03 - CA 6 Rejects Country Club's Attempt to Offset Investment Income with Not-for-profit Activity Losses

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1 03 - CA 6 Rejects Country Club's Attempt to Offset Investment Income with Not-for-profit Activity Losses Losantiville Country Club v. Comm., (CA 6 10/15/2018) 122 AFTR 2d The Court of Appeals for the Sixth Circuit, affirming the Tax Court, has concluded that a Code Sec. 501(c)(7) social club did not intend to profit from its nonmember events and thus could not use losses from those events to offset its investment income. Background. Under Code Sec. 501(c)(7), clubs organized for pleasure, recreation and other nonprofitable purposes are tax exempt if substantially all of their activities are for those purposes, and no part of their net earnings inures to the benefit of any private shareholder. A club may receive up to 35% of its gross receipts from outside income. Within this 35%, not more than 15% of gross receipts may be derived from the use of the club's facilities or services by the general public. In general, organizations that are otherwise exempt from taxation under Code Sec. 501(a) are subject to tax on income from an unrelated trade or business (referred to as unrelated business taxable income, or UBTI). (Code Sec. 511, Code Sec. 512, Code Sec. 513) For social clubs and certain other exempt organizations, UBTI means gross income (excluding any exempt function income ; see below), less deductions that are directly connected with the production of gross income (excluding exempt function income), both computed with certain modifications relating to net operating losses, certain charitable contributions and specific deductions. (Code Sec. 512(a)(3)(A)) Exempt function income of social clubs is: (a) gross income from dues, fees, charges or similar amounts paid by members of the organization as consideration for providing the members or their dependents or guests goods, facilities or services in furtherance of the purposes constituting the organization's basis for exemption; and passive income set aside for certain purposes. (Code Sec. 512(a)(3)(B)) The Supreme Court, in Portland Golf Club v. Comm., (S Ct 1990) 65 AFTR 2d , held that in computing UBTI, a tax-exempt social club may use losses incurred in sales to nonmembers to offset investment income, but only if those sales were motivated by a desire for profit. The social club's food, payroll, and overhead expenses in excess of gross receipts from nonmembers sales were deductible only to the extent provided for in Code Sec. 162, and only if there was a profit motive with respect to sales to nonmembers. 10

2 A 20% accuracy-related penalty applies under Code Sec. 6662(a) where there is an underpayment attributable to negligence or disregard of rules or regs. (Code Sec. 6662(b)(1)) The accuracy-related penalty does not apply to any portion of the underpayment for which the taxpayer shows that there was reasonable cause and that he or she acted in good faith. (Code Sec. 6664(c)(1)) Facts. Losantiville Country Club (Club) is a Code Sec. 501(c)(7) social club with facilities including a golf course, swimming pool, and reception rooms. Club derives income from several sources: membership dues and memberexpenditures on food and drink, facility rentals to nonmembers, and interest and dividends on club investments. These last two sources of income are taxable as UBTI because the Code Sec. 501(c)(7) exemption operates properly only when the sources of income of the organization are limited to receipts from the membership." From 2002 through 2015, Club hosted nonmember events to generate additional revenue and attract new members. Gross receipts from these events always exceeded direct expenses, but every year Club reported a net loss after deducting the indirect expenses attributable to the nonmember sales. Between 2010 and 2012, Club offset its reported investment income with these losses. In 2013, IRS found that Club couldn't deduct these losses because it didn't have a profit motive and thus owed unrelated business income tax on its investment income. IRS also assessed accuracy-related penalties. Club challenged IRS's determination, arguing that IRS was focusing too narrowly on actual profitability vs. profit motive, which it claimed it could could establish under the "hobby loss" rules in Reg (b). This reg sets out nine nonexhaustive factors to consider in determining whether a taxpayer has a profit objective, including, among others, the taxpayer's expertise, the time and effort expended by the taxpayer in carrying out the activity, the amount of any occasional profits, and the taxpayer's financial status. Club also argued that it shouldn't be liable for accuracy-related penalties because it relied on a tax professional. Tax Court's conclusion. The Tax Court found that because Club did not intend to profit from its nonmember sales, it could not offset its investment income with losses relating to these sales. The Tax Court interpretted Portland Golf Club, as requiring Club to show actual profitability to establish that it intended to make a profit, which it was unable to do. In so holding, the Tax Court rejected Club's contention that its intent to profit could be established by the factors set out in Reg (b), finding that Code 11

3 Sec. 183 and its regs were not applicable to Code Sec. 501(c)(7) organizations. The Court also upheld IRS's imposition of accuracy-related penalties for negligence and disregard of the rules and regs, finding that while Club's returns for the years at issue were prepared by professionals, there was no evidence that the preparers had sufficient expertise to justify reliance, that Club provided them with the necessary and accurate information, or that Club relied in good faith on the preparers' judgment Sixth Circuit affirms. The Court of Appeals for the Sixth Circuit, while disagreeing with the Tax Court's reading of Portland Golf Club as requiring actual profitability to prove profit motive, nonetheless found that Club failed to show that it intended to profit and affirmed the Tax Court's decision that Club couldn't offset its investment income with the disputed losses. The Sixth Circuit also disagreed with the Tax Court's rejection of Club's reliance on the hobby loss factors to show profit motive, finding that courts have generally used these principles to guide profit motive analysis. However, as noted above, Club couldn't show a profit motive even when taking the hobby loss factors into account. Notably, Club focused on two of the factors the businesslike way that it planned and conducted nonmember events, and the appreciation of its land but the Court found that these factors were insufficient to show any profit motive for the nonmember events, which consistently produced losses year after year without any attempt by Club to reverse this trend. The Appellate Court also upheld IRS's imposition of a penalty, agreeing with the Tax Court's rejection of Club's reasonable cause defense. 12

4 04 - Voluntary Pastoral Donations to Minister Were Taxable Income, Not Nontaxable Gifts Felton, TC Memo The Tax Court has held that voluntary pastoral donations made payable to the minister of a congregation and tendered via specially marked envelopes were taxable income to him, and not nontaxable gifts. Viewed objectively, the donations were made to keep the minister at his post. Additionally, the specially marked pastoral donations were part of a routine, structured program and the purported gifts far exceeded the sum of the minister s deemed salary and parsonage allowance. Background. Under Code Sec. 61(a), gross income generally includes all income from whatever source derived. Gifts are excluded from income under Code Sec. 102(a). Under the Supreme Court's well-known holding in Comm. v. Duberstein, (S Ct 1960) 5 AFTR 2d 1626), the value of property acquired by gift is excluded if it: comes from a detached and disinterested generosity; is made out of affection, respect, admiration, charity or like impulses; is not made from any moral or legal duty, nor from the incentive of anticipated benefit of an economic nature; and is not in return for services rendered. A minister can exclude the rental value of a home furnished to him, or a rental allowance, if the Code Sec. 107 parsonage allowance rules are met. Facts. Reverend Wayne Felton established a church in Minnesota and built it into a large and success 600-family congregation. His wife, Deondra, was pastor of women s affairs and helped in the business of running the church, which was a tax-exempt organization. For 2008 and 2009, the church used three different types of contribution envelopes. The white ones, available at the door and distributed by ushers to all at services, were for normal contributions that sustained the church. These envelopes had a line marked pastoral for contributions to Rev. Felton. Church staff tracked white envelope donations, included them in members annual contribution statements, and gave Rev. Felton a breakdown showing how much income he had to report. Gold envelopes were for special programs and retreats and also were tracked by church staff and included in members annual statements. The blue envelopes were introduced to replace shake-hand money the custom in some evangelical churches to hand donations to the pastor on the way out of church. Rev. Felton was uncomfortable with the practice. He also said some congregants didn t want to use white envelopes because they did not want a tax deduction for pastoral donations, which they considered to be gifts. The blue envelopes were marked pastoral gift and indicated that checks should be made payable to Rev. Felton. He told his congregation they could donate to him 13

5 in blue envelopes but that they wouldn t get a tax deduction for such donations. Blue envelopes weren t available at the door and were not distributed by ushers; congregants had to ask for one. Rev. Felton, who didn t earn a salary for almost thirteen years while the church was young, didn t take a salary for 2000 and Instead, he received the donations made via blue envelopes, well over $200,000 for each of the years at issue, plus the amounts earmarked for pastoral contributions in white envelopes, which came to $40,000 a year (his deemed salary). He also received a parsonage allowance of $78,000 (not at issue in the case). The Feltons, who prepared their own tax returns, reported the white-envelope donations earmarked for him as income but did not report the blue-envelope donations as income. They claimed these amounts were gifts excludable under Code Sec. 102(a). IRS said the amounts were income, assessed a deficiency, and hit the Feltons with an accuracy related penalty under Code Sec. 6662(a). Tax Court rules for IRS. After reviewing the relatively sparse caselaw on the tax character of donations to clergy, the Tax Court said that the cases showed that the following factors are important in distinguishing between taxable payments and nontaxable gifts: whether the donations are objectively provided in exchange for services; whether the cleric (or other church authorities) requested the personal donations; whether the donations were part of a routinized, highly structured program, and given by individual church members or the congregation as a whole; and whether the cleric receives a separate salary from the church and the amount of that salary in comparison to the personal donations. Donations in exchange for services. The Tax Court said that the cases look at objective rather than subjective intent in determining the nature of a contribution, and there were no objective signs that the blue-envelope contributions were unrelated to future services. Contributions made in blue envelopes were not gifts, but rather from an objective perspective were meant to keep Rev. Felton preaching at the church. He provided intangible religious benefits, and the blue envelopes were in exchange for them and would to any reasonable person look like an incentive for him to keep providing the services. This factor tilted towards income, said the Tax Court. Donation requests. Congregants had to specifically ask an usher for a blue envelope and ushers didn't hawk them. Rev. Felton also preached about tithes and offerings in white envelopes, but he never preached about personal donations in blue envelopes. The fact that the church didn't solicit blue-envelope donations was an objective sign that the transferors proceeded from a detached 14

6 and disinterested generosity, out of affection, respect, admiration, charity or like impulses. This factor tilted towards gift. Routinized, highly structured program. The blue-envelope system in and of itself was evidence of a structured program, said the Tax Court: The envelopes said pastoral gift on them, and specified how to make checks out to Rev. Felton personally. The Court also couldn t ignore the sheer size of blue-envelope donations in 2008 and 2009, or the fact that they were very similar in amount in both years within 10% of each other. The Court found it more likely than not that there was a regularity of the payments from member to member and year to year, an indication that they were the result of a highly organized program to transfer cash from the church to Rev. Felton. These were regular, sizable payments made by people that Rev. Felton provided a service for, and were therefore hard to distinguish from compensation, the Tax Court said. This factor tilted towards income. Ratio of church salary to personal donations. Though the executive board approved a salary for Rev. Felton in 2008 and 2009, the church didn't actually pay it out to him in either of those years. He did receive $40,000 annually in personal donations from some members of the congregation in white envelopes, which he reported as wages in 2008 and The church also gave him a parsonage allowance of almost $80,000 per year. But these amounts were dwarfed by the blue-envelope donations, which amounted to $258,001 in 2008 and $234,826 in 2009, and were around double the sum of the white-envelope donations and parsonage for each year. The Tax Court said that when comparatively so much money flowed to a person from individuals for whom he provided services (even intangible ones), and to whom he expected to provide services in the future, the cash was income and not gifts. The Tax Court also hit the Feltons with a 20% accuracy related penalty under Code Sec. 6662(a), as they couldn t show they acted with reasonable cause and good faith. They couldn t cite any precedent favorable to them, they couldn t show they knew about any of the caselaw in this area when they filed their (late) returns, and there was no evidence about their efforts to compute their proper tax liability when they filed their returns. 15

7 05 - Divided Tax Court Upholds IRS's Collection Determination Melasky, (2018) 151 TC No. 9 The majority of the Tax Court has determined that IRS didn't abuse its discretion in declining to apply proceeds of a levy as the taxpayers requested because the payment via levy wasn't voluntary. While the taxpayers had submitted a check to IRS, which would have been considered voluntary and which they would have been free to designate as applying to a certain tax year, the check ultimately bounced when IRS levied on the bank account, so no payment was made. The Court also found no abuse of discretion in IRS's rejection of the taxpayers' proposed installment agreement. Background on collection due process (CDP) hearings. The IRS Office of Appeals (Appeals) is responsible for conducting administrative hearings in collection matters. (Code Sec. 6330(b)(1)) Once IRS decides to levy, it must notify the taxpayer in writing of the right to a hearing under Code Sec. 6330(a)(1) (i.e., a CDP hearing). If a taxpayer makes a timely written request and states the grounds for the requested hearing, the taxpayer is entitled to a fair hearing conducted by an impartial officer from the Appeals Office, who must verify that the requirements of any applicable law or administrative procedure have been met in processing the case. (Code Sec. 6330(c)(1), Code Sec. 6330(c)(3)(A)) The Appeals Office must also consider any issues raised by the taxpayer that relate to the unpaid tax or proposed levy, including offers of collection alternatives and challenges to the appropriateness of the collection action. (Code Sec. 6330(c)(2)(A), Code Sec. 6330(c)(3)(B)) A taxpayer who is dissatisfied with the findings or conclusions of the CDP hearing can appeal the determination to the Tax Court. (Code Sec. 6330(d)(1)) When the Tax Court receives an appeal from a CDP hearing, however, its review is limited to issues that were properly raised during the CDP hearing. (Goza, (2000) 114 TC 176) Where the taxpayer's underlying liability is not properly at issue, the Tax Court reviews IRS's decision for abuse of discretion only. A determination that is arbitrary, capricious, or without sound basis in fact or law is an abuse of discretion. (Woodral v. Comm., (1999) 112 TC 19, Venhuizen, TC Memo ) In reviewing for abuse of discretion, the Tax Court will generally uphold a notice of determination of less than ideal clarity if the basis for the determination may reasonably be discerned. (Kasper, (2018) 150 TC No. 2) Background on designation of tax payments. In general, taxpayers who submit "voluntary" payments are permitted as a matter of IRS policy to designate the tax liability against which the payment will be applied. (Dixon, (2013) 141 TC 173) Involuntary payments, however, may generally be applied however IRS chooses. 16

8 (Amos, (1966) 47 TC 65) Amounts received as a result of levy are involuntary payments. (Amos) Facts. The taxpayers, David and Audrey Melasky, filed joint returns for their '95, '96, '99, 2000, 2001, 2002, 2003, 2004, 2006, 2008, and 2009 income tax years. On the basis of those returns, IRS made assessments, including interest and additions to tax, with respect to each tax year. The taxpayers have not disputed their liability for these assessed amounts. Since '97, the taxpayers petitioners have submitted several proposed collection alternatives with respect to certain years, and IRS has attempted in various ways to collect the unpaid amounts. On Jan. 27, 2011, the taxpayers hand-delivered to IRS a check which they instructed be applied to their 2009 liabilities. Days later, on Jan. 31, 2011, IRS issued a notice of intent to levy with respect to the taxpayers' 2001, 2002, 2004, 2006, 2008, and 2009 income tax liabilities. On the same day, IRS issued a notice of levy to the taxpayers' bank with respect to their '95, '96, and ' liabilities. As a result of this levy, a hold was placed on their account. On Feb. 9, 2011, the taxpayers submitted to IRS a Form 12153, Request for a Collection Due Process or Equivalent Hearing, with respect to their unpaid income tax liabilities for '95, '96, ' , 2006, 2008, and They checked the boxes for Installment Agreement, Offer in Compromise, and Other. In the space provided next to the Other box, they referred IRS to an attachment in which they contended that the period of limitations on collection had expired with respect to their '95 and '96 liabilities. The taxpayers also noted that the 2011 check had not been deposited as of Jan. 31, 2011, and that their bank placed a hold on their checking account. They requested that the bank account levy proceeds be applied against their 2009 liability. On Feb. 28, 2011, IRS applied the proceeds of the bank account levy to the taxpayers' '95 liability. And, at some point before Mar. 7, 2011, IRS attempted to deposit the 2011 check but it didn't clear, either because of the hold on the bank account or because the funds had already been transferred to IRS. A CDP hearing was held on Aug. 25, 2011 with respect to the taxpayers' 2006, 2008, and 2009 liabilities. Their counsel discussed the possibility of an offer in compromise (OIC) and argued that the bank levy proceeds should be applied against the taxpayers' 2009 liability. IRS directed that the taxpayers meet a number of conditions or it would sustain the levy. The taxpayers later proposed a request for a partial payment installment agreement, and IRS advised that, if they wanted to pursue that, they would have to liquidate certain assets and provide the proceeds to IRS by a set deadline. The taxpayers later advised IRS that they 17

9 would be unable to meet the deadline because their daughter was ill, that they intended to use some of the aforementioned assets to pay her medical expenses, and that Mrs. Melasky's income had permanently decreased. IRS requested documentation of the medical expenses, Mrs. Melasky's decreased income, efforts to liquidate the assets, and the availability of certain funds held in trust for Mrs. Melasky, which the taxpayers claimed couldn't be considered in IRS's analysis of whether to accept their installment agreement. The taxpayers failed to provide this documentation by the set deadline, although they provided some of it later. After extensive back and forth, IRS ultimately rejected the taxpayers' assertion that the assets in the trust couldn't be considered in its installment agreement analysis. Notably, the trust expressly gave Mrs. Melasky discretionary authority to distribute as much income and principal as appropriate to provide for the beneficiaries' (of which she was one) "continued health, maintenance, support, and education." Accordingly, IRS determined that the taxpayers could pay a substantially higher amount than they proposed in their partial payment installment agreement request. On Apr. 20, 2012, IRS issued a notice of determination sustaining the notice of intent to levy, concluding that the period of limitations for collection of the taxpayers '95 and '96 income tax liabilities had not expired, denying their request to apply the proceeds of the levy on their bank account against their 2009 income tax liability, and rejecting their proposed installment agreement. IRS reasoned that it didn't have to apply the bank levy proceeds against the taxpayers' 2009 liability as they requested because the levy was an involuntary payment. IRS also explained that it rejected the installment agreement on the basis that the taxpayers didn't pay over the equity in all of their assets and because of "Mrs. Melasky's unwillingness to take any distributions" from the trust for her own support and maintenance. The taxpayers filed a timely Tax Court petition, and both sides sought summary judgment. The issues before the Court were whether IRS abused its discretion in (1) deciding not to apply the bank account levy proceeds against the taxpayers' 2009 liability as they requested, and (2) rejecting their proposed installment agreement. No abuse of discretion. The majority opinion of the Tax Court found that IRS didn't abuse its discretion. 18

10 With respect to the refusal to apply the bank account levy proceeds as the taxpayers requested, the Court found that these proceeds were an involuntary payment and as such could be applied as IRS saw fit. The taxpayers argued that their 2011 check should be treated as a voluntary payment toward their 2009 liability because that check was written and accepted before the levy. The Tax Court, however, rejected this argument. The Court, citing caselaw, reasoned that a payment by check is a conditional payment subject to the condition subsequent that it be paid upon presentation to the drawee and that there was accordingly no "payment" in this case on Jan. 27, And later, when IRS presented the check for payment, it wasn't honored because of insufficient funds. Accordingly, the taxpayers weren't entitled to direct the application of payment because no payment occurred. The Court also rejected the taxpayers' argument for an equitable exception on account of the fact that the check was dishonored due to an IRS levy, finding no caselaw or other support for this argument, and further finding that IRS didn't cause the check to bounce but such was rather the result of the taxpayers' chronic failure to pay their taxes. With respect to IRS's rejection of the installment agreement, the Court found that IRS didn't abuse its discretion. IRS provided two reasons for its rejection taxpayers' failure to liquidate the equity in their assets as requested, and offering a monthly payment less than they could pay either of which would be an independently sufficient basis for its rejection. The taxpayers were repeatedly instructed to liquidate the equity in their assets, and despite having received multiple extensions, failed to do so. The Court also found that IRS reasonably concluded that the taxpayers would be able to rely on distributions from the trust to pay a portion of the living expenses. In so holding, the Court rejected the taxpayers' arguments to the contrary, including that it would constitute a violation of fiduciary duty for Mrs. Melasky to make distributions to herself. Concurring opinions. There were two concurring opinions. The first concurrence strenuously disagreed with the dissent, and the second generally emphasized the limited scope of the majority opinion. Dissenting opinion. A strongly worded dissent opined that the taxpayers' payment should have been considered made on Jan. 27, 2011 and thus voluntary, reasoning that there were sufficient funds in the account at that time and that the check bounced on account of IRS's later actions. 19

11 06 - Tax Court Determines Standard of Review in Dispute Over Proper Crediting of Payment Melasky, (2018) 151 TC No. 8 In an appeal of the determination in a collection due process (CDP) hearing, the Tax Court, finding that a challenge to the proper crediting of a payment was not a challenge to the underlying tax liability, has determined that the proper standard of review of the taxpayers' dispute as to which year to apply a payment was for abuse of discretion. Background. The IRS Office of Appeals (Appeals) is responsible for conducting administrative hearings in collection matters. (Code Sec. 6330(b)(1)) Once IRS decides to levy, it must notify the taxpayer in writing of the right to a hearing under Code Sec. 6330(a)(1) (i.e., a CDP hearing). If a taxpayer makes a timely written request and states the grounds for the requested hearing, the taxpayer is entitled to a fair hearing conducted by an impartial officer from the Appeals Office, who must verify that the requirements of any applicable law or administrative procedure have been met in processing the case. (Code Sec. 6330(c)(1), Code Sec. 6330(c)(3)(A)) The Appeals Office must also consider any issues raised by the taxpayer that relate to the unpaid tax or proposed levy, including offers of collection alternatives and challenges to the appropriateness of the collection action. (Code Sec. 6330(c)(2)(A), Code Sec. 6330(c)(3)(B)) At a CDP hearing, a person may challenge the existence or amount of his or her underlying tax liability if the person did not receive a notice of deficiency or did not otherwise have an opportunity to dispute such tax liability. (Code Sec. 6330(c)(2)(B)) Code Sec. 6330(c)(4)(A) bars CDP review of any issue that was raised and considered in any previous administrative or judicial proceeding if the person seeking to raise the issue participated meaningfully in the proceeding. A taxpayer who is dissatisfied with the findings or conclusions of the CDP hearing can appeal the determination to the Tax Court. (Code Sec. 6330(d)(1)) When the Tax Court receives an appeal from a CDP hearing, however, its review is limited to issues that were properly raised during the CDP hearing. Where the underlying tax liability is appropriately before the Tax Court, the Court reviews the CDP determinations de novo. Where the taxpayer's underlying liability is not properly at issue, the Tax Court reviews IRS's decision for abuse of discretion only. A determination that is arbitrary, capricious, or without sound basis in fact or law is an abuse of discretion. (Goza, (2000) 114 TC 176) Facts. David and Audrey Melasky had outstanding tax liabilities for '95, '96, '99, , 2006, 2008, and On Jan. 27, 2011, the Melaskys walked into an 20

12 IRS office with a check for $18,000 and asked for it to be applied to their 2009 tax liability. They asserted that this payment paid their entire income tax liability for that year. IRS admitted that it got this check. Its records showed that it posted the $18,000 payment to the Melaskys' 2009 tax liability on that same day. However, there was a reversal of that same amount because the check bounced on January 31, when IRS sent a notice of levy to the Melaskys' bank. This notice froze their entire balance, and either that or IRS's execution of the levy sometime after Jan. 31 made the Melaskys' check bounce. IRS then applied the entire balance that it received from the levy to the Melaskys' '95 tax liability on February 28. IRS also charged the Melaskys $360 as a penalty for writing a bad check. On the same day the notice of levy was issued to the bank, IRS sent the Melaskys a notice of intent to levy that listed only the years 2001, 2002, 2004, 2006, 2008, and The Melaskys asked for a CDP hearing. The settlement officer (SO) assigned to their case reviewed IRS records and determined that the Melaskys had already received notices for tax years '95, '96, '99, and Accordingly, he concluded they weren't entitled to a CDP hearing for those years (which the Melaskys didn't dispute). In the notice of determination, the SO concluded, among other things, that the money IRS received from the bank was procured through levy procedures and therefore was an involuntary payment that IRS was free to apply as it wished. Issue. What is the appropriate standard of review for questions of crediting payments? IRS noted that both parties agreed that the Court should review the determination for tax years 2006 and 2008 for abuse of discretion, but review the determination for tax year 2009 de novo because the Melaskys argued that they had no 2009 tax liability. Court's conclusion. The Tax Court determined that a challenge to the proper crediting of a payment is not a challenge to the underlying tax liability. Therefore, the Court concluded it had to review the taxpayers' dispute as to application of payments only for abuse of discretion. The Court reasoned that the question for the Melaskys' 2009 tax year was about whether IRS properly applied a check. A question about whether IRS properly credited a payment is not a challenge to a tax liability i.e., the amount of tax imposed by the Code for a particular year. It is instead a question of whether the liability remains unpaid. The Tax Court therefore held here that the Melaskys weren't challenging their underlying liability for Accordingly, the Court's standard of review for these specific facts was for abuse of discretion for all years. 21

13 07 - CA 7: No Like-kind Exchange Where Leases Were Characterized as Loans Exelon Corporation v. Comm., (CA 7 10/3/2018) 122 AFTR 2d The Court of Appeals for the Seventh Circuit, affirming the Tax Court, has concluded that a power company did not satisfy the requirements of Code Sec for like-kind exchange treatment because it exchanged its power plants for an interest in financial instruments. The agreements between the power company and the other parties in the exchange were not true leases, but rather were properly characterized as loans since the transactions didn't transfer the benefits and burdens of ownership to the power company. Background. For the years at issue in this case, if specific identification and replacement period requirements set out in Code Sec are met, gain or loss is not currently recognized when property held for productive use in a trade or business or for investment is exchanged for property of like-kind (replacement property) that will be held for productive use in a trade or business or for investment. Qualified intermediaries (QIs) may be used to structure like-kind exchanges, allowing greater flexibility in qualifying for income deferral. Under the regs, "like kind" refers to the nature or character of the property, not to its grade or quality. One kind or class of property may not be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. (Reg (a)-1(b)) Reg (a)-1(c), which provides examples of like-kind property, states that no gain or loss is recognized if a non-dealer in real estate exchanges "a leasehold of a fee with 30 years or more to run for real estate." Generally effective for transfers after Dec. 31, 2017, the Tax Cuts and Jobs Act (TCJA, P.L , 12/22/2017) modified the rule allowing the deferral of gain on like-kind exchanges to allow for like-kind exchanges only with respect to real property that is not held primarily for sale. Facts. Exelon Corporation (Exelon), a corporation engaged in the production, transmission, and distribution of electricity to residential, commercial, and industrial customers in Northern Illinois, sold its fossil fuel power plants in '99 for $4.813 billion. Seeking to manage the taxable gain of $1.6 billion resulting from the sale, Pricewaterhouse Coopers (PwC) suggested a strategy that would allow Exelon to defer the recognition of gain on Exelon's sale of the fossil fuel power plants through a Code Sec like-kind exchange into a "passive leveraged lease investment." Instead of paying the tax on the gain, Exelon would be able to 22

14 reinvest that sum. The deferred tax would be financially similar to a 0% borrowing note. Under the strategy, Exelon would lease the exchanged assets to the lessee under a triple net lease with an end-of-term fixed purchase option. Exelon would pass on a portion of its tax deferral benefit to the lessees through a reduction in rental obligation. The lessee would "defease its rental obligations, and thereby monetize the lower rental cost into an upfront cash benefit." PwC pointed out to Exelon that municipal utilities and rural electric cooperatives seeking to monetize tax benefits that they could not use because of their tax-exempt status would be interested in entering into a sale-leaseback transaction. Accordingly, Exelon pursued a series of like-kind exchanges employing saleleaseback strategies between Exelon and the unrelated tax-exempt public utilities, City Public Service (CPS), a municipal gas and electric utility owned by the City of San Antonio, Texas, and Municipal Electric Authority of Georgia (MEAG), which was created by the State of Georgia to own and operate electric generation and transmission facilities. Exelon fully funded the transactions using the proceeds from the sale of its own power plants. In the transactions, CPS or MEAG would lease a power plant to Exelon for a term exceeding the plant's useful life, receiving in turn a lump-sum payment of cash, and Exelon would sublease the power plant back to CPS or MEAG. Part of the amount paid to CPS or MEAG would be returned to Exelon as a prepayment of the sublease, another part would be set aside for investment and to secure a cancellation option allowing CPS and MEAG to purchase back their power plants at the end of the sublease periods, and the remainder would be retained by CPS and MEAG and used for their own needs. Since exercising the cancellation options was expected to be the only economically viable option, the parties to the transactions anticipated that, at the end of the sublease periods, CPS and MEAG would exercise their cancellation options and regain ownership of the power stations leased to Exelon. The primary tax benefits that Exelon expected to derive were from the deferral of income tax under Code Sec and various deductions related to the replacement properties. Exelon identified appropriate replacement properties, conducted due diligence, and closed the transactions within the timeframes provided for in Code Sec Parties' positions. Exelon argued that the transactions at issue represented valid deferred Code Sec like-kind exchanges, where it exchanged its "active" ownership interests in two power plants in Illinois for "passive" leasehold interests in power plants in Georgia and Texas. Exelon asserted that it acquired benefits and burdens of ownership with respect to assets involved in the transactions because it remained exposed to significant risks not only during the residual period of the head leases (main leases) but also during the leaseback period. It argued that the transactions shouldn't be characterized as sale-in, 23

15 lease-out (SILO) because they were structured not as leveraged leases but as direct leases financed entirely from Exelon's own funds. On the other hand, IRS argued that the transactions among Exelon, CPS, and MEAG did not transfer any benefits and burdens of ownership to Exelon because they were not true leases. IRS contended that the purported exchanges were "prepackaged, promoted tax products which subjected it to no residual value risk, only a theoretical, de minimis credit risk." In essence, as IRS saw it, the transactions were more similar to low-risk loans. Thus, because Exelon exchanged ownership interests in power plants for financial instruments (low-risk loans), it failed to meet Code Sec. 1031's like-kind exchange requirements. Further, IRS argued that because the substance of each transaction was a loan rather than a lease, these loans should generate original issue discount (OID) income under Code Sec And Exelon was not entitled to depreciation deductions under Code Sec. 168, interest deductions under Code Sec. 467, or transaction cost deductions under Code Sec In the alternative, IRS argued that the transactions lack economic substance and urged the Court to disregard the transactions altogether and conclude that Exelon failed to enter into a likekind exchange. IRS maintained that Exelon never expected to realize pretax benefits from the transactions alone, but with the tax deferral benefits available under Code Sec would be able to more than make up for the economic losses associated with the transactions. Tax Court decision. The Tax Court held that the agreements between Exelon and CPS and MEAG were not true leases but rather properly characterized as loans. The substance of the transactions was not consistent with their form; the transactions failed the substance over form test because the transactions did not transfer the benefits and burdens of ownership to Exelon. The Court found that Exelon's return on its investment was predetermined, and it did not have an upside potential or much of downside risk with respect to the CPS or MEAG transactions. The transaction was more indicative of a loan than of a genuine equity investment. As a result, since Exelon exchanged its power plant for an interest in financial instruments, Exelon failed to satisfy the requirements of Code Sec for the '99 tax year. (Exelon Corporation and Subsidiaries, et al. Appellate court decision. The Seventh Circuit found that the record definitively revealed that all of the parties to these transactions fully intended and expected the sublessees to exercise their purchase options at the end of the sublease terms. Accordingly, the Seventh Circuit agreed with the Tax Court's finding that Exelon bore none of the burdens or indicia of ownership such that it was entitled to the benefit of a Code Sec.1031 like-kind exchange. Even assuming that Exelon had a legitimate purpose of availing itself of the tax benefits under Code Sec. 1031, the Seventh Circuit determined that the key issue in this case was whether the taxpayer had acquired the benefits and burdens of ownership. To be entitled to the Code Sec exception, Exelon 24

16 had to acquire a genuine ownership interest in the replacement plants. Ownership for tax purposes was not determined by legal title, but by bearing the benefits and burdens of property ownership. Because the subleases were "net leases," they allocated all of the costs and risks associated with the plants to the sublessees. That, along with each transaction's defeasance structure and the circular flow of money, lead to the inescapable conclusion that Exelon did not face any significant risk indicative of genuine ownership during the terms of the subleases, as the Tax Court found. Exelon's argument that it faced "real risks" of having to return any unaccrued rent in the event of a sublessee bankruptcy was unconvincing. Prior to entering the transactions Exelon was assured and satisfied that CPS could not declare bankruptcy until and unless the City of San Antonio declared bankruptcy, and MEAG was prevented by Georgia law from declaring bankruptcy. The Seventh Circuit rejected Exelon's contention that the Tax Court should have determined whether the lessees would be "economically compelled" to exercise the purchase options. The Seventh Circuit agreed with the Tax Court and other courts that had held that a "reasonable expectation or likelihood" standard rather than, as the taxpayer argued, an economic compulsion or certainty standard, governs the characterization of a tax transaction under the substance-over-form doctrine. The Court also rejected the taxpayer's contention that, for each sublease, the price to exercise the purchase option would be considerably higher than the fair market value of the property at the end of the leases. As a result, Exelon argued that no reasonable person would overpay over $100 million for an asset it could easily replace. However, there were serious flaws in the valuation methodology underlying this assertion (e.g., the appraisal included a 9% state corporate income tax rate when Texas did not impose a state corporate income tax, and it used too high of a discount rate). Further, Exelon's legal counsel interfered with the integrity and independence of the appraisal process by providing the appraiser with the wording of the conclusions it expected to see in the final appraisal reports (there was a detailed list of specific conclusions that Exelon's legal counsel needed in order to issue the necessary tax opinion, and the appraisal's conclusions mirrored those requested almost word for word). The Seventh Circuit found that even if it were to accept that the purchase option prices far exceeded the fair market value of the plants at the end of the subleases, such acceptance would not lead to Exelon's conclusion that "no reasonable person would overpay" that much. While the Court agreed that no reasonable entity would overpay if it was paying with its own money, the sublessees in this case could exercise the purchase options without paying a single cent of their own money. Thus, Exelon's argument did not reflect the economic reality of the transactions. And, because the sublessees did not retain any of the money set aside for the purchase option if they did not exercise it, they 25

17 had no economic incentive not to do so. Indeed, exercising the options left the sublessees in precisely the same position as if they had not entered the transactions, except millions of dollars richer. The Seventh Circuit also rejected Exelon's final argument that the Tax Court erred in its understanding of the end-of-lease physical return conditions. The taxpayer argued that in its application of the reasonably likely standard, the Tax Court confused the terms "availability factor" with "capacity factor," leading it to conclude that it would be too costly for the sublessees to get the plants' capacity factors up to that specified in the return conditions, leaving it reasonably likely that they would exercise their purchase options. Exelon argued that despite its title, the "Estimated Annual Capacity" return condition referred to the plants' availability factors and should not be compared to the capacity factors. Exelon argued that anyone in the industry would recognize this, and that no one in the industry would agree to a return condition based on capacity, which was largely out of the operator's control. As to Exelon's argument that no one in the industry would agree to a return condition based on capacity factor, the Seventh Circuit noted that these were not typical leases. Exelon had a strong incentive to require such a return condition because it did not want the plants back. These transactions were the direct result of Exelon's decision to get out of the fossil fuel business. And Exelon couldn't get around the fact that the subleases' definition of "Estimated Annual Capacity" referred to actual generation not the potential generation. It was, as its title suggests, a reference to the plant's capacity factor. Further, each sublease had another return condition, and if Exelon was correct in its interpretation of the lease terms, each sublease would contain two different irreconcilable return conditions for the availability factor. The Seventh Circuit found that the sublessees were not worried about the return conditions because they always intended to exercise the purchase options. There was never any incentive to not do so. Had they been even remotely concerned, they would have done their own independent appraisal to assess both the value of the plants at the time of the sale and the residual value at the end of the lease terms. Neither chose to do so. Indeed, in its initial draft of a petition in a proceeding allowing CPS to enter into the transaction, the City of San Antonio represented that it intended to exercise the purchase option. Tellingly, the Seventh Circuit noted, this representation was removed at Exelon's legal counsel's and PwC's suggestion. The record also reveals that MEAG, too, always intended to exercise its option. Its own internal documents describing the transaction indicate: "At the end of the lease term, MEAG exercises its purchase option, the money for which has been previously set aside at the beginning of the transaction." 26

18 08 - CA 2 Reverses Tax Court Decision on Variable Prepaid Forward Contracts Estate of Andrew J. McKelvey v. Comm., (CA 2 9/26/2018) 122 AFTR 2d The Court of Appeals for the Second Circuit has reversed a decision of the Tax Court, which had held the extension of the settlement dates of two variable prepaid forward contracts (VPFCs) did not result in either a taxable exchange or a constructive sale. The Second Circuit found that the extension constituted an effective replacement of the original VPFCs with new contracts and remanded the case for the Tax Court to determine whether the termination of obligations under the original contracts resulted in short-term capital gain. The Second Circuit also found that the amount of shares to be delivered at settlement was "substantially fixed" such that a constructive sale occurred, and instructed the Tax Court to compute the amount of long-term capital gain that resulted from it. Background. A standard forward contract is an executory contract in which a forward buyer agrees to purchase from a forward seller a fixed quantity of property at a fixed price, with both payment and delivery occurring on a specified future date. The VPFC is a variation of a standard forward contract, requiring the forward buyer (usually a bank) to pay forward price (discounted to present value) to the forward seller on the date of contract execution, rather than on the date of contract maturity. A forward seller can use the upfront cash prepayment however he or she deems fit; often, the proceeds are used by the forward seller to diversify a concentrated stock position into other securities or financial instruments. In exchange for the cash prepayment, the forward seller becomes obligated to deliver to the forward buyer: (1) shares of stock that have been pledged as collateral at the inception of the contract; (2) identical shares of the stock which have not been pledged as collateral; or (3) an equivalent cash amount. The actual number of shares (or cash equivalent) to be delivered by the forward seller is determined by a formula which takes into account changes in the market price of the underlying stock over the duration of the contract. (See Anschutz Co. v. Comm., (2010) 135 TC 78, aff'd, (CA ), 108 AFTR 2d ) As a general rule, the entire amount of gain or loss on a sale or exchange of property must be recognized under Code Sec. 1001(c). Under Code Sec. 1259(a)(1), if there is a constructive sale of an appreciated financial position, the taxpayer must recognize gain as if the position were sold, assigned, or otherwise terminated at its fair market value (FMV) on the date of the constructive sale. Under Code Sec. 1259(c)(1)(C), a taxpayer is treated as having made a constructive sale of an appreciated financial position if he or she (or a related person) enters into a futures or forward contract to deliver the same 27

19 or substantially identical property. With exceptions not relevant here, the term appreciated financial position means any position with respect to any stock, debt instrument, or partnership interest if there would be gain were such position sold, assigned, or otherwise terminated at its fair market value. (Code Sec. 1259(b)(1)) A forward contract is a contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price. (Code Sec. 1259(d)(1)) In Rev Rul , CB 363, IRS recognized that VPFCs are open transactions when executed and do not result in the recognition of gain or loss until future delivery. The rationale is that a taxpayer entering into a VPFC does not know the identity or amount of property that will be delivered until the future settlement date arrives and delivery is made. In Virginia Iron Coal & Coke Co. (1938), 37 BTA 195, aff'd, (CA4 1938) 21 AFTR 1221, cert denied 1939 (Virginia Coal), the taxpayer wrote an option in exchange for an upfront cash premium. The option contract provided the optionee with the right to extend the option from year-to-year by making annual payments to the taxpayer on or before the first day of August. The optionee failed to make a timely extension payment for the third year, which allowed the option to lapse. However, the parties modified the option and agreed to continue it. The Board of Tax Appeals held that the continuation of the option prevented the taxpayer from realizing gain or loss in the year of lapse because the taxpayer maintained a continuing obligation to perform. The Board of Tax Appeals also reasoned that continuing open transaction treatment was appropriate because it was uncertain whether the premium payments would ultimately be included in the computation of gain or loss from the sale of the underlying property or would constitute income to the taxpayer in connection with the expiration of the option. In Freddie Mac, (2005) 125 TC 248, the taxpayer entered into prior approval purchase contracts to purchase mortgages from loan originators in exchange for a nonrefundable commitment fee. IRS argued that the upfront commitment fees did not constitute option premiums because it was a virtual certainty that the transactions would be consummated. The Tax Court first found that the prior approval purchase contracts had the economic substance of options and so applied the law and policy rationale governing options. Despite the high level of certainty that a transaction would be consummated, the Court held that some uncertainty remained whether the loan originator would exercise the right to sell the mortgage to the taxpayer, and whether the option was exercised or allowed to expire affected the tax treatment of the upfront premiums. The Tax Court found that there wasn't a sale or exchange and approved open transaction treatment. Under Code Sec. 1234A, gains or losses are capital gains or losses if they are attributable to a cancellation, lapse, expiration, or other termination of: (a) a right or obligation (other than a securities futures contract) as to property if the 28