RULINGS AND CASES FINAL COPYRIGHT 2017 LGUTEF Land Grant University Tax Education Foundation, Inc. 551

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1 RULINGS AND CASES 15 SUBSTANTIAL AUTHORITY Substantial Understatement Penalty Definition of Substantial Authority Authorities ACCOUNTING Accrual Method A.M AGRICULTURE ISSUES Deductions Rutkoske v. Commissioner BUSINESS ENTITIES Corporations Zang v. Commissioner Partnerships Ltr. Rul Limited Liability Companies New Millennium Trading v. Commissioner..563 S Corporations Fleischer v. Commissioner Tax-Exempt Ltr. Rul Medical College of Wisconsin Affiliated Hospitals v. United States Ltr. Rul Community Education Foundation v. Commissioner BUSINESS ISSUES Debt vs. Equity Sensenig v. Commissioner Depreciation Nielsen v. Commissioner A.O.D. Stine v. US Domestic Production Activities Deduction.568 C.C.A Employment Tax C.C.A F.A.A F Ltr. Rul Expenses Creigh v. Commissioner Long v. Commissioner Liljeberg v. Commissioner Musa v. Commissioner Home Team Transition Management v. Commissioner Jacobs v. Commissioner Lewis v. Commissioner Income Alexander v. Commissioner Information Letter Marijuana High Desert Relief v. United States The Green Solution v. United States Self-Employment Tax Information Letter Castigliola v. Commissioner Trust Fund Recovery Penalty United States v. Commander McClendon v. United States Byrne v. United States ETHICS Nondisclosure Mescalero Apache Tribe v. Commissioner..580 Minda v. United States Privilege United States v. Micro Cap KY Insurance Company FINANCIAL DISTRESS Land Grant University Tax Education Foundation, Inc. 551

2 Cancellation-of-Indebtedness Income Schieber v. Commissioner FOREIGN TAX Foreign Bank and Financial Accounts Bedrosian v. United States Income Exclusion Qunell v. Commissioner Lock v. Commissioner Information-Reporting Penalties Flume v. Commissioner INDIVIDUAL Affordable Care Act Walker v. Commissioner Charitable Contributions Izen v. Commissioner West 17th Street LLC v. Commissioner..587 RERI s I v. Commissioner Deductions Bulakites v. Commissioner Quintal v. Commissioner Malev v. Commissioner Sas v. Commissioner Dependents Smyth v. Commissioner Earned Income Tax Credit Lopez v. Commissioner Health Savings Account Information Letter Theft Loss Adkins v. United States IRS Collections Cummings v. United States Allen v. Commissioner Innocent Spouse Relief Okorogu v. Commissioner Harris v. Commissioner Taft v. Commissioner Payment F.A.A F Preparer Tax Identification Numbers Steele v. United States LIKE-KIND EXCHANGES Ltr. Rul Estate of Bartell v. Commissioner, Nonacq LOSS LIMITATIONS At-Risk Limits Omega Forex Group v. United States Basis Limits Phillips v. Commissioner Tinsley v. Commissioner Hargis v. Commissioner Hobby Losses Stettner v. Commissioner Passive Activity Losses Hardy v. Commissioner Penley v. Commissioner Makhlouf v. Commissioner Vacation Home Rental Cooke v. Commissioner PENALTIES Accuracy McNeill v. United States Failure-to-File Crummey v. Commissioner Estate of Hake v. United States Tax Return Preparer Foxx v. United States RETIREMENT Contributions T.A.M Income Olson v. Commissioner Individual Retirement Accounts Ltr. Rul Ozimkoski v. Commissioner Trimmer v. Commissioner TAX PRACTICE Filing Deadline Rubel v. Commissioner Injunction United States v. Padron Litigation Costs Nelly Home Care v. United States Nominees United States v. Acacia Corporate Management Power of Attorney Moss v. Commissioner Return Kiselis v. United States Statute of Limitations United States v. Kidwell C.C.A Russian Recovery Fund v. United States United States v. Giaimo Substitute for Return Riggins v. Commissioner TRUSTS AND ESTATES Estate Tax Estate of Powell v. Commissioner Marital Deduction Notice

3 Introduction The myriad rules and procedures of the federal tax system are created and modified through a profusion of laws, administrative and judicial proceedings, congressional and administrative pronouncements, and other legal documents. These rules and procedures are in constant flux, and the tax practitioner must keep up to date on the current authoritative interpretation of the tax laws to provide accurate tax advice and prepare tax returns. The latter portion of this chapter summarizes relevant 2017 rulings and cases that affirm, interpret, modify, and create tax laws. Occasional errors, ambiguities, or contradictions in the rules further complicate the practitioner s task, and the tax practitioner must decide when to attempt to take advantage of the resulting uncertainty to a taxpayer s advantage. The beginning of this chapter explains the I.R.C penalty. It discusses how to determine if there is substantial authority for a position and the types of authorities that constitute substantial authority. 15 SUBSTANTIAL AUTHORITY Statutes, cases, and other types of authority help to establish substantial authority for a position taken on a tax return. I.R.C imposes penalties for understatements of tax if the taxpayer does not have substantial authority for the tax position taken. Substantial Understatement Penalty I.R.C generally imposes a 20% penalty on the amount of the understatement on a tax return that understates the tax due resulting from the following: 1. Negligence or disregard of rules or regulations 2. Substantial understatement of income tax 3. Substantial valuation misstatement under chapter 1 of the Internal Revenue Code 4. Substantial overstatement of pension liabilities 5. Substantial estate or gift tax valuation understatement 6. Disallowance of claimed tax benefits because a transaction lacks economic substance [within the meaning of I.R.C. 7701(o)] or failing to meet the requirements of any similar rule of law 7. Undisclosed foreign financial asset understatement 8. Inconsistent estate basis For purposes of item 1, negligence includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code, and the term disregard includes any careless, reckless, or intentional disregard. There is a substantial understatement of income tax for any tax year if the amount of the understatement of tax for the tax year exceeds the greater of 10% of the tax required to be shown on the return for the tax year or $5,000. Rule for Corporations In the case of a corporation other than an S corporation or a personal holding company (as defined in I.R.C. 542), there is a substantial understatement of income tax for any tax year if the amount of the understatement for the tax year exceeds the lesser of 10% of the tax required to be shown on the return for the tax year (or, if greater, $10,000) or $10,000,000. The penalty does not apply to any portion of the understatement if there is substantial authority to support the position taken on the tax return; or if the taxpayer adequately discloses the relevant facts affecting the tax treatment of the item and there is a reasonable basis for the position taken on the tax return. Substantial Understatement Penalty 553

4 Reasonable Basis The reasonable basis standard is not as stringent as the substantial authority standard. There is a reasonable basis for a position on a tax return if there is some authority for the position even if the weight of contrary authority is greater. However, the reasonable basis standard is not satisfied by a return position that is merely arguable or is merely a colorable claim. It must be reasonably based on authorities that can be used to find substantial authority for a position, considering the relevance and persuasiveness of the authorities and subsequent developments [Treas. Reg (b)(3)]. See the Penalties and Defenses chapter in the 2016 National Income Tax Workbook for a further discussion of the penalty and defenses to the penalty. substantial authority. Rulings and cases are insufficient authority if their facts and circumstances are distinguishable from the taxpayer s facts and circumstances. Taxpayer Intent Two courts have held that for tax positions involving issues of taxpayer intent, substantial authority is determined by the facts rather than the law. The courts reasoned that all tax positions have authority and the deciding factor is whether the taxpayer s tax position is supported by the facts [Osteen v. Commissioner, 62 F.3d 356 (11th Cir. 1995); and Estate of Kluener v. Commissioner, 154 F.3d 630 (6th Cir. 1998)]. Definition of Substantial Authority There is substantial authority for a position taken on a tax return only if the weight of authorities supporting the position is substantial in relationship to the weight of authorities supporting contrary positions. The taxpayer does not have to meet the more-likely-than-not standard, which is a greaterthan-50% likelihood of the position being upheld. However, there is no bright-line test for substantial authority, and the regulations define substantial authority as an objective standard determined by analyzing the law and applying the law to all relevant facts [Treas. Reg (d)(2)]. The possibility that a return will not be audited or, if audited, that an item will not be raised on audit is not relevant in determining whether the substantial authority standard (or the reasonable basis standard) is satisfied [Treas. Reg (d)(2)]. The authority of an item may be diminished by other types of authority that may distinguish or even overrule prior interpretations of tax law. For example, a court can determine that a statute is unconstitutional or that a regulation is void because it was improperly promulgated or it overreaches statutory authority. Any item of authority must also be sufficiently similar in its facts to the taxpayer s facts to be Authorities In determining whether there is substantial authority for a position taken on a tax return, the taxpayer can rely on statutes, regulations, revenue rulings and procedures, and other sources of authority. Taxpayers typically cannot rely on private letter rulings, general counsel memoranda, other IRS information releases and reports, and tax opinions. IRS FAQs In a May 18, 2017, memo, the IRS reminded examiners that frequently asked questions and other items posted on IRS.gov that have not been published in the Internal Revenue Bulletin are not legal authority. The FAQs and other items should not be used to sustain a position unless the items (e.g., FAQs) explicitly indicate otherwise or the IRS indicates otherwise by press release or by notice or announcement published in the Bulletin [ pdf]. In conducting the substantial authority analysis, the weight accorded particular authorities must reflect their relevance and persuasiveness and the type of document providing the authority [Treas. Reg (d)(3)(ii)]. 554 Authorities

5 Internal Revenue Code Although subject to occasional ambiguities, the US Code, including chapter 26, is clear authority for tax return positions unless a federal court has determined that the code provision is unconstitutional. If two or more courts disagree on the constitutionality or interpretation of a portion of the Internal Revenue Code, the authority of a court s decision remains limited to the jurisdiction of each court until an appellate court of wider jurisdiction resolves the conflict. Where code provisions are complex and do not have IRS explanations in regulations or other authoritative pronouncements, a taxpayer s wellreasoned construction of the applicable statutory provision may be substantial authority even though the court accepts the IRS s interpretation in the case [Treas. Reg (d)(3)(ii); Van Wyk v. Commissioner, 113 T.C. 441 (1999)]. Proposed, Temporary, and Final Regulations IRS regulations, cited as Prop. Treas. Reg., Temp. Treas. Reg., or Treas. Reg., are the IRS s interpretation and implementation of federal tax law. Taxpayers can rely on these regulations as authority for a position taken on a tax return. However, a proposed regulation may have limited weight as an authority for a tax position. Temporary and proposed regulations are essentially first drafts issued to provide an opportunity for taxpayers, practitioners, and other interested parties to submit comments to the IRS on the regulations and their intended effect. The IRS considers the comments and issues final regulations. The IRS recognizes that new regulations can affect taxpayers and practitioners knowledge of tax law, and temporary and proposed regulations often include the option for taxpayers to use the new temporary and proposed regulations as authority, or continue to use prior law or regulations until the final regulations are issued. Thus, prior-existing final regulations or other IRS pronouncements may remain substantial authority until the final regulations are published in the Federal Register. The regulations are subject to revision when the experience of taxpayers and the IRS reveals inconsistencies, ambiguities, and limitations. Also, the regulations are subject to review by US courts for proper promulgation under the rules of the Administrative Procedures Act, reasonableness, and statutory authority. Thus, tax practitioners must keep up to date on any changes in the regulations and any court decisions that impact their authority. The preamble to the regulations, published in the Federal Register, is not as authoritative as the regulations themselves, but the preamble often gives background authority for the IRS s position in the regulations, and it can be useful in interpreting the regulations. Revenue Rulings and Revenue Procedures The IRS issues revenue rulings and revenue procedures in the Internal Revenue Bulletin (I.R.B.), available at Prior to 2009, the I.R.B.s were collected in single-volume Cumulative Bulletins, covering 6 months of I.R.B.s. Revenue rulings focus on the IRS interpretation of tax law and regulations and rulings by federal courts. Revenue rulings often relate to a given set of facts and provide a ruling that applies the tax law to those facts. Revenue rulings and revenue procedures can constitute authority for a position taken on a tax return if the taxpayer s facts and circumstances are the same as those in the ruling. Revenue procedures focus more on tax practice aspects of tax law and provide procedures for implementing tax law, IRS regulations, and federal court rulings. Revenue procedures are also used to report changes in monetary limits and factors, such as the annual mileage rate for vehicle deductions. Revenue procedures can constitute authority for a position on a tax return. Tax Treaties Tax treaties and the regulations thereunder, and Treasury Department and other official explanations of such treaties, can support a position on a tax return that involves tax issues with other countries. Federal Court Cases Federal courts have a hierarchy of authority and geographic jurisdiction, and they have a strong preference to follow the precedent of the same or higher courts within their jurisdiction. The US Supreme Court s rulings provide the ultimate national authority for interpreting issues Authorities

6 of tax law, followed by the regional authority of the 13 circuit courts of appeals and the trial courts, including the district courts; the US Tax Court; and federal specialty courts, such as bankruptcy courts. The federal courts have geographical limits on their jurisdiction over taxpayers and other federal courts (see Figure 15.1). The US Tax Court has national jurisdiction over all states and territories of the United States. FIGURE 15.1 Jurisdiction of the Courts Except for the Federal Circuit, each federal circuit court of appeals s jurisdiction to hear appeals is limited geographically, as shown in Figure These courts can hear appeals of the federal district court decisions and US Tax Court decisions by taxpayers in their jurisdictions. Similarly, the rulings of each circuit court of appeals has authority only in that court s jurisdiction, although another circuit court may give weight to another circuit s ruling on a case with similar facts. Jurisdiction of Circuit Courts of Appeals DC Circuit District of Columbia First Circuit Maine, New Hampshire, Massachusetts, Rhode Island, Puerto Rico Second Circuit Vermont, New York, Connecticut Third Circuit Pennsylvania, New Jersey, Delaware, US Virgin Islands Fourth Circuit Maryland, Virginia, West Virginia, North Carolina, South Carolina Fifth Circuit Texas, Louisiana, Mississippi Sixth Circuit Michigan, Ohio, Kentucky, Tennessee Seventh Circuit Wisconsin, Illinois, Indiana Eighth Circuit Minnesota, Iowa, Missouri, Arkansas, Nebraska, North Dakota, South Dakota Ninth Circuit Montana, Idaho, Washington, Oregon, California, Nevada, Arizona, Alaska, Hawaii, Guam, Northern Mariana Islands Tenth Circuit Wyoming, Utah, Colorado, New Mexico, Kansas, Oklahoma Eleventh Circuit Alabama, Georgia, Florida Federal Circuit nationwide jurisdiction The Federal Circuit Court of Appeals has jurisdiction over a variety of subjects, including international trade, government contracts, patents, trademarks, certain money claims against the US government, federal personnel, veterans benefits, and public safety officers benefits claims. Appeals to the court come from all federal district courts, the US Court of Federal Claims, the US Court of International Trade, and the US Court of Appeals for Veterans Claims. The court also hears appeals from certain administrative agencies. The Tax Court s jurisdiction is the entire United States and its possessions. Therefore, a Tax Court opinion involving a taxpayer in California is precedential for a taxpayer in New York. 556 Authorities However, Tax Court cases are appealed to the US circuit court of appeals for the circuit in which the taxpayer lives. If a circuit court of appeals overrules a Tax Court case, the case is overruled only with respect to taxpayers who live in that circuit [Treas. Reg (d)(3)(iii)]. Taxpayers outside the jurisdiction of the circuit court of appeals that overruled the Tax Court are not bound by that appellate decision. The Tax Court issues the following types of written decisions: Regular decisions (T.C.), which are published and precedential Memorandum decisions (T.C. Memo.), which are not published by the Tax Court

7 and are not precedential but can be cited as legal authority Summary decisions (T.C. Summary Opinion), which are not published by the Tax Court and are not precedential but may also be cited While the Treasury regulations that define substantial authority do not distinguish between published and unpublished cases, this is a relevant factor to consider. In a Tax Court bench opinion, the Tax Court judge orally states the opinion in court during the trial session. The Tax Court sends the parties a copy of the transcript reflecting the judge s opinion within a few weeks after the trial. In addition, all bench opinions delivered after March 1, 2008, are posted on the Tax Court s docket inquiry system. A taxpayer cannot rely on a bench opinion as precedent. An authority ceases to be an authority only to the extent that it is overruled or modified, explicitly or implicitly, by a body with the power to overrule or modify the earlier authority. For example, a district court opinion is not authority if overruled, explicitly or implicitly, by the US court of appeals for that district. However, an opinion of the US Tax Court is not considered overruled or modified by a US court of appeals to which the taxpayer does not have a right of appeal, unless the Tax Court adopts the holding of that court of appeals [Treas. Reg (d) (3)(iii)]. See Figure 15.1 for the jurisdictions of the 13 US circuit courts of appeals. A taxpayer can rely on a case as substantial authority even if a court has ruled in the IRS s favor on a particular tax issue if the case contained complex fact situations and complex or unsettled law. Thus, even though a court disagrees with the cases cited by the taxpayer and rules against the taxpayer, the case can be substantial authority for the taxpayer s position to avoid the I.R.C penalty. [See Unger v. Commissioner, T.C. Memo ] Similarly, even where the facts of several past cases are similar to the current taxpayer s facts, courts in different jurisdictions can reach inconsistent results. The current court s choice to follow only some courts rulings does not negate the value of the rejected court rulings as substantial authority. [See Crawford v. Commissioner, T.C. Memo ] Congressional Committee Reports Courts look to congressional committee reports on bills for interpretation of laws only if the court holds that a law, or section of a law, is ambiguous in meaning. Thus, if the meaning of a law is reasonably clear, a contrary interpretation in a congressional committee report will have little weight as an authority for the contrary meaning. The Joint Committee on Taxation is a nonpartisan congressional committee formed of members from the House Committee on Ways and Means and the Senate Finance Committee. The Joint Committee s annual Bluebooks provide explanations of enacted legislation. Use of a Joint Committee analysis is not substantial authority over other forms of legislative history or IRS regulations, but can be a useful guide for understanding legislation subject to various interpretations. Private Letter Rulings and Technical Advice Memoranda A private letter ruling (Ltr. Rul.) is an IRS National Office ruling requested by a taxpayer, and it is limited in authority to the facts of that one taxpayer. A technical advice memoranda (T.A.M.) is an intra-irs ruling from the National Office to district or area IRS directors that responds to questions involving specific taxpayers. Like the Ltr. Rul.s, T.A.M.s carry no precedential authority except for the taxpayer involved in the ruling. A Ltr. Rul. or T.A.M. issued after October 31, 1976, can be substantial authority for the tax treatment of an item by a taxpayer if the treatment is supported by the conclusion of a ruling or a determination letter issued to the taxpayer, by the conclusion of a technical advice memorandum in which the taxpayer is named, or by an affirmative statement in a revenue agent s report with respect to a prior tax year of the taxpayer. The preceding sentence does not apply, however, if 1. there was a misstatement or omission of a material fact or the facts that subsequently develop are materially different from the facts on which the written determination was based; or 2. the written determination was modified or revoked after the date of issuance by a. a notice to the taxpayer to whom the written determination was issued; 15 Authorities 557

8 b. the enactment of legislation or ratification of a tax treaty; c. a decision of the US Supreme Court; d. the issuance of temporary or final regulations; or e. the issuance of a revenue ruling, revenue procedure, or other statement published in the I.R.B. Actions on Decisions and General Counsel Memoranda Actions on Decision (A.O.D.) are formal memorandum prepared by the IRS Office of Chief Counsel that announce the litigation position the IRS will take with regard to the court decision addressed in the A.O.D. A.O.D. are characterized as an acquiescence, a nonacquiescence, or an acquiescence in result only, and indicate whether the IRS will follow a significant adverse opinion of the Tax Court, a district court, the Court of Federal Claims, a bankruptcy court, or an appellate court. General Counsel Memoranda (G.C.M.) are written by the Office of the Chief Counsel for internal use. They contain the reasons behind the adoption of revenue rulings, private letter rulings, and technical advice memoranda and have important precedential value in determining future tax questions [Taxation with Representation Fund v. IRS, 485 F. Supp. 263, at 266 (D. D.C. 1980)]. A taxpayer usually cannot cite a G.C.M. as precedent. IRS Information Releases, Notices, and Announcements Notices, announcements, and press releases provide short-term explanations that the IRS may later incorporate into a revenue ruling, revenue procedure, or regulation. Such statements often include a time limit for reliance by taxpayers and are designed to give advance notice of the IRS s position on specific areas of tax law. Under Rev. Rul , C.B. 262, IRS notices and announcements are accorded the same weight as revenue rulings and revenue procedures. Tax Opinions Although Treas. Reg (d)(3)(iii) specifically states that a written tax opinion by a tax expert is not substantial authority, some cases have held that the reliance on a written tax opinion of a lawyer is substantial authority. [See, e.g., Klamath Strategic Investment Fund, LLC v. United States, 472 F.Supp.2d 885 (E.D. Tex. 2007).] However, most courts have followed the regulations, and found that a tax opinion is not substantial authority. More Than One Position There may be substantial authority for more than one position with respect to the same item or set of facts [Treas. Reg (d)(3)(i)]. That means it is possible for two different taxpayers who take two different positions on the same issue to each have substantial authority for the chosen position. 558 Authorities

9 RULINGS AND CASES This section contains a selection of court cases, Treasury regulations, revenue rulings, revenue procedures, IRS announcements and notices, letter rulings, and IRS chief counsel advice memoranda issued since the publication of the 2016 National Income Tax Workbook. These rulings and cases have been edited and appear in a condensed form. The tax practitioner must read the entire text of the rulings and cases before relying on them. Accounting Accrual Method A.M I.R.C. 451 An accrual method taxpayer with a points-based loyalty rewards program could not subtract certain amounts from gross sales receipts in the year the points are issued. An accrual method taxpayer had a points-based loyalty rewards program designed to enhance its sales. Membership was free of charge, and no purchase was necessary to join. Under the rewards program, members earned points when they purchased qualifying products and services. Qualifying purchases included the purchase of products or services from retail stores or online portals. Gift cards, shipping charges, discounts from vendor coupons, and taxes and fees were not qualifying purchases. Members earned one point for every $1 spent on qualifying purchases. Each point had a value of one cent, but points could not be redeemed for cash. Points expired 5 years after the date earned. Members accumulated points that could be redeemed to purchase products. If members redeemed sufficient points, the product was free. If members had insufficient points, the purchase price was reduced according to the number of points redeemed and the member paid a reduced price. Thus, members could redeem the points for discounts on future purchases or receive free merchandise for redeemed points. Under its current method of accounting, the taxpayer deducted the cost of points in the year a member redeemed the point. The taxpayer proposed to subtract from gross receipts for sales in the tax year in which points are issued an amount equal to the cost of redeeming the award points in the current year and an amount for future redemptions (as defined under Treas. Reg ). I.R.C. 461(h)(4) generally requires that before a liability can be taken into account, all events must have occurred that determine the fact of liability, the amount of the liability must be determinable with reasonable accuracy, and economic performance must have occurred with respect to such liability. Treas. Reg (a)(1) provides that if an accrual method taxpayer issues premium coupons with sales and the coupons are redeemable by the taxpayer in merchandise, cash, or other property, the taxpayer should, in computing the income from such sales, subtract from gross receipts an amount equal to (1) the cost to the taxpayer of merchandise, cash, and other property, used for redemptions in the tax year; plus (2) the net addition to the provision for future redemptions during the tax year (or less the net subtraction from the provision for future redemptions during the tax year). In Rev. Rul , C.B. 139, the IRS ruled that Treas. Reg did not apply to discount coupon expenses because the right of redemption must be unconditional. The coupons must be redeemable without additional consideration from the consumer. Premium coupons generally are issued in connection with the sale of an item and entitle the holder to exchange the coupons for a product, often selected from a catalog, of the consumer s choosing. 15 Accounting 559

10 Ruling Because the points could be redeemed for a product or used as a discount on a purchase of a product the points were not premium coupons under Treas. Reg The points were discount coupons, and the taxpayer could not currently deduct amounts for future redemptions. [A.M (December 9, 2016)] Agriculture Issues Deductions Rutkoske v. Commissioner I.R.C ACCOUNTING Contribution of a qualified conservation easement by a limited liability company was subject to the 50% limitation because the gain from the sale of the subject property was not income from farming as to the company members. The taxpayers were two brothers who each owned a 50% interest in a limited liability company (LLC) taxed as a partnership. The LLC owned 355 acres of farmland, and it leased the property to a farm operating partnership, also wholly owned by the brothers. In 2009, the brothers each spent at least 2,500 hours providing management services and physical labor to grow and harvest crops. In June 2009, the LLC granted a conservation easement to a charitable organization in exchange for $1,504,960. The easement restricted development of the 355 acres. The LLC obtained an appraisal that valued the unencumbered property at $4,970,000 and valued the property encumbered by the conservation easement at $2,130,000. After conveying the conservation easement, the LLC sold its interest in the property to an unrelated party for $1,995,040. The LLC reported a $1,754,115 capital gain from the sale of the property: $1,264,132 from the sale of the conservation easement, and $489,983 from the sale of its remaining property interest. The LLC also reported a noncash charitable contribution for the conservation easement of $1,335,040, the difference between the purported value of the property before the conveyance of the conservation easement and the purported value of the property after the conveyance of the easement, minus the amount received from the sale of the conservation easement ($4,970,000 $2,130,000 $1,504,960). As 50% partners of the LLC, the brothers each claimed, as a pass-through item, noncash charitable contribution deductions of $667,520 on Schedule A (Form 1040), Itemized Deductions. The brothers each reported the $877,057 long-term capital gain from the sale of the LLC s interest in the property on Schedule D (Form 1040), Capital Gains and Losses. I.R.C. 170(b)(1)(E)(i) generally limits the deduction from the donation of a qualified conservation contribution to 50% of the donor s contribution base. Contribution base is defined by I.R.C. 170(b)(1)(G) as the taxpayer s adjusted gross income less the value of other charitable contributions for the year. I.R.C. 170(b)(1)(E)(iv) provides a special rule for contributions of property used in agriculture or livestock production. If the individual is a qualified farmer or rancher for the tax year in which the contribution is made, then that individual may deduct the value of the donation up to 100% of the taxpayer s contribution base, less the amount of all other charitable contributions allowable under I.R.C. 170(b)(1) made during the year. I.R.C. 170(b)(1)(E)(v) defines the term qualified farmer or rancher as an individual whose gross income from the trade or business of farming, within the meaning of I.R.C. 2032A(e)(5), is greater than 50% of the individual s gross income for the tax year. Under section 2032A(e)(5), the following activities generate income from the trade or business of farming: Cultivating the soil or raising or harvesting any agricultural or horticultural commodity (including the raising, shearing, feeding, caring for, training, and management of animals) on a farm Handling, drying, packing, grading, or storing on a farm any agricultural or horticultural commodity in its unmanufactured state, but only if the owner, tenant, or operator of the farm regularly produces more than onehalf of the commodity so treated

11 Planting, cultivating, caring for, or cutting trees; or the preparation (other than milling) of trees for market The taxpayers argued that the income received from the sale of the farmland was farm income. Therefore, the taxpayers received more than 50% of their income from farming, and they could deduct 100% of their contribution bases. The court noted that the taxpayers did not individually own the farmland or the conservation easement. Pursuant to I.R.C. 703(a), while the taxable income of a partnership is generally computed in the same manner as in the case of an individual, the partnership cannot claim a deduction for charitable contributions. Treas (a)(2)(iv) provides that each partner is considered to have paid his or her distributive share of any contribution or gift made by the partnership. I.R.C. 702(a)(4) provides that in determining income tax, each partner must take into account separately his or her distributive share of the partnership s charitable contributions. Thus, the court ignored the LLC and looked at each individual taxpayer to determine whether the taxpayer was a qualified farmer. The taxpayers argued that, although the sale of farmland is not an activity listed in section 2032A(e)(5), the income from the sale of the land should be considered income from farming because the land was used in the trade or business of farming. The court found that section 2032A(e)(5) specifically and unambiguously lists the activities that constitute farming for purposes of section 170, and gain from the sale of farm land is not an activity of farming. As the gain from the sale of the land was more than 50% of each taxpayer s gross income for the tax year, the taxpayers were not qualified farmers or ranchers. Ruling Gain from the sale of farmland was not income from farming for purposes of the exception to the limit for charitable deductions for donation of a qualified conservation contribution. [Rutkoske v. Commissioner, 149 T.C. 6 (2017)] Business Entities Corporations Zang v. Commissioner I.R.C. 61 Amounts transferred to family member officers of a family corporation in excess of wages were income to the taxpayers and not loans. The taxpayers, husband and wife, were the sole officers of a US corporation that was a subsidiary of a Chinese corporation owned by the taxpayer s father. The taxpayers received wages for their work for the corporations and received substantial payments from the US corporation in excess of the wages. The excess payments were made by checks written by the wife to the husband. The taxpayers did not report these excess amounts as income, and argued that the amounts were loans from the US corporation. In 2010, after the IRS commenced an audit of the taxpayers 2005 through 2007 tax returns, the taxpayers executed a promissory note to the parent Chinese corporation for the amount of the excess checks, with payment to be made from the sale of real property owned by the taxpayers. The note did not include a repayment schedule or require any interest payments. From December 2010 to October 2015, the taxpayers made some repayments, including the proceeds of the sale of real property. The court examined the following factors to determine whether the additional checks and cash withdrawals that petitioners received were loans: 1. The ability of the borrowers to repay 2. The existence or nonexistence of a debt instrument 3. Whether there was security, interest, a fixed repayment debt, and a repayment schedule 4. How the parties records and conduct reflected the transaction 5. Whether the borrowers made repayments 15 Business Entities 561

12 6. Whether the lenders demanded repayment 7. The likelihood that the loans were disguised compensation for services 8. The testimony of the purported borrowers and lenders The court held that the nonwage amounts received by the taxpayers were taxable income and not loans because 1. the taxpayers had insufficient income and property to repay the amounts received, 2. no notes were contemporaneously written as the amounts were received, 3. the note from the parent corporation was not secured by any liens, 4. the US corporation did not keep full records of the amounts transferred to the taxpayers, 5. any repayments were made long after the amounts were received, and 6. there was no evidence that either corporation made any demands for repayment. [Zang v. Commissioner, T.C. Memo ] Partnerships Ltr. Rul I.R.C. 707 Liabilities exchanged for additional limited partnership interests were qualified liabilities under the 2016 regulations, and potentially not subject to the disguised sale rules. The taxpayer planned to transfer cash, all its operating assets, and all special class of interests in a partnership in exchange for additional limited partnership interests and new special class of interests in the partnership. The partnership would assume liabilities of the taxpayer and amend the partnership s limited partnership agreement to provide that distributions in respect of the new special class of interests will be reduced each year for the first 3 years following the transfer. The taxpayer liabilities assumed were incurred several years before the exchange, and the proceeds were used to acquire assets, make 562 Business Entities improvements, pay expenses, and otherwise operate the taxpayer s business and that of its subsidiaries, including to refinance other liabilities incurred for the same purposes. The taxpayer represented that (1) none of the liabilities was in default, (2) the liabilities were not incurred in anticipation of the transfer to the partnership, (3) the transfer to the partnership was not considered at the time the liabilities were incurred, (4) the taxpayer would have incurred the liabilities without regard to the transfer to the partnership, and (5) there was no shift in the ownership of the capital of the partnership associated with the transfer. The cash deemed to be distributed under I.R.C. 752(b) upon the assumption of the liabilities did not exceed the taxpayer s basis in its interests in the partnership, and there was no reduction in the taxpayer s interest in the partnership s unrealized receivables and inventory items in connection with the transfer. Under I.R.C. 707 and the accompanying regulations, a transfer of money or other property from a partner to a partnership and a transfer of money or other property from the partnership to the partner may be treated as a sale or exchange. The regulations treat the transfer as a disguised sale if, based on all the facts and circumstances, (1) the transfer of money or other consideration would not have been made but for the transfer of property; and (2) in cases in which the transfers are not made simultaneously, the subsequent transfer is not dependent on the entrepreneurial risks of partnership operations. Treas. Reg (a)(6)(i)(E) provides, in part, that if a partnership assumes or takes property subject to a liability of a partner, it is a qualified liability of the partner only to the extent the liability is a liability that was not incurred in anticipation of the transfer of the property to the partnership. Under Treas. Reg (a)(1), qualified liabilities can potentially avoid the disguised sale rules. Ruling The liabilities exchanged for the additional limited partnership interests would be qualified liabilities. [Ltr. Rul (December 21, 2016)]

13 Limited Liability Companies S Corporations New Millennium Trading v. Commissioner I.R.C. 761, 7701, 6226, 6221, 6231 Fleischer v. Commissioner I.R.C. 61, 482; Treas. Reg (d)-1(c)(2) An LLC formed exclusively to generate losses to offset taxes on capital gains and ordinary income was disregarded for federal income tax purposes. An S corporation sole shareholder was liable for self-employment tax on income earned under contracts entered into by the shareholder individually, and not in the name of the corporation. The taxpayer founded a successful computer software corporation. The taxpayer sold the corporation and expected to recognize significant capital gains and ordinary income on the sale. The taxpayer invested in a limited liability company (LLC) that was a tax shelter. The spread transaction scheme involved creating an LLC taxed as a partnership. The sole purpose of the scheme was to create loss deductions that the taxpayer could use to offset the taxable income from the sale of the software corporation. The IRS determined that the LLC was a sham, and disregarded it for federal income tax purposes. Under I.R.C. 7701(a)(2), a partnership includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not a trust or estate or a corporation. Treas. Reg requires that a partnership must have at least two members. The court considered whether the parties intended to join together as partners to conduct business activity for a purpose other than tax avoidance because the pursuit of a business activity exclusively in furtherance of tax avoidance does not give substance to an entity formed to achieve that purpose. The court found that the LLC formed by the taxpayer and the promoters was formed exclusively for tax avoidance. Therefore, the court held that the LLC was disregarded. [New Millennium Trading v. Commissioner, T.C. Memo ] On February 2, 2006, the taxpayer entered into a financial services agreement contract with LPL. The agreement characterized the taxpayer as an independent contractor. On February 7, 2006, the taxpayer formed a single-owner S corporation with which the taxpayer entered into an employment contract. Under the employment agreement, the taxpayer was paid an annual salary to perform duties as a financial adviser. He was required to (1) act in the clients best interests in managing client investment portfolios, (2) expand the corporation s client base and the overall presence of the corporation, (3) draft and review financial documents, and (4) represent the corporation diligently and responsibly. The agreement gave the corporation the right to reasonably modify the taxpayer s duties at its discretion. The agreement included other provisions commonly found in employment agreements, such as provisions for the reimbursement of expenses and how to terminate the agreement, an arbitration clause, and a noncompete clause. The agreement did not include a provision requiring the taxpayer to remit any commissions or fees from any third party to the corporation. The taxpayer signed the agreement twice once as the corporation s president and once in the taxpayer s individual capacity. On March 13, 2008, the taxpayer entered into a broker contract with MassMutual. He signed the contract in his individual capacity, and the contract did not name the corporation. The contract treated the taxpayer as an independent contractor. The taxpayer included the amounts received from LPL and MassMutual in the corporation s income on Form 1120S and/or on a Schedule C (Form 1040). 15 Business Entities 563

14 Generally, income must be taxed to the person or entity that earned it. While this principle is easily applied between two individuals by simply asking who performed the services or created the goods, the question of who earned the income is not so easily answered when a corporation is involved. The courts consider who controls the earning of the income to determine whether the corporation or a service-provider employee is taxed on income. For a corporation to be the controller of the income (1) the individual providing the services must be an employee of the corporation, and the corporation must be able to direct and control the employee in a meaningful sense; and (2) there must exist between the corporation and the person or entity using the services a contract or other indicator of the corporation s controlling position. Ruling The court found that the contracts with LPL and MassMutual were made by the taxpayer individually. Therefore, the income from the contracts was earned by the taxpayer, not the corporation, and was subject to self-employment tax. [Fleischer v. Commissioner, T.C. Memo ] Tax-Exempt Ltr. Rul I.R.C. 501 A corporation that held and promoted professional rodeos was not eligible for tax-exempt status. for each competing participant, and spectators paid a fee to attend the rodeo events. Membership in the organization was open to anyone who participated in an event. There was no membership fee. Cash prizes for first-place finishers ranged from a few hundred dollars to up to several thousand based on a percentage of the entry fees collected for that event. I.R.C. 501(c)(3) exempts from federal income tax corporations, and any community chest, fund, or foundation, organized and operated exclusively, among other purposes, to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment). Under I.R.C. 501(j)(2), an organization must be organized and operate to conduct national or international sports competitions or support and develop amateur athletes for national or international sports competitions. Ruling The IRS ruled that rodeo competition is not a national or international competition and an organization that promoted and sponsored rodeos did not qualify for section 501(c)(3) taxexempt status. [Ltr. Rul (November 18, 2016)] Medical College of Wisconsin Affiliated Hospitals v. United States I.R.C A nonprofit corporation was entitled to interest on an overpayment of taxes at the federal shortterm rate plus 0.5 percentage points. The taxpayer was a corporation that filed Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. The taxpayer s bylaws stated that it was formed to encourage, promote, and advance information and knowledge concerning rodeos, including the dates of rodeos, names of contestants, prize money, and other information of interest to the members. The taxpayer provided a rodeo venue that conducted approximately 14 rodeos per year. The taxpayer charged entry fees The taxpayer was a nonprofit corporation that received a refund of FICA taxes after the IRS ruled that the taxpayer was not required to withhold and pay the taxes for medical residents. The IRS calculated the interest on the payment using the federal short-term rate plus 3 percentage points. The IRS then demanded back a portion of the interest, claiming that the rate should have been the federal short-term rate plus 2 percentage points for the first $10,000, and then the federal short-term rate plus 0.5 percentage points for the remainder. 564 Business Entities

15 The overpayment rate established under I.R.C is the federal short-term rate plus 3 percentage points (2 percentage points in the case of a corporation). To the extent that an overpayment of tax by a corporation for any taxable period exceeds $10,000, the rate is the federal short-term rate plus 0.5 percentage points. The taxpayer argued that the lower rate applied only to C corporations, and a nonprofit corporation is not a C corporation for purposes of I.R.C. 6621(c)(3). The court rejected this claim, and held that I.R.C. 6621(a) does not apply to only C corporations, and a refund of overpayment of taxes to a nonprofit corporation above $10,000 was entitled to interest at the federal short-term rate plus 0.5 percentage points. [Medical College of Wisconsin Affiliated Hospitals v. United States, 854 F.3d 930 (7th Cir. 2017)] Ltr. Rul I.R.C. 501 A cancer education and research corporation s pet therapy program was consistent with its charitable purpose. The taxpayer was an I.R.C. 501(c)(3) taxexempt organization that was organized to conduct oncology research and education, and to advance general medical research and education. The taxpayer proposed to initiate a pet therapy program to provide playful interaction between therapy dogs and hospital inpatients, particularly children and elderly nursing home residents, to lift their spirits and improve their ability to cope with anxiety. The proposed therapy sessions will be conducted at hospitals and nursing homes at no fee to the participant, the hospital, or the nursing home. Treas. Reg (c)(3)-1(d)(1)(i) includes charitable among the purposes for which an organization described in section 501(c)(3) may be exclusively organized and operated. Treas. Reg (c)(3)-1(d)(2) provides that the term charitable is used in in its generally accepted legal sense, and includes relief of the poor and distressed. Ruling The IRS ruled that the taxpayer s pet therapy program furthers a charitable purpose under section 501(c)(3). [Ltr. Rul , (February 13, 2017)] Community Education Foundation v. Commissioner I.R.C. 501 A foundation s section 501(c)(3) status was revoked for lack of any charitable activity. The taxpayer was a foundation that was granted section 501(c)(3) tax-exempt status in The taxpayer s application stated that its purpose was to provide research and education on public issues impacting African Americans, Hispanic Americans, Asian Americans, Native Americans, and heritage groups through town hall meetings, workshops, congressional forums, and advertising. In 2012, the IRS sent a letter proposing to revoke the taxpayer s section 501(c)(3) status for failure to meet the statutory operational test. The taxpayer filed a protest admitting inactivity from 2001 to 2008 but claiming that it tried to hold events in 2009 and 2010 but failed. The IRS issued a final letter that determined that the taxpayer (1) failed to establish that it was operated exclusively for exempt purposes; (2) failed to maintain or produce any books or records setting forth its revenue, expenses, assets, and activities or programs; and (3) admitted to a significant period of inactivity and failed to demonstrate that it engaged in activities furthering its exempt purposes. In a companion final adverse determination, the IRS modified the taxpayer s private foundation status from classification as a [tax-exempt] public charity to classification as a [taxable] private foundation. Under Treas. Reg (c)(3)-1(c)(1), an organization will satisfy the operational test if it engages primarily in activities that accomplish one or more of the exempt purposes in section 501(c)(3). 15 Business Entities 565

16 The court found that the taxpayer did not engage in any activity that accomplished one or more of the exempt purposes listed in section 501(c)(3), and the court held that the IRS properly revoked the taxpayer s tax-exempt status. [Community Education Foundation v. Commissioner, T.C. Memo ] Business Issues Debt vs. Equity Sensenig v. Commissioner I.R.C. 166, 385 Contributions to unrelated companies were capital investments and not loans where no written documentation was created to establish the terms of the loans, no interest was charged, and no efforts were made to enforce collection of the contributions. The taxpayer was the owner of an S corporation that sold log cabin kits and the sole owner of an S corporation that provided financing to purchasers of log cabin kits. The taxpayer sought investments in the financing corporation from other Amish and Mennonite individuals, and eventually had excess investments. He used the excess investment funds for the financing corporation and to invest in numerous other corporations. The financing corporation advanced large sums of money to these corporations. There were journal entries calling some of the advances loans, but no notes, agreements, or other documents evidencing a loan. It never demanded repayment. The state of Pennsylvania ordered the financing corporation to stop selling unregistered securities to investors. The taxpayer realized that the start-up companies would fail without additional contributions, and claimed that they became worthless. Thus, in 2005, the financing corporation claimed a $10,691,581 business-bad-debt deduction for amounts outstanding from 3 corporations. However, the corporations continued in existence, and the financing corporation continued to advance funds for several more years. 566 BUSINESS ENTITIES A deduction is allowed for any bona fide debt that becomes worthless in the tax year [I.R.C. 166(a) (1) and Treas. Reg (c)]. To be able to deduct a bad debt, a taxpayer must show (1) that the advances made to other companies were debt and not equity; (2) that the debt became worthless in the tax year the deduction is claimed; and (3) that the debt was incurred not as an investment but in connection with a trade or business (in this case, the business of promoting, organizing, and financing or selling corporations). A bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money [section (c)]. A capital contribution is not a debt for purposes of I.R.C An absence of an unconditional right to demand payment is practically conclusive that an advance is an equity investment rather than a loan for which an advancing taxpayer might be entitled to claim a deduction for a bad-debt loss [I.R.C. 166(a) and 385]. The taxpayer failed to provide any written evidence demonstrating that there was a valid and enforceable obligation of the corporation to repay the advances from the financing corporation. There was no written evidence of an enforceable obligation and no provision for a fixed maturity date or a fixed rate of interest. The financing corporation contributed to the corporations without vetting their financial prospects, and the corporations could not obtain regular financing. The high-risk nature of the investments indicated that the advances were venture capital investments, not loans. There was insufficient evidence that the taxpayer and the financing corporation had a reasonable chance to recover the contributions in The court held that the advances made by the financing corporation were capital investments and not loans. The financing corporation could not claim a bad-debt deduction. [Sensenig v. Commissioner, T.C. Memo ]

17 Depreciation Nielsen v. Commissioner I.R.C. 167 The court allocated the cost of real property between depreciable and nondepreciable real property based on the county assessor s allocation for property tax purposes. The taxpayer purchased three rental real estate properties. The taxpayer initially included the value of the land and improvements in the basis subject to depreciation. After the IRS disallowed a depreciation deduction for the value of the land, the taxpayer reallocated the purchase price between the land and buildings for each parcel and claimed depreciation deductions based on the value allocated to each building. The county tax assessor allocated less value to the buildings than that claimed by the taxpayer, and the IRS disallowed the depreciation deductions to the extent they exceeded the allocations by the county assessor. Where a taxpayer purchases real property with improvements, the taxpayer must apportion the purchase price between the land and the improvements. Treas. Reg (a)-5 provides that the basis for depreciation cannot exceed an amount that bears the same proportion to the lump sum as the value of the depreciable property at the time of acquisition bears to the value of the entire property at that time. The court ruled that the county assessor s allocations were reliable and denied the taxpayer s depreciation deductions to the extent that they exceeded those allocations. [Nielsen v. Commissioner, T.C. Summary Opinion ] A.O.D. Stine v. US I.R.C. 167, 168 The IRS issued a nonacquiescence in a case that held that new retail buildings were placed in service when they were ready to hold racks, shelves, and merchandise. The taxpayer was an LLC that owned and operated a retail business selling home-building materials and supplies. In 2007, the taxpayer began construction of two new buildings in the Gulf Opportunity Zone (GO Zone) to function as retail stores. The buildings had been issued certificates of occupancy; were substantially complete; and were fully functional to house and secure shelving, racks, and merchandise. However, the buildings were not ready to operate as retail stores, and customers were not permitted to enter the buildings under the certificates of occupancy in place as of December 31, In 2008, the taxpayer claimed a GO Zone depreciation deduction for 50% of the cost of the two newly constructed buildings. The IRS disallowed the GO Zone deduction, arguing that the properties were not placed in service prior to December 31, 2008, because the retail businesses located in the buildings had not yet opened for business. I.R.C. 1400N(d)(1)(A) allowed a 50% deduction for nonresidential real property placed in service after August 28, 2005 and before January 1, 2009, to assist businesses in Louisiana impacted by hurricanes. Section 1400N(d)(1)(A) states that the GO Zone depreciation is governed by I.R.C. 167 and the related treasury regulations. Treas. Reg (a)-10(b) provides that the depreciation period for an asset begins when a building is placed in service. Prop. Treas. Reg (e)(3) provides that a building is placed in service when a significant portion is made available for use in a finished condition (e.g., when a certificate of occupancy is issued with respect to such portion). The IRS s Audit Technique Guide for Rehabilitation Tax Credits provides guidance for rehabilitated buildings under I.R.C. 47. It states that a certificate of occupancy is one means of verifying the placed in service date for a building. The court held that the taxpayer s buildings were placed in service on the date the buildings were ready and available to perform the function for which they were built, and they were placed in service when they were ready to house and secure racks, shelving, and merchandise. 15 Business Issues 567

18 Ruling The IRS does not agree with the ruling that a retail business building is placed in service when it is ready to house and secure racks, shelving, and merchandise. It is the IRS s position that the buildings are placed in service when they are open for business to customers. [Stine v. United States, No (W.D. La. 2015), nonacq I.R.B. 1072] Domestic Production Activities Deduction C.C.A I.R.C. 199, 861 Legal expenses incurred after enactment of I.R.C. 199 and attributable to products produced and sold prior to the enactment of section 199 did not reduce the domestic production activities deduction. The taxpayers manufactured and sold two classes of products prior to and after enactment of the I.R.C. 199 domestic production activity deduction (DPAD). After the enactment of section 199, the taxpayers incurred legal expenses to defend product liability lawsuits alleging harm from the products manufactured and sold prior to the enactment of section 199. The taxpayer did not capitalize any of the legal expenses. I.R.C. 199(c)(1) provides that qualified production activities income (QPAI) is the excess of a taxpayer s domestic production gross receipts (DPGR) for the tax year over the sum of the taxpayer s cost of goods sold (COGS) that is allocable to DPGR and the taxpayer s other expenses, losses, and deductions (other than the section 199 deduction) that are properly allocable to DPGR. Treas. Reg (c) and (d) require, for purposes of computing QPAI, that certain taxpayers use the section 861 method to allocate and apportion deductions to gross income attributable to DPGR in computing QPAI. Under the section 861 method, a deduction is allocated to a class of gross income, and then, if necessary, apportioned between other groupings of gross income within that class. 568 Business Issues Ruling The legal fees were factually related to the class of gross income attributable to the manufacture and sales of products made prior to the effective date of section 199. Because gross receipts from those sales did not generate gross income attributable to DPGR in the years the gross income was realized, no portion of the deductions for the legal fees at issue should be apportioned under the section 861 method to the statutory grouping of section 199 gross income in tax years after the enactment of section 199. Accordingly, the legal fees do not reduce QPAI and the DPAD deduction. [C.C.A (December 20, 2016)] Employment Tax C.C.A I.R.C An independent contractor safe harbor applies to direct sellers of tangible and intangible consumer products. Issue This chief counsel advice letter discusses whether I.R.C makes any distinction between tangible and intangible consumer products. Under I.R.C. 3508, an individual who performs services as a qualified real estate agent or as a direct seller is not treated as an employee, and the person for whom such services are performed is not treated as an employer for employment tax purposes. A direct seller is any person who is engaged in the trade or business of selling (or soliciting the sale of) consumer products to any buyer on a buy-sell basis, a deposit-commission basis, or any similar basis prescribed by regulations. The products must be sold for resale by the buyer or any other person in the buyer s home or other location that is not a permanent retail establishment. The buyer must also be engaged in the trade or business of selling (or soliciting the sale of) consumer products in the home or other location that is not a permanent retail establishment. Prop. Treas. Reg (g)(3) provides that the term consumer product is limited to tangible goods. However, two cases have held that

19 consumer product includes tangible and intangible goods. Cleveland Institute of Electronics. v. United States, 787 F. Supp. 741 (N.D. Ohio 1992), held that for section 3508 purposes, the term consumer product included both tangible consumer products and intangible consumer services; thus, a homestudy course was a consumer product. R Corp. v. United States, 94-2 U.S.T.C. (CCH) 50,380 (D. Fla. 1994), held that cable television subscriptions were intangible services and were a consumer product under section Both courts noted that the proposed regulation was issued in 1986 but has not been finalized. Ruling The chief counsel advice letter finds that section 3508 applies to persons in the trade or business of selling or soliciting the sale of tangible and intangible consumer products. [C.C.A (October 20, 2016)] common-law employer was ultimately responsible for those taxes. [F.A.A F (November 9, 2016)] Certified Professional Employer Organization The IRS has issued notices of certification to 84 organizations that applied for voluntary certification as a certified professional employer organization (CPEO). Under legislation enacted in late 2014, the IRS established a voluntary certification program for professional employer organizations (PEOs). A CPEO is generally treated as the employer of any individual performing services for a client of the CPEO and covered by a CPEO contract between the CPEO and the client, but only for wages and other compensation paid to the individual by the CPEO [IR-News Rel (June 1, 2017)]. 15 F.A.A F I.R.C. 3401, 6205 An employer was liable for withholding taxes where a contracted professional employer organization (PEO) failed to pay the taxes. The taxpayer was an S corporation that operated a limousine service. The taxpayer contracted with a PEO to administer payroll and pay employee wages. The taxpayer made full payment of the wages and withholding taxes to the PEO, but the PEO did not pay all the taxes to the IRS. I.R.C. 3401(d)(1) provides that if a common-law employer does not have control of the payment of wages, the term employer means the person having control of the payment of wages. There are several cases in which a PEO that receives payroll information and funds from the employer before delivering the payroll to the employees is not considered the employer under section 3401(d)(1). Ruling The IRS ruled that, although the PEO was obligated by state law to withhold and pay employment taxes, under federal tax law, the Ltr. Rul I.R.C A successor employer could credit a predecessor employer s contributions to its employees contribution benefit base. The taxpayer is the parent corporation of five subsidiary corporations. The taxpayer proposed to transfer employees of four of its subsidiaries to the fifth subsidiary. The taxpayer also proposed to transfer all operating assets, either owned by the four transferor subsidiaries or used through leases or contracts, attributed to the transferred employees. I.R.C. 3121(a)(1) provides an exception from the social security tax portion of the FICA tax for remuneration paid by an employer to an employee after the employer has paid wages to the employee equal to the contribution and benefit base for the year. If an employee changes jobs during the tax year, the wages paid by the second employer are generally subject to social security taxes on the entire contribution and benefit base. Although the employee can obtain a refund of the employee portion of social security taxes that exceed the contribution benefit base because the Business Issues 569

20 employee had two or more employers, neither employer is entitled to a refund of the employer portion of social security tax on such wages. However, section 3121(a)(1) provides an exception if a successor employer acquires substantially all the property used in a trade or business of a predecessor employer, or used in a separate unit of a trade or business of a predecessor, and immediately after the acquisition employs in its trade or business an individual who immediately prior to the acquisition was employed in the trade or business of the predecessor. In this case, to determine the contribution and benefit base, remuneration paid by the predecessor employer is considered paid by the successor employer. Under Treas. Reg (a)(1)-1(b)(2), the exception applies only if the parties meet the following three requirements: 1. The successor during a calendar year acquired substantially all the property used in a trade or business, or used in a separate unit of a trade or business, of the predecessor. 2. The employee was employed in the trade or business of the predecessor immediately prior to the acquisition and is employed by the successor in the successor s trade or business immediately after the acquisition. 3. Wages were paid during the calendar year in which the acquisition occurred and prior to such acquisition. Ruling The IRS ruled that the successor subsidiary was eligible to include the wages paid by the predecessor subsidiaries for purposes of determining the contribution benefit base. [Ltr. Rul , November 16, 2016] Expenses Creigh v. Commissioner I.R.C. 162 The taxpayer could not deduct the cost of an EMBA degree because it qualified her for a new trade or business. From 1993 through 2007, the taxpayer worked as a systems software engineer. After having a child 570 Business Issues in 2007, the taxpayer did not work for 3 years. Instead of returning to employment in 2010, the taxpayer started a sole proprietorship computer software consulting business. The taxpayer was unable to find any customers and decided to obtain an executive master of business administration (EMBA) degree to network with fellow students who would eventually work for potential clients. The taxpayer claimed the education expenses, including travel and supplies, as a deduction from the consulting business income on Schedule C (Form 1040). Under I.R.C. 162, to deduct education expenses, a taxpayer must be engaged in a trade or business. Education expenses are deductible if the education maintains or improves skills required by the taxpayer in his or her employment or other trade or business or meets the express requirements of the taxpayer s employer [Treas. Reg (a) (1) and (a)(2)]. Treas. Reg (b)(2) and (b)(3) provide that education expenses are not deductible if the expenses are for education required to meet the minimum requirements of the taxpayer s trade or business, or a program of study leading to the qualification of the taxpayer for a new trade or business. The court held that the EMBA degree did not maintain or improve the skills the taxpayer held before obtaining the degree, but qualified the taxpayer for a new trade or business. Therefore, the education expenses were not an allowable business expense deduction. [Creigh v. Commissioner, T.C. Summary Opinion ] Long v. Commissioner I.R.C. 162 The cost of an MBA degree was a deductible business expense where the degree did not qualify the taxpayer for a new trade or business. The taxpayer originally held a BS and an MS degree in electrical engineering, and from 2005 to 2011, he worked as a design engineer and product line manager for a semiconductor company.

21 In May 2011, the taxpayer resigned and worked at an investment bank for 3 months. In January 2012, the taxpayer worked for a company that provided consultation on technology and financial matters for other businesses. In 2007 through 2010, the taxpayer passed the exams for chartered financial analyst (CFA) and chartered alternative investment analyst (CAIA). In May 2010, the taxpayer began long-distance and occasionally on-campus study for an MBA degree. He received the degree in April The taxpayer s coursework for the MBA program was finance- and management-related, including courses in financial accounting, newproduct management, and corporate valuation. Although the semiconductor company had a reimbursement program for educational expenses of its employees, the taxpayer did not request reimbursement because the taxpayer intended to, and did, terminate employment soon after receiving the degree. The reimbursement policy would have required the taxpayer to refund the amounts reimbursed. The taxpayer claimed education expense deductions against his real estate activity income in 2010 and 2011 on Schedule C (Form 1040). The IRS disallowed the deductions. If the taxpayer did not engage in the real estate activity for profit, the taxpayer cannot claim a Schedule C deduction for the expenses of conducting that activity. However, the taxpayer may deduct unreimbursed employee expenses as miscellaneous itemized deductions on Schedule A, Itemized Deductions, to the extent such expenses exceed 2% of AGI [I.R.C. 62(a)(2), 63(a), (d), 67(a) and (b), and 162(a)]. The taxpayer asserted at trial that his MBA studies enhanced the skills he was using in his position at the semiconductor company and that the company consented to and accommodated his MBA studies. A taxpayer may deduct the cost of an MBA degree as an unreimbursed employee expense if the studies improve on preexisting skills such as management skills and do not qualify a taxpayer for a new trade or business. Courts have held that if the education qualifies a taxpayer to perform tasks and activities significantly different from those the taxpayer could perform before earning the degree, then the education qualified the taxpayer for a new trade or business. A taxpayer is in the same trade or business if her or she is in the same general field and still using the same skills, for example, moving from one position to another that also uses management, administrative, and planning skills. The taxpayer s education expenses in obtaining an MBA degree were deductible unreimbursed employee expenses because the courses did not qualify him for a new trade or business. Rather, they further developed skills he was already using in his current trade or business. [Long v. Commissioner, T.C. Summary Opinion ] Liljeberg v. Commissioner I.R.C. 162, 213 Foreign students travel expenses while participating in the US Summer Work Travel Program (SWTP) were not deductible. The taxpayer was a citizen of Finland who participated in the US State Department s Summer Work Travel Program (SWTP). Before traveling to the United States, the taxpayer was a fulltime student and worked part-time. The taxpayer worked as a lifeguard in Wisconsin for 4 months and earned $4,404 in wages. The taxpayer filed Form 1040NR, U.S. Nonresident Alien Income Tax Return, for 2012 and claimed unreimbursed employee expenses of travel to, from, and in the United States while in the SWTP. He deducted the cost of medical insurance, which he was required to have to participate in the SWTP. Other SWTP participants claimed similar expenses. I.R.C. 162(a)(2) allows a deduction for ordinary and necessary travel expenses incurred while the taxpayer was away from home and incurred in the pursuit of a trade or business. A taxpayer who pursues temporary employment away from the location of his or her usual residence, but who has no business connection with that usual residence, is not away from home for purposes of section 162(a)(2) [Hantzis v. Commissioner, 638 F.2d 248 (1st Cir. 1981)]. 15 Business Issues 571

22 A taxpayer may not deduct personal, living, or family expenses. I.R.C. 213(a) is an exception to the general rule and allows the deduction of medical expenses, including amounts paid for health insurance, to the extent such expenses exceed 10% of a taxpayer s AGI and are not compensated for by insurance or otherwise. Because the taxpayer did not have a trade or business in Finland before entering the SWTP, the taxpayer s tax home became the location of the employment in the United States, and he could not deduct travel to and from the United States. Health insurance was required as a condition of the taxpayer s participation in the SWTP, but insuring against the costs of maintaining a taxpayer s health is primarily a personal concern, not a business concern. The taxpayer could deduct such insurance only under section 213(a). [Liljeberg v. Commissioner, 148 T.C. No. 6 (2017)] Musa v. Commissioner I.R.C The doctrine of consistency applied to a taxpayer who failed to withhold and pay employment taxes for employees but, after the statute of limitations for assessments had expired, claimed deductions relating to the excluded employees. The taxpayer owned and operated a restaurant that employed many of the taxpayer s family members. Although the taxpayer hired payroll companies to handle payment of wages and payroll taxes, the taxpayer did not include most of his family members. The taxpayer paid the family members in cash and did not withhold or pay employment taxes from 2006 through The IRS determined that the taxpayer underreported income and underpaid tax for several tax years, and assessed a civil fraud penalty under I.R.C (which the Tax Court later upheld). The IRS initiated an audit in In 2014, the taxpayer filed amended returns for 2006 through 2010 and increased the deductions for employee expenses based on the complete reporting of the family member employees originally excluded from the taxpayer s employment tax returns. The IRS claimed that the duty of consistency prohibited the increased deductions because the statute 572 Business Issues of limitations had run on the tax returns for 2006 through The Tax Court agreed and determined that the taxpayer owed over $500,000 in income tax and over $380,000 in fraud penalties. The taxpayer appealed the ruling on the duty of consistency. The duty of consistency is an equitable tax doctrine analogous to judicial estoppel, which prevents a party from taking one position in a court proceeding and then taking a contradictory position in a later case. The duty of consistency applies when a taxpayer makes a representation or report on which the IRS has relied and the taxpayer attempts, after the statute of limitations has run, to change the representation or report to recharacterize the situation in a way that harms the IRS. In this case, the taxpayer s initial employment tax reports and payments improperly excluded the family member employees. The IRS assessed employment taxes based on the original filings and payments made by the taxpayer, and the IRS would be harmed because the IRS could not assess taxes for the employees who were not disclosed until the amended returns. The Court of Appeals upheld the Tax Court decision and affirmed that the taxpayer was not allowed to claim employee expense deductions for tax years beyond the statute of limitations for assessments. [Musa v. Commissioner, 854 F.3d 934 (7th Cir. 2017)] Home Team Transition Management v. Commissioner I.R.C. 162 Management fees were not deductible because they were not paid in exchange for management services. The taxpayer was a home health care service provider, owned by a holding company. One owner of the holding company provided administrative services for the taxpayer, and another owner managed the health care services for the taxpayer. The taxpayer paid them both wages.

23 In 2011, 2012, and 2013, the taxpayer made transfers to the holding company and claimed deductions for management fees paid to the holding company. The payments were originally characterized on the taxpayer s books as repayment of intercompany loans from the holding company, but were changed to payment of management fees at the end of each tax year. The annual payments were not based on hours worked or services provided. They were based on the taxpayer s profits and the holding company s need for funds. There was no evidence that the holding company performed any management services for the taxpayer. The IRS determined that the management fees were disguised dividends, and not deductible. Management fees are deductible under I.R.C. 162 if they are ordinary, necessary, and reasonable payments made for services rendered. Treas. Reg (b) provides that any amount paid in the form of compensation, but not in fact for the purchase price of services, is not deductible. The allowance for compensation paid may not exceed what is reasonable under all the circumstances. Thus, a taxpayer must show that the amount paid as compensation (1) is reasonable and (2) is for services actually rendered. The court found that the management fees were not paid for services rendered by the holding company and were not reasonable expenses. Therefore, the fees were not a deductible business expense. [Home Team Transition Management v. Commissioner, T.C. Memo ] Jacobs v. Commissioner I.R.C. 132, 162, 274 A professional hockey team could fully deduct the costs of providing meals to the team players and employees incurred during away games. The taxpayers, husband and wife, owned a National Hockey League (NHL) team, the Boston Bruins, through three entities, two S corporations and an LLC. The NHL collective bargaining agreement requires teams to arrive in a city for an away game at least 6 hours before the start of the game, and they must arrive the day before the game if the flight to the away city is more than 150 minutes. The taxpayers team and supporting employees usually arrive at the hotel in the game city the day before a game and order special meals and snacks to be served at the hotel in nonpublic areas. Team members and employees are required to participate in all meals. The meals are also used to conduct some preparation for the games. The team and employees also use the hotel physical fitness area for medical treatment, training, and exercise. The taxpayers S corporation claimed deductions for the meal expenses incurred during the travel to away games. The IRS assessed a deficiency based on allowance of only 50% of the meal expenses in cities other than Boston. I.R.C. 162(a) allows as a deduction all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. I.R.C. 274(a)(1)(A) disallows a deduction for certain meal and entertainment expenses otherwise deductible under I.R.C. 162 unless the expenses are associated with the active conduct of the taxpayer s trade or business. I.R.C. 274(n) provides, in pertinent part, that the amount allowable as a deduction for food or beverages, and entertainment, amusement, or recreation, shall not exceed 50% of the amount of such expense or item. The 50% limit does not apply to food or beverage expenses that are excludable from gross income under I.R.C. 132(e). For food or beverages expenses to be excludable from the gross income of the recipient under section 132(e), access to the eating facility must be available on substantially the same terms to each member of a group of employees, and cannot discriminate in favor of highly compensated employees. The court found that the pregame meals were made available to all team employees on substantially the same terms. Employee meals provided in a nondiscriminatory manner constitute a de minimis fringe benefit under section 132(e) if 1. the eating facility is owned or leased by the employer; 2. the employer operates the facility; Business Issues

24 3. the facility is located on or near the business premises of the employer; 4. the meals furnished at the facility are provided during, or immediately before or after, the employee s workday; and 5. the annual revenue derived from the facility normally equals or exceeds the direct operating costs of the facility (the revenue/operating cost test). The court found that the contracts with the hotels were essentially leases, and the team contracted with the hotels to provide an eating facility for the team. The hotels were part of the team s business premises because the team conducted significant business duties at the hotels; the meals were provided for the convenience of the employer corporation; and the meals furnished at the hotels were provided during, or immediately before or after, the employees workday. I.R.C. 274(e)(8) exempts from the 50% limitation any expenses for goods or services (including the use of facilities) that are sold by the taxpayer in a bona fide transaction for adequate and full consideration. Treas. Reg (f)(2) (ix) provides that this exception applies to any expenditure by a taxpayer for entertainment to the extent the entertainment is sold to customers in a bona fide transaction for an adequate and full consideration in money. The taxpayers argued that the cost of the meals that the taxpayers provided to their players was part of the expenses that they incurred to provide hockey entertainment. Because the court found that the de minimis fringe benefit exception applied, the court did not address this argument. The court held that the expenses for meals provided to a professional hockey team at away games were fully deductible. [J acobs v. Commissioner, 148 T.C. 24 (2017)] Lewis v. Commissioner I.R.C. 162, 183, 274 Deductions for expenses associated with the taxpayer s ministry and author activities were disallowed because the activities were not a trade or business. 574 Business Issues The taxpayer was a minister who occasionally performed weddings, attended meetings, and conducted seminars. He did not charge for his ministry services, and he had no evidence of any income from his book-writing activities. The taxpayer claimed unreimbursed employee business expense deductions on Schedule A (Form 1040), Itemized Deductions. He claimed expenses associated with the ministry activity, including vehicle mileage and other travel expenses. The IRS disallowed the deductions because the taxpayer did not operate a trade or business. The taxpayer argued at trial that he was an independent contractor in the trade or business of being a minister and author and he was entitled to the deductions on Schedule C (Form 1040), Profit or Loss From Business. I.R.C. 162(a) provides that a taxpayer who is carrying on a trade or business may deduct ordinary and necessary expenses incurred in connection with the operation of the business. To be engaged in a trade or business within the meaning of I.R.C. 162, the taxpayer s primary purpose for engaging in the activity must be for income or profit. Under I.R.C. 183, if the taxpayer cannot show an intent to engage in an activity with a profit motive, the deductions for expenses are limited to the amount of income generated by the activity. The court found that the taxpayer provided no credible evidence of any profit motive for the ministry activities. The taxpayer admitted not charging for the ministry services and presented no records, bank statements, invoices, or other records indicating a bona fide trade or business. Thus, the court held that the taxpayer could not claim any deductions for expenses that exceeded income. Because he had no income from these activities, he could not claim any deductions. The court noted that, even if the ministry was a bona fide trade or business operated for profit, the taxpayer lacked records to substantiate the expenses and claim a deduction. Most of the claimed expenses included automobile and travel-related expenses, which are subject to the strict substantiation requirements of I.R.C. 274(d). To deduct such items, the taxpayer must substantiate through adequate records or other corroborative evidence the amount of the expense,

25 the time and place of the expense, and the business purpose of the expense. Under Temp. Treas. Reg T(c)(2), a taxpayer satisfies the adequate records test if the taxpayer maintains an account book, a diary, a log, a statement of expense, trip sheets, or similar records prepared at or near the time of the expenditures that show each element of each expenditure or use. The taxpayer presented only credit card statements and a spreadsheet created long after the expenses were incurred. The court held that such evidence did not comply with the strict substantiation requirements of section 274(d). A minister and author could not take deductions for expenses because he did not engage in the activities with the intent to make a profit, his deductions were limited to revenue, and he had no revenue from the activities. [Lewis v. Commissioner, T.C. Memo ] Income Alexander v. Commissioner I.R.C. 61, 102 Amounts paid for work performed for an attorney was taxable income and not a gift. The taxpayer was a disbarred workers compensation attorney who did similar work for another attorney. The taxpayer performed case analysis and litigation support services and was paid $15,000. The attorney issued a Form 1099-MISC listing the payments as taxable nonemployee compensation. The taxpayer claimed that the payments were gifts. The attorney died before the trial. I.R.C. 61(a)(1) provides that compensation for services is included in gross income for federal income tax purposes. I.R.C. 102 provides that gross income does not include amounts acquired by gift. The transferor s intent is the most critical consideration, and there must be an objective inquiry into whether the transferor intended the payment as compensation or a gift. Generally, a gift is made from a detached and disinterested generosity... out of affection, respect, admiration, charity, or like impulses [Commissioner v. Duberstein, 363 U.S. 278 (1960)]. The Tax Court found the following evidence of intent to compensate for services: (1) the taxpayer was paid after he performed work for the attorney; (2) the taxpayer submitted a timesheet showing the number of hours he worked; (3) the taxpayer expected to be paid for his work according to the value of the cases he worked on and his contribution toward their success; (4) the taxpayer characterized the initial payment first as a loan that was forgiven, which would not be a gift, and then as an advance paid in anticipation of work he was to perform, which would also not be a gift; and (5) the taxpayer considered himself to be underpaid and confronted the attorney both on the telephone and by letter demanding a reasonable wage. The court held that the money received by the taxpayer for work performed for the attorney was taxable income and not a gift. [Alexander v. Commissioner, T.C. Summary Opinion ] Information Letter I.R.C. 61, 132 Amounts paid from after-tax income to an employer to reimburse the employer for the cost of employee parking are not excludable from taxable income. Issue This IRS information letter considers whether employee parking expenses withheld by an employer from after-tax income may be excluded from taxable income under I.R.C An employer contracted with a parking facility and pays the parking vendor directly for parking for its employees. Employees who wish to use the secure parking must agree, in writing, to reimburse the employer by having the monthly parking fee deducted from their paycheck. The employees cannot get a refund of the withheld funds if they do not use the parking. The cost of the parking is less than the statutory limit in I.R.C. 132(f)(2)(B), as adjusted by I.R.C. 132(f)(6). The employees are not given Business Issues

26 the option of choosing between taxable cash compensation and parking. The employer does not exclude the cost of the parking from the taxable wages of those employees who have elected to use the parking. Instead, the employer simply deducts the cost of the parking from the employees after-tax wages. I.R.C. 132(a)(5) provides that gross income does not include any benefit that is a qualified transportation fringe. I.R.C. 132(f)(1)(C) defines qualified transportation fringes to include qualified parking. Qualified parking includes parking provided to employees on or near the business work premises. Parking is provided by an employer if the parking is on property that the employer owns or leases, the employer pays for the parking, or the employer reimburses the employee for parking expenses. [Treas. Reg (b), Q&A-4] If the employer chooses to reimburse the employee for qualified parking expenses, the employer can do so as an addition to the employee s regular wages, or, alternatively, the employer can provide the reimbursement in place of pay. Reimbursements provided in place of pay are called compensation reduction arrangements. Under compensation reduction arrangements, the employees can elect to reduce their taxable compensation to receive tax-free reimbursements for parking expenses that the employees have actually incurred. Ruling Arrangements where an employer purchases parking spots from a parking vendor and then allows employees who wish to use the parking spots to pay the employer for the parking spots using the employees own after-tax compensation do not meet the definition of qualified parking. [Information Letter (January 25, 2017)] Marijuana High Desert Relief v. United States I.R.C. 280E, 7602, Business Issues A medical marijuana business could not quash a third-party summons by the IRS for bank and state records. The taxpayer operated a medical marijuana business in New Mexico. The IRS audited the business and issued summonses to a bank, the state of New Mexico, and the Public Service Company of New Mexico. The taxpayer challenged the summonses as an attempt to conduct a criminal investigation under the Controlled Substances Act. The IRS argued that it was only enforcing I.R.C. 280E, which disallows deductions for business expenses if the business consists of trafficking in controlled substances (within the meaning of Schedules I and II of the Controlled Substances Act) that are prohibited by federal law or the law of any state in which such trade or business is conducted. I.R.C. 208E references a criminal statute, the Controlled Substances Act. It does not first require a determination by a non-irs government official conducting a criminal investigation that the party claiming a deduction is trafficking in controlled substances. The court noted that the taxpayer had not produced any evidence that the IRS was conducting a criminal investigation beyond the normal scope of a tax audit. I.R.C. 7602(a) authorizes the IRS to examine any books, papers, records, or other data that may be relevant or material to determining the liability of any person for any internal revenue tax, and the IRS has broad authority to issue a summons for a taxpayer to produce records. I.R.C. 7609(b)(2) allows the subject of a summons to bring an action to quash a third-party summons. Under United States v. Powell, 379 U.S. 48 (1964), the IRS must demonstrate that (1) the investigation will be conducted pursuant to a legitimate purpose, (2) the inquiry may be relevant to that purpose, (3) the information sought is not already within the IRS s possession, and (4) the IRS has followed the administrative steps required by the Internal Revenue Code. The court found that the IRS summonses to produce documents were part of and limited to its

27 authorized examination of income and deductions relating to the taxpayer s tax returns. The court also found that the IRS complied with internal administrative procedures and kept the taxpayer fully informed. The court held that the IRS summons for bank and state records were a valid exercise of the IRS authority as part of a tax return audit of a medical marijuana business and refused to stay the earlier court order that dismissed the taxpayer s petition to quash the summons. [High Desert Relief. v. United States, 119 A.F.T.R. 2d (RIA) (D. N.M. 2017)] The Green Solution v. United States I.R.C. 280E, 7421 A marijuana dispensary could not bring an action to enjoin the IRS investigation into the taxpayer s marijuana sales. The taxpayer owned and operated several marijuana dispensaries in Colorado. The IRS audited the taxpayer and sought information from the taxpayer to determine if the taxpayer trafficked in a controlled substance. The taxpayer filed suit to enjoin the IRS investigation, and sought a declaratory judgment that the IRS is acting outside its statutory authority when it makes findings that a taxpayer has trafficked in a controlled substance. I.R.C. 280E disallows a deduction or credit for any amount paid or incurred in carrying on a trade or business that consists of trafficking in controlled substances. I.R.C bars suits for the purpose of restraining the assessment or collection of any tax. Section 7421 applies to preliminary IRS investigations to determine eligibility for deductions such as business expenses of marijuana dispensaries. The court held that a marijuana dispensary action to enjoin the IRS investigation into the taxpayer s marijuana sales was prohibited. [The Green Solution v. United States, 119 A.F.T.R. 2d (RIA) (10th Cir. 2017)] Self-Employment Tax Information Letter I.R.C Taxpayer s postretirement payments were selfemployment income where they were attributable to a preretirement business activity. The taxpayer retired from working as an independent contractor for a business. After retirement, the taxpayer received payments attributable to services that the taxpayer provided prior to retirement. I.R.C. 1402(b) states that payments are subject to self-employment (SE) tax if they are net earnings from self-employment derived by an individual during any tax year. Net earnings are the gross income derived by an individual from any trade or business carried on by such individual. Ruling Postretirement payments are SE income if those payments are attributable to a preretirement trade or business activity of the taxpayer. [Information Letter (November 7, 2016)] Castigliola v. Commissioner I.R.C Distributions to members of a PLLC were subject to SE tax where the members participated in the PLLC management. The taxpayers were the three members of a professional limited liability company (PLLC) that owned and operated a law practice in Mississippi. The PLLC was taxed as a partnership. The PLLC members oral agreement provided for monthly guaranteed payments to each member based on the legal salaries in their area. Any excess profit was distributed to the members. The members paid SE tax on the guaranteed payments but excluded the distributive share payments from SE income, arguing that the payments were made to limited partners. 15 Business Issues 577

28 I.R.C. 1402(a) defines net earnings from selfemployment as gross income derived by an individual from any trade or business carried on by such individual, less the deductions attributable to such trade or business, plus the distributive share (whether or not distributed) of I.R.C. 702(a)(8) partnership income or loss. I.R.C. 1402(a)(13) provides an exclusion from SE income for the distributive share of any item of income or loss of a limited partner, other than guaranteed payments, for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services. The court noted that the code does not provide a definition of limited partner for purposes of section 1402(a)(13). Thus, the court looked to federal and state partnership law. A limited partnership must have general and limited partners, with the general partners having control over the management and operation of the partnership, and limited partners being excluded from management and control. Under Mississippi limited partnership law, a limited partner loses limited liability protection if the limited partner participates in control of partnership affairs. All three taxpayers participated in the management of the PLLC, including hiring and firing of employees, supervision of associate attorneys, and signing PLLC checks. Thus, the court found that the PLLC was controlled by all the members, they were not limited partners under state and federal law, and their distributive shares of the PLLC profits were subject to SE tax. [Castigliola v. Commissioner, T.C. Memo ] Trust Fund Recovery Penalty United States v. Commander I.R.C The taxpayer was a 50% owner of an LLC with one other member. The other member was in charge of hiring, managing, and paying the employees, but both members had management authority. The taxpayer s approval was required for all company decisions, actions, and many significant financial transactions. The taxpayer had checksigning authority for the LLC s bank accounts, and the taxpayer had and exercised power to pay the company s bills and sign paychecks on occasion. The IRS assessed unpaid employee withholding taxes against both members. The other member died, and the taxpayer argued that the taxpayer did not have control over the payment of taxes sufficient to impose liability against the taxpayer. Under I.R.C. 6672, responsible persons, such as officers and managers, can be held personally liable for unpaid trust fund taxes (income, social security, and Medicare taxes) if the trust fund taxes are not paid over when due. Liability arises under section 6672 if (1) the individual was a responsible person within the business, i.e., someone required to collect, truthfully account for, or pay over the trust fund taxes; and (2) the taxpayer willfully failed to do so. A responsible person acts willfully if the person clearly should have known that there was a grave risk that the withholding taxes were not being paid and the person could easily find out if the taxes were paid. Liability under section 6672 is joint and several among responsible persons, and each responsible person can be held liable for the total amount of unpaid withholding. The taxpayer was a responsible party, and he should have known that the withholding taxes were not being paid. Thus, the taxpayer was personally liable for the unpaid withholding taxes. [United States v. Commander, 119 A.F.T.R. 2d (RIA) (D. N.J. 2017)] A member of a two-member LLC was a responsible person in the business and personally liable for unpaid employee withholding taxes. McClendon v. United States I.R.C A company owner who loaned money to the company to pay employees was liable for unpaid withholding taxes. 578 Business Issues

29 The taxpayer was a medical doctor who founded a medical services practice in In May 2009, the taxpayer discovered that the chief financial officer had failed to pay the employee withholding taxes and had embezzled the funds. The company stopped operating and remitted its remaining receivables to the IRS in partial payment of over $10,000,000 in withholding taxes. The taxpayer made a personal loan to the company solely to pay the May 2009 employee wages, and the company terminated. The taxpayer agreed that the taxpayer was a responsible person under I.R.C but argued that the taxpayer did not willfully fail to collect, account for, or pay the taxes owed because the loaned funds were encumbered by the restriction that the funds were to be used solely for payment of wages. An employer s responsible persons, such as officers and managers, can be held personally liable under section 6672 for trust fund recovery penalties if the trust fund taxes are not paid when due (see the analysis in United States v. Commander). The court found that, because the company had borrowed funds from the taxpayer and the taxpayer, as a responsible person, failed to pay those company funds to the IRS, the taxpayer acted willfully in failing to pay the employment taxes. Although the court sympathized with the taxpayer s generous attempt to support the employees, the company was not legally required to pay the loaned funds as wages, and the taxpayer s conscious decision to pay the employees before paying the IRS subjected the taxpayer to the section 6672 penalty. [McClendon v. United States, 119 A.F.T.R. 2d (RIA) (S.D. Tex. 2016)] Byrne v. United States I.R.C The president of a corporation was a responsible person but was not liable for unpaid employment taxes because the president took reasonable steps to have the taxes paid. The taxpayer was the president of a manufacturing corporation. The corporation hired a controller who was responsible for payment of employment taxes. The corporation was subject to periodic audits by independent auditors, as required by its lenders. The taxpayer was informed about irregularities in the accounting practices of the controller and the occasional failure to pay employment taxes, including the last three quarters of The taxpayer attempted to correct the problems by hiring an accountant and a chief financial officer to help the controller with the employment taxes. See the analysis in United States v. Commander for a discussion of when responsible persons can be held personally liable for unpaid trust fund taxes. The court adopted a reasonable cause exception to I.R.C. 6672(a) liability, such that a responsible person s failure to cause the withholding taxes to be paid is not willful if he believed that the taxes were in fact being paid, so long as that belief was, in the circumstances, a reasonable one. The trial court found that the taxpayer was reckless in relying on the controller for payment of the employment taxes and failing to verify the timely payment of the taxes after being informed that the taxes were not paid in 1999 and On appeal, the appellate court affirmed the trial court, holding that the taxpayer had recklessly failed to verify payment of the taxes after several reports that the taxes were not timely paid. However, the court reversed the trial court ruling on the basis that the taxpayer took reasonable steps to have the employment taxes paid and reasonably believed the taxes were paid. The taxpayer was not personally liable for the unpaid withholding taxes as a responsible person in the business who willfully failed to have the withholding taxes paid because the taxpayer took reasonable steps to correct the problem. [Byrne v. United States, 857 F.3d 319 (D. N.J. 2017)] 15 Business Issues 579

30 Ethics Nondisclosure Mescalero Apache Tribe v. Commissioner I.R.C. 6103, 3402 Employer could require discovery from the IRS of tax return information of the taxpayer s independent contractors. The taxpayer was an American Indian tribe that employed workers treated as independent contractors. The IRS reclassified the workers as employees and assessed employment taxes. The taxpayer attempted to obtain Forms 4669, Statement of Payments Received, from the independent contractors for proof that they paid the employment taxes; however, many of the contractors could not be reached or located. The taxpayer sought discovery of the workers tax returns from the IRS to determine whether they paid taxes on their income from the taxpayer as independent contractors. The IRS claimed that the return information was protected from disclosure. Under I.R.C. 3402(d), if an employer fails to deduct and withhold employment tax and its workers pay the tax, the employer is not liable for the tax. I.R.C generally bars the IRS from disclosing tax returns or information on the returns. However, I.R.C. 6103(h)(4) states that a return or return information may be disclosed in a federal or state judicial or administrative proceeding pertaining to tax administration, but only if the treatment of an item reflected on such return is directly related to the resolution of an issue in the proceeding; or such return or return information directly relates to a transactional relationship between a person who is a party to the proceeding and the taxpayer, and it directly affects the resolution of an issue in the proceeding. The court acknowledged that the courts were split on who the IRS could disclose tax return information to. A Fifth Circuit case held that section 6103(h) allows release of third-party return information only to officials of the Department of the Treasury or the Department of Justice. A Tenth Circuit case held that disclosure is proper to nonofficials in judicial and administrative tax proceedings in general. The court held that the IRS could disclose the tax return information as part of litigation involving whether the independent contractors paid the tax on their Form 1099-MISC income. [Mescalero Apache Tribe v. Commissioner, 148 T.C. No. 11 (2017)] Minda v. United States I.R.C. 6103, 7431 The taxpayers could recover statutory damages of $1,000 but no punitive damages for the IRS s wrongful disclosure of the taxpayers audit reports to an unrelated taxpayer. During an examination of the taxpayers returns, the IRS erroneously mailed part of a report to an unrelated taxpayer. The report contained the taxpayers names, social security numbers, and financial information. The Treasury Inspector General for Tax Administration investigated the error and did not conclusively discover how, why, or by whom the improper disclosure occurred except that the report of the taxpayers examination was commingled with another taxpayer s report. The taxpayers sued for improper disclosure and sought statutory and punitive damages. The trial court awarded the taxpayers only the statutory damages of $1,000. The taxpayers argued that they were entitled to additional statutory damages for each item of information disclosed. With some exceptions, I.R.C. 6103(a) prohibits the IRS from disclosing any return or return information. A return is a tax or information return, declaration of estimated tax, or claim for refund filed with the IRS. It includes amendments or supplements to a return, and supporting 580 Ethics

31 schedules, attachments, or lists [I.R.C. 6103(b) (1)]. Return information is a taxpayer s identity; the nature, source, or amount of his or her income, payments, receipts, deductions, exemptions, credits, assets, liabilities, net worth, tax liability, tax withheld, deficiencies, overassessments, or tax payments; or any other data received by, recorded by, prepared by, furnished to, or collected by the IRS [I.R.C. 6103(b)(2)(A)]. I.R.C imposes damages for unauthorized disclosure. The amount of the damages is the greater of $1,000 for each act of unauthorized inspection or disclosure of a return or return information, or the sum of the actual damages sustained by the plaintiff because of such unauthorized inspection or disclosure, plus 1. in the case of a willful inspection or disclosure or an inspection or disclosure that is the result of gross negligence, punitive damages; 2. the costs of the action; and 3. in some cases, reasonable attorney s fees. The court acknowledged that the term each act is not defined in the Internal Revenue Code, but under its ordinary meaning, each act refers to the act of disclosure and not to each item disclosed. The court held that wrongful disclosure of the taxpayers examination report was punishable by a $1,000 fine, with no recovery of punitive damages. [Minda v. United States, 851 F.3d 231 (2017)] Privilege United States v. Micro Cap KY Insurance Company I.R.C formation, including s between the taxpayer and its attorney. The taxpayer refused to produce the s based on attorney-client privilege. The IRS filed a petition to force production of the s. The magistrate judge ruled that the s were protected by the attorney-client privilege and that the doctors had not waived the privilege. On appeal, the IRS argued that the taxpayer and doctors had waived the privilege by filing a Tax Court petition claiming that they had reasonable cause (reliance on the advice of counsel) for taking certain tax positions, including the ones discussed in the s. Use of the reasonable-cause defense may result in a waiver of the attorney-client privilege in a variety of proceedings, including those before the Tax Court, where the defense would necessarily require examination of communications with attorneys. However, the assertion of the reasonable-cause defense in a pleading does not lead to the automatic disclosure of privileged documents. The court held that the taxpayer s communications with its attorneys were protected by the attorney-client privilege and not waived by the filing of a Tax Court case involving the defense of reasonable cause. The court noted, however, that the IRS had not made the document request in the Tax Court case and that the taxpayer still had the opportunity to remove the reasonablecause defense in that case to avoid disclosure of the s. Thus, any waiver of disclosure of the s would not occur until ordered in the Tax Court case. [United States v. Micro Cap KY Insurance Company, 119 A.F.T.R. 2d (RIA) (E.D. Ky. 2017)] 15 Taxpayer s to and from their tax attorneys were protected by the attorney-client privilege. The taxpayer was a captive insurance company formed by two doctors. The doctors sought the advice of attorneys in forming the company. The IRS began an examination of the taxpayer and sought documents concerning the corporate Ethics 581

32 Financial Distress give the taxpayer the ability to pay an immediate tax on income from the canceled debt, not the ability to pay the tax gradually over time. Cancellation-of-Indebtedness Income Schieber v. Commissioner I.R.C. 61, 108 The taxpayers interest in a monthly pension plan was not an asset for purposes of determining insolvency. In 2009, GMC Mortgage canceled a portion of the taxpayers mortgage. The mortgage was secured by real property that was not the taxpayers primary residence. The husband was retired and received monthly payments from a pension plan. His wife had a right to receive monthly payments upon his death. The husband and wife could not convert the interest in the pension plan into a lump sum cash amount, assign the interest, sell the interest, borrow against the interest, or borrow from the plan. The taxpayers were not in bankruptcy in 2009, but excluded a portion of the forgiven debt from their income because they were insolvent immediately before the debt was forgiven. The IRS assessed taxes based on inclusion of the entire forgiven amount in taxable income, claiming that the husband s interest in the pension plan was an asset sufficient in value to make the taxpayers solvent. I.R.C. 61(a)(12) defines gross income to include income from cancellation of debt. However, I.R.C. 108(a)(1)(B) excludes from gross income any amount that would otherwise be includable because of the cancellation of the taxpayer s debt, in whole or in part, if the cancellation occurs when the taxpayer is insolvent. I.R.C. 108(a) (3) provides that the amount of income excluded under I.R.C. 108(a)(1)(B) shall not exceed the amount by which the taxpayer is insolvent. I.R.C. 108(d)(3) defines insolvent as the excess of liabilities over the FMV of assets immediately before the cancellation of debt. An asset must The court held that the taxpayers interest in a pension plan was not included in the taxpayers assets for purposes of determining whether the taxpayers were solvent. [Schieber v. Commissioner, T.C. Memo ] Foreign Tax Foreign Bank and Financial Accounts Bedrosian v. United States 31 U.S.C. 5314, 5321 Whether the taxpayer willfully failed to file an FBAR is an inherently factual question. From the early 1970s through 2007, the taxpayer owned one or two accounts at a Swiss bank. In 2008, one account was transferred to another foreign bank, and the other was transferred to a US bank. Both accounts had balances that significantly exceeded $10,000. The taxpayer did not inform his accountant about the accounts until the 1990s, and claimed that the accountant never asked. When he told the accountant about the accounts, the taxpayer s accountant told him he was breaking the law but just leave it alone. The taxpayer s accountant died in 2007, and he retained a new accountant. The taxpayer disclosed the accounts for the first time on his 2007 tax return (but did not pay any tax on the income from the accounts). He filed for the first time a Report of Foreign Bank and Financial Accounts (FBAR). He included only one of the accounts on the FBAR. Sometime after 2008, the foreign bank told the taxpayer that it would be reporting his foreign account information to the US government. The taxpayer filed an amended 2007 return reporting 582 FINANCIAL DISTRESS

33 the income from the accounts and an amended FBAR reporting both foreign accounts. He took this corrective action after the IRS discovered the accounts, but before it commenced an audit. The IRS imposed a penalty of 50% of the maximum balance of the foreign account for willful failure to file the FBAR. The taxpayer and the IRS moved for summary judgment on the issue of whether the taxpayer willfully failed to file an FBAR. Under 31 U.S.C. 5314(a) and its corresponding regulations, US citizens must report on an annual basis to the IRS any financial interest in, or signature or other authority over, a bank, securities, or other financial account in a foreign country. [See also 31 C.F.R (a).] The required form is the FBAR (TDF ). Failure to timely file an FBAR for each foreign financial account in which a taxpayer has an interest of over $10,000 results in exposure to a civil money penalty that varies depending on the taxpayer s level of culpability [31 C.F.R (c); 31 U.S.C. 5321(a)(5)]. Nonwillful violations of the FBAR reporting requirement result in a penalty not to exceed $10,000, whereas willful violations can lead to a penalty that is the greater of $100,000 or 50% of the balance in the account at the time of the violation. 31 U.S.C. 5321(a)(5)(C)(ii) provides a reasonable-cause exception for nonwillful violations, but not for willful ones. Courts have ruled that a taxpayer has willfully violated section 5321 not only when the taxpayer knowingly violates the rule but also when the taxpayer recklessly does so. The court held that whether the taxpayer willfully failed to submit an accurate FBAR is an inherently factual question. Summary judgment on the issue of the taxpayer s willful failure to file FBARs was improper where issues of fact remained as to the intent of the taxpayer. [Bedrosian v. United States, 119 A.F.T.R. 2d (RIA) (E.D. Penn. 2017)] Income Exclusion Qunell v. Commissioner I.R.C. 911 Income earned by a taxpayer employed in Afghanistan was not eligible for the exclusion of foreign earned income. The taxpayer worked for a US defense contractor and was stationed in Afghanistan in In February 2011, the taxpayer got married and then returned to Afghanistan. His wife and children remained in the couple s home in Illinois. The taxpayer maintained several bank accounts in Illinois. In November 2011, the taxpayer resigned from employment to return to the United States, and he was unemployed the remainder of The taxpayer excluded the income earned in Afghanistan in 2011 as foreign earned income. I.R.C. 911(a) provides that a qualified individual may, subject to certain limitations, elect to exclude from gross income his or her foreign earned income. Under I.R.C. 911(d)(1), the taxpayer must be an individual whose tax home is in a foreign country. The taxpayer must also be a bona fide resident of one or more foreign countries or be physically present in such country or countries for at least 330 days in a 12-month period. I.R.C. 911(d)(3) defines tax home, in the case of an individual, as such individual s home for purposes of section 162(a)(2). Under I.R.C. 162(a)(2), a person s home is generally considered to be the location of his or her regular or principal place of business. However, section 911(d)(3) states that [an] individual shall not be treated as having a tax home in a foreign country for any period for which his abode is within the United States. That is, an individual whose abode is in the United States cannot establish that his or her tax home is in a foreign country. The court found that the taxpayer s abode was in the United States because the taxpayer owned a home there, the taxpayer s spouse and children lived there, and the taxpayer maintained bank accounts there. 15 Foreign Tax 583

34 The court held that the taxpayer s ties to Afghanistan were transitory and did not extend much beyond, if at all, the bare minimum required to perform employment duties there. The court held that the taxpayer s income from temporary employment in Afghanistan was not excludable as foreign earned income. [Qunell v. Commissioner, T.C. Summary Opinion ] Lock v. Commissioner I.R.C Foreign Tax Income earned by a taxpayer employed in Iraq was not eligible for the exclusion of foreign earned income. The taxpayer was employed by a military contractor in Iraq. He provided security services for US State Department personnel and other governmental officials. The taxpayer s spouse and child lived in Florida in a home that the taxpayer and his wife owned. The taxpayer retained a Florida driver s license, maintained bank accounts in Florida, and stored vehicles and firearms at the Florida residence. The taxpayer also maintained business interests in Florida, including rental properties. The taxpayer s employer provided minimal housing for the taxpayer in Iraq and paid for most of the expenses associated with the taxpayer s work and for travel to and from the United States. The taxpayer did not pursue any business opportunities, own any property, or maintain a bank account in Iraq. See the earlier discussion of the section 911(a) exclusion for foreign earned income. The court found that the taxpayer s presence in Iraq was temporary and Iraq was not his tax home. The court held that the taxpayer s wages earned in Iraq were not excludable foreign earned income. [Lock v. Commissioner, T.C. Summary Opinion ] Information-Reporting Penalties Flume v. Commissioner I.R.C. 6038, 6046, 6679 Owners of controlled foreign corporations were required to file Form 5471 in tax years in which they either owned 100% of the stock or sold more than 90% of the stock. The taxpayer was a US citizen residing in Mexico. In 2001, the taxpayer owned 50% of a controlled foreign corporation (CFC) (first corporation) located in Mexico. In 2002, the taxpayer sold 41% of the stock to a Mexican citizen (leaving him with 9%). In 2001, the taxpayer and his wife incorporated another foreign corporation (second corporation) in Belize. Each owned a 50% interest. The taxpayers claimed that they sold a 73% interest. Backdated amended articles of association showed that the taxpayers and their daughter each owned 9% of the corporation, but the sale was otherwise unsupported by evidence. The taxpayers application to open a foreign bank account showed them as each owning 50% of the second corporation. I.R.C. 6038(a)(1) imposes information-reporting requirements on any US person, as defined in I.R.C. 957(c), who controls a foreign corporation. A person controls a foreign corporation if the person owns or constructively owns stock that is more than 50% of the total combined voting power of all classes of voting stock or owns more than 50% of the total value of shares of all classes of stock [I.R.C. 6038(e)(2)]. Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, and the accompanying schedules are used to satisfy the I.R.C reporting requirements. Form 5471 must be filed with the US person s timely filed federal income tax return [Treas. Reg (i)]. Additionally, the information-reporting requirements apply to a US person treated as a US shareholder of a corporation that was a CFC for an uninterrupted period of 30 days during its annual accounting period and who owned stock in the CFC on the last day of the CFC s

35 annual accounting period [I.R.C. 951(a)(1), (b), and 6038(a)(4)]. A US shareholder, with respect to any foreign corporation, is defined by I.R.C. 951(b) as a US person who owns or is considered to own, under I.R.C. 958(b), 10% or more of the total combined voting power of all classes of voting stock of the CFC. I.R.C. 6046(a)(1)(A) requires information reporting by each US citizen or resident who is at any time an officer or director of a foreign corporation, where more than 10% (by vote or value) of stock is owned by a US person. I.R.C. 6046(a) (2) provides that the stock ownership threshold is met if a US person owns 10% or more of the total value of the foreign corporation s stock or 10% or more of the total combined voting power of all classes of stock with voting rights. A US person who disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the stock ownership requirement is required to provide certain information with respect to the foreign corporation [Treas. Reg (c)(1) (ii)(c)]. The penalty for failure to timely file a required Form 5471 is $10,000 per foreign corporation per annual accounting period [I.R.C. 6038(b)(1) and 6679]. If the failure to provide the required information continues for more than 90 days after the day on which the IRS mails notice of the failure to the US person, there is an additional $10,000 penalty for each 30-day period, or fraction thereof, during which the failure continues. However, the increase in any penalty under I.R.C. 6038(b)(2) cannot exceed $50,000. The instructions for Form 5471 describe the categories of persons required to file Form 5471 and the information that each category of filer is required to provide. A category 2 filer is a US person who is an officer or director of a foreign corporation, as described in I.R.C. 6046(a)(1)(A). A category 3 filer is a US person described in I.R.C. 6046(a)(1)(B), a category 4 filer is a US person that controls a foreign corporation as described in I.R.C. 6038(a)(1) and (e), and a category 5 filer is a US person that is a US shareholder of a CFC as described in I.R.C. 6038(a)(4). First corporation: The court found that the taxpayer was a category 5 filer for the first corporation because he was a US shareholder who owned stock in a CFC for an uninterrupted period of 30 days or more during tax year The court also found that the taxpayer was a category 3 filer for the first corporation in 2002 because the taxpayer sold stock to reduce the taxpayer s ownership to less than 10%. Thus, the court held that the taxpayer was required to file Form 5471 for 2001 and Second corporation: The court found that the taxpayer was a category 4 and category 5 filer for 2001 through 2009 because the taxpayer controlled the second corporation and owned individually and constructively 100% of the stock. Thus, the court found that the taxpayer was required to file Form 5471 for 2001 through [Flume v. Commissioner, T.C. Memo ] Individual Affordable Care Act Walker v. Commissioner I.R.C. 36B Married taxpayers were required to repay their advance premium tax credit even though the Marketplace determined that they were eligible for the credit. The taxpayers, husband and wife, enrolled in health insurance for 2014 though a health insurance Marketplace. The taxpayers elected to receive a monthly advance premium tax credit (APTC) of $1,077 to cover part of the cost of the monthly premium. The APTC was paid on their behalf directly to the insurance company. In February 2015, the taxpayers timely filed their 2014 Form 1040A. The taxpayers reported (1) wage income of $16,918; (2) a taxable pension or annuity distribution of $27,192; and (3) social security income of $31,089, of which $19,307 was taxable. The taxpayers reported $63,417 AGI. After filing the 2014 return, the taxpayers separately mailed Form 1095-A, Health Insurance Marketplace Statement, and Form 8962, Premium Tax Credit (PTC). The taxpayers Form 1095-A reflected monthly APTC payments of $1,077, totaling $12,924. Their Form 8962 reported $75,199 MAGI (which included the 15 Individual 585

36 nontaxable portion of social security income) and reflected a family size of two persons. The IRS determined that the taxpayers were ineligible for the premium tax credit (PTC) because their MAGI for 2014, $75,199, exceeded $62,040, which was 400% of the federal poverty level for their family size. The taxpayers asserted that the Marketplace informed them that they qualified for insurance coverage through The taxpayers also asserted that they would not have purchased insurance through the Marketplace if they had known that they did not qualify for the PTC. Under I.R.C. 36B(c)(1)(A), a taxpayer generally qualifies for the PTC if the taxpayer has household income that is equal to an amount that is at least 100%, but not greater than 400%, of the federal poverty level for the taxpayer s family size for the tax year. See also Treas. Reg. 1.36B-2(b)(1). Household income is defined as the MAGI of the taxpayer plus the MAGI of family members for whom the taxpayer properly claims deductions for personal exemptions, and who were required to a file a federal income tax return under I.R.C. 1 [I.R.C. 36B(d); Treas. Reg. 1.36B-1(d), (e)(1)]. MAGI for purposes of eligibility for the PTC is determined by adding to AGI the following amounts, which are normally excludable from income: Amounts excluded from gross income under I.R.C. 911 Tax-exempt interest the taxpayer receives or accrues during the tax year Social security benefits [within the meaning of I.R.C. 86(d)] not included in gross income under section 86 When preparing his or her income tax return, a taxpayer who received the APTC must reconcile the APTC payments made during the year with the amount of the PTC for which he or she is eligible. If the total APTC payments exceed the amount of the PTC for which the taxpayer is eligible, he or she owes the excess as a tax liability, subject to a repayment limitation in I.R.C. 36B(f)(2)(B). The court noted that the Marketplace may have incorrectly informed the taxpayers that they were entitled to a PTC for their insurance in However, the court held that the error did not overide the statute s specific requirement that the taxpayers were eligible for the PTC only if their MAGI did not exceed 400% of the federal poverty level for Therefore, the taxpayers had to repay the APTC for [Walker v. Commissioner, T.C. Summary Opinion ] Charitable Contributions Izen v. Commissioner I.R.C. 170 A charitable deduction was disallowed for a contribution of an airplane because the taxpayer failed to provide a contemporaneous written acknowledgment with the taxpayer s return. The taxpayer claimed a charitable deduction of $338,080 for contribution of a 50% interest in a 40-year-old jet to a museum in The taxpayer and an unrelated LLC originally purchased the jet in 2007 for $42,000. They never used it after the purchase. The taxpayer included with the 2010 return (1) an acknowledgement letter from the president of the museum addressed to the representative of the LLC; (2) a Form 8283, Noncash Charitable Contributions, executed by the museum s director; (3) a donation agreement signed by the president of the museum; and (4) an appraisal of the value of the donation. For gifts of $250 or more, I.R.C. 170(f)(8) requires that the taxpayer secure from the donee organization, and maintain in his or her files, a contemporaneous written acknowledgment (CWA). I.R.C. 170(f)(12) provides stringent requirements for the CWA for contributions of used vehicles, including airplanes, whose claimed value exceeds $500. The CWA must include (1) the name and taxpayer identification number of the donor; (2) the vehicle identification number or similar number; (3) a certification of the intended use or material improvement of the vehicle and the intended 586 Individual

37 duration of such use; (4) a certification that the vehicle would not be transferred in exchange for money, property, or services before completion of such use or improvement; (5) whether the donee organization provided any goods or services in exchange for the vehicle; and, if so, (6) a description and good-faith estimate of the value of such goods or services. Form 1098-C, Contributions of Motor Vehicles, Boats, and Airplanes, is used to provide the information and must be filed by the charitable organization with the IRS and furnished to the donor by February 28, 2011, for a 2010 tax year contribution. The filing requirements are strict, and the doctrine of substantial compliance is not applied. The court found that the museum did not file Form 1098-C and that the documents that the taxpayer provided with the return did not satisfy many of the specific requirements of section 170(f)(12). The donor-taxpayer did not sign the donation agreement, the donation agreement did not contain the taxpayer identification number of the taxpayer, and the deed of gift did not include a certification of the intended use of the aircraft and the intended duration of such use. Thus, the court held that the taxpayer failed to provide a CWA with the taxpayer s return and the charitable deduction was properly denied. [Izen v. Commissioner, 148 T.C. No. 5 (2017)] 15 West 17th Street LLC v. Commissioner I.R.C. 170 A charitable deduction was denied for the grant of a preservation easement to charity because the donor did not provide a CWA with the return and the donee charity included CWA information with its amended return. The taxpayer was an LLC that purchased a building in New York City. In 2007, the taxpayer granted a historic preservation easement on a portion of the building to a charitable trust. The LLC claimed a charitable deduction on its 2007 return and included copies of the property appraisal; a letter from the trust acknowledging the gift; and Form 8283, Noncash Charitable Contributions, executed by the appraiser and the trust representative. The letter from the trust did not state whether the taxpayer received any goods or services in exchange for the contribution. In 2011, the IRS audited the taxpayer s 2007 return and denied the charitable deduction because the taxpayer had not complied with the substantiation requirements. In June 2014, the trust amended its 2007 Form 990, Return of Organization Exempt From Income Tax, to include a statement that no goods or services were provided in consideration for the grant of the easement. See the earlier discussion of the I.R.C. 170(f)(8) (A) requirements for a CWA. I.R.C. 170(f)(8) (D) provides that the CWA requirements shall not apply to a contribution if the donee organization files a return, on such form and in accordance with such regulations as the Secretary may prescribe, that includes the information required in a CWA. However, the exception to the CWA provided in section 170(f)(8)(D) is not self-executing. Therefore, without executing regulations, the IRS has not implemented a regime for donee reporting. The court noted that such regulations were proposed but were withdrawn after receiving negative comments about privacy concerns. The court found that the letter sent by the trust acknowledging the gift was not a sufficient CWA because it did not state whether the trust supplied the taxpayer with anything in consideration for the gift. The grant of a historic preservation easement was not eligible for a charitable deduction because the donor did not provide a complete CWA and the donee s Form 990 did not eliminate the need for a CWA. [15 West 17th Street LLC v. Commissioner, 147 T.C. No. 19 (2016)] 15 Individual 587

38 RERI s I v. Commissioner I.R.C. 170 The donation of a remainder interest in real property was not eligible for the charitable deduction because the donor failed to report the donor s cost or other basis in the property on Form The failure to provide the cost or other tax basis of donated property on Form 8283 prohibited any charitable deduction for donation of the property. [RERI s I v. Commissioner, 149 T.C. 1 (2017)] The taxpayer was an LLC that purchased a remainder interest in commercial real property for $2,950,000. The remainder interest was subject to several covenants limiting the use of the remainder interest. The agreement that created the covenants limited the liability of the owner of the term interest for breach of the restrictions. The taxpayer assigned the remainder interest to a university and claimed a charitable gift deduction for $33,000,000. On Form 8283, Noncash Charitable Contributions, the taxpayer failed to report the taxpayer s basis in or purchase price of the remainder interest. I.R.C. 170(a)(1) allows a deduction for a charitable contribution made within the tax year only if verified under the regulations. Treas. Reg A-13(c) provides substantiation requirements that apply to charitable contributions of property worth more than $5,000. Failure to satisfy those requirements results in denial of a deduction for the contribution under section 170 [Treas. Reg A-13(c)(1)(i)]. To meet the requirements, the donor must obtain a qualified appraisal of the contributed property, attach a fully completed appraisal summary to the return on which the deduction is first claimed, and maintain records containing specified information [Treas. Reg A-13(c)(2)(i) (A), (B), and (C)]. Treas. Reg A-13(c)(4)(ii) (E) requires that the appraisal summary provide, among other things, the adjusted cost or other basis of the donated property. The regulations specifically require the taxpayer to report the cost or other basis of donated property, and the failure to provide such information cannot be excused on the grounds of substantial compliance. 588 Individual Deductions Bulakites v. Commissioner I.R.C. 71, 162, 172, 215 A deduction for voluntary alimony payments that exceeded what was ordered in a separation agreement was disallowed; interest and NOL deductions were disallowed for lack of substantiation. The taxpayer was involved in a work-related lawsuit and borrowed money in 2007 to pay the taxpayer s share of the judgment. The loan was secured by a residence and was due in The taxpayer divorced in 2009, and the divorce agreement provided for $2,000-a-month alimony to the former spouse until the residence sold, at which time the payments were to increase to $8,000 per month. The residence did not sell in 2009, and the taxpayer voluntarily increased the monthly alimony to $5,000 per month. For 2012 and 2013, the payments totaled about $50,000 each year. The taxpayer used tax return preparation software to prepare the returns for 2011 and 2012 and claimed deductions for the alimony payments, interest payments, and net operating losses carried forward. The taxpayer did not present any business records to support the interest payments as business expenses. The taxpayer did not provide a copy of schedules or other information to show the computation of the net operating loss that was carried forward. I.R.C. 215(a) allows a deduction for alimony paid. I.R.C. 71(b)(2) defines alimony, and part of the definition requires that the payment be required by a divorce or separation instrument. A divorce or separation instrument is (1) a decree of divorce or separate maintenance or a written instrument incident to such a decree, (2) a written separation agreement, or (3) a decree requiring a

39 spouse to make such payments. An oral modification of a written separation agreement does not meet the section 71 requirements. Under I.R.C. 162, a taxpayer may deduct interest paid or incurred during the tax year if the interest is an ordinary and necessary expense of carrying on a trade or business. However, a taxpayer is required to provide substantiation of the interest expense and its relationship to the trade or business. The taxpayer provided some evidence of payments on the loan but did not provide any business records regarding the loan, any loan statements, or any loan repayment schedules. The loan was due in 2008, and the taxpayer provided no evidence about why payments were still being made in 2011 and I.R.C. 172 allows a deduction for net operating loss (NOL) carryovers from earlier years, and net operating loss carrybacks from later years if the taxable income for the current year is greater than zero. Treas. Reg (c) provides that a taxpayer substantiates an NOL deduction by filing with the return a concise statement setting forth the amount of the net operating loss deduction claimed and all material and pertinent facts relative thereto, including a detailed schedule showing the computation of the net operating loss deduction. The taxpayer did not file such documentation. The court held that the taxpayer could not deduct alimony paid that exceeded the amount required in the separation agreement. The court also disallowed deductions for interest for lack of substantiation of amounts paid, and disallowed an NOL carryforward because the taxpayer failed to provide adequate substantiation of entitlement to the claimed loss carryforward. [Bulakites v. Commissioner, T.C. Memo ] Quintal v. Commissioner I.R.C. 71, 215 J stated, In accordance with Section 71(b)(1)(B) of the Code, the Husband and Wife expressly agree to designate and hereby do designate all payments required in this Exhibit as excludable and non-deductible payments for purposes of Sections 71 and 215 of the Code, respectively. The husband claimed a deduction for amounts paid, and the wife did not include amounts paid in her income. I.R.C. 71(a) provides the general rule that gross income includes amounts received as alimony or separate maintenance payments. I.R.C. 215(a) allows a deduction for alimony paid during the tax year to the extent it is includable in the recipient spouse s gross income under section 71(a). I.R.C. 71(b)(1) defines alimony as any cash payment if (1) the payment is received by a spouse under a divorce or separation instrument, (2) the divorce or separation instrument does not designate such payment as a payment that is not includable in gross income under section 71 and not allowable as a deduction under section 215, (3) the payor and payee spouses are not members of the same household when the payment is made, and (4) the payment obligation terminates at the death of the payee spouse and there is no liability to make either a cash or a property payment as a substitute for the payment after the death of the payee spouse. Under I.R.C. 71(c) (1), amounts that are payable for the support of children of the payor spouse are not alimony. The court held that the language in Exhibit J violated I.R.C. 71(b)(1)(B), and the taxpayer s payments were not deductible alimony. [Quintal v. Commissioner, T.C. Summary Opinion ] Malev v. Commissioner I.R.C A divorce agreement disqualified monthly payments to a former spouse for a deduction as alimony. The taxpayer was divorced. As part of the divorce agreement, the parties added several exhibits that were incorporated in the divorce decree. Exhibit Expenses for nonconventional treatments of spinal disease were deductible medical expenses. The taxpayer suffered from a spinal disease and decided to receive nonconventional treatment from nonmedical personnel. In 2012, the taxpayer claimed a medical expense deduction for Individual 589

40 the cost of the treatment. The taxpayer claimed that the treatments were successful in improving the taxpayer s condition. In 2016, the taxpayer received a medical diagnosis that recommended integrated medical treatment, which included much of the nonconventional treatment she paid for in I.R.C. 213(a) allows as a deduction the expenses paid during the taxable year, not compensated for by insurance or otherwise, for medical care of the taxpayer. Treas. Reg (e) allows a deduction for an expense paid by a taxpayer for healing services directed toward any structure of the body. The court noted that section 213 and the regulations thereunder do not specifically require that the treatments be furnished by an individual licensed to practice medicine, that such treatments be provided in person, or that the treatments be successful. The court noted that the 2016 diagnosis and treatment recommendation would have clearly supported the deduction for the treatments if it had come prior to the treatments. The court considered the taxpayer s sincere belief that the expenses she paid for the treatments she received were directed to cure or mitigate the symptoms of her spinal disease (even though the court doubted the effectiveness of the treatments). The expenses were not of the type that an individual would routinely incur for nonmedical reasons, and nothing in the record suggested that the relationship between the taxpayer and the service providers was other than professional. The court, in a bench opinion, held that the costs of nonconventional treatments for spinal disease were deductible medical expenses. [Malev v. Commissioner, Tax Court Docket No S (March 1, 2017)] Sas v. Commissioner I.R.C. 62, Individual The taxpayer was not allowed a deduction for legal fees incurred in an employment discrimination lawsuit because the taxpayer did not receive any recovery of damages. The taxpayer was employed by a bank during the first 8 months of Her employment was terminated for breach of fiduciary duty. The bank filed suit to recover a $612,000 bonus paid to the taxpayer in The taxpayer counterclaimed for damages from employment discrimination. The parties settled in Both sides agreed to dismiss all claims and allow the taxpayer to retain the bonus. The taxpayer and her spouse co-owned an accounting and consulting business but reported the business income and loss on Schedule E (Form 1040), Supplemental Income and Loss, and not on Schedule C (Form 1040). In 2010 and 2011, the taxpayer reported the legal fees as negative other income. The IRS argued that the legal fees were reportable only as miscellaneous itemized deductions, subject to the limitation under I.R.C. 67(a). I.R.C. 62(a)(20) allows a deduction for the litigant s legal fees and court costs in connection with any action involving a claim of unlawful discrimination, as defined under I.R.C. 62(e). Section 62(a)(20), however, does not apply to any deduction in excess of the amount includable in the taxpayer s gross income for the tax year on account of a judgment or settlement resulting from the claim. The taxpayer argued that the legal fees were allowed under section 62(a)(20) because the employment discrimination action settlement allowed the taxpayer to retain the bonus, which was taxable income and exceeded the legal fees. The court disagreed because the lawsuit itself did not generate any additional taxable income. Legal fees may be deductible under I.R.C. 162 as ordinary and necessary business expenses. Expenses are deductible under section 162 if the taxpayer establishes that they were ordinary, necessary, and paid or incurred during the tax year; and were directly connected with, or proximately resulted from, a trade or business of the taxpayer. The deductibility of legal fees under section 162 depends on the origin and character of the claim for which the legal fees were incurred and whether that claim bears a sufficient nexus to the taxpayer s business or income-producing activities. The taxpayer argued that, although the employment discrimination claim was not

41 directly related to the consulting business, the claim involved the professional reputation of the taxpayer, which would affect the consulting business. The court disagreed, holding that the employment discrimination lawsuit originated from the taxpayer s employment with the bank and did not affect the consulting business. The court noted that the taxpayer s involvement with the consulting business was not clearly and fully described by the taxpayer in this case. The court held that legal fees incurred in the employment discrimination lawsuit were deductible only as itemized miscellaneous deductions subject to the 2%-of-AGI floor. [Sas v. Commissioner, T.C. Summary Opinion ] Dependents Smyth v. Commissioner I.R.C. 151, 152 A grandparent could not claim grandchildren as dependents because their parents had claimed them as dependents. The taxpayer lived with an adult son, the son s wife, and their two children for all of The taxpayer provided all the financial support for the household. The taxpayer claimed the two grandchildren as dependents after her unemployed son said that he was not going to claim them as dependents or even file a return. The IRS denied the dependency exemptions because the son, contrary to his statements to the taxpayer, filed a return listing the children as dependents, obtained a refund, and spent it on drugs. The son then created an amended return deleting the children as dependents, but he did not properly file the amended return. He gave a copy of the amended return to the IRS counsel 2 weeks before the trial. To claim a dependent deduction for a child, the child must be a qualifying child of the taxpayer. Under I.R.C. 152, a qualifying child must (1) bear a certain relationship to the taxpayer, including a child or grandchild; (2) share a home with the taxpayer for more than one-half of the tax year; (3) be less than 19 years old; (4) provide not more than one-half of his or her own financial support for the tax year; and (5) not file a joint return. However, I.R.C. 152(c)(4)(A) provides that if the child is a qualifying child of a parent and someone else, the child is considered the qualifying child of a parent. The other person cannot claim the child as a qualifying child unless the parent does not claim the child as a dependent on his or her tax return. The taxpayer argued that the amended return that deleted the claim for the dependents allowed the taxpayer to claim the children as dependents. The court held that the taxpayer was not entitled to claim the grandchildren as dependents. The parents amended return was not properly filed, and the parents did not release their claim of the children as dependents. [Smyth v. Commissioner, T.C. Memo ] Earned Income Tax Credit Lopez v. Commissioner I.R.C. 32 A taxpayer proved sufficient income to support her claim for the earned income tax credit. The taxpayer was a self-employed cosmetologist, specializing in hairstyling. She filed Schedule C (Form 1040) reporting $17,800 income in 2012 and $17,581 in She operated her business at her residence. Her customers paid in cash, and the taxpayer did not maintain any records of the transactions. The taxpayer claimed the earned income tax credit on the 2012 and 2013 tax returns based on the income from the business and two qualified children. The IRS adjusted the income on the Schedules C to zero and disallowed the earned income tax credit for lack of any taxable income. The taxpayer presented written statements from 12 regular customers testifying as to the amounts paid by them during the tax years. 15 Individual 591

42 I.R.C. 32(a)(1) allows an eligible individual a credit against income tax. The credit is computed as a percentage of the taxpayer s earned income, which is defined in I.R.C. 32(c)(2)(A) to include wages and net earnings from self-employment. A taxpayer claiming the credit must establish that he or she had earned income and the amount of that income. The Tax Court found that, although the taxpayer had no written records to support the full amount of income reported for her cosmetology business, the written statements from customers was sufficient to find that the taxpayer had $10,000 in business income in both tax years. The court held that the taxpayer had taxable income to support allowance of the earned income tax credit, although at a lesser amount than originally claimed. [Lopez v. Commissioner, T.C. Summary Opinion ] Health Savings Account Information Letter I.R.C Individual A taxpayer enrolled in Medicare is ineligible to contribute funds to an HSA and may withdraw the funds contributed without a fine. The taxpayer retired in September 2014 and enrolled in Medicare Parts A and B. In February 2015, the taxpayer returned to work and enrolled in a health savings account (HSA) provided by the employer. The taxpayer attempted to withdraw from Medicare but has not received an answer. Under I.R.C. 223, to be eligible for an HSA, an individual must be covered under a high-deductible health plan (HDHP) on the first day of the month, not be covered by any other health plan that is not an HDHP (with certain limited exceptions), not be entitled to benefits under Medicare, and not be claimed as a dependent on another person s tax return. Entitled to benefits under Medicare means enrolled in Medicare. Thus, if an individual is enrolled and receiving benefits from any part of Medicare, he or she cannot contribute to an HSA. Ruling Because the taxpayer was enrolled in Medicare, the taxpayer was not eligible to establish an HSA and had to withdraw the amounts contributed to the HSA and include them in taxable income. There is no fine or penalty for the withdrawal of the funds from the HSA. [Information Letter (March 8, 2017)] Theft Loss Adkins v. United States I.R.C. 165 The taxpayers theft loss from a pump and dump stock scheme is allowed in a tax year in which the taxpayer is reasonably certain of no recovery, even if the claim is not abandoned. The taxpayers, husband and wife, made investments through an investment adviser working for a broker-dealer. The broker used a pump and dump scheme. It purchased stock, encouraged the clients to purchase the stock to raise the price, and then sold its purchased stock at inflated prices, causing the stock price to drop and resulting in losses for the taxpayers. In 2002, the taxpayers discovered that they had been the victims of fraud and sought restitution. In May 2004, the broker was convicted of securities fraud. Criminal proceedings against other principals of the brokerage firm continued from 2005 to 2009, and the taxpayers continued to arbitrate with regard to restitution payments. In 2006, the taxpayers claimed a theft loss deduction for tax year The IRS disallowed the deduction because the taxpayers still had a reasonable expectation of recovery, at least as to some of the losses. The Court of Federal Claims upheld the IRS s determination, and the taxpayers appealed. Treas. Reg (d)(3) provides that any loss arising from theft shall be treated as sustained in the tax year in which the taxpayer discovers the loss. However, for purposes of I.R.C. 165, if, in the year of discovery, there is a claim for

43 reimbursement and a reasonable prospect of recovery, there is no deduction for the loss for which reimbursement may be received. The taxpayer can only deduct the loss in the tax year in which the taxpayer can ascertain, with reasonable certainty, whether the taxpayer will receive reimbursement. Treas. Reg (d)(2)(i) states that whether a reasonable prospect of recovery exists with respect to a claim for reimbursement is a question of fact to be determined upon an examination of all facts and circumstances. Whether reimbursement will be received may be ascertained with reasonable certainty for example, by a settlement of the claim, by an adjudication of the claim, or by an abandonment of the claim. When a taxpayer claims that he or she has abandoned a claim for reimbursement, the taxpayer must be able to produce objective evidence of the abandonment, such as the execution of a release. The Claims Court determined that there are two standards for deductibility of a theft loss, one for the year of discovery of the loss (reasonable prospect of recovery), and one for the tax years after discovery of the theft loss (reasonable certainty of no reimbursement). The Claims Court held the taxpayers to the higher reasonable certainty standard. Other courts have required only a single test, whether the taxpayer demonstrates with reasonable certainty that there was no reasonable prospect of recovery. The appellate court acknowledged that the continuance of the arbitration proceedings was evidence of the taxpayers belief in a possible recovery, but such evidence was not conclusive proof of such belief. Thus, the appellate court remanded the case for a fuller determination of all facts and circumstances surrounding the taxpayers continuance of the arbitration proceedings. The reasonable certainty requirement for losses claimed after the year of discovery is the same test as the reasonable prospect of no recovery applied to the year the loss was discovered. The court remanded the case to apply the correct standard. [Adkins v. United States, 856 F.3d 914 (Fed. Cir. 2017)] IRS Collections Cummings v. United States I.R.C. 6159, 6331, 7122 A tax levy was not blocked by an improperly filed offer in compromise, and there was insufficient evidence to determine whether the taxpayer s installment agreement request was pending at the time of levy. The taxpayer owed approximately $125,000 for tax liabilities and civil penalties related to payroll taxes in his individual and business capacities. The IRS had been levying against the taxpayer s wages, but the levies stopped in May 2013 because the employer refused to cooperate. In March 2013, the taxpayer submitted an installment agreement request (IAR) to the IRS agent assigned to the taxpayer s account. The IRS did not respond to the request. The taxpayer s attorney contacted the IRS by fax twice to inquire about the IAR. He also left a voic message for the agent. He did not receive a response. The IRS sent another levy request to the employer in September The employer notified the taxpayer that it had received a levy request, and this was his first notice that a levy had been issued. In December 2013, the employer began withholdings from the taxpayer s wages, which continued until June The IAR was officially rejected in February 2014, the taxpayer appealed, and the IRS sustained the rejection. At some point, the taxpayer filed an offer in compromise (OIC). The IRS could not process the OIC because the taxpayer did not include the application fee and 20% down payment. In addition, the taxpayer sent the OIC to the wrong IRS office. In the OIC, the taxpayer requested the IRS use the improperly levied wages to pay the fee and down payment. In April 2015, the IRS levied against funds in the taxpayer s thrift saving plan (TSP). The taxpayer filed suit, alleging that the IRS improperly issued the levies. 15 IRS 593

44 594 IRS I.R.C. 6331(a) authorizes the IRS to collect unpaid tax liabilities through the issuance of a levy. I.R.C. 6331(k) states that the IRS cannot issue a levy while certain offers are pending or an installment agreement is pending or in effect. Specifically, no levy may be made during the period that an OIC under I.R.C is pending with the IRS. Additionally, no levy may be made during the period that an offer for an installment agreement under I.R.C is pending with the IRS. An OIC is pending beginning on the date the IRS accepts the offer for processing. Rev. Proc , C.B. 517, provides that the IRS accepts an OIC for processing when it determines that (1) the offer is submitted on the proper version of Form 656 and Form 433-A or B, as appropriate; (2) the taxpayer is not in bankruptcy; (3) the taxpayer has complied with all filing and payment requirements listed in the instructions to Form 656; (4) the taxpayer has enclosed the application fee, if required; and (5) the offer meets any other minimum requirements established by the IRS. A determination is made to accept an offer to compromise for processing when an IRS official with delegated authority to accept an offer for processing signs the Form 656. Treas. Reg provides that a proposed installment agreement must be submitted according to the procedures, and in the form and manner, prescribed by the IRS. A proposed installment agreement becomes pending when it is accepted for processing. The proposed installment agreement remains pending until the IRS accepts the proposal, the IRS notifies the taxpayer that the proposal has been rejected, or the taxpayer withdraws the proposal. A taxpayer can request an installment agreement by letter, phone contact, voic , , or other communication between the taxpayer and the IRS [I.R.M ]. But mere receipt of a request for an installment agreement does not constitute it being accepted for processing and therefore pending. The IRS claimed that the IAR was requested on the incorrect form and was sent to the wrong IRS office. The IRS argued that the IAR could not be processed because the taxpayer had not complied with all tax-filing requirements. Finally, the IRS argued that the IAR could not be pending because no transaction and action codes had been placed in the IRS Data Retrieval System. The court found that (1) the I.R.M. allows several methods of submitting an IAR, (2) there are no statutory or regulatory requirements that a taxpayer be in compliance with tax-filing requirements to request an IAR and that requirement is discretionary, and (3) the absence of the codes was not conclusive proof that the IAR was not pending. The court held that there was insufficient evidence to grant summary judgment on whether the taxpayer s IAR was pending at the time of a levy. However, the taxpayer s OIC was not pending because it was not properly submitted and the IRS had not signed Form 656. [Cummings v. United States, 119 A.F.T.R. 2d (RIA) (S.D. Ind. 2017)] Allen v. Commissioner I.R.C The IRS properly rejected a taxpayer s partialpayment installment agreement because the taxpayer was not current on estimated tax payments. The taxpayer was self-employed as an investigator. The taxpayer was assessed unpaid taxes for 2004 through 2010, including penalties for failure to file and timely pay taxes and failure to pay estimated taxes. The taxpayer submitted Form 12153, Request for a Collection Due Process or Equivalent Hearing, and checked the following boxes on that form: Installment Agreement, Offer in Compromise, and I Cannot Pay Balance. The taxpayer did not contest the amount of taxes and penalties owed but sought an installment agreement. The IRS settlement officer initially agreed to a partial payment installment agreement (PPIA) conditioned on the taxpayer making an up-front payment of his past-due 2015 estimated taxes. When the taxpayer failed to comply with this condition, the officer closed the installment agreement case, and the IRS issued a notice of determination upholding a levy of the taxpayer s assets. The taxpayer argued that the requirement to pay estimated taxes as a condition of the installment agreement was an abuse of discretion by the settlement officer.

45 In proposing a levy, an IRS settlement officer is required under I.R.C. 6330(c)(3) to (1) properly verify that the requirements of any applicable law or administrative procedure have been met, (2) consider any relevant issues the taxpayer raised, and (3) determine whether any proposed collection action balances the need for the efficient collection of taxes with the legitimate concern that any collection action be no more intrusive than necessary. The I.R.M. provides guidelines for settlement officers to follow in determining the terms of a PPIA for a taxpayer who can pay some (but not all) of his or her outstanding tax liability. The taxpayer must be in compliance with filing, withholding, federal tax deposit, and estimated tax payment requirements [see I.R.M (1)]. The court held that the IRS settlement officer did not abuse discretion in requiring the taxpayer to be current on estimated tax payments as a condition for acceptance of a PPIA. [Allen v. Commissioner, T.C. Memo ] Innocent Spouse Relief Okorogu v. Commissioner I.R.C A taxpayer who tacitly consented to a joint return was entitled to innocent spouse relief. The taxpayer was initially a stay-at-home mother and later worked as a clinical researcher. Her husband emotionally and physically abused the taxpayer, frequently in the presence of their children, and he strictly and secretively controlled the family s finances and tax matters. Forms 1040, U.S. Individual Income Tax Return, electing the status of married filing jointly were filed timely for tax years 2011 and Although the returns for 2011 and 2012 purported to bear the taxpayer s electronic signature, she did not participate in the preparation of these returns and did not sign them. The returns did not report amounts received for unemployment compensation and cancellation-of-indebtedness income. The IRS disallowed all expenses claimed as deductions on Schedules C for the husband s business activity for 2011 and 2012, disallowed Schedule A (Form 1040) itemized deductions, and made adjustments for the unreported income. The taxpayer sought and received equitable innocent spouse relief from the IRS. The taxpayer s spouse challenged the grant of relief, arguing that no valid joint return was filed because the taxpayer did not sign the electronic tax return. I.R.C. 6015(f) provides that a requesting spouse may be relieved from joint and several liability if taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or any deficiency (or any portion of either). Under I.R.C. 6015(a)(1), equitable innocent spouse relief can be granted only for an individual who has made a joint return. See also Rev. Proc , 4.01(1), I.R.B at 399. The court discussed prior cases that involved the issue of whether spouses intended to make a joint return and noted that the absence of the signature of one spouse does not necessarily preclude a finding of a valid joint return where the facts otherwise indicate that both spouses intended an income tax return to be a joint return. This tacit consent rule holds that the intent to file a joint return may be inferred from facts demonstrating that a nonsigning spouse tacitly approved or acquiesced in the other spouse s filing of the joint return. In this case, the taxpayer s spouse physically abused the taxpayer for several years and dominated the couple s finances. The taxpayer was not allowed to see the tax returns or provide a signature. The IRS accepted the return as a joint return, the taxpayer would have signed the return if given a chance, and the taxpayer made no attempt to file an amended return to change the filing status. The failure of the taxpayer to sign an electronic joint return for 2011 and 2012 did not invalidate the return and did not prevent the taxpayer from receiving equitable innocent spouse relief. [Okorogu v. Commissioner, T.C. Memo ] IRS

46 Harris v. Commissioner I.R.C IRS The taxpayer was granted innocent spouse relief from a deficiency attributable solely to the former spouse s business. The taxpayer was divorced in The taxpayer and her husband had filed a joint return for 2011, which included a Schedule C (Form 1040) for the taxpayer s real estate business activity and a Schedule C (Form 1040) for the husband s cattle ranching activity. The husband s Schedule C showed a substantial loss attributable to a depreciation deduction taken for a new barn constructed in The taxpayer was not involved in the cattle ranching activity but did review and sign the 2011 joint return. The IRS disallowed most of the 2011 loss deduction on the husband s Schedule C (Form 1040) because the cattle ranching activity was not entered into with the intent to make a profit. The taxpayer filed Form 8857, Request for Innocent Spouse Relief, but the IRS denied the request for relief. Under I.R.C. 6015(c), each spouse is treated as if he or she filed a separate return and is only liable for the taxes on his or her own income. Under section 6015(c), a requesting spouse may elect to allocate a deficiency to the income that gave rise to the deficiency if the following four conditions are met: (1) the requesting spouse filed a joint return; (2) at the time of the election, the requesting spouse is not married to the nonrequesting spouse; (3) the requesting spouse elects the application of section 6015(c) no later than 2 years after the date on which collection activities began; and (4) the deficiency remains unpaid. The IRS agreed that the taxpayer met all four conditions. Section 6015(c) relief is not available if the requesting spouse had actual knowledge of the erroneous tax item giving rise to the deficiency. Although the taxpayer was aware of the former spouse s cattle activity, the taxpayer was not aware that the activity was not entered into with an intent to make a profit because the taxpayer did not participate in the activity. The court held that the taxpayer was entitled to relief under I.R.C. 6015(c) for the deficiency attributable solely to the former spouse s cattle activity. [Harris v. Commissioner, T.C. Summary Opinion ] Taft v. Commissioner I.R.C The taxpayer was entitled to innocent spouse relief and a refund of amounts retained by the IRS to pay taxes owed on income attributable solely to the former spouse. For the 2010 tax year, the taxpayer and her husband filed a joint return. The taxpayer s husband directed the accountant to prepare the electronic return, and it was filed without the taxpayer s review or signature. The return failed to include dividends received by the husband. The couple divorced in The taxpayer filed her 2012 return and claimed a refund. The IRS retained a portion of the refund to pay the taxes assessed for the undeclared dividends from the 2010 return. The taxpayer filed Form 8857, Request for Innocent Spouse Relief, requesting that the taxpayer be relieved of the liability resulting from the unreported dividends and requesting a refund of the money that was credited to that liability. The IRS determined that the taxpayer was eligible for relief under I.R.C. 6015(c) but was not entitled to a refund. The taxpayer sought relief under I.R.C. 6015(b), which allows a refund. I.R.C. 6015(b)(1) provides that a taxpayer will be relieved of liability for an understatement of tax if (1) a joint return was made for the tax year in question; (2) there is an understatement of tax attributable to erroneous items of the nonrequesting spouse; (3) the requesting spouse establishes that in signing the return he or she did not know, and had no reason to know, that there was such understatement; (4) taking into account all the facts and circumstances, it would be inequitable to hold the requesting spouse liable for the deficiency attributable to the understatement; and (5) the requesting spouse elects to invoke this

47 section within 2 years after the date the IRS began collection actions with respect to the requesting spouse. Courts have used the following four factors to determine whether the taxpayer had reason to know about the understatement: 1. The requesting spouse s level of education 2. The requesting spouse s involvement in the family s business and financial affairs 3. The presence of expenditures that appear lavish or unusual when compared to the family s past levels of income, standard of living, and spending patterns 4. The culpable spouse s evasiveness and deceit concerning the couple s finances The court found that the taxpayer did not have education or experience in financial affairs; she did not handle the family finances, especially the secret dealings of her former spouse; she did not make lavish expenditures; and her former spouse hid his financial affairs and secretly filed the return. The court also found that condition (4) of section 6015(b) was met because the former spouse s secrecy and wasteful spending depleted the family assets. Thus, it was inequitable to hold the taxpayer liable for the actions of her former spouse. The court held that the taxpayer was entitled to innocent spouse relief under section 6015(b) and entitled to a refund of payments made on the unpaid taxes attributable to her former spouse s failure to report dividends. [Taft v. Commissioner, T.C. Memo ] Payment F.A.A F I.R.C Taxpayers may not direct excess tax deposits to be applied to the tax liability of another taxpayer. Issue A Field Attorney Advice letter discusses whether a person making a deposit under I.R.C for a potential tax liability may direct the IRS to apply all or a portion of any excess to the liability of another person. Under I.R.C. 6603, a taxpayer can deposit funds to pay certain types of tax (including income tax) that have not been assessed by the IRS at the time of the deposit. To the extent that such deposit is used to pay tax, for purposes of I.R.C (relating to interest on underpayments), the tax is treated as paid when the deposit is made. Except where the taxpayer directs otherwise, multiple deposits are treated as used for the payment of tax in the order deposited. Rev. Proc , I.R.B. 798, sets out procedures for taxpayers to make, withdraw, or identify deposits to suspend the running of interest on potential underpayments. Rev. Proc provides that a taxpayer who makes a deposit that exceeds the ultimate tax liability may direct the IRS to apply the excess as payment of another tax liability of the taxpayer. There is no authority for a taxpayer to direct payment of the excess to the liability of another taxpayer, even if the tax liability is also shared by that other taxpayer. Ruling A taxpayer may not direct the allocation of an excess tax deposit to pay the liability of another taxpayer. [F.A.A F (February 27, 2017)] Preparer Tax Identification Numbers Steele v. United States I.R.C The IRS may require tax return preparers to obtain PTINs but may not charge a fee for obtaining the PTINs. The plaintiffs were tax return preparers required by the IRS to obtain preparer tax identification numbers (PTINs) and pay a fee. The plaintiffs argued that, because the court in Loving v. IRS, 742 F.3d 1013 (D.C. Cir. 2014), held that the IRS could not regulate tax return preparers, the assignment of a PTIN did not confer any benefit to return preparers, and a fee for the PTINs was not authorized by 31 U.S.C. 9701(b). IRS

48 Treas. Reg (d) states that beginning after December 31, 2010, all tax return preparers must have a PTIN or other identifying number that was applied for and received at the time and in the manner, including the payment of a user fee, as may be prescribed by the IRS. Under I.R.C. 6109(a)(4), [a]ny return or claim for refund prepared by a tax return preparer shall bear such identifying number for securing proper identification of such preparer, his employer, or both, as may be prescribed. Agencies are authorized to prescribe regulations establishing the charge for a service or thing of value provided by the agency [31 U.S.C. 9701(b)]. The court found that the IRS may require the use of PTINs, but it may not charge fees for PTINs because this would be equivalent to imposing a regulatory licensing scheme, and the IRS does not have such regulatory authority after Loving v. IRS. [Steele v. United States, 119 A.F.T.R. 2d (RIA) (D. D.C. 2017)] Ongoing Litigation In July 2017, the court enjoined the IRS from charging a fee for PTINs and ordered the IRS to refund PTIN fees paid from September 1, 2010, to present [Steele v. United States, 119 A.F.T.R. 2d (RIA) (D. D.C. 2017)]. On July 24, 2017, the United States filed a request for a stay of the injunction pending any appeal in the case. PTINs Like-Kind Exchanges Ltr. Rul I.R.C Communication towers and supporting equipment were like-kind to property improved with cable distribution systems. The taxpayer was a communications services provider that offered communications infrastructure to its customers. The taxpayer owned fee simple or long-term leasehold interests in multiple wireless communication tower sites, each tower site consisting of fencing around the tower site, an antenna support structure for mounting antennas that are affixed to the land by a concrete foundation and attachment hardware, a nearby equipment hut with HVAC systems installed in the hut, and the land underlying the site itself. All the taxpayer s towers are permanently affixed to the land or would be extensively damaged if removed. The taxpayer exchanged its towers for cable distribution systems consisting of fiber-optic and copper cables installed either above or below ground and various other associated properties, including telephone poles for carrying the cables, underground conduits, concrete pads, attachment hardware, pedestals, guy wires, and anchors. The cable distribution systems are permanently affixed to the land or are intended to be removed only at the end of their respective useful lives. The IRS is currently issuing PTINs without a fee. See the IRS Issues chapter of this book for additional information about the ongoing need for a PTIN and the class action lawsuit to recover PTIN fees paid. I.R.C allows nonrecognition of gain or loss on an exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for like-kind properties held for productive use in a trade or business or for investment. Treas. Reg (a)-1(b) defines like-kind with reference to the nature or character of the property and not to its grade or quality. Ruling The taxpayer s real property held by fee simple or long-term leases and improved with towers is 598 IRS

49 like-kind to the real property improved with the cable distribution systems. [Ltr. Rul (November 14, 2016)] Estate of Bartell v. Commissioner, Nonacq. I.R.C The IRS issued a nonacquiescence in a case that allowed like-kind exchange treatment of a sale of business property. The taxpayer was a family-owned S corporation that operated drug stores. The taxpayer worked with a professional qualified intermediary service to purchase land for development of a new drug store. Under the agreement with the intermediary, the intermediary would purchase the land and the taxpayer would have the right to purchase the land at a stated time and price. The land and subsequent construction of a store on the land was financed by a loan guaranteed by the taxpayer. After the construction of the store, the taxpayer leased the store from the qualified intermediary. At that time, the taxpayer entered into an agreement to sell property to an unrelated party, also with a qualified intermediary. The proceeds of the sale of the taxpayer s property were used by the second qualified intermediary to acquire the new store and land from the first qualified intermediary. The Tax Court held that the transactions qualified for like-kind exchange treatment because the qualified intermediary held legal title in the land and store until shortly before the exchange occurred. The IRS does not agree with the holding in the case and generally will not follow the holding. I.R.C allows nonrecognition of gain or loss on an exchange of properties held for productive use in a trade or business or for investment if such properties are exchanged solely for like-kind properties held for productive use in a trade or business or for investment. Although Rev. Proc , C.B. 308, addresses specified reverse parking arrangements, the transactions occurring in this case occurred prior to the issuance of Rev. Proc Thus, the court applied general like-kind exchange principles and case law to the transactions in this case. In reviewing the case law involving deferred exchanges, the court noted that courts have allowed great latitude to taxpayers in structuring deferred exchanges. Thus, the court held that the taxpayer s preexchange, temporary possession of the replacement property pursuant to a lease from the exchange facilitator did not prevent like-kind exchange treatment of the transactions. The court noted that the length of time that the qualified intermediary owned the first property was 17 months, much longer than has been allowed in similar cases, and indicated that a longer period could make such transactions ineligible for like-kind exchange treatment. The IRS did not provide any reason for its nonacquiescence in the holding of Estate of Bartell. Ruling The IRS nonacquiesced as to a decision that allowed like-kind exchange treatment for a delayed exchange in which the qualified intermediary held the exchanged property for over 17 months. [Estate of Bartell v. Commissioner, 147 T.C. 140 (2016), nonacq I.R.B. 194] Loss Limitations At-Risk Limits Omega Forex Group v. United States I.R.C. 465 Pass-through losses were disallowed because the partner had no assets at risk in partnership. The taxpayer was a dentist who claimed passthrough losses in 1998 and 1999 from a partnership that engaged in currency speculation. The taxpayer claimed to have contributed $200,000 to the partnership in 1998 and $100,000 in In both cases, the contribution was in the form of a note to the partnership, although the taxpayer denied the loan. The court found that the only money paid by the taxpayer in 1998 was the fee Loss Limitations

50 charged by the partnership promoter. For 1999, the taxpayer contributed stock to the partnership, but the proceeds of liquidating the stock were deposited in an off-shore account controlled by the taxpayer. Funds in the account were used to pay personal expenses by the taxpayer. The IRS disallowed the losses. Under I.R.C. 465, deductions of losses from certain investment activities are limited to the aggregate amount the taxpayer-investor has at risk. I.R.C. 465(b)(2) provides that a taxpayer s amount at risk includes cash contributions and certain amounts borrowed with respect to the activity for which the taxpayer is personally liable for repayment or for which the taxpayer has pledged property, other than property used in the activity, as security for the borrowed amounts. The court held that the taxpayer was not at risk as to the contributions to the partnership because the taxpayer retained control and use of the funds through the off-shore account. [Omega Forex Group v. United States, 119 A.F.T.R. 2d (RIA) (D. Utah 2017)] Basis Limits Phillips v. Commissioner I.R.C An S corporation shareholder s basis in the corporation was not increased by the shareholder s liability for deficiency judgments as guarantor of the corporation s loans. The taxpayer owned 50% of an S corporation in the real estate development business in Florida and Alabama. Her husband worked for the corporation. After the collapse of the real estate market in 2008, the corporation defaulted on many of its loans used to purchase and develop real estate. The taxpayers were listed as co-guarantors for most of the loans. The lenders sued the corporation on the defaulted loans and sued the taxpayers personally on the guarantees. The taxpayers were unable or unwilling to pay the judgments. The taxpayers sought professional tax advice and claimed the judgment amounts on 600 Loss Limitations the guarantees as an increase in the wife s basis in the S corporation, which allowed the wife to claim deductions for carried-over net operating losses from prior tax years. The wife assigned $1,553,360 of the judgment amounts to her stock basis in 2008 and $30,187,249 in The IRS denied the loss deductions because the loan guaranties and judgments did not increase the wife s basis in the S corporation. I.R.C. 1366(d) provides that the aggregate amount of losses and deductions taken into account by an S corporation shareholder cannot exceed the sum of the adjusted basis of the shareholder s stock and the shareholder s adjusted basis in any indebtedness of the S corporation to the shareholder. For a taxpayer to acquire additional basis in an S corporation s indebtedness, there must be an actual economic outlay by the taxpayer. The mere guaranty of a corporation s debt is insufficient to increase a shareholder s basis. The taxpayers argued that the judgments were an actual economic outlay because the creditors looked to the wife for payment. The court disagreed, stating that the time to determine whether the lender looked to the taxpayers as the primary obligor is when the loans were made. The court found that the loans were made by the corporation and more than adequately secured by the collateral provided by the corporation. The taxpayer did not provide any evidence or testimony from the lenders that they looked to the taxpayers as the primary obligor on the loans. The court held that a shareholder s guarantee of an S corporation s loans could not increase the shareholder s basis in the corporation after becoming liable for deficiency judgments on the loans. [Phillips v. Commissioner, T.C. Memo ] Tinsley v. Commissioner I.R.C An S corporation shareholder s basis in the corporation was not increased by a loan to the corporation where there was no evidence that the creditor looked to the taxpayer for payment of the loan.

51 The taxpayer was the sole shareholder in an S corporation that operated a computer business. The corporation obtained a loan and the taxpayer personally guaranteed the loan. In 2010, the corporation was liquidated but remained liable for the loan. The taxpayer continued the business in the corporate name. In 2011, the loan was renewed in the name of the terminated corporation and was again guaranteed by the taxpayer. The taxpayer continued to make payments on the loan, although there was no evidence as to whether the payments were made from the corporation s bank account or the taxpayer s personal account. The corporation s 2010 final tax return reported an ordinary business loss and no basis for the taxpayer s stock. The taxpayer claimed the 2010 loss on his individual return. The IRS disallowed the loss because of lack of proof that the taxpayer had any basis in the taxpayer s interest in the S corporation. I.R.C. 1366(d)(1) limits the aggregate amount of losses and deductions the shareholder may take into account to the sum of (1) the adjusted basis of the shareholder s stock in the S corporation arising from capital contributions to the S corporation and (2) the shareholder s adjusted basis in any indebtedness of the S corporation. The taxpayer argued that the taxpayer assumed the loan upon the liquidation of the corporation s liquidation, and the assumption of the loan was a contribution of capital to the corporation. A guarantee of an S corporation loan by a shareholder would increase the shareholder s basis if the lender looked to the shareholder as the primary obligor for payment of the loan. However, the taxpayer did not become the sole obligor on the loan because there was no evidence of the source of the funds for the payments on the loan after the corporation liquidated, and no evidence that the renewal of the loan after the liquidation changed the terms or the named obligor on the loan. In addition, the taxpayer presented no evidence that the creditor looked solely to the taxpayer for repayment. There was no evidence that the taxpayer was the borrower and then advanced funds to the S corporation. The court held that the loan did not increase the taxpayer s basis in the corporation, and the loss was disallowed. [Tinsley v. Commissioner, T.C. Summary Opinion ] Hargis v. Commissioner I.R.C Deductions of losses from pass-through entities were disallowed because the taxpayers failed to show their basis in the entities was sufficient to cover the losses. The taxpayers, husband and wife, owned and operated nursing homes. The husband owned several S corporations that operated the nursing homes, and the husband actively managed the day-to-day operations of the facilities. The wife was a member of several LLCs that owned the real and personal property used by the S corporations. The S corporations borrowed operating funds from the LLCs, from commercial lenders, and from the other S corporations. The taxpayers were listed as coborrowers on the loans, but the loans from the LLCs and other S corporations carried no interest and were paid from income as available. The taxpayers provided no evidence that any of the lenders looked to the taxpayers for payment of the loans. The LLC s borrowed funds from commercial lenders to acquire nursing homes and to remodel the homes. The wife presented no evidence to show that the wife was personally liable for any portion of the loans, although the wife was listed as a guarantor of some of the loans along with other members of the LLCs. None of the loans were reported as recourse obligations of the LLCs. The taxpayers claimed pass-through losses from the S corporations and LLCs based on an increase in their bases in the entities from the loans. The IRS disallowed the loss deductions because the taxpayers did not have any basis in their interests in the S corporations or LLCs. See the earlier discussion of the I.R.C. 1366(d) (1) basis limits for S corporation shareholders. In this case the court found no evidence that the husband was more than potentially liable 15 Loss Limitations 601

52 personally for any of the S corporation loans. The evidence showed that the lenders looked only to the S corporations for payment and never asked the husband for payment. Although the loans required the husband to be a coborrower, there was insufficient evidence that the lenders looked to the husband for payment. The LLCs were taxed as partnerships for federal tax purposes [Treas. Reg (a)]. A deduction for a partner s distributive share of partnership losses is allowed only to the extent of the adjusted basis of the partner s interest in the partnership at the end of the partnership year in which the loss occurred [I.R.C. 704(d)]. Any increase in a partner s share of liabilities of the partnership is considered a contribution by the partner to the partnership and increases the basis of the partner s interest in the partnership [I.R.C. 722, 752(a); Treas. Reg (b)]. The court found that the LLC tax returns did not report the amount of LLC liabilities, and the wife failed to provide any evidence of the amount of the liabilities or the wife s share of those liabilities. The pass-through losses from S corporations and LLCs were disallowed because the S corporation shareholder and LLC member failed to show that loans made by the entities increased the taxpayers basis in the entities. [Hargis v. Commissioner, T.C. Memo ] Hobby Losses Stettner v. Commissioner I.R.C. 183 Losses from the taxpayers racing activity were disallowed because the racing activity was not engaged in with the intent to make a profit. The taxpayers, husband and wife, engaged in car racing activities in 2006 and The taxpayers filed Schedule C (Form 1040) for the activity for 2006 and 2007 and ceased the activity for 2007 through In 2009, the taxpayers filed bankruptcy, which was attributable to the racing losses. 602 Loss Limitations In 2011, the taxpayers restarted the racing activity under a new entity. The taxpayers filed Schedules C (Form 1040) for 2011 through In tax years 2011 and 2012, they reported net losses, and in 2013 through 2015, they reported a small net profit, although the court found that actual expenses exceeded revenues in 2013 and Despite having no formal business education and having incurred substantial losses while operating the former racing entity, the husband was confident that he could operate the new entity for a profit. He believed that nearly 20 years of racing experience, reading periodicals and online resources, and consulting with drivers who were regularly successful established the requisite expertise for operating a profitable racing business. In 2011, the husband was unemployed and spent 40 to 60 hours per week on the racing activity. In 2012 through 2015, the husband was employed and spent 15 to 20 hours per week on the racing activity. The activity generated revenues from race winnings, a sponsorship, and sales of used parts and cars. The taxpayer did not maintain separate records, a written business plan, or a separate bank account for the activity. Under I.R.C. 183, if the taxpayer cannot show an intent to engage in an activity with a profit motive, the deductions for expenses are limited to the amount of income generated by the activity. Pursuant to I.R.C. 183(d), an activity is presumed to be engaged in for profit if the activity produces income that exceeds deductions for any 3 of the 5 consecutive years that end with the tax year, unless the IRS establishes to the contrary. I.R.C. 183(e) allows a taxpayer to elect to defer the determination of whether the presumption applies until the close of the fourth tax year following the tax year in which he or she first engaged in the activity. The election must be made within 3 years after the due date of the taxpayer s return (determined without extensions) for the tax year in which the taxpayer first engages in the activity, but not later than 60 days after the taxpayer received a written notice (if any) from the appropriate IRS official proposing to disallow deductions attributable to an activity not engaged in for profit under I.R.C. 183.

53 The taxpayers timely filed Form 5213, Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit. However, the taxpayer did not produce gross income in excess of deductions for 3 of the preceding 5 tax years, and the taxpayer was not entitled to the presumption that the activities were engaged in for profit under section 183(d). Treas. Reg (b) lists the following nine factors that are used to determine whether an activity is engaged in with the intent to make a profit: 1. The manner in which the taxpayer carries on the activity 2. The expertise of the taxpayer or his or her advisers 3. The time and effort expended by the taxpayer in carrying on the activity 4. The expectation that assets used in the activity may appreciate in value 5. The success of the taxpayer in carrying on other similar or dissimilar activities 6. The taxpayer s history of income or losses with respect to the activity 7. The amount of occasional profits, if any, which are earned 8. The financial status of the taxpayer 9. Whether elements of personal pleasure or recreation are involved The court found that the racing activity was not engaged in with the intent to make a profit. The taxpayers did not carry on the activity in a business-like manner because the taxpayers did not keep separate records or bank accounts, did not have a written business plan, and did not make any changes to the activity to improve profitability. The taxpayers had no expectation that the activity s assets would appreciate, and they had no history of profit from racing activities. The activity had 4 years of losses and 1 year of profit, although the court expressed skepticism that the taxpayers had reported all costs in the year with profit, and the taxpayers received personal pleasure and enjoyment from the racing activity. The taxpayers were not allowed deductions in excess of revenues from the racing activity because the racing activity was not engaged in with the intent to make a profit. [Stettner v. Commissioner, T.C. Memo ] Passive Activity Losses Hardy v. Commissioner I.R.C. 469 The taxpayer s distributions from a limited liability company were passive income where the company activity was not grouped with the taxpayer s business activity. The taxpayer was a plastic surgeon who practiced at a facility owned by a limited liability company (LLC). The taxpayer owned a minority interest and did not have any involvement in management of the LLC. The taxpayer also performed surgery at a local hospital if the surgery could not be performed at the LLC facility. The taxpayer s patients paid the taxpayer separately for the surgery and paid the LLC for use of the facility if the surgery took place there. The taxpayer received distributions from the LLC that were not dependent on the number of surgeries performed at the LLC facility. The taxpayer, through advice from an accountant, did not group the taxpayer s surgery services with the distributions from the LLC, and the taxpayer treated the LLC distributions as passive income that offset passive losses from other activities. In general, a passive activity is any trade or business in which the taxpayer does not materially participate [I.R.C. 469(c)(1)]. A taxpayer materially participates in an activity if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis [I.R.C. 469(h)(1)]. Treas. Reg (c) describes when a taxpayer can group activities to determine material participation. It provides that one or more trade or business activities or rental activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section Loss Limitations

54 469. Whether activities constitute an appropriate economic unit depends on the facts and circumstances but the regulation gives the greatest weight to the following five factors: 1. Similarities and differences in types of trades or businesses 2. The extent of common control 3. The extent of common ownership 4. Geographical location 5. Interdependencies between or among the activities The taxpayer did not group the LLC activities with the surgical practice activities, and the two activities were sufficiently separate to support not grouping them. The taxpayer held only an investment interest in the LLC because the taxpayer was not involved in the operation of the surgical facility on a regular, continuous, and substantial basis. The court noted that the taxpayer s medical practice and the surgical facility provided different services and that the taxpayer did not create the LLC to generate passive income. The court also noted that the LLC facility received separate payments from the taxpayer s patients and made distributions to the taxpayer independent from the taxpayer s use of the facility, indicating the taxpayer s interest in the facility as an investor. The court held that the LLC distributions were passive income to the taxpayer. [Hardy v. Commissioner, T.C. Memo ] Windham v. Commissioner I.R.C. 469 The taxpayer s losses from rental properties were not passive activity losses because she was a real estate professional who materially participated in rental activities. The taxpayer was employed as a stockbroker. She worked about 2½ hours each day the US stock markets were open. The taxpayer also owned 12 rental properties and used a home office to manage the properties during the times when she was not working as a stockbroker. The taxpayer did not make the election to treat all the rental properties as one activity for federal tax purposes. 604 Loss Limitations The taxpayer presented a written summary of the hours spent on each property with a total of 901 hours for the tax year involved. The court did not identify the written summary as a contemporaneous log, or a document created for the litigation, but found the taxpayer s testimony and written evidence credible. The taxpayer claimed a net loss from the rental activities that offset her income from the stockbroker activities. A passive activity is any trade or business in which the taxpayer does not materially participate or any rental real estate activity regardless of material participation [I.R.C. 469(a)(1), (c)(1), and (2)]. Under I.R.C. 469(c)(7)(A), rental real estate activities will not be considered per se passive activities if the taxpayer is a qualifying taxpayer in a real property trade or business (i.e., a real estate professional). A taxpayer qualifies as a real estate professional if the taxpayer owns at least one interest in rental real estate and meets the requirements of I.R.C. 469(c)(7)(B). More than one-half of the personal services performed in trades or businesses by the taxpayer during such tax year must be performed in real property trades or businesses in which the taxpayer materially participates, and the taxpayer must perform more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. The court first examined whether the taxpayer materially participated in the rental activities. Temp. Treas. Reg T(a) sets forth seven tests that a taxpayer can satisfy to prove material participation in an activity. The following three of those tests were applicable in this case: The individual s participation in the activity for the tax year constitutes substantially all the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year. The individual participates in the activity for more than 100 hours during the tax year, and such individual s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not

55 owners of interests in the activity) for such year. Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year. The court found that, under all three tests, the taxpayer spent a substantial amount of time and money on each rental property throughout the tax year sufficient to materially participate in all the rental activities. Based on the written time summary and the amount of time spent as a stockbroker, the court found that the taxpayer spent more time on the rental activity than the stockbroker activity and spent more than 750 hours during the tax year on the rental activities. The court held that the losses from the rental activities were not passive activity losses because the taxpayer was a real estate professional who materially participated in the rental activities. [Windham v. Commissioner, T.C. Memo ] Penley v. Commissioner I.R.C. 469 The taxpayer s losses from rental real estate activities were passive activity losses. The taxpayer worked full-time, 2,194 hours in 2012, as an entry-level technician and a sales account representative. The taxpayer was also a real estate broker. The taxpayer and his spouse owned an S corporation that marketed commercial and residential properties. The S corporation owned two single-family rental properties and was involved in the sale of a third property to a client. The taxpayer spent some time remodeling and refurbishing the third property after the sale because the property was in poor condition. The taxpayer paid for or performed all the remodeling, but the client was liable for the mortgage. The taxpayer claimed to have spent approximately 2,520 hours on his real estate activities in Approximately 1,000 of the claimed hours were spent on remodeling the client s property. The taxpayer presented a calendar listing the property where the taxpayer worked on a particular day, a brief description of the work performed, an estimate of the number of hours worked, and the number of miles driven to and from the property. See the earlier discussion of the definition of a passive activity and the exception that applies if the taxpayer is a qualifying taxpayer in a real property trade or business (i.e., a real estate professional). The court found that the taxpayer s calendar was not credible evidence because it appeared to exaggerate the hours he worked. The court pointed out that the 2,520 hours spent on the properties plus the 2,194 spent as an employee meant that the taxpayer would have worked an average of 12 hours per day in In addition, the court noted that the calendar did not provide start and stop times, time spent on breaks or meals, or travel time. Thus, the court found that the taxpayer did not spend more time on the real estate activity than at his other employment. The court held that the losses from the taxpayer s rental real estate activity were passive activity losses. [Penley v. Commissioner, T.C. Memo ] Makhlouf v. Commissioner I.R.C. 469 Rental activity losses were passive activity losses where the taxpayer failed to provide sufficient evidence of the number of hours spent on the activity. The taxpayers, husband and wife, were retired. They owned a rental property in the United States and they co-owned an interest in several rental properties in Egypt. The taxpayers claimed a loss deduction for the US property, and the IRS disallowed most of the losses as passive activity losses. In preparation for trial, the taxpayers constructed spreadsheets of the hours spent on the rental properties based on personal diaries and some receipts. The taxpayers claimed that they were real estate professionals under I.R.C. 469 because they spent more than 750 hours during the tax year on the activities and materially participated in the rental activities. Loss Limitations

56 See the earlier discussion of the definition of a passive activity and the exception that applies if the taxpayer is a qualifying taxpayer in a real property trade or business (i.e., a real estate professional). The court found the taxpayers record of hours spent on the rental activities was unreliable because several of the entries had inflated times for simple tasks. The record duplicated several tasks by attributing them to both the husband and the wife, it often used the same time for different tasks, it rounded most of the times to the nearest hour, and none of the entries provided details of the time and work spent. The court held that the taxpayers failed to prove that they spent more than 750 hours per year on the rental activity. Therefore, losses from the activity were passive activity losses. [Makhlouf v. Commissioner, T.C. Summary Opinion ] Vacation Home Rental Cooke v. Commissioner I.R.C. 280A Losses from rental property were disallowed because the taxpayer had more than 14 days per year of personal use at the property. The taxpayer and his domestic partner each owned 50% of an LLC that was taxed as a partnership. The LLC owned a bed and breakfast property in another state and was initially managed by an in-residence manager. The taxpayer and his partner made several trips to the property, spending 26 days at the property in 2010 and 33 days in The taxpayer claimed that all but two of the days were spent in business activities on the property but did not produce any contemporaneous written evidence to support the claim. The taxpayer claimed to have performed repairs on the properties during the visits but admitted that each property had a caretaker who performed such services. However, the taxpayer presented only personal testimony and records created during the IRS audit. 606 Loss Limitations Under I.R.C. 280A(a), generally no trade or business activity deduction is allowed with respect to any dwelling unit that the taxpayer uses as a residence during the tax year. Thus, any deductions to which a taxpayer would otherwise be entitled under either I.R.C. 162 or I.R.C. 212 are disallowed if the taxpayer used the property as a residence during the tax year. A dwelling unit is used as a residence if the taxpayer uses it for personal purposes for more than the greater of 14 days or 10% of the number of days during the tax year that the unit is rented at a fair rental value [I.R.C. 280A(d)(1)]. A pass-through entity is considered to have made personal use of a dwelling unit on any day on which any beneficial owner would be considered to have made personal use of the unit. If a taxpayer uses a dwelling unit for personal purposes for any part of a day, that day is counted as one day of personal use for determining whether the taxpayer used the unit as a residence during the tax year [I.R.C. 280A(d)(2)]. Pursuant to section 280A(d)(2), if the taxpayer is engaged in repairs and maintenance of the dwelling unit substantially full-time on any day, such use will not constitute personal use of the unit. Prop. Treas. Reg A-1(e)(6) states that a dwelling unit shall not be deemed to have been used by the taxpayer for personal purposes on any day on which the principal purpose of the use of the unit is to perform repair or maintenance work on the unit. The proposed regulation sets forth a factsand-circumstances test to determine the taxpayer s principal purpose for the use of the unit. The facts and circumstances include, but are not limited to, the amount of time devoted to repair and maintenance work, the frequency of use for repair and maintenance work, and the presence and activity of companions. The court found that the taxpayer failed to provide sufficient evidence of any repair, maintenance, or business-related work performed by the taxpayer during his stays at the property. Therefore, the stays were held to be personal visits and the losses incurred by the LLC were not allowed. [Cooke v. Commissioner, T.C. Memo ]

57 Penalties Accuracy McNeill v. United States I.R.C An accuracy-related penalty was not imposed where the taxpayer showed reasonable reliance on tax advice. The taxpayer was the managing partner and tax matters partner of a partnership set up to facilitate the transfer of foreign debt to the partnership to provide the taxpayer with artificial losses to offset income from other sources. The taxpayer obtained opinions from accountants and tax attorneys as to the legality of the transactions. The court acknowledged that the transactions appeared to conform to black letter tax law but were disallowed under the economic substance doctrine, the sham partnership doctrine, and the doctrine of substance over form. The IRS determined that the transaction was an illegal tax-avoidance technique and assessed taxes and penalties. The taxpayer challenged the imposition of the penalties, arguing that he had reasonable cause for the tax position and acted in good faith. The IRS argued that the taxpayer failed to show that he received and relied on any tax advice as to the transactions involved. In addition, the IRS argued that the taxpayer was sophisticated about tax matters, the taxpayer did not provide accurate information to the tax advisers, and the advice given was not based on reasonable or supported assumptions. is a greater-than-50% likelihood that the tax treatment of the item will be upheld if challenged by the IRS. The regulations set forth several requirements that must be shown to establish such reliance. The taxpayer must show the advice was based on all pertinent facts and circumstances and the law as it relates to those facts and circumstances [Treas. Reg (c)(1)(i)]. The advice relied on must not be based on any unreasonable factual or legal assumptions, and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person [Treas. Reg (c)(1)(ii)]. The taxpayer s reliance on the advice must itself be objectively reasonable. Reliance is not reasonable if the taxpayer knew or should have known that the transaction was too good to be true, based on all the circumstances, including the taxpayer s education, sophistication, business experience, and purposes for entering into the transaction. The court held that the accuracy-related penalties were improperly assessed because the taxpayer reasonably relied on the professional tax opinions. [McNeill v. United States, 119 A.F.T.R. 2d (RIA) (D. Wyo. 2017)] Failure-to-File Crummey v. Commissioner I.R.C A taxpayer who filed fictitious trust returns claiming personal income as trust income and claiming false deductions was liable for the failure-to-file and fraudulent failure-to-file penalties. 15 Under I.R.C. 6664(c)(1), the accuracy-related penalty will not be imposed if the taxpayer establishes there was reasonable cause for the position that resulted in the penalty and the taxpayer acted in good faith in taking that position. Treas. Reg (b)(1) provides a defense to the imposition of an accuracy-related penalty where the taxpayer shows reasonable reliance on the advice of competent and independent counsel who analyzes all the pertinent facts and authorities, and who unambiguously states there Prior to 2005, the taxpayer filed Form 1040, U.S. Individual Income Tax Return, but in 2005 and 2006, the taxpayer filed Form 1041, U.S. Tax Return for Estates and Trusts, for a fictitious trust. The taxpayer reported personal income as income of the trust and claimed deductions for managing the trust and income distributions, resulting in zero taxable income and a request for a refund of withheld employment taxes. The IRS assessed penalties for failure to file and for fraudulent failure to file. Penalties 607

58 To qualify as a tax return, a document must (1) purport to be a return, (2) be executed under penalty of perjury, (3) contain sufficient data to allow calculation of tax, and (4) represent an honest and reasonable attempt to satisfy the requirements of the law. In determining whether a taxpayer s failure to file legitimate tax returns was fraudulent, the courts consider whether the taxpayer did the following: 1. Understated income 2. Maintained inadequate records 3. Failed to file tax returns 4. Gave implausible or inconsistent explanations of behavior 5. Concealed assets 6. Failed to cooperate with tax authorities 7. Engaged in illegal activities 8. Attempted to conceal illegal activities 9. Dealt in cash 10. Failed to make estimated tax payments The court found that the taxpayer knowingly did not file using the correct form, and he did not make an honest and reasonable attempt to comply with tax law. He ignored clear authority on his personal tax theory, did not consult with a tax professional, and understated and mischaracterized income. In an appellate decision designated as not for publication, the court held that the penalties for failure to file and fraudulent failure to file a return were properly assessed against the taxpayer. [Crummey v. Commissioner, 119 A.F.T.R. 2d (RIA) (5th Cir. 2017)] Estate of Hake v. United States I.R.C A penalty for late filing of an estate tax return was improper where the executors reasonably relied on professional tax advice and the filing rules were complex. The decedent died in October 2011, and her two sons were appointed as executors of the estate. Because of disputes over the estate, the executors hired a law firm to provide estate tax assistance. The attorneys recommended that the executors request an extension of time to file the estate tax return and to pay the estate tax. The estate filed Form 4678, Application for Extension of Time To File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes. The IRS granted a 6-month extension to file the estate tax return and a 1-year extension for payment of any estate tax. However, the attorneys erroneously informed the executors that the extension for filing was 1 year. The estate paid an estimate of the taxes early but did not file the return until 6 months after the extension. The estate sought abatement of the late-filing penalty. Under I.R.C. 6651(a)(1), when a taxpayer fails to file a tax return by the due date, including any extension of time for filing, a late penalty applies unless the taxpayer shows that such failure is due to reasonable cause and not due to willful neglect. Treas. Reg (c)(1) provides that reasonable cause will excuse a failure to timely file only if the taxpayer exercised ordinary business care and prudence, and was nevertheless unable to file the return within the prescribed time. The court noted that the issues surrounding the timely filing of estate tax returns, extensions to file, and extensions to pay were sufficiently complex and would confuse most nonlawyer executors. Although the court acknowledged conflicting rulings in similar cases, the court followed precedent in the Third Circuit Court of Appeals and found that the executors had reasonable cause for filing the estate tax return late because they reasonably relied on the advice of tax professionals to determine the proper date for filing the return. [Estate of Hake v. United States, 119 A.F.T.R. 2d (RIA) (M.D. Penn. 2017)] 608 Penalties

59 Tax Return Preparer Foxx v. United States I.R.C A tax return preparer was subject to a penalty for failure to make reasonable inquiries as to the taxpayer s business income used to support a claim for earned income tax credit. The taxpayer was a tax return preparer who held himself out as the tax doctor. He prepared a 2007 tax return for a client who had only $15.51 employment income. The client gave the return preparer information about her children. She testified that the return preparer told her that she would be eligible for a tax refund if she had income from a business. The client obtained a business license for an auto-detailing business that did not exist. On the sole basis of the business license and notes the return preparer made, the client included $18,000 in business income on the return and claimed the earned income tax credit (EITC). The IRS audited the return, and the client admitted to the false business income. The IRS assessed a penalty against the return preparer for a willful understatement of tax liability. I.R.C. 6694(b) assesses a penalty against any tax return preparer who prepares a tax return that willfully understates liability or shows a reckless or intentional disregard of the rules or regulations. Understatement of liability is defined in I.R.C. 6694(e) as any understatement of the net amount payable with respect to any tax imposed by this title or any overstatement of the net amount creditable or refundable with respect to any such tax. Under Treas. Reg in effect in 2008, a tax return preparer was required to perform due diligence before filing a tax return claiming the EITC. This due diligence included an obligation to make reasonable inquiries if the information furnished to, or known by, the preparer appeared to be incorrect, inconsistent, or incomplete. The court found that the return preparer did not examine any bank statements, business expense receipts, or business ledgers. He had an obligation to make reasonable inquiries into any auto-detailing business purportedly conducted by his client after she did not provide adequate documentation of the business. The court held that the failure of the tax return preparer to make reasonable inquiries into the taxpayer s alleged business was an intentional or reckless disregard of relevant Treasury regulations and justified imposition of the section 6694(b) penalty. [Foxx v. United States, 130 Fed. Cl. 415 (2017)] Due Diligence See the New and Expiring Legislation chapter of this book for a discussion of the I.R.C. 6695(g) due diligence penalty that requires a tax return preparer to exercise due diligence in claiming the child tax credit, additional child tax credit, the American opportunity tax credit, and the EITC. Retirement Contributions T.A.M I.R.C. 414, 415 Contributions to two employment benefit plans must be aggregated where the plans are provided by two entities in a controlled group. The taxpayer, a medical doctor, was the sole owner and employee of two entities (Entity 1 and Entity 2) that were characterized as a brothersister controlled group. Entity 2 was a partner in a third entity that provided medical imaging services (Entity 3). Entity 1 provided an employee benefit plan solely for the taxpayer (Plan A). Entity 3 sponsored an employee-benefit plan (Plan B). Entity 2 was a participating employer in Plan B and the taxpayer participated in Plan B as the sole employee of Entity 2. Although the Plan B funds may be commingled, all contributions are 15 Retirement 609