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Federal Tax Research Bulletin - The Latest Tax and Accounting Articles


Parker's Federal Tax Bulletin
Issue 171     
June 4, 2018    

 

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 1. In This Issue ... 

 

Tax Briefs

IRS Issues June 2018 AFRs; Taxpayer Who Failed 39-Week Test Can't Deduct Moving Expenses; Mileage Costs Incurred to Visit Customer Facilities Were Personal Commuting Expenses; Trust Owners Are Taxable on Income from Partnerships Owned by the Trust ...

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IRS Updates and Consolidates Guidance on Charitable Contributions

The IRS issued a revenue procedure which sets forth the extent to which grantors and contributors may rely on the listing in IRS databases of organizations eligible to receive tax-deductible contributions under Code Sec. 170, for purposes of determining whether the grants or contributions to such organizations are deductible under Code Sec. 170, and for certain other purposes. The revenue procedure also provides safe harbors for determining that a grantor's or contributor's grant or contribution will not cause the grantor or contributor to be considered to be responsible for, or aware of, an act that results in an organization's loss of public charity classification and for determining that a grant or contribution is considered an unusual grant. Rev. Proc. 2018-32.

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Partnership Consisting of Disregarded Entities Did Not Qualify for TEFRA Small Partnership Exception

The D.C. Circuit held that a partnership consisting of two single-member LLCs classified as disregarded entities did not qualify for the exception under the Tax Equity and Fiscal Responsibility Act (TEFRA) for small partnerships because a small partnership cannot have a partner that is a passthrough entity. The D.C. Circuit rejected the taxpayers' arguments that the individuals, not the LLCs, were the actual partners of the partnership, finding that the partnership agreement clearly named the LLCs as the partners and that the definition of a pass-thru partner in the regulations was a reasonable interpretation of an ambiguous statute. Mellow Partners v. Comm'r, 2018 PTC 148 (D.C. Cir. 2018).

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IRS Responds to State Legislative Attempts to Circumvent Limitation on SALT Deduction

The IRS issued a notice informing taxpayers that it intends to propose regulations addressing the federal income tax treatment of certain payments made by taxpayers for which taxpayers receive a credit against their state and local taxes. The notice was issued as several states are considering legislation intended to circumvent TCJA's limitation on the deduction for state and local taxes. Notice 2018-54.

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Former University Employee Can't Exclude Tuition Waiver from Income

The Tax Court held that a taxpayer who received a tuition waiver as part of a severance package when his employment at a university was terminated, and who later applied the waiver to his dependent child's tuition, was not entitled to exclude the value of the waiver from income because he was not either a current or retired employee of the university. The Tax Court rejected the taxpayer's argument that he was an employee for the year at issue because he received a Form W-2 reporting the value of the waiver, and found that the university's elimination of his position in a workforce reorganization did not constitute separation from the university by retirement. Voigt v. Comm'r, T.C. Summary 2018-25.

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Entertainment Company Was a Trade or Business, but Failed to Substantiate Expenses

The Tax Court held that an entertainment company that signed artists and produced, promoted and distributed their work was engaged in a trade or business for profit because, although the company never earned a profit during the years at issue, the owner had prior business successes in the music industry, ran the company in a businesslike manner, and devoted significant capital to make it a profitable business. However, the owner's losses from the business were denied because the court found that the company's bank statements, which were the only evidence of the expenses produced by the owner, were insufficient to establish the amounts and business purpose of the expenses. Barker v. Comm'r, T.C. Memo 2018-67.

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Professional Gambler Can't Deduct Track's Takeout in Calculating Gambling Losses

The Ninth Circuit affirmed a Tax Court decision which held that an accountant, who was also a professional gambler, could not deduct from his ordinary income that portion of his losing wagers representing the track's "takeout" - the percentage of all monies wagered on a horse race that the track retains to offset its business costs. The court rejected the taxpayer's argument that the takeout was an expense to him separate and apart from the wager itself and was therefore deductible as an ordinary and necessary expense from non-gambling income under Code Sec. 162(a). Lakhani v. Comm'r, 2018 PTC 135 (9th Cir. 2018).

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Fifth Circuit Affirms Tax Court's Holdings on Closing Agreement and Offer in Compromise

The Fifth Circuit held that, where the IRS entered a closing agreement showing zero tax liability but later found that its calculations were incorrect and assessed a liability of approximately $2 million, the Tax Court did not exceed its jurisdiction in holding that the assessments were not barred by the closing agreement because the agreement was not a legal impediment to assessment and did not fix the taxpayer's liability for any particular year. The Fifth Circuit also found no error in the denial by the IRS Office of Appeals of an offer in compromise of $40,000 where the taxpayer's own estimate of net worth and expected future income was approximately $545,000. Estate of Duncan v. Comm'r, 2018 PTC 134 (5th Cir. 2018).

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 2. Tax Briefs 

 

AFRs

IRS Issues June 2018 AFRs: In Rev. Rul. 2018-16, the IRS issued a ruling which prescribes the applicable federal rates for June 2018. This guidance provides various prescribed rates for federal income tax purposes including the applicable federal interest rates, the adjusted applicable federal interest rates, the adjusted federal long-term rate, the adjusted federal long-term tax-exempt rate and are determined as prescribed by Code Sec. 1274.

 

Deductions

Taxpayer Who Failed 39-Week Test Can't Deduct Moving Expenses: In Rabadi v. Comm'r, T.C. Memo. 2018-70, the Tax Court held that a couple could not deduct moving expenses for the year at issue because (1) they failed to substantiate the expenses involved, and (2) they did not establish that the husband stayed and worked in a new location for the requisite 39 weeks to be eligible to deduct moving expenses. In addition, the court found the couple liable for the accuracy-related penalties under Code Sec. 6662(a).

Mileage Costs Incurred to Visit Customer Facilities Were Personal Commuting Expenses: In Fehr v. Comm'r, T.C. Summary 2018-26, the Tax Court held that a taxpayer, who worked as a sales manager and visited various local customer facilities in the course of performing his job-related duties, was not entitled to deductions for unreimbursed employee business expenses because the court concluded that the pattern of the taxpayer's activity strongly suggested that the expenditures at issue were predominantly personal and only indirectly related to the conduct of company business. The court noted that the taxpayer's logs showed that on many days he drove from his home to a customer's facility, had lunch, and then returned home and that he likewise reported mileage expenses for round trips from his home to the company headquarters; thus, the miles that the taxpayer drove constituted nondeductible personal commuting expenses.

 

Estates, Trusts, and Gifts

Trust Owners Are Taxable on Income from Partnerships Owned by the Trust: In Full-Circle Staffing, LLC v. Comm'r, T.C. Memo. 2018-66, the Tax Court held that a trust which owned four partnerships was a sham and thus, the income from the four partnerships was taxable to the couple that owned the trust. However, the court did not uphold the penalty assessments against the couple because the couple had relied on tax professionals to prepare their tax return and thus met the reasonable cause exception for avoiding the penalties.

 

Healthcare

IRS Updates Premium Tax Credit for 2019 Adjustments: In Rev. Proc. 2018-34, the IRS issued the 2019 indexing adjustments for certain provisions under Code Sec. 36B. In particular, the IRS updated the Applicable Percentage Table in Code Sec. 36B(b)(3)(A)(i), which is used to calculate an individual's premium tax credit.

 

Partnerships

Partnership's Transfer Property Transfer Was a Quid Pro Quo Exchange; Charitable Deduction Denied: In Triumph Mixed Use Investments III, LLC, v. Comm'r, T.C. Memo. 2018-65, the Tax Court held that a partnership could not deduct more than $11 million in charitable contributions as the result of its transfer of real property and development credits to a city in which it was developing a planned community. The court concluded that benefits received by the partnership in exchange for the contribution had substantial value and the tax matters partner did not report or value those benefits on the partnership tax return.

Partners Can't Rely of Tax Shelter Promoter's Advice to Avoid Penalties: In RB-1 Investment Partners v. Comm'r, T.C. Memo. 2018-64, the Tax Court held that two brothers, who were partners in a partnership which sold a family business and engaged in a Son-of-BOSS deal to manufacture tax losses to offset the resulting gains, were liable for accuracy-related penalties on the resulting tax deficiencies. According to the court, the partners could not meet the reasonable-cause-and-good-faith defense to the penalties by relying on the advice of a tax shelter promoter.

 

Procedure

Facebook Doesn't Have Enforceable Right to Take Its Case to IRS Appeals: In Facebook, Inc. & Subs v. IRS, 2018 PTC 139 (N.D. Calif. 2018), a district court held that Facebook did not have an enforceable right to take its tax case, in which the IRS asserted that Facebook undervalued certain intangible property that it transferred to its Ireland-based subsidiary by approximately $7 billion, to IRS Appeals, or to compel the IRS to do so. The court concluded that (1) Facebook lacked standing because the deprivation of a nonexistent right to access IRS Appeals does not constitute injury in fact, and (2) the IRS's decision not to refer Facebook's tax case to IRS Appeals was not reviewable under the Administrative Procedure Act.

Statute Doesn't Prevent IRS from Seizing and Selling Marijuana Equipment: In CCA 201820018, the Office of Chief Counsel advised that, pursuant to Code Sec. 6331 and Code Sec. 6335, the IRS may administratively seize and sell gas chromatographer mass spectrometers (GCMS) and liquid chromatographer mass spectrometers (LCMS) used by taxpayers involved in the marijuana industry to measure cannabinoids in marijuana. According to the Chief Counsel's Office, GCMSs and LCMSs are not drug paraphernalia under the Drug Paraphernalia Statute (28 U.S.C. Sec. 863) and, thus, there is generally no restriction on the seizure and sale of such items.

Taxpayer Not Entitled to Attorney's Fees After Suing IRS for FOIA Records: In Hohman v. IRS, 2018 PTC 144 (E.D. Mich. 2018), a district court held that a taxpayer, who brought suit against the IRS for failing to timely provide information she had requested under FOIA, was not entitled to attorney's fees and costs because she had not substantially prevailed in the litigation. The court rejected the taxpayer's argument that she substantially prevailed because she obtained relief through a judicial order and instead sided with the IRS and found that the filing of the taxpayer's complaint did not cause the release of records because the filing of the complaint was not reasonably necessary to obtain the requested records and the lawsuit did not have "a causative effect" on the release of the requested records.

Lawyer's Failure to Provide Required Info Precludes Offer-in-Compromise: In Solny v. Comm'r, T.C. Memo. 2018-71, the Tax Court sustained a proposed collection action by the IRS against a lawyer who had outstanding tax liabilities of almost $200,000. The court noted that at his collection due process hearing, the lawyer sought a collection alternative but did not supply any of the required forms or necessary financial information and thus it was not an abuse of discretion for the IRS to reject collection alternatives and sustain the collection action.

 

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 3. In-Depth Articles 

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IRS Updates and Consolidates Guidance on Charitable Contributions

The IRS issued a revenue procedure which sets forth the extent to which grantors and contributors may rely on the listing in IRS databases of organizations eligible to receive tax-deductible contributions under Code Sec. 170, for purposes of determining whether the grants or contributions to such organizations are deductible under Code Sec. 170, and for certain other purposes. The revenue procedure also provides safe harbors for determining that a grantor's or contributor's grant or contribution will not cause the grantor or contributor to be considered to be responsible for, or aware of, an act that results in an organization's loss of public charity classification and for determining that a grant or contribution is considered an unusual grant. Rev. Proc. 2018-32.

Background

The IRS has issued several revenue procedures to describe the extent to which grantors and contributors may rely on the IRS's identification of an organization's tax-exempt and foundation status and to provide safe harbors with regard to the effect of grants and contributions on an organization's foundation status. In Rev. Proc. 81-6, the IRS provides a safe harbor to all grantors and contributors to determine if they were entitled to rely on the classification of an organization as a public charity, and would be deemed not to have knowledge of, be responsible for, or be aware of a substantial and material change in an organization's source of support that gave rise to the revocation of a determination letter or ruling classifying the organization as a public charity.

In Rev. Proc. 81-7, the IRS provides a safe harbor to grantors and contributors as to the grants and contributions that will be considered unusual grants. Under Reg. Sec. 1.170A-9(f)(6)(ii) and Reg. Sec. 1.509(a)-3(c)(3), the receipt of an "unusual grant" will not result in a grantee organization losing its classification as a public charity and becoming a private foundation because an unusual grant is excluded from both the numerator and the denominator of the applicable support fraction for purposes of determining whether the organization is publicly supported under Code Sec. 170(b)(1)(A)(vi) and Code Sec. 509(a)(1) or under Code Sec. 509(a)(2). Thus, a grantor or contributor who makes a grant or contribution that is an "unusual grant" to a publicly supported organization will not be responsible for an act that results in the organization's loss of classification as a publicly supported organization and is entitled to rely on the organization's classification as a publicly supported organization.

In Rev. Proc. 89-23, the IRS provides an additional safe harbor to private foundation grantors and contributors for determining if they were entitled to rely on the classification of an organization, and would be deemed not to have knowledge of, or be responsible for, or aware of, a substantial and material change in an organization's source of support that gave rise to the revocation of a determination letter or ruling classifying the organization as a public charity. This additional safe harbor was provided to private foundations because in general their reliance on the classification of an organization relates to their liability for excise taxes under Code Sec. 4942 and Code Sec. 4945 if they make grants or contributions to other private foundations, rather than to the deductibility of contributions.

As an update to earlier revenue procedures, in Rev. Proc. 2011-33, the IRS sets forth the extent to which grantors and contributors may rely on the listing of an organization in IRS Pub. 78, Cumulative List of Organizations Described in Code Sec. 170(c), for purposes of deducting contributions under Code Sec. 170 and making grants under Code Sec. 4942, Code Sec. 4945, and Code Sec. 4966.

IRS Databases of Organizations Eligible to Receive Deductible Contributions

To assist the general public, the IRS maintains and updates two different publicly available compilations of information on organizations eligible to receive tax-deductible contributions under Code Sec. 170. The first compilation lists organizations that are eligible to receive tax-deductible charitable contributions (Tax Exempt Organization Search (Pub. 78 data)) and the second compilation is an extract of certain information concerning tax-exempt organizations from the IRS electronic Business Master File (BMF) (the EO BMF Extract).

IRS Combines Prior Procedures into One Revenue Procedure

In order to simplify compliance for grantors and contributors, the IRS issued Rev. Proc. 2018-32, which combines the safe harbors of Rev. Proc. 81-6, Rev. Proc. 81-7, and Rev. Proc. 89-23 and the reliance revenue procedure of Rev. Proc. 2011-33, and replaces them with one revenue procedure on deductibility and reliance issues for grantors and contributors - Rev. Proc. 2018-32.

General Reliance Rule under Revenue Procedure 2018-32

Under Rev. Proc. 2018-32, if an organization listed in or covered by Tax Exempt Organization Search (Pub. 78 data) or the EO BMF Extract ceases to qualify as an organization to which contributions are deductible under Code Sec. 170 and the IRS revokes a determination letter or ruling concluding that the organization is one to which contributions are deductible under Code Sec. 170, grantors and contributors to that organization may generally rely on the determination letter or ruling information provided in Tax Exempt Organization Search (Pub. 78 data) or the EO BMF Extract that contributions to the organization are deductible under Code Sec. 170 until the date of a public announcement stating that the organization ceases to qualify as an organization contributions to which are deductible. The public announcement may be made via the Internal Revenue Bulletin, on the portion of the IRS website (at {{www.irs.gov }}{) that relates to exempt organizations, or by such other means designated to put the public on notice of the change in the organization's status.

Safe Harbor Rules under Revenue Procedure 2018-32

There are several safe harbor rules in Rev. Proc. 2018-32. One of the safe harbor rules provides that grantors and contributors will not be considered responsible for, or aware of, an act that results in the loss of classification due to a change in financial support if the aggregate of grants or contributions received from such grantor or contributor for the taxable year of the recipient organization in which the grant or contribution is received is 25 percent or less of the aggregate support received by the recipient organization for the four tax years immediately preceding such tax year. If a grant or contribution is made during the first four and one-half months of the recipient organization's tax year, the computation period may consist of the four tax years immediately preceding such tax year or the four tax years immediately preceding the prior taxable year. This safe harbor provision is not applicable if the grantor or contributor has actual knowledge of the loss of classification of public charity status or after the date of a public announcement that the organization ceases to qualify as a public charity.

Under another safe harbor rule, private foundation grantors or contributors will not be considered responsible for, or aware of, an act that results in a recipient organization's loss of classification as a public charity due to a change in financial support if the recipient organization has received a determination letter or ruling that it is described in Code Sec. 170(b)(1)(A)(vi) and Code Sec. 509(a)(1) or in Code Sec. 509(a)(2) and the recipient organization is not controlled directly or indirectly by the private foundation. This safe harbor does not apply if the private foundation grantor or contributor has actual knowledge of the loss of classification of public charity status or after the date of a public announcement that the organization ceases to qualify as a public charity.

Finally, a safe harbor is provided for certain "unusual grants" as defined in Reg. Sec. 1.170A-9(f)(6)(ii) and Reg. Sec. 1.509(a)-3(c)(3).

Effective Date

Rev. Proc. 2018-32 is effective May 16, 2018 and supersedes Rev. Proc. 81-6, Rev. Proc. 81-7, Rev. Proc. 89-23, and Rev. Proc. 2011-33.

For a discussion of rules relating to organizations that are qualified to receive tax deductible contributions, see Parker Tax ¶84,115.

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Partnership Consisting of Disregarded Entities Did Not Qualify for TEFRA Small Partnership Exception

The D.C. Circuit held that a partnership consisting of two single-member LLCs classified as disregarded entities did not qualify for the exception under the Tax Equity and Fiscal Responsibility Act (TEFRA) for small partnerships because a small partnership cannot have a partner that is a passthrough entity. The D.C. Circuit rejected the taxpayers' arguments that the individuals, not the LLCs, were the actual partners of the partnership, finding that the partnership agreement clearly named the LLCs as the partners and that the definition of a pass-thru partner in the regulations was a reasonable interpretation of an ambiguous statute. Mellow Partners v. Comm'r, 2018 PTC 148 (D.C. Cir. 2018).

Background

Mellow Partners was a partnership formed in November 1999 and dissolved less than a month later. Mellow's partnership agreement stated that it was formed to invest in securities and other assets. The agreement also stated that the partnership was formed by and between MB 68th Street Investments LLC (68th Street) and WNM Hunters Crest Investments LLC (Hunters Crest). Myer Berlow, the sole member of 68th Street, and William Melton, the sole member of Hunters Crest, signed the partnership agreement on behalf of their respective LLCs. The LLCs were treated as disregarded entities and did not file tax returns for 1999.

In 2000, Mellow filed a Form 1065 partnership return with Schedules K-1 attached identifying 68th Street and Hunters Crest as Mellow's partners. Mellow answered "No" to the question on the Form 1065 of whether it was subject to the consolidated audit procedures under the Tax Equity and Fiscal Responsibility Act (TEFRA). Notwithstanding that assertion, the IRS audited Mellow and issued a Final Partnership Administrative Adjustment (FPAA) setting forth adjustments to Mellow's partnership items. The FPAA concluded that Mellow was formed solely for tax avoidance purposes, lacked economic substance, and constituted an economic sham for tax purposes. According to the FPAA, Mellow's partners engaged in a series of offsetting transactions involving digital options that were designed to generate losses to offset the partners' tax liabilities. The partners' outside bases in their partnership interests were reduced to zero and accuracy related penalties under Code Sec. 6662 were applied.

Mellow petitioned the Tax Court to challenge the FPAA. It asserted that the FPAA improperly asserted adjustments that were not partnership items over which the court had jurisdiction. The Tax Court found that the IRS's adjustments in the FPAA were correct and rejected Mellow's jurisdiction argument. Mellow appealed to the D.C. Circuit.

Analysis

TEFRA allows the IRS to bring a partnership level proceeding to adjust partnership items by issuing a FPAA to the partnership's partners. TEFRA procedures apply to all business entities that are required to file a partnership return. However, a limited exception applies for small partnerships, defined as having 10 or fewer partners, each of whom is an individual, C corporation, or an estate of a deceased partner. Reg. Sec. 301.6231(a)(1)-1(a)(2) provides that the small partnership exception does not apply if any partner is a "pass-thru partner" as defined in Code Sec. 6231(a)(9). That statute defines a pass-thru partner as a partnership, estate, trust, S corporation, nominee, "or other similar person through whom other persons hold an interest in the partnership."

Mellow argued that a disregarded entity is treated as a nullity for all tax purposes; therefore, if a disregarded single member LLC is a partner in a partnership, the LLC's owner, rather than the LLC, is the partner. On that basis, Mellow asserted that it was a partnership consisting not of two LLCs but two individual partners and, as such, qualified for the small partnership exception. Mellow reasoned that the list of entities in Code Sec. 6231(a)(9) does not include disregarded entities or single member LLCs, and contended that a "similar person" under the statute must be one who can have multiple owners, because the catchall phrase refers to "a similar person through whom other persons [plural] hold an interest."

Mellow also challenged the Code Sec. 6662 penalty, for the first time on appeal, by arguing that the IRS failed to comply with the written approval requirement in Code Sec. 6751(b)(1). Mellow argued that it would have been premature to raise the issue in the Tax Court because the Second Circuit's decision in Chai v. Comm'r, 2017 PTC 124 (2d Cir. 2017), holding that the signature requirement is part of the IRS's burden of production, created new law and was decided after the Tax Court's decision in this case. Mellow asked the D.C. Circuit to remand the case to the Tax Court to determine whether the IRS met its Code Sec. 6751(b)(1) obligations.

The D.C. Circuit held that Mellow did not qualify for the small partnership exception and declined to consider its challenge to the penalty. The court found ample evidence in the record to reject Mellow's argument that Berlow and Melton, and not the LLCs, were Mellow's partners. Mellow had stipulated in the Tax Court proceeding that its only partners were the LLCs. The partnership agreement stated that it was formed by and between the LLCs, and it identified Hunters Crest as its managing partner. The partnership agreement was signed by Berlow and Melton on behalf of their respective LLCs. Mellow issued Schedules K-1 to the LLCs, not to their individual owners.

The court found no authority for Mellow's assertion that an LLC's tax classification dictated whether the LLC or its sole owner was treated as a partner in a partnership comprised of two single member LLCs under TEFRA. In the court's view, the check-the-box regulations merely determine the tax consequences of that particular entity. They do not determine the tax consequences of a higher-level partnership composed of two or more disregarded entities, nor do they specify who holds a partnership interest for TEFRA purposes.

The D.C. Circuit also rejected Mellow's argument that the pass-thru partner provision should not be applied to narrow the contours of the small partnership exception. The court explained that although Code Sec. 6231(a)(9) does not expressly include disregarded single member LLCs as pass-thru partners, the IRS has consistently interpreted Code Sec 6231(a)(9) to include disregarded entities. The court cited Rev. Rul. 2004-88 which, in the court's view, clearly provides that a partnership is not a small partnership if it has pass-thru partners and concludes that a single member LLC constitutes a pass-thru partner. According to the court, the IRS's position in Rev. Rul. 2004-88 had been consistently maintained and was entitled to deference. The D.C Circuit agreed with the conclusion in Seaview Trading, LLC v. Comm'r, 2017 PTC 272 (9th Cir. 2017), where the Ninth Circuit found that the IRS's position in Rev. Rul. 2004-88 was consistent with the statute and eminently reasonable.

The D.C. Circuit found that the IRS's determination was further supported by the language of Code Sec. 6231(a)(9). The court agreed with Seaview's finding that the "other similar person" catchall phrase expressly contemplates its application beyond the specific enumerated entities. In the court's view, the IRS's focus on whether an entity holds legal title on behalf of another was consistent with the plain text of the statute, which specifically refers to the holding of a partnership interest on behalf of another. The D.C. Circuit was unpersuaded that a "similar person" had to be an entity that could have multiple owners; as the court explained, Mellow was ignoring the plain meaning of the plural term "persons" in the statute, which in the court's view necessarily includes the singular "person."

The D.C. Circuit rejected Mellow's Code Sec. 6751(b)(1) challenge to the penalty because Mellow failed to raise it in the Tax Court. The court reasoned that in other Tax Court cases decided after Chai, the issue of whether the IRS had met its Code Sec. 6751(b)(1) obligations was raised while that dispute remained pending. In the court's view, nothing precluded Mellow from raising a Code Sec. 6751(b)(1) challenge in the Tax Court; although Chai was decided after the Tax Court's decision in this case, the statute had been in existence since 1998. In the court's view, Mellow was free to bring the same challenge raised by the taxpayer in Chai. By failing to do so, Mellow failed to preserve the argument and the court declined to consider it.

For a discussion of TEFRA audit procedures, see Parker Tax ¶28,505. For a discussion of procedural requirements for computing penalties, see Parker Tax ¶262,195.

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IRS Responds to State Legislative Attempts to Circumvent Limitation on SALT Deduction

The IRS issued a notice informing taxpayers that it intends to propose regulations addressing the federal income tax treatment of certain payments made by taxpayers for which taxpayers receive a credit against their state and local taxes. The notice was issued as several states are considering legislation intended to circumvent TCJA's limitation on the deduction for state and local taxes. Notice 2018-54.

The Tax Cuts and Jobs Act of 2017 (TCJA) limits an individual's deduction under Code Sec. 164 for the aggregate amount of state and local taxes paid during the calendar year to $10,000 ($5,000 in the case of a married individual filing a separate return). State and local tax payments in excess of those amounts are not deductible. This new limitation applies to tax years beginning after December 31, 2017, and before January 1, 2026.

In response to this new limitation, some state legislatures are considering or have adopted legislative proposals that would allow taxpayers to make transfers to funds controlled by state or local governments, or other transferees specified by the state, in exchange for credits against the state or local taxes that the taxpayer is required to pay. The aim of these proposals is to allow taxpayers to characterize such transfers as fully deductible charitable contributions for federal income tax purposes, while using the same transfers to satisfy state or local tax liabilities.

In response to the state initiatives, the IRS issued Notice 2018-54. The notice informs taxpayers that the Department of the Treasury and the IRS intend to propose regulations addressing the federal income tax treatment of payments made by taxpayers for which taxpayers receive a credit against their state and local taxes.

In the notice, the IRS stated that, despite state efforts to circumvent the new statutory limitation on state and local tax deductions, taxpayers should be mindful that federal law controls the proper characterization of payments for federal income tax purposes. In addition, the IRS said that it intends to propose regulations addressing the federal income tax treatment of transfers to funds controlled by state and local governments (or other state-specified transferees) that the transferor can treat in whole or in part as satisfying state and local tax obligations. The proposed regulations will make clear that the requirements of the Internal Revenue Code, informed by substance-over-form principles, govern the federal income tax treatment of such transfers. According to the IRS, the proposed regulations will clarify the relationship between the federal charitable contribution deduction and the new statutory limitation on the deduction for state and local tax payments.

For a discussion of the deductibility of state and local taxes, see Parker Tax ¶83,125.

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Former University Employee Can't Exclude Tuition Waiver from Income

The Tax Court held that a taxpayer who received a tuition waiver as part of a severance package when his employment at a university was terminated, and who later applied the waiver to his dependent child's tuition, was not entitled to exclude the value of the waiver from income because he was not either a current or retired employee of the university. The Tax Court rejected the taxpayer's argument that he was an employee for the year at issue because he received a Form W-2 reporting the value of the waiver, and found that the university's elimination of his position in a workforce reorganization did not constitute separation from the university by retirement. Voigt v. Comm'r, T.C. Summary 2018-25.

John Voigt worked in Tulane University's computer information sciences department from 1985 to 1991. His position was eliminated in June 1991 along with about 100 others as part of Tulane's plan to streamline and reorganize its workforce. The reason given on Voigt's separation notice was "elimination of position." After leaving Tulane, Voigt worked at several other jobs and later became self-employed. He did not work for Tulane in any capacity after 1991.

Voigt's severance package included payment of accrued vacation time, severance pay, six months of health plan coverage, and an extended tuition waiver. Under the tuition waiver policy, an employee with five or more years of full time service would receive a total number of annual tuition waivers equal to the number of years of service. The use of the waivers was limited by certain requirements, including that the applying student satisfy Tulane's admission guidelines.

Voigt's daughter, Gabrielle, attended Tulane as a full time undergraduate student from 2012 through 2015. Voigt filed applications for Gabrielle to receive tuition waivers as his dependent for the spring and fall semesters of 2013, the year at issue. Tulane credited Gabrielle's account $21,575 based on her father's eligibility for the waiver.

In 2014, Tulane issued to Voigt a 2013 Form W-2 reflecting wages of $21,575 along with withheld amounts for Social Security and Medicare. Voigt also received a bill from Tulane for 2013 FICA taxes of $1,650. Voigt emailed Tulane to inquire about the Form W-2. A payroll department employee replied that, because Voigt received the tuition waiver benefit and was not an employee, the waiver was considered income. Voigt asked for confirmation of his dates of employment with Tulane and the employee responded back showing Voigt was employed from February 1985 to June 1991. Voigt did not report the $21,575 on his 2013 tax return.

The IRS sent a notice of deficiency in 2016 stating that Voigt had failed to report the waiver amount as income for 2013, resulting in a deficiency of approximately $6,900. Voigt challenged the notice in the Tax Court.

Under Code Sec. 117(d), gross income does not include a qualified tuition reduction. To qualify, the reduction must be provided to an employee of a qualified educational institution for undergraduate education of either the employee or someone treated as an employee under Code Sec. 132(h). Code Sec. 132(h) provides that a former employee who separated from service due to retirement, and the dependents of an employee, are treated as employees for purposes of Code Sec. 117(d).

Voigt argued that he was an employee of Tulane in 2013 because he received a Form W-2, which contained references to employer and employee. Voigt concluded that, based on the Form W-2, Tulane thought he worked there sometime in 2013. In the alternative, Voigt asserted that he qualified as retired under Code Sec. 132(h). He argued that the term is not defined in the statute and that being laid off is a type of early retirement. Voigt also challenged the IRS's position that he received the waiver benefit in 2013, arguing that it represented money that he earned some 20 years earlier. The Tax Court inferred that Voigt felt the income should have been taxed in 1991 under a theory of constructive receipt.

The Tax Court held that Voigt was required to include the waiver in income in 2013 because he was not a current or retired employee of Tulane and he received the income in that year. The court reasoned that the issuance of a Form W-2 does not create an employment relationship and found that Voigt presented no other evidence to prove that he was employed by Tulane in 2013. Voigt had conceded he did not work for the university in any capacity after his termination in 1991, the court noted. Tulane's records and communications with Voigt also showed that he had not been an employee since 1991.

The Tax Court found that Voigt was not treated as an employee as a result of having separated from service with Tulane by retirement. The court explained that the plain meaning of retirement involves termination of a career due to age or health. In the court's view, the record did not support Voigt's assertion that he retired under that definition. The notice of separation issued by Tulane stated the reason for termination as "elimination of position," even though retirement was a preprinted option. Voigt's severance package included assistance in finding other employment, and it included a letter from Tulane's president explaining that the terminations were necessary due to rising costs. Additionally, Voigt continued working for other employers after leaving Tulane. For these reasons, the court found that Voigt's termination was not the result of age, years of service or health considerations.

The Tax Court also rejected Voigt's argument that the waiver was not taxable as income in 2013. The court found that although the waiver was made available to Voigt in 1991, he could not receive the benefit until he or his dependent satisfied Tulane's admission guidelines and enrolled in the university. As such, there were substantial limitations that precluded Voigt from having constructively received the waiver before it was redeemed against tuition actually charged. Therefore, the court concluded that the benefit was properly included in income for 2013, the year it was actually received.

For a discussion of the exclusion for qualified tuition reductions, see Parker Tax ¶77,310.

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Entertainment Company Was a Trade or Business, but Failed to Substantiate Expenses

The Tax Court held that an entertainment company that signed artists and produced, promoted and distributed their work was engaged in a trade or business for profit because, although the company never earned a profit during the years at issue, the owner had prior business successes in the music industry, ran the company in a businesslike manner, and devoted significant capital to make it a profitable business. However, the owner's losses from the business were denied because the court found that the company's bank statements, which were the only evidence of the expenses produced by the owner, were insufficient to establish the amounts and business purpose of the expenses. Barker v. Comm'r, T.C. Memo 2018-67.

Cecile Barker is an experienced aerospace engineer with a background in music. In the mid-1960s he formed the group Peaches & Herb, which achieved considerable commercial success, and in 1973 he co-produced a song by Gladys Knight & the Pips. Barker left the music business and formed an aerospace engineering company in the 1970s. In 2001, he sold that company and decided to reenter the music business.

Barker formed SoBe Entertainment International LLC in 2002. He contributed all of SoBe's capital and owned 95 percent of its profits and losses. His son, Yannique, and daughter, Angelique, split the other five percent. SoBe is an independent entertainment company that signs artists and celebrities, produces music and videos, and promotes its artists and distributes their work. As SoBe's chief executive officer (CEO) and managing member, Barker devoted 40 to 60 hours per week to the business. He consulted music industry professionals before forming SoBe, and hired several high profile producers to bolster SoBe's chances of success. SoBe employed a marketing professional and, at one time, chief financial officer (CFO). In total, SoBe had eight employees and regularly hired independent contractors.

Yannique Barker was one of SoBe's signed artists. SoBe had several artist contracts and renewed at least one. SoBe also contracted with producers and writers to work with its artists. SoBe also entered into a distribution agreement with Universal Music to distribute music digitally. SoBe advertised online and through its websites in addition to placing ads in print magazines. SoBe was also a member of the trade organization Record Industry Association of America.

Barker saw stars like Adele and Taylor Swift as examples of how one artist could make his company profitable. Although none of his artists had achieved such a level of success, they had each contributed to the catalog of songs that SoBe owned. SoBe's catalog had value in March 2016 and it placed a song in a TV show on ABC.

SoBe was founded at a time of major change to the music industry, as online platforms made it possible to buy or sell music at low cost or share it for free. SoBe cut costs as a result of the effects of these platforms, reducing its employees from 17 to 8, and moving its recording studio to a less expensive location. SoBe had never earned a profit and its cumulative losses increased from year to year.

SoBe employed John McQuagge as its CFO and controller from 2006 through 2010. McQuagge used Quickbooks software to produce SoBe's general ledger and journals. SoBe had two separate bank accounts, one used as a primary operating account and the other used for payroll. McQuagge balanced the accounts against monthly bank statements. While SoBe kept records of the checks it used to pay its expenses from 2006-2010, other expenses recorded in SoBe's general ledger were paid by credit card or cash, for which no documentation existed other than bank statements.

SoBe had two outside accounting firms prepare its tax returns for 2003-2011. SoBe provided its accountants with all of its Quickbooks records. Accountant Stanley Foodman prepared SoBe's returns for 2006-2009. Foodman also prepared Barker's personal income tax returns for 2005-2011. Foodman calculated Barker's net operating losses (NOLs) and total capital contributions to SoBe for 2002-2011 and listed each of his individual capital contributions to SoBe in 2006-2009. Foodman determined that Barker made over $45 million in capital contributions to SoBe from 2002-2011. This calculation was based on the Schedules K-1, Partner's Share of Income, Deductions, Credits, etc. from SoBe, supplemented by SoBe's general ledger and bank statements.

Barker reported income from sources other than SoBe, mostly capital gains, interest and dividends. His 2011 income came mostly from Mistral, a defense contractor Barker helped found. Foodman calculated Barker's income or loss after taking into account Barker's interest and dividend income, net capital gains and losses, and share of gain or loss reported on the Schedules K-1 from SoBe and other businesses in which he held an interest.

Barker was the victim of identity theft when someone filed a tax return for 2011 using his social security number. Barker eventually filed his 2011 Form 1040 in August 2016. His return showed a loss from SoBe of over $800,000 and an NOL carryover of $19.6 million for 2011. The IRS issued a notice of deficiency in June 2014, determining various adjustments to Barker's income and deductions. The notice showed that Barker owed approximately $1.2 million in tax for 2011 and that a 25 percent addition to tax applied for Barker's failure to file his return on time. Barker challenged the notice in the Tax Court.

The IRS asserted that SoBe did not incur any operating losses (and thus, no losses flowed through to Barker) because SoBe was a hobby rather than a trade or business. In the IRS's view, Barker lacked the actual and honest objective of making a profit. The IRS also argued that Barker could not substantiate the expenses giving rise to SoBe's operating losses. Barkley contended that SoBe was run as a business from its formation and that making a profit was always its primary objective. He also challenged the addition to tax by arguing that his late filing was due to the identity theft.

The Tax Court held that, under the facts and circumstances, Barker operated SoBe as a trade or business with the actual and honest objective of making a profit. The Tax Court found that Barker had prior business successes in the music industry and had run successful defense contracting businesses, having helped to turn one of them around after several years without a profit. In the court's view, Barker leveraged his experience and contacts in the music industry as he prepared for SoBe's formation. He also ran SoBe in a businesslike manner, working there full time and devoting significant capital to it.

Although SoBe had never been profitable, the court found that it had positioned itself to make a profit by amassing a catalog of songs that it had been able to monetize. The court also took into account the turmoil in the music industry and the difficulties faced by artists and producers during the years at issue. The fact that Barker's son, Yannique, was a SoBe artist did not mean that SoBe was merely a vehicle to fund Yannique's musical aspirations, according to the Tax Court, because SoBe had other artists and did not devote most of its resources to Yannique. Nor did the fact that Barker enjoyed the creative aspects of the music industry, and had income from other sources. prevent SoBe from being engaged in a trade or business, given the other factors indicating a profit motive.

Although SoBe was engaged in a trade or business for profit, the Tax Court found that Barker failed to provide evidence on which the Tax Court could determine or even estimate the amount of SoBe's business expenses for all prior years of its operation. The court found that the only documentation to support SoBe's business expense deductions for previous years were SoBe's bank statements. Those statements, in the court's view, did not document the amounts of SoBe's expenses paid by cash or credit card, nor did they describe the business purpose of the expenditures. The court found that Barker had produced SoBe's general ledger only for 2005-2009 and that his testimony was insufficient to fill in the gaps. The Tax Court reasoned that Barker had access to additional documentation, including SoBe's general ledger for all years of its existence, but failed to produce it; therefore the court presumed that such documentation would be unfavorable to Barker.

The Tax Court also held that Barker failed to provide enough evidence for it to determine his NOL deduction for 2011. Barker failed to substantiate SoBe's income and business expenses for all prior years and, in turn, the amount of losses for which he claimed a deduction for 2011. If the court could not estimate the amount of SoBe's operating losses, it could not know how much flowed through to Barker. Moreover, even if Barker had substantiated SoBe's expenses, the court could not determine how much of those losses were absorbed by Barker's other income in the years before 2011, because Barker did not produce his returns for 2002-2004 and those that he produced for later years were missing crucial information.

The Tax Court also upheld the penalty assessment after rejecting Barker's argument that his identity theft issue excused his failure to file his 2011 return on time. The court reasoned that Barker was a sophisticated businessman who should have known that he was required to file his return, and that his accountants and return preparers could have made inquiries.

For a discussion of determining whether an activity is engaged in for profit, see Parker Tax ¶97,505. For a discussion of ordinary and necessary business expenses, see Parker Tax ¶90,110.

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Professional Gambler Can't Deduct Track's Takeout in Calculating Gambling Losses

The Ninth Circuit affirmed a Tax Court decision which held that an accountant, who was also a professional gambler, could not deduct from his ordinary income that portion of his losing wagers representing the track's "takeout" - the percentage of all monies wagered on a horse race that the track retains to offset its business costs. The court rejected the taxpayer's argument that the takeout was an expense to him separate and apart from the wager itself and was therefore deductible as an ordinary and necessary expense from non-gambling income under Code Sec. 162(a). Lakhani v. Comm'r, 2018 PTC 135 (9th Cir. 2018).

Observation: The Tax Cuts and Jobs Act of 2017 (TCJA) clarified the scope of the term "losses from wagering transactions" as that term is used in Code Sec. 165(d). The clarification provides that this term includes any deduction otherwise allowable in carrying on any wagering transaction. The TCJA provision thus reversed the result reached by the Tax Court in Mayo and is effective after December 31, 2017, and before December 31, 2025.

For 2005-2009, Shiraz Lakhani was a CPA who operated an accounting practice in California that included the preparation of tax returns. During those years, Lakhani was also a professional gambler whose gambling activities were limited to parimutuel wagering on horse races. Lakhani, who placed bets on races occurring both at California racetracks and at racetracks in other states, reported his gambling winnings and losses on a separate Schedule C for each of the years at issue.

On each of the gambling Schedules C, he reported the gross amount he received on winning bets as "Gross receipts or sales," and he reported the amounts he bet as "Cost of goods sold," subtracting the latter from the former, to determine his gross income or loss from gambling. He also reported and deducted miscellaneous other expenses associated with his gambling activities and reported the sum of his gambling winnings, losses, and miscellaneous other expenses as his income or loss (net gambling income or loss, respectively) from gambling for the year. He then combined his net gambling income or loss with his accounting practice income for the year and reported the sum as his total net "Business income or (loss)" for the year.

For each of 2005, 2006, 2008, and 2009 (gambling loss years), Lakhani's net gambling loss exceeded his accounting practice income, so that Line 12 of each Form 1040 reported a business loss. For 2007, in which he reported a net gambling gain, and for 2009, Lakhani claimed net operating loss carryover deductions, which arose out of unused net gambling losses incurred in prior years.

Upon auditing Shiraz's tax returns, the IRS adjusted each of the gambling loss years by disallowing Shiraz's deduction for his net gambling losses on the basis of Code Sec. 165(d), which provides that gambling losses are allowed only to the extent of the gains from such transactions. The IRS also disallowed the net operating loss carryovers to 2007 and 2009.

For the years at issue, Code Sec. 165(d) provided that taxpayers could not deduct gambling losses in excess of winnings. However, the limitation in Code Sec. 165(d) did not limit deductions for expenses incurred to engage in the trade or business of gambling. In Mayo v. Comm'r, 136 T.C. 81 (2011), the Tax Court held that a gambler's business expenses were not "losses from wagering transactions" subject to the Code Sec. 165 deduction limitation. Such business expenses, the Tax Court concluded, were deductible under Code Sec. 162. In AOD-2011-06, the IRS acquiesced to that decision. For the years at issue, the limitation in Code Sec. 165(d) thus did not limit deductions for expenses incurred to engage in the trade or business of gambling.

In parimutuel wagering, the entire amount wagered on horse races is referred to as the betting pool or "handle." The pool can be managed to ensure that the event manager (i.e., the track) receives a share (or a percentage) of the betting pool regardless of who wins a particular event or race. That share is referred to as the "takeout," and the percentage, set by state law, varies from state to state, generally ranging from 15 percent to 25 percent and often depending upon the type of bet, e.g., "straight" or "conventional" win, place, or show wagers or "exotic" (multiple horse or multiple race) wagers, with the latter usually resulting in higher takeout percentages. The takeout is used to defray the track's expenses, including purse money for the horse owners, taxes, license fees, and other state-mandated amounts. What remains from the takeout after those expenses are paid is the track's profits.

Lakhani argued that, in extracting takeout from the betting pools, the tracks are acting in the capacity of a fiduciary because they are collecting taxes and fees that they are then sending to the different state and local tax authorities. He likened the process to that of an employer collecting payroll taxes from employees and sending the payroll taxes to the IRS and state agencies. According to Lakhani, his pro rata share of the takeout was a business expense and, as such, was not a loss from gambling subject to disallowance under Code Sec. 165(d). In making this argument, Lakhani cited the Tax Court's opinion in Mayo.

The IRS argued that, even if a deduction for takeout were available to Lakhani, his failure to furnish the factual information necessary to make a reasonable determination of the takeout percentage applicable to his losing bets (e.g., the extent to which those bets were attributable to the various parimutuel pools with varying takeout percentages at tracks in various states) was sufficient to bar Lakhani's right to a passthrough deduction for takeout expenses.

The Tax Court agreed with the IRS and held that Lakhani's attempt to analogize the track's retention and disbursement of takeout to an employer's payroll tax obligations with respect to its employees was misguided. First and foremost, the court observed, none of the payments the track makes from the "handle" (i.e., betting pool) discharge any obligation of any bettor. And while reduction of the parimutuel pool by the amount of the takeout reduces the amount in the pool available to pay winning wagers, none of the takeout can be said to come from a winning bettor's wager, which in all events must be returned to him in full with at least a small profit. Because the takeout is not an obligation or expense of the bettor, the court said, it cannot qualify as the bettor's deductible nongambling business expense under Mayo. Thus, the court held that Lakhani was not entitled to a passthrough deduction of such expenses. Lakhani appealed to the Ninth Circuit.

The Ninth Circuit affirmed the Tax Court after concluding that Lakhani's position was not sound. The court noted that the track's takeout, as mandated by California law, came from all of the money wagered, so it was not an expense to the taxpayer separate and apart from the wager. Furthermore, the Ninth Circuit agreed with the Tax Court's assessment that the takeout cannot be said to add to the loss of a losing bettor, who loses the same amount whether the takeout is 15 percent or nothing at all.

The Ninth Circuit also found that the Tax Court's decision was consistent with its decision in Mayo, recognizing a distinction between deductions for wagering losses limited to gains, and the deductions available for non-wagering gambling expenses that could be deducted from other income. In Mayo, the Ninth Circuit noted, the Tax Court allowed the taxpayer to deduct, among other expenses, car, office, travel, telephone, internet, admission, and ATM fees. Thus, the court concluded, since the IRS did not contest Lakhani's deductions for similar fees, the Tax Court's decision was consistent with Mayo, because Mayo did not involve, as Lakhani's case did, the house takeout.

For a discussion of the rules with respect to reporting gambling income or losses, see Parker Tax ¶85,120.

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Fifth Circuit Affirms Tax Court's Holdings on Closing Agreement and Offer In Compromise

The Fifth Circuit held that, where the IRS entered a closing agreement showing zero tax liability but later found that its calculations were incorrect and assessed a liability of approximately $2 million, the Tax Court did not exceed its jurisdiction in holding that the assessments were not barred by the closing agreement because the agreement was not a legal impediment to assessment and did not fix the taxpayer's liability for any particular year. The Fifth Circuit also found no error in the denial by the IRS Office of Appeals of an offer in compromise of $40,000 where the taxpayer's own estimate of net worth and expected future income was approximately $545,000. Estate of Duncan v. Comm'r, 2018 PTC 134 (5th Cir. 2018).

Jannette and Robert Duncan held partnership interests through RCD Investments, Inc. (RCD). The Duncans used RCD to participate in a Son-of-BOSS (SOB) transaction which reduced their individual income tax liability for 1999 and 2000. RCD also claimed bad debt deductions resulting in a net operating loss (NOL) for 2001. The Duncans carried the NOL back to claim a large refund for 1996.

Robert Duncan died in 2003. His estate was valued at over $8 million. The IRS informed Mrs. Duncan and Mr. Duncan's estate (the Duncans) that it would audit RCD's tax returns shortly before the estate's inventory was prepared. Months later, Mrs. Duncan agreed to participate in an IRS initiative offering reduced penalties to taxpayers who conceded the benefits of SOB transactions. Mrs. Duncan also agreed to the disallowance of a bad debt deduction taken by RCD in 2001. To formalize these agreements, Mrs. Duncan signed two Forms 4549, Income Tax Discrepancy Adjustments, specifying the tax liability for 1996 and 2000. These forms reflected that the Duncans owed taxes, but attributed the deficiencies to the disallowance of the bad debt deduction from 2001, not the SOB transaction.

The parties also entered a closing agreement on Form 906, Closing Agreement On Final Determination Covering Specific Matters, which required the Duncans to concede all claimed benefits and attributes from the SOB and pay a 10 percent penalty on any deficiency related to the transaction. The agreement stated that the Duncans would make full payment of their tax, penalties and interest resulting from the application of the terms of the agreement. At the time, the IRS's calculations (reflected on the Form 4549) showed the cancellation of the SOB related deductions, but no tax deficiency. The IRS countersigned the Form 906 without requiring payment.

The IRS later determined that its initial calculations were incorrect. Updated Forms 4549 were sent reflecting that the Duncans owed approximately $82,000 for 1996 and $2 million for 2000, including $739,000 from the cancelled SOB deduction and a 10 percent penalty. Mrs. Duncan signed the new Forms 4549 in July 2006, waiving the right to appeal or contest the liability and consenting to immediate collection.

When the IRS attempted to collect the tax, the Duncans disputed their tax liability in two collections due process (CDP) hearings. In the hearing for 1996, the Duncans submitted an offer in compromise (OIC) premised on doubt as to liability. The Duncans argued that they never agreed to the assessment and that the IRS failed to send them a notice of deficiency. In the 2000 hearing, the Duncans disputed the underlying liability. The IRS Office of Appeals (Appeals) concluded that by signing the Form 4549 for 1996, the Duncans had agreed to the 1996 liability and waived assessment restrictions. For 2000, Appeals determined that the Duncans had waived challenges to their underlying liability by signing the closing agreement and Form 4549 for that year. Notices of determination were issued sustaining the levies for both years.

The Duncans appealed to the Tax Court, which remanded the case to Appeals to consider the Duncans' new OIC based on doubt as to collectability. The Duncans offered $40,000 when their liability was approximately $3.47 million. They asserted that Mrs. Duncan had $545,000 in net assets and expected future income, but special circumstances justified the offer, including her advanced age (91), a life insurance loan obligation, and losses on an office building.

Appeals rejected the offer. It did not compute the Duncans' precise reasonable collection potential (RCP), but estimated that the Duncans owned $3.2 million in assets and had dissipated about $3.4 million from Mr. Duncan's estate, which the government would likely be able to recover though a lawsuit against the estate trustee. Appeals determined that calculating an exact RCP would be impossible due to the Duncans' interconnected web of family partnerships and trusts. Based on its estimate of the Duncans' assets, the likelihood of a full recovery by suing the trustee, and the large gap between the $40,000 offer and the Duncans' own RCP estimate of $545,000, Appeals rejected the OIC and issued a notice of determination requiring full payment.

Returning to the Tax Court, the Duncans argued that Appeals had abused its discretion in failing to verify that the IRS had complied with applicable law and procedures. The Duncans also attempted to challenge their underlying tax liabilities, but the Tax Court held that they had waived that right by signing the Forms 4549 agreeing to the liability. The Duncans also argued that the closing agreement barred the assessments because, by executing the closing agreement without requiring payment, the IRS had implicitly represented that no tax related to the SOB transaction would ever be due.

The Tax Court held that Appeals did not abuse its discretion by deciding that the closing agreement did not bar assessment. In the Tax Court's view, the closing agreement did not purport to fix the tax liability for a specific year, but rather to memorialize that the Duncans would relinquish all benefits from the SOB transaction. The Tax Court also concluded that Appeals properly rejected the Duncans' $40,000 OIC and did not err in basing the rejection on an inexact RCP estimate. The Duncans appealed to the Court of Appeals for the Fifth Circuit.

On appeal, the Duncans argued that by interpreting the closing agreement in the course of considering their argument that the closing agreement barred the assessments, the Tax Court erroneously rendered a decision on the merits of the underlying tax liabilities in excess of its jurisdiction. The Duncans also said that Appeals abused its discretion by failing to follow procedures required by the Internal Revenue Manual (IRM) including calculating the exact RCP.

The Fifth Circuit affirmed the Tax Court's holding that Appeals did not abuse its discretion by concluding that the IRS properly assessed the Duncans' tax liabilities. The Fifth Circuit also agreed with the Tax Court that the closing agreement did not fix the Duncans' liability, but only acknowledged that the Duncans would pay the correct taxes and penalties arising from the disallowed SOB transaction. The Fifth Circuit found that although the agreement required payment upon execution, it did not purport to settle the Duncans' liability. In the Fifth Circuit's view, the agreement allowed the IRS to recalculate the liability, and the IRS's failure to require payment on execution did not change the plain terms of the agreement.

The Fifth Circuit rejected the Duncans' argument that Appeals abused its discretion by failing to follow the applicable IRM procedures. In the court's view, Appeals was not required to calculate the Duncans' exact RCP. Given the disparity between the Duncans' $40,000 offer and their own $545,000 RCP, Appeals had ample justification to reject the OIC, the Fifth Circuit reasoned. The Fifth Circuit also concluded that Appeals correctly considered assets dissipated from Mr. Duncan's $8 million estate.

For a discussion of closing agreements, see Parker Tax ¶263,160. For a discussion of offers in compromise, see Parker Tax ¶263,165.

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