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Federal Tax Research Bulletin - The Latest Tax and Accounting Articles


Parker's Federal Tax Bulletin
Issue 236     
September 23, 2020    

 

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 1. In This Issue ... 

 

Tax Briefs

Debtor Can't Invoke CARES Act Provision to Extend Term of Bankruptcy Plan; Final Regs Clarify Effect of Personal Exemption on Premium Tax Credit; Rehabilitation Credit Regs Finalized Without Any Modifications ...

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IRS Finalizes Bonus Depreciation Regs; Withdraws Partnership Look-Through Rule

The IRS issued final bonus depreciation regulations, which generally affect taxpayers who depreciate qualified property acquired and placed in service after September 27, 2017. Among other changes, the final regulations (1) withdraw a complex partnership-look thru rule contained in the proposed regulations which addressed the extent to which a partner was deemed to have a depreciable interest in property held by a partnership; (2) clarify the application of the five-year safe harbor rule for depreciable interests in used property; (3) clarify a de minimis interest rule relating to dispositions of property to an unrelated party within 90 calendar days after the taxpayer originally placed such property in service; and (4) remove a cut-off date for when larger self-constructed property must be placed in service to qualify for bonus depreciation. T.D. 9916.

Read more ...

Final Regs Address the Effect of Sections 67(g) and 642(h) on Trusts and Estates

The IRS issued final regulations clarifying that the following deductions allowed to an estate or non-grantor trust are not miscellaneous itemized deductions, and are therefore not affected by the suspension of the deductibility of miscellaneous itemized deductions for tax years beginning after December 31, 2017, and before January 1, 2026: (1) costs paid or incurred in connection with the administration of an estate or non-grantor trust that would not have been incurred if the property were not held in the estate or trust; (2) the personal exemption of an estate or non-grantor trust; (3) the distribution deduction for trusts distributing current income; and (4) the distribution deduction for estates and trusts accumulating income. The final regulations also provide guidance on determining the character, amount, and allocation of deductions in excess of gross income succeeded to by a beneficiary on the termination of an estate or non-grantor trust. T.D. 9918.

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Taxpayer Who Set up Nonprofit S Corporation Can't Pass Thru Losses

The Tax Court held that a taxpayer could not deduct losses from an S corporation organized under the Kentucky Nonprofit Corporation Act because, under state law, he was not entitled to dividends or any other distributions of earnings on the S corporation. The court noted that the Kentucky Nonprofit Act prohibits the distribution of dividends or profits to an organization's members, directors, and officers and prohibits the issuance of shares of stock. Deckard v. Comm'r, 155 T.C. No. 8 (2020).

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IRS Finalizes Eligible Terminated S Corporation Regulations

The IRS finalized regulations on the definition of an "eligible terminated S corporation" (ETSC), as well as regulations relating to distributions of money by an ETSC after an S corporation post-termination transition period (PTTP). The IRS also amended the regulations to eliminate the no-newcomer rule and extend the treatment of distributions of money during the PTTP to all shareholders of the S corporation. T.D. 9914.

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Taxpayer Filed a Valid Return, Despite Lack of Identity Protection PIN

The Tax Court held that an electronically filed tax return that was rejected by the IRS for failure to include an Identity Protection Personal Identification Number (IP PIN) nevertheless started the running of the three-year statute of limitations period under Code Sec. 6501. The court rejected the IRS's argument that, by omitting an IP PIN, the taxpayer failed to file a valid return until he resubmitted the return with an IP PIN; and, because the taxpayer's initial return was valid, the court concluded there was no reason to toll the statute of limitations period until the second return was filed. Fowler v. Comm'r, 155 T.C. No. 7 (2020).

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IRS Finalizes Regs Clarifying the Definition of Qualifying Relative for Years 2018-2025

The IRS issued final regulations that clarify the definition of a qualifying relative under Code Sec. 152(d)(1) for purposes of various Code provisions for years 2018 through 2025. The final regulations provide that, in determining whether an individual is a qualifying relative for purposes of various provisions of the Code that refer to Code Sec. 152 in years in which the exemption amount in Code Sec. 151(d) is zero, the exemption amount is the Code Sec. 152(d)(1)(B) inflation-adjusted exemption amount in the annual revenue procedure setting forth inflation-adjusted items. T.D. 9913.

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Couple's Lavish Spending Prevents Discharge of Taxes in Bankruptcy

The Eleventh Circuit affirmed a bankruptcy court's judgment that a couple's tax debt was non-dischargeable under 11 U.S.C. Sec. 523(a)(1)(c) because the couple willfully evaded payment of the taxes. The court held that, while making an offer in compromise (OIC) to the IRS is not, by itself, an act to evade taxes, the couple's OICs were inadequate and unrealistic offers considering their income and discretionary spending as well as the fact that they were submitted to the IRS at conveniently low points in the couple's highly profitable business venture. Feshbach v. IRS, 2020 PTC 286 (11th Cir. 2020).

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 2. Tax Briefs 

 

Bankruptcy

Debtor Can't Invoke CARES Act Provision to Extend Term of Bankruptcy Plan: In In re Roebuck, 2020 PTC 287 (Bankr. W.D. Pa.), a bankruptcy court rejected confirmation of a debtor's proposed amended bankruptcy plan, which had the support of the bankruptcy trustee and which relied on Section 1329(d) of the Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act") and which sought to extend the term of the plan beyond five years. The court held that the debtor could not invoke Section 1329(d) of the CARES Act because that provision applies only to plans confirmed under Bankruptcy Code Section 1325(a) before March 27, 2020, and the debtor's interim confirmation plan did not qualify as a confirmed plan under Section 1325.

 

Credits

Final Regs Clarify Effect of Personal Exemption on Premium Tax Credit: In T.D. 9912, the IRS issued final regulations under Code Sec. 36B and Code Sec. 6011 that clarify that the reduction of the personal exemption deduction to zero for tax years beginning after December 31, 2017, and before January 1, 2026, does not affect an individual taxpayer's ability to claim the premium tax credit. The final regulations affect individuals who claim the premium tax credit.

Rehabilitation Credit Regs Finalized Without Any Modifications: In T.D. 9915, the IRS finalized proposed regulations, without any modifications, which provide that the rehabilitation credit is properly determined in the year a qualified rehabilitated building (QRB) is placed in service but allocated ratably over the five-year period beginning in such year as required by the Tax Cuts and Jobs Act of 2017 (TCJA), rather than being allocated entirely to the tax year the QRB is placed in service as under Code Sec. 47 before the TCJA. The final regulations, which add Reg. Sec. 1.47-7(a) through (f), include: (1) a general rule for calculating the rehabilitation credit; (2) definitions of ratable share and rehabilitation credit determined; (3) a rule coordinating the changes to Code Sec. 47 with the special rules in Code Sec. 50; and (4) examples illustrating the interaction of Code Sec. 47 with rules in Code Sec. 50(a) (recapture in case of dispositions, etc.), Code Sec. 50(c) (basis adjustment to investment credit property), and Code Sec. 50(d)(5) (relating to certain leased property when the lessee is treated as owner and subject to an income inclusion requirement).

 

Deductions

Taxpayer Can't Deduct Expenses for Meals with Current and Former Spouse: In Franklin v. Comm'r, T.C. Memo. 2020-127, the Tax Court held that a taxpayer who deducted numerous expenses for meals, entertainment, and travel failed to adequately substantiate and document such expenses. The court noted that the taxpayer's meal log included several charges for meals with his former spouse and his current spouse and had asserted unconvincingly that the purpose of these meetings was to discuss real estate opportunities.

 

Excise Taxes

Powered Glider Kit Refurbished Tractors Did Not Qualify for Excise Tax Safe Harbor: In Schneider National Leasing, Inc. v. U.S., 2020 PTC 292 (E.D. Wisc. 2020), a district court held that 912 of a trucking company's purchase of 976 tractors were not repaired or modified and thus did not fall within the safe harbor provisions of Code Sec. 4052(f) and were subject to the 12 percent excise tax under Code Sec. 4051(a)(1)(E). The court agreed with the IRS that, with respect to the taxpayer's 912 powered glider kit refurbished tractors, the taxpayer's manufacture and subsequent use or lease of the refurbished tractors did not meet the safe harbor because the taxpayer had not "repaired or modified" articles for purposes of that provision.

 

Insurance Companies

Final Insurance Regulations Implement Legislative Changes: In T.D. 9911, the IRS issued final regulations that provide guidance on the computation of life insurance reserves and the change in basis of computing certain reserves of insurance companies. The final regulations implement recent legislative changes and affect entities taxable as insurance companies.

 

International

Soldier's Ties to U.S. Preclude Eligibility for Foreign Earned Income Exclusion: In Haskins v. Comm'r, 2020 PTC 289 (11th Cir. 2020), the Eleventh Circuit affirmed a Tax Court holding that an Army intelligence officer who lived and worked on a base in Afghanistan was not eligible for the foreign earned income exclusion under Code Sec. 911(a) given her strong ties to the United States and her weak ties abroad. The court noted that the taxpayer maintained strong connections to the United States in the form of her driver's license, home in Arizona, and bank account and that she continued to be involved in her family's finances, as reflected by her supporting her son's schooling, paying household bills, and buying gift cards for her husband.

IRS Defers Applicability Date One Year for Foreign-Related Regs: In Notice 2020-73, the IRS announced its intention to amend the applicability dates in Reg. Secs. 1.861-9T, 1.985-5, 1.987-11, 1.988-1, 1.988-4, and 1.989(a)-1 of the 2016 final regulations and Reg. Sec. 1.987-2 and Reg. Sec. 1.987-4 of the related 2019 final regulations to provide that the 2016 final regulations and the related 2019 final regulations apply to tax years beginning after December 7, 2021 (the amended applicability date). Previously, the regulations were set to apply to tax years beginning after December 7, 2020.

 

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 3. In-Depth Articles 

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IRS Finalizes Bonus Depreciation Regs; Withdraws Partnership Look-Through Rule

The IRS issued final bonus depreciation regulations, which generally affect taxpayers who depreciate qualified property acquired and placed in service after September 27, 2017. Among other changes, the final regulations (1) withdraw a complex partnership-look thru rule contained in the proposed regulations which addressed the extent to which a partner was deemed to have a depreciable interest in property held by a partnership; (2) clarify the application of the five-year safe harbor rule for depreciable interests in used property; (3) clarify a de minimis interest rule relating to dispositions of property to an unrelated party within 90 calendar days after the taxpayer originally placed such property in service; and (4) remove a cut-off date for when larger self-constructed property must be placed in service to qualify for bonus depreciation. T.D. 9916.

Background

The Tax Cuts and Jobs Act of 2017 (TCJA) made several significant changes to the additional first year depreciation deduction provisions in Code Sec. 168(k) (i.e., the bonus depreciation deduction). First, the bonus depreciation deduction percentage was increased from 50 to 100 percent. Second, property eligible for the bonus depreciation deduction was expanded, for the first time, to include certain used depreciable property and certain film, television, or live theatrical productions. Third, the placed-in-service date was extended from before January 1, 2020, to before January 1, 2027 (and from before January 1, 2021, to before January 1, 2028, for longer production period property or certain aircraft property described in Code Sec. 168(k)(2)(B) or (C)). Fourth, the date on which a specified plant eligible for bonus depreciation may be planted or grafted by the taxpayer was extended from before January 1, 2020, to before January 1, 2027.

In August of 2018, the IRS issued proposed regulations (REG-104397-18) relating to the bonus depreciation rules as amended by the TCJA (2018 Proposed Regulations). The 2018 proposed regulations updated existing regulations and provided a new regulation, Reg. Sec. 1.168(k)-2, for property acquired and placed in service after September 27, 2017. In September of 2019, the IRS issued final regulations in T.D. 9874 (2019 Final Regulations), which clarified the rules relating to the increase of the bonus depreciation benefit and the expansion of the universe of qualifying property, particularly to certain classes of used property authorized by the TCJA. Concurrently, the IRS issued additional proposed regulations under Code Sec. 168(k) in REG-106808-19 (2019 Proposed Regulations) that addressed comments the IRS received regarding the 2018 Proposed Regulations.

On September 21, 2020, in T.D. 9916, the IRS finalized the 2019 Proposed Regulations. The final regulations address bonus depreciation issues that were not addressed in the 2019 Final Regulations, and provide some clarifying changes to the 2019 Final Regulations. Specifically, the final regulations (1) withdraw a complex partnership-look thru rule contained in the proposed regulations which addressed the extent to which a partner was deemed to have a depreciable interest in property held by a partnership; (2) clarify the application of the five-year safe harbor rule for depreciable interests in used property; (3) clarify a de minimis interest rule relating to dispositions of property to an unrelated party within 90 calendar days after the taxpayer originally placed such property in service; (4) remove a cut-off date for when larger self-constructed property must be placed in service to qualify for bonus depreciation; (5) provide that, for purposes of determining whether the mid-quarter convention applies, depreciable basis is not reduced by the amount of bonus depreciation; and (6) clarifies the term "qualified improvement property." The IRS also moved the bonus depreciation rules for consolidated groups to Reg. Sec. 1.1502-68.

Partnership Look-Through Rule Withdrawn

The 2019 Proposed Regulations contained a complex Partnership Look-through Rule, which addressed the extent to which a partner is deemed to have a depreciable interest in property held by a partnership. Under that rule, a person would be treated as having a depreciable interest in a portion of property before the person's acquisition of the property if the person was a partner in a partnership at any time the partnership owned the property. The Partnership Look-through Rule further provided that the portion of property in which a partner was treated as having a depreciable interest was equal to the total share of depreciation deductions with respect to the property allocated to the partner as a percentage of the total depreciation deductions allocated to all partners during the current calendar year and the five calendar years immediately before the partnership's current year.

At least one practitioner requested that the Partnership Look-through Rule be withdrawn and replaced with a rule that treats a partner as having a depreciable interest in an item of property only if the partner was a controlling partner in a partnership at any time the partnership owned the property during the applicable look-back period. The IRS agreed that the rule should be withdrawn because the complexity of applying it would place a significant administrative burden on both taxpayers and the IRS. Thus, under the final regulations, a partner will not be treated as having a depreciable interest in partnership property solely by virtue of being a partner in the partnership. In addition, the IRS determined that a replacement rule that applies only to controlling partners is not necessary because the related party rule in Code Sec. 179(d)(2)(A) applies to a direct purchase of partnership property by a current majority partner, and the series of related transactions rules in Reg. Sec. 1.168(k)-2(b)(3)(iii)(C) (discussed below) prevents avoidance of the related party rule through the use of intermediary parties.

Five-year Safe Harbor for Depreciable Interest in Used Property

Used property qualifies for the bonus depreciation deduction if the property was not used by the taxpayer or a predecessor at any time before such acquisition. The 2019 Final Regulations provide that property is treated as used by the taxpayer or a predecessor at any time before acquisition by the taxpayer or predecessor if the taxpayer or the predecessor had a depreciable interest in the property at any time before such acquisition, whether or not the taxpayer or the predecessor claimed depreciation deductions for the property. To determine if the taxpayer or a predecessor had a depreciable interest in the property at any time before acquisition, the 2019 Final Regulations provide that only the five calendar years immediately before the taxpayer's current placed-in-service year of the property are taken into account. This is known as the "Five-Year Safe Harbor." If the taxpayer and a predecessor have not been in existence for this entire five-year period, the 2019 Final Regulations provide that only the number of calendar years the taxpayer and the predecessor have been in existence are taken into account.

With respect to the Five-Year Safe Harbor, practitioners raised the following issues:

  • whether the "placed-in-service year" is the tax year or the calendar year;
  • whether the portion of the calendar year covering the period up to the placed-in-service date of the property is taken into account; and
  • how the Five-Year Safe Harbor applies to situations where the taxpayer or a predecessor was not in existence during the entire five-year look-back period.

In the preamble to the final regulations, the IRS advised that it intended for the "placed-in-service year" to be the current calendar year in which the property is placed in service by the taxpayer. Additionally, it intended the portion of that calendar year covering the period up to the placed-in-service date of the property to be considered in determining whether the taxpayer or a predecessor previously had a depreciable interest. This approach, the IRS said, is consistent with an exception to the de minimis use rule in Reg. Sec. 1.168(k)-2(b)(3)(iii)(B)(4) of the 2019 Proposed Regulations (discussed below). Pursuant to that exception, when a taxpayer places in service eligible property in Year 1, disposes of that property to an unrelated party in Year 1 within 90 calendar days of that placed-in-service date, and then reacquires the same property later in Year 1, the taxpayer is treated as having a prior depreciable interest in the property upon the taxpayer's reacquisition of the property in Year 1. This rule, the IRS noted, would be superfluous if the Five-Year Safe Harbor did not consider the portion of the calendar year covering the period up to the placed-in-service date of the property.

Accordingly, the IRS amended the final regulations in Reg. Sec. 1.168(k)-2(b)(3)(iii)(B)(1) to clarify that the five calendar years immediately before the current calendar year in which the property is placed in service by the taxpayer, and the portion of such current calendar year before the placed-in-service date of the property determined without taking into account the applicable convention, are taken into account to determine if the taxpayer or a predecessor had a depreciable interest in the property at any time prior to acquisition (look-back period). The IRS also amended Reg. Sec. 1.168(k)-2(b)(3)(iii)(B)(1) to adopt the suggestion that both the taxpayer and the predecessor be subject to a separate look-back period. The final regulations clarify that if the taxpayer or a predecessor, or both, have not been in existence during the entire look-back period, then only the portion of the look-back period during which the taxpayer or a predecessor, or both, have been in existence is taken into account to determine if the taxpayer or the predecessor had a depreciable interest in the property.

De Minimis Use Rule

The 2019 Proposed Regulations provided an exception, known as the De Minimis Use Rule, to the prior depreciable interest rule in the 2019 Final Regulations when a taxpayer disposes of property to an unrelated party within 90 calendar days after the taxpayer originally placed such property in service. The 2019 Proposed Regulations provided that the De Minimis Use Rule did not apply if the taxpayer reacquires and again places in service the property during the same tax year the taxpayer disposed of the property.

Practitioners requested clarification regarding the application of the De Minimis Use Rule in the following situations:

Situation 1: The taxpayer places in service property in Year 1, disposes of that property to an unrelated party in Year 1 within 90 calendar days of that original placed-in-service date, and then reacquires and again places in service the same property later in Year 1 and does not dispose of the property again in Year 1.

Situation 2: The taxpayer places in service property in Year 1, disposes of that property to an unrelated party in Year 2 within 90 calendar days of that original placed-in-service date, and then reacquires and again places in service the same property in Year 2 or later.

Situation 3: The taxpayer places in service property in Year 1 and disposes of that property to an unrelated party in Year 1 within 90 calendar days of that original placed-in-service date, then the taxpayer reacquires and again places in service the same property later in Year 1 and disposes of that property to an unrelated party in Year 2 within 90 calendar days of the subsequent placed-in-service date in Year 1, and the taxpayer reacquires and again places in service the same property in Year 4.

With respect to Situation 1, the IRS noted that, pursuant to Reg. Sec. 1.168(k)-2(g)(1)(i) of the 2019 Final Regulations, the bonus depreciation deduction is not allowable for the property when it was initially placed in service in Year 1 by the taxpayer. The bonus depreciation deduction also is not allowable when the same property is subsequently placed in service in Year 1 by the same taxpayer under the De Minimis Use Rule in the 2019 Proposed Regulations. A practitioner argued that the bonus depreciation deduction should be allowable for the property when it is placed in service again in Year 1 and is not disposed of again in Year 1, because the bonus depreciation deduction is not allowable for the property when it initially was placed in service in Year 1 by the taxpayer. The IRS said that it agreed with this if the property is originally acquired by the taxpayer after September 27, 2017, but did not agree with respect to property that was originally acquired by the taxpayer before September 28, 2017, as the exception to the De Minimis Use Rule was intended to prevent certain churning transactions involving such property. According to the IRS, property that is placed in service, disposed of, and reacquired in the same tax year is more likely to be part of a predetermined churning plan.

With respect to Situation 2, the IRS said that the bonus depreciation deduction is allowable for the same property by the same taxpayer twice (in Year 1 when the property is initially placed in service, and in Year 2 when the property is placed in service again). The IRS noted that this result is consistent with the De Minimis Use Rule in the 2019 Proposed Regulations, and this result was not changed in the final regulations.

With respect to Situation 3, the IRS noted that the De Minimis Use Rule provides only one 90-day period that is disregarded in determining whether the taxpayer had a depreciable interest in the property before its reacquisition. That 90-day period is measured from the original placed-in-service date of the property by the taxpayer. As a result, the second 90-day period in Situation 3 (during which the taxpayer reacquired the property in Year 1, again placed it in service in Year 1, and then disposed of it in Year 2) is taken into account in determining whether the taxpayer previously used the property when the taxpayer again places in service the property in Year 4. Accordingly, the IRS clarified the De Minimis Use Rule in the final regulations to reflect these results. The IRS also added additional examples to the final regulations to illustrate the application of the De Minimis Use Rule in the three situations described above.

Series of Related Transactions

In the 2019 Proposed Regulations, the IRS provided special rules for a series of related transactions (Proposed Related Transactions Rule). Under the Proposed Related Transactions Rule, the relationship between the parties under Code Sec. 179(d)(2)(A) or (B) in a series of related transactions would be tested immediately after each step in the series, and between the original transferor and the ultimate transferee immediately after the last transaction in the series. The Proposed Related Transactions Rule also provided that the relationship between the parties in a series of related transactions is not tested in certain situations.

The IRS agreed with practitioners that the Proposed Related Transactions Rule should be simplified and that the rule should be modified to take into account changes in the relationship between the parties, including a party ceasing to exist, over the course of a series of related transactions. For example, under the Proposed Related Transaction Rule, the IRS said that in a situation where, pursuant to a series of related transactions, A transfers property to B, B transfers property to C, and C transfers property to D, relatedness is tested after each step and between D and A. The IRS noted that if, at the beginning of the series, C was related to A but, before acquiring the property, C ceases to be related to A, or A ceases to exist, the Proposed Related Transactions Rule does not address how to treat such changes.

Accordingly, the final regulations addresses such situations and provide that each transferee in a series of related transactions tests its relationship under Code Sec. 179(d)(2)(A) or (B) with the transferor from which the transferee directly acquires the depreciable property (immediate transferor) and with the original transferor of the depreciable property in the series. The transferee is treated as related to the immediate transferor or the original transferor if the relationship exists either immediately before the first transfer of the depreciable property in the series or when the transferee acquires the property. Any transferor in a series of related transactions that ceases to exist during the series is deemed to continue to exist for purposes of testing relatedness. The final regulations also provide a special rule that disregards certain transitory relationships created pursuant to a series of related transactions.

Finally, the final regulations provide that, if a transferee in a series of related transactions acquires depreciable property from a transferor that was not in existence immediately before the first transfer of the property in the series (new transferor), the transferee tests its relationship with the party from which the new transferor acquired the depreciable property. The IRS provides examples illustrating these revised rules in these final regulations.

Acquisition of a Trade or Business or an Entity

Under the 2019 Proposed Regulations, a contract to acquire all or substantially all of the assets of a trade or business, or to acquire an entity, is binding if it is enforceable under state law against the parties to the contract and certain conditions do not prevent the contract from being a binding contract. This applies to a contract for the sale of stock of a corporation that is treated as an asset sale as a result of an election under Code Sec. 338.

The IRS said it was aware of potential questions regarding whether this rule also applies to a contract for the sale of stock of a corporation that is treated as an asset sale as a result of an election under Code Sec. 336(e). The IRS noted that the federal income tax consequences of a Code Sec. 336(e) election made with respect to a qualified stock disposition not described, in whole or in part, in Code Sec. 355(d)(2) or Code Sec. 355(e)(2) are similar to the federal income tax consequences of a Code Sec. 338 election. Accordingly, in the final regulations, the IRS has clarified that this provision applies to a contract for the sale of stock of a corporation that is treated as an asset sale as a result of an election under Code Sec. 336(e) made for a disposition described in Reg. Sec. 1.336-2(b)(1).

Component Election

Under the 2019 Proposed Regulations, a taxpayer could elect to treat one or more components acquired or self-constructed after September 27, 2017, of certain larger self-constructed property as being eligible for the bonus depreciation deduction (Component Election). The larger self-constructed property must be qualified property under Code Sec. 168(k)(2), as in effect before the enactment of the TCJA, for which the manufacture, construction, or production began before September 28, 2017. However, the election is not available for components of larger self-constructed property when such components are not otherwise eligible for the bonus depreciation deduction.

Under the 2019 Proposed Regulations, larger self-constructed property that is placed in service by the taxpayer after December 31, 2019, or larger self-constructed property described in Code Sec. 168(k)(2)(B) or (C), as in effect on the day before enactment of the TCJA, that is placed in service after December 31, 2020, is not eligible larger self-constructed property. Accordingly, any components of such property that are acquired or self-constructed after September 27, 2017, do not qualify for the Component Election. Practitioners requested that the final regulations remove this cut-off date for when the larger self-constructed property must be placed in service because it does not reflect the intent of the TCJA of promoting capital investment, modernization, and growth.

The IRS agreed with the practitioners and the final regulations provide that eligible larger self-constructed property also includes property that is manufactured, constructed, or produced for the taxpayer by another person under a written contract that does not meet the definition of a binding contract under Reg. Sec. 1.168(k)-2(b)(5)(iii) of the 2019 Final Regulations (written non-binding contract) and that is entered into before the manufacture, construction, or production of the property for use by the taxpayer in its trade or business or for its production of income. Further, the final regulations remove the requirement that the larger self-constructed property be qualified property under Code Sec. 168(k)(2), as in effect on the day before the enactment of the TCJA, and instead provide that the larger self-constructed property must be (1) MACRS property with a recovery period of 20 years or less, computer software, water utility property, or qualified improvement property under Code Sec. 168(k)(3) as in effect on the day before the enactment date of the TCJA, and (2) qualified property under Reg. Sec. 1.168(k)-2(b) of the 2019 Final Regulations and these 2020 final regulations, determined without regard to the acquisition date requirement in Reg. Sec. 1.168(k)-2(b)(5), for which the taxpayer begins the manufacture, construction, or production before September 28, 2017. As a result of this change, the cut-off dates for when the larger self-constructed property must be placed in service by the taxpayer now align with the placed-in-service dates under Code Sec. 168(k)(6) and Reg. Sec. 1.168(k)-2(b)(4)(i).

Definition of Qualified Improvement Property

While the TCJA committee reports indicated that qualified improvement property was to have a 15-year life -- the same as it did before TCJA -- thus making such property eligible for the bonus depreciation deduction, a drafting error prevented such property from being included in the list of 15-year property. Because qualified improvement property was not specified in Code Sec. 168(e)(3)(E) as 15-year property, such property had the recovery period specified in Code Sec. 168(c) -- 39 years for nonresidential real property placed in service in tax years after 2017. However, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which was signed into law in March of 2020, fixed this glitch as if it never happened (Pub. L. 116-136, Sec. 2307). Thus, such property meets the bonus depreciation criteria specified in Code Sec. 168(k)(2)(A) (i.e., the recovery period is 20 years or less) and such property is eligible for bonus depreciation.

The final bonus depreciation regulations amend Reg. Sec. 1.168(b)-1(a)(5)(i)(A) to provide that such improvements must be made by the taxpayer. The IRS said that it was aware of questions regarding the meaning of "made by the taxpayer" with respect to third-party construction of the improvement and the acquisition of a building in a transaction described in Code Sec. 168(i)(7)(B) (pertaining to treatment of transferees in certain nonrecognition transactions) that includes an improvement previously made by, and placed in service by, the transferor or distributor of the building. According to the IRS, an improvement is made by the taxpayer if the taxpayer makes, manufactures, constructs, or produces the improvement for itself or if the improvement is made, manufactured, constructed, or produced for the taxpayer by another person under a written contract. In contrast, if a taxpayer acquires nonresidential real property in a taxable transaction and such nonresidential real property includes an improvement previously placed in service by the seller of such nonresidential real property, the improvement is not made by the taxpayer.

Effective Date

Taxpayers can apply the final bonus depreciation regulations under Reg. Sec. 1.168(k)-2 and Reg. Sec. 1.1502-68, in their entirety, to depreciable property acquired and placed in service or certain plants planted or grafted, as applicable, after September 27, 2017, by the taxpayer during a tax year ending on or after September 28, 2017, provided the taxpayer consistently applies all rules in the final regulations. However, once the taxpayer applies the final regulations for a tax year, the taxpayer must continue to apply them in all subsequent tax years. Alternatively, taxpayers can rely on the 2019 Proposed Regulations for depreciable property acquired and placed in service or certain plants planted or grafted, as applicable, after September 27, 2017, by the taxpayer during a tax year ending on or after September 28, 2017, and ending before the taxpayer's first tax year that begins on or after January 1, 2021, if the taxpayer follows the 2019 Proposed Regulations in their entirety, except for Reg. Sec. 1.168(k)-2(b)(3)(iii)(B)(5) (relating to the partnership look-through rule which has been withdrawn), and in a consistent manner.

For a discussion of the bonus depreciation rules, see Parker Tax ¶94,200.

[Return to Table of Contents]

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Final Regs Address the Effect of Sections 67(g) and 642(h) on Trusts and Estates

The IRS issued final regulations clarifying that the following deductions allowed to an estate or non-grantor trust are not miscellaneous itemized deductions, and are therefore not affected by the suspension of the deductibility of miscellaneous itemized deductions for tax years beginning after December 31, 2017, and before January 1, 2026: (1) costs paid or incurred in connection with the administration of an estate or non-grantor trust that would not have been incurred if the property were not held in the estate or trust; (2) the personal exemption of an estate or non-grantor trust; (3) the distribution deduction for trusts distributing current income; and (4) the distribution deduction for estates and trusts accumulating income. The final regulations also provide guidance on determining the character, amount, and allocation of deductions in excess of gross income succeeded to by a beneficiary on the termination of an estate or non-grantor trust. T.D. 9918.

Background

Code Sec. 67 generally provides that, in the case of an individual, the miscellaneous itemized deductions for any tax year are allowed only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income (AGI). However, Code Sec. 67(g), enacted into law in the Tax Cuts and Jobs Act of 2017 (TCJA), prohibits individual taxpayers from claiming miscellaneous itemized deductions for any tax year beginning after December 31, 2017, and before January 1, 2026. Code Sec. 67(b) defines miscellaneous itemized deductions as itemized deductions other than those listed in Code Sec. 67(b)(1) through (12).

Code Sec. 67(e) provides that an estate or trust computes its AGI in the same manner as that of an individual, except that the following additional deductions are treated as allowable in arriving at AGI: 

(1) deductions for costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such estate or trust; and 

(2) deductions allowable under Code Sec. 642(b) (personal exemption of an estate or non-grantor trust), Code Sec. 651 (deduction for trusts distributing current income), and Code Sec. 661 (deduction for trusts accumulating income). 

Code Sec. 67(e) further provides the IRS with authority to make appropriate adjustments in the application of Code Sec. 641 through Code Sec. 685 to take into account the provisions of Code Sec. 67.

Code Sec. 642(h) provides that if, on the termination of an estate or trust, the estate or trust has: 

(1) a net operating loss (NOL) carryover under Code Sec. 172 or a capital loss carryover under Code Sec. 1212, or 

(2) for the last tax year of the estate or trust, deductions (other than the deductions allowed under Code Sec. 642(b) with respect to the personal exemption or Code Sec. 642(c) with respect to charitable contributions) in excess of gross income for such year,

then such carryover or excess will be allowed as a deduction, in accordance with the regulations, to the beneficiaries succeeding to the property of the estate or trust.

Proposed Regulations

In May, the IRS issued proposed regulations (REG-113295-18) clarifying that expenses described in Code Sec. 67(e) remain deductible in determining the AGI of an estate or non-grantor trust during the tax years in which Code Sec. 67(g) applies. Accordingly, under the proposed regulations, Code Sec. 67(g) did not deny an estate or non-grantor trust (including the S portion of an electing small business trust) a deduction for expenses described in Code Sec. 67(e)(1) and (2) because such deductions are allowable in arriving at AGI and are not miscellaneous itemized deductions.

The proposed regulations also provided that if, on termination of an estate or trust, the estate or trust has for its last tax year deductions (other than the deductions allowed under Code Sec. 642(b) or Code Sec. 642(c)) in excess of gross income, the excess deductions are allowed under Code Sec. 642(h)(2) as items of deduction to the beneficiaries succeeding to the property of the terminated estate or trust. The proposed regulations provided that each deduction comprising the excess deductions under Code Sec. 642(h)(2) retains, in the hands of the beneficiary, its character (specifically, as allowable in arriving at AGI, as a non-miscellaneous itemized deduction, or as a miscellaneous itemized deduction) while in the estate or trust and does not change when succeeded to by a beneficiary on termination of the estate or trust. Furthermore, the proposed regulations provided that an item of deduction succeeded to by a beneficiary remains subject to any limitation applicable under the Code in the computation of the beneficiary's tax liability.

In addition, the proposed regulations provided that an item of deduction succeeded to by a beneficiary remains subject to any additional applicable limitation under the Code, and must be separately stated if it could be so limited, as provided in the instructions to Form 1041, U.S. Income Tax Return for Estates and Trusts, and the Schedule K-1 (Form 1041), Beneficiary's Share of Income, Deductions, Credit, etc.

The proposed regulations provided that the provisions of Reg. Sec. 1.652(b)-3 are used to allocate each item of deduction among the classes of income in the year of termination for purposes of determining the character and amount of the excess deductions under Code Sec. 642(h)(2). Accordingly, the amount of each separate deduction remaining after application of Reg. Sec. 1.652(b)-3 comprises the excess deductions available to the beneficiaries succeeding to the property of the estate or trust as provided under Code Sec. 642(h)(2). Furthermore, the proposed regulations provided that excess deductions are allowable only in the tax year of the beneficiary in which, or with which, the estate or trust terminates. That is, excess deductions of a terminated estate or trust may not carry over to a subsequent year of the beneficiary.

Final Regulations

On September 21, the IRS issued final regulations in T.D. 9918. The final regulations adopt the proposed rule specifying that Code Sec. 67(e) expenses remain deductible in determining an estate or non-grantor trust's AGI during years 2018 - 2025 without modification. In addition, the final regulations provide clarifications and modifications in response to practitioners' comments.

Practitioners requested guidance on how excess deductions are to be reported by terminated estates or trusts and by their beneficiaries. The IRS noted that it released instructions for beneficiaries that chose to claim excess deductions on Form 1040 in the 2019 or 2018 tax year based on the proposed regulations. The IRS also said that it plans to update the instructions for Form 1041, Schedule K-1 (Form 1041), and Form 1040 for the 2020 and subsequent tax years to provide for the reporting of excess deductions that are Code Sec. 67(e) expenses or non-miscellaneous itemized deductions.

One practitioner asked for an ordering rule clarifying whether excess deductions on termination of a trust allowed as a deduction to the beneficiary are claimed before, after, or ratably with the beneficiary's other deductions, particularly when the amount of the excess deductions and other deductions exceed the beneficiary's gross income. In response, the final regulations clarify that beneficiaries may claim all or part of the excess deductions under Code Sec. 642(h)(2) before, after, or together with the same character of deductions separately allowable to the beneficiary.

The proposed regulations included an example illustrating computations under Code Sec. 642(h) when there is an NOL. The example explained that the beneficiaries of the trust cannot carry back any of the NOL of the terminating estate that was made available to them under Code Sec. 642(h)(1). Practitioners requested that the example be revised to take into account the amendments to Code Sec. 172(b)(1)(D) made by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) (Pub. L. 116-136), which generally allows NOLs arising in tax years beginning after December 31, 2017, and before January 1, 2021, to be carried back five years before being carried forward. Practitioners asked for the revision to reflect that a beneficiary could carry back the NOL carryover the beneficiary succeeds to under Code Sec. 642(h)(1) for NOLs arising in tax years beginning in 2018, 2019, and 2020.

The IRS responded that, in general, an NOL incurred by a taxpayer may only be used as a deduction by that taxpayer, and cannot be transferred to another taxpayer. An exception is provided, however, in Code Sec. 642(h), which (as noted above) provides that if the terminated estate or trust has an NOL carryover, the carryover is allowed as a deduction to the beneficiaries succeeding to the property of the estate or trust. The IRS reasoned that the use of the word "carryover" in Code Sec. 642(h)(1) means that the estate or trust incurred an NOL and either already carried it back to the earliest allowable year or elected to waive the carryback period, and now is limited to carrying over the remaining NOL. The IRS reasoned that, because the NOL is a carryover for the estate or trust, the beneficiary succeeding to that NOL may, under Code Sec. 642(h)(1), only carry it forward, and the CARES Act amendments do not change this result. Thus, the practitioners' comments were not adopted in the final regulations.

The final regulations apply to tax years beginning after the date of publication in the Federal Register, but taxpayers may choose to apply the amendments to Reg. Sec. 1.67-4, Reg. Sec. 1.642(h)-2, and Reg. Sec. 1.642(h)-5 in T.D. 9918 to tax years beginning after December 31, 2017.

For a discussion of the deductibility of estate and trust administration expenses as miscellaneous itemized deductions, see Parker Tax ¶85,115. For a discussion of the deductibility of unused loss carryovers and excess deductions on the termination of an estate or trust, see Parker Tax ¶53,135.

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Taxpayer Who Set up Nonprofit S Corporation Can't Pass Thru Losses

The Tax Court held that a taxpayer could not deduct losses from an S corporation organized under the Kentucky Nonprofit Corporation Act because, under state law, he was not entitled to dividends or any other distributions of earnings on the S corporation. The court noted that the Kentucky Nonprofit Act prohibits the distribution of dividends or profits to an organization's members, directors, and officers and prohibits the issuance of shares of stock. Deckard v. Comm'r, 155 T.C. No. 8 (2020).

Background

Waterfront Fashion Week, Inc. (Waterfront) was organized on May 8, 2012, as a nonstock, nonprofit corporation under the Kentucky Nonprofit Corporation Acts. The articles of incorporation were signed by attorney D. Kevin Ryan as "Organizer" and filed with the Kentucky Secretary of State. In 2014, in his capacity as Waterfront's president, Clinton Deckard filed with the IRS Waterfront's election to be treated as an S corporation, effective retroactively to the date of its incorporation in 2012. Waterfront produced an event called Waterfront Fashion Week that was held at the Louisville Waterfront Park from October 17 to 19, 2012. This event was marketed as benefiting Waterfront Development Corp., a nonprofit organization that maintains the Louisville Waterfront Park. The event failed, however, to break even. Consequently, Waterfront made no cash charitable contribution to Waterfront Development Corp.

On September 28, 2013, the Kentucky Secretary of State administratively dissolved Waterfront for failure to file its 2013 annual report. On December 16, 2013, after filing a reinstatement application, Waterfront was reinstated as a corporation duly incorporated under Kentucky law. On September 30, 2014, the Kentucky Secretary of State once again administratively dissolved Waterfront, this time for failure to file its 2014 annual report. This time Waterfront did not seek reinstatement.

In October of 2014, Waterfront mailed to the IRS Form 2553, Election by a Small Business Corporation. The Form 2553 indicated that Waterfront was electing to be an S corporation retroactively as of the date of its incorporation, May 8, 2012. Deckard signed the Form 2553 in his capacity as Waterfront's president and also signed the shareholder's consent statement, indicating that he held a 100 percent ownership interest acquired on May 8, 2012.

On January 13, 2015, Waterfront filed untimely Forms 1120S, U.S. Income Tax Return for an S Corporation, for its 2012 and 2013 tax years, reporting operating losses of $277,967 and $3,239 for 2012 and 2013, respectively. Attached to the Forms 1120S were Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., reporting that Deckard had 100 percent stock ownership of Waterfront during 2012 and 2013.

Deckard later filed untimely individual income tax returns claiming Waterfront's reported operating losses of $277,967 and $3,239 for 2012 and 2013, respectively, as offsets against his individual taxable income. The IRS disallowed these losses on the ground that Waterfront had not made a valid S corporation election or, alternatively, that Deckard was not a shareholder or beneficial owner of Waterfront for tax years 2012 and 2013 for purposes of subchapter S and so was not entitled to claim passthrough losses from Waterfront on his individual income tax returns.

The case went before the Tax Court where the IRS filed a motion for partial summary judgment and Deckard filed a cross-motion for partial summary judgment. These motions asked the Tax Court to decide (1) whether Waterfront made a valid S corporation election, and (2) whether Deckard was a shareholder of Waterfront for the 2012 and 2013 tax years.

Deckard argued that he should be considered Waterfront's sole shareholder because he held exclusive beneficial ownership of the corporation. To support his argument, he asserted the following: (1) that on or about July 22, 2011, he hired Extraordinary Events, an unrelated event-planning business, to coordinate Waterfront Fashion Week; (2) that on May 3, 2012, he hired Attorney Ryan to advise him on the creation of a legal entity to conduct Waterfront Fashion Week because Extraordinary Events had advised Deckard that a tax-exempt entity would encourage sponsors to make tax-deductible contributions to the legal entity; (3) that Attorney Ryan never advised Deckard that sponsors might be able to deduct sponsorships as trade or business expenses even if the legal entity lacked tax-exempt status; (4) that on May 8, 2012, Attorney Ryan formed Waterfront under the Kentucky Nonprofit Corporation Acts; (5) that during 2012 and 2013, Deckard was president of Waterfront and its "sole decision maker"; (6) that on or about August 10, 2012, Deckard terminated the agreement with Extraordinary Events because it had failed to recruit enough sponsors or raise enough contributions to fund Waterfront Fashion Week; (7) that he then assumed "complete control" over planning Waterfront Fashion Week, abandoned plans for Waterfront to obtain federal tax-exempt status, and began treating Waterfront as a "for-profit business that I owned entirely"; and (8) that in August 2012 he made over $275,000 of contributions to Waterfront representing over 85 percent of the total cost of Waterfront Fashion Week.

Analysis

The Tax Court began by noting that the critical question was whether Deckard should be considered a shareholder of Waterfront during 2012 and 2013. The Tax Court agreed with the IRS that Deckard was not a shareholder or beneficial owner of Waterfront for tax years 2012 and 2013 for purposes of subchapter S and thus was not entitled to claim passthrough losses from Waterfront on his individual income tax returns. The court concluded that, while it assumed Deckard's assertions with respect to the activities surrounding Waterfront were true and the IRS did not expressly dispute such assertions, Deckard was not properly treated as Waterfront's shareholder for subchapter S purposes as a matter of law. The court looked to Reg. Sec. 1.1361-1(e)(1), which provides that the person who must include in gross income dividends distributed with respect to the stock of the corporation (if the corporation were a C corporation) is considered to be the shareholder of the corporation.

Citing that same regulation, the Ninth Circuit, in Cabintaxi Corp. v. Comm'r, 63 F.3d 614 (7th Cir. 1995), observed that the determination of whether a person is an S shareholder on the date of an S election is equivalent to the question of whether, had there been a valid election, that person would have been required to report as personal income profits earned by the corporation on that date. The answer, the Tax Court noted, depends on whether the person would have been deemed a beneficial owner of shares in the corporation, entitled therefore to demand from the nominal owner the dividends or any other distributions of earnings on those shares. The Tax Court said that, in making this determination, the courts look to state law. The Tax Court noted that neither the IRS nor Deckard had cited, and the court said it could not find, any case addressing beneficial ownership in a nonstock, nonprofit corporation for purposes of subchapter S.

Nonprofits, the Tax Court noted, generally do not have owners because they are prohibited from distributing profits to insiders who are in positions to exercise control, such as members, officers, or directors. Consequently, there is no interest in a nonprofit corporation equivalent to that of a stockholder in a for-profit corporation who stands to profit from the success of the enterprise. In fact, the court noted, the Kentucky Nonprofit Act prohibits the distribution of dividends or profits to the organization's members, directors, and officers and prohibits the issuance of shares of stock. Deckard, the court found, did not otherwise possess an ownership interest in Waterfront equivalent to that of a shareholder. 

Thus, the court concluded that, in the light of this nondistribution constraint, treating Deckard as a shareholder of Waterfront would be fundamentally incompatible with the purpose and operation of subchapter S, which generally taxes an S corporation's income currently at the shareholder level. In addition, the court noted that Deckard lacked dissolution rights in Waterfront typical of a shareholder and thus, none of Waterfront's assets could be distributed to him upon Waterfront's dissolution.

For a discussion of eligibility to be an S corporation shareholder, see Parker Tax 30,110.

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IRS Finalizes Eligible Terminated S Corporation Regulations

The IRS finalized regulations on the definition of an "eligible terminated S corporation" (ETSC), as well as regulations relating to distributions of money by an ETSC after an S corporation post-termination transition period (PTTP). The IRS also amended the regulations to eliminate the no-newcomer rule and extend the treatment of distributions of money during the PTTP to all shareholders of the S corporation. T.D. 9914.

Background

Generally, a distribution by a C corporation to its shareholders with respect to their stock ownership is treated as a taxable dividend to the extent of the corporation's earnings and profits. However, following the termination of a corporation's S election, Code Sec. 1371(e) allows shareholders of the resulting C corporation to benefit from the corporation's former status as an S corporation with respect to distributions of money during the corporation's post-termination transition period (PTTP), which is generally the one-year period after the corporation terminates its S election. Specifically, during the PTTP, a distribution of money by the C corporation is characterized as a distribution from the corporation's accumulated adjustments account (AAA). The receipt of such a distribution is tax-free to the extent of the recipient shareholder's basis in its stock and the corporation's AAA balance. If the distribution exceeds the recipient shareholder's basis in its stock, but not the corporation's AAA, then the distribution is tax-free to the extent of the recipient shareholder's basis, with the remainder treated as gain from the sale of property. If the distribution exceeds the corporation's AAA, then the excess is taxed as a dividend from current earnings and profits (CE&P)) or any AE&P from the corporation's previous existence as a corporation taxed under subchapter C. Without Code Sec. 1371(e), shareholders of the former S corporation would be precluded from receiving distributions allocable to AAA.

The Tax Cuts and Jobs Act of 2017 (TCJA) added new Code Sec. 481(d) and Code Sec. 1371(f), effective as of December 22, 2017 (i.e., the date of enactment of the TCJA). Code Sec. 481(d)(1) permits a corporation that qualifies as an eligible terminated S corporation (ETSC) to take into account any Code Sec. 481 adjustments which are attributable to the revocation of an S election over the Code Sec. 481(d) inclusion period, which is the six-tax-year-period beginning with the year of change.

An ETSC is defined in Code Sec. 481(d)(2) as a C corporation meeting the following three requirements: (1) the corporation was an S corporation on December 21, 2017; (2) the S corporation revoked its election under Code Sec. 1362(a) to be an S corporation (that is, the S election) during the two-year period beginning on December 22, 2017 (revocation requirement); and (3) the owners of the stock of the corporation, determined on the date the corporation made a revocation of its S election, are the same owners (and own identical proportions of the corporation's stock) as on December 22, 2017 (shareholder identity requirement).

Code Sec. 1371(f) extends the period during which shareholders of an ETSC can benefit from its AAA generated during the corporation's former status as an S corporation (ETSC period) by providing that, in the case of distributions of money following the PTTP, the distributing ETSC's AAA is allocated to a distribution of money to which Code Sec. 301 would otherwise apply (qualified distribution), and the qualified distribution is chargeable to AE&P in the same ratio as the amount of such AAA bears to the amount of such AE&P. In enacting Code Sec. 1371(f), Congress determined that it was important to provide rules to ease the transition from S corporation to C corporation for the affected taxpayers because, based on the TCJA's revisions to the Code, taxpayers that previously elected to be taxed as S corporations may prefer instead to be taxed as C corporations.

In November of 2019, the IRS issued proposed regulations in REG-131071-18 under Code Sec. 1371, Code Sec. 481, and Code Sec. 1377 relating to the ETSC changes made by the TCJA. The IRS has now finalized those regulations in T.D. 9914 with some modifications in response to comments received.

Compliance Tip: The final regulations apply to tax years beginning after the date these regulations are published in the Federal Register. However, a corporation can choose to apply them in their entirety to tax years beginning on or before such date if all shareholders of the corporation consistently report and apply the rules in their entirety for the corporation's subsequent tax years.

Revocation Date

The date on which a corporation revokes its S election is critical for determining ETSC qualification. A corporation can allow the effective date of its S election revocation to occur automatically by operation of Code Sec. 1362(d)(1)(C), or it can specify an effective date under Code Sec. 1362(d)(1)(D). For example, a revocation made before the 16th day of the third month of an S corporation's tax year generally is effective retroactively on the first day of that tax year.

In contrast, under Code Sec. 1362(d)(1)(C)(ii), a revocation made after the 15th day of the third month of a corporation's tax year generally is effective prospectively on the first day of the corporation's following tax year. Alternatively, the corporation may specify an immediate or prospective effective date for a revocation by expressing a date (in terms of a stated day, month, and year) that occurs on or after the date on which the revocation is made.

In response to a practitioner's comment, the IRS modified the regulations so that Reg. Sec. 1.481-5(c)(2) provides that, solely with regard to revocations with retroactive effective dates, a revocation may be treated as having been made on the effective date of such revocation. Accordingly, a corporation may test compliance with the revocation requirement and the shareholder identity requirement on either the date the revocation was made or, in the case of a revocation with a retroactive effective date, the date the revocation was effective.

Observation: The practitioner had noted that, under the proposed regulations, in the absence of such a rule, a corporation would not satisfy the shareholder identity requirement for qualifying as an ETSC if the corporation (i) had the same shareholders (and in identical proportions) on both December 22, 2017, and the retroactive effective date of the revocation, but (ii) experienced a change in shareholder ownership during the period between the retroactive effective date of the revocation and the date on which the revocation was made.

In addition, the final regulations clarify the text of Reg. Sec. 1.1362-2(a)(2) to provide explicitly that Code Sec. 7503 applies where the last day prescribed for making a revocation occurs on a Saturday, Sunday, or legal holiday. Therefore, under the revocation provision that requires that a corporation make a revocation during the two-year period to qualify as an ETSC, a revocation made on December 23, 2019, will be treated as made during the two-year period for purposes of this rule.

No-Newcomer Rule

A no-newcomer rule in the last sentence of Reg. Sec. 1.1377-2(b), as in effect prior to the effective date of the final regulations, limited the special treatment provided under Code Sec. 1371(e)(1) (with respect to distributions of money during a corporation's PTTP) solely to those shareholders who were shareholders of the corporation at the time that it terminated or revoked its S election (i.e., legacy shareholders).

In the proposed regulations, the IRS noted that in the absence of a no-newcomer rule, shareholders that were shareholders on the date that the corporation's S election revocation was made would continue to receive qualified distributions, whether or not there are new shareholders or changes in the historical S corporation shareholders' proportionate interests on or after such date. Moreover, new shareholders, whether eligible S corporation shareholders or not, that acquire stock of an ETSC on or after the date that the revocation was made may receive qualified distributions, all or a portion of which may be sourced from AAA. According to the IRS, such outcomes would best implement the plain language of Code Sec. 1371(f) and the policy objective of easing the transition of affected taxpayers from S corporation status to C corporation status. Accordingly, the proposed regulations did not impose a no-newcomer rule with respect to the ETSC period. Because the rules pertaining to the PTTP and to the ETSC period serve a similar objective of easing the transition from S corporation to C corporation status, the IRS determined that the rules regarding newcomers (i.e., non-legacy shareholders) should be consistent. Therefore, based on the rationale for rejecting a no-newcomer rule with respect to the ETSC period, the IRS determined that such a rule should also not apply with respect to the PTTP and proposed the removal of the no-newcomer rule.

A practitioner recommended that the final regulations include an additional transition rule where, if shares of a former S corporation were transferred to a newcomer pursuant to a binding agreement entered into before the applicability date of the final regulations, then, except upon unanimous agreement of current shareholders of a corporation that are legacy shareholders, the no-newcomer rule would apply during the PTTP, and a similar rule would apply during the ETSC period. The IRS, however, rejected the recommendation saying that it intended the applicability date provisions in the proposed regulations, and as adopted in the final regulations, to afford corporations transition flexibility in applying Reg. Sec. 1.1377-2(b) with regard to the PTTP. Reg. Sec. 1.1377-2(b), as revised by the final regulations to eliminate the no-newcomer rule for special treatment under Code Sec. 1371(e)(1) of distributions of money by a corporation with respect to its stock during the PTTP, applies to a corporation's tax years beginning after the date of publication of the final regulations. In the case of a corporation using the calendar year as its annual accounting period, newcomers are not entitled to receive distributions of AAA before January 1, 2021, unless the corporation chooses to apply Reg. Sec. 1.1377-2(b) before January 1, 2021. Corporations to which the commenter's transition rule would have applied generally will thus have completed their PTTPs prior to the applicability of Reg. Sec. 1.1377-2(b). Distributions of AAA during those PTTPs would have been limited to legacy shareholders. Additionally, the IRS said, the practitioner's proposed transition rule would add complexity in administering the rules.

For a discussion of the rules surrounding ETSCs, see Parker Tax ¶34,580.

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Taxpayer Filed a Valid Return, Despite Lack of Identity Protection PIN

The Tax Court held that an electronically filed tax return that was rejected by the IRS for failure to include an Identity Protection Personal Identification Number (IP PIN) nevertheless started the running of the three-year statute of limitations period under Code Sec. 6501. The court rejected the IRS's argument that, by omitting an IP PIN, the taxpayer failed to file a valid return until he resubmitted the return with an IP PIN; and, because the taxpayer's initial return was valid, the court concluded there was no reason to toll the statute of limitations period until the second return was filed. Fowler v. Comm'r, 155 T.C. No. 7 (2020).

Background

Robin Fowler e-filed his 2013 Form 1040 on October 15, 2014 (October 15 submission). Fowler authorized Bennett Thrasher, LLP, a CPA firm, to file a return on his behalf in its capacity as an electronic return originator (ERO). Jeffrey Call, a partner at Bennett Thrasher, e-signed the 2013 Form 1040 with a Practitioner Personal Identification Number (PIN) and transmitted it directly to the IRS on October 15, 2014. Call received a Submission ID, which is a globally unique 20-digit number assigned to electronically filed tax returns.

The IRS's software received the October 15 submission that same day and sent Call a rejection notice, citing code "IND- 181" for failure to provide a valid Identity Protection Personal Identification Number (IP PIN) with the e-filed return. The IRS typically issues IP PINs to taxpayers who have been victims of identity theft. Fowler acknowledged that his identity was compromised in 2013. The IRS's records reflected that it sent Fowler an IP PIN on December 30, 2013, but Fowler claimed that he did not receive the IP PIN before making the October 15 submission.

Fowler resubmitted his 2013 Form 1040 on October 28, 2014 (October 28 submission), but subsequently received a letter in December 2014 notifying him that the IRS had not received his 2013 return. Call e-filed a 2013 Form 1040 on Fowler's behalf a third time on April 30, 2015 (April 30 submission). Fowler obtained an IP PIN from the IRS on or before April 30, 2015, and it was included in the April 30 submission. With the exception of the IP PIN, the tax information in the April 30 submission was identical to the information in the first and second submissions. The IRS's software reviewed and accepted the April 30 submission on the same day. The IRS sent Fowler a notice of deficiency for the 2013 tax year on April 5, 2018. Thereafter, Fowler filed a Tax Court petition challenging the notice on grounds that it was sent after the expiration of the three-year statute of limitations under Code 6501(a).

Under Code Sec. 6501(b)(1), the three-year statute of limitations period begins on the due date of the return if it is timely filed or on the actual filing date if the return is filed late. The Tax Court held in Appleton v. Comm'r, 140 T.C. No. 14 (2013), that the filing of a return triggers the limitations period if (1) the document that the taxpayer submitted constitutes a return, and (2) the taxpayer properly filed the return. Under Beard v. Comm'r, 82 T.C. 766 (1984), aff'd 793 F.2d 139 (6th Cir. 1986), a taxpayer filing constitutes a return if (1) it purports to be a return and provides sufficient data to calculate tax liability, (2) the taxpayer made an honest and reasonable attempt to satisfy the requirements of the tax law, and (3) the taxpayer executed the document under penalties of perjury (signature requirement).

The IRS argued that the IP PIN is a part of the signature requirement under Beard and that because the October 15 submission did not include an IP PIN, it failed the signature requirement and therefore was not a return. The IRS pointed out that the Internal Revenue Manual (IRM) states that an electronic return filed with a missing or incorrect IP PIN will be rejected. The IRS also said that it needs an IP PIN to authenticate the person who provides the return as the taxpayer he or she purports to be.

Tax Court's Analysis

The Tax Court found that Fowler's October 15 submission constituted a return under Beard and that Fowler properly filed it. Therefore, the court held that the limitations period expired before the IRS issued the notice of deficiency and granted summary judgment for Fowler.

The court found that the October 15 submission easily satisfied the first two prongs of the Beard test because it purported to be a return, was submitted on a Form 1040, and appeared to be an honest and reasonable attempt to comply with the tax laws. The court noted that the only difference between the October 15 submission (which the IRS rejected) and the April 30 submission (which the IRS accepted) was that the October 15 submission did not include an IP PIN. The court explained that the second prong of the Beard test was intended to distinguish a tax protester return from a return that on its face shows an attempt to properly report income and deductions, and in the court's view, Fowler's return did not belong in the tax protester category.

As to the third Beard requirement, the court noted that notwithstanding the IRS's authority under Code Sec. 6061 to prescribe forms or regulations defining the signature method for any return and to develop procedures for the acceptance of signatures in digital or other electronic form, there is little regulatory guidance as to what constitutes a valid signature. The court found that the instructions to the 2013 Form 1040 stated that to file electronically, the taxpayer must sign the return electronically using either a Self-Select PIN or a Practitioner PIN, and the court noted that Call included a Practitioner PIN on Fowler's e-filed return in accordance with the instructions. The court found no IRS guidance in the Form 1040 instructions or elsewhere characterizing an IP PIN as a signature. In the court's view, the IRS could not disavow the 2013 Form 1040 instructions, on which Fowler justifiably relied, to accommodate its litigation position.

The court rejected the IRS's reliance on the IRM, reasoning that an IP PIN does not become part of the signature requirement simply because the IRS's software will reject an e-filed return without it. The court found that the IRS's Modernized e-File (MeF) system, which the IRS uses to process e-filed returns, rejects returns for numerous errors that may not cause a return to fail the Beard test. The court also disagreed with the IRS's argument that it needs the IP PIN for taxpayer authentication purposes. The court noted that (1) the IRS acknowledged in CCA 201650019 that an element other than an e-signature may be needed to authenticate an electronic return; (2) when an ERO such as Bennett Thrasher prepares a return, the ERO is instructed to verify the taxpayer's identity, which seemed to make the IP PIN superfluous in Fowler's case; and (3) most fundamentally, Code Sec. 6061 puts the onus on the government to prescribe the signature method. On the last point, the court said that the Code does not require a taxpayer to deduce what constitutes a signature from the function of signatures in the legal world or the IRS's inherently esoteric authentication needs. The court concluded that, because Fowler's October 15 submission included a Practitioner PIN, which was identified as an e-signature in the Form 1040 instructions, the October 15 submission satisfied the Beard test and, accordingly, constituted a return for statute of limitations purposes.

The court also held that Fowler's return was properly filed under the second prong of the Appleton test based on an affidavit from Call stating that he submitted the 2013 Form 1040 to the IRS on Fowler's behalf. The court noted that Fowler provided a transmission log from Bennett Thrasher showing the 20-digit submission ID an e-filer receives after submitting a return. Most significantly, in the court's view, was the fact that the IRS acknowledged in its court filings that Fowler submitted a return on October 15, 2014, and that it was rejected because it did not include an IP PIN. The court explained that the filing inquiry focuses only on the mode of filing, not the content of the return, and the court noted that the IRS did not raise any issue with how Fowler delivered the October 15 submission to the MeF system.

For a discussion of the statute of limitations on assessments, see Parker Tax ¶260,130.

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IRS Finalizes Regs Clarifying the Definition of Qualifying Relative for Years 2018-2025

The IRS issued final regulations that clarify the definition of a qualifying relative under Code Sec. 152(d)(1) for purposes of various Code provisions for years 2018 through 2025. The final regulations provide that, in determining whether an individual is a qualifying relative for purposes of various provisions of the Code that refer to Code Sec. 152 in years in which the exemption amount in Code Sec. 151(d) is zero, the exemption amount is the Code Sec. 152(d)(1)(B) inflation-adjusted exemption amount in the annual revenue procedure setting forth inflation-adjusted items. T.D. 9913.

Background

Generally, Code Sec. 151 allows a taxpayer to claim exemption deductions for the taxpayer and his or her spouse, and for any dependents. Under Code Sec. 152(a), a dependent means either a qualifying child or a qualifying relative. The definition of a "qualifying relative" in Code Sec. 152(d)(1) includes the requirement in Code Sec. 152(d)(1)(B) that the individual have gross income for the calendar year that is less than the exemption amount as defined in Code Sec. 151(d). Such an individual must also satisfy the requirement of Code Sec. 152(d)(1)(C) that the individual receive more than one-half of his or her support from the taxpayer claiming the individual as a qualifying relative.

Before being amended by the Tax Cuts and Jobs Act (TCJA), Code Sec. 151(d) provided for an exemption amount of $2,000 that was adjusted annually for inflation. Before the enactment of TCJA, the IRS had determined in Rev. Proc. 2017-58 (modified and superseded by Rev. Proc. 2018-18) that the exemption amount for calendar year 2018 was $4,150. TCJA added Code Sec. 151(d)(5) to provide special rules for tax years 2018 through 2025 regarding the exemption amount in Code Sec. 151(d). Code Sec. 151(d)(5)(A) provides that, for a tax year beginning after December 31, 2017, and before January 1, 2026, the exemption amount is zero, thereby suspending the deductions for personal exemptions and the dependency exemption. However, Code Sec. 151(d)(5)(B) provides that the reduction of the exemption amount to zero is not taken into account in determining whether a deduction under Code Sec. 151 is allowed or allowable to a taxpayer, or whether a taxpayer is entitled to a deduction under Code Sec. 151, for purposes of any other provision of the Code.

TCJA also amended Code Sec. 24 to create a $500 credit for certain dependents of a taxpayer other than a qualifying child described in Code Sec. 24(c) for whom the child tax credit is allowed. Under Code Sec. 24(h)(4), the $500 credit applies to two categories of dependents: (1) qualifying children for whom a child tax credit is not allowed, and (2) qualifying relatives as defined in Code Sec. 152(d). This new credit applies for tax years 2018 through 2025.

The definition of "head of household" in Code Sec. 2(b)(1)(A) includes the requirement that the taxpayer maintain as his or her home a household for a qualifying individual for a specified period of time. A qualifying individual under Code Sec. 2(b)(1)(A)(ii) includes a qualifying relative if the taxpayer is entitled to a deduction under Code Sec. 151 for such person for the tax year. As noted above, taxpayers are allowed a deduction under Code Sec. 151 for individuals who are dependents as defined in Code Sec. 152, including qualifying relatives described in Code Sec. 152(d).

Before the enactment of TCJA, alimony and separate maintenance payments were deductible by the payor spouse and includible in income by the recipient spouse under Code Secs. 61(a)(8), 71(a), and 215(a). Under Code Sec. 71(c), child support payments were not treated as alimony. TCJA repealed Code Secs. 61(a)(8), 71 and 215, and, in a conforming change, also repealed Code Sec. 682, relating to amounts included in the income of an estate or trust in case of divorce. The repeal of Code Sec. 682 applies to any divorce or separation instrument executed after 2018, and for any instrument executed before 2019 and later modified to apply the provisions of the TCJA. To conform with the repeal of Code Sec. 71, TCJA amended Code Sec. 152(d)(5) regarding the source of a qualifying relative's support. As previously mentioned, Code Sec. 152(d)(1)(C) requires that an individual receive more than one-half of his or her support from the taxpayer to be claimed as a qualifying relative of that taxpayer. TCJA provides, consistent with prior law, that payments of alimony or separate maintenance paid to a spouse or former spouse are not treated as support of a dependent provided by the payor spouse. However, TCJA revised the language of Code Sec. 152(d)(5) to eliminate references to Code Sec. 71 and Code Sec. 682, which were repealed by the TCJA.

On August 28, 2018, the IRS issued Notice 2018-70 to announce its intent to issue proposed regulations providing that the reduction of the exemption amount to zero under Code Sec. 151(d)(5)(A) for tax years 2018 through 2025 will not be taken into account in determining whether an individual meets the requirement of Code Sec. 152(d)(1)(B) to be a qualifying relative. In June of 2020, the IRS published proposed regulations (REG-118997-19) providing, consistent with Notice 2018-70, that in determining whether an individual is a qualifying relative for purposes of various provisions of the Code that refer to Code Sec. 152 in years in which the exemption amount is zero, the Code Sec. 151(d) exemption amount will be the inflation-adjusted Code Sec. 152(d)(1)(B) exemption amount in the annual revenue procedure setting forth inflation-adjusted items. The proposed regulations also modified earlier proposed regulations (REG-137604-07) that provided rules regarding the definition of a dependent under Code Sec. 152, and included references to repealed Code Sec. 71 and Code Sec. 682.

Final Regulations

Last week, the IRS finalized the proposed regulations issued in REG-118997-19 with no substantive change. The final regulations provide that the exemption amount, for purposes other than a deduction for a personal or dependency exemption under Code Sec. 151, is $4,150 for tax year 2018, and for tax years 2019 through 2025, the exemption amount, as adjusted for inflation, is the Code Sec. 152(d)(1)(B) exemption amount, as set forth in guidance published in the Internal Revenue Bulletin.

Observation: The exemption amount is $4,200 for 2019 (Rev. Proc. 2018-57); and $4,300 for 2020 (Rev. Proc. 2019-44).

The final regulations also describe certain payments to a payee spouse for purposes of the support test without references to repealed Code Sec. 71 and repealed Code Sec. 682. Finally, the final regulations clarify an issue regarding a statutory cross reference in Code Sec. 24(h)(4) to "a qualifying child described in subsection (c)." As was proposed in the proposed regulations, the final regulations clarify in Reg. Sec. 1.24-1 that the statutory cross reference is a reference to Code Sec. 24(c), rather than to Code Sec. 152(c).

For additional discussion of claiming dependency exemptions, see Parker Tax ¶10,720. For a discussion of the child tax credit, see Parker Tax ¶100,701.

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Couple's Lavish Spending Prevents Discharge of Taxes in Bankruptcy

The Eleventh Circuit affirmed a bankruptcy court's judgment that a couple's tax debt was non-dischargeable under 11 U.S.C. Sec. 523(a)(1)(c) because the couple willfully evaded payment of the taxes. The court held that, while making an offer in compromise (OIC) to the IRS is not, by itself, an act to evade taxes, the couple's OICs were inadequate and unrealistic offers considering their income and discretionary spending as well as the fact that they were submitted to the IRS at conveniently low points in the couple's highly profitable business venture. Feshbach v. IRS, 2020 PTC 286 (11th Cir. 2020).

Background

Matthew Feshbach is an investment professional and former hedge-fund manager. Mr. Feshbach used an investment strategy that allowed him to delay the recognition of his taxable income from investments. He and his wife, Kathleen, built a $14 million home in Monte Sereno, California, in the 1990s. But events in the late 1990s forced him to close out his investment positions and incur a tax liability of $1.9 million in 1999. The Feshbachs made some payments to the IRS and received other credits during the 1999 tax year but did not submit a payment with their tax return.

In 2001, the Feshbachs made an offer in compromise (OIC) to the IRS to settle their 1999 tax debt for $1 million - about half what they owed. They made an immediate payment of $200,000 and said they would make another payment after they sold their house in Bellaire, Florida, where they were living by the time. Considering the Feshbachs' high income and allowable expenses, the IRS called the offer a "nonstarter." The Feshbachs paid the $200,000 but withdrew the offer before the IRS could reject it and opted instead for a temporary agreement in which they would make monthly payments of $1,000 while the IRS suspended its collection efforts.

The Feshbachs dug a deeper hole by liquidating securities in order to make the $200,000 payment to the IRS and by the end of 2001 they owed the IRS around $5.1 million. However, the debt did not seem insurmountable, as Mr. Feshbach founded a highly profitable hedge fund in 2001 that earned more than $13 million over the next nine years. However, the Feshbachs would also spend about $8.5 million on personal expenses and charitable contributions in that same period, leaving a balance of more than $3.8 million on their tax debt. In 2002, the Feshbachs had $764,000 in expenses, including a domestic payroll of over $58,000 and personal expenses of $383,000.

The Feshbachs made a second OIC in 2002, which was a higher dollar value than the first offer but a lower percentage of their total liability. The IRS determined that the Feshbachs were earning much more income than they had reported. The Feshbachs represented on a Form 433-A financial disclosure that they were earning about $15,000 per month, or $180,000 annually, yet they reported income of over $611,000 on their 2002 tax return. For the next three years after submitting their second OIC, the Feshbachs reported more than $10 million in income.

In 2008, the Feshbachs made a third OIC of $120,000 on a $3.6 million balance for the 2001 tax debt. They proposed monthly payments of $2,500 over 48 months. Along with this offer they submitted another Form 433-A in which they claimed a monthly income of $833, or $9,996 annually. At that time, they were incurring monthly household expenses of over $12,000. An IRS officer later testified that he knew either that the Feshbachs' income was understated or their expenses overstated or a combination of the both. On their 2008 tax return, the Feshbachs claimed an income of $193,205 (19 times what they reported on the Form 433-A). After a lengthy review process, the IRS concluded in 2010 that the Feshbachs had the means to pay $15,000 per month. The Feshbachs made four payments of $15,000 but ceased payments altogether in 2011, when they filed for Chapter 7 bankruptcy.

In the bankruptcy court, the Feshbachs initiated an adversary proceeding seeking a determination that their 2001 tax liability either partially or fully dischargeable. The bankruptcy court held that the taxes were non-dischargeable under 11 U.S.C. Sec. 523(a)(1)(C) because the Feshbachs willfully attempted to evade or defeat the taxes. The bankruptcy court relied primarily on the Feshbachs' total income and spending over the previous nine years. It found that they earned over $13 million during that time period and therefore had the capacity to pay the taxes in full, yet they chose to spend more than $8.5 million on personal expenses and charitable contributions. The bankruptcy court also held that, although the issue of a partial discharge had not been resolved in the Eleventh Circuit, most courts had concluded that a partial discharge is not permitted under 11 U.S.C. Sec. 523(a)(1)(C). The Feshbachs appealed, and a district court affirmed. The Feshbachs appealed to the Eleventh Circuit.

In In re Jacobs, 490 F.3d 913 (11th Cir. 2007), the Eleventh Circuit set forth a two-prong test for determining whether a tax debt is non-dischargeable due to willful evasion under 11 U.S.C. Sec. 523(a)(1)(C). Under the conduct prong, the government must prove that the debtor attempted to evade or defeat a tax, and under the mental state prong, the government must prove that the attempt was done willfully. The Feshbachs argued that both of the lower courts erred in holding that their personal spending alone could satisfy the conduct prong for willful evasion. As to their mental state, the Feshbachs asserted that the government was required to prove that their overspending was undertaken with the specific intent to evade taxes. They also asserted that even under the lower civil willfulness standard, their efforts to compromise with the IRS yielded substantial penalties and interest, which suggested a lack of willful evasion.

Analysis

The Eleventh Circuit affirmed the bankruptcy court's holding that the Feshbachs willfully evaded the payment of their 2001 tax liability. The court found no error in the bankruptcy court's determination that the Feshbachs' lavish spending on personal luxuries instead of paying their taxes met the conduct requirement. The court also found that the bankruptcy applied the correct legal standard in its mental state determination and correctly determined that the Feshbachs' conduct was willful under that standard.

The court found that a finding of willful evasion under 11 U.S.C. Sec. 523(a)(1)(C) was supported by the Feshbachs' personal spending habits and also in their conduct related to the OIC process. In the court's view, there was ample evidence that the Feshbachs approached the IRS with inadequate and unrealistic OICs given their income and spending and that they used the OIC process to delay the payment of their taxes. The court found that Mr. Feshbach was more sophisticated than the average taxpayer and knew that a pending offer would halt IRS collection efforts. The court said that the Feshbachs took advantage of the offer process by continuing to maintain an extravagant lifestyle, and the court rejected their assertion that the expenses were for a business purpose of cultivating an appearance of wealth in order to attract clients. The court also noted the vast disparities between the income the Feshbachs reported to the IRS during the settlement process and the income they actually earned. According to the court, the inference that the Feshbachs clouded their income and spending bolstered the finding that the Feshbachs used the OIC process as a delay tactic. The court found that the Feshbachs submitted meager offers to the IRS at conveniently low points in their highly profitable business venture.

Regarding the Feshbachs' mental state, the court found that the bankruptcy court applied the correct standard, which requires only a voluntary, conscious, and intentional attempt to violate a known duty to pay taxes, rather than specific intent as the Feshbachs argued. Applying that standard, the court found that the Feshbachs' excessive discretionary spending was evidence of willfulness. The court also noted that the bankruptcy court relied on contemporaneous notes by IRS officers that the Feshbachs' offers were intended to delay collection in reaching its conclusion that the Feshbachs acted willfully. The court rejected the Feshbachs' argument that the substantial penalties and interest the Feshbachs incurred negated their willfulness; the court said this argument was probative at best, and did not show that the bankruptcy court committed clear error.

The Eleventh Circuit also upheld the bankruptcy court's denial of a partial discharge. The court agreed that partial discharge would have been relevant only if the Feshbachs were unable to pay the entire debt, and the court found nothing in the record to suggest as much, particularly given that the Feshbachs earned $13 million over nine years and their tax debt was less than half that amount.

For a discussion of the dischargeability of tax debts in bankruptcy, see Parker Tax ¶16,160.

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