CURRENT FEDERAL TAX DEVELOPMENTS OCTOBER 6, 2014

Transcription

1 CURRENT FEDERAL TAX DEVELOPMENTS OCTOBER 6, 2014 CONTENTS Section: 41 S Corporation CEO/Shareholder Salary Found Unreasonably High, Court Substantially Reduces Research Credit... 2 Citation: Suder, et al v. Commissioner, TC Memo , 10/1/ Section: 162 IRS Finalizes Liberalized Regulations on Reimbursements for Local Travel Expenses... 3 Citation: TD 9696, 9/30/ Section: 183 Despite Decades of Losses, Taxpayer Found to Have Profit Motive for Business as Artist... 4 Citation: Crile v. Commissioner, TC Memo , 10/2/ Section: 1471 IRS Provides Guidance in FAQ on Website for Use of Substitute W-8 Series Forms to Meet FACTA Requirements... 6 Citation: FACTA General Provisions Frequently Asked Questions from irs.gov, 9/25/ Section: 2031 Estate's Claimed Discounts on Fractional Interests of Art Allowed in Full When IRS Only Argues No Discounts Are Allowed... 6 Citation: Estate of Elkins v. Commissioner, CA 5, 114 AFTR 2d , 9/15/ Section: 2511 Merger of Companies Controlled by Father and Three Sons Resulted in Disguised Gift from Father to Sons... 8 Citation: Cavallaro v. Commissioner, TC Memo , 9/17/

2 SECTION: 41 S CORPORATION CEO/SHAREHOLDER SALARY FOUND UNREASONABLY HIGH, COURT SUBSTANTIALLY REDUCES RESEARCH CREDIT Citation: Suder, et al v. Commissioner, TC Memo , 10/1/14 In what be looked as the tax equivalent of the man bites dog news story, in the case of Suder, et al v. Commissioner, TC Memo we have a case where the IRS argued successfully that a taxpayer who was an owner-employee of an S corporation received excessive compensation. Readers may reasonably wonder if a) the IRS had lost its mind in arguing the same and b) whether a similar level of insanity affected the taxpayer who challenged the position. But the issue in this case was not a case of payroll taxes, the issue most often driving compensation issues in an S corporation setting. Rather, in this case the issue related to expenses to be counted in determining the amount allowed as a research credit under IRC 41. The IRS had attempted to attack the research credit in full, arguing the taxpayer s activities failed to qualify for the credit and that there was not sufficient required documentation of such expenses. The Tax Court rejected the IRS position in those areas. However the Tax Court did find that the CEO s salary needed to be tested for reasonableness under IRC 174(e) in order for the appropriate proportion of it to be treated as expenses includable for research purposes and used in the credit computation. For the years in question, Mr. Suder s compensation ranged from $8,674,815 to $10,954,175 each year. Those wages constituted approximately two-thirds of the qualified expenses for the years in question. Under IRC 174(e), amounts are considered research expenses only to the extent that the amount thereof is reasonable under the circumstances. The Tax Court noted that the House Committee Report related to the enactment of 174(e) stated that the test for reasonableness would be similar to the one under 162 for reasonable compensation. Since an appeal of the case would be to the Fifth Circuit Court of Appeals, the Tax Court outlined the criteria the Fifth Circuit had held to be relevant in determining reasonableness of compensation. Those tests are: The employee s qualifications; The nature, extent and scope of the employee s work; The size and complexities of the business; A comparison of salaries paid with gross income and net income;(5) the prevailing general economic conditions; Comparison of salaries with distributions to stockholders; The prevailing rates of compensation for comparable positions in comparable concerns; The salary policy of the taxpayer as to all employees The Court noted that the taxpayer, while qualified, had become semi-retired by the years in question, working approximately 20 to 30 hours a week. The Court also noted that the wages of Mr. Suder, a 90% shareholder, and the one other shareholder approximated the ratio of their stock holdings and that Mr. Suder s compensation was far greater than that of any other employee. The Court found no evidence that Mr. Suder s compensation was tied to his contribution to research and development and that, in fact, his involvement there appeared to be less than in previous years. The Court noted that a key issue was the comparison of Mr. Suder s pay with that of other similarly situated CEOs. The Tax Court effectively rejected the IRS expert s report, but it also rejected a key component of the taxpayer s expert report justifying the CEO s salary the inclusion of a royalty component that made up the vast majority of the justification in his report for Mr. Suder s income. The Court found that the expert had little 2

3 justification for the royalty amounts computed and, more to the point, the taxpayer admitted that the company had never paid Mr. Suder based on royalty compensation. The Court concluded that [i]t appears that Mr. Longnecker included royalty amounts in his compensation analysis in an attempt to justify Mr. Suder s wages and excluded them as erroneous and unreliable. Based on that holding, the Court reduced Mr. Suder s compensation to amounts ranging from $2,366,090 to $2,643,907 for the years in question, well below the amounts originally claimed. Given the large portion of the research expenses that relied upon Mr. Suder s compensation, the Court substantially reduced the allowed research credit. SECTION: 162 IRS FINALIZES LIBERALIZED REGULATIONS ON REIMBURSEMENTS FOR LOCAL TRAVEL EXPENSES Citation: TD 9696, 9/30/14 In TD 9696 the IRS finalized regulations (Reg , Reg ) that adopted with few changes proposed regulations issued in 2012 (which taxpayers were allowed to rely upon pending the issuance of final regulations) to liberalize rules that allow, in limited circumstances, for the deduction of non-away-from-home expenses by the employer when paid for employees without treating them as income of the employee. Qualified payments in such circumstances may qualify as working condition fringes under Reg (a) if paid directly by the employer, or as an allowable reimbursement under a properly structured accountable reimbursement plan pursuant to Reg (c)(4). Reg (a) provides a facts and circumstances test to determine if local lodging expenses represent a legitimate expense of the employer and, thus, could qualify as a working condition fringe or a proper excludable reimbursement. The regulation notes that [e]xpenses paid or incurred for lodging of an individual who is not traveling away from home (local lodging) generally are personal, living, or family expenses that are nondeductible by the individual under section 262(a). However the regulations goes on to note that some exceptions will be allowed to that treatment if it can be shown the payment properly relates to the taxpayer s trade or business, based on all relevant facts and circumstances. Specifically the regulation provides [o]ne factor is whether the taxpayer incurs an expense because of a bona fide condition or requirement of employment imposed by the taxpayer s employer. Interestingly enough, this is the only example factor given in the facts and circumstances section, meaning that advisers may find examining agents will focus solely on this factor. Conversely, the regulation notes that [e]xpenses paid or incurred for local lodging that is lavish or extravagant under the circumstances or that primarily provides an individual with a social or personal benefit are not incurred in carrying on a taxpayer s trade or business. Advisers should be ready to deal with agent complaints that a payment or reimbursement falls into these categories, as the wording of the regulation strongly suggests that such a finding would result in automatic disallowance of the deduction. As an alternative to the facts and circumstances test (which the author believes may prove difficult to have an agent concede has been met on exam) the regulation offers a safe harbor test. From a practical standpoint, advisers should counsel client that, if at all possible, they should try and arrange their affairs to meet the safe harbor if they wish to be able to pay the expense and have it excluded from employees income. The safe harbor imposes the following four conditions: The lodging is necessary for the individual to participate fully in or be available for a bona fide business meeting, conference, training activity, or other business function; 3

4 The lodging is for a period that does not exceed five calendar days and does not recur more frequently than once per calendar quarter; If the individual is an employee, the employee s employer requires the employee to remain at the activity or function overnight; and The lodging is not lavish or extravagant under the circumstances and does not provide any significant element of personal pleasure, recreation, or benefit. [Reg (b)] The employer should be sure to document the first, third and fourth conditions (which involve some subjective elements) and be sure to not violate the purely objective days second test. The regulation ends with six detailed examples the employer should study to understand how the IRS views proper and improper expenses. SECTION: 183 DESPITE DECADES OF LOSSES, TAXPAYER FOUND TO HAVE PROFIT MOTIVE FOR BUSINESS AS ARTIST Citation: Crile v. Commissioner, TC Memo , 10/2/14 In the case of Crile v. Commissioner, TC Memo a taxpayer who held a teaching position at a college was challenged by the IRS for deduction related to her business as an artist. On paper the numbers looked bad for this taxpayer. For the years in question the taxpayer reported gross receipts of no more than $6,525 in any of the years involved ( ) in fact, she had no receipts whatsoever in 2008 from the art activity. Her claimed losses ranged from $37,076 to $63,271 during the years in question, with most years being much closer to the high rather than low end of that range. The taxpayer had been a professional artist from 1971 to 2013, but had only shown a profit in one prior year and, possibly, for 2013 (her 2013 return was apparently not available at the time of trial). Many advisers would suspect such a taxpayer s case was dead on arrival when the IRS showed up. But that would not prove to be the case here. While the financial results of her artistic business had proven disappointing, the Court did not find that she lacked the requisite profit motive. As the Court reminds us, the results of operations, while important, are not the sole arbiter of whether the hobby loss rules of 183 will apply to block loss deductions. The IRS actually objected both on the basis that her operation was a hobby (with 183 applying) and, alternatively, that she had claimed deductions that were not justified under 162. This case only dealt with the hobby loss issue, with the Court delaying trial on the expense issue until later. But the Court did comment that many of her claimed expenses clearly were personal expenses which would be disallowed under 262(a) thus, her economic losses were far less than actually claimed. Under Reg (b) the following factors are to be considered in determining if the taxpayer had a true profit motive in operating the activity: The manner in which the taxpayer conducts the activity; The expertise of the taxpayer or her advisers; The time and effort spent by the tax-payer in carrying on the activity; The expectation that assets used in the activity may appreciate in value; The success of the taxpayer in carrying on other similar or dissimilar activities; The taxpayer s history of income or losses with respect to the activity; The amount of occasional profits, if any; The financial status of the taxpayer; and Elements of personal pleasure or recreation 4

5 For the first criteria, the Court noted that it has not previously required a particularly rigorous standard for recordkeeping for artists. It found that Ms. Crile s records were similar to that the Court had found adequate for an artist in the case of Churchman v. Commissioner, 68 T.C. 696 (1977). The Court also found that taxpayer engaged in significant marketing activities related to her business, thus finding the first factor favored the taxpayer in finding a true profit motive. The second point was effectively conceded by the IRS. The taxpayer was an artist that had sold art to various organizations, including the U.S. government, for public display in various locations, as well as in various galleries. She had many years of artistic experience. This factor again favored the finding of a profit motive. The taxpayer worked 30 hours per week on her art activity when classes were in session and full time otherwise. The Court also found that her job as an art professor, far from detracting from her career as an artist, was rather synergistic with it. This also argues in favor of the taxpayer. The IRS contended that, at this point, there was no reasonable prospect that appreciation in her art could overcome the long history of losses from the activity. However the Tax Court decided that wasn t the issue rather, the true issue is whether the taxpayer could reasonably expect the value of her inventory to increase and noted that the value of artists inventory increase dramatically late in their careers. The Court found this factor favored the taxpayer, though not as strongly as the first three. The Court noted that for the fifth factor, this case had a reversed fact pattern compared to most hobby loss cases. Normally a taxpayer has a successful career and then embarks on the activity that leads to the hobby loss challenge. In this case the taxpayer was an artist for 25 years before obtaining her faculty position. The Court found the factor to have little relevance in this case, but since the taxpayer could reasonably have viewed her success in her faculty position could have led to an increased chance of success as an artist. The history of losses is, in the Court s view, less significant for artists as they have a significant challenge but a mere failure to be profitable does not show that there is not a profit motive. Also, somewhat interestingly, the Court reasoned that, based on what it has seen from the years before it, she quite likely claimed personal expenses in prior years. Thus, the Court reasoned, her real losses were likely far smaller than claimed and, perhaps, there were multiple years of economic profit. The taxpayer argued that the financial crisis in the last half of the first decade of the 2000s depressed art prices. The Court agreed this impacted her results in those years, but note that this does not explain her long history of losses in earlier years. Overall the Court concluded this test favors the IRS, but then notes no one factor is determinative or, to put it simply, the Court is telegraphing it is going to rule in the taxpayer s favor. The Court found that being an artist is a speculative venture, and that it is possible to be wildly successful after years of losses. Thus the fact that she had only been profitable once in the past and was possibly on the way to her second year for 2013 was evidence she might be able to break through the factor weighs in her favor, though the Court notes not by much. The Court did not find that her financial status was such that she was using the losses from the art activity primarily to shelter her income. The Court noted she had been an artist for years before becoming a professor, thus this factor was deemed neutral. The Court also found that the taxpayer, in her artistic venture, had undertaken a number of not terribly enjoyable research activities in support of her artistic venture, including at one point for a series in a Fires of War series visiting Kuwait and accompanying firefighters to burning oil fields. She also spent many hours on mundane activities related to her art business rather than creating the art. The Court found this factor to be neutral or slightly favoring the taxpayer. Since the Court found that only the history of losses favored the IRS, it concluded the taxpayer had shown she had an appropriate profit motive and thus did not agree with the IRS that 183 denied her a deduction for losses. 5

6 SECTION: 1471 IRS PROVIDES GUIDANCE IN FAQ ON WEBSITE FOR USE OF SUBSTITUTE W-8 SERIES FORMS TO MEET FACTA REQUIREMENTS Citation: FACTA General Provisions Frequently Asked Questions from irs.gov, 9/25/14 The IRS has issued a revised portion (in Question 8) of the FACTA General Provisions Frequently Asked Questions (FAQ) that discusses the use of a Substitute Form W-8 withholding certificate to comply with the FACTA requirements. The FAQ provides that a substitute Form W-8BEN, W-8BEN-E, W-8ECI, W-8EXP, or W-8IMY whose content is substantially similar to the IRS forms may be used where the partner jurisdiction does not decline such treatment. The FAQ provides: A payor may develop and use a substitute form that is in a foreign language, provided that you make an English translation of the form and its contents available to the IRS upon request. A payor may combine Forms W-8BEN, W-8BEN-E, W-8ECI, W-8EXP, and W-8IMY into a single substitute form. A payor may provide a substitute form that does not include all of the chapter 4 statuses provided on the Form W-8, but the substitute form must include any chapter 4 status for which withholding may apply, such as the categories for a nonparticipating FFI or passive NFFE. A payor may provide with the form an alternative certification that reflects the requirements under an applicable intergovernmental agreement (IGA) instead of the certification of chapter 4 status otherwise required by the form. The payor must provide instructions similar to those in the official form along with its substitute form. As well, the payor can incorporate the substitute W-8 into other business forms so long as the required certifications are clearly set forth. Nevertheless, the payor may not: Use a substitute form that requires the payee, by signing, to agree to provisions unrelated to the required certifications, or Imply that a person may be subject to 30% withholding or backup withholding unless that person agrees to provisions on the substitute form that are unrelated to the required certifications. The document must still provide that the data provided in the W-8 substitute area is being provided under penalties of perjury. Substitute forms may also be used in place of W8-BEN, subject to similar conditions. SECTION: 2031 ESTATE'S CLAIMED DISCOUNTS ON FRACTIONAL INTERESTS OF ART ALLOWED IN FULL WHEN IRS ONLY ARGUES NO DISCOUNTS ARE ALLOWED Citation: Estate of Elkins v. Commissioner, CA 5, 114 AFTR 2d , 9/15/14 The IRS found, at least in the view of the Fifth Circuit Court of Appeals, that by arguing that no discounts should be allowed for the value of fractional interests in art works, it was effectively conceding that if a discount 6

7 was allowed the taxpayer s discount would be the one used since the IRS had presented no contrary evidence to support a different discount. In the case of Estate of Elkins v. Commissioner, CA 5, 114 AFTR 2d the Fifth Circuit agreed with the Tax Court that the IRS was in error in arguing no discount applied, but erred when the Tax Court rejected the estate s experts values and used its own 10% discount for valuing the fractional interests. The case involved an estate of a decedent that held 64 pieces of art. He owned a 50% interest in the art, the other ½ being held evenly by each of his three children individually. The other 61 pieces of art he owned a % interest in, again with each of his children holding an equal share of the remaining % interest in the art. The taxpayer and his children imposed numerous restrictions on the transfer of interests in the pieces of art. At trial a daughter testified that the family had no interest in selling the art pieces and would resist any attempt to sell them. She did agree, hypothetically, that she and her siblings might be willing buyers of such art, but only if experts assured her that she was paying a fair price for the interests. She testified that the experts she would look to would be similar to those testifying on the values at trial. The estate produced three experts to testify on the value of these fractional interests. The Court notes: They concluded that any hypothetical willing buyer would demand significant fractional-ownership discounts in the face of becoming a co-owner with the Elkins descendants, given their financial strength and sophistication, their legal restraints on alienation and partition, and their determination never to sell their interests in the art. The IRS presented no experts on discounts that would be applicable in these cases. Rather the Tax Court heard two IRS rebuttal witnesses, only one of which it deemed to offer testimony germane to the issues in the case. That expert testified that there was no recognized market for partial interests in art, but did not testify there never had been, nor ever could be, such a sale. Based on that record, the Tax Court concluded that the IRS was in error in arguing no discounts were allowed merely due to the lack of a recognized market in fractional interests. However, the Court found that a buyer would pay a much higher price than the discounts the estate claimed, allowing only a 10% discount from percentage of the agreed upon full market value of 100% interests in the pieces. The Fifth Circuit found that the Tax Court, as a matter of law, could not impose a different discount level in this case. The Tax Court did not note that it found errors in the testimonies of the estate s experts and also did not note any valid IRS criticisms of that testimony, having rejected the no discounts position. The Fifth Circuit found first that the Tax Court should have held for the taxpayer based solely on the failure of the IRS to carry its burden of proof once the estate presented initially sufficient evidence to show a discount, triggering a shift in the burden under IRC But, the Court noted, even ignoring that and using the preponderance of the evidence standard the Tax Court claimed to apply, the Court should have allowed the estate s discount because there simply was no other evidence of value of the fractional interests presented. The case is good news for taxpayers (at least those whose cases would be heard on appeal by the Fifth Circuit), since it indicates that the IRS may decide to take a position that the taxpayer s discounts are excessive rather than that there is no discount or at least argue the excessive discount position as an alternative theory to support an assessment. But, more generally, it also shows the risks of a go for broke strategy where the party stakes their entire case on one finding. 7

8 SECTION: 2511 MERGER OF COMPANIES CONTROLLED BY FATHER AND THREE SONS RESULTED IN DISGUISED GIFT FROM FATHER TO SONS Citation: Cavallaro v. Commissioner, TC Memo , 9/17/14 Advisers must always be aware that any transaction involving related parties may, upon IRS scrutiny, be viewed as having economic results different from those the taxpayer reported for tax purposes. In the case of Cavallaro v. Commissioner, TC Memo , the Tax Court decided the IRS s view of the transaction more closely reflected the economic reality of the situation than did the taxpayer s reporting position. In the taxpayer s view, there had been a merger of two companies, one owned by William Cavallaro and one owned by his three sons. The senior Cavallaro s company, Knight Tool Company, made tools and machine parts. In 1982 Mr. Cavallaro and one of sons developed an automated liquid dispensing machine which they called CAM/ALOT. In 1987 the three sons incorporated Camelot Systems, Inc. which sold the CAM/ALOT machines manufactured by Knight. As you might expect, the overall operations were intertwined, with the companies sharing the same building, used the same payroll and accounting services and collaborated in future development of the machine. In 1994 Mr. Cavallaro was counseled with regard to his estate plan. During this planning process, it was concluded that the value of the technology related to the machine really resided in the son s company (Camelot Systems). The attorney counseling the Cavallaros concluded that the intellectual property had been transferred when Camelot Systems was formed in Unfortunately, there was no documentation that such a transfer had taken place rather the attorney based the transfer on the fact that Mr. Cavallaro had handed the minute book to one of his sons when Camelot was formed. His position was that this was a symbolic transfer of the technology. However, there was no written document backing up this transfer, so the attorney had the Cavallaros prepare affidavits and a confirmatory bill of sale for the 1987 transfer. About the same time, the taxpayer s accounting firm, noticing the potential estate planning problem, arrived at a somewhat different plan. The accounting firm (apparently not aware or, or not persuaded by, the symbolic transfer of the intellectual property with the minute book in 1987) decided that the two firms needed to be merged so that Mr. Cavallaro could then begin to transfer interests to his sons. Thus, the accounting firm advised that there should be a merger. The accounting firm appeared to presume that Mr. Cavallaro would end up with a majority of such shares and, presumably, a gifting program would then begin. In 1995 they merged the two companies into one, with the sons receiving 81% of the shares in the merged entity, executing a combination of the two advisers plans. This split of value was based on the attorney s position that since Camelot Systems was the real owner of the intellectual property related to the machine, that company was far more valuable than Knight. Given their position that each party received an ownership interest based on the value of the companies each owned an interest in, the senior Mr. Cavallaro did not file a gift tax return for The IRS decided to conduct an income tax examination the companies for 1994 and During that exam, the IRS decided that there could be a gift tax issue and began looking to obtain documents from the accounting firm with regard to work done for the companies. The taxpayers fought the IRS s attempt to obtain information, but in 2002 the First Circuit Court of Appeals held for the IRS. In 2005 the taxpayers filed a Form 709 for 2005, taking the position that there was no taxable gift made during the year. The IRS, initially not undertaking a valuation of Camelot Systems, issued a notice of deficiency on the gift tax issue. Initially the IRS appeared to believe that Camelot Systems was an empty shell company with no value, though by the trial date the IRS had modified its position. In its trial position, the IRS argued that, based on the relative values of the two companies, 35% of the shares should have gone to the sons for 8

9 their Camelot Systems shares and 65% of the shares should have gone to Mr. Cavallaro for his interest in Knight. Thus, the 46% reduction in shares from what Mr. Cavallaro should have received to the 19% he did receive represented a taxable transfer to his sons. The IRS position was that the symbolic transfer was not a true transfer at all and, in fact, the parties never viewed the intellectual property as owned by Camelot Systems until after they visited the attorney in The Tax Court agreed with the IRS. The Court noted that Knight was the only party listed in public documents as owning any of the intellectual property related to the machine and had claimed ownership of that technology in prior tax filings related to R&D credits. The Court found: If Camelot had offered itself to the market for acquisition claiming ownership of the CAM/ALOT technology, it is inconceivable that a hypothetical acquirer would do anything other than demand to see documentation of Camelot s ownership interest--documentation that we have found does not exist. An unrelated hypothetical acquirer would never have been be satisfied with Camelot s mere assertions of ownership, or its statements that an oral agreement effecting the transfer occurred at some point after Camelot s incorporation. Instead, upon realizing no such documentation was available, an unrelated party either would have offered to purchase Camelot at a much lower price or (more likely) would have walked away from the deal altogether. Similarly, the Court found: Likewise, if Knight were dealing with an unrelated party which sold machines that had been manufactured at Knight's risk by Knight employees on Knight premises using technology developed by Knight personnel, where Knight had owned the only public registrations of intellectual property and had claimed ownership of the technology in prior tax filings, it defies belief to suggest that Knight would have simply disclaimed the technology and allowed the unrelated party to take it. If an unrelated party had purchased Camelot before the merger and had then sued Knight to confirm its supposed acquisition of the CAM/ALOT technology, without doubt that suit would fail. Camelot did not even own the CAM/ALOT trademark registration. The fact that Knight and not Camelot owned the properties rendered the valuations provided by the taxpayer s experts to be significantly misstated, as they assumed that Camelot owned the property. With that property moved back to Knight, it was clear that the sons had ended up with a disproportionate share of the merged entity. That extra interest transferred was subject to gift tax. However, the Court did find that the taxpayer, having relied on the advice of professionals who were given all relevant facts, had reasonable cause for their failure to file gift tax returns or pay gift tax. Thus the Court found that no penalties were due. The case is an illustration of the risks of attempting to take advantage of prior sloppiness (in this case, the intertwined operations of the two companies) to attempt to argue for an interpretation of the past that just happens to end up accomplishing a taxpayer favorable goal. While sometimes advisers do need to attempt to interpret ambiguities related to past actions where documentation was not maintained, the adviser should be aware that the Court will generally want to see objective evidence that, in fact, what the adviser is now arguing is the proper interpretation is the one that the parties believed at the time. Similarly, the adviser, to properly serve his/her client, should take a look at available facts (especially those already in the possession of the IRS or that are part of the public record) and determine if a reasonable person could view those facts and come to a contrary result. Unfortunately, putting up a symbolic handing over of a minute book against the public registration of the trademark in the father s name and the father s company claiming ownership in prior tax returns to claim tax benefits seems somewhat inadequate justification and, certainly, the Tax Court did not find it adequate. 9

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