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Parker's Federal Tax Bulletin
Issue 76     
November 21, 2014     

 

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 1. In This Issue ... 

 

Tax Briefs

Final Regs Clarify Rules for E&P Allocations in Tax-Free Transfers; IRS Issues Final Regs on Allocation of Basis in All Cash D Reorganizations; Property Received from Executor Not Eligible for First-Time Homebuyer Credit ...

Read more ...

S Corp's AAA Resets to Zero Following Post-Termination Transition Period

The IRS's Office of Chief Counsel has advised that the AAA balance of a corporation that terminated its S status was reset to zero when its post-termination transition period (PTTP) ended, and thus remained zero when the corporation re-elected S status after an intervening C corporation period. CCA 201446021 (11/14/14).

Read more ...

Supreme Court to Review Obamacare Insurance Subsidy Case in Wake of Circuit Split

The Supreme Court has granted review of a Fourth Circuit decision that upheld IRS regulations extending tax-credit subsidies to health insurance purchased through federally run Exchanges, bringing to a head the latest challenge to the Affordable Care Act (ACA). King v. Burwell, No. 14-114 (S. Ct. 11/10/14)

Read more ...

Expert Trainer's Involvement in Thoroughbred Venture Helps Taxpayers Avoid Hobby Classification

The Tax Court gave considerable weight to the involvement of a professional trainer as a co-owner in a thoroughbred racing venture in holding that heavy losses incurred in 2009 and 2010 by the taxpayers were not hobby losses. Annuzzi v. Comm'r, T.C. Memo 2014-233 (11/13/14).

Read more ...

IRS Clarifies Application of One-Per-Year Limit on IRA Rollovers; Provides Transition Rule

The IRS has issued guidance clarifying the application of the one-per-year limit on tax-free rollovers between IRAs and provided a transition rule. Announcement 2014-32 (11/10/14).

Read more ...

Software Licensing Arrangement Qualifies for Domestic Production Activities Deduction

A taxpayer's revenue from licensing software to contracting parties who use the software to perform services for end users qualified as gross receipts for purposes of the Code Sec. 199 domestic production activities deduction. The taxpayer's license to end users did not mean the taxpayer was providing services to the end users. TAM 201445010 (11/07/14).

Read more ...

Net-Worth Method Used to Support Fraud Determination Against Surf Shop Owners

The Tax Court upheld the IRS's use of the "net worth and personal expenditures" method (net-worth method) of income reconstruction; finding a family running a chain of surf and skateboard shops was liable for taxes on underreported income and civil fraud penalties. Worth v. Comm'r, T.C. Memo 2014-232 (11/13/14).

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Ninth Circuit Reverses Tax Court: Partners Cannot Selectively Opt Out of TEFRA Proceedings

The Ninth Circuit Court of Appeals has reversed the Tax Court, holding that a partner with both direct and indirect partnership interests cannot make separate elections to opt out of TEFRA proceeding with respect to each type of interest. JT USA v. Comm'r, 2014 PTC 570 (9th Cir. 11/14/14).

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Proprietor of a Residential Glass Business Failed to Establish He Was a Real Estate Professional

The rental real estate activities of a taxpayer who failed to properly document that he was a real estate professional were treated as passive activities. The taxpayer's failure to keep records of time spent on specific activities that could be considered "construction" or "reconstruction" in his residential glass business proved fatal to his bid to claim real estate professional status. Cantor v. Comm'r, T.C. Summary Opinion 2014-103 (11/06/14).

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IRS Issues Regs on Failure to File Gain Recognition Agreements; Relaxes Standards for Penalty Relief

The IRS has issued final and temporary regulations relaxing the existing reasonable cause standard for obtaining relief from penalties for failure to timely file an initial gain recognition agreement (GRA), or to satisfy other reporting obligations associated with certain transfers of property to foreign corporations in nonrecognition exchanges. The regulations, which finalize proposed regulations issued last year, affect U.S. persons that transfer property to foreign corporations. T.D. 9704 (11/19/14).

Read more ...

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 2. Tax Briefs 

 

C Corporations

Final Regs Clarify Rules for E&P Allocations in Tax-Free Transfers: In T.D. 9700 (11/10/14), the IRS issued final regulations under Code Sec. 312 clarifying current regulations on allocation of earnings and profits in tax-free transfers from one corporation to another. The IRS also issued final regulations under Code Sec. 381 that modify the definition of an acquiring corporation with regard to certain acquisitions of assets.

IRS Issues Final Regs on Allocation of Basis in All Cash D Reorganizations: In T.D. 9702 (11/12/14), the IRS issued final regulations on the determination of the basis of stock or securities in certain reorganizations where no stock or securities of the issuing corporation is issued and distributed in the transaction. The final regulations clarify that only a shareholder that owns actual shares in the issuing corporation in such a reorganization can designate the actual share of stock of the issuing corporation to which the basis, if any, of the stock or securities surrendered will attach.

 

Credits

Property Received from Executor Not Eligible for First-Time Homebuyer Credit: In Est. of Menges v. Miller, 2014 PTC 563 (M.D. Pa. 11/04/14), the district court held that the taxpayer was not eligible for the first-time homebuyer tax credit with respect to property she had received from the executor of her grandmother's estate. As the taxpayer was a beneficiary and acquired the property from a "related person" (the executor of the grandmother's estate), she did not "purchase" the property within the meaning of Code Sec. 36(c)(3) and thus was not entitled to the credit.

 

Deductions

Theft Loss Deduction Allowed under "Qualified Investor" Safe Harbor: In CCA 201445009 (11/07/14), the taxpayer transferred to third parties money that was to be used to purchase investments, but that was not so used. The Office of Chief Counsel concluded that the taxpayer was a "qualified investor" under the Rev. Proc. 2009-20 Ponzi scheme safe harbor and was thus able to deduct theft losses for amounts invested in a fraudulent scheme.

Individual Taxpayers' NOL Deductions Denied for Insufficient Substantiation: In Boring v. Comm'r, T.C. Summary 2014-105 (11/10/14), the Tax Court decided the taxpayers were not entitled to claim an $87,787 NOL carryover due to a lack of substantiation. The taxpayers' only support for the NOLs were their prior-year tax returns, which the court determined was not sufficient to establish that the losses were actually incurred.

 

Exempt Organizations

Surviving Entity Still Exempt after Merger of Two Exempt Organizations: In PLR 201446026 (11/14/14), the IRS ruled that the merger of two tax-exempt entities would not adversely affect the surviving entity's exempt status under Code Sec. 501(c)(6). Although the target entity was previously recognized as exempt under Code Sec. 501(c)(4), it worked collaboratively with the surviving entity on issues of common concern and was effectively operating in a manner similar to an organization exempt under Code Sec. 501(c)(6). Because the surviving entity was expected to continue operating in a manner consistent with Code Sec. 501(c)(6), the IRS ruled that its exemption would not be jeopardized by the merger.

 

Healthcare Taxes

IRS Releases Guidance on Eligibility for Minimum Essential Coverage under Pregnancy-Based Medicaid and CHIP Programs: In Notice 2014-71 (11/07/14), the IRS provides guidance on eligibility for minimum essential coverage for purposes of the Code Sec. 36B premium tax credit for pregnancy-related Medicaid and Children's Health Insurance Program (CHIP) programs. An individual enrolled in a qualified health plan who becomes eligible for Medicaid coverage for pregnancy-related services that is minimum essential coverage, or for CHIP coverage based on pregnancy, is treated as eligible for minimum essential coverage under the Medicaid or CHIP coverage for purposes of the premium tax credit only if the individual enrolls in the coverage.

 

Liens and Levies

Transfer of Apartment to Trust Deemed Fraudulent; Challenge to Tax Liens Dismissed: In U.S. v. Nassar, 2014 PTC 565 (S.D.N.Y. 11/10/14), the district court denied the taxpayer's motion to dismiss a lien on an apartment held in trust. The IRS had attached the lien under the independent theories that the trust was merely the taxpayer's nominee, and that the transfer of the apartment to the trust was a fraudulent conveyance under New York law. Because the taxpayer transferred the apartment for $10 consideration at a time when he was facing significant financial liabilities (thus making it difficult for creditors to reach), yet still continued personal enjoyment of the premises, the court found the the IRS had adequately plead that the taxpayer had, at the very least, a general intent to defraud his subsequent creditors and denied the taxpayer's motion to dismiss the lien.

 

Procedure

Tax Preparer Permanently Barred from Preparing Taxes after Fraud Conviction: In U.S. v. Majette, 2014 PTC 568 (D.N.J. 11/12/14), the IRS sought a permanent injunction to prohibit a tax preparer from preparing income tax returns for others. The preparer had prepared and filed false federal income tax returns on behalf of his customers, and is currently incarcerated after pleading guilty to two tax fraud offences. The court determined such an injunction was necessary to prevent further fraud.

Taxpayer's Bankruptcy Petition Didn't Bar Petition with Tax Court: In Perry v. Comm'r, T.C. Memo. 2014-231 (11/10/14), the taxpayer filed a petition for redetermination with the Tax Court, and 3-1/2 hours later filed a petition for bankruptcy with a California U.S. Bankruptcy Court. The IRS sought to dismiss the case in the Tax Court on the grounds that an automatic stay barred the case. The court held that as the taxpayer had filed with the Tax Court before she filed with the Bankruptcy Court, and thus before the automatic stay took effect, the court still had jurisdiction to hear the case.

 

Retirement Plans

IRA's Purchase of Shares in a Trust Owning Gold is Not an Acquisition of Collectibles: In PLR 201446030 (11/14/14), the IRS ruled that the acquisition of shares in a trust, whose assets are principally gold bullion, by the trustee of an IRA is not the acquisition of a collectible within the meaning of Code Sec. 408(m). Thus, an IRA owning shares of the trust will not be treated as making a deemed distribution under Code Sec. 408(m)(1) solely by virtue of owning such shares. However, an exchange of those shares for the underlying gold would constitute the acquisition of a collectible and would trigger a deemed distribution.

Taxpayer's Default on 401(k) Loan Triggers Deemed Distribution: In Scroggins v. Comm'r, T.C. Summary 2014-106 (11/13/14), the Tax Court determined that a taxable distribution from the taxpayer's 401(k) retirement plan occurred when he stopped making payments on a loan from the plan in late 2010. The taxpayer argued that the default should be treated as occurring in 2011, but the court concluded that the default happened when he stopped making payments in 2010, and in accordance with Reg. Sec. 1.72(p)-1, Q&A-10, the deemed distribution should be included in income for that year.

 

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 3. In-Depth Articles 

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S Corp's AAA Resets to Zero Following Post-Termination Transition Period

The IRS's Office of Chief Counsel has advised that the AAA balance of a corporation that terminated its S status was reset to zero when its post-termination transition period (PTTP) ended, and thus remained zero when the corporation re-elected S status after an intervening C corporation period. CCA 201446021 (11/14/14).

Facts

The taxpayer was incorporated as a C corporation and operated as such until it made its first election to be treated as an S corporation. At that time, the taxpayer had accumulated earnings and profits (E&P) and after its S election, continued to generate annual profits.  

When its majority shareholders later revoked its S election, the taxpayer had a positive balance in its accumulated adjustments account (AAA). During the post-termination transition period (PTTP), the taxpayer distributed a portion of its AAA to its shareholders pursuant to Code Sec. 1371(e), but left a positive balance at the end of the PTTP.

Observation: An S corporation's AAA is an account of the S corporation not apportioned among the shareholders. For S corporations with E&P from a prior period as a C corporation or a merger with a C corporation, the AAA tracks the corporation's ability to make tax-free distributions to shareholders. To the extent a corporation has a positive AAA, and the distribution does not exceed a shareholder's basis in the stock, the S corporation can make tax-free distributions to that shareholder.

After an intervening C corporation period, the taxpayer made another S election, and continues to operate as an S corporation today. The taxpayer represents that it converted from C to S to C and back to S to take advantage of individual and corporation tax rates available at the time of each conversion.  

The taxpayer requested a ruling regarding whether its AAA balance from its first S period survived the period between the end of the PTTP and the time it once again became an S Corporation.

Analysis

Code Sec. 1368(e)(1) provides that an AAA is adjusted for the S period in a manner similar to the adjustments under Code Sec. 1367 and that no adjustment will be made for federal taxes attributable to any tax year in which the corporation was a C corporation. Code Sec. 1368(e)(2) defines the term "S period" as the most recent continuous period during which the corporation has been an S corporation. Reg. Sec. 1.1368-2(a)(1) provides that on the first day of the first year for which the corporation is an S corporation, the balance of the AAA is zero.

The Chief Counsel's Office advised that an S Corporation's AAA is reset to zero after the PTTP and remains zero into a subsequent S period. The Chief Counsel's Office noted that legislative history did not include a detailed definition of "S period," nor did it indicate whether Congress intended an AAA to survive a break in S status, but there was reason to believe that undistributed taxable income expires at the end of any given S period.

The Chief Counsel's Office recognized an argument could be made that, when read together, Code Secs. 1368(e)(1) and (2) merely provide that the corporation's AAA will not be adjusted during any period that the corporation is not an S corporation. However, the Chief Counsel's Office reasoned this interpretation was too narrow because if AAA survives the PTTP, but may not be adjusted during the C corporation period under Code Sec. 1368(e), certain events, such as redemptions, occurring while the taxpayer is a C corporation may economically require adjustments forbidden by the statute, leading to distortions.

The Chief Counsel's Office ultimately concluded that the plain language of the statute states that the AAA will reset to zero when the PTTP ends. Code Sec. 1368(e)(2) defines the "S period" as the most recent continuous period during which the corporation has been an S corporation and Code Sec. 1.1368-2(a)(1) states that on the first day of the first year for which the corporation is an S corporation, the balance of the AAA is zero. Additionally, because the statute specifically grants a PTTP, it implies that the PTTP is the only time the corporation may draw down its AAA by making distributions after termination of S corporation status.

For a discussion of PTTP, see Parker Tax ¶34,580.

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Supreme Court to Review Obamacare Insurance Subsidy Case in Wake of Circuit Split

The Supreme Court has granted review of a Fourth Circuit decision that upheld IRS regulations extending tax-credit subsidies to health insurance purchased through federally run Exchanges, bringing to a head the latest challenge to the Affordable Care Act (ACA). King v. Burwell, No. 14-114 (S. Ct. 11/10/14)

Observation: If the Supreme Court follows a similar time table to the one that played out in the landmark 2012 Obamacare decision, the court may issue a ruling on King v. Burwell toward the end of its spring term next June.

Background

Earlier this year, two appellate courts reached opposite conclusions on the same day on the legality of health insurance subsidies in states with federally run insurance Exchanges. The issue before the courts was whether the Code Sec. 36B premium assistance credit is available for insurance purchased through federal Exchanges. Code Sec. 36B includes language that could be interpreted as limiting the availability of the premium assistance credit to taxpayers who enroll in qualified health plans on state-established Exchanges. However, the IRS, in final regulations issued in May 2012, interpreted Code Sec. 36B to allow credits for insurance purchased on either a state or a federally established Exchange. The IRS's broader interpretation of "Exchange" has significant implications. By making credits more widely available, the regulations give the individual and employer mandates broader effect than they would have if credits were limited to state-established Exchanges.

The individual mandate requires individuals to maintain "minimum essential coverage" and, in general, enforces that requirement with a penalty. However, the penalty does not apply to individuals for whom the annual cost of the cheapest available coverage, less any Code Sec. 36B tax credits, would exceed 8 percent of their projected household income. Thus, by making tax credits available in the states with federal Exchanges, the IRS rule significantly increases the number of people who must purchase health insurance or face a penalty.

Observation: The IRS rule affects the employer mandate in a similar way. Like the individual mandate, the employer mandate uses the threat of penalties to induce large employers to provide their full-time employees with health insurance. Specifically, the ACA penalizes any large employer who fails to offer its full-time employees suitable coverage if one or more of those employees enrolls in a qualified health plan with respect to which a Code Sec. 36B credit is allowed or paid with respect to the employee. As a result, the employer mandate's penalties hinge on the availability of credits. If credits were unavailable in states with federal Exchanges, employers there would face no penalties for failing to offer coverage. The IRS regulation has the opposite effect: by allowing credits in such states, it exposes employers there to penalties and thereby gives the employer mandate broader reach.

The conflicting circuit court decisions involved individuals in states that had not established a state-run Exchange and were facing penalties as a result of failing to buy comprehensive health insurance. In Halbig v. Burwell, 2014 PTC 363 (D.C. Cir. 2014), rev'g 2014 PTC 23 (D. D.C. 2014), the D.C. Circuit held that Code Sec. 36B, by its plain language, does not authorize the IRS to provide tax credits for insurance purchased on federal Exchanges; thus, the court vacated the part of the regulations that allows the credit in such cases. In King v. Burwell, 2014 PTC 364 (4th Cir. 2014), aff'g 2014 PTC 88 (E.D. Va. 2014), the Fourth Circuit reached the opposite conclusion and found that the statute is ambiguous and that the IRS's interpretation is a permissible construction of the statutory language. As such, the court was required to defer to the IRS's interpretation.

Petition to Supreme Court

The losing party in the Fourth Circuit decision, represented by Michael Carvin of Jones Day, petitioned the Supreme Court to hear an expedited appeal. Carvin, who represented David King and others in their challenge to the IRS guidance under Code Sec. 36B, filed a 43-page Petition for a Writ of Certiorari with the Supreme Court. The petition presents the court with the following question: Can the IRS issue regulations to extend tax-credit subsidies to coverage purchased through Exchanges established by the federal government under Section 1321 of the ACA?

According to Carvin, the reasons for granting the petition are simple and compelling. Two federal Circuits have divided over whether the IRS has authority to spend tens of billions of dollars per year to subsidize health coverage in 36 states. According to the petition, if the ACA means what it says, as the D.C. Circuit held, the consequences are profound: It means millions of people are ineligible for subsidies and exempt from the ACA's individual mandate penalty. It means hundreds of thousands of employers are free of the ACA's employer mandate. It means a fundamental change in the health insurance market in two-thirds of the country. And it means that the IRS is illegally spending billions of taxpayer dollars every month without congressional authority. Uncertainty over this issue, the petition states, is simply not tenable.

The Supreme Court has so granted review. In a related development, On November 12, the D.C. Circuit canceled a full-panel December rehearing of Halbig v. Burwell, effectively putting the case on hold pending the Supreme Court's decision on the Fourth Circuit case.

For a discussion of the Code Sec. 36B premium assistance credit, see Parker Tax ¶ 102,601.

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Expert Trainer's Involvement in Thoroughbred Venture Helps Taxpayers Avoid Hobby Classification

The Tax Court gave considerable weight to the involvement of a professional trainer as a co-owner in a thoroughbred racing venture in holding that heavy losses incurred in 2009 and 2010 by the taxpayers were not hobby losses. Annuzzi v. Comm'r, T.C. Memo 2014-233 (11/13/14).

Mel and Jean Annuzzi, operate Annuzzi Concrete Services, Inc. (ACS), in San Francisco. Mel has been the president of ACS for more than two decades. Jean works at ACS part time and has principal responsibility for the company's finances, including bookkeeping and accounting. In the early 1980s the Annuzzis began to buy race horses, hoping to make money by winning purses at horse races, selling race horses at a profit, and breeding foals that could be raced successfully or sold. They do not own or ride horses for pleasure; they do not allow anyone other than qualified professionals to ride their horses; they do not show their horses; they own no farm; and they do not keep horses as pets.

Since the beginning of ACS, the Annuzzis have co-owned most of their horses with Terry Knight, sharing income and expenses. Knight is a highly successful second-generation professional thoroughbred trainer who sits on the board of the California Thoroughbred Trainers Association. Horses he has trained have earned almost $12,7 million. Knight owned more than 50 horses with the Annuzis, in most cases with a 50-50 split. Mel estimated that he spent 30 hours per week on the thoroughbred activity. Knight devoted 10-16 hours a week to training the Annuzzis' horses and additional time to consulting with the Annuzzis about buying, breeding, and selling thoroughbreds. Jean kept the books and records of the thoroughbred activity and estimated that she devoted 25-30 hours a week to these recordkeeping activities.

The Annuzzis had modest profits or losses from the thoroughbred activity from 1981 to 2008. Two factors adversely affected the profitability of the thoroughbred activity during 2009-2010. First was their decision to put greater emphasis on breeding foals, which generates current expenses but defers income. The foals were too young to race in 2009 and 2010. Second, in 2007 most California race tracks introduced synthetic turf, which caused numerous injuries to the Annuzzis' horses in the ensuing years. As a result, the Annuzzis suffered losses of $81,114 and $55,797 in 2009 and 2010 respectively. For those years, The IRS determined that the Annuzzis did not engage in their thoroughbred activity with the intent to make a profit and disallowed the losses under Code Sec. 183.

Code Sec. 162(a) allows as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." To be entitled to such deductions, taxpayers must show that they engaged in the activity with an actual and honest objective of making a profit. Under Reg. Sec. 1.183-2(a), losses are not allowable for an activity a taxpayer carries on primarily for sport, as a hobby, or for recreation. Under Ninth Circuit precedent in Wolf v. Comm'r, 4 F.3d 709 (9th Cir. 1993), a taxpayer can escape the Code Sec. 183(a) bar on deductibility only by demonstrating that his predominant, primary, or principal objective in engaging in the activity was to realize an economic profit independent of tax savings.

Reg. Sec. 1.183-2(b) provides a nonexclusive list of nine factors relevant in ascertaining whether a taxpayer conducts an activity with the intent to earn a profit. The factors listed are:

(1) the way the taxpayer conducts the activity;  

(2) the expertise of the taxpayer or his advisers;  

(3) the time and effort the taxpayer spends in carrying on the activity;  

(4) the expectation that assets used in the activity may appreciate in value;  

(5) the taxpayer's success 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;  

(8) the taxpayer's financial status; and  

(9) elements of personal pleasure or recreation.

The Tax Court held that, although overall the factors did not strongly weigh in the favor of either the Annuzzis or the IRS, the preponderance of the evidence indicated that the Annuzzis' predominant objective in engaging in their thoroughbred activity was to realize an economic profit independent of tax savings.  

The court determined that factors (1), (2), and (4) weighed strongly in the Annuzzis favor, as they conducted their throughbred activities as a business for profit, had gained expertise over the decades and strongly relied on Mr. Knight's expertise, and had reasonable expectation that the horses would be profitable. The court decided that factors (3) and (7) only slightly favored the Annuzzis, as they had to split their time between ACS and their thoroughbred activities, and because they only made modest profits, if any. Factor (5) was neutral, as there was no credible relation between the success of ACS and their thoroughbred activities. Factors (6), (8), and (9) weighed in the IRS's favor, as the Annuzzis had many years of consecutive losses, generated substantial benefits from these losses, and derived recreational pleasure from these activities.

Central to the court's conclusion was Knight's involvement, not only as the trainer, but also as the co-owner of horses. The court stated that, in a very real sense, he and the Annuzzis embarked on a joint venture to own, train, race, and sell thoroughbred horses. The evidence clearly established that Knight embarked on this venture with the intent to make a profit and the court concluded that the Annuzzis' motivation was the same as his. Thus, the Tax Court held that the losses sustained were not hobby losses under Code Sec. 183.

For a discussion of the hobby loss rules, see Parker Tax ¶ 97,501.

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IRS Clarifies Application of One-Per-Year Limit on IRA Rollovers; Provides Transition Rule

The IRS has issued guidance clarifying the application of the one-per-year limit on tax-free rollovers between IRAs and provided a transition rule. Announcement 2014-32 (11/10/14).

Background

Generally, under Code Sec. 408(d)(3)(A)(i), an amount distributed from an IRA is not included in the recipient's gross income to the extent the amount is rolled over into an IRA for the recipient's benefit within 60 days after the recipient receives the distribution. This is generally referred to as a "60-day rollover." Code Sec. 408(d)(3)(B) provides that an individual may make only one nontaxable 60-day rollover between IRAs in any one-year period.

Previously, proposed regulations and IRS Publication 590, Individual Retirement Arrangements (IRAs), provided that the one-rollover-per-year limitation applied on an IRA-by-IRA basis. However, the Tax Court in Bobrow v. Comm'r, T.C. Memo. 2014-21, held that the limitation applies on an aggregate basis, meaning that an individual cannot make more than one nontaxable 60-day rollover within each one-year period even if the rollovers involved different IRAs. In Announcement 2014-15, the IRS indicated that it anticipated following the Bobrow interpretation of Code Sec. 408(d)(3)(B), and accordingly that it would withdraw the proposed regulations and revise Publication 590 to follow that interpretation; however, the IRS also stated that it would not apply the Bobrow interpretation before 2015. The IRS withdrew the proposed regulations on July 11, 2014.

One-Per-Year Limit Clarified

The IRS has now issued Announcement 2014-32 to address certain concerns that have arisen since the release of Announcement 2014-15. According to Announcement 2014-32, the IRS will apply the Bobrow interpretation of Code Sec. 408(d)(3)(B) for distributions that occur on or after January 1, 2015.

This means that an individual who receives an IRA distribution on or after January 1, 2015, cannot roll over any portion of that distribution into an IRA if he or she has received a distribution from any IRA in the preceding one-year period that was rolled over into an IRA. However, as a transition rule for distributions in 2015, a distribution occurring in 2014 that was rolled over is disregarded in determining whether a 2015 distribution can be rolled over, provided that the 2015 distribution is from a different IRA that neither made nor received the 2014 distribution. In other words, a distribution from an IRA received during 2014 and properly rolled over (normally within 60 days) to another IRA, will have no impact on any distributions and rollovers during 2015 involving any other IRAs owned by the same individual.

The transition rule will give IRA owners a fresh start in 2015 when applying the one-per-year rollover limit to multiple IRAs. The Bobrow aggregation rule, which takes into account all distributions and rollovers among an individual's IRAs, will apply to distributions from different IRAs only if each of the distributions occurs after 2014.

Exceptions to One-Per-Year Limit

A rollover from a traditional IRA to a Roth IRA (a Roth IRA conversion) is not subject to the one-rollover-per-year limitation, and such a rollover is disregarded in applying the one-rollover-per-year limitation to other rollovers. However, a rollover between an individual's Roth IRAs would preclude a separate rollover within the one-year period between the individual's traditional IRAs, and vice versa. For these purposes, the term "traditional IRA" includes a Code Sec. 408(k) simplified employee pension (SEP) and a Code Sec. 408(p) SIMPLE IRA.

The one-rollover-per-year limitation also does not apply to a rollover to or from a qualified plan, and such a rollover is disregarded in applying the one-rollover-per-year limitation to other rollovers. Nor does the limitation apply to trustee-to-trustee transfers.

Practice Tip: IRA trustees can accomplish a trustee-to-trustee transfer by transferring amounts directly from one IRA to another or by providing the IRA owner with a check made payable to the receiving IRA trustee.

For a discussion of the rules for rollovers of distributions from IRAs, see Parker Tax ¶134,540.

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Software Licensing Arrangement Qualifies for Domestic Production Activities Deduction

A taxpayer's revenue from licensing software to contracting parties who use the software to perform services for end users qualified as gross receipts for purposes of the Code Sec. 199 domestic production activities deduction. The taxpayer's license to end users did not mean the taxpayer was providing services to the end users. TAM 201445010 (11/07/14).

The taxpayer designs, develops, and licenses unique computer software for certain contracting parties. End users subscribe to a product or service by entering into a subscriber agreement with both the taxpayer and the respective contracting party. Under such an agreement, an end user submits a service request to the contracting party, who then uses the licensed computer software and their own data to perform the requested service, providing the end user with the results. In some cases, the taxpayer grants the end user a license to use the results. Under the subscriber agreement, the contracting party collects fees from the end users, and pays the taxpayer an amount as provided under the respective master agreement. From time to time, a contracting party will ask the taxpayer to waive the fees relating to the services performed for certain end user projects. The taxpayer's agreement to waive its fees is documented in a letter addressed to the contracting party and is described as a "royalty waiver."

The IRS's Large Business and International (LB&I) division maintained that the taxpayer derives its gross receipts directly from end users as a result of services provided by the taxpayer, and receives no compensation from the contracting parties for the license of computer software. The taxpayer's position was that it derives gross receipts directly from the license of computer software to the contracting parties. The issue before the IRS's National Office was whether, for purposes of the domestic production activities deduction under Code Sec. 199, the taxpayer derived domestic production gross receipts (DGPR) from the license of computer software to contracting parties, or non-DPGR from providing services to end users.

Code Sec. 199(a)(1) allows a deduction equal to 9 percent of the lesser of the taxpayer's

(1) qualified production activities income (QPAI) for the tax year, or  

(2) taxable income for the tax year.  

Code Sec. 199(c)(1) defines QPAI for any tax year as an amount equal to the excess (if any) of (1) the taxpayer's DPGR for that tax year, over (2) the sum of (i) the cost of goods sold that are allocable to such receipts; and (ii) other expenses, losses, or deductions that are properly allocable to such receipts.  

Code Sec. 199(c)(4)(A)(i)(I) defines DPGR to mean the taxpayer's gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States. Code Sec.199(c)(5) defines QPP to include computer software.

The IRS rejected the LB&I division's position, concluding that the taxpayer did derive DPGR from the license of computer software to the contracting parties for the years involved and was thus entitled to deductions under Code Sec. 199.  

The IRS noted that the taxpayer's relationships with the contracting parties were not joint ventures. Rather, the agreements were transactions that generally occurred in two steps, with each party performing discrete activities. First, the taxpayer produces computer software for a contracting party, and then licenses that software to that party. Second, the contracting parties use the computer software and its own data to provide services to end users. The IRS also noted that the use of the contracting party's own data in conjunction with the licensed software showed that the services performed for the end users required both the contracting party and the taxpayer, and the taxpayer could not have performed such services on its own. In the IRS's view, the substance of the taxpayer's relationship with the contracting parties was that the taxpayer simply produces the computer software used by the contracting parties to provide services to end users.  

The IRS disagreed with LB&I that the taxpayer's license to end users meant the taxpayer was providing services to the end users. Instead, the license indicates the limits of the license provided by the taxpayer to the contracting parties.

The IRS found that the master agreements allow the contracting parties to use the computer software to provide the services to end users only so as long as the taxpayer was able to restrict an end users rights with respect to the results. Thus, the IRS concluded that the taxpayer was directly paid by the contracting parties for the license of computer software, which led to the taxpayer receiving DPGR.

For a discussion of Code Sec. 199 domestic production activities deductions, see Parker Tax ¶96,101.

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Net-Worth Method Used to Support Fraud Determination Against Surf Shop Owners

The Tax Court upheld the IRS's use of the "net worth and personal expenditures" method (net-worth method) of income reconstruction; finding a family running a chain of surf and skateboard shops was liable for taxes on underreported income and civil fraud penalties. Worth v. Comm'r, T.C. Memo 2014-232 (11/13/14).

The Worth family, Donald, Marie, and their son, Frank, operated a chain of seven surf and skateboard shops across California, called White Sands. Frank was responsible for about half of the stores and Donald and Marie operated the other half. Marie also managed the books and prepared tax returns. As manager of the heavily cash-based business, Frank had the authority to write checks on certain White Sands bank accounts, wrote checks or used cash to pay vendors for merchandise as it came in, and wrote checks to reimburse himself for business expenses he paid. Frank also supervised inventory and receipts from store branches. There were no formal ownership arrangements; however, Donald and Frank held themselves out as joint owners, and Frank testified in previous cases that he was a part-owner. Frank reported income from the business on his Form 1040 Schedule C and never received a Form W-2 from White Sands.

Banking irregularities lead the IRS and state authorities to institute a criminal investigation into the business, resulting in Frank pleading guilty to willfully making and subscribing to a false return for 2000, and Donald and Marie pleading the same for 1998-2000. All three admitted to knowingly and willfully understating the business' gross receipts to decrease tax liability.

The IRS determined deficiencies for Donald and Marie and for Frank based on unreported income using the net-worth method, because the lack of complete and reliable records precluded using the simpler bank-deposit method. The IRS has great latitude in reconstructing a taxpayer's income, and the reconstruction need only be reasonable in light of all surrounding facts and circumstances. The net-worth approach is a permissible method that seeks an approximation, rather than a precise determination, of the taxpayer's gross income.

Observation: Under the net-worth method, the IRS reconstructs a taxpayer's income by determining net-worth at the beginning and end of each year in issue. The net worth increase (or decrease) for each year is then adjusted by adding nondeductible expenses (such as everyday living costs) and subtracting receipts from nontaxable sources (such as gifts, inheritances, and loans).  

An increase in net worth for a given year creates an inference of additional gross income for that year, provided that the IRS: (1) establishes the taxpayer's opening net worth with reasonable certainty and (2) either shows a likely source of unreported income or negates possible nontaxable sources. Brooks v. Commissioner, 82 T.C. 413 (1984).

The primary issue before the Tax Court was whether the Worths failed to report income for 1998-2000 as determined by the IRS using the net-worth method of reconstructing income.

The court determined that the net-worth method was computed correctly and that the family was liable for the deficiencies. The court reasoned that the Worths failed to maintain accurate books or records from which tax liabilities could be computed and did not present any affirmative case to rebut the IRS's arguments.

The court rejected the Worths' arguments that the IRS agent was not a qualified expert, thus making her testimony inadmissible, finding that that the IRS agent was not testifying as an expert, but permissibly providing factual information as to how the audit was conducted and how net-worth was calculated. Moreover, the IRS audit properly investigated and accounted for alleged cash-hoards as well as other alleged loans from Donald and Marie to Frank, which could have lowered the taxpayers' AGI. Lastly, the court determined that based on the IRS audit, criminal investigation, and admissions, Frank was a 50 percent owner of White Sands during the years at issue and thus half of the assets of White Sands was properly allocated to him for purposes of the net-worth analysis.

The Tax Court ultimately upheld the IRS's deficiencies and determined the family members were liable for the civil fraud penalty because of the understatements of income, false statements, lack of credible testimony, insufficient records, and attempts to conceal income by structuring bank deposits to fall under the reporting limit required for banks.

For a discussion of the IRS's examination authority, see Parker Tax ¶ 263,110.

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Ninth Circuit Reverses Tax Court: Partners Cannot Selectively Opt Out of TEFRA Proceedings

The Ninth Circuit Court of Appeals has reversed the Tax Court, holding that a partner with both direct and indirect partnership interests cannot make separate elections to opt out of TEFRA proceeding with respect to each type of interest. JT USA v. Comm'r, 2014 PTC 570 (9th Cir. 11/14/14).

In the 1970s, off-road motorcycle enthusiast John Gregory and his wife, Rita, founded a business that became very successful at selling accessories to enthusiasts of motocross and paintball. In 2000, the Gregorys decided to sell the assets of their company (JT USA, LP) to a large paintball equipment manufacturer for $32 million. Faced with the problem of having to pay tax on a very large capital gain, their solution was to use an alleged Son-of-BOSS transaction to create losses large enough to offset their gain. To effectuate the tax shelter, the Gregorys implemented a complex ownership structure in which they held both direct and indirect interests in JT USA.

The IRS challenged the transaction that produced the losses, sending a letter to the Gregorys shortly before the statute of limitations expired. The Gregorys responded by opting out of the TEFRA proceedings in their capacity as indirect partners, and opting into the proceeding in their capacity as direct partners. The Tax Court held that Code Sec. 6223(e)(3)(B) allowed the Gregorys to make separate elections as direct and indirect partners, and thus their elections to opt out as indirect partners were valid. The IRS appealed.

Observation: The Tax Equity and Fiscal Responsibility Act of 1982(TEFRA) created the unified partnership audit and litigation procedures contained in Code Secs. 6221 through 6234. TEFRA procedures streamline partnership audits by allowing the IRS to deal primarily with a tax management partner to coordinate administration and settlement. In certain situations, a partner may elect out of these proceedings and thus not be bound by the results.

The issue before the Ninth Circuit was whether the Tax Court's interpretation that Code Sec. 6223(e)(3)(B) allowed partners holding both direct and indirect interests to make separate elections with respect to each type of interest was correct.

Code Sec. 6223 details requirements for giving notice to partners of partnership administrative proceedings. Under Code Sec. 6223(e)(3)(B), if the IRS fails to provide notice to a partner and proceedings are ongoing, the partner is a party to the proceedings unless the partner elects to have the partnership items of the partner treated as nonpartnership items (i.e., the partner opts out).

The Ninth Circuit held the Tax Court erred in concluding that the Gregorys could opt out of the proceedings with respect to their indirect partnership interests, and remanded the case for the court to determine the validity of the IRS's adjustments to partnership items. The appeals court found that the Tax Court and the Gregorys had overcomplicated their interpretation of Code Sec. 6223(e)(3)(B), and that a plain-meaning interpretation was appropriate. The court noted that the statute says the partner, not an indirect partner or any other subset of the term "partner," and allows the partner to have the partnership items of that partner to be treated as nonpartnership items, not some of that partner's items to be treated as such. The use of the definitive article "the" convinced the court that the language of Code Sec. 6223(e)(3)(B) is clear and unambiguous, and means that unless a partner elects to have all of his or her partnership items treated as nonpartnership items, the partner cannot elect out of the TEFRA proceeding.

The court also looked to the legislative history of Code Sec. 6223(e)(3)(B) and its regulations to further support its interpretation of the statute. H.R. Conf. Rep. No. 97-760 (1982) states that the partner will be a party to TEFRA proceedings unless he or she elects to have all partnership items treated as nonpartnership items. Reg. Sec. 301.6223(e)-2T(c)(1) tracks the language of the conference report, stating that an opt-out election applies to all partnership items for the year. Additionally, the court observed that the Tax Court's ruling would permit duplicative proceedings and the potential for inconsistent treatment of partners in the same partnership, which would be contrary to TEFRA's goal of streamlining partnership proceedings.

For a discussion of TEFRA audit procedures, see ¶28,505.

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Proprietor of a Residential Glass Business Failed to Establish He Was a Real Estate Professional

The rental real estate activities of a taxpayer who failed to properly document that he was a real estate professional were treated as passive activities. The taxpayer's failure to keep records of time spent on specific activities that could be considered "construction" or "reconstruction" in his residential glass business proved fatal to his bid to claim real estate professional status. Cantor v. Comm'r, T.C. Summary Opinion 2014-103 (11/06/14).

Howard Cantor was the owner of ABS Glass, a sole proprietorship in the business of providing glazing services involving repairs and/or installation of automobile windshields and windows and repairs and/or installation of glass and glass products in buildings. ABS Glass was divided into an "automotive" division and a "residential" division.

Cantor was more actively involved with the residential division, which offered various services, including the repair and installation of glass for shower and bathtub enclosures, windows, shelving, table tops, mirrors, and cabinets. Cantor did not maintain any form of contemporaneous log in which he recorded the time spent on the various activities within the residential division, although he clearly spent more than 750 hours per year providing services in connection with the division.

In addition to his ABC Glass activities, Cantor also owned (with his wife) four rental properties for which he reported net rental real estate losses in 2007 and 2008. The IRS disallowed losses after determining that Cantor did not meet the requirements of Code Sec. 469(c)(7) and, therefore, the rental activities were considered passive activities subject to the passive activity loss limitation rules.

Under Code Sec. 469, taxpayers are generally precluded from deducting passive activity losses, including losses from rental activity. However, a taxpayer who is a "real estate professional" within the meaning of Code Sec. 469(c)(7) can deduct rental activity losses. A taxpayer is a real estate professional under Code Sec. 469(c)(7)(B) for a tax year if:  

(1) more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates; and  

(2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

The sole issue before the Tax Court was whether Cantor qualified as a real estate professional. Cantor argued that the services he performed in connection with the residential division of ABS Glass were "construction" or "reconstruction" activities that qualified the residential division of ABS Glass as a real property trade or business under Code Sec. 469(c)(7)(C) for both years at issue.

The Tax Court held that Cantor did not qualify as a real estate professional. The court noted that while some services Cantor performed (such as installing windows) would be considered construction or reconstruction, many other services (such as cutting and installing mirrors) would not. As Cantor did not keep contemporaneous logs showing how much of his time was spent on any particular activity, it was impossible to compare the time he spent in real property trade or business with time spent in other trades or businesses, as required by Code Sec. 469(c)(7)(B). Thus, Cantor was not an individual described in Code Sec. 469(c)(7) for either of the years at issue, and the IRS properly disallowed deductions for rental activity losses.

For a discussion of the deductibility of rental losses, see Parker Tax ¶ 247,105.

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IRS Issues Regs on Failure to File Gain Recognition Agreements; Relaxes Standards for Penalty Relief

The IRS has issued final and temporary regulations relaxing the existing reasonable cause standard for obtaining relief from penalties for failure to timely file an initial gain recognition agreement (GRA), or to satisfy other reporting obligations associated with certain transfers of property to foreign corporations in nonrecognition exchanges. The regulations, which finalize proposed regulations issued last year, affect U.S. persons that transfer property to foreign corporations. T.D. 9704 (11/19/14).

According to the IRS, the existing reasonable cause standard may not be satisfied by U.S. transferors in many common situations even though the failure was not intentional and not due to willful neglect. The IRS believes that full gain recognition under Code Sec. 367(a)(1) should apply only if a failure to timely file an initial GRA or a failure to comply with the Code Sec. 367(a) GRA regulations with respect to an existing GRA is willful. The IRS further believes that the penalty imposed by Code Sec. 6038B generally should be sufficient to encourage proper reporting and compliance.

Accordingly, the IRS has issued final and temporary regulations that provide that a U.S. transferor seeking either to (1) avoid recognizing gain under Code Sec. 367(a)(1) on the initial transfer as a result of a failure to timely file an initial GRA, or (2) avoid triggering gain as a result of a failure to comply in all material respects with the GRA regulations or the terms of an existing GRA, must demonstrate that the failure was not a willful failure. For this purpose, willful is to be interpreted consistent with the meaning of that term in the context of other civil penalties (for example, Code Sec. 6672), which would include a failure due to gross negligence, reckless disregard, or willful neglect. Whether a failure is willful will be determined based on all the relevant facts and circumstances. For example, the GRA regulations require a GRA to include information about the adjusted basis and fair market value of the property transferred. Filing a GRA and intentionally not providing such information, including noting on the GRA that this information is ''available upon request,'' would be a willful failure.

In addition, the regulations modify the process through which requests for relief from a failure to file or a failure to comply are evaluated by eliminating the requirement for the IRS to respond to such relief requests within 120 days.

The regulations clarify that the Code Sec. 6038B penalty will apply to a failure to comply in any material respect with the Code Sec. 367(a) GRA regulations or the terms of an existing GRA, such as a failure to properly file a GRA document (including an annual certification or new GRA). Under the regulations, a failure to comply would have the same meaning for purposes of the Code Sec. 367(a) GRA regulations and the Code Sec. 6038B regulations; however, the current reasonable cause standard will continue to apply to U.S. transferors seeking relief from the Code Sec. 6038B penalty.

In addition, the Code Sec. 6038B penalty will continue to apply, as provided under the current Code Sec. 6038B regulations, if both (1) a Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, is not filed with respect to the initial transfer, and (2) there is a failure to file an initial GRA. In this case, the current reasonable cause standard would continue to apply to U.S. transferors seeking relief from the Code Sec. 6038B penalty.

Compared with the 2013 proposed regulations, the final regulations require more detailed information with respect to a transfer of stock or securities to be reported on Form 926. The U.S. transferor must report on the Form 926 the fair market value, adjusted tax basis, and gain recognized with respect to the transferred stock or securities, as well as any other information that the form, its accompanying instructions, or other applicable guidance requires.

As in the proposed regulations, the final regulations provide rules similar to those that apply to to GRAs for (1) failures to file the required documents or statements and otherwise comply with the regulations under Code Sec. 367(e)(2) (relating to liquidating distributions to foreign parent corporations) and related Code Sec. 6038B regulations and (2) failures to file certain other statements required under Reg. Sec. 1.367(a)3 in connection with certain transfers of stock or securities to foreign corporations.

In addition, the final regulations extend relief for failures that are not willful to certain other reporting obligations under Code Sec. 367(a) that were not covered by the proposed regulations. Specifically, Reg. Sec. 1.367(a)2 (providing an exception to gain recognition under Code Sec. 367(a)(1) for assets transferred outbound for use in the active conduct of a trade or business outside of the United States) and Reg. Sec. 1.367(a)7 (regarding application of Code Sec. 367(a) to an outbound transfer of assets by a domestic target corporation in an exchange described in Code Sec. 361) are revised so that a taxpayer may, solely for purposes of Code Sec. 367(a), be deemed not to have failed to comply with reporting obligations under Reg. Secs. 1.367(a)2 and 1.367(a)7 by demonstrating that the failure was not willful.

The new regulations are generally effective on November 19, 2014. and generally apply to documents required to be filed on or after that date. However, Reg. Sec. 1.367(a)-7 applies to transfers occurring on or after April 18, 2013 (with certain exceptions discussed in Reg. Sec. 1.367(a)-7(j)).

For a discussion of gain recognition agreements see Parker Tax ¶47,460.

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