Tax Update. Taxpayer Alert: Special Tax Reporting Required for Certain Loss Transactions

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1 December 2008 Taxpayer Alert: Special Tax Reporting Required for Certain Loss Transactions Certain entities and individuals who have realized losses this year may inadvertently have triggered a special requirement to report those losses to the IRS under the rules for so-called reportable transactions. Form 8886, Reportable Transaction Disclosure Statement, must be attached to a taxpayer s return when the taxpayer has incurred a loss exceeding the applicable threshold amount, unless an exception applies. This special reporting regime originally targeted abusive tax shelter transactions, but the broad scope of the reporting requirement captures many loss transactions that are not abusive. Accordingly, taxpayers may not be aware of the need for special reporting of certain losses. Because taxpayers can face substantial penalties for failure to properly report such losses, it is essential to properly identify and report loss transactions that are subject to the special reporting regime. Given the significant recent declines in the value of most investments this year (i.e., stocks, bonds, real estate and interests in funds) this reporting requirement is likely to affect more taxpayers and filers this year than in past years. Reportable Loss Transactions A loss transaction is reportable on Form 8886 if it results in the taxpayer claiming a loss under Code Section 165 (such as investment losses and losses incurred in a trade or business) if the loss exceeds certain thresholds, as follows: Individuals, S corporations and trusts: $2 million in any single taxable year or $4 million in any combination of taxable years; $50,000 for foreign currency losses of individuals and trusts. C corporations: $10 million in a single taxable year or $20 million in any combination of taxable years. Partnerships: If all partners are corporations, the higher C corporation thresholds are used; otherwise, the lower Practice Tip: Disregarded Entities Must Pay Their Own Employment Taxes in 2009 Beginning January 1, 2009, all disregarded entities must pay their own employment taxes under their own names and Employer ID numbers (EIN). If the entity does not have an EIN it must obtain one. Additionally, the entity must withhold income tax, FICA and FUTA from employee paychecks. The entity is liable for its share of FICA and FUTA. It must file forms in the 94X series, file with the Social Security Administration, and send copies of employees statements on Forms W-2. Finally, the entity must make timely deposits of withheld money to the IRS. These requirements apply to entities that are wholly owned by corporations. notable In January 2009, Joan C. Arnold became a member of the Board of Regents, representing the Third Circuit, for the American College of Tax Counsel. in this issue 1 Taxpayer Alert: Special Tax Reporting Required for Certain Loss Transactions 1 Practice Tip: Disregarded Entities Must Pay Their Own Employment Taxes in Notable 3 IRS Replaces Intermediary Transaction Tax Shelter Notice 3 Speakers Corner 6 REITs: Looking to the Rooftops 8 Pepper Hamilton s Tax Practice Group

2 thresholds for individuals, corporations and trusts are applicable. A transaction that results in a taxpayer claiming a loss in multiple tax years is reportable if the cumulative amount of the loss claimed exceeds the applicable threshold for a combination of years. The aggregation of losses arising from a single transaction applies only for the taxable year of the transaction and the succeeding five years. Exceptions Importantly, under Rev. Proc , certain loss transactions are exempt from the reporting rules. Disposition of Asset with Qualifying Basis A loss arising from the sale or exchange of an asset with a qualifying basis may be exempt from reporting. However, this exception does not apply to the disposition of an interest in a pass-through entity such as a partnership or LLC interest, stock of an S corporation, or shares of a mutual fund or real estate investment trust. Accordingly, interests in hedge funds, private equity funds and venture funds generally will not fall under this exception because such entities are usually structured as partnerships or LLCs. In general, an asset has a qualifying basis if the basis of the asset is equal to, and is determined solely by reference to, the amount paid in cash by the taxpayer for the asset and for any improvements to the asset. For example, if a fund purchases publicly traded corporate stock for cash in an open market purchase, the stock would be an asset with a qualifying basis. In addition, the basis of an asset may be a qualifying basis if the asset was acquired in certain nonrecognition transactions (such as tax-free reorganizations) and if the taxpayer s basis for the property exchanged in the nonrecognition transaction was a qualifying basis. Other Exceptions Rev. Proc provides a list of 11 other exceptions to the reporting of loss transactions. For example, some mark to market and hedging losses are excepted. In addition, losses arising from casualty or theft (including embezzlement) are excepted. Mutual funds that qualify as regulated investment companies (RICs) under the Code are exempt from complying with the reporting requirements. This exception also extends to any investment vehicle that is 95 percent owned by one or more RICs. However, the RIC exemption does not extend to non-ric shareholders who incur a loss on the disposition of shares of a RIC. Therefore, RIC investors who hold RIC shares in a taxable account will be required to report a loss on the sale or redemption of the shares unless an exception applies (e.g., the loss does not exceed the applicable threshold). Example: Loss Reporting Applicable to Fund of Funds The interplay of the reporting rules and exceptions can have some surprising results, especially in the fund of funds context. For example, Assume that Fund A is a fund of funds that invests its assets in other hedge funds and RICs. Fund A s investors consist of individuals and taxable trusts. Fund A has an investment in underlying Fund X (a partnership for tax purposes) with a tax basis equal to $4 million and a fair market value of $1.9 million. Fund A redeems its entire investment in Fund X recognizing a loss of $2.1 million in Fund A s loss of $2.1 million exceeds the applicable threshold of $2 million. Fund A s loss does not meet the qualifying basis exception because Fund X is a passthrough entity. None of the other exceptions applies. Accordingly, Fund A must report the loss on Form However, an individual investor in Fund A need not file Form 8886 with respect to the Fund X loss that flows through to such investor unless the amount of such loss allocated to such investor exceeds $2 million, in which case both Fund A and the investor must report the loss. Example: Loss Reporting by Individual Hedge Fund Investor Assume that individual B has invested $5 million in a hedge fund Z, a partnership that invests in publicly traded stocks, bonds and options. The value of B s interest in Fund Z has declined to $2.4 million. B redeems his entire interest in Fund Z for $2.4 million and realizes a loss of $2.6 million. B s loss exceeds the applicable threshold of $2 million. B s loss does not meet the qualifying basis exception because Fund Z is a pass-through entity. None of the other exceptions applies. Accordingly, B must report the $2.6 million loss on Form Penalties Under Code Section 6707A, the penalty for failing to file Form 8886 for a reportable loss transaction ranges from -2-

3 $10,000 in the case of individuals to $50,000 in the case of partnerships, corporations or other non-natural persons. Reporting by Material Advisors In addition to taxpayers, certain advisors ( material advisors ) also may be required to report the transaction to the IRS and to maintain lists of information related to the loss transaction. The material advisor reporting and list maintenance rules apply when an advisor, such as an attorney or accountant, has made a tax statement (generally, a tax statement includes any oral or written statement that relates to a tax aspect of the transaction) if the advisor s fee exceeds certain thresholds ($50,000 where substantially all of the tax benefits from the transaction go to natural persons, and $250,000 in all other cases). Therefore, advisors who make a tax statement concerning a loss transaction need to be alert to these reporting rules, and taxpayers should be aware that such advisors may be required to report information about them and their transactions to the IRS. Author: Joan M. Roll rollj@pepperlaw.com IRS Replaces Intermediary Transaction Tax Shelter Notice In July 2008, we advised you of the IRS issuance of Notice , which had the potential to treat transactions that were not tax motivated as tax shelters subject to various reporting rules, and to subject unsuspecting participants to significant penalties for failure to comply with these reporting obligations. (See our Tax Update, Beware the Inadvertent Tax Shelter, July 1, 2008.) In response to a wave of criticism relating to the breadth of Notice , the IRS on December 1, 2008, retroactively superseded Notice with new Notice As in the case of Notice , new Notice clarifies Notice and defines those transactions that will be considered as Intermediary Transactions. If a transaction is considered to be an Intermediary speakers corner Philip E. Cook, Jr. will present a state and local tax update to the PICPA Pittsburgh Chapter Tax Conference on January 9. Philip E. Cook, Jr. will present a state and local tax update to the Community College of Allegheny County on January 24. Steven D. Bortnick will be speaking on Tax Due Diligence in Acquisitions at a live national teleconference with interactive Q&A on January 29, from 1:00-2:30 p.m. (EST). This teleconference is sponsored by Lorman Education Services. Further details are available at teleconference/teleconference.php?sku= Joan C. Arnold, Howard S. Goldberg, and Todd B. Reinstein will be speaking on Consolidated Return Issues Affecting Use of Favorable Tax Attributes and Current Topics in Consolidated Return Area at the Twenty-First Annual Tax Executive Institute Houston Chapter Tax School in Houston on February 4. Steven D. Bortnick will speak on Private Equity Deal Structures to the University of Michigan Private Equity Club in Ann Arbor on February 9. Charles L. Potter, Jr. will present a Pennsylvania tax update at Penn State on February 23, 24, and 26. Transaction, it will be treated as a listed transaction, and, thus, bring into play the tax shelter rules and the penalties for failure to comply with these rules. Notice is intended to narrow the scope of Notice by (1) providing that a transaction will be an Intermediary Transaction as to a person only if the transaction was pursuant to a Plan; (2) providing revised objective criteria indicative of an Intermediary Transaction; (3) providing certain safe harbor exceptions to the definition of an Intermediary Transaction and (4) indicating that a transaction may be an Intermediary Transaction with respect to some people and not others. Components of an Intermediary Transaction According to Notice , a transaction must have all four of the following components to be the same or substantially similar to the listed transaction described -3-

4 in Notice Accordingly, even if a transaction is engaged in pursuant to a Plan (described below), a transaction will not be an Intermediary Transaction unless each of the following components exist. 1. A corporation, T, directly or indirectly owns (e.g., through a pass-through entity, such as a partnership, or a member of a consolidated group of which T is a member) assets, the sale of which would result in taxable gain (T s Built-in Gain Assets) and as of the Stock Disposition Date (defined in 2, below) T does not have (and any consolidated group of which T is a member does not have) sufficient tax benefits to entirely eliminate or offset such taxable gain or the tax on such gain. The tax that would result from a sale of T s Built-in Gain Assets is referred to as the Built-in Tax. However, the Built-in Tax is deemed to be zero (and, thus, the transaction is not an Intermediary Transaction) if the amount of the Built-in Tax is less than five percent of the value of the T stock disposed of in component 2, below At least 80 percent of the stock of T (determined by vote or value) is disposed of by T s shareholders other than in liquidation, in one or more related transactions within a 12-month period (the Stock Disposition). The first date on which at least 80 percent of T s stock has been disposed of is the Stock Disposition Date. 3. Within 12 months of the Stock Disposition Date, at least 65 percent (determined by value) of T s Built-in Gain Assets are disposed of (the Sold T Assets) to one or more buyers in one or more transactions in which gain is recognized with respect to the Sold Assets. Sales to other members of a controlled group (within the meaning of Section 1563 of the Internal Revenue Code) or certain partnerships are disregarded provided there is no plan to dispose of at least 65 percent (by value) of T s Built-in Gain Assets to one or more persons that are not members of such controlled group or such partnerships. 4. At least 50 percent of T s Built-in Tax that would otherwise result from the disposition of the Sold T Assets is offset, avoided or not paid. The Plan A transaction will be an Intermediary Transaction only if it involves a corporation T that would have a federal income tax obligation with respect to the disposition of T s Built-in Gain Assets in a transaction that would afford the acquirer Notice provides that it generally is effective as of January 19, However, Notice does not impose any requirements with respect to certain reporting obligations before December 1, 2008 that were not otherwise imposed by Notice or acquirers a cost or fair market value basis in the assets. An Intermediary Transaction is structured to cause the tax obligation for the taxable disposition of T s Built-in Gain Assets to arise in connection with the disposition by shareholders of T of all or a controlling interest in T s stock under circumstances where the person or persons primarily liable for any federal income tax obligation with respect to the disposition of T s Built-in Gain Assets will not pay that tax (the Plan). The Plan can be effected regardless of the order in which T s stock or assets are disposed. No Intermediary Transaction will be deemed to exist if there is no shareholder engaging in the transaction pursuant to the Plan and no buyer of assets engaging in the transaction pursuant to the Plan. Engaging in the Transaction Pursuant to a Plan A transaction that has all four components of an Intermediary Transaction, described above, will only be treated as an Intermediary Transaction with respect to a person that engages in the transaction pursuant to the Plan, described above. A person engages in a transaction pursuant to the Plan only if the person knows or has reason to know the transaction is structured to effectuate the Plan. Knowledge is imputed to certain people. A shareholder of T who is any of (1) a 5 percent shareholder (determined by vote or value), (2) officer or (3) director of T is deemed to engage in the transaction pursuant to the Plan if any of the following persons knows or has reason to know the transaction is structured to effectuate the Plan: (i) Any officer or director of T; (ii) any of T s advisors engaged by T to advise T or the shareholders with respect to the transaction; or (iii) any advisor engaged by that shareholder to advise it with respect to the transaction. Where T has -4-

5 more than five officers, the term officer for these purposes is limited to the chief executive officer of T (or the person acting in such capacity) and the four highest compensated officers for the taxable year, other than the chief executive officer. Notice specifies that a person will not be treated as engaging in a transaction pursuant to the Plan merely because he or she has been offered attractive pricing terms. However, the Notice also indicates that a person can engage in the transaction pursuant to the Plan even if he or she does not understand the mechanics of how the tax liability purportedly might be offset or avoided, or the specific financial arrangements or relationships of other parties or of T after the Stock Disposition. Importantly, the Notice provides that a transaction may be an Intermediary Transaction with respect to a shareholder and not an asset buyer or vice versa. Similarly, a transaction may be an Intermediary Transaction with respect to some shareholders and not others or some buyers and not others. However, as discussed above, at least one selling shareholder or one buyer of assets must engage in the transaction pursuant to the Plan in order for the transaction to be an Intermediary Transaction. This is an important improvement over Notice Participants in an Intermediary Transaction A person who engages in a transaction pursuant to the Plan will be considered to be a participant in an Intermediary Transaction (and, thus, be subject to disclosure rules) if (1) all four components of an Intermediary Transaction are present; (2) no safe harbor (described below) applies to such person; (3) at least one shareholder or one buyer of assets participated in the transaction pursuant to the Plan and (4) either (a) the person s tax return reflects tax consequences or a tax strategy described in Notice or (b) such person knows or has reason to know that the taxpayer s tax benefits are derived directly or indirectly from tax consequences or a tax strategy described in Notice Safe Harbor Exceptions Notice contains three safe harbors that apply to specific persons who otherwise would be treated as participants in an Intermediary Transaction. These are: 1. Any shareholder if the only T stock he or she disposes of is traded on an established securities market and prior to the disposition, the shareholder and persons related to such shareholder did not hold at least 5 percent (determined by vote or value) of any class of T stock disposed of by the shareholder; 2. Any shareholder, T or M 2 if after the acquisition of the T stock, the acquirer of the T stock is the issuer of stock or securities that are publicly traded on an established securities market in the United States, or is consolidated for financial reporting purposes with such an issuer; 3. Any buyer of assets if the only Sold T Assets it acquires are either (a) securities that are traded on an established securities market and represent less than a 5 percent interest in that class of security or (b) the assets are not securities and do not include a trade or business. Effective Date Transactions similar to those identified in Notice were treated as listed transactions since January 19, Accordingly, Notice provides that it generally is effective as of January 19, However, Notice does not impose any requirements with respect to certain reporting obligations before December 1, 2008 that were not otherwise imposed by Notice Penalties and Other Considerations Notice goes on to identify certain penalties and other considerations arising from the treatment of a transaction as a Intermediary Transaction, including: the $200,000 penalty for failure of a participant to disclose a listed transaction; the penalty ($200,000, or 50 to 75 percent of gross income derived) for failure of a material advisor to make disclosure; the $10,000-per-day penalty for the failure by a material advisor to provide a list of persons advised in connection with the transaction; the excise tax on tax-exempt investors that invest in listed transactions; a 20 percent penalty for underpayments related to negligence, substantial understatements or reportable transactions; and the tolling of the statute of limitations on the assessment for persons who fail to disclose reportable transactions. -5-

6 Pepper Perspective Notice represents a significant improvement over Notice in limiting the possibility of inadvertently engaging in a transaction deemed to be a tax shelter. However, some ambiguities will have to be clarified over time (e.g., if a T has tax benefits sufficient to offset either gain/tax with respect to Built-in Gain Assets or operating income for the year, but not both, does Intermediary Transaction component 1 exist or not). Given the potentially significant penalties and other adverse consequences to the treatment of a transaction as an Intermediary Transaction, potential participants and their advisors will need to continue to be very careful to avoid such treatment. Endnotes Author: Steven D. Bortnick bortnicks@pepperlaw.com 1 For purposes of determining whether T (or its consolidated group) has sufficient tax benefits to offset gain/tax with respect to T s Built-in Gain Assets, any tax benefits attributable to other listed transactions are ignored, as are tax benefits attributable to built-in loss property acquired within 12 months before any Stock Disposition (defined in connection with component 2) to the extent such built-in losses exceed built-in gains. 2 Notice does not use the abbreviation M for any entity up until this point. Rather, M was used to represent the tax-indifferent entity that acts as an intermediary corporation that purchases stock of T in the Intermediary Transaction initially described in Notice Thus, while the existence of an intermediary is not necessary in order to find an Intermediary Transaction after the effective date of Notice , the application of a safe harbor to such an intermediary serves as a reminder that such an intermediary would be a participant in an Intermediary Transaction under the general rules set out in the reportable transactions regulations. REITs: Looking to the Rooftops In these turbulent times, commercial property owners are looking for ways to maximize the value of their properties and create new streams of revenue. Two recent IRS rulings open up new opportunities for real estate investment trusts (REITs) looking to take advantage of rooftop spaces in an effort to increase revenues. Rooftop Communications PLR considers a novel ownership structure in which a REIT acquired interests in leases of building rooftops and other spaces that had been leased to tenants to use for communications equipment. Rather than acquiring the rooftops and land, the REIT indirectly acquired (through a joint venture with an unrelated partner) the landlord s interests in existing triple-net leases of building rooftops used for communications equipment. The REIT acquired all the landlord s rights, including the rights to receive and collect rent, but did not assume any of the landlord s obligations under the leases. The REIT also acquired the right to enter into a successor ground lease with the landlord upon the expiration of the existing tenant s lease. A key tax issue for the REIT was whether the landlord s interests in the leases constituted qualifying assets for purposes of satisfying the Internal Revenue Code requirement that a REIT invest 75 percent of its assets in real estate assets. 1 For this purpose, qualifying assets include interests in real property including leaseholds of land or improvements thereof, and options to acquire such leaseholds. 2 Rooftops, and the air rights above rooftops, are qualifying real estate assets. 3 Although in this case the REIT did not own an actual leasehold interest in the rooftops, the IRS concluded that the REIT s acquisition of the landlord s interests in leases was analogous to holding a leasehold interest in the rooftops. Therefore, the IRS concluded that the REIT s interests were qualifying assets for the 75 percent test. Having reached this conclusion, the IRS logically concluded that the income from the leases would qualify as rents from real property for purposes of satisfying the requirement that a REIT earn 75 percent of its gross income from qualifying real estate sources. 4-6-

7 Green Buildings In PLR , a REIT sought to reduce its dependence on public utilities by generating a portion of the building s electricity and steam on site. The REIT planned to install an electrical generating unit on the property that would be used to generate electricity for tenants. During peak load times, the generating unit would supply a major portion of the tenants electricity, and the balance would be provided by the utility companies. In addition, waste heat from the generating unit would be used to supply steam to tenants. The REIT sought a ruling from the IRS that the proposed activity of generating and supplying utilities would not jeopardize its REIT qualification. At issue was the requirement that a REIT earn 75 percent of its gross income from real estate sources, such as rents from real property. 5 Rents from real property include charges for services that are customarily furnished or rendered in connection with the rental of real property. 6 Regulations provide that in areas where it is customary to furnish electricity or other utilities to tenants, a REIT may submeter those utilities. 7 Here, the REIT proposed to go beyond submetering utilities and to actually generate a portion of the electricity and steam provided to its tenants. The IRS ruled that the generation of electricity and steam by the REIT would be considered a customary service and thus the rental income from the property, including any separate charges for utilities, would qualify as rents from real property for the 75 percent REIT income test. In so ruling, the IRS placed reliance on the REIT s representation that the electricity and steam would be solely for the use of the tenants and for the operation of the building. Pepper Perspective The IRS ruling position on electricity and steam generation should allow REITs to reap the benefits of greener buildings and reduce reliance on the regional power grid. For example, under the rationale of this ruling, an argument can be made that a REIT can install rooftop solar panels or microgeneration equipment to generate electricity for use of the tenants and the building, and the generation could be viewed as a customary service. Endnotes 1 Section 856(c)(4). 2 Section 856(c)(5)(C). 3 See Rev. Rul C.B Section 856(c)(3). 5 Section 856(c)(3). 6 Section 856(d)(1)(B). 7 Treasury Regulation Section (b)(1). The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Please send address corrections to phinfo@pepperlaw.com. Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington 2008 Pepper Hamilton llp. All Rights Reserved. Author: Joan M. Roll rollj@pepperlaw.com This publication may contain attorney advertising. -7-

8 Pepper Hamilton s Tax Practice Group Federal and International Tax Issues Annette M. Ahlers ahlersa@pepperlaw.com Joan C. Arnold arnoldj@pepperlaw.com James W. Barson barsonj@pepperlaw.com Steven D. Bortnick bortnicks@pepperlaw.com Gordon R. Downing downingg@pepperlaw.com W. Roderick Gagné gagner@pepperlaw.com Howard S. Goldberg goldbergh@pepperlaw.com Benjamin M. Hussa hussab@pepperlaw.com Bryan D. Keith* keithb@pepperlaw.com Timothy J. Leska leskat@pepperlaw.com Ellen McElroy mcelroye@pepperlaw.com Marc D. Nickel nickelm@pepperlaw.com Michelle Parten partenm@pepperlaw.com Lisa B. Petkun petkunl@pepperlaw.com Todd B. Reinstein reinsteint@pepperlaw.com Joan M. Roll rollj@pepperlaw.com Leonard Schneidman schneidmanl@pepperlaw.com James H. Stevralia stevraliaj@pepperlaw.com Laura D. Warren warrenl@pepperlaw.com State and Local Tax Issues Philip E. Cook, Jr cookp@pepperlaw.com Lance S. Jacobs jacobsls@pepperlaw.com Charles L. Potter, Jr potterc@pepperlaw.com Employee Benefits Issues Jonathan A. Clark clarkja@pepperlaw.com David M. Kaplan kapland@pepperlaw.com Andrew J. Rudolph rudolpha@pepperlaw.com *Admitted in the Commonwealth of Virginia only; supervision by principals of Pepper Hamilton llp who are members of the DC Bar. -8-