MSCPA FEDERAL TAX COMMITTEE FEDERAL TAX FORUMS TAX ACCOUNTING BY LORRAINE A. TRAVERS

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1 IRS explains E&P adjustment following switch in depreciation recovery period--plr A business that begins depreciating assets using a short recovery period and/or a rapid recovery method may later find it necessary to use a longer recovery period and/or a slower recovery method for those assets. Such a switch is a change in method of accounting for depreciation and, if the business is a corporation, also involves a change in method of computing depreciation for earnings and profits (E&P) purposes. A recent private letter ruling (PLR) explains the E&P adjustment mechanics in a situation involving a dramatic switch in depreciation classification-from 5-year property to 39-year property. Background. Depreciation deductions generally are determined by the general depreciation system (GDS) of Code Sec. 168(a). However, the alternative depreciation system (ADS) of Code Sec. 168(g) must be used for certain purposes, including computing corporate E&P. ( 312(k)(3) ) Code Sec. 446(e) generally provides that a taxpayer who changes the method of accounting on the basis of which it regularly computes income in keeping the taxpayer's books must obtain IRS's consent to computing taxable income under the new method. A change in method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. A material item is any item that involved the proper time for the inclusion of the item in income or the taking of a deduction. ( Reg (e)(2) (ii)(a) ) In determining whether a taxpayer's accounting practice for an item involves timing, generally the relevant question is whether the practice permanently changes the amount of a taxpayer's lifetime taxable income. If the practice does not permanently affect the taxpayer's life-time taxable income but does or could change the tax year in which income is reported, it involves timing and is therefore a method of accounting. A change in the period of recovery, a change in the convention, or a change in the depreciation method of a depreciable asset is a change in method of accounting under Code Sec. 446(e). ( Reg (e)(2)(ii)(d)(2)(i) ) A taxpayer that uses a different tax accounting method from that used in the preceding year generally must make adjustments under Code Sec. 481(a) to prevent items of income or expense from being duplicated or entirely omitted. The adjustments may be positive (increasing taxable income) or negative (decreasing taxable income). Rev Proc 79-47, CB 528, sets forth the effect on E&P of an adjustment required by Code Sec. 481(a) for a change in method of accounting for taxable income purposes under Code Sec. 446(e). To prevent distortions, when computing (current and accumulated) E&P available for the payment of dividends, the taxpayer must follow its new method for reporting taxable income and must take the applicable Code Sec. 481(a) adjustment into account over the same period as it does for purposes of computing taxable income. Facts. Taxpayer is a domestic C corporation that plans to make a REIT (Real Estate Investment Trust) election for federal income tax purposes under Code Sec. 856 to Code Sec. 859 beginning with the tax year ending Date 3. On Date 4, Taxpayer filed a Form 3115, Application for Change in Accounting Method, to change its method of accounting for depreciation for D, an unidentified type of asset that it uses in its trade or business. Under Taxpayer's current method of accounting, D assets placed in service after '86 were classified as 5-year property under Code Sec. 168(e)(1), and depreciated under the GDS rules of Code Sec. 168(a). For E&P purposes, Taxpayer depreciated these assets under the ADS rules of Code Sec. 168(g) using a 9-year recovery period. D assets placed in service after '80 and before '87 similarly were treated as 5-year property for regular depreciation purposes and 12-year property for E&P purposes. 1

2 Under Taxpayer's proposed method of accounting, it will classify D assets placed in service after '86 as nonresidential real property under 168(e)(2), depreciating them under the GDS, using the straight-line method of depreciation, the mid-month convention, and a 39-year recovery period. In computing its E&P, Taxpayer must depreciate its nonresidential real property placed in service after '86 under the ADS, using the straight-line method of depreciation, the mid-month convention, and a 40-year recovery period. Similar changes will be made to reclassify D assets placed in service after '80 and before '87. Taxpayer had two ruling requests relating to the E&P change made necessary by the change in its method of accounting for depreciation. (1) Must it secure IRS's permission for the E&P change? IRS said that Taxpayer's change in method of accounting for depreciation of the D assets for taxable income purposes requires a correlative change in computing depreciation of the D assets for E&P purposes. Accordingly, IRS consent is not required to make that change for E&P purposes, separate and apart from the consent required to change its method of accounting for depreciation for taxable income purposes. (2) How is the E&P change implemented? If the change in method of accounting for E&P purposes is not a change in method of accounting requiring additional consent, Taxpayer asked IRS to rule that it may implement its change in computing depreciation for E&P purposes by taking the adjusted basis of the property at the beginning of the tax year of change for E&P purposes and using the proper depreciation method, convention, and recovery period for E&P purposes to compute E&P depreciation over the remaining recovery period. IRS said Taxpayer's approach was consistent with the Code Sec. 446 regs, but that these regs did not provide guidance on how to change depreciation for E&P purposes. Here, Taxpayer is changing its method of accounting for depreciation of D assets for taxable income purposes under Code Secs. 446(e) and 481(a), and must take into account the required Code Sec. 481(a) adjustment in computing taxable income. Taxpayer also is changing its depreciation of D assets for E&P purposes. In correcting this change in depreciation for E&P purposes, Taxpayer must take into account the adjustment that must be made to its E&P due to the change in computing E&P for depreciation of D assets over the same period of time as it does for the Code Sec. 481(a) adjustment due to the change in method of accounting for depreciation of D assets for taxable income purposes under Code Sec. 446(e). Because Taxpayer must take into account the Code Sec. 481(a) adjustment arising from the change in method of accounting for depreciation for taxable income purposes over four years, it must take the correlative adjustments arising from the change in computing depreciation for E&P purposes over the same period of time as it takes into account the Code Sec. 481(a) adjustment (i.e., over four years) Thomson Reuters/Tax & Accounting. All Rights Reserved. Automatic accounting method change rules to reflect new retail inventory method reg- -Rev Proc , IRB In a Revenue Procedure, IRS has provided the exclusive procedures by which a taxpayer obtains IRS's automatic approval to make certain accounting method changes within the retail inventory method. These changes correspond to a recently issued final reg that clarified several aspects of computing ending inventory values under the retail inventory method. Background on accounting method changes. Under Code Sec. 446(e) and Reg (e)(2), except as otherwise provided, a taxpayer must secure IRS's consent before changing a method of accounting for federal income tax purposes. Reg (e)(3)(ii) authorizes IRS to prescribe 2

3 administrative procedures providing the limitations, terms, and conditions necessary to permit a taxpayer to obtain consent to change a method of accounting under Code Sec. 446(e). Rev Proc , CB 330, provides procedures for a taxpayer to obtain automatic consent to change to a method of accounting described in its Appendix. When a change in method of accounting is made on a cut-off basis, in general, only the items arising on or after the beginning of the year of change are accounted for under the new method of accounting. ( Rev Proc , Sec ) Code Sec. 481(a) requires certain adjustments necessary to prevent amounts from being duplicated or omitted when a taxpayer's taxable income is determined under a method of accounting different from the method used to determine taxable income for the preceding tax year. Background on the retail inventory method. A taxpayer, such as a department store, may use the retail inventory method to compute the value of ending inventory at approximate cost (retail cost) or approximate lower of cost or market (retail LCM), by multiplying the retail selling prices of goods on hand at the end of the tax year by a "cost complement." The cost complement is the value of beginning inventory plus the cost of purchases divided by the retail selling prices of beginning inventory and purchases. On Aug. 14, 2014, IRS released a final reg ( Reg ) on the retail inventory method, that clarified a taxpayer's treatment of certain sales-based vendor allowances, margin protection payments, permanent markups and markdowns, and temporary markups and markdowns when determining the cost complement. The final reg applies to tax years beginning after Dec. 31, The final reg provides, among other things:... that a taxpayer using the retail inventory method may not reduce the numerator of the cost complement by the amount of an allowance, discount, or price rebate that, under Reg (e), must reduce only cost of goods sold;... that a taxpayer using retail LCM generally may not reduce the numerator of the cost complement by the amount of an allowance, discount, or price rebate that is related to or intended to compensate for a reduction in the taxpayer's retail selling price of inventory (a "margin protection payment");... that a taxpayer using the retail inventory method generally must adjust the denominator of the cost complement for all permanent markups and markdowns, but may not reduce the denominator for temporary markups or markdowns;... an alternative method for a taxpayer using retail LCM to compute the cost complement by reducing the numerator by the amount of margin protection payments if the taxpayer also reduces the denominator of the cost complement by the amount of the reductions in retail selling price to which the margin protection payments relate (related markdowns);... a second alternative method for a taxpayer using retail LCM to account for margin protection payments when computing the cost complement under which a taxpayer that is able to determine the amount of its margin protection payments, but cannot determine the amount of the related markdowns, may compute the cost complement by reducing the numerator by the amount of margin protection payments and adjusting the denominator by the amount that, in conjunction with the reduction of the numerator, maintains what would have been the cost complement percentage before taking into account the margin protection payments and related markdowns; and... that a taxpayer using one of the alternative methods described above must use that method for all cost complements. New guidance. Rev Proc applies to a taxpayer using the retail inventory method that wants to change its method of accounting to comply with the new final reg. It modifies Rev Proc , 3

4 by adding a new section titled "Retail inventory method" to the Appendix to that Rev Proc ( 21.16). The new guidance applies to a taxpayer using the retail inventory method that wants to change: (1) from adjusting to not adjusting the numerator of the cost complement by the amount of an allowance, discount, or price rebate that is required under Reg (e) to reduce only cost of goods sold; (2) from adjusting to not adjusting the denominator of the cost complement for temporary markups and markdowns; (3) in the case of a retail LCM taxpayer: (a) from adjusting to not adjusting the numerator of the cost complement by the amount of a margin protection payment; (b) from adjusting to not adjusting the denominator of the cost complement for permanent markdowns; or (c) from using one method for computing the cost complement described in Reg (b)(3) to using a different method described in Reg (b)(3) (i.e., the general method or the two new alternatives described above); (4) in the case of a taxpayer using the retail cost method, from not adjusting to adjusting the denominator of the cost complement for permanent markups and markdowns. The scope limitations in section 4.02(1) through (4) and (7) of Rev Proc (taxpayer under examination; consolidated group member; partnerships and S corporations ; Code Sec. 381(a) transactions; and prior five-year item changes) do not apply to the new sets of procedures for the taxpayer's first and second tax years beginning after Dec. 31, Mechanics of making change(s). A taxpayer that wants to make multiple changes under for the same year of change should file a single Form 3115, and a taxpayer making a change under for its first or second tax year beginning after Dec. 31, 2014 may either: (i) use a Code Sec. 481(a) adjustment as provided in Rev Proc , Sec and Rev Proc , Sec. 5.04, or (ii) implement the change on a cut-off basis. If a cut-off basis is used, the change applies only to the computation of ending inventories after the beginning of the year of change (see Rev Proc , Sec for more details). The designated automatic accounting method change number for changes in methods of accounting under is "204." A taxpayer changing its method of accounting under must file a signed copy of its completed Form 3115 with IRS in Ogden, UT, no later than the first day of the year of change and no later than the date the taxpayer files the original Form 3115 with its federal income tax return for the year of change. Effective date. Rev Proc , like the new final reg, is effective for tax years beginning after Dec. 31, Thomson Reuters/Tax & Accounting. All Rights Reserved Taxpayer wasn't real estate professional; losses barred by passive activity rules-- Schumann, TC Memo The Tax Court has determined that an individual who was the president and majority shareholder of a number of businesses did not qualify as a real estate professional for either of two years at issue. The Court also determined that: a) the rental income that he received for the use of two properties that he owned by two of his businesses was subject to the self-rental rules and therefore considered nonpassive income that could not be offset by passive losses stemming from other properties; and b) he was barred under Code Sec. 280A from deducting expenses related to two apartments on a cruise 4

5 ship that he owned and personally used. Background. Taxpayers are allowed deductions for certain business and investment expenses under Code Sec. 162 and Code Sec However, if the taxpayer is an individual, 469 generally disallows any "passive activity loss" (i.e., aggregate losses over income from any trade or business in which the taxpayer does not materially participate) for the tax year and treats it as a deduction for the next tax year. ( Code Sec. 469(a), Code Sec. 469(b) ) A taxpayer is treated as materially participating in an activity only if his involvement in its operations is regular, continuous, and substantial. (Code Sec. 469(h)(1), with tests for whether a taxpayer is considered to have materially participated in Reg T ) Rental activity is generally treated as a per se passive activity regardless of whether the taxpayer materially participates. ( Code Sec. 469(c)(2) ) However, an exception under Code Sec. 469(c)(7) provides that the rental activities of a taxpayer in a real property trade or business aren't subject to Code Sec. 469(c)(2) 's per se rule and are instead subject to the material participation requirements of Code Sec. 469(c)(1). ( Reg (e)(1) ) Under this rule, a taxpayer qualifies as a real estate professional if: (1) more than one-half of the personal services performed in trades and businesses by the taxpayer during the tax 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 tax year in real property trades or businesses in which the taxpayer materially participates. ( Code Sec. 469(c)(7)(B) ) For purposes of determining whether a taxpayer is a real estate professional, a taxpayer's material participation is considered separately with respect to each rental property unless the taxpayer elects, by filing a statement with his original income tax return for the tax year, to treat all interests in rental real estate as a single rental real estate activity. ( 469(c)(7)(A), Reg (e)(1) ) The self-rental rules under Reg (f)(6) reclassify net rental income as nonpassive income if the taxpayer receives the rental income for use of an item of his property in a business in which he materially participates. Rental income that is reclassified as nonpassive cannot be offset by passive losses. Under Code Sec. 280A, "no deduction otherwise allowable... shall be allowed with respect to the use of a dwelling unit which is used by the taxpayer during the taxable year as a residence." A dwelling unit is a residence if the taxpayer uses it for personal purposes for a number of days equal to the greater of 14 days or 10% of the number of days during the year for which the unit is rented at a fair rental value. ( Code Sec. 280A(d)(1) ) Facts. Douglas Schumann has incorporated four companies: an S corporation in Connecticut (CT corp) of which he was president and majority shareholder during the years at issue (2008 & 2009); an S corporation in Maine (ME corp) of which he was president and majority shareholder; a Florida corporation of which he was sole shareholder; and an S corporation (Jet Co) that was formed to hold ownership of Schumann's aircraft. During 2008 and 2009, Schumann owned two commercial rental properties, one in Connecticut (CT property) and one in Maine (ME property). During those years, he rented the CT property to CT Corp and the ME property to ME corp. Also in 2008 and 2009, he owned an airplane hangar in FL and 12 residential properties in Florida (FL properties), all of which were within a mile of his home. He did not rent out any of the Florida properties in 2008, and he was able to rent out only one property in He hired a number of individuals and companies to assist him with maintaining the FL properties during the years at issue. Schumann also owned two apartments on a cruise ship (cruise apartments). He used one as his residence while aboard the ship, and he spent at least 92 days aboard in 2008 and 162 days a-board in 5

6 2009. He testified that the second apartment was offered as an auction item to raise money for charities and was used as such for between 15 and 26 weeks during Original and amended reporting positions. On his Form 1040 for 2008, Schumann reported: nearly $5.4 million of wages from CT corp and $10,000 of wages from ME corp; $21,643 and $729,959 of nonpassive income from ME corp and CT corp, respectively, on Schedule E; and $629,994 of rental income from CT corp for the CT property and $75,000 of rental income from ME corp for the ME property. On an amended return for that year, Schumann made changes to his Schedule E by adding eight of the FL properties and his cruise apartment. He reported zero rental income with respect to these properties, but claimed $843,770 of expenses for the FL properties (including insurance, mortgage interest, and other costs) as well as $239,328 of maintenance fees and nearly $2 million of depreciation for the cruise apartment. He also attached a document entitled "Rental Real Estate Professional Election" in which he stated that he was a "qualified real estate professional under Code Sec. 469(c)(7) " and wished to elect under Code Sec. 469(c)(7)(A) to treat all interests in real estate as a single rental real estate activity. On his Form 1040 for 2009, Schumann reported: $856,989 of wages from CT corp and $10,000 of wages from ME corp; $371,525 and nearly $2.3 million of nonpassive income from ME corp and Jet Co, respectively, on Schedule E; $659,223 of nonpassive loss from CT corp; and $1.2 million of rental income from CT corp for the CT property and $300,000 of rental income from ME corp for the ME property. In addition, Schumann listed all 12 of his FL properties, both of his cruise apartments, and his airplane hangar on his Schedule E. He reported only $31,000 of rental income from one of the FL properties and $3,600 of rental income from his airplane hangar. He reported over $2.8 million of expenses for the FL properties and, for his cruise apartments, reported $400,755 of maintenance fees and $315,000 of depreciation. He also attached a document entitled "Rental Real Estate Professional Election," identical to the one he attached to his amended 2008 tax return. IRS's deficiency notice & pleadings. In 2012, IRS issued a deficiency notice to Schumann in which it determined that he was not entitled to the refund claimed on his amended 2008 return because he didn't qualify as a real estate professional. For 2009, IRS disallowed a deduction of nearly $1.9 million in rental real estate losses under the Code Sec. 469 passive loss limitations. Schumann filed a timely petition with the Tax Court. In its first amended answer, IRS asserted that Schumann improperly reported the rental payments that he received from CT corp and ME corp in both 2008 and 2009 as passive rental income, reasoning that the rental income was nonpassive income under the self-rental rules and that he cannot offset this income with his passive losses. Then, in a second amended answer, IRS asserted that Schumann's 2009 rental real estate losses were limited by Code Sec. 280A. Tax Court sides with IRS. The Tax Court first concluded that, since Schumann didn't file a statement with his original 2008 return electing to treat all of his interests in rental real estate as a single real estate activity, it had to determine on a property-by-property basis whether he materially participated. However, it found that he did file such a statement with his original 2009 return and was thus entitled for that year to treat his properties as a single real estate activity. The Court then turned to the material participation tests of Reg T(a) and found that, while a taxpayer may establish hours of participation by any reasonable means, and contemporaneous daily reports aren't necessarily required ( Reg T(f)(4) ), Schumann's narrative summary of his activities fell short of meeting this standard. Among other things, it didn't differentiate between hours worked in 2008 & 2009, it seemed to include hours worked in 2010, and it was based on documents 6

7 that contained contradictions. The Court then concluded that he didn't meet any of the material participation tests under Reg T based on his failure to show, among other things, that he spent more than 500 hours working on any of any of the properties in 2008 or all of the properties in Accordingly, since he failed to show that he materially participated, he didn't qualify as a real estate professional for either of the years at issue, and IRS's disallowance of his loss deductions with respect to the FL properties was upheld. The Court then turned to IRS's argument that Schumann's net rental income from the CT and ME properties was nonpassive income under the self-rental rules, noting that these rules would apply to the income if he materially participated (i.e., on a regular, continuous, and substantial basis under Reg T(a)(7) ) in CT corp or ME corp during the years at issue. The Court observed that his tax reporting-wages of over $5 million and of $10,000 from CT corp and ME corp, respectively, in 2008, and $856,989 and $10,000 in 2009-indicated that he was an active participant in both. Schumann claimed that his reporting for both years was "tax provisioning" and that he didn't actively provide services to either company, but the Court rejected his claim based on the fact that he was the majority shareholder, president, and a director of both companies and that he was financially responsible for both during the years at issue. Thus, the Court agreed with IRS that his net rental income was nonpassive and couldn't be offset by any passive activity losses incurred with respect to any other properties. Finally, the Court concluded that, because Schumann used both of his cruise apartments for personal purposes for at least 14 days in 2009, both apartments should be treated as residences for that year and the deductions claimed with respect to them are subject to Code Sec. 280A 's limitations Thomson Reuters/Tax & Accounting. All Rights Reserved. "Facilities upgrade" payments from car manufacturer were income to dealership-- Legal Advice Issued by Associate Chief Counsel In Legal Advice Issued by Associate Chief Counsel, IRS has concluded that payments that a car manufacturer made to car dealerships to encourage the dealerships to expand, modernize and/or renovate the dealerships' facilities were income to the dealerships, as opposed to reductions in the cost of the renovations, etc., adjustments to the purchase price of cars, or non-shareholder contributions to capital. Facts. The Legal Advice sets out three fact situations. In all three, a manufacturer (X) developed a brand standardization plan for dealerships that sell X's vehicles. The plan includes a standard, modernized look for dealership facilities. X offers a Program to encourage dealerships to undertake the changes needed to implement X's plan to improve dealerships' facilities. In Situation 1, the dealership, A, is eligible to receive payments equal to z% of the project's construction costs, provided the work complies with X's standardization plan. A receives half of the total payments at the beginning of the project and the other half upon completion of the project. If A does not satisfactorily complete the project to improve its facilities, A must repay some or all of payments. In Situation 2, the plan includes several required elements: (1) improvements to the dealership B's facilities; (2) upgrades to B's software, internet capabilities and website enhancement; and (3) training for sales and service employees. A participating dealership is required to complete all required elements of the plan. Payments are made quarterly for the duration of B's participation in Program, and payments are made only if B meets certain progress goals for each of the required elements during the preceding quarter. The amount of each payment is determined by a formula based on the 7

8 number of vehicles that B purchased from X during the preceding quarter. In Situation 3, Program provides for two distinct types of payments. The first type is determined by $x for each vehicle sold during Program, and dealership C's right to these payments begins to accrue for the calendar year in which X approves the plan. The second type of payment is determined by using a formula based on the expected costs of the improvements. Background. Code Sec. 61 generally provides that gross income means all income from whatever source derived. The term "income" is broadly defined as "instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." (Glenshaw Glass Co., (S Ct 1955) 47 AFTR 162 ) Generally, when payments are made by vendors to retailers as an inducement to purchase merchandise, the payments do not constitute separate items of gross income but instead are an adjustment to the price of the merchandise purchased (purchase price adjustment). (Affiliated Foods, Inc., (2007) 128 TC 62 ) As established in case law, the test for whether a payment, credit, allowance or rebate is a purchase price adjustment is what the parties intend and for what purpose the payment, credit, allowance, or rebate was paid. If the purpose was to adjust the price of the item between the parties, then the consideration given, in whatever form, is a purchase price adjustment and is not a separate item of gross income. (Pittsburgh Milk Co, (1956) 26 TC 707 ) It does not follow that all allowances, discounts, and rebates made by a seller of property constitute adjustments to the selling prices. For example, allowances made in consideration of prepayment of an account receivable are in effect payments of interest. (Pittsburgh Milk) Code Sec provides that the basis of acquired property is generally the cost of the property. Code Sec. 1016(a) provides that the basis of property is increased by the cost of capital improvements. An expenditure to produce tangible property is a capital expenditure if it meets the requirements of Reg (a)-2. An expenditure to improve tangible property is a capital expenditure if it meets the requirements of Reg (a)-3. Code Sec. 118(a) provides that the gross income of a corporation does not include any contribution to the capital of a corporation. Code Sec. 118(a) applies even when the contribution to the capital of a corporation is made by a nonshareholder. The Supreme Court has said that, to determine when a transfer by a nonshareholder to a corporation is a contribution of capital to the transferee corporation excludable from the gross income of the transferee corporation, one must examine the intent or motive of the transferor and the economic effect on the transferee corporation. Factors indicative of the transferor's intent or motive are whether the benefit to the transferor is direct or indirect, specific or general, or certain or speculative. Where the transfer is not made with the purpose of receiving direct service or recompense, but only of obtaining advantage for the general community, the result is a contribution to capital. (Chicago, Burlington, & Quincy Railroad Co., (S Ct 1973) 32 AFTR 2d ) In all three Situations, payments are income to the dealerships. IRS concluded that in each of the 3 Situations, the payments are includable in the dealerships' gross income under Code Sec. 61. The dealerships are responsible for contracting with the construction providers and are liable for payments to the construction providers. The dealerships, not the manufacturer, own the property that the dealerships construct or improve with the payments. The dealerships receive payments to defray their expense for construction of, or improvements, to their property. The dealerships have an accession to wealth over which they have complete dominion and control. Even though subsequent conditions may require the dealerships to return some or all of the payments, the dealerships must recognize taxable income when the dealerships receive the payments (if the dealership uses the cash method of accounting) or when the all events test is met (if the dealer- 8

9 ship uses the accrual method of accounting). (See, e.g., Healy, (1953) 43 AFTR 382 ; Schlude, (S Ct 1963) 11 AFTR 2d 751 ) Further, the payments that dealership B in Situation 2 receives for modifications to its customer service practices, computer systems, website, or other systems, are also gross income under Code Sec. 61. IRS said the facts and conclusion here are similar to those in John B. White, Inc., (1971) 55 TC 729, aff'd per curiam (CA ) 29 AFTR 2d In White, an auto manufacturer paid its authorized dealer amounts for leasehold improvements to induce the dealer to move its dealership to another location. IRS then noted that, although the manufacturer may make the payments for the intended purpose of defraying the dealerships' costs of improvements to the dealerships' facilities, the dealerships own the properties, and the payments do not reduce the basis in the dealerships' property. And the payments are not purchase price adjustments to vehicles. IRS noted that Freedom Newspapers, Inc., TC Memo , Rev Rul 76-96, CB 23, and Rev Rul , CB 299 held that a payment that a taxpayer receives as an inducement to purchase an asset is not includable in gross income and results in a reduction of the basis of the asset. But here, the contracts between the manufacturer and dealership reflected that the purpose of the payments was to provide an incentive to the dealerships to undertake and complete the upgrades to their facilities and to defray the dealerships' costs for the upgrades. Nothing in the contracts suggested that the payments were an adjustment to the purchase price of the vehicles. Further, using the number of vehicles sold in Situation 2, or vehicles purchased in Situation 3, to calculate the amount of the payments was simply a formula to calculate the amount of the payments and was not a formula to reach the net selling price of the vehicles. Finally, the payments were not nonshareholder contributions to capital under Code Sec The payments failed the Chicago, Burlington & Quincy test; the manufacturer did not have the proper intent or motive because the manufacturer's motive was not to obtain advantage for the general community. The manufacturer's payments to the dealerships were for the direct benefit of the manufacturer. The purpose of Programs was to provide an incentive for dealerships to upgrade their facilities, which could result in increased dealership sales of vehicles for the benefit of the manufacturer Thomson Reuters/Tax & Accounting. All Rights Reserved. Disregarded entity's passive investment activities constitute insurance business--plr In a private letter ruling (PLR), IRS has concluded that the passive investment activities of a life insurance company's subsidiary, which intends to make a check-the-box election to be disregarded as a separate entity, are properly treated as an insurance business. Accordingly, the subsidiary's income and expenses will be included in computing the company's life insurance company taxable income and won't be subject to certain limitations on the use of nonlife losses. Background. In general, life insurance companies are taxed on their life insurance company taxable income (LICTI; i.e., gross income less applicable deductions). ( Code Sec. 801(a) ) In computing LICTI, any loss from a noninsurance business is limited under the principles of Code Sec. 1503(c), which provides special rules for the application of certain losses against the income of insurance companies. ( Code Sec. 806(b)(3)(C) ) In general, to the extent a life insurance company has losses from a noninsurance business, Code Sec. 803(b)(3)(C) and Code Sec. 1503(c) limit the use of non life losses against life income to the lesser of 35% of the nonlife losses or 35% of the life income, and 9

10 also limit the carryover of unused losses to 35%. Code Sec. 806(b)(3)(A) defines noninsurance business as "any activity which is not an insurance business," and Code Sec. 806(b)(3)(B) further provides that any activity which is not an insurance business is nonetheless treated as an insurance business if: (i) it is of the type traditionally carried on by life insurance companies for investment purposes, and (ii) the carrying on of such activity (other than in the case of real estate) does not constitute the active conduct of a trade or business. The legislative history to Code Sec. 806 provides that, in general, "insurance business" refers to the business activity of issuing insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies, together with investment activities and administrative services that are re-quired to support or are substantially related to contracts issued or reinsured by the taxpayer. Facts. Holding Company is a domestic insurance holding company that, through its direct and indirect subsidiaries, engages in a wide variety of insurance, financial services and other investmentrelated businesses. Holding Company is the parent company of Parent, a domestic stock holding company, which in turn owns all of the stock of Company. Company is a domestic life insurance company, and Company and its affiliates' business operations consist of life insurance products, annuities, mutual funds, pension and institutional products. Subsidiary is a domestic corporation that Parent acquired and that invests in Passive Investment Activities and also performs consulting activities with respect to similar Passive Investment Activities. After receiving regulatory approval, and for non-tax business reasons, Holding Company directed Parent to contribute the stock of Subsidiary to Company. Holding Company files a life-nonlife consolidated federal income tax return with its eligible members on a calendar year basis under a 1504(c)(2)(A) election (i.e., to include, subject to certain limitations, life insurance companies taxed under Code Sec. 801 in a consolidated return with other corporations that are not life insurance companies). Both Company and Subsidiary are eligible members included in Holding Company's life-nonlife consolidated return. Holding Company group has treated Company as part of the life insurance subgroup, and Subsidiary as part of the nonlife subgroup. Proposed transaction. Holding Company proposes that Subsidiary segregate the consulting activities in a separate company owned by Holding Company or one of its non-life subsidiaries. Holding Company will continue to treat the consulting activity as part of the non-life subgroup. After segregation, Subsidiary will make a "check the box" election (under Reg , on Form 8832) to be disregarded as a separate entity. Following the check-the-box election, Company, for tax purposes, will hold the assets relating to the Passive Investment Activities and will continue such investment activities to support life insurance and annuity contracts issued by Company. Favorable ruling. As requested, IRS favorably ruled that Subsidiary's Passive Investment Activities are properly treated as an insurance business following Subsidiary's check-the-box election, and that Subsidiary's income and expenses should thus be included in computing tentative LICTI and are not limited by Code Sec. 806(b)(3)(C) or Code Sec. 1503(c). In reaching its conclusion, IRS looked to the legislative history underlying 806, as well as 806(b) (3)(C) 's two-prong test for treating certain activities as an insurance business. It observed that, following Subsidiary's check-the-box election, the assets relating to the Passive Investment Activities will be held by Company in order to support life insurance and annuity contracts issued by Company. Moreover, IRS found that the Passive Investment Activities are of the type of activity traditionally carried on by life insurance companies for investment purposes, and that the carrying on of such activity does not constitute the active conduct of a trade or business. Accordingly, the Passive Investment Activities will not be considered a non insurance business under 806(b)(3) Thomson Reuters/Tax & Accounting. All Rights Reserved. 10

11 IRS OKs related entities' like-kind swap of building for new structure on leased land-- PLR A real estate owner normally will have to pay a tax on gain when it sells an appreciated-in-value building and reinvests the proceeds in a new structure built on land it has leased. However, if the building is owned and the land is leased by different entities in which the real estate owner has an interest, tax on the gain may be avoided by structuring the transaction as a like-kind exchange. A recent private letter ruling shows how this can be done. Background. Under Code Sec. 1031, gain or loss isn't recognized currently on the exchange of property held for productive use in a trade or business or for investment for property of like kind that will be held for productive use in a trade or business or for investment. The replacement property must be identified within 45 days after the date that the property given up in the exchange is relinquished. Additionally, the taxpayer must actually receive the replacement property no later than (a) 180 days after the date that the property given up in the exchange is relinquished, or (b) the due date (with regard to extensions) for the taxpayer's return for the year in which the relinquished property is given up, whichever is earlier. ( Code Sec. 1031(a)(3) ) When a two-way (or direct) exchange of like-kind property isn't possible, the solution often is a multiparty deferred exchange. For example, Seller transfers his property to a qualified intermediary (QI), who then acquires suitable replacement property and then exchanges the replacement property for Seller's property. Detailed rules carried in Reg (k)-1 must be followed for an intermediary to be treated as a QI. Parking transaction safe harbor. In a variation of what has come to be known as a "parking" transaction, replacement property may be parked with an accommodation party until the taxpayer is ready to arrange the final steps of the exchange. The transaction can be set up so that the accommodation party is treated as the owner of the replacement property for federal income tax purposes. In Rev Proc , CB 308, addressing parking transactions, IRS said it won't challenge the qualification of property as either replacement or relinquished property, or the treatment of the exchange accommodation titleholder (EAT) as the beneficial owner of either type of property, if the property is held in a qualified exchange accommodation arrangement (QEAA). Under Rev Proc , property is held in a QEAA if all the following requirements are met: (1) Qualified indicia of ownership of the property are held by the EAT from the date of acquisition by the EAT until the property is transferred to the taxpayer as replacement property or to someone other than the taxpayer or a disqualified person as relinquished property. The EAT can't be the taxpayer or a disqualified person under Reg (k)-1(k) ) and either it must be subject to federal income tax, or if it is treated as a partnership or S corp, more than 90% of its interests or stock must be owned by partners or shareholders who are subject to federal income tax. (2) When the qualified indicia of ownership of the property are transferred to the EAT, it is the taxpayer's bona fide intent that the property represent either replacement property or relinquished property in an exchange intended to qualify for Code Sec treatment. (3) No later than five business days after qualified indicia of ownership of the property are transferred to the EAT, the taxpayer and the EAT enter into a written QEAA providing that: (a) the EAT is holding the property for the benefit of the taxpayer to facilitate an exchange under Code Sec and Rev Proc ; (b) both parties agree to report the acquisition, holding, and disposition of the property as provided in the rev proc; and (c) the EAT will be treated as the beneficial owner of the property for all federal income tax purposes. Both parties must report the federal income tax attributes of the property on their federal returns in a manner consistent with this agreement. 11

12 (4) No later than 45 days after the transfer of qualified indicia of ownership of the replacement property to the EAT, the relinquished property is properly identified in a way consistent with the identification requirements in Reg (k)-1(c). The taxpayer may properly identify alternative and multiple properties under the rules of Reg (k)-1(c)(4). (5) No later than 180 days after the transfer of qualified indicia of ownership of the property to the EAT, (a) the property is transferred (either directly or indirectly) through a QI (as defined in Reg (k)-1(g)(4) ) to the taxpayer as replacement property; or (b) the property is transferred to a person who is not the taxpayer or a disqualified person as relinquished property. (6) The combined time period that the relinquished property and the replacement property are held in a QEAA does not exceed 180 days. ( Rev Proc , Sec ) The safe harbor allows the parties to enter into financing and other arrangements to make the reverse like-kind exchange (i.e., one is which replacement property is acquired before the sale of the taxpayer's relinquished property) work. For example:... the taxpayer may loan or advance funds to the EAT or guarantee a loan or advance to the EAT; and... the taxpayer may manage the property, supervise improvements, act as a contractor, or otherwise provide services to the EAT with respect to the property. ( Rev Proc , Sec ) In Rev Proc , CB 294, IRS modified Rev Proc , to provide that the safe harbor rules do not apply if the taxpayer owns the property intended to qualify as replacement property before initiating a QEAA. Rev Proc , will not apply to replacement property held in a QEAA if the property is owned by the taxpayer within the 180-day period ending on the date of transfer of qualified indicia of ownership of the property to the EAT. Under Code Sec. 1031(f)(1), gain or loss on an exchange between persons treated as related (under Code Secs. 267(b) or 707(b)(1) ) must generally be recognized if either the property transferred or the property received is disposed of within two years after the exchange. And nonrecognition treatment under the like-kind exchange rules doesn't apply to any exchange that is part of a transaction or series of transactions structured to avoid the purposes of the related party exchange rule. ( Code Sec. 1031(f)(4) ) Facts. Taxpayer, an LLC that is treated as a partnership for federal income tax purposes, is partially owned by DE, a disregarded entity for federal income tax purposes that is wholly owned by LP, and partially owned by Management Co., a real estate investment trust (REIT) subsidiary which is also wholly owned by LP. In turn, LP is an affiliate of Trust, which is a publicly held statutory REIT. Under Code Sec. 1031(f)(3), LP and Taxpayer are related for purposes of the like-kind exchange rules. The relinquished property. Taxpayer owns RQ, a retail building, and will enter into an agreement to sell it to an unrelated third party. Taxpayer will then enter into an exchange agreement (QI Agreement) with a qualified intermediary (QI), to whom it will assign its rights in the contract to sell RQ, with notice being given to the buyer. The QI Agreement will satisfy the regs' requirements for such agreements. In particular, QI won't be Taxpayer or a disqualified person, and Agreement will expressly limit Taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by QI. To secure QI's obligations to acquire replacement property and transfer it to Taxpayer, QI will enter into a Qualified Exchange Trust Agreement (Trust Agreement) and deposit the funds from the sale of RQ into a master customer trust account (Qualified Exchange Trust) with Trustee of which Tax-payer will be a beneficiary. Trustee is not Taxpayer or a disqualified person. Trust Agreement will limit Taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of cash or cash equivalent 12

13 held by Trustee as required by the regs. The replacement property. The Ground Lessee of Building, a large, outdated, and vacant urban office building, is an LLC that is treated as a disregarded entity for tax purposes and is wholly- owned by LP. The Ground Lessor of the property is an LLC that is treated as a disregarded entity for tax purposes and is partially owned by LP. Ground Lessee will demolish the building and then sublease the vacant land to EAT, or sublease the building to EAT which will then proceed to demolish it. The sublease will have an over-30-year term, which is represented to be in excess of the useful life of the improvements, and which will be at fair rental value for the land alone. The sub-lease will allow construction of improvements by EAT. Taxpayer represents that all safe-harbor requirements in Rev Proc will be met. Also, Taxpayer will advance to EAT the necessary funds to build the improvements on the leased land, and will oversee construction. Final steps of the transaction. Taxpayer will assign to QI its rights in the Accommodation Agreement to acquire RP (defined as the qualified indicia of ownership of the improvements and ground lease of Building). On or before the 180th day from the effective date of the sublease, EAT will, following QI's direction, transfer RP directly to Taxpayer. EAT will only hold the replacement property, not the relinquished property. Neither Taxpayer nor Ground Lessee will dispose of either of their interests within two years after the last transfer that was part of the exchange. Like-kind exchange treatment approved. The PLR says that based on the representations made, Taxpayer will successfully complete a Code Sec like-kind exchange of a fee interest in improved real estate for a long-term lease of a tract of land for a period of more than 30 years, plus improvements. IRS ruled that Code Sec. 1031(f)(1) didn't apply because Taxpayer will be exchanging property with QI, who is not a related person to Taxpayer. And Code Sec. 1031(f)(4) won't apply because, although a related party provides a part of the RP, there will be no cashing out by any of the related parties within two years of the last transfer in the series of transactions. Finally, Rev Proc won't apply because the RP held by EAT has not been owned by Taxpayer. The PLR concludes that Taxpayer will not be in actual or constructive receipt of money or other property for Code Sec purposes by employing the proposed transaction. Additionally, since the Rev Proc requirements will be met, EAT will be treated as the beneficial owner of RP for federal income tax purposes when RP is held under the Accommodation Agreement. However, if other property is transferred to Taxpayer because of the contractors' failure to timely complete improvements on RP before its transfer to Taxpayer, then it will have taxable boot. Also, to the extent the cost of the improvements is less than the funds held by Trustee, if Taxpayer does not timely identify and acquire additional like-kind replacement property, then Taxpayer will receive the remaining qualified funds as taxable boot Thomson Reuters/Tax & Accounting. All Rights Reserved. Final regs delay employer mandate for midsize employers & phase in coverage for large firms--t.d. 9655, 02/10/2014, Reg H-1, Reg H-2, Reg H-3, Reg H-4, Reg H-5, Reg H-6 IRS has issued final regs that provide guidance to employers that are subject to the shared responsibility provisions for employee health coverage under 4980H, which was enacted by the Affordable Care Act (ACA). The most significant provisions in the regs are a one-year delay of the employer mandate for midsize employers and a phased-in coverage requirement for large employers. 13