AICPA Conference Addresses Tax Planning in the Wake of "Status Quo" Election

Washington, D.C. - To provide tax practitioners with some clarity in a hazy post-election environment, the AICPA offered presentations by some of the nation's top legislative analysts at its Federal Tax Conference on November 7-8.

Perhaps the most informative address was delivered by Don Longano, a principal at PwC responsible for analyzing federal tax legislation. Longano provided insights into what practitioners can expect as a result of the reelection of President Obama and the continuation of the current majorities in the House and Senate.

Fiscal Cliff Looms

Probably the biggest challenge facing the President and Congress is the "fiscal cliff." This refers to three big fiscal policy deadlines that require some action in the near future. First, there is the "sequestration." The sequestration mandates large across-the-board discretionary spending cuts, affecting both defense and entitlement programs, unless Congress reaches a budget agreement. The cuts are set to go into effect on January 3, 2013. The second is the federal debt limit which will be reached in late 2012, according to some estimates, and will require bi-partisan Congressional action. And finally, funding for the government expires on May 27, 2013, which will also require bi-partisan Congressional action.

According to Longano and other speakers, if the sequestration happens, the country will be thrown into a recession. Keeping the country on the road to recovery while paying down the country's debt is a delicate balancing act, and it's unclear, given the election results, how the fiscal cliff will be resolved.

Expiration of 2001-2003 Tax Cuts and Payroll Tax Relief

Also on the front burner is whether or not to let the 2001-2003 tax cuts expire. In Longano's opinion, the Administration will likely let the cuts expire, thus increasing everyone's tax rate. Then a proposal would be put forth to lower the tax rates on individuals making less than a certain amount, maybe $250,000. This could work, he said, because no action would be required to let the 2001-2003 tax cuts expire, and "new" tax cuts are generally popular and easy to pass. There seemed, however, to be a consensus among speakers that there is little appetite in Washington for extending the payroll tax relief that was in effect for 2011 and 2012.

Expiration of Favorable Estate and Gift Tax Rates and Exemptions

There is also the issue of the expiration at the end of 2012 of favorable estate, gift, and generation skipping transfer tax rates and exemptions. Unless Congress enacts another change, those rates will revert to the rates in effect before the enactment of the 2001 tax law. Under those rules, a single graduated rate schedule with a top rate of 55 percent and a single effective exemption amount of $1 million would apply for purposes of determining the tax on cumulative taxable transfers by lifetime gift or bequest. However, the Administration has proposed making permanent the estate tax rules as in effect in 2009. In that case, the top tax rate would be 45 percent and the exemption amount would be $3.5 million for estate and generation skipping transfer taxes, and $1 million for gift taxes. Regardless, it would seem prudent to have clients in this position consider making large gifts in 2012 to use some or all of the larger exemption amounts currently in effect.

PPACA Implementation

Because this was a "status quo" election, there is no mandate to repeal the Affordable Care Act. The controversial law has effectively cleared the last hurdle to full implementation. Thus, two new taxes on high income individuals (the .9% and 3.8% so-called "Medicare" taxes) will go into effect on January 1, 2013, as scheduled.

AMT Patch

With respect to the AMT patch that expired in 2011, it is expected that Congress will cobble something together for the 2012 tax year. If Congress ever enacted real tax reform, taxpayers wouldn't need the AMT patch. But this is unlikely to happen in the near future. Thus, the AMT patch has to be one of Congress' top priorities. Speaking on Wednesday, IRS Commissioner Douglas Shulman noted that IRS forms already take into account that an AMT patch will be enacted. If that does not happen, there could be a big delay in releasing the 2012 tax forms according to Shulman.

Increased Rates on Capital Gains and Dividend Income

In addition to losing the low tax rates on ordinary income put into place in 2001-2003, tax rates are also scheduled to go up on capital gains and dividend income. For anyone who is expected to be subject to increased rates on dividend income or capital gains, including the 3.8 percent Medicare tax on investment income, Longano and other speakers recommended that such clients harvest investment gains now while the tax rates are low. Beginning in 2013, the 3.8 percent Medicare tax applies to the lesser of (1) net investment income; or (2) the excess of modified adjusted gross income over a threshold amount. The threshold amount is $250,000 in the case of individuals filing a joint return or a surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in any other case.

The Administration's Proposals

Some of the Administration's proposals for FY13 (October 1, 2012 - September 30, 2013) that are considered to have a chance of moving forward as part of a larger tax reform bill include the following:

1. A reduction in the corporate tax rate from 35 percent to 28 percent, fully offset with base-broadening options

2. Expanding and making permanent the research and development credit

3. An increase in the Section 199 deduction for domestic manufacturing to 10.7 percent to provide a 25 percent rate for certain domestic manufacturing income

4. A minimum tax on foreign profits

5. Permanently extending AMT relief

6. Freezing the estate tax at 2012 levels

7. Reducing the value of certain deductions by limiting them to a 28 percent rate.

Five-Year Cost of Existing Deductions

The Joint Committee on Taxation has released a schedule showing the cost to the Treasury (in billions of dollars) of certain deductions over a five-year period, including the following:

Exclusion of pension contributions and earnings ($933.7)

Exclusion for employer-provided health care ($725.0)

Mortgage interest deduction ($464.1)

Reduced rates on capital gains and dividends ($456.7)

Exclusion from tax of Medicare benefits ($347)

Earned income tax credit ($294.1)

Deduction for state and local income taxes, sales, and property taxes ($230.3)

Deduction for charitable contributions ($228.4)

Conclusion

In conclusion, Longano noted that the fiscal situation is so complicated and has so many moving pieces, that it's unrealistic to expect any major tax reform immediately. He believes that by late December, Congress and the President will somehow enact short-term tax relief, including an AMT patch. But in the long term, taxpayers should expect that, if there are tax rate reductions, they will be accompanied by base broadening measures.

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Track Coach Wins Hobby Loss Case after Years of Losses

Most hobby loss cases involve horses or yachts. But recently, the Tax Court was asked to decide whether a taxpayer's coaching business, which had losses for eight straight years and a profit of $43 in the ninth year, was really an activity not engaged in for profit. In Parks v. Comm'r, T.C. Summary 2012-105 (10/25/12), the Tax Court rejected the IRS's arguments and held that the coach could take a Schedule C deduction for his expenses. In so holding, the Tax Court concluded that the coach did all the right things, except make a profit, to show that his activity was not meant as a hobby. The case is instructional for preparers who have clients operating businesses at a loss and who run the risk of having the IRS deny their deductions under the hobby loss rules.

OBSERVATION: The court also noted that, in the the years following the years at issue, the taxpayer's income was increasing and deductions were decreasing - mostly due to the taxpayer turning a gang member into a world class Olympic athlete. In addition, while not mentioned in the facts of the case, the court did include in its evaluation of the factors to be considered the fact that the taxpayer's marriage and personal life were negatively affected by the fact that he devoted a large portion of his nonemployment time to his private coaching activity.

Facts

John Parks graduated from Auburn University with a degree in communications/journalism and broadcasting. He received a master's degree in 1995 from the University of Montevallo with a certification in secondary education. He began his coaching career in 1984, and from 1988 to 1991 he served as the assistant track coach at Auburn, where he was responsible for, among other things, camps and clinics sponsored by Auburn.

John worked in writing and publishing. He published freelance articles for various publications on track and field, and at one point he was the editor, publisher, and owner of a cross-country running magazine. From August 1999 through May 2006, he worked as a track coach at McKay High School in Salem, Oregon. During 2006 through 2008, John was a teacher and an athletic coach specializing in track. From February 2007 through June 2008, he worked as a track coach at Stayton High School in Stayton, Oregon. After that, he worked as an assistant track coach at Portland State University in Portland, Oregon. In 2012, he was a teacher at West Salem High School, assistant track coach at Oregon State University, and an athletic coach for Nike.

In 2006, John stopped writing and publishing and began devoting a substantial portion of his nonemployment time to a private track and field coaching activity. In October 2006, he consulted with Loren Seagrave concerning ways to increase the profitability of his private coaching activity. Seagrave is recognized as an expert in sprint and power development and coaches several Olympic and world champion track athletes. John paid Seagrave for his advice, which was to speak at more regional and national clinics, training camps, and universities. He also advised John to advertise and develop opportunities to enter the professional track ranks by showcasing the abilities of his most gifted runners.

After receiving Seagrave's advice, John focused more on college and professional runners and started conducting more track camps and clinics. John also began focusing more time on a running club that he ran from 2003 through 2008. He charged $125 to $200 per participant, depending on the season. He usually had between 12 and 20 participants and hoped to expand that to 80 or 100. However, during 2006, John lost the use of the McKay track facilities he had been using for his private coaching and had to use substandard facilities at a community college. In February 2007, although he continued to teach at McKay, John became the track coach at Stayton and was able to use the track facilities there for his private coaching. The travel between these locations and the loss of several of his private coaching athletes (caused by the loss of the McKay track facilities) were detrimental to John's private coaching activity, and as a result his 2006 year was unprofitable. In spite of these setbacks, John continued to pursue his private coaching activity.

John's 2007 year was also unprofitable because some of the athletes he was coaching at the time qualified for national meets, and he incurred large expenses for travel. John believed that national exposure of his athletes would eventually lead to more coaching opportunities, including coaching professional athletes. John's 2008 year was unprofitable for reasons similar to those he encountered during 2007.

In 2006, John began training a high school student and former gang member, Ryan Bailey. In the summer of 2008, Bailey became a qualifier for the Olympic trials in Eugene, Oregon. Bailey ran the sixth-fastest time for an American runner in the 100 meters, and his race times indicated that he was one of the world's fastest runners in the 100- and 200-meter distances. In 2009, John became Bailey's professional coach and manager and entered into a contract with Bailey that entitled John to $5,000 for 2009 and $10,000 in subsequent years, plus a percentage of any bonus that Nike agreed to pay Bailey. As a result, John's reputation and the quality of athletes he coached improved and continued to improve through the time of the Tax Court trial.

IRS Adjustments

John's wages from being a teacher and track coach during 2006, 2007, and 2008 were approximately $56,000, $56,000, and $65,000, respectively. John kept records for his private coaching activity on a computer, and he entered income from coaching contemporaneously on the computer. He also maintained all of his expense receipts for his activity and periodically recorded them on the computer. For years 2003-2011, John had income of $87,000 from his coaching business and expenses of $240,631. The only year he showed a net profit was in 2011 and the profit was $43.

The IRS audited John's 2006 through 2008 tax returns and reclassified John's expenses for all three years from Schedule C, Profit or Loss From Business, to Schedule A, Itemized Deductions, so that expenses in excess of income were not deductible, thereby generating income tax deficiencies. According to the IRS, John's private coaching activity was an activity not engaged in for profit within the meaning of Code Sec. 183.

Hobby Loss Rules

If an individual engages in an activity but does not engage in that activity for profit, no deduction attributable to that activity is allowed, except as provided in Code Sec. 183. Code Sec. 183(b)(1) allows deductions that are otherwise allowable without regard to whether the activity is engaged in for profit, and Code Sec. 183(b)(2) allows deductions that would be allowable if the activity were engaged in for profit, but only to the extent the gross income derived from the activity exceeds the deductions allowable by reason of Code Sec.183(b)(1). Code Sec. 183(c) defines an activity not engaged in for profit as any activity other than one with respect to which deductions are allowable for the tax year under Code Sec. 162 or under Code Sec. 212(1) or (2).

To take a deduction under Code Sec. 162 or Code Sec. 212(1) or (2), the taxpayer must establish that he engaged in the activity with the predominant, primary, or principal objective of realizing an economic profit independent of tax savings. Although a reasonable expectation of profit is not required, the facts and circumstances must indicate that the taxpayer entered into the activity, or continued the activity, with the actual and honest objective of making a profit. In making this determination, more weight is accorded to objective facts than to the taxpayer's statement of intent.

Factors the courts consider in determining whether an activity is engaged in for profit include: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his 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, that are earned; (8) the financial status of the taxpayer; and (9) the elements of personal pleasure or recreation. All facts and circumstances are to be taken into account, and no single factor or group of factors is determinative.

Tax Court's Analysis

The Tax Court examined the nine different factors and concluded the following with respect to each factor:

(1) Manner in Which Business Was Carried On: The court found that John maintained receipts and concurrently entered the income received into a computerized recordkeeping system and, within a reasonable time, transferred expense information to the system. He sought the professional help of Seagrave, who advised him on approaches for a more successful and profitable coaching business. By following Seagrave's advice, John began coaching more athletes with higher potential, including one with a worldwide reputation. Overall, the court stated, John's approach to his coaching activity was businesslike, and he sought ways to improve his success, including the abandonment of his journalistic pursuits. Thus, this factor weighed in John's favor.

(2) Expertise of the Taxpayer or His Advisers: There was no doubt in the court's mind that John had the expertise to coach track and field. Thus, this factor was favorable to John.

(3) Time and Effort Expended in Carrying on the Activity: The court found that John spent a substantial portion of his nonemployment time on his private coaching activity. While not mentioned in the facts of the case, the court also noted that John's marriage and personal life were negatively affected by the fact that he devoted a large portion of his nonemployment time to his private coaching activity. Accordingly, the court found this factor to be favorable to John.

(4) The Expectation That Assets Used in the Activity May Appreciate in Value: No significant assets were used in connection with John's activity, rendering this factor neutral.

(5) The Success in Carrying on Other Similar or Dissimilar Activities: The court noted that before 2006 John did not carry on similar or dissimilar activities. Other than his publication activity, John's source of income was his employment as a teacher and a coach. Accordingly, the court found this factor to be neutral.

(6) History of Income or Losses with Respect to the Activity: While noting that the three years before the court were loss years, the court also looked at the three years following the years at issue and found that John's expenses dropped and gross receipts rose precipitously so that by 2011 he cleared a modest profit. However, the court said that although it appeared that John was attempting and succeeding in the pursuit of more profitable approaches to his coaching activity, the first five years in the activity resulted in continuous losses, causing this factor to weigh against John.

(7) The Amount of Occasional Profits, if Any, That Are Earned: The court concluded that although John improved his potential for gain, the continued losses without meaningful gain were a factor that weighed against John for this analysis.

(8) Financial Status: The court found that the expenses John incurred in his private coaching activity were not intended to produce substantial tax benefits by reducing ordinary income. In these circumstances, the court observed, it is more likely that the expenses were a financial hardship to John, reducing the amount available for his living expenses. Thus, the court found this factor weighed in John's favor.

(9) Elements of Personal Pleasure or Recreation: The court noted that John's professional and personal pursuit has always been teaching and coaching. This pursuit, the court observed, is difficult to label as a hobby, despite that fact that John might derive personal pleasure from his involvement. On the basis of the amount of nonemployment time expended and the nature of the activity, the court found that this factor weighed in John's favor.

Thus, of the nine factors, the Tax Court found five favorable, two unfavorable, and two neutral. The unfavorable factors, the court noted, involved John's history of income and losses and whether he earned profits. With respect to those factors, the court noted that John's income was increasing, losses were decreasing, and his potential for success improving. Ultimately, the court found and held that John was engaged in his private coaching activity for profit for his 2006, 2007, and 2008 tax years and that his deductions were not limited by Code Sec. 183.

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IRS Issues Tax Relief to Those Affected by Hurricane Sandy; Qualified Disaster Payments Excludible from Income

The IRS is granting various forms of tax relief for those affected by Hurricane Sandy. IR-2012-82 (10/31/12); IR-2012-83; IR-2012-84 (11/2/12); IR-2012-85 (11/3/12); IR-2012-86 (11/4/12); Notice 2012-68.

In IR-2012-82, the IRS announced that it is granting taxpayers and tax preparers affected by Hurricane Sandy until November 7 to file returns and accompanying payments normally due October 31. The relief applies to taxpayers and tax preparers in an area affected by Hurricane Sandy or otherwise affected by the storm that hit the Mid-Atlantic and Northeastern United States. This relief primarily applies to businesses whose payroll and excise tax returns and payments were normally due October 31. No action is required on the part of the taxpayer; this relief is automatic. Regular federal tax deposits are due according to current rules. However, the IRS notes that if taxpayers or tax practitioners receive a penalty notice for this period, they can contact the IRS at the number on the notice to request penalty abatement due to reasonable cause on account of the storm.

Following qualifying disaster declarations issued by the Federal Emergency Management Agency (FEMA), the IRS announced in IR-2012-83, that certain taxpayers in Connecticut, New Jersey, and New York will receive the following tax relief: affected individuals and businesses will have until February 1, 2013, to file returns due in late October and pay any taxes due. This includes the fourth quarter individual estimated tax payment, normally due January 15, 2013. It also includes payroll and excise tax returns and accompanying payments for the third and fourth quarters, normally due on October 31, 2012, and January 31, 2013, respectively. It also applies to tax-exempt organizations required to file Form 990 series returns with an original or extended deadline falling during this period.

The IRS will abate any interest, late-payment, or late-filing penalty that would otherwise apply. The IRS automatically provides this relief to any taxpayer located in the disaster area. Taxpayers need not contact the IRS to get this relief.

Beyond the relief provided by law to taxpayers in the FEMA-designated counties (see below), the IRS will work with any taxpayer who lives outside the disaster area but whose books, records, or tax professional are located in the areas affected by Hurricane Sandy. All workers assisting the relief activities in the covered disaster areas who are affiliated with a recognized government or philanthropic organization are eligible for relief. Taxpayers who live outside the impacted area and think they may qualify for this relief need to contact the IRS at 866-562-5227.

In addition, the IRS is waiving failure-to-deposit penalties for federal payroll and excise tax deposits normally due on or after the disaster area start date and before November 26, if the deposits are made by November 26, 2012. Details on available relief can be found on the disaster relief page on IRS.gov.

The tax relief is part of a coordinated federal response to the damage caused by the hurricane and is based on local damage assessments by FEMA. For information on disaster recovery, individuals should visit disasterassistance.gov. So far, IRS filing and payment relief applies to the following localities:

In Connecticut (starting Oct. 27): Fairfield, Middlesex, New Haven, and New London Counties and the Mashantucket Pequot Tribal Nation and Mohegan Tribal Nation located within New London County;

In New Jersey (starting Oct. 26): Atlantic, Bergen, Cape May, Essex, Hudson, Middlesex, Monmouth, Ocean, Somerset, and Union;

In New York (starting Oct. 27): Bronx, Kings, Nassau, New York, Queens, Richmond, Rockland, Suffolk, and Westchester.

In IR-2012-84, the IRS alerted employers and other taxpayers that because Hurricane Sandy is designated as a qualified disaster for federal tax purposes, qualified disaster relief payments made to individuals by their employer or any person can be excluded from those individuals' taxable income.

In IR-2012-85, the IRS said that, in response to shortages of clear diesel fuel caused by Hurricane Sandy, it will not impose a tax penalty when dyed diesel fuel is sold for use or used on the highway.

Finally, in Notice 2012-68 and IR-2012-86, in an effort to expand the availability of housing for disaster victims and their families, the IRS announced that it will waive low-income housing tax credit rules that prohibit owners of low-income housing from providing housing to victims of Hurricane Sandy who do not qualify as low-income.

For a discussion of tax relief in disaster situations, see Parker Tax ¶79,300.

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Couple Entitled to First-Time Homebuyer Credit under Expanded Provision Added in 2009

In an issue of first impression, the Tax Court held that a married couple was entitled to the first-time homebuyer credit because one spouse had lived in a principal residence for more than five consecutive years during the eight years before the purchase of the new residence. Packard v. Comm'r, 139 T.C. No. 15 (11/5/12).

Robert Packard married Marianna Kanehl on November 22, 2008, but they continued to live in separate homes until they bought a house together on December 1, 2009. Before buying the home, Marianna owned a principal residence where she lived for more than five consecutive years during the eight years before December 1, 2009. Robert had no present ownership interest in a principal residence during the three-year period ending on December 1, 2009. When they filed their 2009 income tax return, Robert and Marianna filed as married filing jointly and claimed a $6,500 first-time homebuyer credit on the basis of the exception provided in Code Sec. 36(c)(6).

For certain years, under Code Sec. 36(a), an individual who was a first-time homebuyer of a principal residence in the United States was entitled to a tax credit for the year the home was purchased. Code Sec. 36(c)(1) defines a first-time homebuyer as any individual if such individual (and if married, such individual's spouse) had no present ownership interest in a principal residence during the three-year period ending on the date of the purchase of the principal residence. In 2009, Code Sec. 36(c)(6) was added to the Code. That provision stated that, in the case of an individual (and, if married, such individual's spouse) who owned and used the same home as that individual's principal residence for any five-consecutive-year period during the eight-year period ending on the date of the purchase of a subsequent principal residence, the individual is treated as a first-time homebuyer for purposes of the credit with respect to the purchase of such subsequent home.

Before the addition of Code Sec. 36(c)(6), the first-time homebuyer credit was limited to individuals who had no present ownership interest in a principal residence during the three-year period ending on the date of purchase of the principal residence for which the credit was claimed. Married couples could qualify for the credit only if neither spouse had a present ownership interest in a principal residence during the three-year period. Code Sec. 36(c)(6) expanded the scope of the first-time homebuyer credit by making it available to individuals who had owned and lived in the same home for at least five consecutive years during the eight years before purchasing a new principal residence.

The Tax Court was asked to decide whether the exception provided in Code Sec. 36(c)(6) required that, for a married couple, both husband and wife had to co-own and live together at the same residence for the five-consecutive-year period during the eight-year period ending on the date of purchase of the new home, or whether a married couple could also qualify for the exception in Code Sec. 36(c)(6) if one spouse qualified for the exception under Code Sec. 36(c)(6) and the other qualified as a first-time homebuyer under Code Sec. 36(c)(1). The IRS argued that, because Robert lived elsewhere during the five consecutive-year period and did not co-own the prior home, he and Marianna were not entitled to the first-time homebuyer credit.

The Tax Court disagreed with the IRS and held that, because Marianna qualified for the first-time homebuyer credit under the exception in Code Sec. 36(c)(6) and because Robert qualified for the first-time homebuyer credit under Code Sec. 36(c)(1), Robert and Marianna were entitled to the first-time homebuyer credit of $6,500.

For a discussion of the first-time homebuyer credit, see Parker Tax ¶102,705.

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Obligation to Repay Government Entities Upon Extinguishment of Easement Does Not Preclude Deduction

In an issue of first impression relating to the perpetuity requirement of conservation easement donations, an obligation to repay governmental entities does not mean the donee failed to receive its proportionate share of any extinguishment proceeds. Irby v. Comm'r, 139 T.C. No. 14 (10/25/12).

Charles and Irene Irby are members of Irby Ranches, an LLC taxed as a partnership. The LLC conveyed conservation easements encumbering two parcels of land to Colorado Open Lands (COL), a qualified charitable organization, in bargain sale transactions. The purchase portion of the transactions was funded with grants from three governmental agencies that were established to assist in the conservation of open land: (1) the Farm and Ranchland Protection Program (FRPP) of the National Resources Conservation Service (NRCS), an agency of the U.S. Department of Agriculture (USDA); (2) Great Outdoors Colorado (GOCO), a voter-created trust fund organization of the State of Colorado; and (3) the Gunnison County Land Preservation Board. One of the provisions of the deeds conveying the properties was that if the land should be condemned or the easement otherwise extinguished, the three governmental agencies that funded the bargain purchase would be reimbursed a certain amount of the proceeds relating to such condemnation or extinguishment and COL would retain the remaining amount.

The LLC reported gain with respect to the sale portion and a charitable contribution with respect to the remaining portion (the bargain portion) of the transactions. The Irbys reported their respective shares of the gain and deducted their share of the charitable contributions on their respective individual tax returns for years 2003 and 2004.

Under Code Sec. 170(h)(5)(A), a contribution is not treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity. Reg. Sec. 1.170A-14(g)(1) provides that, in general, for the conservation purpose of the donation to be enforceable in perpetuity, the interest in the property retained by the donor must be subject to legally enforceable restrictions that will prevent uses of the retained interest inconsistent with the conservation purposes of the donation. Even with the strictest protections, the possibility exists that an unexpected change in the conditions surrounding the property may make it impossible or impractical to continue the use of the property for conservation purposes. Thus, Reg. Sec. 1.170A-14(g)(6)(i) provides that the conservation purposes will continue to be treated as protected in perpetuity if the restrictions limiting the use of the property for conservation purposes are extinguished by judicial proceeding and all of the donee's proceeds from a subsequent sale or exchange of the property are used by the donee organization in a manner consistent with the conservation purposes of the original contribution.

Upon auditing the Irbys' tax return, the IRS disallowed the charitable contribution deductions they claimed for the bargain portion of the transactions. According to the IRS, (1) the conservation purpose for the easements was not protected in perpetuity because COL was required to reimburse the funding government agencies in the event it received proceeds should the land to which the easements related be condemned and the easements extinguished; (2) the Irbys' appraisal report was not a qualified appraisal because the report did not include statements that the appraisal was prepared for income tax purposes; and (3) the Irbys did not obtain contemporaneous written acknowledgments from COL indicating the amount of goods or services that the Irbys received for the contribution.

The Tax Court held that the conservation purpose of the easements was protected in perpetuity, the appraisal report met the requirements of a qualified appraisal, and the Irbys obtained the contemporaneous written acknowledgment of the transactions as required by law. The Tax Court noted that the case presented an issue of first impression: whether COL's obligation to repay the governmental entities meant that COL failed to receive its proportionate share of any extinguishment proceeds. The court rejected the IRS's argument that COLs' obligation to repay the grant money upon the extinguishment or condemnations of the easements meant that COL's entitlement to the proceeds was merely superficial. With respect to the IRS's concern as to whether all the extinguishment proceeds would be used by COL in a manner consistent with the conservation purposes of the original contribution, the court said it was mindful that while some conservation easements are gratuitously donated, others, such as the ones at issue, were acquired through bargain sale transactions. Because the Irbys required some cash consideration for the easements, the court said, COL would not have been able to further the desired conservation purpose derived by its obtaining and holding the Irby parcel easements were it unable to receive government funding.

Nor did the court share the IRS's fear that the policies and intentions do not require either the parties or their successors in interest to use the proceeds for the conservation purposes of the West and East Parcel Easements. The court said it was convinced that these institutions and their respective employees would fulfill their obligations under federal, state, and local laws. Indeed, the court noted, reimbursement under the terms of the deeds of conservation easement would enhance the ability of the NRCS, GOCO, and the Gunnison County Land Preservation Board to conserve and protect more land, since the reimbursed funds would be used to do just that.

With respect to the IRS's argument that none of the documents individually contained sufficient information to constitute a contemporaneous written acknowledgment, the court found no authority to indicate that the contemporaneous written acknowledgment may not be made up of a series of documents.

For a discussion of the rules relating to contributions of partial interests, such as easement contributions, see Parker Tax ¶84,155.

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Self-Employment Tax Applies to LLC Member Guaranteed Payments, Tax Court Holds

Guaranteed payments to an LLC member were subject to self-employment tax because the member was more than a passive investor. Howell v. Comm'r, T.C. Memo. 2012-303 (11/1/12).

In 1999, Michael Howell and his wife, Lauren, and Harold Bruzee formed a California limited liability company (LLC) named Intelemed. Intelemed is a medical technology company that provides software and hardware to hospitals. The software consists of a remote access system that enables doctors to access hospital records from outside the hospital. Michael and Harold came up with the concept that led to the formation of Intelemed. Like Michael, Harold had a background in computer networking. Harold also had the connection with the hospital to make Intelemed a success.

When Intelemed was first organized, Michael decided to make Lauren a member of Intelemed rather than himself, ostensibly because she had better credit and petitioners intended to use her credit and credit card to secure loans for Intelemed and/or to purchase items for the business. Consistent with that decision, the limited liability company operating agreement for Intelemed provided that Intelemed's members were Lauren and Harold; Lauren held 60 percent of the membership units and Harold held 40 percent. Under the operating agreement, Lauren was the record owner of a 60 percent capital interest and could dissolve Intelemed at any time and appoint the manager of Intelemed. Lauren was entitled to receive an allocation of net profits or losses in proportion to her capital interest. During the years at issue Intelemed's principal place of business was at the Howells' personal residence. Michael met with clients, set up service agreements, and handled marketing. Lauren signed Intelemed documents and discussed marketing strategies with Michael. She also allowed Michael to use her personal credit card to make purchases on behalf of Intelemed.

On its 2000 Form 1065, Intelemed reported guaranteed payments to Michael and Lauren of $35,000 and $64,000, respectively, and $57,000 to Harold. On its 2001 Form 1065, Intelemed reported guaranteed payments to Michael and Lauren of $0 and $149,000, respectively, and $80,000 to Harold. These were deducted in calculating the partnership's ordinary income. The Howells filed untimely joint federal income tax returns on which they reported Intelemed's payments to Lauren as distributive shares of partnership income properly classified as passive income not subject to self-employment tax. Michael paid self-employment tax on their distributive share of partnership income but not on the guaranteed payments. The IRS issued a deficiency notice assessing self-employment tax on the guaranteed payments of both Michael and Lauren. The Howells argued that, under Code Sec. 1402(a)(13), Lauren was a passive investor and not subject to self-employment tax and subsequently disavowed that the payments made were guaranteed payments. While a partner generally must include his or her distributive share of income in his net earnings from self-employment, Code Sec. 1402(a)(13) provides an exception for a limited partner. That exception provides that there is excluded from self-employment earnings the distributive share of any item of income or loss of a limited partner other than guaranteed payments to that partner for services actually rendered to or on behalf of the partnership, to the extent those payments are established to be in the nature of remuneration for those services.

The Tax Court held that the guaranteed payments were subject to self-employment tax and that Lauren was more than a passive investor in Intelemed. The court said the Howells could not subsequently disavow the form of the transaction as reported on the Forms 1065. While Code Sec. 1402(a)(13) does not define the term limited partner, the Tax Court noted that, in Renkemeyer, Campbell & Weaver, LLP v. Comm'r, 136 T.C. 137 (2011), it held that the taxpayers in that case were not limited partners for purposes of Code Sec. 1402(a)(13) because the distributive shares received arose from legal services they performed on behalf of a law firm and did not arise as a return on the partners' investment.

PRACTICE TIP: The Tax Court noted that Lauren contributed services that were relatively minimal in comparison to her husband's services and implied that, had there been documentation proving the extent to which the payments to her did not constitute payments for services rendered, such payments might have escaped self-employment tax. However, there was no such documentation.

For a discussion of partnership income and self-employment taxes, see Parker Tax ¶20,590.

Episodic and Intermittent Periods of Disability Didn't Excuse Taxpayer's Late Tax Filing

The taxpayer's illnesses were more episodic than long-term and thus did not excuse her from timely filing the gift tax return. Stine v. U.S., 2012 PTC 283 (Fed. Cl. 10/23/12).

Margaret Stine was required to file a gift tax return for 2007. The return was due on April 15, 2008, but wasn't filed until September of that year. Also in September, Margaret paid the gift taxes due. She acknowledged that the form and payment were late but requested the abatement of penalties due to a combination of acute but temporary health issues. The IRS assessed a penalty of $450,000, denied her request for an abatement, and also assessed interest of $21,500 on the penalty. The penalty was assessed under Code Sec. 6651, which states in relevant part that failure to timely file a tax return and taxes owed will be subject to penalty unless it is shown that such failure is due to reasonable cause and not due to willful neglect. Margaret appealed the penalty, but her appeal was denied. She then requested a refund of the penalty and interest and received no response from the IRS. Margaret then filed a refund suit in the Court of Federal Claims.

Both Margaret and the IRS relied on the Supreme Court's decision in U.S. v. Boyle, 469 U.S. 241 (1985), the leading case interpreting the terms reasonable cause and willful neglect in Code Sec. 6651(a). In that decision, the Supreme Court observed that the IRS has identified several categories of reasonable cause for a delayed filing, including the death or serious illness of the taxpayer or a member of his immediate family. Although only reasonable cause was at issue in Boyle, the Court defined both terms and concluded that a tax penalty under Code Sec. 6651(a) may be imposed for: (1) reckless indifference to the taxpayer's obligations under the tax laws; (2) failure to exercise ordinary business care and prudence; or (3) failure to show that the taxpayer was unable to file a timely return.

As the Federal Claims Court noted, the Supreme Court in Boyle did not decide how ill someone must be to escape the Code Sec. 6651(a) penalty, or whether a taxpayer's disability might eliminate the requirement in Reg. Sec. 301.6651-1(c)(1) for the exercise of ordinary business care and prudence. Additionally, the court observed, the Federal Circuit, to which this case would be appealable, has not ruled on these issues.

The Federal Claims Court noted that while there is no bright line separating health problems that diminish a taxpayer's ability to timely file taxes and serious illnesses that provide reasonable cause under Code Sec. 6651(a), certain patterns could be seen in prior decisions. Lengthy hospitalizations during tax season or prolonged symptoms that fully disable a person have been considered indications of serious illness that might constitute reasonable cause under Code Sec. 6651(a). The Federal Claims Court cited the Seventh Circuit decision in In re Carlson, 126 F.3d 915 (7th Cir. 1997) which found that the type of illness or debilitation that might create reasonable cause is one that because of severity or timing makes it virtually impossible for the taxpayer to comply - things like an emergency hospitalization or another incapacity occurring around tax time.

With respect to Margaret's health problems, the court noted that most were treated on an outpatient basis and concluded that her brief hospitalization for knee surgery in February 2008 did not provide reasonable cause. Similarly, while agreeing with Margaret's doctors that she had a bad year in 2008 due to problems with upper respiratory infections, knee pain, reactions to medications, heart palpitations, and blurred vision, the court found that these did not rise to the level of acute health crises that provided reasonable cause under Code Sec. 6651(a).

One seminal case on taxpayer disability and Code Sec. 6651(a) cited by the court was Williams v. Comm'r, 16 T.C. 893 (1951). The analysis of reasonable cause in that decision is often cited by the Tax Court. The principle of law that was derived from the Williams decision is that a taxpayer's serious illness must be of a duration that is commensurate with the failure to timely file a tax return. In other words, episodic or intermittent periods of disability are not sufficient to excuse a late tax filing - the disability must have rendered the taxpayer effectively unable to meet the obligation during the overall period of time relevant to the filing obligation. The court found that Margaret's illnesses were more episodic than long-term and thus did not excuse her from timely filing the gift tax return. Finally, the fact that Margaret was able to attend to other financial affairs during the same period of time belied the fact that she was incapacitated to the extent she could not timely file the return.

For a discussion of the penalty under Code Sec. 6651(a) and the exceptions to the penalty, see Parker Tax ¶262,105.

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District Court Rejects IRS Attempt to Impose RRTA Taxes on Employee Benefits

Payments made by a railroad with respect to financial gains realized by employees from the exercise of nonqualified stock options and made with respect to moving and relocation expense benefits were not subject to Railroad Retirement Tax Act (RRTA) taxes. BNSF Railway v. U.S., 2012 PTC 285 (N.D. Tex. 10/25/12).

In 2011, BNSF Railway filed a refund claim for taxes that it and its predecessors, and affected employees, paid to the IRS under the Railroad Retirement Tax Act for 1993 through 1998. BNSF sought refunds of two categories of tax payments. The first were payments BNRR made with respect to financial gains realized by their respective employees from the exercise by the employees of nonqualified stock options (NQSOs) they had received as part of their benefits of employment, and the second were payments BNRR made with respect to moving and relocation expense benefits received by their respective employees.

The main focus of BNSF's arguments in support of both categories of its refund claims was on the use of the word "money" in the definition of "compensation" in Code Sec. 3231(e)(1)(iii) on which RRTA taxes were paid. BNSF argued that the term "money" was not ambiguous, that the plain meaning of "money" was controlling in determining what constituted "compensation" for RRTA purposes, and that the plain meaning of "money" included only cash, coins, or other mediums of exchange. Thus, BNSF argued, the financial gains realized by the employees from the exercise of their NQSOs did not constitute any form of money remuneration subject to RRTA taxes, nor, according to BNSF, were the relocation benefits subject to RRTA taxes. With respect to the relocation benefits, BNSF noted that they were not any form of money remuneration inasmuch as the payments made by BNSF and its predecessors were made directly to third parties on behalf of the employees and no "money" was paid by BNSF or its predecessors to the employees. According to BNSF, the relocation benefits were excludible from "compensation" for RRTA purposes as bona fide and necessary expenses incurred or reasonably expected to be incurred in the business of the employer.

A district court agreed with BNSF and held that the NQSOs and relocation benefits were not subject to the RRTA tax. The court rejected the IRS's attempt to play a definitional shell game by substituting the Code Sec. 3121(a) definition of the term "wages" for the Code Sec. 3231(e)(1) definition of the term "compensation." The Code Sec. 3121(a) definition, the court noted, states that the term wages means all remuneration for employment, whereas, in contrast, the Code Sec. 3231(e) (1) definition limits the meaning of the term "compensation" drastically by substituting the word "money" for the word "all" in front of the word "remuneration."

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Overstatement of Easement Contribution Leads to Substantial Penalties for Partnership

A partnership's conservation easement contribution was overstated, and the overstatement was a gross valuation misstatement; thus, the accuracy-related penalty applied. Whitehouse Hotel Limited Partnership v. Comm'r, 139 T.C. No. 13 (10/23/12).

In 1997, Whitehouse Hotel Limited Partnership conveyed a qualified real property interest, viz, a perpetual conservation restriction, to Preservation Alliance of New Orleans, Inc., d.b.a. Preservation Resource Center of New Orleans (PRC), a Louisiana nonprofit corporation. The IRS and the partnership disagreed as to the value of the qualified conservation contribution. In Whitehouse Hotel Ltd. Partnership v. Comm'r, 131 T.C. 112 (2008), the Tax Court held that the value of the property conveyed had been overstated and that the overstatement amounted to a substantial valuation misstatement or a gross valuation misstatement and, thus, the resulting accuracy-related penalty was not excused on account of reasonable cause. The court rejected the partnership's objection to the appraisal testimony of the IRS's expert witness. The partnership had objected on the grounds that (1) the IRS appraiser was not qualified to testify as an expert as to "facade donations" and (2) even if he was so qualified, his written report was per se unreliable since it was not in conformance with the Uniform Standards of Professional Appraisal Practice (USPAP). The Tax Court held the appraiser was qualified to testify as an expert and it did not accept the USPAP as the defining standard of reliability. According to the Tax Court, failure to adhere to USPAP may affect the weight accorded to an expert appraiser's testimony, but that failure does not necessarily preclude a court's receiving the expert's testimony into evidence.

On appeal, the Fifth Circuit in Whitehouse Hotel Ltd. Partnership v. Comm'r, 615 F.3d 321 (5th Cir. 2010), vacated and remanded the Tax Court decision. The Fifth Circuit instructed the Tax Court to reconsider its finding as to the value of the contribution and reconsider its determination sustaining the accuracy-related penalty.

On remand, the Tax Court held that the deduction was overstated, that the overstatement was a gross valuation misstatement, and that the accuracy-related penalty applied. The Tax Court noted that the Fifth Circuit was correct in that it did not explicitly decide whether the highest and best use of the property was as a luxury hotel or as a nonluxury hotel. What the Tax Court did decide was that the partnership's expert erred in his opinion that the highest and best use of the property differed after the conveyance because the servitude prevented the partnership from adding stories to one of the buildings. The Tax Court discussed the Fifth Circuit's finding that a property's highest and best use is critical for determining its fair market value. But, citing the Supreme Court's decision in Olson v. U.S., 292 U.S. 246 (1934), the Tax Court noted that the highest and best use of property does not itself identify the fair market value of the property; rather, it forms the foundation for the opinion of value. Even if a potential use is profitable and the property is adaptable for that use, that use is not necessarily the measure of the value of the property. Instead, it is to be considered to the extent the prospect of demand for the use affects market value. According to the Tax Court, the point to be taken is that, although the highest and best use of property may determine a ceiling on how much a willing buyer would pay for the property, it does not necessarily determine a floor on how little a willing seller would accept. In other words, the court stated, the hypothetical willing buyer and the hypothetical willing seller who populate the standard definition of fair market value will not invariably conclude their negotiation over price at a price reflecting the value of the property at its highest and best use.

The Tax Court found that, even if the partnership's expert was right that the highest and best use of the property before the conveyance was a luxury hotel development, that did not necessarily lead to the conclusion that the fair market value of the parcel is much (if indeed any) greater than the price that would be predicted for the parcel taking into account its second best use; i.e., development as a nonluxury hotel. In the end, the Tax Court continued to reject the methodologies used by the partnership's expert and instead accepted the IRS's expert's methodology and his view that the value of the subject property under the comparable-sales approach should be determined on the basis of sales of buildings suitable for conversion into hotels - luxury or not.

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Tenth Circuit Reverses BAP; Nonrefundable Portion of Child Tax Credit Is Includible in Bankruptcy Estate

The Colorado law exempting federal or state income tax refunds from a bankruptcy estate does not apply to the nonrefundable portion of the child tax credit. In re Borgman, 2012 PTC 280 (10th Cir. 10/23/12).

Richard Borgman filed for Chapter 7 bankruptcy in Colorado in 2009. He listed his prospective tax refunds for the 2009 tax year, including a child tax credit (CTC), as exempt property on Schedule C of his bankruptcy petition. Richard's tax for 2009 was $818. Richard, who has one qualifying child, claimed an $818 CTC and this reduced his total tax to zero. He also qualified for the additional CTC, which he claimed on Line 65 of Form 1040, in the amount of $182. Between the additional CTC and the other refundable credits for which he qualified, Richard's payments totaled $3,770, all of which was refunded to him.

Under Code Sec. 24(d)(1), for certain taxpayers with earned income, a portion of the CTC that exceeds actual tax liability is refundable. The refundable component is called the additional child tax credit and it is claimed in the section of the Form 1040 devoted to Payments.

The bankruptcy trustee objected to his claim, on the grounds that Richard was claiming an exemption on a child tax credit, which is related to a nonrefundable portion credited against the amount of tax owed. Section 13-54-102(l)(o) of Colorado law exempts from a bankruptcy estate the full amount of any federal or state income tax refund attributed to an earned income tax credit or a child tax credit. Richard argued that the plain language of the Colorado law exempted the full amount of a tax refund attributed to a CTC, and that a refund that is made larger by operation of a CTC in any form is attributed to that credit. Moreover, Richard argued that, even if the exemption statute was ambiguous on this point, it should be construed liberally in his favor. Because Colorado opted out of the federal bankruptcy exemption rules, exemptions for Colorado bankrupts are governed by Colorado law.

A bankruptcy court judge sustained the trustee's objection and disallowed the exemption. Richard appealed to the Bankruptcy Appellate Panel (BAP) and the BAP reversed the bankruptcy court's decision. The trustee then appealed the BAP's reversal.

The Tenth Circuit reversed the BAP's decision and held that the bankruptcy court's disallowance of the disputed exemption was correct. The Tenth Circuit noted that Colorado courts have never addressed the question of whether the amount of a federal income tax refund attributed to a CTC under Section 13-54-102(1)(o) includes an amount equal to the nonrefundable CTC. However, the court stated, when the statutory language is clear and unambiguous, the statute must be interpreted as written without resort to interpretive rules and statutory construction. The Tenth Circuit concluded that Section 13-54-102(1)(o) unambiguously applies only to refunds and, thus, does not encompass the nonrefundable portion of the CTC.

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