THE ELITE QUARTERLY Taxation T.M.

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1 THE ELITE QUARTERLY Taxation Published by CPElite, Inc. The Leader in Continuing Professional Education Newsletters CPE for Enrolled Agents, CFPs, CPAs, and Licensed Accountants Volume XXIII, Number 2, Summer 2014 Issue 4 Hours of CPE Credit (Taxation) Phone and fax # , cpeliteinc@aol.com, web site We hope that you are having a great summer. If you have not renewed your newsletter subscription for 2014, you may still do so. Please don t forget our referral program you receive a $50 referral discount off the price of either of our packages (or a $50 check, if you have subscribed already) when you refer another tax professional who orders any of our packages. Also, we have a referral discount program for new customers you refer who choose to order courses or single newsletters. Under this promotion, the referral discount equals 25% of the new customer s order. So for each of your referrals that order this newsletter as a single issue, you will receive a $10 referral discount. Here are items in this newsletter. 1. IRS Rulings and Other Items (pages 1-5), including the most recent HSA and depreciation amounts, and a new IRS position on the one-year rule for IRA distribution rollovers. 2. Court Decisions (pages 5-12), including a Supreme Court decision on severance payments, several cases on specific passive activity loss issues, and a case illustrating the need for care in ESOP transactions. 3. Treasury Item (pages 12-13) on final regulations on the Section 83 definition of substantial risk of forfeiture. 4. An Elite Possibility (pages 13-14) on an altered tax environment that favors charitable contributions of appreciated property. 5. Quiz Questions (pages 14-16). 6. Newsletter and Subscription Information (page 19), providing three options for using our newsletter for CPE credit. 7. Course Information (pages 19-20). 8. Enrolled Agent and CFP Information (page 19). 9. CPA and Licensed Accountant Self-Study CPE Information (page 19). LEARNING OBJECTIVE AND CONTENT LEVEL The primary learning objective of this newsletter is to make accounting and tax practitioners aware of recent IRS and Treasury items, and court decisions which are likely to have an impact on most tax practices. The content level of the newsletter material is an overview of these items. PREREQUISITES There are no prerequisites nor is advance preparation required for our newsletters IRS IRS ISSUES 2015 AMOUNTS FOR HEALTH SAVINGS ACCOUNTS In Revenue Procedure [4/23/14], the IRS reports annual inflation adjustments related to health savings accounts (HSAs) for The maximum deduction for 2015 contributions is $3,350 for self-only coverage (up $50 from 2014) and $6,650 for family coverage (up $100 from 2014). The high-deductible health plan must have an annual deductible that is not less than $1,300 for self-only coverage (up $50 from 2014) and $2,600 for family coverage (up $100 from 2014). The 2015 annual out-of-pocket expense maximums of $6,450 for self-only coverage and $12,900 for family coverage increased by $100 and $200, respectively, from IRS WILL FOLLOW TAX COURT DECISION ON ONE-YEAR RULE FOR IRA ROLLOVERS Section 408 provides generally that any amount distributed from an IRA is not included in the distributee s gross income as long as it is rolled over into another IRA of the taxpayer within 60 days of the distribution. Also, Section 408 provides than an individual is permitted one such rollover in any oneyear period. The one-year period begins on the day of the distribution. In Bobrow [1/28/14], the Tax Court considered whether the one-year rollover rule applies to each of a taxpayer s IRAs, or across all of a taxpayer s IRAs. The court agreed with the position of the IRS and against that of the taxpayer in deciding that the one-year rule applies across all of a taxpayer s IRAs. The position the IRS argued in court was counter to its position in IRS Publication 590 where, by both statement and example, it provides that the one-year rule applies across all of a taxpayer s IRAs. In Announcement [3/20/14], the IRS states that it intends to follow the Tax Court decision, and apply the one-rollover-per-year limitation as an aggregate limit. Consistent with its position in the announcement, the IRS states that it intends to withdraw a proposed Treasury regulation and revise Publication 590 to align its new position with the decision. The IRS will not apply its new position to any IRA distribution that occurs before January 1, SUSPENDED PASSIVE ACTIVITY LOSSES ARE FREED UP ON REAL PROPERTY FORECLOSURE The taxpayer buys real property for $1 million, financing it fully with a recourse mortgage. He leases it to a third party, thus the property is per se passive under the passive activity loss rules. He has no other passive

2 activities. When the property has accumulated $100,000 of suspended net losses, the taxpayer defaults on the debt, and the lender forecloses. At foreclosure, when the taxpayer is insolvent (liabilities exceed assets by $200,000), the basis of the property is $800,000, it is worth $825,000, and the mortgage balance is $900,000. Does the foreclosure qualify as a fully taxable disposition if it triggers excludable foreclosure COD income under Section 108(a)(1)(B)? The IRS identifies the tax consequences of this transaction in Letter Ruling Under the passive activity loss rules, if the taxpayer disposes of his entire interest in a passive activity in a fully taxable transaction to an unrelated property, the suspended losses from the activity are freed up and become deductible in the year of disposition. The IRS notes that neither the Internal Revenue Code nor the Treasury regulations provide any specific guidance on what is a fully taxable disposition under the passive activity loss rules, but the legislative history offers some helpful guidance. The Senate report issued with the birth of the passive activity loss rules in 1986 indicates that Congress intended the term fully taxable disposition to refer to a transaction that constitutes a final disposition of all property used in a passive activity that allows for a full accounting of all income, gains, and losses resulting from the ownership and use of the property in the activity over time. The IRS states that a foreclosure is a sale or exchange for federal income tax purposes for which a taxpayer realizes gain or loss. It concludes a foreclosure qualifies as a fully taxable transaction. For the transaction above, the federal income tax consequences are: the taxpayer realizes and recognizes $25,000 of foreclosure gain ($825,000 - $800,000); $100,000 of suspended passive losses are freed up and currently deductible; and, $75,000 ($900,000 - $825,000) of COD income is excluded from the taxpayer s gross income (since it is less than his $200,000 of insolvency at the time of foreclosure). The taxpayer does not reduce the $100,000 of nonpassive losses by the $75,000 of COD income. LLC MEMBER GUARANTEE OF LLC DEBT AFFECTS LLC MEMBERS The IRS considered three issues in IRS Advice Memorandum AM when an LLC is classified as a partnership for federal income tax purposes. First, it considered the effect on the guaranteeing member s amount at risk when he guarantees LLC debt. The IRS states that all LLC members have limited liability with respect to LLC debt. However, an LLC member who guarantees LLC debt becomes personally liable for the debt and is in a position akin to general partners. It concludes that the member is at risk with respect to the LLC debt guaranteed, without regard to whether the LLC member waives any right to subrogation, reimbursement, or indemnification against the LLC. However, the amount at risk is limited to the extent three conditions are satisfied: (1) the guaranteeing member has no right of contribution or reimbursement from persons other than the LLC; (2) the guaranteeing member is not otherwise protected against loss through nonrecourse financing, guarantees, stop loss agreements, or similar arrangements (Section 465(b)(4)); and, (3) the guarantee is bona fide and enforceable by the LLC s creditors under local law. Second, the IRS considered the effect on an LLC member s amount at risk when the member guarantees debt that is qualified nonrecourse financing. Qualified nonrecourse financing is an amount borrowed (1) by the taxpayer with respect to the activity of holding real property, (2) from a qualified person, (3) for which no person is personally liable for repayment, and (4) which is not convertible debt. The IRS notes that LLC members may not include LLC liabilities in their at-risk amounts unless they are personally liable for the debt. They are not at risk with respect to amounts protected against loss through nonrecourse financing, with the exception of qualified nonrecourse financing. But, when an LLC member guarantees qualified nonrecourse financing, that debt is no longer qualified nonrecourse financing. The IRS concludes that the guaranteeing member s amount at risk is increased, but only to the extent the debt previously was not taken into account by the guaranteeing member, and he meets the three Section 465(b)(4) conditions listed above. Third, the IRS concludes that since the LLC member s guarantee of the qualified nonrecourse financing causes it no longer to have that status, other LLC members no longer may include in their at-risk amount any part of the guaranteed debt. IRS PROVIDES LIMITATIONS FOR PASSENGER VEHICLES FOR 2014 PURCHASES In Revenue Procedure [2/25/14], the IRS specifies the inflation-indexed depreciation deduction limitations for owners of passenger vehicles and the income inclusion amounts for lessees of passenger vehicles first purchased or leased in calendar year Separate limitations are provided for trucks and vans. The term trucks and vans refers to passenger vehicles that are built on a truck chassis, including minivans and sport utility vehicles that are built on a truck chassis. Since the bonus depreciation rules were not extended to 2014, there are not two separate first-year amounts (with or without bonus depreciation). The amounts for passenger automobiles which are placed in service in 2014 are: 2014 $3,160; 2015 $5,100; 2016 $3,050; and, each succeeding year $1,875. For trucks and vans placed in service in 2014, the annual deduction limitations are: 2014 $3,460; 2015 $5,500; 2016 $3,350; and, each succeeding year $1,975. The 2014, 2015, and 2016 amounts for trucks and vans are the only changes from the corresponding 2013 amounts: each increases by $100 from the 2013 amounts. IRS PROVIDES TAXPAYER RELIEF FOR INCORRECT IRA ROLLOVER In Letter Ruling , a taxpayer maintained three separate retirement plans: (1) an employer plan; (2) a SEP-IRA; and, (3) a traditional IRA. In 2012, the taxpayer attained age 70 ½ and was required to take his first required minimum distribution (RMD) by either December 31, 2012, or April 1, He decided to take the RMD in 2012 so he contacted a financial 2

3 advisor to calculate the RMD for each plan. The total RMD for the three plans was distributed from his SEP- IRA to a nonretirement account during the months of January, February, and May of In September of 2012, the taxpayer was informed by the employer plan administrator that he was required to take a RMD from the account. It was not until then that he understood that the RMD distribution from the SEP-IRA incorrectly included the RMD amount attributable to the employer plan. He requested that the SEP-IRA distribution be reversed but he was denied. On October 26, 2012, the taxpayer made a rollover from the nonretirement account to the employer plan account, well after the 60 days had passed from the initial distribution. On December 28, 2012, the RMD from the employer plan was distributed to the taxpayer. Then the taxpayer requested that the IRS waive the 60-day rollover requirement with respect to the distribution from the SEP-IRA and subsequent rollover into the employer plan. IRC Section 408(d)(3)(I) provides that the Secretary may waive the 60-day requirement where the failure to waive such requirement would be against equity or good conscience. Rev. Proc provides that in determining whether to grant a waiver of the 60-day rollover requirement, the IRS will consider all relevant facts and circumstances, including: (1) errors committed by a financial institution; (2) inability to complete a rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error; (3) the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed); and, (4) the time elapsed since the distribution occurred. The IRS noted that the information presented is consistent with the taxpayer s assertion that his failure to accomplish a timely rollover was due to a mistake by the taxpayer s financial adviser who acknowledged that the advice he gave the taxpayer was in error. Accordingly, the IRS waived the 60-day requirement. Note: According to Publication 590, if the taxpayer has more than one traditional IRA, the taxpayer must determine a separate required minimum distribution for each IRA. However, the combined RMD can be taken from any one or more of the IRAs. A SEP-IRA is treated as a traditional IRA for this purpose so the part of the distribution from the traditional IRA attributable to the SEP-IRA RMD was proper and not an issue in the ruling. IDENTITY THEFT LEADS TOP 12 TAX SCAMS FOR 2014 In IRS News Release [2/19/14], the IRS issued its annual "Dirty Dozen" list of tax scams, reminding taxpayers to use caution to protect themselves against a wide range of schemes ranging from identity theft to return preparer fraud. First on the list is identity theft and refund fraud. The IRS indicated that its work on these matters continues to grow and touches nearly every part of the organization. Other scams that made the list include: (1) pervasive telephone scams with callers pretending to be from the IRS; (2) phishing, primarily by sending s; (3) impersonation of charitable organizations, particularly after a major disaster strikes; and, (4) return preparer fraud. As an example of its fight against identity theft, the IRS in IRS News Release [2/24/14], announced the release of its IRS Criminal Investigation Annual Report for Fiscal Year 2013, reflecting significant increases in enforcement actions against tax criminals and a robust rise in convictions, including identity theft. During the 2013 Fiscal Year, the criminal investigation unit initiated over 1,400 investigations and recommended prosecution of over 1,250 individuals who were involved in identity theft crimes. This report also announced a very impressive conviction rate of 93% involving criminal violations of the Code and related financial crimes, including identity theft. IRS RULES THAT FILING STATUS CHANGE ON AN AMENDED RETURN IS IMPERMISSIBLE In Letter Ruling , a husband and wife filed a joint return. After the deadline for filing had expired, but before the end of the three-year assessment period under Section 6501(a), the husband filed an amended return reporting additional income tax due. On the amended return, the husband filed as head of household. The first issue the IRS considered in the ruling was whether the husband could change filing status. It ruled that the election to file married filing jointly is irrevocable after the time to file has expired (Treasury Regulation (a)(1)). If the election to file a joint return was valid, since the amended return was filed after the time for filing a return for the tax years at issue had passed, the husband was not permitted to change filing status to head of household on the amended return. The second issue the IRS considered was whether an assessment of additional tax reported on the amended return that only the husband had signed is valid against either spouse and, if not, whether the assessment must be abated by the IRS. It ruled that as long as the assessment of additional tax reported on the amended return was made before the three-year assessment period had expired based on the original joint return, the assessment was valid against the husband. Further, because the assessment based on the amended return was valid, the IRS lacked the authority to abate the assessment against the husband. To the extent that the IRS determines that the husband owes more tax than what was reported and assessed based on the amended return, including any amount the husband is liable for based on the proper filing status of married filing jointly, it may issue a notice of deficiency to the husband for that amount. **REVIEW QUESTIONS AND SOLUTIONS** 1. Which one of the following 2015 HSA amounts for self-only coverage had the greatest change from 2014? a. The maximum deduction for an HSA contribution. b. The out-of-pocket expense maximum. c. The high-deductible health plan s annual deductible. 3

4 2. When will the IRS begin applying the one-year rule across all of the taxpayer s IRAs for the 60- day rollover requirement for IRA distributions? a. January 1, b. March 20, c. January 28, A taxpayer s rental real property, her only passive activity, has the following characteristics: $25,000 suspended losses, $200,000 basis, $205,000 value, and $225,000 debt balance. The bank forecloses on the property when the taxpayer is insolvent by $100,000. How much of the suspended losses are deductible in the year of the bank foreclosure? a. $25,000. b. $20,000. c. $0. 4. Which one of the following is not correct about a recent IRS ruling on the debt of an LLC treated as a partnership? a. An LLC member who guarantees LLC debt generally increases his at-risk amount for the amount that he guarantees. b. The IRS states generally that no LLC member has limited liability with respect to LLC debt. c. An LLC member increases his amount at risk for the LLC s qualified nonrecourse financing that he guarantees. 5. The taxpayer places a truck in service in her business in What is the maximum amount of depreciation that she may take for the truck in 2016? a. $3,050. b. $3,350. c. $3, In an IRS ruling dealing with IRA rollovers and the required minimum distribution (RMD) rules, which one of the following statements is true? a. If a taxpayer has multiple traditional IRAs, a RMD must be made from each IRA. b. One circumstance where a waiver for the 60- day rollover requirement may be granted is if the taxpayer s employment is terminated during the 60 days. c. For purposes of the RMD rules, a SEP-IRA is treated the same as a traditional IRA. 7. For Fiscal Year 2013, what was the IRS conviction rate for criminal violations of the Code and related financial crimes? a. 93%. b. 55%. c. Less than 50%. 8. True or False. In a recent IRS ruling where a husband filed an amended return with a change in filing tax, the IRS ruled that it could abate the assessment of additional tax the husband reported on the amended return. Solutions 1. "B" is the correct response. The out-of-pocket expense maximum increased $100 from A" is an incorrect response. This amount of $3,350 increased $50 from C" is an incorrect response. This amount of $1,300 increased $50 from Revenue Procedure "A" is the correct response. The IRS will not apply its new position across all of the taxpayer s IRAs to any IRA distribution that occurs before January 1, B" is an incorrect response. This was the date of the IRS announcement stating its new position on the one-year rule. "C" is an incorrect response. This was the date of the Tax Court decision in which the court ruled the rule applies across all of the taxpayer s IRAs. Announcement "A" is the correct response. The foreclosure is treated as a fully taxable disposition under the passive activity loss rules, freeing up all of the activity s suspended losses ($25,000). B" is an incorrect response. This is the amount of COD income. "C" is an incorrect response. The foreclosure is treated as a fully taxable disposition, so suspended passive activity losses are deductible in the year of disposition. Letter Ruling "B" is the correct response. The IRS states that all LLC members have limited liability with respect to LLC debt. A" is an incorrect response. The IRS states that an LLC member is at risk with respect to LLC debt that he guarantees, without regard to whether the LLC member waives any right to subrogation, reimbursement, or indemnification against the LLC. "C" is an incorrect response. The LLC member increases his amount at risk for the amount of the LLC s qualified nonrecourse financing that he guarantees. Advice Memorandum AM

5 5. "B" is the correct response. For 2016, the maximum depreciation deduction for trucks and vans placed in service in 2014 is $3,350. A" is an incorrect response. $3,050 is the maximum depreciation deduction for 2016 for passenger automobiles placed in service in "C" is an incorrect response. $3,460 is the maximum depreciation deduction for 2014 for trucks and vans placed in service in Revenue Procedure "C" is the correct response. While separate RMDs must be made out of 401(k) plans and IRAs, a SEP-IRA is treated as a traditional IRA so the RMD for IRAs can me made only from one of the IRAs. A" is an incorrect response. According to Publication 590, the combined RMD can be taken from any one or more of the IRAs. "B" is an incorrect response. In a 2003 revenue procedure, the IRS provides four examples of facts and circumstances that it will examine in determining whether to grant a waiver of the 60-day rollover requirement. Employee termination is not one of the examples. Letter Ruling "A" is the correct response. The conviction rate involving criminal violations of the Code and related financial crimes was 93%. "B" is an incorrect response. The impressive 93% conviction rate included identity theft crimes. "C" is an incorrect response. The IRS Criminal Investigation Annual Report for Fiscal Year 2013 reported significant increases in enforcement actions against tax criminals and a robust rise in convictions (93%). IRS News Release and IRS News Release False is the correct response. The husband had filed the amended return before the end of the three-year assessment period. Because the assessment based on the amended return was valid, the IRS lacked the authority to abate the assessment against the husband. True is the incorrect response. The IRS lacked the authority to abate the assessment against the husband on the amended return. Letter Ruling COURT DECISIONS SUPREME COURT DECIDES SEVERANCE PAYMENTS ARE FICA WAGES In Quality Stores, Inc. [3/25/14], the Supreme Court considered whether severance payments were FICA wages subject to employer and employee FICA taxes. The payments were made to employees terminated against their will, were varied based on job seniority and time served, and were not linked to the receipt of state unemployment benefits. Quality Stores was an agricultural-specialty retailer who entered Chapter 11 bankruptcy proceedings in The company terminated thousands of employees whom it paid severance payments because of reduction of work force or discontinuance of a plant or operation. The payments were made pursuant to one of two different termination plans (payments were based on job grade and / or management level, and time of service). The company reported the severance payments as W-2 wages, subject to income and FICA taxes. Then it filed for FICA tax refund claims. The IRS neither allowed nor denied the claim, and the company sought a refund in bankruptcy court. The bankruptcy court ruled in the company s favor, and the district court and the Sixth Circuit agreed that the severance payments were not FICA wages. The Supreme Court agreed to hear the IRS s appeal from the Sixth Circuit. The Supreme Court addresses two questions in its decision: (1) whether FICA s definition of wages encompasses severance payments; and, (2) whether the Internal Revenue Code provision (Section 3402(o)) that relates to income tax withholding is a limitation on the meaning of wages for FICA purposes. As to the first question, the court stated that an employer pays FICA taxes on wages... with respect to employment. Congress defined wages broadly. Employment encompasses any service, of whatever nature, performed... by an employee for the person employing him. The court stated that severance payments made to terminated employees are remuneration for employment. It noted that, as with Quality Stores, severance payments often vary according to the function and seniority of the particular employee who is terminated. The court likened severance payments to other benefits offered by employers to employees, for example health and retirement benefits, stock options, or merit-based bonuses. It stated that severance payments can be an alternative or supplemental form of remuneration. It observed that there is a specific FICA exemption for termination-related payments made because of retirement for disability, stating that an exemption would not be necessary were severance payments generally not within the FICA definition of wages. FICA s definition of wages provides a lengthy list of specific exemptions, and the court felt that the specificity of the exemptions reinforces FICA s broad definition of wages. Since 1950, FICA has contained no exception from wages for severance payments. As to the second question, the court examined Code Section 3402(o) relating to income tax withholding and whether it is a limit on the FICA meaning of wages. It noted that per stipulation by both Quality Stores and the IRS, the Sixth Circuit determined that severance payments constitute supplemental unemployment compensation benefits (SUBs). The Supreme Court states that the income tax withholding provision (Section 3401(a)) defines wages broadly. It contains specific exemptions. Severance payments are not one of the exemptions. The court examined the regulatory background of Section 5

6 3402(o), and noted that SUB plans by companies originally were for the purpose of offering second-level protection against layoff by supplementing state unemployment benefits. Their effectiveness was weakened if SUBs were defined as wages under federal law, because some states only provided unemployment benefits if terminated employees were not earning wages from their employers. In response to this employer concern, in the 1950's and 1960's the IRS issued revenue rulings taking the position that SUB payments were not wages under FICA as well as for purposes of income tax withholding. However, SUB payments still were taxable income. Consequently, a terminated employee receiving SUB payments could face significant tax liability at the end of the tax year. At the Treasury Department s urging, in 1969 Congress addressed the withholding problem by enacting Section 3402(o), which provides that all severance payments, both SUBs and severance payments that the IRS considered wages, shall be treated as if they were wages for income tax withholding purposes. The court concluded that Section 3402(o) does not narrow the term wages under FICA to exempt all severance payments. The Supreme Court reversed the Sixth Circuit s decision, in deciding that the severance payments made by Quality Stores were taxable FICA wages. Planning Pointer: The Supreme Court noted that the IRS still provides that severance payments tied to the receipt of state unemployment benefits are exempt not only from income tax withholding but also from FICA taxation. An employer who structures severance payments such that they are linked to the employee s receipt of state unemployment benefits should avoid FICA taxes on the payments. VIOLATION OF ESOP RULES PROVES VERY COSTLY TO TAXPAYER In 1996, S Corporations became eligible to establish employee stock ownership plans (ESOPs). While these changes made available to small business owners significant tax and other advantages, the ESOP rules are very technical and filled with traps if these rules are not followed to the letter. The Ries Enterprises, Inc. case [1/27/14] illustrates some of the technical rules of ESOPs and severe tax consequences that can occur if the rules are violated. The taxpayer was a solely owned S Corporation engaged in the rental and leasing business and decided to sponsor an employee stock ownership plan. The ESOP initially was funded with a $200,000 loan from the S Corporation. The loan proceeds were used to purchase 80% of the S Corporation stock. The S Corporation s original owner s interest was reduced to 20% and he became the sole trustee of the ESOP as well as being the only employee of the S Corporation. During the year the ESOP was formed, it made a loan payment to the S Corporation and released from a suspense account 8.5 shares of the S Corporation, all of which were allocated to the individual shareholder. The IRS argued that the latter transaction violated Section 409(p) resulting in an excise tax under Section 4979A as well as penalties for not filing a return to report the excise tax and penalties for not paying the tax. Under Section 409(p), for an ESOP holding stock in an S corporation, no portion of the plan s assets during a nonallocation year may accrue for the benefit of any disqualified person. The individual shareholder was a disqualified person because his deemed-owned shares in the S Corporation exceeded 10%. A nonallocation year is any plan year in which a disqualified person owns at least 50% in the S Corporation. Because all of the stock that was released was allocated to the individual shareholder, he was deemed to own all of the stock of the ESOP. Therefore, he was deemed to own 100% of the stock in this case so the year is a nonallocation year. As a result, the Tax Court ruled that the rules of Section 409(p) were violated and that the Section 4979A excise tax of 50% of the prohibited allocation applies. The taxpayer also was held liable for additions to tax for failing to file a timely return and make timely payment of the excise tax. TAX COURT RULES THAT TRUST CAN QUALIFY AS REAL ESTATE PROFESSIONAL A complex residuary trust owned rental real estate properties and was involved in other real estate business activities, for example holding and developing real estate. The trust s six trustees were five children (also beneficiaries of the trust) of their deceased father who had formed the trust, and an independent trustee. The trustees acted as a management board for the trust and made all major decisions regarding the trust s property. Each trustee was paid a trustee fee directly by the trust. Three of the children worked full time for an LLC that was owned wholly by the trust. The children received wages from the LLC for their LLC work. The LLC managed most of the trust s rental real estate properties and, in addition to the children, employed several other people. The trust conducted some of its rental real estate activities directly, some through wholly owned entities, and the rest through entities in which it owned majority interests and in which two of the children owned minority interests. The trust conducted its real estate holding and development operations through entities in which it owned majority or minority interests and in which the same two children owned minority interests. The trust incurred losses from its rental real estate properties. On its Form 1041, the trust treated its rental real estate activities, in which it engaged both directly and through its ownership interests in a number of entities, as nonpassive activities. The IRS determined that the trust s rental real estate activities were passive activities, thereby increasing the trust s passive activity losses. In Frank Aragona Trust [3/27/14], the issue was whether the real estate professional rule of Section 469(c)(7) applies to the trust. Section 469(c)(7) provides that the general rule that any rental activity is treated automatically as a passive activity does not apply to the rental real estate activity of any taxpayer who meets the requirements of Section 469(c)(7). There are two requirements: (1) more than one-half of the taxpayer s personal services in trades or businesses for the taxable year are performed in real property trades or businesses in which the taxpayer materially participates; and, (2) the taxpayer performs more than 750 hours of services during the year in real property trades or businesses in 6

7 which the taxpayer materially participates. The court noted that Treasury regulations provide that personal services means any work performed by an individual in connection with a trade or business. The IRS argued that since personal services refer to work performed by an individual, a trust cannot perform personal services. The Tax Court rejected the IRS position, stating that a trust is capable of performing personal services, and so can satisfy Section 469(c)(7). The court stated that if the trustees are individuals, and they work on a trade or business as part of their trustee duties, their work can be considered work performed by an individual in connection with a trade or business. It stated that if Congress had wanted to exclude trusts from Section 469(c)(7), it could have done that by limiting the exception to any natural person. It noted that in another passive activity rental real estate provision that grants a limited rental real estate loss offset of $25,000 against nonpassive income, it did just that, in providing the $25,000 allowance to any natural person. The court examined the Congressional committee reports for the Section 469(c)(7) provision, and noted that the exception applies to individuals and closely C Corporations. In that the reports did not say only individuals and closely held C Corporations, the court read that to not compel the conclusion that only individuals and closely held C Corporations can qualify for Section 469(c)(7). The court next dealt with how to determine if the trust materially participates in an activity. It noted that neither the Internal Revenue Code nor the Treasury regulations provide a method for such a determination. The court made the determination. It concluded that the activities of the trustees, including their activities of the LLC, should be considered in determining whether the trust materially participated in the trust s real estate operations. It found that when the activities of all six trustees in their roles as trustees and as employees of the LLC were considered, the trust materially participated in the trust s real estate operations. It decided that the trust qualified for the Section 469(c)(7) exception. Therefore, the trusts s rental real estate activities were not per se passive activities. Further, the court decided that the trust materially participated in its rental real estate activities, and thus those activities were not passive activities. DOCTOR S PAYMENT TO HOSPITAL TO RELEASE HIM FROM HIS OBLIGATION TO WORK IN THE COMMUNITY WAS NOT DEDUCTIBLE AS A BUSINESS EXPENSE In Dargie [2/5/14], the taxpayer had entered into an award agreement whereby a hospital agreed to pay the taxpayer s tuition for medical school. After graduation and completion of his residency, the agreement specified that he was to repay this award by either (1) working as a doctor in a specified underserviced community for four years, or (2) repaying two times the conditional award payments he received or a lesser amount agreed to by the parties. After completing his medical training, he decided to work in a much larger city and repaid the hospital $121,440, which represented $73,000 in principal and the balance in interest expense. He did not report this payment on his tax return. Two years later he amended his original return and claimed the payment on Schedule C as an ordinary and necessary business expense. The taxpayer argued that the payment was deductible as a business expense because it enabled him to pursue his for-profit medical practice in a different area of the state. The IRS argued that the payment did not qualify as a deduction because it was a reimbursement for educational expenses that allow an individual to meet the minimum requirements for practicing a given profession. Therefore, the expenses are personal and not deductible. One of the requirements in the Treasury regulations for an expense to qualify as a business expense is that the expense must arise in connection with or proximately result from that trade or business. The Sixth Circuit noted that to determine whether an expense is a non-deductible personal expense or a deductible business expense, courts look to the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer. That is, the circumstances under which the taxpayer received the money determine its business or personal characterization, not the circumstances under which he repaid it. The Sixth Circuit ruled that the payment represented a reimbursement of education expenses. It further ruled that since the education expenses were necessary to meet the minimum educational requirements for qualification in his employment as a physician, the education expenses were not deductible. REAL ESTATE PROFESSIONAL CLASSIFICATION DOES NOT EXEMPT TAXPAYER FROM HAVING TO MATERIALLY PARTICIPATE IN HER RENTAL ACTIVITIES In Gragg [3/31/14], the taxpayer and her husband filed joint returns. The husband was a W-2 business professional, the wife a 1099-MISC real estate sales person. They reported net rental real estate losses for two real estate rental properties that they owned, and they did not elect to treat the two properties as one activity. The IRS denied the taxpayers the rental real estate losses, arguing they were passive and had to be carried forward to future tax years. The taxpayers argued that, since the wife was a real estate professional under Section 469(c)(7), the rental losses were not subject to the passive loss limitations. Both sides agreed that the wife was a real estate professional. The issue that a California district court addressed in the case was whether the taxpayers must establish their material participation in her rental real estate activities separate and apart from her undisputed material participation in her profession as a real estate agent. The court observed that the purpose of the real estate professional rule was to alleviate the unfairness between the real estate professional and other professionals. Other professionals could use losses from their business against active income, whereas real estate professionals could not offset losses from rental real estate (per se passive) related to their profession against their business professional income. But, the court noted that the code framework for the real estate professional does not automatically exempt the professional from having to 7

8 demonstrate material participation in the rental real estate activities separately from material participation in the primary occupation as a real estate trade or business professional. The taxpayers primary contention was that the wife s status as a full-time real estate agent automatically established her material participation in her separate real estate rental activities. The court agreed with the IRS that, regarding the taxpayer s rental real estate activities, unless the taxpayer makes an affirmative election to treat all interests in rental real estate as one activity, the taxpayer must establish material participation (using one of the seven regulationspecified rules for establishing material participation, e.g., the 500-hour test) in each rental real estate activity. As the taxpayer was unable to prove by reasonable means that she materially participated in each rental real estate activity, each was passive, and the loss from each could not be used currently to offset her income as a real estate professional involved in real estate sales. Planning Pointer: The real estate professional may elect to treat all interests in rental real estate as one activity, increasing the likelihood of materially participating in those interests. HUSBAND S PARTICIPATION IN REAL ESTATE BUSINESS NOT ATTRIBUTABLE TO WIFE ON HER SEPARATE RETURN UNDER PASSIVE ACTIVITY LOSS RULES A married couple lived together, but filed separate returns for the tax year. The wife was an employee for a real estate investment company, and she did not own more than a 5% interest in the company. Note: A taxpayer s services as an employee in a real estate trade or business do not count as services for purposes of the special passive activity real estate professional rule unless the taxpayer is a 5% owner of the business. The wife had a rental real estate property for which she claimed a $29,583 loss on her return. The IRS denied the loss deduction, asserting that she did not satisfy the real estate professional rules of Section 469(c)(7)(B). The wife argued she was entitled to the deduction because her husband met the two requirements for a real estate professional ((1) he performed more than 750 of hours of service in a real estate trade or business, and (2) he performed more than half of his services in a real estate trade or business). Her position was based on a Treasury regulation that treats the participation of a taxpayer s spouse in an activity as participation by the taxpayer for purposes of the Section 469 passive activity loss rules without regard to whether the spouses file a joint return. In Oderio [3/10/14], the Tax Court relied on the flush language of Section 469(c)(7)(B) in upholding the IRS s position. The court also stated that clarifying language in the Treasury regulation on which the wife relied, while permitting for spousal attribution generally, does not permit attribution to meet the two requirements for a real estate professional. The court stated that where married taxpayers file a joint return and use the real estate professional rule, one of the taxpayers must satisfy both of the requirements for a real estate professional. It stated that a married taxpayer filing separately must satisfy separately the two requirements to avoid per se passive activity treatment for rental losses: as for a joint return, one spouse s services are not attributable to the other spouse in determining if one is a real estate professional. The court decided that the spouse s loss from the rental real estate property was passive. Note: The court stated that the wife was not entitled to the limited $25,000 rental loss offset of Section 469(I) either because she was married filing separately and lived with her husband for the tax year. A COURT ORDER TO CLAIM DEPENDENT IS NOT SUFFICIENT TO CLAIM EXEMPTION DEDUCTION In Swint [2/24/14], the taxpayer was married to her husband who had a child from a previous marriage. According to an agreed entry filed by a state court in 1998, the father, who was the noncustodial parent, would be entitled to a dependency exemption deduction and a child tax credit for his child if he was current in his child support obligations. The agreed entry was not signed by either parent of the child. The taxpayer and her husband (now deceased) filed a joint return in 2009 and as in the case of the prior eleven years, the child support payments were up to date so they claimed the dependent exemption deduction and the child tax credit on their tax return. Section 152(e) provides that a child will be treated as a qualifying child of the noncustodial parent rather than of the custodial parent when certain requirements are met. One of the requirements is that the custodial parent signs a written declaration that he or she will not claim the child as a dependent for any taxable year beginning in the calendar year of the declaration. The declaration must be made either on a completed Form 8332 or on a statement conforming to the substance of Form In 2008, the Treasury regulations were amended to provide that for taxable years starting after July 2, 2008, a court order or decree or a separation agreement may not serve as a written declaration. If a written declaration was executed in a taxable year beginning on or before July 2, 2008, the requirements for the form of a written declaration that were in effect at the time the written declaration was executed are examined. The IRS denied the taxpayer s 2009 dependent deduction and child credit as a result of the 2008 changes in the regulations. The taxpayer argued that the agreed entry filed in 1998 suffices as a written declaration conforming to the substance of Form The Tax Court reviewed the law in effect at the time of the court order and noted that the custodial parent s signature requirement was in effect at that time. It ruled that a court order that is not signed by the custodial parent does not satisfy the express statutory requirements of Section 152(e). Therefore, the father s dependent exemption deduction for the minor child was denied by the Tax Court. Because the child tax credit hinges on whether the child is a qualifying child under Section 152, it also was denied. TAXPAYER LOSES BOTH ISSUES SURROUNDING A CONSERVATION EASEMENT DEDUCTION In Esgar Corporation [3/7/14], three taxpayers each received acres in a land distribution from a partnership in which that they had an interest. Shortly 8

9 after receiving the distribution, each taxpayer donated a conservation easement to a reserve. As a result of their donation, the taxpayers received state tax credits, a portion of which they sold within two weeks from receiving the tax credits. The two primary issues in the case are (1) what is the proper valuation of the conservation easements, and (2) what is the character of the gain resulting from the sale of tax credits. Before the land distribution, the partnership owned 2,200 acres of which 1,470 were leased to a gravel mine company. The method used to determine the value of the easements was the before and after valuation method. The taxpayer and IRS agreed that the combined value after the easements was $75,000. A qualified appraiser based his before valuation on the basis of the land s highest value had the easements not been granted. He determined that the properties would have realized their greatest potential as a gravel mining operation and valued the easements at a combined value of $2,274,500. The donations granted a perpetual easement over the properties, giving the reserve the right to preserve the natural condition of the land and protect its biological, ecological, and environmental characteristics. The grant specifically prohibited the mining of sand, gravel, rock, or any other minerals on the properties. The Tax Court sided with the IRS that the property s best use before the easement was agriculture, not gravel mining. There was no demand for additional gravel mining at the time of the easement, or in the reasonably foreseeable future. Based on the agricultural use, the Tax Court valued the land at $224,050 resulting in a much lower conservation easement deduction than calculated by the appraiser. The Tenth Circuit concluded that the Tax Court did not clearly err by concluding that the best use of the land was agriculture so it upheld the valuation. With respect to the character of the gain from the sale of the tax credits, one taxpayer reported it as ordinary income, one reported it as a shortterm capital gain, and one reported it as a long-term capital gain. The argument for the long-term capital gain treatment was based on holding the underlying real property for longer than one year. That is, the taxpayers relinquished development rights in the property through the donation of conservation easements and received the tax credits as part of the consideration for the donation. The Tenth Circuit agreed with the Tax Court that the character of the gain on the sale of the tax credits is short-term capital gain for the following reasons: (1) they had no property rights in a conservation easement contribution state tax credit until the donation was complete and the credits were granted; (2) the holding period in their tax credits began at the time the credits were granted and ended when they were sold (two weeks later); and, (3) the tax credits did not replace the value of the donated easements through any type of like-kind exchange, thus no "tacking" of holding periods was permitted. FIFTH CIRCUIT DENIES DEDUCTION FOR UNREIMBURSED PARTNERSHIP-RELATED EXPENSES PAID BY THE PARTNER Suppose you are a partner in a partnership providing professional services and you incur expenses in connection with your services as a partner which are not reimbursed by the partnership. Examples of such expenses are cell phone costs, professional dues and licenses, travel, home office expenses, computer and printer expenditures, and local transportation costs. Since partners by law are not employees, the payment of these expenses by the partner would not qualify them as unreimbursed employee business expenses. So is a partner not allowed to deduct these expenses on his or her individual income tax return? The McLauchlan [3/6/14] case addresses this issue. The taxpayer was a partner in a law firm. He reported his income from the partnership on Schedule C (should have been Schedule E) and deducted partnership-related expenses incurred by the partner against the income. On the basis of a 1981 Seventh Circuit decision, the Fifth Circuit noted that generally a partner may not deduct the expenses of the partnership on his individual return, even if the expenses are incurred by the partner in furtherance of partnership business. However, if under a partnership agreement, a partner has been required to pay certain partnership expenses out of his own funds, he is entitled to deduct the amount from his individual gross income. The partnership agreement in the current case expressly provided that expenses that its partners incurred for business meals, automobiles, travel and entertainment, conventions, continuing legal education seminars and professional organizations would be borne by the partner unless approved for reimbursement by the managing partner. Because the managing partner routinely reimbursed these expenses, the taxpayer was not required ultimately to bear any of these expenses. The taxpayer argued that other expenses beyond those mentioned in the partnership agreement were expected to be borne by the partner and therefore should be deductible. The taxpayer alleged these included expenses for cellular phones, office furniture, advertising, computers, and home office. The Fifth Circuit agreed with the Tax Court that the taxpayer s vague and general testimony regarding expenses he was allegedly expected to incur as a partner without reimbursement was not credible. Because all of the taxpayer s claimed expenses either were reimbursable by the partnership, or were not partnership expenses he was required to incur, the Fifth Circuit affirmed the Tax Court's conclusion that none of the expenses incurred by the taxpayer was deductible. Planning Pointer: Some of this area of law appears to be more form than substance and, with proper planning, partners who routinely incur partnership-related expenses that are not reimbursable by the partnership should be able to deduct these expenses. Specifically, the partnership agreement should list those expenses that are reimbursable and provide as detailed a list as possible the expenses which are expected to be incurred by the partners of the partnership but are not eligible for reimbursement. In this case, the latter expenses will be deductible under the exception noted above. PROFESSIONAL GAMBLER DENIED BUSINESS DEDUCTION FOR RACETRACK S PORTION OF TAKEOUT FROM PARIMUTUEL BETTING POOLS The taxpayer was a CPA whose accounting practice included preparing tax returns. He also was a 9

10 professional gambler for the five tax years in question. His gambling activities were limited to parimutuel wagering on horse races. He reported his accounting practice results and wagering results on separate Schedules C. On his gambling Schedule C, he netted his gambling winnings, losses, and miscellaneous other expenses. He combined his net wagering income or loss with his accounting practice income, and reported the net amount as net business income or loss for the year. For four of the five tax years, his net wagering loss exceeded his accounting practice income, resulting in a net loss. For the year he reported a net wagering gain, he claimed a net operating loss carryover deduction from prior years. The IRS disallowed the net wagering loss under Section 165(d) that limits deductible wagering losses to wagering gains, and it disallowed the net NOL carryovers. The Tax Court answered two questions in Lakhani [3/11/14]: (1) Could the taxpayer deduct the portion of each bet referred to as the takeout percentage that applies to the parimutuel pool formed to receive the bet?; and, (2) Is Section 165(d) not applicable to professional gamblers? In parimutuel betting on horse races, the entire amount wagered is referred to as the betting pool, or handle. The pool can be managed to ensure that the race track receives a share of the betting pool. That share is referred to as the takeout, is set by the state (varying from state to state from 15% to 25%), and is used to defray the track s expenses. Expenses include purse money for the horse owners, taxes, licenses fees, and other state-mandated amounts. What remains are the track s profits, from which come amounts that are paid to winning bettors. The taxpayer argued that, in extracting the takeout, the track was acting as a fiduciary: it collected taxes and fees and remitted those amounts to state and local tax authorities. He argued that his pro rata share of the takeout was a business expense deductible under Section 162, and not a loss from a wagering transaction subject to disallowance under Section 165(d). The court stated that none of the takeout comes from a winning bettor s wager. It agreed with the IRS that the taxes, license fees, and other expenses paid from the takeout were expenses imposed on the track, not the bettors. As those amounts were track expenses, not bettor expenses, they were not bettor nonwagering business expenses that could be deducted. The court disallowed the taxpayer a passthrough deduction for his purported share of the takeout amount. As to Section 165(d) s applicability to professional gamblers, the court examined the Congressional committee report s explanation when the predecessor of Section 165(d) was added to the tax code. The provision was added to extend the loss deduction for gambling transactions to legal gambling transactions. The court stated that the basis for enactment of the provision originally was to force taxpayers to report their gambling gains if they desired to deduct their gambling losses. It asserted that the original basis for enactment of the provision continues to constitute a rational basis for applying Section 165(d) to gambling losses. The court rejected the taxpayer s argument that the application of Section 165(d) to net gambling losses violated the professional gambler s constitutional right to equal protection of the laws (the legal professional gambler is not treated the same as any other profession). Note: The court also upheld the IRS s imposition of the Section 6662 accuracy penalty on the taxpayer for substantially understating his income tax. It decided the taxpayer did not have reasonable cause and did not act in good faith. It stated that the taxpayer was a CPA with an active tax preparation practice, and he should have been aware of the Section 165(d) limitation on net gambling losses. **REVIEW QUESTIONS AND SOLUTIONS** 9. True or False. Severance payments that are tied to the receipt of state unemployment benefits are subject to FICA taxes. 10. In a recent court case involving employee stock ownership plans (ESOPs), which one of the following statements is true? a. An ESOP may not own more than 50% of the corporation s stock. b. The individual shareholder was a disqualified person because his deemedowned shares in the S Corporation exceeded 10%. c. A nonallocation year is any plan year in which a disqualified person owns at least 80% in the S Corporation. 11. True or False. In a recent case, the court counted the activities of a trust s trustees in determining if the trust materially participated in the trust s real estate operations. 12. In a recent court case involving the payment by the taxpayer to a hospital for education expenses that the hospital had paid for the taxpayer, which one of the following statements is true? a. The taxpayer argued that the payment qualified as a deductible education expense. b. The taxpayer did not have to make the payment if he worked in a designated underserved community for four years. c. The hospital demanded repayment because the taxpayer did not complete his medical degree. 13. True or False. For a recent case in which a taxpayer was a real estate professional who had rental real estate activities, the court stated that generally the taxpayer must establish material participation in each rental real estate activity. 14. Which one of the following was not a fact in a recent Tax Court case involving the passive activity real estate professional rule where a married couple filed separate returns? 10

11 a. The husband met both of the requirements of the real estate professional rule. b. The husband and wife lived together for the tax year. c. Only the wife worked in a real estate business. 15. Regarding a recent court case involving a noncustodial parent s exemption deduction for his minor child, which one of the following statements is false? a. A court order assigning the dependent exemption after 2008 will satisfy Section 152(e) if the court order is signed by both parents. b. The court found that the custodial parent s signature requirement under Section 152(e) was in effect in the year of the divorce (1998). c. The Tax Court denied the noncustodial parent a dependent exemption deduction for his minor child. 16. Regarding a recent court case involving conservation easements, which one of the following statements is true? a. The Tenth Circuit agreed with the Tax Court s determination of how the easement should be valued. b. The holding period of the land was added to the holding period of the state tax credits received from the state after the conservation easement was completed. c. The Tenth Circuit ruled that the before value of the land should be based on the land s use as a gravel mine. 17. In a recent court case involving a partner s payment of partnership-related expenses, which type of expense, if any, did the Fifth Circuit allow the partner to deduct? a. Expenses mentioned in the partnership agreement that should be borne by the partner but typically were reimbursed by the partnership after the approval for reimbursement by the managing partner. b. Other expenses beyond those mentioned in the partnership agreement that were expected to be borne by the partner. c. None of the expenses. 18. True or False. In a recent case involving a professional gambler, the court permitted the Solutions gambler / taxpayer a deduction for the part of his winning wagers that the track held and used to defray its track expenses. 9. False is the correct response. In its recent decision on severance payments, the Supreme Court noted that the IRS still provides that severance payments tied to the receipt of state unemployment benefits are exempt from FICA taxes. True is the incorrect response. Severance payments that are tied to the receipt of state unemployment benefits are exempt not only from income tax withholding but also from FICA taxation. Quality Stores, Inc "B" is the correct response. The deemed ownership threshold for a disqualified person in this case is greater than 10%. A" is an incorrect response. There is no maximum ownership limitation in the corporation for an ESOP. "C" is an incorrect response. A nonallocation year is any plan year in which a disqualified person owns at least 50%, not 80%, in the S Corporation. Ries Enterprises, Inc True is the correct response. The court concluded that the activities of the trustees, including their activities in an LLC that was wholly owned by the trust, should be considered in determining whether the trust materially participated in its real estate operations. False is the incorrect response. The court noted that neither the Internal Revenue Code nor the Treasury regulations provide a method for determining trust participation. So, the court made the determination by including the activities of the trust s trustees. Frank Aragona Trust. 12. "B" is the correct response. The major purpose of the award was to provide an incentive to the doctor to work in an underserved community. If he worked there four years, he did not have to pay back the award. A" is an incorrect response. The taxpayer argued unsuccessfully that the payment was deductible as a business expense because it enabled him to pursue his for-profit medical practice in a different area of the state. "C" is an incorrect response. He finished his degree as well as his residency. Dargie. 13. True is the correct response. The court stated that the taxpayer must prove material participation in each activity unless the taxpayer affirmatively 11

12 elects to treat all interests in rental real estate as one activity. False is the incorrect response. If the taxpayer elects to treat all rental real estate as one activity, then the hours worked in each rental property included in the election are used to satisfy the material participation requirement. Gragg. 14. "C" is the correct response. The wife was a real estate investment company employee, and the husband met the two requirements for a real estate professional. A" is an incorrect response. The husband met both of the requirements. "B" is an incorrect response. The married couple lived together for the tax year. Oderio. 15. "A" is the correct response. In 2008, the Treasury regulations were amended to provide that for taxable years starting after July 2, 2008, a court order or decree or a separation agreement may not serve as a written declaration. B" is an incorrect response. Neither the custodial parent nor the noncustodial parent signed the court order in the year of the divorce. "C" is an incorrect response. The Tax Court denied the exemption deduction because the custodial parent failed the signing requirement provided in IRC Section 152(e). Swint. 16. "A" is the correct response. The Tenth Circuit concluded that the Tax Court did not clearly err by concluding that the best use of the land was agriculture so it upheld the Tax Court s valuation. B" is an incorrect response. Since there was no like-kind exchange, there was no tacking of holding period. "C" is an incorrect response. The Tenth Circuit agreed with the Tax Court that the best use of the land was agriculture, not gravel mining. Esgar Corporation. 17. "C" is the correct response. Because all of the taxpayer s claimed expenses either were reimbursable by the partnership, or were not partnership expenses he was required to incur, the Fifth Circuit affirmed the Tax Court's conclusion that none of the expenses incurred by the taxpayer were deductible. A" is an incorrect response. Since the expenses mentioned in the partnership agreement were generally reimbursed by the partnership, these expenses were not deductible. "B" is an incorrect response. The partnership agreement did not list expenses that it generally did not reimburse. McLauchlan. 18. False is the correct response. The court stated that the takeout was for the track s expenses, not the bettor s expenses, and as such were not deductible by the bettor. True is the incorrect response. The court denied the taxpayer a deduction for an amount that it concluded did not represent one of the taxpayer s expenses. Lakhani TREASURY TREASURY ISSUES FINAL REGULATIONS ON THE DEFINITION OF SUBSTANTIAL RISK OF FORFEITURE Under Section 61, a landmark case many years ago defined income as an accession to wealth, which is clearly realized, over which the taxpayer has complete dominion and control. So if a taxpayer receives property in exchange for services, the taxpayer must recognize ordinary income equal to the value of the property received. What if there are strings attached to the property? For example, if the taxpayer had to continue providing services for a period of time before the property could be sold, then under Section 61, the taxpayer does not have complete dominion and control over the property until the property can be transferred. After the enactment of Section 61, Section 83 was added to the Code to clarify when income is realized in cases dealing with the receipt of property in connection with the performance of services when certain restrictions exist. Section 83(a) provides that when property is received for services rendered, the excess of the fair market value of the property over the amount paid (if any) for the property is included in gross income in the first taxable year in which the rights of the person having the beneficial interest in the property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable. Common applications of Section 83 are in the areas of stockbased compensation (particularly bonuses) and the receipt of a partnership interest in exchange for current or future services where certain restrictions apply for a period of time. In Treasury Decision 9659 [2/26/14], the Treasury provides final regulations which clarify whether a substantial risk of forfeiture exists in connection with property subject to Section 83. The regulations provide that a substantial risk of forfeiture may be established only through a service condition or a condition related to the purpose of the transfer. In determining whether a substantial risk of forfeiture exists based on a condition related to the purpose of the transfer, both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered. Specifically, property is not transferred subject to a substantial risk of forfeiture in any of the following situations: (1) the facts and circumstances demonstrate that the forfeiture condition is unlikely to be enforced; (2) the employer is required 12

13 to pay the fair market value of a portion of the property to the employee upon the return of the property; and, (3) the risk exists that the value of property will decline during a certain period of time. A nonlapse restriction, standing by itself, also will not result in a substantial risk of forfeiture. Note: For property received under Section 83, Section 83(b) allows the service provider to report the net value (fair market value less consideration paid, if any) of the property received in gross income in the year the property is received. **REVIEW QUESTIONS AND SOLUTIONS** 19. On July 1, 2014, Kathy Dicks agrees to provide services to the ABC partnership for two years. ABC reports its income on the calendar year. For her services, Kathy is to receive $2,000 per month plus a 20% interest in the partnership. During the two-year period her services are rendered, she is not allowed to sell the partnership interest and the interest may be forfeited if the management of ABC finds her services to be unsatisfactory. On July 1, 2014, the value of her 20% interest is estimated to be $50,000. How much, if any, of the $50,000 must be reported on Kathy s 2014 individual income tax return assuming she has not made a Section 83(b) election? Solutions a. $50,000. b. $12,500. c. $ "C" is the correct response. The regulations provide that a substantial risk of forfeiture may be established through a service condition. Since Kathy has to work two years before the substantial risk of forfeiture is eliminated, Section 83(a) is satisfied and she does not have to recognize income in the year the property was received. A" is an incorrect response. $50,000 would be correct if there were not a substantial risk of forfeiture of the property by the end of "B" is an incorrect response. $12,500 would be correct if the $50,000 was recognized over the period the services are to be performed. In this case, six of the 24 months have been completed at the end of Treasury Decision AN ELITE POSSIBILITY If some of your clients were brave enough to invest in the stock market during the downturn in 2008 and 2009, many of their stocks may have doubled in value as the Dow Jones and other indices all have done very well over the last few years. With recent changes in the tax law, now is a great time to consider making charitable donations of appreciated property such as stock. Not only will clients reduce income taxes from the deduction, they also will save taxes by not recognizing a gain from the sale of the stock. Some of the law changes which make stock donation relatively less costly than selling the stock today compared to pre-2013 are: (1) increasing the highest marginal tax rate from 35% to 39.6% thereby making deductions more valuable; (2) increasing the maximum tax on capital gain income from 15% to 20% for taxpayers in the 39.6% marginal tax bracket; (3) adding the 3.8% tax on investment income for taxpayers with higher adjusted gross income amounts ($250,000 for joint filers, $125,000 for married persons filing separately, and $200,000 for all other taxpayers); and, (4) reinstating the phaseouts of the exemption deduction and itemized deductions. Consider taxpayers who plan on filing a joint return who estimate that they will have $500,000 of taxable income after itemizing their deductions. Not included in this estimate is a stock they are considering disposing of since it has appreciated significantly in a relatively short time (say 3-4 years). The value of the stock is $40,000 and its basis is $20,000. Based on their taxable income, if they sell the stock, they will incur additional tax of $4,998 computed as follows: (1) $4,000 of capital gains tax ($20,000 x 20%); (2) $760 of investment income tax ($20,000 x 3.8%); and, (3) $238 of additional tax as a result of losing itemized deductions from the 3% phaseout ($20,000 x 3% x 39.6%). Their exemption deduction is zero because of the phaseout provision and the amount of their AGI. If they donate the stock, the tax savings from the donation is $15,840 ($40,000 x 39.6%) so the after-tax cost of donating the stock versus selling the stock and keeping the net proceeds is $19,162 ($40,000 - $15,840 - $4,998). The after-tax percentage is actually below 50% or in this case 47.9% ($19,162/$40,000). Prior to 2013, the after-tax percentage would have been 57.5% (($40,000 - $14,000 - $3,000)/$40,000). What about someone who is not in the top tax bracket? While not as significant as when the taxpayer is in the top bracket, there are some extra savings from donating the stock after the law changes. The greater the appreciation, the greater the savings. **REVIEW QUESTIONS AND SOLUTIONS** 20. During 2014, a taxpayer is considering whether to donate 100 shares of ABC common stock to his church or to sell it and keep the net proceeds. The stock cost $30,000 and it is now worth $90,000. The taxpayer is in the 39.6% tax bracket and subject to the investment income tax, the taxpayer s itemized deductions are subject to the 3% AGI reduction, and the exemption deduction has been fully phased out. What is the net aftertax cost of donating the stock to the church (the difference between the after-tax proceeds from selling and the tax savings from the donation)? a. $39,367. b. $40,080. c. $42,

14 Solutions 20. "A" is the correct response. The tax on the $60,000 gain from the stock sale is $12,000 ($60,000 x 20% ) of capital gain tax, $2,280 ($60,000 x 3.8%) of investment income tax, and $713 ($60,000 x 3% x 39.6%) of extra income tax from losing $1,800 (3% of $60,000) of itemized deduction. This results in $75,007 ($90,000 - $12,000 - $2,280 - $713) of after-tax proceeds from selling the stock. The tax savings from donating the stock is $35,640 ($90,000 x 39.6%). Therefore, the after-tax cost of selling the stock is $39,367 ($75,007 - $35,640). B" is an incorrect response. $40,080 would be correct if there were no extra income tax resulting from the 3% phaseout of itemized deductions. "C" is an incorrect response. $42,360 would be correct if there were no tax on investment income and there was no 3% phaseout of itemized deductions. An Elite Possibility All rights reserved. The reproduction or translation of these materials is prohibited without the written permission of CPElite. The material contained in CPElite's courses and newsletters qualifies for CPE credit designed to enhance the professional knowledge of the individual. The material is sold with the understanding that CPElite is not engaged in rendering legal, accounting, tax, or other professional services in a consulting capacity "We have entered into an agreement with the Office of Director of Practice, Internal Revenue Service, to meet the requirements of 31 Code of Federal Regulations, Section 10(g), covering maintenance of attendance records, retention of program outlines, qualifications of instructors and length of class hours. This agreement does not constitute an endorsement by the Director of Practice as to the quality of the program or its contribution to the professional competence of the enrolled individual." CPElite, Inc. is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be addressed to the National Registry of CPE Sponsors, 150 Fourth Avenue North, Suite 700, Nashville, TN, Web site: ***** QUIZ QUESTIONS ***** Place your answers to the following20 Multiple Choice Questions on the enclosed answer sheet (page 17). ON-LINE TESTERS GO TO CPELITE.COM. 1. For 2015, how much is the out-of-pocket expense maximum for self-only coverage? a. $6,350. b. $6,650. c. $6, Regarding the 60-day rule for rollovers of IRA distributions, which one of the following is false? a. The one-year period for permitted rollovers begins 60 days after the distribution. b. The Tax Court recently decided that the rule applies across all of the taxpayer s IRAs. c. Beginning in 2015, the IRS will apply the rule across all of the taxpayer s IRAs. 3. Regarding a recent IRS ruling on a taxpayer s rental real property that was foreclosed on, which one of the following statements is true? a. The foreclosure was treated as a fully taxable transaction. b. The Code provides clear guidance on what is a fully taxable disposition under the passive activity loss rules. c. Treasury regulations provide clear guidance on what is a fully taxable disposition under the passive activity loss rules. 14