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Federal Tax Research Bulletin - The Latest Tax and Accounting Articles

              

Parker's Federal Tax Bulletin
Issue 120     
July 29, 2016     

 

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 1. In This Issue ... 

 

Tax Briefs

August AFRs Issued; Safe Harbors Issued for Section 355 Transactions; Sports Team Didn't Produce Broadcasts of Its Games, Income Wasn't DPGR; Deductions Allowed Despite Lack of Substantiation Where City Destroyed Records ...

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No Casualty Loss Deduction Allowed for Payments to Repair Collapsed Retaining Wall

The Tax Court held that because the collapse of a retaining wall was due to progressive deterioration that had begun at least 20 years before the wall's collapse, the owner of a co-op was not entitled to a casualty loss deduction for amounts paid to fix the wall. The court rejected the taxpayer's argument that the collapse of the wall was due to excessive spring rain which overstressed a recently installed drainage system and caused rapidly accelerating movement in the wall in the four weeks immediately preceding the collapse. Alphonso, T.C. Memo. 2016-130.

Read more ...

Online Gambling Accounts with Offshore Sites Didn't Require FBAR Reporting

The Ninth Circuit partially reversed a district court and held that because a taxpayer's accounts with two poker gambling websites were not "financial accounts" for which the taxpayer was required to file a Foreign Bank and Financial Accounts Report (FBAR), penalties for his late filing of those forms were not applicable. However, the court found that a money transmitter through which the taxpayer funded his online gambling was a "financial institution" for FBAR purposes, and affirmed the $10,000 penalty for his late filing of the FBAR for his account with that company. U.S. v. Hom, 2016 PTC 267 (9th Cir. 2016).

Read more ...

Deduction for Section 167(h) Geological and Geophysical Expenses Applies to Non-Owners Also

The Tax Court rejected IRS arguments that the deduction under Code Sec. 167(h) for geological and geophysical expenses paid or incurred in connection with the exploration for, or development of, oil or gas within the U.S. only applies to owners of mineral interests. As a result, a corporation that conducted marine surveys and sold data generated by the surveys to companies engaged in oil and gas exploration and development could deduct its survey expenses under Code Sec. 167(h). CGG Americas, Inc. v. Comm'r, 147 T.C. No. 2 (2016).

Read more ...

Couple Can Deduct Most of Wages Paid to Children Doing Jobs for Family Machinery Business; No Losses Allowed for Other Part-Time Businesses Found to be Hobbies

The Tax Court held that a married couple, who ran a successful business refurbishing and selling embroidery machinery, could deduct a majority of the wages they paid their children for work performed for the business. However, the court disallowed deductions relating to a cattle raising activity, a deer hunting preserve, and a lake resort activity, finding that the couple did not operate the businesses for a profit because they had no business plans for those activities, nor did they advertise their existence. Embroidery Express, LLC v. Comm'r, T.C. Memo. 2016-136.

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IRS Eliminates Requirement to Submit Copy of Section 83(b) Election With Returns

The IRS has issued final regulations eliminating the requirement to file a copy of Code Sec. 83(b) elections (to include in gross income the value of property received in connection with services performed) with returns. The final regulations apply to property transferred on or after January 1, 2016. T.D. 9779 (7/26/16).

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Seventh Circuit Reverses Tax Court; Taxpayer Not Entitled to Abatement of Interest

The Seventh Circuit reversed a Tax Court decision which held that a taxpayer was entitled to a partial abatement of the interest he had paid on overdue payroll taxes. The court did not agree with the Tax Court's use of "unfairness" as a criterion for abatement. King v. Comm'r, 2016 PTC 259 (7th Cir. 2016).

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Taxes Not Dischargeable in Bankruptcy Where Debtor Filed Return 7 Years Late

The Ninth Circuit affirmed a district court's order, which reversed a bankruptcy court, and held that a debtor's tax liabilities were nondischargeable in bankruptcy because the debtor's late-filed Form 1040 did not represent an honest and reasonable attempt to satisfy tax law requirements and, thus, the debtor did not file a "return" within the meaning of 11 U.S.C. Section 523(a)(1)(B)(i). Agreeing with other circuits, the Ninth Circuit held that In re Hatton, 220 F.3d 1070 (9th Cir. 2000), which adopted the Tax Court's widely-accepted definition of "return," applied to the Bankruptcy Code as amended in 2005. In re Smith, 2016 PTC 249 (9th Cir. 2016).

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Income from Exempt Organization's Inherited Rental Properties Won't Lead to UBTI

The IRS, in a private letter ruling, determined that commercial real estate properties that a Code Sec. 501(c)(3) organization inherited from its sole financier would not cause it to incur unrelated business taxable income (UBTI). The IRS ruled that both rental income from the properties and any gain on potential sales of the properties would be excluded from UBTI under the real property exclusions in Code Sec. 512(b). PLR 201630009.

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 2. Tax Briefs 

 

Applicable Federal Rates

August AFRs Issued: In Rev. Rul. 2016-18, the IRS issued the applicable federal rates for August 2016.

 

C Corporations

Safe Harbors Issued for Section 355 Transactions: In Rev. Proc. 2016-40, the IRS provides two safe harbors under which a distributing corporation will not be considered to lack control of a distributed corporation within the meaning of Code Sec. 355(a). The safe harbors apply where (1) no action is taken by the distributed corporation that would result in an unwind at any time prior to 24 months after the distribution, or where (2) the distributed corporation engages in an unwind as a result of an unanticipated third party transaction (e.g. a merger).

 

Deductions

Sports Team Didn't Produce Broadcasts of Its Games, Income Wasn't DPGR: In CCA 201630015, the IRS Office of Chief Counsel (IRS) advised that for purposes of Code Sec. 199, a television network produced broadcasts of sports games on its own behalf pursuant to the rights granted to it in a contract with the taxpayer sports team, rather than on behalf of the team. Accordingly, the IRS determined that the taxpayer was not the producer of the broadcasts, and any gross receipts the team derived from the contract were not domestic production gross receipts (DPGR).

Deductions Allowed Despite Lack of Substantiation Where City Destroyed Records: In Probandt v. Comm'r, T.C. Memo. 2016-135, the Tax Court held that, despite having no written records, a taxpayer was entitled to travel and meal expenses. The taxpayer's records had been destroyed when, while he was in China, a city tore down his storage unit under eminent domain. Finding that the taxpayer could not have retrieved his records in the short amount of time the city provided, the court determined he was eligible for "exceptional circumstances" substantiation under Reg. Sec. 1.274-5T(c)(4) and allowed partial deductions based on credit card records.

 

Employment Tax

Puerto Rican Resident Liable for U.S. Self-Employment Tax: In Curet v. Comm'r, T.C. Memo. 2016-138, the Tax Court determined that a taxpayer was liable for deficiencies and penalties for his failure to report self-employment taxes on his income earned while he was a resident of Puerto Rico. The court noted that although Code Sec. 933(1) generally exempts bona fide residents of Puerto Rico from U.S. income tax, Reg. Sec. 1.1402(a)-9 requires such individuals to compute net earnings from self-employment in the same manner as a U.S. taxpayer.

 

Gross Income and Exclusions

Settlement Proceeds from Workplace Discrimination Suit Not Excludable: In Tritz v. Koskinen, 2016 PTC 250 (C.D. Cal. 2016), a district court granted an IRS motion for summary judgment and dismissed a taxpayer's argument that settlement proceeds she received from a workplace discrimination suit against the USPS shouldn't be included in her income under Code Sec. 104(a)(2). The court found that the damages received in the settlement were for emotional distress, and that Code Sec. 104(a)(2) only excepts from income damages for physical injury or sickness.

California Taxpayers Affected by Gas Leak Can Exclude Reimbursements from Income: In Announcement 2016-25, the IRS announced that it will not require residents of southern California affected by the 2015 Southern California Gas Company (SoCal Gas) natural gas leak to include in income relocation and cleaning expense reimbursements paid by SoCal Gas.

Temporary Regs Issued on Lease of Investment Credit Properties: In T.D. 9776 (7/22/16), the IRS issued temporary regulations that provide guidance regarding the income inclusion rules under Code Sec. 50(d)(5) that are applicable to a lessee of investment credit property when a lessor of such property elects to treat the lessee as having acquired the property. The temporary regs also provide rules regarding income inclusion on the termination or disposition of a lease of such property.

 

IRS

Monthly Guidance on Corporate Bond Yield Issued: In Notice 2016-46, the IRS provides guidance on the corporate bond monthly yield curve, the corresponding spot segment rates used under Code Sec. 417(e)(3), and the 24-month average segment rates under Code Sec. 430(h)(2).

IRS Issues Code Section 45K Reference Price for 2015: In Notice 2016-43, the IRS published the reference price under Code Sec. 45K(d)(2)(C) for purposes of determining the amount of the enhanced oil recovery credit under Code Sec. 43, the marginal well production credit under Code Sec. 45I, and the percentage depletion in case of oil and natural gas produced from marginal properties under Code Sec. 613A. For calendar year 2015, the reference price is $44.39.

 

Partnerships

Extension of Code Section 754 Election Period Granted: In PLR 201630013, the IRS granted a partnership's request for an extension of time to file an election under Code Sec. 754 to adjust the partnership's basis pursuant to Code Sec. 743. The IRS noted that the partnership had adjusted the basis of partnership property as if there were a Code Sec. 754 election in effect and did not take any position inconsistent with such an election. 

 

Procedure

Tax Court Won't Reconsider Holding Embezzler Not Liable for Deficiency: In Senyszyn v. Comm'r, T.C. Memo. 2016-137, the Tax Court denied the IRS's motion for reconsideration of a prior opinion in which it declined to apply the doctrine of collateral estoppel to uphold whatever minimum deficiency would have been consistent with a taxpayer's prior conviction for tax evasion. The court had found that, contrary to an IRS agent's analysis, the taxpayer repaid to a former business associate more than the amount the agent determined the taxpayer to have misappropriated and that there was no deficiency.

Taxpayer Held In Contempt of Court For Failure to Produce Documents: In U.S. v. Belcik, 2016 PTC 253 (M.D. Fla. 2016), a district court determined that a taxpayer had properly invoked his Fifth Amendment privilege against self-incrimination when he refused to answer questions a revenue agent asked relating to a failure to file tax returns and tax evasion. However, the court found the privilege did not extend to the taxpayer's blanket refusal to produce documents requested by the IRS, and held the taxpayer in contempt of court.

IRS Could Not Rely on Waiver Where Delinquent Returns Lead to Reassessments: In U.S. v. Trevitt, 2016 PTC 255 (M.D. Ga. 2016), a district court found that although a married couple had signed Forms 870 waving their rights to notices of deficiency, their filing of delinquent returns lead to a reassessment that substantially increased their liabilities, requiring the IRS to send a notice of deficiency or obtain a new waiver before making an additional assessment. Because the IRS had not done so, the court held that the IRS's assessments were invalid.

 

S Corporations

S Corp's Inadvertent Termination Relief Granted Pending Distributions: In PLR 201629001, the IRS determined that an S corporation's election terminated because for three consecutive years more than 25 percent of the corporation's income was passive activity income under Code Sec. 1362(d). The IRS found that the taxpayer's advisors inadvertently failed to inform it of the passive investment rules, and ruled that the taxpayer could continue to be an S corporation provided it distributed all of its accumulated earnings and profits and made an adjustment pursuant to Code Sec. 1362(f)(4).

 

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 3. In-Depth Articles 

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No Casualty Loss Deduction Allowed for Payments to Repair Collapsed Retaining Wall

The Tax Court held that because the collapse of a retaining wall was due to progressive deterioration that had begun at least 20 years before the wall's collapse, the owner of a co-op was not entitled to a casualty loss deduction for amounts paid to fix the wall. The court rejected the taxpayer's argument that the collapse of the wall was due to excessive spring rain which overstressed a recently installed drainage system and caused rapidly accelerating movement in the wall in the four weeks immediately preceding the collapse. Alphonso, T.C. Memo. 2016-130.

Background

Christina Alphonso is a tenant-stockholder of Castle Village Owners Corp., a New York cooperative housing corporation (i.e., co-op). Castle Village owns a tract of land in Manhattan on which five high-rise residential buildings sit. Before May 12, 2005, the grounds near those five Castle Village apartment buildings were supported by a retaining wall of stone masonry construction that had been built between 1921 and 1925. Before May 12, 2005, the retaining wall in question ran parallel to Riverside Drive for approximately 800 feet and had an average height of 65 feet.

In 1985, Castle Village retained an engineer to perform an inspection of the retaining wall. In a letter to Castle Village, the engineer indicated that a portion of the retaining wall showed signs of movement and instability and that several cracks were observed and that relief drains appeared not to function properly. For the next 20 years, various engineering and architectural firms were hired to address issues with the retaining wall. There were two documented times when work was performed either directly on the wall or close to the wall - the installation of rock anchors/bolts in 1986 and drainage modifications beyond the top of the wall in 2004.

On May 12, 2005, a 150-foot portion of the retaining wall collapsed onto Riverside Drive. The various consultants whom Castle Village had retained over the previous 20 years had reported their findings about the retaining wall in numerous letters, reports, proposals, and/or memoranda sent to Castle Village. Most of the major problems in and around the retaining wall that those consultants had observed and described in those respective documents were observed in and around the 150-foot section of the retaining wall that collapsed.

On her 2005 Form 1040, Alphonso reported a casualty loss of $26,390 and, after making reductions required by Code Sec. 165(h)(1) and (2) (relating to the dollar limitation per casualty and the limitation on the deductible amount), she claimed a casualty loss deduction of $23,188. The IRS disallowed the deduction.

Losses Deductible as Casualty Losses

Under Code Sec. 165(a), (c) and (h), an individual can deduct losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty. A loss is treated as sustained during the tax year in which the loss occurs, as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such tax year. As defined in Code Sec. 165(c)(3), the term "other casualty" refers to an event that shares characteristics with a fire, storm, or shipwreck. A casualty is an event which is due to a sudden, unexpected, or unusual cause.

In Fay v. Helvering, 120 F.2d 253 (2d Cir. 1941), the Second Circuit held that the progressive deterioration of property through a steadily operating cause is not a casualty. The Tax Court, in Carlson v. Comm'r, T.C. Memo. 1981-702, held that a collapse, even one that occurs suddenly, is not a casualty when the collapse is caused by progressive deterioration. Similarly, in Hoppe v. Comm'r, 42 T.C. 820 (1964), the Tax Court held that a loss that is accelerated by a contributing factor such as rain or wind is not a casualty if the loss is caused by progressive deterioration.

However, in Helstoski v. Comm'r, T.C. Memo. 1990-382, the Tax Court held that the taxpayers sustained a casualty loss when a storm caused a dam to fail, which resulted in damage to the taxpayers' property and a decrease in the fair market value of the property. The court rejected the IRS's contention that the cause of the damage was gradual erosion of the earth that occurred over a period of years.

Alphonso I

In Alphonso v. Comm'r, 136 T.C. 247 (2011) (Alphonso I), the Tax Court initially denied Alphonso's casualty loss deduction on the grounds that Alphonso held no property interest in the cooperative's grounds sufficient to entitle her to the deduction. She appealed to the Second Circuit, arguing that her right to use the grounds and to exclude persons who are not tenants or the guests of tenants, coupled with her obligations as a tenant-stockholder under the cooperative lease, constituted a property interest in the land sufficient to entitle her to the casualty loss deduction. In Alphonso v. Comm'r, 2013 PTC 17 (2d Cir. 2013), the Second Circuit agreed with Alphonso and vacated the Tax Court's holding and remanded the case back to the Tax Court. According to the Second Circuit, under New York law, Alphonso's right to use the grounds, shared with other residents of Castle Village and their respective guests but not with anyone else, was a property interest in the grounds.

Alphonso's Arguments

Before the Tax Court, Alphonso argued that the cause of the collapse of the retaining wall was excessive rainfall during the months of January through May 2005, which overstressed the recently installed drainage system (i.e., the 2004 drainage modifications) and caused rapidly accelerating movement in the wall in the four weeks immediately preceding the collapse. Proceeding from that core contention, Alphonso argued that the Tax Court's decision in Helstoski supported her position that the collapse of the retaining wall was a casualty within the meaning of Code Sec. 165(c)(3).

Tax Court's Decision

The Tax Court disagreed with Alphonso and held that the collapse of the retaining wall was not a casualty within the meaning of Code Sec. 165(c)(3) and thus Alphonso was not entitled to a casualty loss deduction. According to the court, the cause of the collapse of the retaining wall was due to a progressive deterioration in and around that wall that had begun at least 20 years before the wall's collapse on May 12, 2005. The court found that although the spring 2005 rainfall and the 2004 drainage modifications may have been contributing factors to the particular time at which the retaining wall collapsed, they did not cause that collapse.

With respect to Alphonso's reliance on the decision in Helstoski, the court said that reliance was misplaced. The court found the facts in Helstoski with respect to the cause of the failure of the dam and the loss to the taxpayers' property to be materially distinguishable from the facts dealing with the cause of the collapse of the retaining wall and the loss to Alphonso's property value.

For a discussion of casualty losses, see Parker Tax ¶84,505.

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Online Gambling Accounts with Offshore Sites Didn't Require FBAR Reporting

The Ninth Circuit partially reversed a district court and held that because a taxpayer's accounts with two poker gambling websites were not "financial accounts" for which the taxpayer was required to file a Foreign Bank and Financial Accounts Report (FBAR), penalties for his late filing of those forms were not applicable. However, the court found that a money transmitter through which the taxpayer funded his online gambling was a "financial institution" for FBAR purposes, and affirmed the $10,000 penalty for his late filing of the FBAR for his account with that company. U.S. v. Hom, 2016 PTC 267 (9th Cir. 2016).

Background

During 2006, John Hom gambled online through internet accounts with PokerStars.com and PartyPoker.com. Both websites allowed Hom to deposit money or make withdrawals. Hom used an account at FirePay.com, an online organization that receives, holds, and pays funds on behalf of its customers, to fund his online poker accounts. In 2006, FirePay ceased allowing U.S. customers to transfer funds from their accounts to offshore internet gambling sites. In 2007, Hom continued to gamble online through his PokerStars account, and used Western Union and other online financial institutions to transfer money from his bank account to his poker accounts.

At various points in both 2006 and 2007, the aggregate amount of funds in Hom's FirePay, PokerStars, and PartyPoker accounts exceeded $10,000.

After the IRS detected discrepancies in Hom's federal income tax returns for 2006 and 2007, it opened a Foreign Bank and Financial Accounts Report (FBAR) examination. Individuals generally must file an FBAR by June 30 to report foreign financial accounts exceeding $10,000 maintained during the previous year. Hom did not file his 2006 or 2007 FBARs until June 26, 2010.

In 2011, the IRS assessed penalties against Hom for failure to submit FBARs regarding his interest in his FirePay, PokerStars, and PartyPoker accounts. The IRS assessed a $30,000 penalty for 2006, which included a $10,000 penalty for each of the three accounts, and a $10,000 penalty for 2007 based solely on Hom' PokerStars account.

In 2014, a district court upheld the penalties, finding that Hom's accounts with FirePay, PokerStars, and PartyPoker were reportable because they functioned as institutions engaged in the business of banking, they were located in a foreign country, and each account had an aggregate of $10,000 at some point during the years at issue. Hom then appealed to the Ninth Circuit.

Analysis

Generally, under 31 CFR Section 103.24, an individual must file an FBAR for a reporting year if:

(1) he or she is a U.S. person;

(2) he or she has a financial interest in, or signature or other authority over, a bank, securities, or other financial account;

(3) the bank, securities, or other financial account is in a foreign country; and

(4) the aggregate amount in the accounts exceeds $10,000 in U.S. currency at any time during the year.

For purposes of the FBAR requirements, "other financial accounts" include a "financial institution," which is defined under 31 USC 5312(a) as a number of specific types of businesses, including "a commercial bank," "a private banker," and "a licensed sender of money or any other person who engages as a business in the transmission of funds."

The Ninth Circuit determined that Hom's FirePay account fit within the definition of a "financial institution." The court noted that FirePay acted as an intermediary between Hom's bank account and the online poker sites. Hom could carry a balance in his FirePay account, and he could transfer his FirePay funds to either his bank account or his online poker accounts, the court observed. The court also found that FirePay charged fees to transfer funds and as such, it acted as "a licensed sender of money or any other person who engages as a business in the transmission of funds" and therefore qualified as a "financial institution." In addition, the court noted that Hom's FirePay account was also "in a foreign country" because it was located in and regulated by the United Kingdom. Accordingly, the court found that the FirePay account required the filing of the FBAR form, and affirmed the penalties for that account

In contrast, the court remarked, Hom's PokerStars and PartyPoker accounts did not fall within the definition of a "bank, securities, or other financial account." PartyPoker and PokerStars primarily facilitate online gambling, the court said; Hom could carry a balance on these accounts, and he needed a certain balance in order to "sit" down to a poker game. But, the court said, the funds were used to play poker and the court found no evidence that the accounts served any other financial purpose for Hom.

While the IRS had argued that the poker sites were functioning as banks, the court found that argument lacked support. Noting that neither the statute nor the regulations define "banking," the court turned to the plain meaning of the term. The Merriam-Webster dictionary, the court observed, defines "bank" as, "an establishment for the custody, loan, exchange, or issue of money, for the extension of credit, and for facilitating the transmission of funds." The court found there was no evidence that PartyPoker and PokerStars were established for any of those purposes, rather than merely for the purpose of facilitating poker playing.

Observation: The IRS also attempted to argue that PokerStars and PartyPoker were "casinos" and thus qualified as financial institutions, but because the IRS did not raise that argument before the district court and it explicitly disclaimed reliance on that theory, the Ninth Circuit declined to address it.

Finding that Hom's accounts with the online poker sites did not require him to file FBAR forms, the court reversed the penalties imposed for those accounts.

For a discussion of the information reporting requirements for foreign bank accounts, see Parker Tax ¶203,170.

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Deduction for Section 167(h) Geological and Geophysical Expenses Applies to Non-Owners Also

The Tax Court rejected IRS arguments that the deduction under Code Sec. 167(h) for geological and geophysical expenses paid or incurred in connection with the exploration for, or development of, oil or gas within the U.S. only applies to owners of mineral interests. As a result, a corporation that conducted marine surveys and sold data generated by the surveys to companies engaged in oil and gas exploration and development could deduct its survey expenses under Code Sec. 167(h). CGG Americas, Inc. v. Comm'r, 147 T.C. No. 2 (2016).

In 2006 and 2007, CGG Americas, Inc. (CGGA), a Texas corporation, conducted marine surveys of the outer continental shelf in the Gulf of Mexico. The surveys involved the use of geophysical techniques that detected or suggested the presence of oil and gas in the area surveyed. The data initially generated by the surveys was raw acoustic data. CGGA processed this data to create usable information such as visual representations (including maps) of geological formations in the earth's subsurface. CGGA licensed the data - i.e., both the raw acoustic data and the information that resulted from processing it - to its customers on a nonexclusive basis for a fee. CGGA's customers were companies engaged in oil and gas exploration and development. The customers used the data to identify new areas where subsurface conditions were favorable for oil and gas development and production, determine the size and structure of previously identified oil and gas fields, determine how to develop oil and gas reserves and produce oil and gas, determine which oil and gas properties to acquire, and determine where to drill wells.

On its 2006 and 2007 tax returns, CGGA deducted the expenses incurred to conduct the surveys and to process data from the surveys as geological and geophysical expenses. Under Code Sec. 167(h)(1), any geological and geophysical expenses paid or incurred in connection with the exploration for, or development of, oil or gas within the U.S. (as defined in Code Sec. 638) is allowed as a deduction ratably over the 24-month period beginning on the date that such expense was paid or incurred.

The IRS disallowed the deductions. According to the IRS, CGGA's survey expenses were not geological and geophysical expenses paid or incurred in connection with the exploration for, or development of, oil or gas within the meaning of Code Sec. 167(h). The IRS cited two reasons for disallowing the deduction. First, the IRS argued, the phrase "geological and geophysical expenses" used in Code Sec. 167(h) is a term of art that refers only to expenses incurred by taxpayers that own mineral interests, that is, oil or gas interests. For tax purposes, the IRS said, the phrase refers exclusively to expenses related to the exploration for oil or gas incurred by taxpayers who are exploration and production companies or otherwise owners of mineral interests. Since CGGA did not own any mineral interests, the IRS contended that the survey expenses were not "geological and geophysical expenses" as that term is used in Code Sec. 167(h).

Second, the IRS argued that the survey expenses were not paid or incurred in connection with the exploration for, or development of, oil or gas. An expense is paid or incurred in connection with such exploration or development within the meaning of Code Sec. 167(h), the IRS said, only when paid or incurred in connection with the taxpayer's own exploration or development, not when paid or incurred by a taxpayer in connection with the exploration or development by other taxpayers (i.e., CGGA's customers).

The Tax Court rejected the IRS's arguments and held that CGGA was entitled to deduct the survey expenses under Code Sec. 167(h). With respect to the IRS's argument that the phrase "geological and geophysical expenses" is restricted to expenses incurred by taxpayers that own mineral interests, the court looked at the various court cases cited by the IRS to support this conclusion. The court found that none of the opinions cited defined a "geophysical expense" as including only an expense incurred by owners of mineral interests.

The court also reviewed three IRS rulings for the same proposition, including two that were referred to in the legislative history of Code Sec. 167(h). One of those, the court noted, had an introductory statement which clarified that the ruling was written to apply only to a particular subset of geological and geophysical exploration expenditures, and the other had an introductory sentence which clarified that the ruling governed only the treatment of geological and geophysical expenditures in a particular situation. As to the one that was not referenced in the legislation, the court rejected the IRS's interpretation that the ruling implied that geological and geophysical exploration expenses included only expenditures by mineral-interest owners, saying that the ruling did not purport to describe all types of geological and geophysical exploration expenditures.

For a discussion of the amortization of geological and geophysical costs under Code Sec. 167(h), see Parker Tax ¶95,130.

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Couple Can Deduct Most of Wages Paid to Children Doing Jobs for Family Machinery Business; No Losses Allowed for Other Part-Time Businesses Found to be Hobbies

The Tax Court held that a married couple, who ran a successful business refurbishing and selling embroidery machinery, could deduct a majority of the wages they paid their children for work performed for the business. However, the court disallowed deductions relating to a cattle raising activity, a deer hunting preserve, and a lake resort activity, finding that the couple did not operate the businesses for a profit because they had no business plans for those activities, nor did they advertise their existence. Embroidery Express, LLC v. Comm'r, T.C. Memo. 2016-136.

Background

In 2005, 2006, and 2007, Brent and Lynette McMinn operated a business which primarily involved acquiring used embroidery machinery, refurbishing it, and selling it. The McMinns would purchase and refurbish approximately 300 to 500 embroidery machines a year. The business was very successful, averaging $8,750,000 in sales annually.

Four of the couple's six children - K.M., Dylan, Travis, Courtney - completed a variety of tasks to help run the embroidery business. The couple, through a sole proprietorship, paid the children by the job with each child receiving a large payment at year end that was based at least partially on the performance of the business. K.M. would clean the offices and also assisted with inventory and cleaning machines. Dylan and Travis both assisted with the transportation and refurbishing of the embroidery machines. Courtney worked full time for the business as a receptionist. Courtney was not claimed as a dependent on the McMinns' income tax returns, but the other three children were.

Sometime before 2005, the McMinns acquired 176 acres of land that surrounded their residence to raise cattle. However, by 2005, Brent decided that raising cattle was not profitable and he decided to use the land for a deer hunting preserve. The McMinns did not have a written business plan or consult with experts for advice on developing a deer hunting preserve but instead relied on acquaintances for advice. They did not market the preserve, purchase any deer, or upgrade the fences.

In 2004, the couple formed Spring Lake Resort, LLC, with the purpose of developing land as a resort. Before the formation of Spring Lake Resort, the couple built a pavilion on the resort property that included restrooms and three campsites that could accommodate recreational vehicles. After additional improvements, the resort area included jet ski docks, fish pads, automatic fish feeders, and fire pits; a dam was rebuilt, and a bridge was added. The couple did not advertise the resort. They did not have a written business plan or any expertise in the developing a resort.

In 2010, the IRS issued the McMinns' notices of deficiency for 2004, 2005, and 2006, determining, in part, that the couple had not operated their cattle and deer activity and their resort activity with profit objectives. The IRS also disallowed deductions for the wages the couple paid to K.M., Dylan, Travis, and Courtney through their businesses.

The Wages Paid to the Children Were Partially Deductible

The Tax Court noted that payments made to minor children by a parent for services rendered in connection with the parent's trade or business can qualify as a business expense deduction under Code Sec. 162 if the applicable requirements are met, citing Denman v. Comm'r, 48 T.C. 439 (1967).

Because the couple's arrangement with Courtney was different from that of the other children, the court analyzed her wages separately. The court noted that during the years at issue she worked full-time for her parents' business. The court found she acted as a receptionist for the McMinn' embroidery business, sorting the mail, answering calls, and scheduling appointments. The court noted that the couple paid her on the basis of what they had paid former secretaries and that Courtney was not claimed as a dependent of the McMinns' for any of the years at issue. In addition, the court found that for the amount of work Courtney completed as a full-time employee, the wages paid were not unreasonable. Accordingly, the court determined that the wages paid to Courtney were deductible.

With regard to the wages paid to the other children, the court noted that the couple placed little economic value on the jobs the children completed throughout the year but paid them significant bonuses at the end of the year. Although Brent testified that he paid the children on the basis of what he would pay an unrelated party, he introduced no evidence proving as much. The court noted the bonuses were the largest part of the children's wages and were paid once the taxpayers had the opportunity to determine the financial status of the business. The court found that the bonuses were not typical of a bona fide employer-employee relationship and were instead partially for familial support. In addition, the court found that the couple failed to maintain records adequate to substantiate the expenses. However, the court stated, Brent, three of the children, and an unrelated third-party credibly testified in court regarding the children's work, and the court found the testimony sufficient to establish that the children actually worked for the couple's embroidery business.

As a result, the court concluded that the amounts paid to the children throughout the first 11 months of each year at issue were reasonable and thus deductible. For December, the court held that the taxpayers could deduct the average of the children's wages, disallowing the remaining balance of the payments and bonuses.

Other Activities Were Not Operated for Profit

Code Sec. 183(b) limits the deductions relating to an activity not engaged in for profit. Reg. Sec. 1.183-2(b) provides a nonexclusive list of nine factors relevant in ascertaining whether a taxpayer conducts an activity with the intent to earn a profit. The factors listed are: (1) the way the taxpayer conducts the activity; (2) expertise of the taxpayer or his advisers; (3) time and effort the taxpayer spends in carrying on the activity; (4) expectation that assets used in the activity may appreciate in value; (5) taxpayer's success in carrying on other similar or dissimilar activities; (6) taxpayer's history of income or losses with respect to the activity; (7) amount of occasional profits earned, if any; (8) taxpayer's financial status; and (9) elements of personal pleasure or recreation. No factor or group of factors is controlling, nor is it necessary that a majority of factors point to one outcome.

The Tax Court determined that neither the cattle and deer activity, nor the resort activity, were engaged in by the taxpayers for profit. The court found that of the nine factors, only the fact that the land the taxpayers used had appreciated in value (factor 4) weighed in favor of the taxpayers.

The court found that the couple did not carry on the activities in a businesslike manner (factor 1), noting they did not prepare business plans, did not advertise the deer hunting preserve or the resort, did not keep cattle or deer during the years at issue and did not even place road signs indicating the existence of the resort. The couple also had no expertise in the activities (factor 2) and did not hire experts to advise them, instead relying on acquaintances. Although the couple did not provide any evidence of the time spent on the activities (factor 3), the court found that their time was primarily devoted to their successful embroidery business. The court noted that the taxpayers were successful entrepreneurs, but found they had no prior experience operating a successful resort or a successful cattle ranch or deer hunting preserve (factor 5).

In addition, the court found that the activities showed consistent losses for the years at issue (factors 6 and 7) and that, because their embroidery business had such substantial income, they could afford a hobby with losses that cut into those profits (factor 8). Lastly, the court determined the couple derived personal pleasure from the activities (factor 9), noting that they enjoyed the use of the land intended for the cattle and deer activities and had built a personal residence near the resort's lake.

For a discussion of the deductibility of compensation, see Parker Tax ¶91,101.

For a discussion of the determination of whether an activity is engaged in for profit, see Parker Tax ¶97,505.

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IRS Eliminates Requirement to Submit Copy of Section 83(b) Election With Returns

The IRS has issued final regulations eliminating the requirement to file a copy of Code Sec. 83(b) elections (to include in gross income the value of property received in connection with services performed) with returns. The final regulations apply to property transferred on or after January 1, 2016. T.D. 9779 (7/26/16).

Code Sec. 83 addresses the tax consequences of a transfer of property in connection with the performance of services. Under Code Sec. 83(b) a taxpayer may elect to include in gross income, for the tax year in which the property is transferred, the excess of the fair market value of the property at the time of transfer over the amount paid for the property. The taxpayer may make this election even if he or she paid full value for the property at the time of the transfer, and thus realized no bargain element in the transaction.

Under Reg. Sec. 1.83-2(c), the Code Sec. 83(b) election is made by filing a written statement with the IRS office where the service provider files a return. Prior to the amendments made in T.D. 9779, the taxpayer was also required to submit a copy of the statement with his or her income tax return for the tax year in which the property was transferred.

In proposed regulations issued in July 2015, the IRS noted that in recent years many taxpayers who wish to electronically file (e-file) their annual income tax return have been unable to do so because of the requirement in Reg. Sec. 1.83-2(c) that a copy of the Code Sec. 83(b) election be submitted with the taxpayer's income tax return. As commercial software available for e-filing income tax returns does not consistently provide a mechanism for submitting a Code Sec. 83(b) election with an individual's e-filed return, an individual who has made such an election would be unable to e-file his or her income tax return in compliance with the regulation and would have to paper file his or her return to comply.

In order to remove this obstacle to e-filing an individual tax return, the final regulations eliminate the requirement under Reg. Sec. 1.83-2(c) that a copy of the Code Sec. 83(b) election be submitted with an individual's tax return for the year the property is transferred.

Taxpayers are still required under Code Sec. 83(b)(2) to file a Code Sec. 83(b) election with the IRS no later than 30 days after the date that the property is transferred to him or her, which will provide the IRS with the original election.

Practice Tip: Although taxpayers no longer need to file a copy of their Code Sec. 83(b) election with their returns, they should still keep any such elections on record until the period of limitations expires for the return that reports the sale or other disposition of the property.

The final regulations apply to property transferred on or after January 1, 2016. Taxpayers may rely on the proposed regulations (which contained guidance identical to that in the final regs) for property transferred on or after January 1, 2015.

For a discussion of Code Sec. 83(b) elections, see Parker Tax ¶ 124,525.

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Seventh Circuit Reverses Tax Court; Taxpayer Not Entitled to Abatement of Interest

The Seventh Circuit reversed a Tax Court decision which held that a taxpayer was entitled to a partial abatement of the interest he had paid on overdue payroll taxes. The court did not agree with the Tax Court's use of "unfairness" as a criterion for abatement. King v. Comm'r, 2016 PTC 259 (7th Cir. 2016).

Charles King was a lawyer who failed to pay his quarterly payroll taxes for several years. After the IRS caught up with him, King asked to pay the overdue taxes in installments. Initially, the IRS agreed. However, after formally assessing the taxes and penalties that King owed, as well as the interest on those taxes, the IRS told King that he had to provide additional financial information before his eligibility for an installment plan could be determined. Eventually, the IRS decided that King's income and assets were too high to justify an installment program; he had had enough income and assets to pay the payroll taxes when they were due, together with any penalties and interest that had accrued by that date.

King paid the taxes in October 2011 but requested abatement of the interest that had accrued after March 5, 2009, the date on which the IRS had told him it would honor his request for an installment payment plan. He argued that, had the IRS informed him from the outset that he would not be allowed an installment plan, he would have paid the payroll taxes sooner and, as a result, would have owed less or maybe no interest for having delayed paying the taxes. The IRS turned King down and King took his case to the Tax Court.

Code Sec. 6404(a) allows the abatement of the unpaid portion of an assessment of any tax or any liability in respect thereof, which (1) is excessive in amount, or (2) is assessed after the expiration of the statute of limitations period, or (3) is erroneously or illegally assessed. The IRS told King that the interest he'd been charged was not excessive and had been calculated in the usual and customary way.

The Tax Court held that King was entitled to a partial abatement of the interest he had paid. The court concluded that the IRS's authority to abate interest that is excessive in amount must incorporate a concept of "unfairness" under all of the facts and circumstances. According to the court, the IRS's failure to communicate to King the deficiencies of his proposed installment agreement was unfair to King. The court concluded that the interest that had accrued to the IRS as a result of this unfairness was therefore "excessive," and the IRS's denial of King's request to abate the excessive interest was an abuse of discretion. However, the Tax Court concluded that King was entitled to an abatement only of the interest that had accrued during the two-month period after the IRS had assessed the amount King owed, after which King knew or should have known the requirements for submitting an installment agreement. The IRS appealed.

The Seventh Circuit reversed the Tax Court's decision. According to the court, the IRS was on sound ground in refusing to abate the interest King owed on his overdue payroll taxes for three reasons. First, the court said, was the vagueness of "unfairness" as a criterion for abatement; the word is an invitation, the court noted, to arbitrary, protracted, and inconclusive litigation. Second, the court said, the nebulous standard of "unfairness" could result in a significant loss of tax revenues. Third, the court found that the Tax Court's approach was inconsistent with Reg. Sec. 301.6404-1, which defines the statutory term "excessive in amount" to mean "in excess of the correct tax liability."

For a discussion of when a taxpayer is entitled to an abatement of interest, see Parker Tax ¶261,570.

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Taxes Not Dischargeable in Bankruptcy Where Debtor Filed Return 7 Years Late

The Ninth Circuit affirmed a district court's order, which reversed a bankruptcy court, and held that a debtor's tax liabilities were nondischargeable in bankruptcy because the debtor's late-filed Form 1040 did not represent an honest and reasonable attempt to satisfy tax law requirements and, thus, the debtor did not file a "return" within the meaning of 11 U.S.C. Section 523(a)(1)(B)(i). Agreeing with other circuits, the Ninth Circuit held that In re Hatton, 220 F.3d 1070 (9th Cir. 2000), which adopted the Tax Court's widely-accepted definition of "return," applied to the Bankruptcy Code as amended in 2005. In re Smith, 2016 PTC 249 (9th Cir. 2016).

Background

After Martin Smith failed to timely file his 2001 tax return, the IRS prepared a Substitute for Return (SFR) based on information the IRS had gathered from third parties. In March 2006, the IRS mailed Smith a notice of deficiency. Smith did not challenge the notice of deficiency within the allotted 90 days and the IRS assessed a deficiency against him of $70,662.

Three years later, in May 2009, Smith filed a Form 1040 for 2001 on which he wrote "original return to replace SFR." On this late-filed form, Smith reported a higher income than the one the IRS calculated in its assessment, thereby increasing his tax liability. The IRS added the additional arrearage to its assessment. Two months after that, in July 2009, Smith submitted an offer in compromise, which the IRS rejected. Smith later lost his job and the IRS allowed him to pay his tax bill in monthly installments of $150.

About five months later, Smith declared bankruptcy and sought to have his 2001 tax debt discharged in bankruptcy. Smith and the IRS agreed that the increase in the assessment based on Smith's late-filed 2001 tax return was dischargeable, but they disputed whether the IRS's original $70,662 assessment was also dischargeable. The bankruptcy court ruled that it was but a district court reversed that decision. Smith appealed to the Ninth Circuit.

Analysis

Bankruptcy Code Section 523(a)(1)(B)(i) exempts from discharge "any . . . debt for a tax . . . with respect to which a return, or equivalent report or notice, if required . . . was not filed or given." In In re Hatton, 220 F.3d 1057 (9th Cir. 2000), the Ninth Circuit adopted the Tax Court's widely-accepted definition of "return" for purposes of Bankruptcy Code Section 523(a)(1)(B)(i). In Hatton, the Ninth Circuit stated that in order for a document to qualify as a tax return:

(1) it must purport to be a return;

(2) it must be executed under penalty of perjury;

(3) it must contain sufficient data to allow calculation of tax; and

(4) it must represent an honest and reasonable attempt to satisfy the requirements of the tax law.

When the Ninth Circuit decided Hatton, the Bankruptcy Code did not define the term "return." Congress subsequently amended the Bankruptcy Code in 2005 and it added the following definition of a return: "the term return' means a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements)." While observing that it had not yet interpreted this new definition, the Ninth Circuit noted that both Smith and the IRS, the Tax Court, and several circuit courts agreed that Hatton's four-factor test still applied.

The dispute between Smith and the IRS centered on whether Smith's filing met the fourth requirement of the operative test. In other words, was his filing of his 2001 tax return an honest and reasonable attempt to satisfy the requirements of the tax law?

The Ninth Circuit held that Smith's belated acceptance of responsibility was not a reasonable attempt to comply with the Tax Code. The court noted that many of its sister circuits have held that post-assessment tax filings are not "honest and reasonable" attempts to comply and are therefore not "returns" at all. In the instant situation, the court observed, Smith failed to make a tax filing until seven years after his return was due and three years after the IRS went to the trouble of calculating a deficiency and issuing an assessment. To the court, this meant that the filing of Smith's 2001 tax return was not an honest and reasonable attempt to comply with the tax law.

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Income from Exempt Organization's Inherited Rental Properties Won't Lead to UBTI

The IRS, in a private letter ruling, determined that commercial real estate properties that a Code Sec. 501(c)(3) organization inherited from its sole financier would not cause it to incur unrelated business taxable income (UBTI). The IRS ruled that both rental income from the properties and any gain on potential sales of the properties would be excluded from UBTI under the real property exclusions in Code Sec. 512(b). PLR 201630009.

Background

Under the facts of PLR 201650009, a foundation was a Code Sec. 501(c)(3) tax-exempt organization classified as a private foundation under Code Sec. 509(a). The foundation's exempt purpose was to receive funds, administer investments, and distribute funds to other Code Sec. 501(c)(3) organizations. Historically, the foundation invested in cash and publicly traded bonds and securities.

The foundation's funding had come solely from an individual, who had recently died. The decedent left a will providing that the foundation would receive, among other things, commercial real estate properties that were primarily office rental properties. The decedent's executor intended to distribute these real estate properties to the foundation as single member limited liability companies, with any debt encumbering the properties to be paid in full by the estate prior to, or simultaneously with, the transfer of the properties.

The foundation intended to continue to hold the properties as part of a diversified investment portfolio that would also contain cash and publicly traded securities. The real estate properties were to be held as income producing properties and not as inventory used in a trade or business. The decision to sell or keep any one of the individual real estate properties was to be made on a property-by-property basis, taking into consideration the foundation's overall investment portfolio, investment strategy, and capital appreciation. The foundation anticipated that any sales of the real estate properties would be sporadic and occasional.

The foundation requested a private letter ruling from the IRS addressing whether the rental income received from the commercial real estate properties, or any income received as a result of the sale of the properties, would be excluded from unrelated business taxable income.

Analysis

Code Sec. 511(a) imposes a tax for each taxable year on the unrelated business taxable income (UBTI) of every organization described in Code Sec. 501(c). Code Sec. 512(a)(1) provides that the term "unrelated business taxable income" means the gross income derived by any organization from any unrelated trade or business regularly carried on by it.

Code Sec. 512(b)(3)(A) provides that, in computing UBTI, all rents from real property and all rents from personal property leased with such real property (if the rents attributable to such personal property are an incidental amount of the total rents received or accrued under the lease) are excluded. In addition, Code Sec. 512(b)(5) generally excludes from the computation of UBTI all gains or losses from the sale, exchange, or other disposition of property. This exclusion does not extend to stock in trade or other property of a kind which would properly be includible in inventory, or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business.

With regard to the rental income, the IRS noted that the foundation's commercial real estate properties were "real property," as defined in Reg. Sec. 1.512(b)-1(c)(3). The rental income, the IRS found, was from rents of the real property or from personal property leased with the real property that would be an incidental amount of the total rents received or accrued under the lease. The IRS noted that no part of the rent paid depended on the income or profits derived by any person from the property leased, and that the foundation would not provide services to the lessees. Thus, the IRS ruled, the income from the commercial real estate properties the foundation received by bequest consisted of rent that was excluded from UBTI by Code Sec. 512(b)(3).

With regard to the sale of the properties, the IRS noted that the foundation intended to hold the real estate properties as part of a diversified investment portfolio, at least in the near term, and that any sales of the real estate properties would be sporadic and occasional. The foundation had indicated that it might decide to make capital improvements to the real estate properties as needed, but that the real estate properties would not be held for the primary purpose of improving the properties for immediate resale. The IRS found that the real estate properties would be held as income producing properties and not as inventory used in a trade or business. Accordingly, the IRS ruled that any income from the sale, exchange, or other disposition of the commercial real estate would also be excluded from the computation of UBTI by Code Sec. 512(b)(5).

For a discussion of unrelated business taxable income, see Parker Tax ¶66,120.

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