludable from gross income. However, the Tax Court held that the refundable portions of the QEZE Real Property Tax Credit were includible in the taxpayers’ gross income to the extent that they actually benefited from previous deductions for property-tax payments.

McMahon commented that he agreed with the Tax Court’s decision in which the Tax Court correctly rejected the taxpayers’ argument that the credits should be excluded from gross income under the general welfare doctrine, which excludes from gross income welfare and food stamps, because these credits were not based on need.

3. Deductible Expenses v. Capitalization

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In ABC Beverage Corp. v. United States, 756 F.3d 438 (6th Cir. 2014), the Sixth Circuit held that a taxpayer, who previously leased a building, could deduct the cost of the lease after purchasing the building and terminating the lease. Here, the taxpayer operated a bottling facility in a leased building. The taxpayer believed that the cost of the lease was excessive and therefore exercised an option to purchase the building.

The taxpayer’s appraiser determined that the fair market value of the building (without the lease) was $2.75 million, while the fair market value of the building with the lease was at least $9 million. Eventually, the taxpayer purchased the building for over $9 million and deducted $6.25 million as a business expense for terminating the lease.

The IRS argued that the taxpayer was not entitled to deduct the value of the lease because § 167(c)(2) provides that “[i]f any property is acquired subject to a lease,” the taxpayer is prohibited from allocating any part of the property’s cost to the leasehold interest and is required to capitalize the entire cost of the property. The Sixth Circuit disagreed and held that § 167(c)(2) only applies if the lease continues after the purchase. The Sixth Circuit acknowledged that their decision conflicts with an earlier Tax Court decision, Union Carbide Foreign Sales Corp. v. Commissioner, 115 T.C. 423 (1993).

4. Miscellaneous Deductions

In Rent-A-Center, Inc. v. Commissioner, 142 T.C. 1 (2014), a reviewed opinion, the Tax Court analyzed a captive insurance company structured in a brother-sister arrangement.

The parent of an affiliated group of domestic corporations conducted its business through stores owned and operated by its subsidiaries. The parent formed a Bermudian insurance company (the “Company”) and each subsidiary entered into an insurance contract with the Company. Pursuant to the contract, each subsidiary paid the Company an amount, which was determined by an actuarial calculation to cover each subsidiary’s workers’ compensation, automobile, and general liability risks, and the Company, in return, reimbursed a portion of each subsidiary’s claims relating to these risks. The subsidiaries deducted, as insurance expenses, the deductible payments to the Company. The IRS disallowed the deductions.

The Tax Court ruled in favor of the taxpayers because the Company was formed for a valid business purpose, was a separate, independent, and viable entity, was financially capable of meeting its obligations, and reimbursed the taxpayer’s subsidiaries when they suffered an insurable loss. In addition, the Tax Court ruled that the Company was a bona fide business because it operated in accordance with Bermuda’s laws, was subject to Bermuda’s regulatory authority and charged actuarially determined premiums. Finally, the Tax Court found that the payments were insurance premiums because they shifted risk between the parent’s operating subsidiaries and the Company.

5. At-Risk and Passive Activity Losses

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A. Real Estate Professional Exception.

In Frank Aragona Trust v. Commissioner, 142 T.C. 165 (2014), the taxpayer trust owned a single-member LLC (the “LLC”), a disregarded entity, which conducted an extensive rental real estate business. Three of the six trustees of the trust were full time employees of the LLC. The LLC incurred substantial losses, which the trust deducted against income and gains from non-passive activities. The IRS disallowed the deductions arguing that the losses were passive activity losses.

Before the Tax Court, the IRS argued the losses were disallowed because (1) trusts are categorically barred from qualifying under the § 469(c)(7) exception and (2) even if trusts are not categorically barred, the trust did not materially participate in a real-property trade or business.

The Tax Court rejected the IRS’s arguments and held that the trust was allowed to deduct the losses. First, the Tax Court ruled that trusts are not categorically barred from qualifying under the § 469(c)(7) exception because nothing in the statutes or the regulations limits the application of § 469(c)(7) to individuals and closely held corporations. Next, the Tax Court ruled that the activities of the three trustees, who were involved in the management of the day-to-day operations of the LLC, were properly considered in determining that the trust materially participated in the real-estate operations of the LLC.

B. Guaranty.

In Moreno v. United States, 2014 WL 2112864 (W.D. La. May 19, 2014), the District Court for the Western District of Louisiana considered whether a taxpayer could claim a $4.7 million loss arising from the acquisition and leasing of a Learjet aircraft by a disregarded LLC of which he was the sole member. The LLC purchased the aircraft with a loan secured by the aircraft, which was personally guaranteed by both the taxpayer and Dynamic Industries, Inc. (“Dynamic”). Dynamic was a wholly-owned subsidiary of another corporation of which the taxpayer owned 98% of the stock.

The IRS denied the loss and argued that the taxpayer was not “at risk” because § 465(b)(4) provides that a “taxpayer shall not be considered at risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements.” Two tests have been formulated to determine whether a taxpayer is protected against loss within the meaning of § 465(b)(4): the “economic realities” test (applied by the Second, Eighth, Ninth, and Eleventh Circuits) and the “payor of last resort” test (applied by the Sixth Circuit). The District Court held that even though the taxpayer did not have sufficient liquidity to pay the loan and controlled each entity, the taxpayer was “at risk” for 50% of the loan under either test because, if the LLC defaulted, the taxpayer and Dynamic were jointly liable.

6. IRAs

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In Clark v. Rameker, 134 S. Ct. 2242 (2014), the Supreme Court affirmed the Seventh Circuit’s decision that an IRA inherited from someone other than the recipient’s spouse is not exempt from the claims of creditors in bankruptcy. The Supreme Court ruled that inherited IRAs are not “retirement funds” within the meaning of 11 U.S.C. § 522(b)(3)(C), accordingly, they are not exempt from the claims of creditors in bankruptcy.

7. Cancellation of Debt Income

In Mylander v. Commissioner, T.C. Memo. 2014-191 (2014), the Tax Court considered whether taxpayers, who guaranteed a loan, were required to recognize cancellation of debt income (“COD income”) when they were released from their obligations after the principal obligor defaulted. The Tax Court held that the taxpayers did not recognize COD income because they did not receive any valuable consideration in exchange for acting as guarantors.

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II. Protecting the Spirit of the Law (Luke / Solomon)

Charlene Luke, a Professor at the University of Florida, and Eric Solomon of Ernst & Young, discussed the vehicles that the IRS employs to deny a taxpayer from claiming the federal tax benefits of a transaction if the IRS suspects the transaction is nothing more than an elaborate scheme to avoid taxes. Luke and Solomon addressed the recent developments in this area, most notably, the codification of the Economic Substance Doctrine (the “ESD”) and related penalty amendments in 2010.

1. Overview

When structuring a transaction, practitioners must be aware not only of the anti-avoidance rules codified in the Code and the Regulations but also of the various judicial doctrines that could preclude a client from obtaining the federal tax benefits of the proposed transaction. A practitioner’s failure to consider these issues when structuring a transaction could result in the disallowance of the federal tax benefits, the imposition of penalties against the client, or the imposition of penalties against the practitioner.

2. The Code & Regulations

Specific and general anti-avoidance rules are codified throughout the Code and Regulations. The specific anti-avoidance rules include §§ 362(e)(2) and 704(c)(1)(C), the anti-loss duplication rules for corporations and partnerships, respectively. The general anti-avoidance rules include § 269, which disallows tax benefits if the principal purpose for an acquisition was the evasion or avoidance of federal income tax. Treas. Reg. § 1.752-2(j) provides that a partner’s obligation to make a payment may be disregarded if the facts and circumstances indicate that a principal purpose of the arrangement is to eliminate the partner’s economic risk of loss with respect to that obligation, if the substance of the arrangement is otherwise. The general anti-avoidance rules include Treas. Reg. § 1.701-2, which authorizes the IRS to recast a transaction that has tax results inconsistent with the intent of subchapter K.

3. Economic Substance Doctrine (ESD)

A. Codification of ESD. In 2010, Congress codified the ESD, in § 7701(o), and certain related penalty provisions, in §§ 6662(b)(6) and 6664(c)(2). Section 7701(o) generally provides that if the ESD is relevant, the taxpayer must establish that:

(1) the transaction changes in a meaningful way (apart from its federal income tax effects) the taxpayer's economic position; and

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(2) the taxpayer has a substantial purpose (apart from those tax effects) for entering into the transaction.

Prior to the enactment of § 7701(o), the circuit courts of appeal disagreed as to whether the taxpayer had to establish both elements of the test. The codification of the ESD resolved this circuit-split and now a taxpayer must meet both elements of the test to establish that a transaction has economic substance.

B. Application of the ESD. For the ESD to apply, the following elements must be present:

(1) There must be a “Transaction.” For purposes of the ESD analysis, Notice 2014-58 addresses the facts and circumstances that the IRS will consider when determining whether the steps of a plan should be aggregated into one transaction or disaggregated into multiple transactions. Generally, when a plan involves a series of interconnected steps with a common objective, the steps should be aggregated into one “transaction.” However, when a series of steps includes a tax-motivated step that is not necessary to achieve a non-tax objective, the steps of the “transaction” may be disaggregated and only the tax motivated step may be considered.

(2) The ESD Must be Relevant to the Transaction. The determination of whether the ESD is “relevant” is to be determined in the same manner as if the ESD had been codified. Luke commented that she believes that the primary purpose for including the “relevant” provision in § 7701(o) was to maintain the pre-codification balance of decision-making between tax agencies and courts.

(3) The Transaction Must Have Economic Substance. The taxpayer must establish the first prong of the ESD test by proving that the transaction changes in a meaningful way (apart from its federal income tax effects) the taxpayer's economic position. This is an objective inquiry.

(4) The Taxpayer Must Have a Substantial Purpose for Entering Into the Transaction. The taxpayer must establish the second prong of the ESD test by proving that he has a substantial purpose (apart from those tax effects) for entering into the transaction. The second prong is a subjective inquiry that focuses on the taxpayer’s unique motivations for engaging in the transaction.

C. Penalties. A taxpayer is subject to penalties if a transaction lacks economic substance, as follows: (1) 20% of the underpayment if the transaction is disclosed and (2) 40% of the underpayment if the transaction is not disclosed. There is no reasonable cause exception for this penalty, so, in effect, the penalty is a strict liability penalty.

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D. Effect of the Codification of the ESD on Other Judicial Doctrines. Because the ESD requires a taxpayer to establish that the transaction had economic substance and a substantial purpose (other than tax avoidance), Luke and Solomon commented that they believe that the ESD has subsumed the Sham Transaction Doctrine.

4. Other Theories to be Considered

A. Sham Transaction. (the asserted facts are false)

B. Business Purpose. (tax benefits are sustained only if the transaction has a business purpose)

C. Substance Over Form. (a transaction will be treated in accordance with its substance rather than its form)

D. Step Transaction Doctrine. (steps can be ignored, reordered or integrated)

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III. Current Issues in Tax Administration (Wilkins)

William J. Wilkins, the Chief Counsel of the IRS, discussed some of the significant issues facing IRS leadership.

1. Reduction in Personnel

Wilkins addressed the pervasive impacts that the reduction in the IRS’s budget has had upon the IRS. Budget cuts have resulted in hiring freezes, reductions in the number of IRS attorneys (by almost 14%) and reductions in support staff (by 30%). Wilkins candidly remarked that the IRS has been unable to deliver the customer service experience that it hoped to during the 2014 tax season. Hopeful for the future, however, Wilkins stated that the IRS leadership’s highest priority is to rebuild its personnel by recruiting more attorneys from law school for the honors program and hiring more support staff and paralegals.

2. Increased Responsibilities

Despite the reduction in its workforce, the IRS’s responsibilities have dramatically increased due to the rollout of FATCA and the ACA. By way of example, solely with respect to the ACA, the IRS has overseen the execution of 47 final treasury regulations, 49 proposed treasury regulations, 72 notices, 3 revenue rulings, and 12 new IRS publications.

3. Tax Exempt Organization Controversy

Since May 2013, certain members of the IRS leadership have been replaced and, due to the commencement of lawsuits and congressional investigations, the IRS has spent a significant amount of time and resources defending the lawsuits and cooperating with the investigations.

4. Technology

Wilkins remarked that the IRS has struggled to keep up with technological advances. Three significant initiatives are (1) to update the IRS’s online information tools to make them more useful and user-friendly, (2) to create a virtual service delivery system that would enhance the taxpayer’s ability to take care of the taxpayer’s various tax-related obligations online, and (3) to create a “real time” tax system.

Using a real time tax system, the IRS could embed third-party information into its pre-screening filters, which would alert a taxpayer when he files his return that the information on the return does not match the IRS’s records. This could provide the opportunity for taxpayers to fix their returns before the IRS accepts them. This system would allow prompt error resolution and allow taxpayers to correct mistakes immediately, which Wilkins believes will help reduce back-end auditing.

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Wilkins also discussed the success of the IRS’s recent technology projects. These projects include:

A. IRS Direct Pay (available at http://www.irs.gov/Payments/Direct-Pay). IRS Direct Pay is a free service allowing the taxpayer to pay his individual tax bill or estimated tax payment directly from a checking or savings account. The taxpayer receives instant confirmation that his payment has been submitted.

B. IRS2Go . IRS2Go, a smartphone application, lets a taxpayer check the status of his tax refund and obtain helpful tax information.

C. Get Transcript (available at http://www.irs.gov/Individuals/Get-Transcript). Get Transcript allows taxpayers (who have social security numbers) to immediately obtain copies online of their Tax Return Transcripts, Tax Account Transcripts, Records of their Account Transcripts, Wage and Income Transcripts, and Verification of Non-Filing Letter.

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IV. Debt v. Equity for U.S. Federal Tax Purposes (Shashy / Friel)

Abraham N.M. Shashy, former Chief Counsel of the IRS and partner at King & Spalding, LLP, and Michael Friel, Associate Dean and the Director of the University of Florida Levin College of Law Graduate Tax Program, discussed debt-equity issues for U.S. federal tax purposes.

1. Common Contexts in Which Debt-Equity Issues Arise

Debt-equity classification issues commonly arise in the following contexts:

A. The treatment of yield payments.

(1) Debt Instruments. Generally, (1) the yield is taxable to the holder as interest income subject to ordinary rates as high as 39.6%, §§ 1, 11, 61, and 451, (2) the yield is deductible by the issuer as interest, §§ 163, 461, and (3) the timing of the inclusion or deduction is determined under the holder’s and issuer’s respective method of accounting, unless the original issue discount rules apply, §§ 451, 461, 1271-76, see also § 163.

(2) Equity Instruments. Generally, the consequences to the holder depend on whether the issuer is a corporation or partnership for tax purposes. If the issuer is a corporation, the yield is treated as either a dividend, return of basis, or gain to the holder. § 301. If the issuer is a partnership, the yield is either a distribution (return of basis or gain), a guaranteed payment (taxable as ordinary income), or proceeds of a disguised sale. §§ 707(a)(2)(B), 707(c), 731-32. Unless the issuer is a partnership and the yield is a guaranteed payment, the issuer gets no deduction for the yield. § 707(c).

(3) Generally, the yield payment by a corporate issuer to a foreign holder is subject to U.S. withholding tax at a rate of 30%. §§ 871(a)(1), 881(a)(1), 1441, but see §§ 871(h), 881(c). The U.S. withholding tax rate under an applicable tax treaty may differ depending on whether the instrument is classified as debt or equity.

B. The consequences of worthlessness.

(1) If the instrument is debt (other than a “security” (as defined in § 165(g)(2))), generally, the holder is entitled to an ordinary loss (a business bad debt) or a short-term capital loss (a non-business bad debt) in the year of worthlessness. § 166. The amount of the loss is the holder’s adjusted basis for the debt. The issuer has cancellation of debt income equal to the unpaid adjusted price of the debt. § 61(a)(12), but see § 108.

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(2) If the instrument is corporate equity or a “security” (as defined in § 165(g)(2)), generally, the holder is deemed to recognize a loss as though the instrument were sold on the last day of the taxable year in which the instrument becomes worthless. § 165(g)(1). The issuer of equity is unlikely to recognize income from worthlessness. §§ 721, 1032.

C. The receipt of principal repayments.

(1) If the instrument is debt, generally, on the retirement of any debt instrument, the holder recognizes gain or loss depending upon the holder’s basis. §§ 1271, 1001.

(2) If the instrument is equity, the tax consequences differ depending upon whether the entity is treated as a partnership or a corporation for tax purposes. If a partnership, a principal repayment is generally either treated as a partnership distribution or as a disguised sale. §§ 707(a)(2)(B), 731. If a corporation, a principal repayment gives rise to a redemption that must be tested under § 302 for dividend or sale treatment.

(3) If the holder of the instrument is a foreign person, the determination of whether the instrument is debt or equity is a high-stakes decision. If the instrument is debt, a foreign holder would not be subject to U.S. tax. If the instrument is equity, however, the principal repayment is subject to a 30% withholding tax if it constitutes a dividend under §§ 301 and 302, but would be tax free if it is classified as a sale of stock under § 302. If the instrument is equity in a partnership, a principal repayment likely would be subject to U.S. withholding and could result in gain that could subject the foreign holder to U.S. taxation under Rev. Rul. 91-32. §§ 731, 875, 1446.

D. The Issuance for Property.

(1) If the instrument constitutes debt, generally, the holder will have a taxable transaction and may recognize gain or loss, § 1001, but see § 453, the issuer takes a cost basis in the acquired property, § 1012, and the holder and issuer both begin new holding periods.

(2) If the instrument constitutes equity, generally, the holder will not recognize gain or loss, §§ 351, 721, but see § 351(g), the issuer would have a carried over basis for acquired property, §§ 362, 723, and the holder and issuer have tacked holding periods, § 1223.

2. Framework for Debt-Equity Issues

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A. Code and Treasury Regulations. Section 385(a) authorizes the Treasury to issue regulations as necessary or appropriate for the determination of whether an interest in an entity is to be treated as debt or equity. Section 385(b) suggests a nonexclusive list of factors that may be included in such regulations. Currently, there are no regulations proposed or in effect that implement the statutory provisions of § 385. In 1983, the IRS withdrew regulations previously in effect under § 385. Section 385(c) provides that the issuer of the interest and the holder of the interest are generally bound by the issuer’s characterization of the interest as either debt or equity.

B. Administrative Guidance. Notice 94-47 also provides factors to be considered when determining whether an instrument constitutes debt or equity.

C. Judicial Authorities. Most of the relevant guidance and analysis in this area is found in judicial authorities, which provide a multitude of factors to be used to distinguish debt from equity. No single factor is determinative because courts examine the totality of the facts in making this determination. The speakers compiled a list of twelve factors that courts have commonly considered to determine whether an instrument is debt or equity:

(1) Intent of the Parties. Whether the parties intend the instrument to be debt is a significant element in determining whether an instrument constitutes debt or equity. See Malone & Hyde, Inc. v. Commissioner, 49 T.C. 575 (1968), acq. 1968-2 C.B. 2. The subjective intent of the parties is best determined indirectly using objective factors. See Estate of Mixon, 464 F.2d 394, 407 (5th Cir. 1972).

(2) Identity of Interest Between Creditor and Stockholder. Whether the advances were made by the shareholders to the entity, in proportion to each shareholder’s respective interest in the entity. See Bauer v. Commissioner, 748 F.2d 1365, 1370 (9th Cir. 1984).

(3) Management and Participation and Voting Rights. Whether a creditor has the right to participate in the management of the entity. A holder’s right to participate in the management of the issuer is generally indicative of equity rather than indebtedness. See Zilkha & Sons, Inc. v. Commissioner, 52 T.C. 607, 616 (1969).

(4) Debtor’s Ability to Obtain Funds From Outside Sources. Whether the issuer could obtain a loan from a third-party on similar terms. The ability of an issuer to borrow funds on similar terms from third-party sources supports treatment of the instrument as bona fide indebtedness. See NA General Partnership, 103 T.C.M. 1916 (2012).

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(5) Debt-Equity Ratio and Adequate Capitalization. Whether the issuer is adequately capitalized; if not, the “debt” may be recharacterized as equity. See Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (5th Cir. 1972). Although there is no bright-line rule regarding what constitutes “adequate capitalization,” Shashy said that a debt-equity ratio exceeding 3/1 may suggest improper capitalization.

(6) Risk Analysis. Whether the creditor is exposed to the same degree of risk that a third-party lender would ordinary bear.

(7) Formal Designation. Whether the issuer characterized the instrument as debt or equity. The fact that an issuer characterizes an instrument as indebtedness, while not determinative, is significant evidence that the instrument is intended as indebtedness for U.S. federal income tax purposes. See Commissioner v. O.P.P. Holding Corp., 76 F. 2d 11, 13 (2d Cir. 1935), acq., 1959-2 C.B. 6.

(8) Status Relative to Other Creditors. Whether the creditor’s unsubordinated right to be repaid under the instrument is equal or superior to other creditors. If so, the creditor’s status supports classification of the instrument as indebtedness. § 385(b)(2); see also Notice 94-47.

(9) Adequate Interest and Lack of Payment Contingencies. Whether the creditor has a fixed right to adequate interest and to be repaid. A bona fide lender, as a general matter, has a fixed right to interest at a rate that is fair and adequate. See Sabine Royalty Corp. v. Commissioner, 17 T.C. 1071 (1951), acq. 1952-1 C.B. 4. Also, in addition to a fixed right to interest, a bona fide lender also requires a fixed right to be repaid principal when due. See Gloucester Ice & Cold Storage Co., 298 F.2d 183, 185 (1st Cir. 1962).

(10) Source of Payments. Whether the issuer is required to repay the indebtedness regardless of whether the issuer makes a profit. Courts have determined that indebtedness exists when, among other things, a debtor is required to pay principal and interest regardless of its profits or lack thereof and is reasonably expected to be able to do so. See Gilbert v. Commissioner, 248 F. 2d 399, 402 (2d Cir. 1957).

(11) Fixed Maturity Date or Payable on Demand. Whether the instrument provides that the debt must be repaid by a fixed maturity date or on demand. This is often considered to be one of the most important factors for determining whether an instrument is debt because this establishes the creditor’s right to legally demand repayment.

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(12) Coincidence with Corporate Formation. Whether the debt was issued at the time the entity was formed. An advance of funds coincident with corporate formation indicates that the instrument is equity. Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968).

This list is non-exhaustive, indeed, the speakers even included a thirteenth factor that embodies all other factors that courts have used to determine whether an instrument is debt or equity (like the right to enforce payment of principal and interest upon default or the creditor’s failure to timely demand repayment).

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V. Residency, Domicile, and Foreign Trust Considerations for Inbound Nonresident Aliens (Kasner)

Stewart L. Kasner, a partner at Baker & McKenzie LLP, discussed how tax practitioners must act as a “goalie” for their foreign clients in order to protect them from being subject to U.S. income taxes and transfer taxes.

1. U.S. Federal Income Tax

If a foreigner is considered a U.S. resident for federal income tax purposes, he is subject to U.S. federal income taxation on his worldwide income. Generally, a foreigner is deemed to be a U.S. resident if he (1) becomes a U.S. citizen, (2) becomes a lawful permanent resident by obtaining a “green card,” or (3) meets the “substantial presence test” by being present in the U.S. (i) for at least 31 days during the calendar year, and (ii) for 183 days or more (determined by adding all the days of the current calendar year and 1/3 and 1/6 of the days of the first preceding calendar year and the second preceding calendar year, respectively). A person can avoid meeting the substantial presence test by staying in the U.S. for 121 days or less each year.

There are exceptions to the substantial presence test. One exception is if a foreigner can establish that he has a closer connection to a foreign country. A foreigner can qualify for this exception if: (1) he was present in the U.S. for less than 183 days in the current calendar year; (2) he has a tax home in a foreign country; (3) he can establish that he has a closer connection to the same foreign country where his tax home is located; (4) he has not applied for a green card or taken any affirmative steps to obtain a green card; and (5) he files a Form 8840 with a Form 1040NR, his non-resident alien income tax return. The third element is a facts and circumstances test. Some of the facts that the IRS will consider are where the taxpayer votes, receives his health care, registers his vehicles, and operates his businesses.

A foreigner’s income tax consequences may change if the U.S. has entered into an income tax treaty with the foreigner’s home country.2

2. U.S. Federal Estate and Gift Tax

A foreign person is subject to U.S. federal transfer taxes if he is a domiciliary of the U.S. A foreign person is deemed a U.S. domiciliary for transfer tax purposes if he is physically present in the U.S. and intends to reside in the U.S. indefinitely.

2 At this time, the U.S. has entered into income tax treaties with the United Kingdom, France, Italy, Germany, Switzerland, Netherlands, Sweden, Russia, Japan, China, Mexico, Venezuela, Barbados, Jamaica, and Trinidad and Tobego. There is a proposed treaty between the U.S. and Chile; however, the treaty has not yet been ratified.

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If a U.S. domiciliary, the foreign person is subject to U.S. federal estate tax on his worldwide assets and U.S. federal gift tax on gratuitous transfers made during his lifetime.

If a foreign person is not deemed a U.S. domiciliary for transfer tax purposes, he is subject to transfer taxes on real property or tangible personal property (i.e. art, cars, boats, planes) located in the U.S. The transfer of U.S. situs intangibles is subject to estate tax but not gift tax. The foreign person only receives an exemption of $60,000 on death transfers and transfer taxes are imposed at graduated rates from 26% (over $60,000) and 40% (over $1 million).

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VI. Dealer v. Investor Revisited (Genz)

Peter J. Genz a partner at King & Spalding LLP discussed whether the gain from the sale of property is characterized as capital gain or ordinary income, which depends on whether the seller is treated as a “dealer” or an “investor” for federal tax purposes.

1. Statutory Framework

A seller may be entitled to preferential tax treatment with respect to gain realized on the sale of a “capital asset.” Section 1221(a) defines a “capital asset” as property held by the taxpayer but specifically excludes from the definition of “capital asset” any property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. § 1221(a)(1). This exclusion is interpreted broadly because capital gain treatment is an exception from the normal tax requirements. Corn Products Co. v. Commissioner, 350 U.S. 46, 52 (1955).

2. Taxpayer Held the Property Primarily for Sale to Customers

A. Primarily. In Malat v. Riddell, 383 U.S. 569, 572 (1966), the Supreme Court ruled that “primarily” means “principally or of first importance” and requires more than just a substantial or essential purpose to sell. The courts generally look at the taxpayer’s entire history with respect to the property when analyzing this element. However, the courts recognize that a taxpayer’s entire history may not be relevant if the taxpayer changes his original purpose for owning the property and transitions from an investor to a dealer (for example, a long-time owner of a vacant lot later decides to subdivide the lot and sell the lots) or from a dealer to an investor (for example, a developer abandons his plans to develop property and holds the improved property for an extended period of time as an investment).

B. Sale to Customers. In Kemon v. Commissioner, 16 T.C. 1026, 1032-33 (1951), acq., when analyzing whether a security trader was a dealer or an investor, the Tax Court provided that “those who sell ‘to customers’ are comparable to a merchant in that they purchase their stock in trade, in this case securities, with the expectation of reselling at a profit, not because of a rise in value during the interval of time between purchase and resale, but merely because they hope to find a market of buyers who will purchase from them in excess of cost.” Mr. Genz commented that courts have generally not assigned the same significance to the “customer” phrase in real estate sales because any buyer of real estate is a customer.

3. Profits from Everyday Operation of a Business

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In two seminal cases in this area, Corn Products and Malat, the Supreme Court analyzed the purpose of this exception. In Corn Products, the Supreme Court stated that the legislative intent behind the exclusion was that profits and losses arising from the everyday operation of a business should be considered ordinary income or loss rather than capital gain or loss. Subsequently, in Malat, the Supreme Court stated the purpose of the exclusion was to differentiate the tax treatment of the profits and losses arising from the everyday operation of a business from the realization of appreciation in value accrued over a substantial period of time. Genz commented that practitioners should consider the Supreme Court’s standards and the “ordinary retailing activities” analysis in Treas. Reg. § 1.857-5(a) to help predict the outcome of dealer cases. If a seller of real property does not want to risk classification as a dealer, Genz suggested that he should take great care to avoid activities that add value to the real property prior to selling it, for example, he should not subdivide undeveloped land into tracts and begin selling the subdivided lots.

4. The Seller Must be Involved in a Trade or Business

In Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987), the Supreme Court held that to be engaged in a trade or business, a taxpayer must be involved in the activity with continuity and regularity, and the taxpayer’s primary purpose for engaging in the activity must be for income or profit.

5. Factors

Many cases apply the dealer test at the time of the sale.

Renting an asset for an extended period of time suggests an investor counting on appreciation (as opposed to a dealer).

Because all of the elements are inherently factual, courts analyze several factors to determine whether the taxpayer is a dealer or investor. In United States v. Winthrop, 417 F.2d 905, 910 (5th Cir. 1969), the Fifth Circuit analyzed the following seven factors: (1) the nature and purpose of the acquisition of the property and the duration of ownership; (2) the extent and nature of the taxpayer’s efforts to sell the property; (3) the number, extent, continuity, and substantiality of the sales; (4) the extent of subdividing, developing, and advertising to increase sales; (5) the use of a business office for the sale of the property; (6) the character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and (7) the time and effort the taxpayer habitually devotes to the sales.

6. Self-Employment Tax

Self-employment taxes are not imposed on gains or losses from the sale of property that is neither inventory nor held primarily for the sale to customers in the ordinary course of a trade or business (§ 1402(a)(3)(C)) or sales of capital assets (§ 1402(a)(3)(A)).

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7. Section 453

Dealer dispositions cannot be reported on the installment method. § 453(b)(2)(A), (l)(1)(B).

Thursday, April 23rd

VII. Taxing Bets on the Future: Partnership Options and Carried Interests (Burke / Sowell)

Professor Karen C. Burke, the Richard B. Stephens Eminent Scholar a d Professor of Law at the University of Florida, and James B. Sowell, Principal at KPMG, LLP, discussed how a partnership can incentivize high-level employees by linking part of the return on their services to the success of the business. In particular, Burke and Sowell addressed the taxation of the issuance of a profits interest that may be vested or unvested.

1. Overview

In determining the taxation of the transfer of an interest, it is necessary to determine whether the interest is a capital interest or profits interest and whether the interest was vested or unvested. A capital interest received in exchange for the performance of services can be vested or unvested.

2. Vested Interest – Capital Interest v. Profits Interest

A vested interest means that the interest can be freely transferred and it is not subject to a substantial risk of forfeiture. Unvested means the interest does not meet one or both of those conditions. A service provider who receives a vested capital interest must recognize taxable compensation income at the time the interest is granted. The amount of compensation income is equal to the fair market value of the partnership interest granted. The partnership receives a corresponding tax deduction. The grant of a profits interest is a non-taxable event if the IRS safe harbor applies.

A. IRS Safe Harbor (Rev. Proc. 93-27).

(1) Capital Interest - An interest that gives the holder the right to share in the proceeds of a hypothetical liquidation.

(2) Profits Interest – An interest that is not a capital interest. The receipt of the profits interest for services is not a taxable event to the partner or partnership unless one of the following occurs:

- The interest relates to a substantially certain and predictable stream of income from partnership assets;

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- The recipient disposes of the interest within 2 years of receipt; or - The interest is a limited partnership interest in a “publicly traded partnership”

under § 7704(b).

B. Case Law. The courts have held that a transfer of a capital interest is a transfer of property and taxed pursuant to § 83. Crescent Holdings, LLC, 141 T.C. 477 (2013); Mark IV Pictures, Inc., T.C. Memo. 1990-571. The courts have been less clear about the taxability of the profits interests to service providers. See, e.g., Campbell, 943 F.2d 815 (8th Cir. 1991) (suggesting in dicta that the receipt of profits interest was not taxable due to speculative value of interest); St. John, 84-1 U.S.T.C. ¶9158 (S.D. Il. 1983) (holding that the liquidation value approach was proper for valuing profits interest issued for services where the partnership value was undetermined and speculative); Diamond, 492 F.2d 286 (7th Cir. 1974) (finding the value of a profits interest readily determinable when sold soon after receipt); see also GCM 36346.

C. Takeaway. The holder of the interest can look to see if the interest qualifies under the safe harbor in order to classify the interest as a profits interest. If the interest does not qualify or if one of the exceptions applies, the holder may attempt to rely on Campbell and St. John to the extent that the value of the profits interest is zero based on the highly speculative nature of the interest.

3. Unvested Interests – Taxation of Capital Interest vs. Profits Interest

A service provider who receives an unvested capital interest does not recognize taxable income until the risk of forfeiture lapses and the interest becomes transferable. At that time, the provider has taxable compensation income equal to the fair market value of the partnership interest and the partnership has a corresponding tax deduction. If the service provider makes a timely § 83(b) election, the provider recognizes taxable compensation income equal to the fair market value at the time of grant and the partnership has a corresponding tax deduction.

A. Rev. Proc. 2001-43 “clarifies” Rev. Proc. 93-27. An unvested profits interest is treated similarly to the grant of a vested profits interest as long as certain conditions are met:

(1) Both the partnership and the service provider treat the service provider as a partner beginning with the date of grant;

(2) The service provider picks up the K-1 items associated with the partnership interest (i.e. income, gain, loss, etc.) on his or her Form 1040;

(3) No compensation deduction is taken in connection with the grant of the partnership interest; and

(4) All of the requirements of Rev. Proc. 93-27 are satisfied.

If each of the preceding items are met, Rev. Proc. 2001-43 states that the § 83(b) election with respect to the partnership interest is not required. Essentially, the partnership and holder are

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treated as if the holder made a valid § 83(b) election and valued the partnership interest at zero.

B. Failure to Qualify under the Safe Harbor. If the service provider is outside the revenue procedures and no election is made under § 83(b), the taxpayer may attempt to rely on a recent decision. Crescent Holdings, LLC, 141 T.C. 477 (2013) (analyzing compensatory capital interest for which no § 83(b) election was made held that holder of interest subject to a substantial risk of forfeiture was not the owner of the interest for federal tax purposes).

4. Proposed Regulations

Proposed regulations and a proposed revenue procedure (Notice 2005-63, 2005-24 I.R.B. 1221) were issued on May 2, 2005, addressing compensatory partnership interests. If finalized, compensatory partnership interests (capital and profits) and the timing of income and deductions would be subject to § 83.

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VIII. Defending Conservation Easements in an Adverse Tax Environment (Levitt)

Ronald Levitt, a Shareholder at Sirote & Permutt, PC, discussed how to prepare and defend a conservation easement in today’s environment where any practitioner with a client taking a deduction for a conservation easement should expect some level of IRS review.

1. What is a conservation easement?

A. Code Section . Section 170(f)(3) denies a deduction for a charitable gift of a partial interest. One exception to the general rule is for a gift of a qualified conservation contribution. Under §170(h), a “qualified conservation contribution” occurs if (i) a qualified real property interest (ii) was contributed to a qualified organization (iii) to be used exclusively for conservation purposes. Generally, a conservation easement is a set of restrictions on a taxpayer’s use of property. The taxpayer still owns title to the property, but a qualified charity has the right to enforce the restrictions imposed upon the property.

B. Benefits . The benefits include –

(1) An assurance that the land keeps it current use (i.e. golf course, hunting land, etc.) and that the land stays in the family since the easement discourages the sale and development of the property.

(2) A benefit to the environment by protecting wildlife, forests, and green spaces (i.e. walking trails, vistas, wildlife sanctuaries etc.).

(3) A charitable deduction for the difference between (i) the valuation of the highest and best use of the property and (ii) the valuation of the property with the limited use. See I.R.C § 170(h).

(4) A possible estate tax exclusion or deduction. See I.R.C. § 2055(f) and § 2031(c).

C. Parties Involved . (the landowner (i.e. taxpayer), a land trust or governmental organization, a qualified appraiser, a biologist or other scientist, and tax practitioners (i.e. the taxpayer’s lawyer and CPA))

2. What are the requirements?

A. Perpetuity . The conservation restrictions must be recorded and forever restrict the uses described in the easement. For this reason, any outstanding mortgages, encumbrances, liens, mineral rights, title issues, or other rights of third parties must be subordinated to the rights of the land trust to enforce the conservation easement restrictions. The subordination must be effective before the grant of the easement.

B. Qualified Organization . The easement must be given to a qualified governmental

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organization or tax-exempt organization (i.e. a land trust). The land trust must review the property periodically to assure that the property is in compliance with the terms of the easement and that the purpose of the conservation is being preserved. If a landowner violates the terms of the easement, the land trust must have the ability and desire to take appropriate enforcement actions that are available under the law.

C. Valid “Conservation Purpose” . In § 170(h)(4), Congress defined four types of valid “conservation purposes” as follows:

(1) Preservation of land for outdoor recreation by, or education of, the general public;

(2) Protection of a significant, relatively natural habitat of fish, wildlife, or plants, or similar ecosystem;

(3) Preservation of open space, including farmland and forest land, for the scenic enjoyment of the general public, or preservation of open space pursuant to a clearly defined governmental conservation policy, provided such preservation will yield a significant public benefit; and

(4) Preservation of a historically important land area or certified historic structure.

Practically, if one of the areas is present, the landowner and the land trust must agree on a set of restrictions that will preserve the conservation purpose of the property in perpetuity. These restrictions become the core of the documents governing the conservation easement.

D. Substantiation and Reporting . Prior to filing his tax return, the taxpayer should obtain baseline documentation that details the condition of the property and the conservation values associated with it. The fundamental documentation of the conservation easement must be carefully drawn, and the execution and recording of the documents must be done in the proper time and manner. In addition, the donor’s tax return must include a form that is signed by the appraiser and by the land trust and that sets out certain information about the donation and the donated property. It is of utmost importance to follow these strict formalities.

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IX. Defending Against the IRS rubbing Salt in the Wound (Aughtry)

David D. Aughtry, Shareholder at Chamberlain, Hrdlicka, White, Williams & Aughtry, discussed the legal and factual arguments for penalty abatement. This summary will focus on Aughtry’s discussion of reasonable reliance as a basis for penalty abatement.

1. Overview

In seeking abatement of an IRS penalty, the taxpayer may rely upon “reasonable cause.” Aughtry commented that tax penalty abatement is generally appropriate when the taxpayer exercises ordinary business care and prudence, but nevertheless fails to comply with their obligations. One of the most common claims of “reasonable cause” is reasonable reliance on a tax advisor.

2. Statistics

While the 1955 Internal Revenue Code included 10 penalty provisions, the current Internal Revenue Code includes over 150 penalty provisions.

3. Recent Case Law

In CNT Investors, LLC v. Commissioner, 144 T.C. No. 11 (March 23, 2015), the Tax Court provided an important resource for practitioners analyzing penalty abatement cases founded upon reliance on a tax advisor. The Court outlines the specific elements for a taxpayer seeking to assert reasonable reliance and good faith under § 6664(c) and the corresponding regulations –

(1) Whether the taxpayer relied upon a competent advisor who had sufficient expertise to justify reliance;

(2) Whether the taxpayer affirmatively provided the necessary and accurate information to the advisor on whose advice the taxpayer relied;

(3) Whether the taxpayer actually received the advice and relied upon it in good faith;

It is important to note that the overriding factor in determining proper tax liability under the law is the taxpayer’s effort to assess his proper tax liability. The taxpayer should show that under the circumstances, the taxpayer reasonably relied on the advice.

Assuming reasonable reliance, there appears to be no obligation to seek a second opinion. See United States v. Boyle, 469 U.S. 241, 251 (1985).

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X. “Review” of an Individual Judge’s Opinion by the Full Tax Court (Gustafson)

Judge David D. Gustafson, a Judge at the United States Tax Court, provided some insights into the Tax Court (“Court”). In particular, Judge Gustafson discussed the process leading to a review by the Court and the actual review by the full Court.

1. Types of Tax Court CasesThe three types of Tax Court cases are (1) a review by the full Tax Court, (2) division opinions (i.e. formally published by the Court and designated as precedent), and (3) memorandum opinions.

2. Process Leading to Review by the Court

The authoring judge makes a report and submits the proposed opinion to the Chief Judge. The Chief Judge considers it with input from other judges and staff attorneys. The Chief Judge determines whether to recommend that the report be reviewed by the Court. If the Chief Judge does not recommend the report for review, the opinion is released. If the Chief Judge does recommend the report for review, the opinion is referred to the full Court for review at the “Court Conference.”

3. Types of Cases Selected for Review

While there is no bright line rule for review by the full Court, cases that are submitted to the full Court are generally where (i) a regulation is overturned, (ii) precedent is being overturned, (iii) there is widespread application and the result may be controversial, or (iv) there is general disagreement among the judges. Opinions are typically provided to each judge prior to publishing. As such, there is often collaboration with other judges in authoring an opinion. Many disagreements are often settled here, prior to the authoring judge submitting the proposed opinion to the Chief Judge.

4. Process of Court Conference Review

The process of Court Conference Review is confidential and not open to the public. Judge Gustafson explained that the review typically begins with the authoring judge providing a presentation in the conference room consisting of the judges on the Court. Once the presentation is finished, each individual judge is allowed to offer his or her opinion regarding the report and ask questions. Upon the completion of the discussion, the judges vote on whether to adopt the report. If a majority of judges approve, the report is published subject to concurring and dissenting opinions. At the time the opinion is published, it will be the first time that the parties learn that the case was subject to review by the full Court. Court review is not available on motion of the parties.

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XI. The Examination and Appeals Process (Kay)

Sheldon “Shelly” M. Kay, Partner at Sutherland and former IRS Chief of Appeals, and Samuel C. Ullman, Professor of Law at the University of Florida and Consulting Counsel at Bilzin Sumberg, discussed the IRS examination and Appeals Process.

Taxpayer is afforded opportunity to challenge the IRS positions both administratively and judicially on either or both substantive and procedural errors.

1. Examination Overview

In an examination, the IRS agent’s job is to (1) make determinations of fact, (2) apply the service’s position on the law, and (3) determine the correct tax liability. The examination is primarily a fact-gathering exercise and presents little opportunity to present a legal argument.

2. Types of Examination

The three types of examination are as follows –

(1) Correspondence examination – conducted through mail by a Tax Compliance Officer who is located at an IRS campus. It deals with issues that can be settled without a meeting.

(2) Office examination – Conducted in the area by a Tax Compliance Officer and involves a meeting with the taxpayer or his representative. It deals with issues that cannot be settled through correspondence.

(3) Field Examination – Conducted by a Revenue Agent or Tax Compliance Officer from the area officer usually at the taxpayer’s place of business or the representative’s office. It is the most expensive, time-consuming, and complex type of audit.

3. Techniques for IRS to obtain Information in an Examination

The IRS tries to obtain as much information as possible from the taxpayer on a voluntary basis. The IRS lists the documents it wants in an Information and Document Request (“IDR”). The taxpayer’s failure to comply with an IDR typically results in the issuance of a (i) delinquency notice, (ii) then a pre-summons letter, and (iii) finally a summons under § 7602. If the IRS seeks information from a third party, the IRS must provide the taxpayer with notice in order to provide the taxpayer the opportunity to attempt to squash the action in a federal district court. Taxpayer defenses to an IDR include, but are not limited to, procedural defects, improper purposes, bad faith, or undue burden.

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4. Appeals

The IRS Appeals Division is an independent group within the IRS that is charged with acting as a neutral participant to resolve tax controversies, without litigation, on a basis which is fair and impartial to both the government and the taxpayer. The case can be referred to Appeals through one of the following - (1) revenue agent’s report, (2) early referral (see Rev. Proc. 99-28), (3) competent authority (4) fast-track settlement (see Rev. Proc. 2003-40), or (5) Tax Court (see Rev. Proc. 87-24).

5. Advantages and Disadvantages of Appeals

Advantages include avoiding the expense and publicity of litigation, allowing additional negotiating time, deferring the payment of taxes, providing flexibility for related cases, increasing the likelihood of settling without litigations, and providing the opportunity to discuss complex cases.

Disadvantages include the statute of limitations remaining open (taxpayer must extend) and that the case will not be resolved quickly because the appeals process is time consuming.

6. Recommendations

Mr. Kay provided the following tips for practitioners engaging the Appeals process.

(1) The Protest should tell a story and include all facts that prove the case – add in expert reports, present new facts, and provide an order of the issues.

(2) Always ask appeals for a rebuttal by the agent if there is one and remember to keep it professional - “It’s not personal Sonny, it’s strictly business.”

(3) Prepare for the conference – determine whether there are any coordinated issues (who is the coordinator and who has settlement authority), know your appeals team (who is participating, what are their roles), and structure a brief but compelling presentation. Be proactive and communicate early and often.

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XII. Foreign Investments in U.S. Real Property (Sherman)

William B. Sherman, Partner with Holland & Knight, discussed the income, estate and gift tax considerations when investing in U.S. real property.

1. Income Tax

Non-resident aliens (“NRA”) and Foreign Corporations are subject to income tax on (i) income effectively connected with a U.S. business (“ECI”), (ii) U.S. sourced fixed, determinable, annual or periodical (“FDAP”) income (passive income), (iii) capital gains, if the NRA is in the U.S. for 183 days or more, and (iv) gain from the disposition of a U.S. real property interest (“FIRPTA”).

Each source of income is taxed as follows:

(1) Effectively connected income is generally taxed at the same rates as a U.S. person (branch profits tax applicable to foreign corporations).

(2) U.S. Source FDAP income is subject to a 30% withholding tax unless reduced by an income tax treaty.

(3) FIRPTA gains are treated the same as ECI.

2. Estate and Gift Tax of NRAs

Only U.S. situs assets are subject to estate tax including real property located in the U.S., shares of stock in a U.S. corporation (for estate tax purposes only), tangible personal property located in the U.S., certain debt obligations of U.S. persons and U.S. government, and intangible property used in the U.S. One planning note is that NRAs are taxed on gifts of tangible (but not intangible) property located in the US. Accordingly, gifts of stock (and potentially partnership interests) are not subject to gift tax.

3. Determination of U.S. Income and Estate Tax Residency

There are different tests for income and estate/gift tax. As such, it is possible that an individual is not a resident for income tax purposes but is a resident for estate tax purposes (and vice versa).

For income tax purposes, there are two objective tests (other than becoming a U.S. citizen – (1)the Green card test, and (2) the “substantial presence test” which is met by an individual being present in the U.S. (i) for at least 31 days during the calendar year, and (ii) for 183 days or more (determined by adding all the days of the current calendar year, 1/3 of the proceeding year, and 1/6 of the days of the second preceding calendar year).

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For estate tax purposes, there is one subjective test – whether the foreign person was physically present in the U.S. with the intention to remain indefinitely (similar to state residency).

4. Real Property Rental Income for a NRA

The first issue is whether to classify the income as FDAP or ECI income.

Since FDAP is subject to a 30% withholding tax on gross income (assuming no tax treaty applies), the lessee has a withholding tax obligation. Failure to comply can result in grossed-up tax liability. As such, it is important that the lessee always determines whether the lessor is a NRA. This may be difficult in the situation where the lessor is a partnership. In that case, it is recommended that the lessee request a Form W-9 from the lessor.

The lessee should also be aware of situations where the leasing activity leads the foreign owner to have ECI. While rental of one property under a “net” lease is not effectively connected, see, e.g. Rev. Rul. 75-32, renting to multiple tenants could make it effectively connected, see Pinchot v. Commissioner, 113 F. 2d 718 (CA 2 1940).

A. Practical Considerations . It is often recommended that the Lessor elect to treat the income as ECI under §§ 871(d), 882(d), or a treaty equivalent so that the lessor has access to additional deductions. If the rental income is ECI, the lessor may provide a Form W-8ECI to the lessee in order to eliminate the withholding tax obligation of lessee. Nevertheless, if the lessor is a partner in a partnership, the partnership will have a tax withholding obligation under § 1446.

5. Proceeds from the Sale of Real Property

Gain from the sale of real property treats a foreign seller as if engaged in trade or business in the U.S. The seller is taxed at the same rates applicable to U.S. sellers and the gain can qualify for long-term capital gain treatment, if applicable. The buyer has a withholding requirement of 10% of the amount realized on the sale under § 1445. The problem is that the amount withheld may exceed the tax liability. There are exceptions, including, but not limited to, the filing of Form 8288-B prior to the sale, the seller providing a non-foreign affidavit, or the sales price is less than $300,000 and the buyer will use the property as his or her residence.

6. Planning

(1) Understand investor characteristics – Home country taxation, residency, intent, type of investor (i.e. real estate, stock, etc.)

(2) Ascertain investment characteristics and objectives:i. Use – personal use, business, investment

ii. Types of income generated from real estate: Rent, interest, dividends, capital gains, services and others

iii. Capital – equity, debt iv. Exit – anticipated timing, method

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(3) Consider choice of entity – wholly-owned, joint ventures, passive investment (4) Withholding and compliance (5) Estate and gift taxes

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XIII. It Still Takes a Village: Balancing Professionalism, Privilege, and Advocacy in Tax Controversies (Campagna)

Larry Campagna, Shareholder at Chamberlain, Hrdlicka, White, Williams & Aughtry, discussed how professionalism must be part of who we are as lawyers. While ethical rules may be amended and tweaked, the duty to practice in a fashion that honors and promotes the profession must never waiver. Mr. Campagna provided a number of case studies in professionalism that raised ethical questions, discussed Kovel Accountant Issues, and provided practical tips for preparation for an IRS interview.

1. Misleading Correspondence (H Graphics / Access Case)

A taxpayer in an examination submitted an offer of settlement with different terms than the original offer presented by the IRS. While the taxpayer stated that it was his offer of settlement, neither the cover letter nor the revised offer indicated what changes were made to the offer. The IRS accepted the offer unbeknownst of the changes and subsequently argued that the agreement was invalid due to fraud and deception by the taxpayer. Significantly, the IRS TEFRA coordinator admitted that the changes would have been “immediately obvious” if compared. While the Court ultimately upheld the agreement since the taxpayer indicated that it was “his” settlement agreement, the Court reasoned that the IRS had the burden of proof and was unable to meet that burden.

The question presented for attorneys is how to balance our duty to zealously represent our client with our moral, ethical, and legal duties as lawyers? If there is no trust in other practitioners, we would be required to triple check every document to ensure no words have been added or changed. However, aren’t we always under a duty to know exactly what we are signing?

In the opinion, Judge Ruwe commented on the professional responsibility issue as follows: “We believe it appropriate to express our view that taxpayers, their counsel, and representatives of the Internal Revenue Service ought to conduct themselves in a way that eliminates the undercurrents of suspicion that arose in this case.”

2. Overreach by Government Counsel

In Dixon v. Commissioner, 316 F.3d 1041 (9th Cir. 2003), after the defense learned that a key witness for the government had a secret deal with the IRS, the Ninth Circuit found fraud on the court and provided that the IRS was required to give each defendant the same settlement that the IRS had given to the cooperating witness. The Court instructed the taxpayers to file ethics complaints against the IRS attorneys. As a result of this case, the IRS attorneys were eventually sanctioned by the state bar and disbarred from practicing before the IRS.

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3. Grand Jury Subpoena Correspondence

By way of background, grand jury proceedings are secret, but witnesses are generally free to discuss their testimony with counsel and others, unless the investigation is for fraud on a financial institution. Additionally, federal law prohibits knowingly intimidating, corruptly persuading, or misleading a witness. However, it is often routine for government attorneys to send letters to grand jury witnesses with language similar to the following – “Disclosure of the existence of this subpoena could impede the investigation being conducted and thereby obstruct law enforcement.” Defense lawyers may believe this to be intimidation or misleading, while prosecutors often view it as attempting to keep the investigation as secret as possible. The question is whether the attorney has crossed the line. Some courts have found it to be misconduct of the prosecutor for issuing overbroad warnings. See, e.g., In re Grand Jury Proceedings, 814 F.2d 61, 67 (1st Cir. 1987).

4. Kovel Accountant Issues

In United States v. Kovel, 296 F.2d 918 (2d Cir. 1961), the Second Circuit extended the attorney-client privilege to cover communication made to an accountant who had been hired by the attorney to assist on the tax issues in a criminal investigation. Some recommendations to bolster Kovel accountant privileges include – (i) no blanket claims of privilege, (ii) documentation of the attorney-client privilege, (iii) avoid the accountant having multiple roles (i.e. not a good fact if accountant assists in investigation while preparing the return), (iv) use a Kovel contract, and (v) document work product claims.

5. IRS Interview

Advisor can negotiate with an agent in advance to try and limit the scope of the IRS interview. For example, the advisor may attempt to determine and negotiate the questions that will be asked, who will be present (counsel or agent), whether the meeting will be transcribed or recorded, the issues that will be covered, documents that will be used or requested, and the location of the interview. It is important to understand that the IRS’s objective is to establish the taxpayer’s intent. While the taxpayer’s intent will be the focus of the interview, the taxpayer will benefit from the interview because he will be able to determine the IRS’s areas of interest and the strength of the IRS’s case.

6. Manipulation of Clients during Interviews

It is important to guard the line between interviewing and coaching – i.e. telling someone the letter of the law is probably safe, but telling someone what to say or insinuating the facts could be crossing the line. It’s important to learn the facts and defend the case based on the facts – always ask open-ended questions.

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In order to ensure that an attorney is practicing the law ethically, before acting, an attorney should always ask himself “how would it look if this action occurred before a judge?”

CITE AS:  

LISI Estate Planning Newsletter #2314 (June 18, 2015) at http://www.leimbergservices.com  Copyright 2015 Leimberg Information Services, Inc. (LISI).  Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

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