Prop. Regs Would Withdraw Onerous Covered Opinion Rules and Modify Disclaimer Rules in Circular 230

Under the rules in Circular 230, which govern tax practice before the IRS, tax practitioners must meet minimum standards of conduct with respect to written tax advice, and those who do not are subject to disciplinary action, including suspension or disbarment.

Sections 10.35 and 10.37 of Circular 230 contain comprehensive rules for written tax advice. Practitioners have been complaining about the detailed rules in Section 10.35 on covered opinions since they were issued in 2004. According to practitioners, the rules are overly broad, difficult to apply, and do not necessarily produce higher quality tax advice. Practitioners have also complained that the rules unduly interfere with their client relationships and are not an ethical standard that everyone, including clients, can easily understand. Some practitioners have also opined that these rules (1) may reduce, rather than enhance, tax compliance due to the perception that a covered opinion takes more time to produce and is more expensive for the client than other tax advice; and (2) increase the likelihood that practitioners will provide oral advice to their clients when written advice is more appropriate because the covered opinion rules do not govern oral advice.

Another concern the IRS said it has been hearing from practitioners is about the unrestrained use of disclaimers on nearly every practitioner communication, regardless of whether the communication contains tax advice. Practitioners have said this practice discourages compliance with the ethical requirements because some practitioners have concluded that, if they include a disclaimer, they are free to disregard the standards in Circular 230 regarding written tax advice. The disclaimers also lead to confusion for clients because clients often do not understand why the disclaimer is present and its consequences. In addition, practitioners have complained that the disclaimer's widespread overuse causes clients to ignore the disclaimers altogether, and may render their use in some circumstances irrelevant.

As a result of these continuing complaints, the IRS has issued proposed regulations (REG-138367-06 (9/17/12)) that would eliminate the covered opinion rules in Section 10.35, expand the requirements for written advice under Section 10.37, and withdraw the proposed regulations in Section 10.39 governing requirements for state or local bond opinions. The proposed regulations would also broaden the scope of the procedures to ensure compliance (i.e., Section 10.36) by requiring that a practitioner with principal authority for overseeing a firm's federal tax practice take reasonable steps to ensure the firm has adequate procedures in place for purposes of complying with Circular 230. The proposed regulations would clarify that practitioners must exercise competence when engaged in practice before the IRS and that the prohibition on a practitioner endorsing or otherwise negotiating any check issued to a taxpayer with respect to a federal tax liability applies to government payments made by any means, electronic or otherwise. In addition, the proposed regulations would expand the categories of violations subject to the expedited proceedings in Section 10.82 to include failures to comply with a practitioner's personal tax filing obligations that demonstrate a pattern of willful disreputable conduct and also clarify the Office of Professional Responsibility's scope of responsibility.

COMPLIANCE TIP: The proposed regulations are not effective until finalized.

Elimination of Covered Opinion Rules

Currently, Circular 230, Section 10.35, provides that a covered opinion is written advice (including electronic communications) by a practitioner concerning one or more federal tax issues arising from:

(1) a transaction that is the same as or substantially similar to a transaction that, at the time the advice is rendered, the IRS has determined to be a tax avoidance transaction and identified by published guidance as a listed transaction;

(2) any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, the principal purpose of which is the avoidance or evasion of any tax imposed by the Internal Revenue Code; or

(3) any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, a significant purpose of which is the avoidance or evasion of any tax imposed by the Internal Revenue Code, if the written advice is:

(a) a reliance opinion;

(b) a marketed opinion;

(c) subject to conditions of confidentiality; or

(d) subject to contractual protection (Circular 230, Section 10.35(b)(2)(i)).

According to the IRS, significant progress has been made in combating abusive tax shelters and schemes, and preventing unscrupulous individuals from promoting those arrangements. In recent years, heightened awareness of the ethical standards governing tax advice contributed to this improved state and has benefited practitioners, taxpayers, and the government. At the same time, the IRS said there is no direct evidence to suggest that the overly technical and detailed requirements of current Section 10.35 were responsible for, or particularly effective at, curtailing the behavior of individuals attempting to profit from promoting frivolous transactions or transactions without a reasonable basis. For these reasons, the proposed regulations eliminate the covered opinion rules in Section 10.35 and instead subject all written tax advice to streamlined standards under proposed Section 10.37, as described below.

OBSERVATION: According to the IRS, the elimination of the covered opinion rules is expected to save tax practitioners approximately $5.3 million. This number, the IRS stated, does not include a number of other significant savings to both tax practitioners and taxpayers relating to the cost of obtaining a covered opinion under the current rules that would occur as a result of the proposed regulations. The IRS noted that practitioners spend many hours each year determining whether they need to prepare a covered opinion for a client or if the advice falls into one of the exceptions. This requires significant time to, among other things, research and review the complicated covered opinion rules and discuss the issue with other practitioners in the firm to determine the right course of action. If the practitioner decides, after undertaking these activities, that a covered opinion is necessary, the practitioner must discuss the covered opinion rules with the client, including how the rules affect the scope of the work that the client has asked the practitioner to perform, because the client will incur significant extra costs to obtain the written advice the client requested. These significant extra costs can, in some cases, tip the scales against obtaining written advice.

Revised Rules for Written Advice

Proposed Section 10.37 of Circular 230 would replace the covered opinion rules with basic principles to which all practitioners must adhere when rendering written advice. Specifically, the proposed regulations revise Section 10.37 to state affirmatively the standards to which a practitioner must adhere when providing written advice on a federal tax matter. It requires, among other things, that the practitioner base all written advice on reasonable factual and legal assumptions, exercise reasonable reliance, and consider all relevant facts that the practitioner knows or should know. A practitioner must also use reasonable efforts to identify and ascertain the facts relevant to written advice on a federal tax matter under the proposed regulations. Consistent with current Section 10.37, the proposed regulations provide that a practitioner must not, in evaluating a federal tax matter, take into account the possibility that a tax return will not be audited or that an issue will not be raised on audit.

The proposed regulations would eliminate the provision in the current regulations that prohibits a practitioner from taking into account the possibility that an issue will be resolved through settlement if raised when giving written advice evaluating a federal tax matter. According to the IRS, the current rule may unduly restrict the ability of a practitioner to provide comprehensive written advice because the existence or nonexistence of legitimate hazards that may make settlement more or less likely may be a material issue for which the practitioner has an obligation to inform the client. The proposed regulations provide that the IRS will continue to apply a heightened standard of review to determine whether a practitioner has satisfied the written advice standards when the practitioner knows or has reason to know that the written advice will be used in promoting, marketing, or recommending an investment plan or arrangement a significant purpose of which is the avoidance or evasion of any tax imposed by the Internal Revenue Code.

The proposed regulations would also provide that a practitioner may rely on the advice of another practitioner only if the reliance on that advice is reasonable and in good faith considering the facts and circumstances. The reliance is not considered reasonable when the practitioner knows or should know that the opinion of the other practitioner should not be relied on, the other practitioner is not competent to provide the advice, or the other practitioner has a conflict of interest.

Unlike current covered opinion rules, the proposed regulations do not require that the practitioner describe in the written advice the relevant facts (including assumptions and representations), the application of the law to those facts, and the practitioner's conclusion with respect to the law and the facts. Rather, the scope of the engagement and the type and specificity of the advice sought by the client, in addition to all other appropriate facts and circumstances, are factors in determining the extent that the relevant facts, application of the law to those facts, and the practitioner's conclusion with respect to the law and the facts must be set forth in the written advice. Also, unlike the current covered opinion rules, the proposed regulations provide that the practitioner may consider these factors in determining the scope of the written advice. Further, the determination of whether a practitioner has failed to comply with the requirements of the proposed rules under Section 10.37 would be based on all facts and circumstances, not on whether each requirement is addressed in the written advice.

IRS Aims to Eliminate Overuse of Disclaimers

Currently, many practitioners use a Circular 230 disclaimer at the conclusion of every email or other writing as a measure to remove the advice from the covered opinion rules. In the preamble to the proposed regulations, the IRS notes that in many instances, these disclaimers are frequently inserted without regard to whether the disclaimer is necessary or appropriate. These types of disclaimers are routinely inserted in any written transmission, the IRS noted, including writings that do not contain any tax advice. The proposed removal of the covered opinion rules, the IRS stated, eliminates the detailed provisions concerning covered opinions and disclosures in written opinions. Proposed Section 10.37 on written advice does not include the disclosure provisions in the current covered opinion rules. As a result, the IRS expects that these proposed regulations, if adopted, would eliminate the use of a Circular 230 disclaimer in email and other writings.

IRS Clarifies General Standard of Practitioner Competence

Although a practitioner can be sanctioned for incompetent conduct under Section 10.51 of Circular 230, no provision of Circular 230 specifically requires a practitioner to exercise competence when engaged in practice before the IRS. Under the proposed regulations, Section 10.35 would be revised to clarify that a practitioner must possess the necessary competence when engaged in practice before the IRS. Proposed Section 10.35 specifies that competent practice requires the knowledge, skill, thoroughness, and preparation necessary for the matter for which the practitioner is engaged.

Electronic Negotiation of Taxpayer Refunds Prohibited

Under proposed Section 10.31 of Circular 230, a practitioner may not endorse or otherwise negotiate any check (including directing or accepting payment by any means, electronic or otherwise, into an account owned or controlled by the practitioner or any firm or other entity with whom the practitioner is associated) issued to a client by the government in respect of a federal tax liability. The revision is meant to clarify that the prohibition on practitioner negotiation of taxpayer refunds applies in the modern-day electronic environment in which the IRS and practitioners operate. The proposed regulations would also expand Section 10.31 to apply to all individuals who practice before the IRS, not just those practitioners who are tax return preparers.

OBSERVATION: According to the IRS, there are a small number of unscrupulous preparers and practitioners who attempt to manipulate the electronic refund process with the intent to defraud their clients and the IRS. The proposed regulations would clarify that it constitutes disreputable conduct for a practitioner to direct the payment (or accept payment) of any monies issued to a client by the government in respect of a federal tax liability to the practitioner or any firm or entity with which the practitioner is associated and that such conduct is subject to sanction.

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IRS Rejects Basis Harvesting by S Shareholders Attempting to Recognize Built-in Losses

A recent trend with certain S corporations is the conversion of these corporations to a single member LLC or an LLC taxable as a partnership. The new entity then continues the business of the S corporation. According to the IRS, it is seeing these conversions where the S corporation's primary business is property development or homebuilding. Often the current fair market value of the property is lower than the outstanding liability associated with the property. The major reason for converting to a pass-through entity is to allow the S corporation to recognize any built-in loss associated with the asset and pass the loss onto the S shareholder. The shareholders attempt to increase their basis in the S stock by the amount of liabilities assumed, thus allowing the deduction of losses that would otherwise be suspended.

In CCM 201237017, the Office of Chief Counsel was asked whether, in such situations, an S shareholder can increase stock basis upon the distribution of encumbered assets to the shareholder. According to the Chief Counsel's Office, while the liabilities associated with the distributed assets are accounted for in calculating the S corporation's gain or loss on the assets distributed in the liquidation, no adjustment to the shareholder's stock basis is allowed for any liability assumed on the liquidation.

Tax Treatment of S Corporation Liquidations

Under Code Sec. 1371, except as otherwise provided in the Code, and except to the extent inconsistent with subchapter S, the provisions relating to C corporations apply to an S corporation and its shareholders. C corporation rules provide that amounts received by a shareholder in a distribution in complete liquidation of a corporation are treated as full payment in exchange for the stock. Generally, the rules relating to corporate distributions of property being treated as a dividend do not apply to any distribution of property by an S corporation in complete liquidation.

Upon the complete liquidation of an S corporation, the S corporation recognizes gain or loss on the distribution of property to its shareholders as if it sold that property for its fair market value. To the extent any of the property is subject to a liability or a shareholder assumes a liability of the liquidating corporation, fair market value is presumed to be not less than the amount of the outstanding liability. Gain or loss associated with the liquidating sale is accounted for at the corporate level. However, no loss is allowed to the S corporation if it distributes property to a related person and the distribution is either not pro rata or the liquidating corporation acquired the property in a Code Sec. 351 transaction, or as a contribution to capital, within the five-year period ending on the date of distribution. Any resulting corporate-level gain or loss is then passed through to the shareholder.

Tax Treatment of S Shareholders upon a Complete Liquidation of the S Corporation

In determining a shareholder's tax for the tax year in which the S corporation's tax year ends (or for the final tax year of a shareholder who dies, or of a trust or estate that terminates, before the end of the corporation's tax year), the shareholder's pro rata share of the following are taken into account: (1) the S corporation's items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder; and (2) the S corporation's nonseparately computed income or loss. If, during the last tax year of an S corporation, a loss or deduction is disallowed because it exceeds a shareholder's basis in the stock, then the loss or deduction is treated as incurred by the shareholder on the last day of the post-termination transition period.

An S shareholder can increase S stock basis for any period by the sum of the following items determined with respect to that shareholder for such period: (1) the items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder; (2) any nonseparately computed income or loss; and (3) the excess of the deductions for depletion over the basis of the property subject to depletion.

The basis of each shareholder's stock in the S corporation is decreased for any period (but not below zero) by the sum of: (1) distributions by the corporation that were not includible in the S shareholder's income; (2) the items of loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder; (3) any nonseparately computed loss; (4) any expense of the corporation not deductible in computing its taxable income and not properly chargeable to a capital account; and (5) the amount of the shareholder's deduction for depletion for any oil and gas property held by the S corporation to the extent such deduction does not exceed the proportionate share of the adjusted basis of such property allocated to the shareholder.

Generally, when an S shareholder does not have enough basis to take a loss or deduction, the loss or deduction is suspended until the shareholder has enough basis. This disallowed loss is personal to the shareholder and cannot be transferred to another person. If a shareholder transfers some but not all of the shareholder's stock in the corporation, the amount of any disallowed loss or deduction is not reduced and the transferee does not acquire any portion of the disallowed loss or deduction. If a shareholder transfers all of his stock in the S corporation, any disallowed loss or deduction is permanently lost.

Adjustments to an S shareholder's stock basis are determined as of the close of the corporation's tax year, and the adjustments generally are effective as of that date. However, if a shareholder disposes of stock during the corporation's tax year, the stock adjustments are effective immediately before the disposition. Generally, adjustments to stock basis are made in the following order: (1) any increase in basis attributable to items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder and any increase in basis due to excess depletion deductions; (2) any decrease in basis attributable to distributions by the corporation that were not includible in the income of the shareholder by reason of Code Sec. 1368; (3) any decrease in basis attributable to noncapital, nondeductible expenses and the oil and gas depletion deduction; and (4) any decrease in basis attributable to certain loss items.

Liquidating distributions received by an S corporation shareholder are treated as in full payment for the exchange of stock. The shareholder takes into account its portion of the corporate-level gain or loss to adjust his stock basis before calculating shareholder-level gain or loss.

Chief Counsel's Opinion

Citing Ford v. U.S., 311 F.2d 951 (Ct. Cl. 1963) and Rev. Rul. 58-228, the Office of Chief Counsel said that the shareholder of a liquidating S corporation must reduce its amount realized by the amount of any liability assumed. The shareholder's basis in the asset received in liquidation, however, is not affected by the assumption of a liability or receipt of property subject to a liability. To the extent the amount of the liability assumed exceeds the fair market value of the asset, the shareholder may recognize either a short-term or long-term capital loss on the complete liquidation of the S corporation.

Before determining gain or loss from liquidating distributions, the Chief Counsel's Office noted, a shareholder's stock basis is first adjusted for current-year pass-through items. Pass-through losses suspended because of the basis limitation rules that remain after the basis of the redeemed stock has been reduced to zero, do not reduce gain or increase loss resulting from liquidation. If a shareholder is going to increase basis to use up suspended losses, this must be done before the final distribution through additional capital contributions or loans. Otherwise, the loss is permanently disallowed. The Chief Counsel's Office concluded that there is no authority allowing a shareholder to restore basis after liquidation is completed as can be done under the post-termination transition period rules.

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Accounting Firm Partners Had Constructive Receipt of Stock Received in Sale

Partners in an accounting firm that sold its consulting business had constructive receipt of shares of another company received in the sale because, while those shares had some restrictions, the partners were able to receive dividends from, and vote, the shares. Hartman v. U.S., 2012 PTC 253 (Fed. Cir. 9/10/12).

In late 1999, Ernst & Young LLP (E&Y) was preparing to sell its consulting business to Cap Gemini, S.A., a French corporation. At the time, William Hartman was an accredited consulting partner of E&Y. In 2000, E&Y and Cap Gemini devised a Master Agreement for the sale of E&Y's consulting business. Under the Master Agreement, E&Y would form a new entity, Cap Gemini Ernst & Young U.S. LLC (CGE&Y), and would then transfer E&Y's consulting business to CGE&Y in exchange for an interest in CGE&Y. Each accredited consulting partner in E&Y, including William, would then receive a proportionate interest in CGE&Y. Each partner would terminate his partnership in E&Y, retaining his interest in CGE&Y. The accredited consulting partners would then transfer all their interests in CGE&Y to Cap Gemini. In exchange for their respective interests in CGE&Y, E&Y and the accredited consulting partners were to receive shares of Cap Gemini common stock.

As a part of the transaction described in the Master Agreement, each accredited consulting partner was also required to execute and sign a Consulting Partner Transaction Agreement (Partner Agreement) between the partners, E&Y, Cap Gemini, and CGE&Y. Under the Partner Agreement, the Cap Gemini shares received by each accredited consulting partner would be placed into separate Merrill Lynch restricted accounts in each individual partner's name. The Partner Agreement further provided that for a period of four years and 300 days following the closing of the transaction, the accredited consulting partners could not directly or indirectly, sell, assign, transfer, pledge, grant any option with respect to or otherwise dispose of any interest in the Cap Gemini common stock in their restricted accounts, except for a series of scheduled offerings as set forth in a separate Global Shareholders Agreement (Shareholders Agreement). The Shareholders Agreement provided for an initial sale of 25 percent of the shares held by each accredited consulting partner in order to satisfy each partner's tax liability in the year 2000 as a result of the transaction, and subsequent offerings of varying percentages at each anniversary following closing.

Although their right to sell or otherwise dispose of Cap Gemini shares was restricted, the accredited consulting partners enjoyed dividend rights on the Cap Gemini shares beginning on January 1, 2000, without restriction. The dividends earned on the Cap Gemini shares were not subject to forfeiture. Additionally, the accredited consulting partners had voting rights on the Cap Gemini shares held in the restricted accounts, though they provided powers of attorney to the CEO of CGE&Y to vote the shares on their behalf. In addition to the restrictions on the sale of the shares, certain percentages of the Cap Gemini shares were subject to forfeiture as liquidated damages. The percentage of shares subject to forfeiture declined over the life of the agreement and expired entirely at four years and 300 days following closing.

William and the other E&Y accredited consulting partners signed the Partner Agreement before May 1, 2000, and the transaction closed on May 23, 2000. By signing the Partner Agreement, William became a party to the Master Agreement and agreed not to take any position in any tax return contrary to the Master Agreement without the written consent of Cap Gemini. The document further provided that the gain on the sale of the distributed CGE&Y shares was reportable on Schedule D of each partner's U.S. federal income tax return for 2000.

William received 55,000 total shares of Cap Gemini common stock, which were deposited into his restricted account. Twenty-five percent of William's Cap Gemini shares (necessary for payment of income taxes related to the transaction) were sold in May of 2000 for approximately $2.2 million, which was deposited into William's restricted account. Following closing of the transaction, the value of Cap Gemini shares dropped drastically, from approximately $155 per share at closing to $56 per share by October 2001. William voluntarily quit CGE&Y on December 31, 2001. Upon his departure, William forfeited 10,560 shares of his Cap Gemini stock and received a credit for the taxes he paid on those shares in his 2000 tax return pursuant to Code Sec. 1341, which provides for the computation of tax where a taxpayer restores amounts previously held under a claim of right. In December 2003, the Hartmans filed an amended federal tax return for 2000, claiming that they had received only the 25 percent of Cap Gemini shares that had been monetized in the year 2000, with the remainder being received in 2001 and 2002. They sought a refund of $1.3 million. The IRS rejected the claim and the Hartmans filed suit in the Court of Federal Claims.

The IRS argued that, although the shares were not actually received in 2000, William nonetheless had constructively received the shares in accordance with Reg. Sec. 1.451-2. The Court of Federal Claims agreed and the Hartmans appealed to the Federal Circuit.

The Federal Circuit affirmed the Court of Federal Claims and held that, under Reg. Sec. 1.451-2, William constructively received the Cap Gemini shares in 2000. The court noted that while the partners' rights with respect to the Cap Gemini common stock were restricted, the Cap Gemini shares were set aside for each partner in a Merrill Lynch account in each partner's name, and the partners were able to receive dividends from and vote the shares (though subject to a power of attorney) during the period of time in which the sale of the shares was restricted. The risk of a decline in the value of the shares and the benefits of any increase in the value of the shares accrued entirely to the accredited consulting partners. Under the agreement, the shares immediately vested in the partners to ensure that the shares would not be treated as deferred compensation for future services. Thus, the benefit of ownership of the Cap Gemini stock to each accredited consulting partner extended far beyond the mere crediting of the stock on the books of the corporation.

The court rejected William's argument that the Cap Gemini shares were not constructively received because he could not access them under the provisions of the Partner Agreement. There are many situations, the court stated, where a taxpayer cannot immediately draw upon the account. According to the court, the quintessential example of constructive receipt covers the situation in which a taxpayer cannot, by his own agreement, presently receive an asset.

For a discussion of constructive receipt, see Parker Tax ¶241,515.

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Shareholders of Closely Held Corporation Liable for Tax Deficiencies as Transferees

A transaction entered into by shareholders of a closely held corporation was, in reality, a disguised liquidation with a circular flow of cash, and the shareholders were liable for tax deficiencies as transferees. Billy F. Hawk, Jr., GST v. Comm'r, T.C. Memo. 2012-259).

Billy F. Hawk, Jr., died in 2000. At the time of his death, Mr. Hawk was the majority shareholder and chief executive officer of Holiday Bowl, Inc., a Tennessee corporation that operated two bowling alleys in Tennessee. After the administration of Mr. Hawk's estate, all of his shares of stock in Holiday Bowl passed to his wife, Nancy, and the Billy F. Hawk, Jr., Exempt Marital Trust and the Billy F. Hawk, Jr., GST Non-Exempt Marital Trust.

Nancy and Rob Kelley, vice president and trust officer of Regions Bank and cotrustee of the trusts, decided to sell Holiday Bowl. To do so, they worked with a lawyer, Wayne Thomas. Subsequently, MidCoast Credit Corp. expressed an interest in buying the stock of Holiday Bowl. In 2003, Mr. Thomas advised Nancy and Mr. Kelley that he and other attorneys at his firm concluded that it would be a reasonable exercise of Nancy's and Mr. Kelley's discretion to proceed with this transaction.

The sale went through and the purchase price for the Holiday Bowl stock was calculated by taking the cash assets then held by Holiday Bowl ($4,185,389), adding prepaid taxes ($29,980), and subtracting an amount equal to 64.25 percent of Holiday Bowl's 2003 tax liability ($791,690). That formula yielded a purchase price of $3,423,679. Mr. Thomas believed that MidCoast was financing the purchase of Holiday Bowl through a combination of cash that it had on hand and a loan from Sequoia Capital, an offshore entity. During November 2003, Holiday Bowl, Midcoast, and Sequoia Capital entered into an escrow agreement with the Atlanta, Georgia, law firm Morris, Manning & Martin L.L.P. (Morris Manning). Morris Manning agreed to serve as the escrow agent. Pursuant to that escrow agreement, Holiday Bowl's cash and the purchase funds borrowed by MidCoast from Sequoia Capital were to be deposited into Morris Manning's escrow account and Holiday Bowl's cash was not to be released to MidCoast until the Holiday Bowl shareholders received the purchase price.

The agreement pursuant to which MidCoast acquired Holiday Bowl's stock stipulated that the purchaser would prepare and file all tax returns and pay all taxes due for the tax period ending December 31, 2003. Nancy, Mr. Kelley, and the representatives of Holiday Bowl believed MidCoast would file tax returns and pay Holiday Bowl's tax liability for its 2003 tax year, and they did not expect that, following its acquisition of Holiday Bowl, MidCoast would promptly sell Holiday Bowl to another entity. However, immediately after the sale of the Holiday Bowl stock closed on November 12, 2003, MidCoast resold the Holiday Bowl stock to Sequoia Capital.

In 2004, Holiday Bowl filed its Form 1120, U.S. Corporation Income Tax Return. It reported a total gain from the sale of its assets on July 1, 2003, of $2,694,726. It also reported losses from transactions described only as Int Rate Swap Opti and DKK/USD Bina and reported an overall taxable loss of $1,267,260.

The IRS audited Holiday Bowl's 2003 income tax return and requested that Holiday Bowl provide documents substantiating the claimed losses, but no documentation was provided. Subsequently, the IRS issued a notice of deficiency to Holiday Bowl for income tax deficiencies of almost $1 million for Holiday Bowl's 2003, 2004, and 2005 tax years. The IRS also determined that Holiday Bowl was liable for penalties of almost $400,000. According to the IRS, Holiday Bowl had been dissolved, and the assets of Holiday Bowl had been transferred to Nancy, the trusts, and others who were, directly or indirectly, the shareholders of Holiday Bowl. Citing Code Sec. 6901, the IRS said that, as transferees, these individuals and entities were liable for the tax deficiencies.

The IRS argued that the transaction was a typical intermediary transaction. Such transactions, the IRS stated, involve a closely held corporation that: (1) has recognized significant taxable gain from the sale of its assets; (2) has insufficient tax benefits to offset the resulting tax liability; (3) has no other liabilities; and (4) holds only cash. In such transactions, a promoter "purchases" the stock from the shareholders at a price equal to its net value less a percentage (typically 50 percent) of the corporation's tax liability. Effectively, the corporation's own cash is used to pay the shareholders for their stock. To the extent the corporation has any cash after the stock purchase, it is removed by the purchaser and the corporation is rendered insolvent and unable to pay its corporate tax liability. The IRS is unable to collect the unpaid tax from the corporation because it has no assets or from the promoter because the promoter does not receive any direct transfers and uses foreign entities and bank accounts.

The Tax Court agreed with the IRS and held that the transaction was a disguised liquidation with a circular flow of cash. According to the court, Holiday Bowl did not receive reasonably equivalent value in the transaction. The court concluded that, under Tennessee law, the taxpayers were liable for the tax deficiencies as transferees.

For a discussion of transferee liability, see Parker Tax ¶262,530.

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Taxpayers' Activities Failed the Experimentation Test; No Research Credit Allowed

A couple was not entitled to research tax credits because the activities at issue failed to satisfy the process-of-experimentation test. U.S. v. Davenport, 2012 PTC 259 (N.D. Texas 9/14/12).

Morris Davenport and David Davenport are 50 percent shareholders in Burly Corporation. Burly manufactures residential metal roofing and stand-alone metal buildings through its subsidiary, Mueller Supply Company Inc. (Mueller), which was purchased by the Davenport family in 1984. In 2006, the Davenports filed amended tax returns for the 2002 and 2003 tax years in which they claimed research tax credits under Code Sec. 41(b) for in-house research and contract research expenses incurred in conjunction with software developed to manage, automate, and integrate all aspects of Mueller's business, including automation and integration of manufacturing, design, sales, accounting, and shipping. The Davenports referred to this undertaking as the OneWorld Project and the resulting software system that was developed for use by Mueller as the OneWorld system.

As part of the process, Mueller purchased a license from International Business Machines (IBM) for an ERP Bridge. An IBM representative testified that an ERP Bridge is data collection software that consists of base code developed for all of IBM's customers that is used as a starting point and customized to meet a particular customer's needs. Among other things, the ERP Bridge was used to interface with the OneWorld system and run the terminals and wireless devices that were nonspecific to any particular customer. By customization, the IBM representative meant changing code or writing computer programs from scratch. Configuration, on the other hand, referred to selecting what was already there and filling in options without changing the computer code or instructions.

The IRS rejected the research credits claimed by the Davenports and asserted that it erroneously refunded the 2003 amounts. The IRS filed for summary judgment in district court.

Under Code Sec. 41, a tax credit is available for a certain percentage of a taxpayer's qualified research expenses. Under Code Sec. 41(b)(1), qualified research expenses are the sum of the taxpayer's in-house research expenses and contract research expenses paid or incurred by the taxpayer during the tax year in carrying on any trade or business. Code Sec. 41(d)(1) provides that qualified research must meet certain criteria, including that substantially all the activities comprising the research must constitute elements of a process of experimentation.

According to the IRS, the Davenports were not entitled to the research credits claimed because the activities at issue failed to satisfy the process of experimentation test. With regard to that issue, the IRS argued that a process of experimentation is a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result, or the appropriate design of that result, is uncertain as of the beginning of the taxpayer's research activities. A process of experimentation requires use of scientific method to discover information to resolve the uncertainty. Mueller employees, the IRS stated, were engaged in testing and reporting the results of the tests to IBM for technical changes to the software package and that did not satisfy the process of experimentation test.

The Davenports argued that the IRS's argument that the Mueller employees were engaged in testing and reporting the results of the tests to IBM for technical changes to the software package evinced a hypothesis, test, analyze, retest type process of experimentation envisioned by the Tax Court in its decision in Union Carbide v. Comm'r, T.C. Memo. 2009-50, aff'd, 2012 PTC 256 (2d Cir. 9/7/12). Thus, the Davenports said, there was a genuine dispute of material facts as to whether the research activities involved a process of experimentation under Code Sec. 41(d). Thus, the Davenports contended, the IRS should not be granted summary judgment.

The district court held that the Davenports were not entitled to the research credits and granted summary judgment to the IRS. The court rejected the Davenports' position because, it said, the evidence established that the testing performed by IBM and Mueller was not done to test and refine a hypothesis to determine the strengths and weakness of the alternative tested or to determine whether other alternatives might be better suited for achieving the Davenport's goal. Rather, the integration and script testing performed was done after IBM developed or customized the Mueller OneWorld System for the purpose of validating that it worked as intended and met the business requirements of Mueller that were previously communicated to IBM. More importantly, the court stated, the evidence established that any uncertainty that existed as to the capability or the method of achieving that result, or the appropriate design of that result occurred only during the project, not at the outset of the project or as of the beginning of the Davenports' research activities as required by Reg. Sec. 1.41-4(a)(5)(I) to satisfy the process of experimentation test.

OBSERVATION: In Union Carbide v. Comm'r, 2012 PTC 256 (9/11/12), the Second Circuit affirmed the Tax Court in another tax research credit case. In that case, Union Carbide Corporation (UCC) conducted three research projects at two production plants. The research was conducted on products that were in the process of being manufactured for sale and were in fact sold. Nevertheless, UCC requested a research credit not just for the additional costs of supplies associated with the research, but also for the costs of all the supplies used in the production of the product even though those supplies would have been used regardless of any research performed. The Tax Court held that UCC was not entitled to research credits for the entire amount spent for the supplies. Instead, the court said UCC was entitled to a credit for only those additional supplies that were used to perform the research.

For a discussion of the research tax credit, see Parker Tax ¶104,900.

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Company's Executive Is Liable for Responsible Person Penalty

Where a taxpayer owned stock in a company, served on the board of directors, possessed authority to sign or co-sign checks, and had significant control over corporate affairs, he was liable for the responsible person penalty. Collins v. U.S., 2012 PTC 257 (N.D. Ill. 9/12/12).

Harold Collins filed a suit against the IRS for erroneous collection of tax. The IRS filed a counterclaim against Thomas McDermott, among others, alleging that they were liable for an unpaid federal taxes attributable to their failure to pay over to the IRS the trust fund portion of income taxes and FICA taxes that had been withheld from wages paid to the employees of Heartland Memorial Hospital during the second and third quarters of 2005.

On June 9, 2004, Thomas was named chairman of the executive committee. The committee had the primary responsibility for handling day-to-day business transactions, including payment of payroll and related tax liabilities. Along with the establishment of the executive committee, Heartland established a policy requiring that all transactions over $10,000 be approved by Thomas. Later that year, the Heartland board approved a sale-leaseback transaction in which Heartland was to sell its hospital building to Munster Medical Holdings (MMH) and lease the building back. Thomas was a 50 percent co-owner of MMH, and after the transaction closed Thomas remained the largest shareholder.

At the start of 2005, Michael Baker was hired as Chief Operating Officer of Heartland, and during his interview, Baker was advised that Thomas was not to be trusted. After Baker was hired, Thomas's relationship with Heartland began to turn sour. He was removed from the executive management committee on March 5, 2005, though he continued to serve as a board member after that date. He also continued to serve on the executive management committee of Heartland's Merrillville location, where he maintained an office. Thomas retained check-signing authority, along with other board members, on behalf of Heartland. During the second and third quarters of 2005, Thomas signed 4,327 checks totaling over $8 million. These checks included at least three checks to himself for $50,000; $20,000; and $25,000. Thomas also signed at least four checks to MMH, each for amounts between $100,000 and $298,723.

Thomas was aware of the unpaid payroll taxes, and in July 2005, attended a board meeting at which the board established payroll and taxes as the top priority for cash payments. Heartland was acquired by Wright Capital Partners in September 2005, Thomas was announced as

the president of the post-acquisition company. Thomas claimed that he was assured the payroll taxes would be paid in full by Wright. However, Thomas never asked for a check to be cut to pay the payroll taxes, and during the relevant periods he continued to sign checks to pay other creditors after he was aware that the payroll taxes were not being paid. The issue of the unpaid payroll taxes was also discussed at a meeting held at Thomas's home between June and October of 2005. Additionally, board members were presented with financial statements showing unpaid payroll taxes. Heartland's comptroller resigned on August 22, 2005, citing the unpaid payroll taxes as one of the reasons.

The IRS assessed a responsible person penalty under Code Sec. 6672 on Thomas. Under Code Sec. 6672, every responsible person who willfully fails to collect, account for, or pay over the withheld taxes may be held personally responsible for any unpaid amount. Thomas argued that he was not involved in the day-to-day affairs of Heartland and that his role within the organization was so diminished after he was removed from the executive management committee in March 2005 that he had no influence over Heartland's financial decisions or priorities.

A district court agreed with the IRS and held that Thomas was a responsible person who acted willfully in failing to pay withheld taxes to the IRS. The court cited the Seventh Circuit's decision in U.S. v. Kim, 111 F.3d 1351 (7th Cir. 1997) in which the court stated that an analysis of a taxpayer's responsibility focuses on whether the taxpayer could have impeded the flow of business to the extent necessary to prevent the corporation from squandering the taxes it withheld from its employees. Indicia of responsible person status, the court stated, include: holding corporate office, owning stock in the company, serving on the board of directors, possessing authority to sign checks, and control over corporate financial affairs. The district court concluded that Thomas met four of the five indicia of a responsible person enumerated in Kim (he did not hold corporate office during the relevant time period), strongly suggesting that he was a responsible person. He owned stock in the company, served on the board of directors, possessed authority to sign or co-sign checks, and had significant control over corporate affairs. In addition to the stock Thomas owned, he had a significant financial stake in Heartland, as a major lender and, through MMH. The court noted that he signed over 4,000 checks, totaling more than $8 million, during the second and third quarters of 2005. Not only did Thomas sign checks to other creditors, he signed checks to himself and to MMH, of which he was the largest owner. Thomas may not have had the power to stop the flow of business entirely, the court observed, but the undisputed evidence demonstrated that he unquestionably had the power to impede it.

For a discussion of the responsible person penalty, see Parker Tax ¶210,105.

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Final Regs Address When Property Is Traded on an Established Market

IRS issued final regulations that apply to determine when property is traded on an established market (i.e., publicly traded) for purposes of determining the issue price of a debt instrument. T.D. 9599 (9/13/12).

The issue price of a debt instrument has important income tax consequences. As an initial matter, the difference between the issue price of a debt instrument and its stated redemption price at maturity measures whether there is any original issue discount (OID) associated with the instrument. A debt-for-debt exchange (including a significant modification of existing debt) in the context of a workout may result in a reduced issue price for the new debt, which generally would produce cancellation-of-debt (COD) income for the issuer, a loss to the holder whose basis is greater than the issue price of the new debt, and OID that generally must be accounted for by both the issuer and the holder of the new debt. These consequences, exacerbated by the effects of the credit crisis on the debt markets in recent years, have focused attention on the definition of when property is traded on an established market. The IRS has now finalized proposed regulations under Reg. Sec. 1.1273-2 that define when property is traded on an established market.

Although the final regulations substantially follow the framework established in the proposed regulations, comments received on the proposed regulations prompted several changes. First, the final regulations dispense with the category of exchange-listed property because the small amount of debt that is listed rarely actually trades over the exchange. Moreover, the IRS stated, although stock, commodities, and similar property are commonly listed on and traded over a board or exchange, such property typically will be the subject of frequent sales or quotes and would be covered in a separate category of publicly traded property. A debt instrument that is issued for stock, commodities, or similar exchange-traded property is therefore tested under the rule for property where there is a sales price or quote within the 31-day period ending 15 days after the issue date of the debt instrument. According to the IRS, eliminating the category of property listed on an exchange also eliminates the need for the de minimis trading exception in the proposed regulations, which was intended to exclude property that is listed on an exchange but trades in a negligible quantity.

Second, the final regulations require that issue price be reported consistently by issuers and holders. Under the final regulations, an issuer's determination as to whether property is traded on an established market and, if it is, the fair market value of the property generally is binding on the holders of the debt instrument. Information on pricing and recent sales generally is easily accessible by the issuer of a debt instrument, making the issuer the logical person to determine issue price. The issuer must make the fair market value of the property (which can be stated as the issue price of the debt instrument) available to holders in a commercially reasonable fashion, which can be a posting to a web site or similar electronic publication, within 90 days of the date the debt instruments are issued. If a holder makes a contrary determination that the property is or is not traded on an established market, or uses a fair market value that is different from the value determined by the issuer, the holder must file a statement with its income tax return that explicitly states that it is using a different determination, the reasons for the different determination and, if applicable, describes how fair market value was determined.

Finally, the final regulations expand and clarify the $50 million exception for small debt issues in the proposed regulations. According to the IRS, participants in the debt trading markets indicated that liquidity begins to noticeably diminish when an issue falls below $100 million. The final regulations therefore expand the small debt issue exception from $50 million to $100 million, which creates an automatic exclusion for debt that is the least likely to be publicly traded. The final regulations also clarify that the exception applies based on the outstanding stated principal amount of the debt instruments in an issue when the determination is made.

For a discussion of the rules relating to original issue discount, see Parker Tax ¶83,585.

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