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Parker's Federal Tax Bulletin
Issue 59     
April 1, 2014     

 

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 1. In This Issue ... 

 

Tax Briefs

Depreciation Expenses Includible in Calculating Qualified Settlement Fund Income; No Dependency Deduction for Student Who Financed Her Education; IRS Bars Appraisers from Valuing Facade Easements for Five Years ...

Read more ...

Supreme Court Holds That Severance Payments Are FICA Wages

Reversing a decision of the Sixth Circuit, the U.S. Supreme Court held that severance payments made to employees terminated against their will are taxable wages under FICA. U.S. v. Quality Stores, Inc. 2014 PTC 151 (3/25/14).

Read more ...

IRS Adopts Stricter Interpretation of One-Year Waiting Period for IRA Rollovers

The IRS announced that, consistent with a recent Tax Court decision, it will apply a more restrictive interpretation of the one-rollover-per-year limitation of Code Sec. 408(d)(3)(B), beginning in 2015. Announcement 2014-15.

Read more ...

Gambling CPA Can't Deduct Allocable Share of Racetrack's "Take Out" Expenses

Because a race track's "takeout" expenses represented obligations of the race track and not the bettors, the taxpayer could not deduct his share of such expenses. Lakhani v. Comm'r, 142 T.C. No. 8 (3/11/14)]

Read more ...

Failure to File Joint Return Precludes Rental Loss Deductions

Taxpayer was not allowed to use spousal attribution rules to qualify as a "real estate professional" because she didn't file a joint return. Oderio v. Comm'r, T.C. Memo. 2014-39 (3/10/14).

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Husband Cannot Change to Head of Household Filing Status on Amended Return

A husband who filed an amended income tax return, after the time for filing a return for the tax year at issue had passed, could not change his filing status from married filing jointly to head of household on the amended return. CCM 201411017.

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Payments for Providing Business Methodology Were Ordinary Income

Payments received by a sales manager for developing a client engagement methodology for his former employer were ordinary income and not capital gain because the transfer of the methodology without the transfer of all substantial rights of value in the methodology did not amount to a sale of a capital asset. Kamieneski v. Comm'r., T.C. Summary 2014-22 (3/11/14).

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Payments under Stock Swap Agreement Are Deductible in Year of Payment

Characterizing payments made under a swap agreement as an adjustment to the sales price was more appropriate than characterizing the payments as nonperiodic payments amortizable over the life of the agreement. CCA 201411032.

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Chief Counsel's Office Clarifies Rules for Grouping Activities under Passive Loss Rules

A taxpayer must have an ownership interest in each separate activity before those activities may be grouped together and treated as one activity for purposes of Code Sec. 469; a trade or business activity cannot become an "activity of the taxpayer" simply by virtue of being grouped with another activity of the taxpayer in which the taxpayer owns an interest. CCA 201411025.

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Conservation Easements Were Properly Valued by IRS for Charitable Deduction

The value of conservation easements donated by a group of investors in property near a gravel mining operation was properly determined by an expert appraiser who took into account the property's current use for agriculture and its remote likelihood of development for gravel mining; proceeds from the sale of state tax credits received by the investors as a result of the donations were reportable as short-term capital gain. Esgar Corporation v. Comm'r., 2014 PTC 122 (10th Cir. 3/7/14).

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State Law Limiting Duration of Easements Precludes Charitable Deduction

Because North Dakota law prohibited real property easements from being granted in perpetuity, the taxpayer could not take charitable contribution deductions for donations of conservation easements. Wachter v. Comm'r, 142 T.C. No. 7 (3/11/14).

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Non-qualified Stock Options Were Taxable Compensation to Railroad Employees

Nonqualified stock options offered to employees of a rail carrier as part of a compensation package were properly taxed as compensation under the Railroad Retirement Tax Act; however, the case was remanded to determine whether moving expense benefits paid by the rail carrier qualified as taxable compensation or were properly excluded as a travel expense. BNSF Railway Company v. U.S., 2014 PTC 134 (5th Cir. 3/13/14).

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 2. Tax Briefs 

 

Deductions

Depreciation Expenses Includible in Calculating Qualified Settlement Fund Income: In CCA 201411027, the Office of Chief Counsel advised that, with respect to a prior ruling in CCA 201347019, depreciation expenses relating to commercial real estate properties held by a receivership were necessary expenses incidental to the purposes of the receivership namely, the administration, preservation, and realization of the assets the receiver was ordered to take control of for the benefit of defrauded investors and the distribution of the net recovered amounts to those investors. Thus, the Chief Counsel's Office stated, the depreciation expenses at issue were an administrative cost or other incidental expense that was deductible in calculating the modified gross income of a qualified settlement fund under Reg. Sec. 1.468B-2(b)(2). [Code Sec. 468B].

No Dependency Deduction for Student Who Financed Her Education: In Burse v. Comm'r, T.C. Summary 2014-21 (3/10/14), the Tax Court held that the taxpayer could not take a dependency exemption for his wife's daughter, who was a college student. Because the student financed her education with student loans, the proceeds of those loans counted as support she provided for herself and, thus, the taxpayer did not contribute over half of the student's support. [Code Sec. 152].

IRS Bars Appraisers from Valuing Facade Easements for Five Years: In IR-2014-31 (3/19/14), the IRS announced that its Office of Professional Responsibility entered into a settlement agreement with a group of appraisers from the same firm accused of aiding in the understatement of federal tax liabilities by overvaluing facade easements for charitable donation purposes. Under the settlement agreement, the appraisers admitted to violating relevant provisions of Circular 230 related to due diligence and submitting accurate documents to the government. [Code Sec. 170].

 

Foreign

Rev. Proc. Addresses Eligibility Rules for Certain Individuals in Foreign Countries: In Rev. Proc. 2014-25, the IRS provides information to any individual who failed to meet the eligibility requirements of Code Sec. 911(d)(1) because adverse conditions in a foreign country precluded the individual from meeting those requirements for tax year 2013. The countries listed in the revenue procedure are Egypt, Lebanon, Pakistan, and Yemen. [Code Sec. 911].

 

Original Issue Discount

April 2014 AFRs Issued: In Rev. Rul. 2014-12, the IRS issued the applicable federal rates for April 2014. [Code Sec. 1274].

 

Procedure

IRS Can't Foreclose on Taxpayer's Home Where Her Ex-Husband Owed IRS: In Smith v. U.S., 2014 PTC 124 (D. Conn. 3/7/14), a district court looked to the present possessory interest of the taxpayer and her ex-husband, not the past possessory interest, in ruling against the IRS, and for the taxpayer, with respect to a forced sale of property on which the IRS had a lien. The court stated that it hoped to avoid an unfair result because the ex-wife had possession of the property and the lien was the result of the ex-husband's nonpayment of taxes and the court used its limited discretion to avoid ordering a foreclosure to satisfy the lien. [Code Sec. 6323].

Union Not Fined for Turning Over Taxpayer's Retirement Funds to IRS: In Dillender v. Carpenters' Pension Trust Fund of St. Louis, 2014 PTC 125 (M.D. Tenn. 3/7/14), a magistrate judge recommended that a taxpayer's complaint seeking compensatory damages from a carpenter's union for paying a portion of his retirement account to the IRS be dismissed. The judge held that, upon being served with a notice of levy, the union was legally required by Code Sec. 6332(a) to pay over to the IRS retirement funds belonging to the taxpayer. [Code Sec. 6332].

CPA's Conviction for Attempting to Evade Taxes Upheld: In U.S. v. Baisden, 2014 PTC 126 (D. Neb. 3/10/14), a district court denied a CPA's motion to have the court vacate his conviction for willfully attempting to evade and defeat the income tax due for a married couple in the amount of $236,000. [Code Sec. 7201].

IRS Announces Interest Rates for Second Quarter of 2014: In Rev. Rul. 2014-11, the IRS announced that interest rates on tax overpayments and underpayments will remain the same for the calendar quarter beginning April 1, 2014. The rates will be 3 percent for overpayments (2 percent in the case of a corporation), 3 percent for underpayments, 5 percent for large corporate underpayments, and .5 percent for the portion of a corporate overpayment exceeding $10,000. [Code Sec. 6621].

 

Retirement Planning

IRS Provides Guidance on the Corporate Bond Monthly Yield Curve: In Notice 2014-16, the IRS provides guidance on the corporate bond monthly yield curve (and the corresponding spot segment rates), and the 24-month average segment rates under Code Sec. 430(h)(2). [Code Sec. 430].

 

Tax Accounting

IRS Ruling Addresses Method Change for Calculating E&P: In PLR 201410029, the IRS ruled that a change in the taxpayer's method of accounting for depreciation for taxable income purposes under Code Sec. 446(e) and Code Sec. 481(a) requires a correlative change in computing depreciation for earnings and profits (E&P) purposes under Code Sec. 312(k)(3). Accordingly, IRS consent is not required to make that change for E&P purposes, separate and apart from the consent required to change the taxpayer's method of accounting for depreciation for taxable income purposes. Further, because the depreciation deduction for taxable income is not the same for E&P purposes, additional adjustments are required to account for the change in computing depreciation for E&P purposes, which are made under Code Sec. 312 and the accompanying regulations. [Code Sec. 446].

 

Tax Practice

Practitioner Recommendations Requested by IRS: In Notice 2014-18, the IRS is soliciting recommendations from practitioners of items that should be included on the 2014-2015 IRS Priority Guidance Plan. In reviewing recommendations and selecting projects for inclusion on the 2014-2015 Priority Guidance Plan, IRS will consider (1) whether the recommended guidance resolves significant issues relevant to many taxpayers; (2) whether the recommended guidance promotes sound tax administration; (3) whether the recommended guidance can be drafted in a manner that will enable taxpayers to easily understand and apply the guidance; (4) whether the recommended guidance involves regulations that are outmoded, ineffective, insufficient, or excessively burdensome and that should be modified, streamlined, expanded, or repealed; (5) whether the IRS can administer the recommended guidance on a uniform basis; and (6) whether the recommended guidance reduces controversy and lessens the burden on taxpayers or the IRS.

 

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 3. In-Depth Articles 

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High Court Reverses Sixth Circuit; Holds That Severance Payments Are FICA Wages

Generally, all compensation for employment is considered wages subject to tax under the Federal Insurance Contributions Act (FICA), unless it is specifically excluded. Thus, salaries, bonuses, fees, commissions, and similar items are FICA wages if paid as compensation for employment. Further, IRS regulations state that unless an exception applies, compensation for an employee's services constitutes wages even though at the time the compensation is paid, the employer/ employee relationship no longer exists.

In view of the broad definition of FICA wages, it came as a bit of a surprise when, in a 2012 case, the Sixth Circuit held that severance payments made to employees terminated against their will were not wages taxed by FICA. To reach its holding, the Sixth Circuit relied not on FICA's definition of wages, but on Code Sec. 3402(o), a provision governing income tax withholding. The Sixth Circuit's decision on the issue of whether Code Sec. 3402(o) may apply to exclude severance pay from FICA wages created a split in the circuits. In CSX Corp. v. U.S., 518 F.3d 1328 (Fed. Cir. 2008), rev'g 32002 PTC 31 (Fed.Cl. 2002), the Federal Circuit held that Code Sec. 3402(o) does not apply for that purpose.

The U.S. Supreme Court has now held in U.S. v. Quality Stores, Inc. 2014 PTC 151 (3/25/14) that the Sixth Circuit's conclusion was incorrect, and that the severance pay at issue was subject to FICA tax.

Facts

Quality Stores, Inc., entered bankruptcy proceedings in 2001. Before and after the filing of an involuntary Chapter 11 bankruptcy petition, Quality Stores made severance payments to employees who were involuntarily terminated as a result of a reduction in work force or discontinuance of a plant or operation. The severance payments varied based on job seniority and time served, and were made under plans that did not tie payments to the receipt of state unemployment insurance. Quality Stores paid and withheld FICA taxes on the severance payments. Later, believing that the payments should not have been taxed as wages under FICA, Quality Stores sought a refund on behalf of itself and about 1,850 former employees. When the IRS did not allow or deny the refund, Quality Stores initiated proceedings in the Bankruptcy Court, which granted summary judgment in its favor. The district court and Sixth Circuit affirmed, concluding that the severance payments are not wages under FICA.

Sixth Circuit's Analysis

Code Sec. 3402(o)(2) defines supplemental unemployment compensation benefits, or "SUB payments," as an amount that is paid to an employee under an employer's plan because of the employee's involuntary separation from employment resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions and that is included in the employee's gross income. The Sixth Circuit determined that the severance payments at issue constituted SUB payments under that definition and as such were not taxable wages under FICA.

The heading to Code Sec. 3402(o)(1) reads, "Extension of withholding to certain payments other than wages." Further, Code Sec. 3402(o)(1)(A) provides that for purposes of Chapter 24 of the Code (relating to income tax withholding), any SUB payments paid to an individual are to be treated as if they were payments of wages by an employer to an employee for a payroll period.

The Sixth Circuit recognized the FICA definition of wages, unlike the definition of wages for federal income tax withholding purposes, does not expressly include or exclude SUB payments; nor do the FICA regulations address the subject. However, the court viewed the instruction in Code Sec. 3402(o) that SUB payments are to be treated "as if" they were wages for income tax withholding purposes as implying that Congress did not consider SUB payment to be wages; rather, Congress allowed SUB payments to be treated as wages to facilitate federal income tax withholding on those payments, thereby alleviating final tax payment problems for employees. In light of this "clear congressional intent," the Sixth Circuit approved the bankruptcy court's reasoning that if SUB payments are not wages but are only treated as if they were wages for purposes of federal income tax withholding, then SUB payments also are not wages under the nearly identical definition of wage found in the FICA provisions.

Supreme Court's Analysis

The Supreme Court held that the severance payments at issue in Quality Stores are taxable wages for FICA purposes. The Court noted that Code Sec. 3121(a) defines "wages" broadly as all remuneration for employment. The Court found that, as a matter of plain meaning, severance payments fit this definition: They are a form of remuneration made only to employees in consideration for employment. Code Sec. 3121(b) defines "employment" as any service performed by an employee for an employer. Citing its decision in Social Security Bd. v. Nierotko, 327 U. S. 358 (1946), the Court stated that, by varying severance payments according to a terminated employee's function and seniority, the severance payments at issue confirmed the principle that "service" means not only work actually done, but the entire employer-employee relationship for which compensation is paid. According to the Court, this broad definition of wages is reinforced by the specificity of FICA's lengthy list of exemptions. For example, the exemption for severance payments made because of retirement for disability under Code Sec. 3121(a)(13)(A), would be unnecessary if severance payments generally were not considered wages.

The Court found that FICA's statutory history sheds further light on the definition of wages. FICA originally contained definitions of "wages" and "employment" identical in substance to the current ones, but in 1939, Congress excepted from wages dismissal payments not legally required by the employer. Since that exception was repealed in 1950, FICA has contained no general exception for severance payments.

The Court also found that the Code provisions governing income tax withholding do not limit the meaning of wages for FICA purposes. Like the Code's FICA provisions, Code Sec. 3401(a) has a broad definition of "wages" and contains a series of specific exemptions. Code Sec. 3402(o) says that supplemental unemployment compensation benefits or SUB payments, which include severance payments, are to be treated "as if" they were wages. Contrary to the Sixth Circuit's and Quality Stores' reading, this "as if" instruction does not mean that severance payments fall outside the definition of wages for income-tax withholding purposes and, in turn, are not covered by FICA's definition. Nor can Quality Stores rely on the heading of Code Sec. 3402(o), which refers to "certain payments other than wages." The Court found that the heading to Code Sec. 3402(o) falls short of declaring that all the payments listed in Code Sec. 3402(o) are "other than wages." Instead, Code Sec. 3402(o) must be understood in terms of the regulatory background against which it was enacted.

In the 1950's and 1960's, because some states provided unemployment benefits only to terminated employees not earning wages, IRS rulings took the position that severance payments tied to the receipt of state benefits were not wages. To address the problem that severance payments were still considered taxable income, which could lead to a large year-end tax liability for terminated workers, Congress enacted Code Sec. 3402(o), which treats both SUB payments and severance payments that the IRS considered wages "as if" they were wages subject to withholding.

Observation: Although Code Sec. 3402(o) does not provide a basis for excluding severance pay from FICA wages as SUB payments, the IRS has provided an administrative exemption that excludes certain supplemental unemployment benefits from wages for FICA purposes. The IRS's administrative exemption is based on Rev. Rul. 56-249. To qualify for the administrative exemption, the supplemental unemployment benefits must, among other requirements, be tied to an employee's receipt of state unemployment compensation benefits, which was not the case in the Quality Stores case.

By extending this treatment to all SUB payments, Congress avoided the practical problems that might arise if the IRS later determined that SUB payments besides severance payments linked to state benefits should be exempt from withholding. The Court concluded that, considering this regulatory background, the assumption that Congress meant to exclude all SUB payments from the definition of "wages" is unsustainable.

[Return to Table of Contents]

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IRS Adopts Stricter Interpretation of One-Year Waiting Period for IRA Rollovers

An individual can make only one tax-free rollover from one traditional IRA to another in any one-year period. For at least as far back as 1981 - the year the IRS issued proposed regulations relating to the one-year waiting period - the IRS has interpreted that rule as applying to IRAs on an-IRA-by-IRA basis. However, in the wake of a recent Tax Court case that rejected that interpretation a case in which the IRS took a litigating position contrary to the proposed regulations and IRS Publication 590 the IRS announced that it would apply the one-year waiting period on an aggregate basis to all of an individual's IRAs. In Announcement 2014-15, the IRS also stated that it will not apply this more restrictive interpretation to IRA distributions occurring before 2015.

One-Year Waiting Period for IRA Rollovers

Under Code Sec. 408(d)(3)(A), a taxpayer can roll over, tax free, a distribution from a traditional IRA into the same or another traditional IRA. Generally, the individual must make the rollover contribution by the 60th day after the day the individual receives the distribution from the IRA. Code Sec. 408(d)(3)(B) provides that an individual can make only one such rollover in any one-year period. The one-year waiting period begins on the date the individual receives the IRA distribution.

Prop. Reg. Sec. 1.408-4(b)(4)(ii) and IRS Publication 590, Individual Retirement Arrangements (IRAs), provide that the one-year waiting period is applied on an IRA-by-IRA basis. Under this interpretation, an individual who makes a tax-free rollover of any part of a distribution from a traditional IRA cannot, within a one-year period, make a tax-free rollover of any later distribution from that same IRA. The individual also cannot make a tax-free rollover of any amount distributed within the same one-year period from the IRA into which he or she made the tax-free rollover.

Looking at it from another perspective, applying the one-year waiting period on an IRA-by-IRA basis also means that if an individual maintains more than one IRA say, IRA-1, IRA-2, and IRA-3 - and rolls over the assets of IRA-1 into IRA-3, he or she would not be precluded from making a tax-free rollover from IRA-2 to IRA-3 or any other IRA within one year after the rollover from IRA-1 to IRA-3. However, a recent Tax Court opinion, Bobrow v. Comm'r, T.C. Memo. 2014-21, held that the one-year waiting period applies on an aggregate basis, rather than on an IRA-by-IRA basis. That means an individual cannot make an IRA-to-IRA rollover if he or she has made such a rollover involving any of the individual's IRAs in the preceding one-year period.

Bobrow Case

In the Bobrow case, Alvan Bobrow maintained two IRAs a regular traditional IRA and a rollover IRA (which apparently contained amounts he had rolled over from an employer plan). On April 14, 2008, Alvan requested and received a distribution of $65,064 from his traditional IRA. On June 6, 2008, he requested and received a distribution of exactly the same amount from his rollover IRA. On June 10, 2008 within 60 days of the April 14 distribution Alvan moved $65,064 back into his traditional IRA. On August 4, 2008 within 60 days of the June 10 distribution he moved $65,064 back into his rollover IRA.

Alvan took the position that the Code Sec. 408(d)(3)(B) one-year waiting period is specific to each IRA maintained by a taxpayer and does not apply across all of a taxpayer's IRAs. Thus, Code Sec. 408(d)(3)(B) did not bar nontaxable treatment of the distributions made from his traditional IRA and his rollover IRA.

The Tax Court, however, held that Alvan's interpretation was incorrect. According to the court, the plain language of Code Sec. 408(d)(3)(B) limits the frequency with which a taxpayer may elect to make a nontaxable rollover contribution. By its terms, the one-year limitation is not specific to any single IRA maintained by an individual, but instead applies to all IRAs maintained by a taxpayer. The court observed that Code Sec. 408(d)(3)(B) speaks in general terms: An individual cannot receive a nontaxable rollover from "an individual retirement account or individual retirement annuity" if that individual has already received a tax-free rollover within the past year from "an individual retirement account or an individual retirement annuity." In other words, a taxpayer who maintains multiple IRAs cannot make a rollover contribution from each IRA within one year.

As a result, in the one-year period beginning on April 14, 2008, Alvan could have completed only one distribution and repayment as a nontaxable rollover contribution. When he withdrew funds from his rollover IRA on June 6, 2008, the taxable treatment of his April 14, 2008, withdrawal from his traditional IRA was still unresolved, since he had not yet repaid those funds. However, by recontributing funds on June 10, 2008, to his traditional IRA, Alvan satisfied the requirements of Code Sec. 408(d)(3)(A) for a nontaxable rollover contribution, and the April 14, 2008, distribution was therefore not includible in his gross income. Thus, Alvan had already received a nontaxable distribution from his traditional IRA on April 14, 2008, when he received a subsequent distribution from his rollover IRA on June 6, 2008. According to the court, Code Sec. 408(d)(3)(B) disallowed nontaxable treatment for this second distribution. As a result, the June 6, 2008, distribution from Alvan's rollover IRA was includible in his gross income for 2008.

IRS Will Follow Bobrow

In Announcement 2014-15, the IRS stated that it anticipates that it will follow the interpretation of Code Sec. 408(d)(3)(B) in Bobrow and, accordingly, intends to withdraw the proposed regulation and revise Publication 590 to the extent needed to follow that interpretation.

The IRS noted that these actions will not affect an IRA owner's ability to transfer funds from one IRA trustee directly to another, because, under Rev. Rul. 78-406, such a "trustee-to-trustee transfer" is not a rollover and, therefore, is not subject to the one-waiting period under Code Sec. 408(d)(3)(B).

Practice Tip: A trustee-to-trustee transfer may be accomplished by any reasonable means of direct payment to the receiving IRA. If the payment is made by wire transfer, the wire transfer must be directed only to the trustee or custodian of the receiving IRA. If payment is made by check, the check must be negotiable only by the trustee or custodian of the receiving IRA.

Under a very limited exception, the one-year waiting period also does not apply to a distribution that meets all three of the following requirements:

(1) it is made from a failed financial institution by the Federal Deposit Insurance Corporation (FDIC) as receiver for the institution;

(2) it was not initiated by either the custodial institution or the depositor; and

(3) it was made because the custodial institution is insolvent, and the receiver is unable to find a buyer for the institution.

Transition Relief

The IRS noted in Announcement 2014-15 that it has received comments about the administrative challenges presented by the Bobrow interpretation of the one-year waiting period. Recognizing that the adoption of the Tax Court's interpretation of the one-year waiting period will require IRA trustees to make changes in the processing of IRA rollovers and in IRA disclosure documents and that this will take time to implement, the IRS stated that it will not apply the Bobrow interpretation of the one-year waiting period to any rollover that involves an IRA distribution occurring before January 1, 2015.

Finally, the IRS stated that regardless of the ultimate resolution of the Bobrow case, it expects to issue a proposed regulation under Code Sec. 408 that would provide that the IRA rollover limitation applies on an aggregate basis. However, in no event would the regulation be effective before January 1, 2015.

[Return to Table of Contents]

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Gambling CPA Can't Deduct Allocable Share of Racetrack's "Take Out" Expenses

It's difficult, but not impossible, for a gambler to deduct gambling expenses as a business expense. However, gambling losses are not treated as a business expense but instead are deductible up to gambling winnings, and only as an itemized deduction. While the gambling winnings are reported as gross income on page 1 of the Form 1040, the losses are deductible only if the taxpayer itemizes his or her deductions and then, only to the extent of gambling winnings.

In Lakhani v. Comm'r, 142 T.C. No. 8 (3/11/14), a CPA who lost more money gambling at the race track than he made in his accounting practice argued that he was entitled to deduct his pro rata shares of the track's "takeout" from the parimutuel betting pools, which would wholly or partially offset the disallowed net gambling losses for the years at issue. Unfortunately, the Tax Court rejected the CPA's argument, holding that because the takeout expenses represented obligations of the race track and not the bettors, the CPA was not entitled to deduct any portion of such expenses.

Facts

For 2005-2009, Shiraz Lakhani was a CPA who operated an accounting practice in California that included the preparation of tax returns. He reported the income and expenses from his accounting practice on a Form 1040, U.S. Individual Income Tax Return, Schedule C, Profit or Loss From Business. During those years, Shiraz was also a professional gambler whose gambling activities were limited to parimutuel wagering on horse races. Shiraz placed bets on races occurring both at California racetracks and at racetracks in other states.

Shiraz reported his gambling winnings and losses on a separate Schedule C (i.e., his gambling Schedule C) for each of the years at issue. On each of the gambling Schedules C, he reported the gross amount he received on winning bets as "Gross receipts or sales," and he reported the amounts he bet as "Cost of goods sold," subtracting the latter from the former, to determine his gross income or loss from gambling. He also reported and deducted miscellaneous other expenses associated with his gambling activities and reported the sum of his gambling winnings, losses, and miscellaneous other expenses as his income or loss (net gambling income or loss, respectively) from gambling for the year. He then combined his net gambling income or loss with his accounting practice income for the year and reported the sum of the two on page 1, Line 12 of his Form 1040 as his total net "Business income or (loss)" for the year.

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

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

General Rules for Deducting Gambling Losses

Taxpayers must report the full amount of their gambling winnings for a year (with no reduction for gambling losses) as income on page 1 of Form 1040. Under Code Sec. 67(b)(3), taxpayers can deduct their gambling losses for the year separately on Schedule A (Form 1040) as a miscellaneous itemized deduction not subject to the 2 percent floor. Under Code Sec. 165(d), taxpayers cannot deduct gambling losses in excess of winnings.

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

Example: Ronald is in the trade or business of gambling on horse races. During the year, Ronald incurred $10,000 of business expenses relating to gambling. He also had an $11,000 loss from gambling (gambling gains of $120,000 less gambling losses of $131,000). Ronald cannot deduct the $11,000 of excess gambling losses over gambling gains. However, he can deduct the $10,000 of gambling business expenses on his Schedule C.

Parimutuel Wagering and the "Takeout"

In parimutuel wagering, the entire amount wagered on horse races is referred to as the betting pool or "handle." The pool can be managed to ensure that the event manager (i.e., the track) receives a share (or a percentage) of the betting pool regardless of who wins a particular event or race. That share is referred to as the "takeout," and the percentage, set by state law, varies from state to state, generally ranging from 15 percent to 25 percent and often depending upon the type of bet, e.g., "straight" or "conventional" win, place, or show wagers or "exotic" (multiple horse or multiple race) wagers, the latter usually resulting in higher takeout percentages.

The takeout is used to defray the track's expenses, including purse money for the horse owners, taxes, license fees, and other state-mandated amounts. What remains from the takeout after those expenses are paid is the track's profits. The takeout may also be used to cover any shortfall in the amount available in the parimutuel pool, after reduction for takeout, to pay off the winning bettors. That circumstance, generally referred to as the creation of a "minus pool," arises by virtue of the requirement, in many states, that the track provide a minimum profit to winning ticket holders.

Taxpayer's Argument

Shiraz argued that, in extracting takeout from the betting pools, the tracks are acting in the capacity of a fiduciary because they are collecting taxes and fees that they are then sending to the different state and local tax authorities. He likened the process to that of an employer collecting payroll taxes from employees and sending the payroll taxes to the IRS and state agencies.

According to Shiraz, his pro rata share of the takeout is a business expense and, as such, is not a loss from gambling subject to disallowance under Code Sec. 165(d). In making this argument, Shiraz cited the Tax Court's opinion in Mayo.

Shiraz also argued that the Code Sec. 165(d) limitation does not apply to the expenses, including the net gambling losses, of a professional gambler because professional gamblers are entitled to the same protection as any other profession when the activity is legal and conducted as a profession. According to Shiraz, Congress enacted Code Sec. 165(d) many decades ago, only because, at that time gambling was taboo. Now that gambling is legal in most states, Shiraz said, Code Sec. 165(d) is a discriminatory, unconstitutional deprivation of professional gamblers' right to equal protection under the law. Thus, he argued, Code Sec. 165(d) should be considered unconstitutional and struck down since gambling is part of American life and professional gamblers are "recognized in society and on television."

IRS's Arguments

The IRS's main arguments against allowing Shiraz's deductions were the following:

(1) because the race track takeout is paid from the pool remaining from losing bets, it is inseparable from the gambling transaction and constitutes gambling losses subject to the Code Sec. 165(d) limitation; and

(2) the taxes, license fees, and other expenses discharged from the takeout are expenses owed and paid by the track, not by the individual bettor.

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

With respect to Shiraz's equal protection argument, the IRS pointed out that, in Valenti v. Comm'r, T.C. Memo. 1994-483, the Tax Court rejected that argument after noting the historical distinction between gambling and other forms of business activity. In Valenti, the court held that where a classification that differentiates the business of gambling from other businesses has a rational basis, that rational basis must be supported. The Tax Court concluded that the argument in Valenti that Code Sec. 165(d) violates equal protection as applied to those engaged in the trade or business of gambling bordered on the frivolous. Thus, the IRS said, Shiraz's equal protection argument was contrary to settled law and, therefore, should be rejected.

Tax Court's Analysis

The Tax Court began its analysis by agreeing with the IRS that, because the taxes, license fees, and other expenses discharged from the takeout are expenses imposed upon the track and not the bettors, Shiraz was not entitled to a deduction for any of those expenses.

The court said that Shiraz's attempt to analogize the track's retention and disbursement of takeout to an employer's payroll tax obligations with respect to its employees was misguided. First and foremost, the court observed, none of the payments the track makes from the "handle" (i.e., betting pool) discharge any obligation of any bettor. And while reduction of the parimutuel pool by the amount of the takeout reduces the amount in the pool available to pay winning wagers, none of the takeout can be said to come from a winning bettor's wager, which in all events must be returned to him in full with at least a small profit.

Because the takeout is not an obligation or expense of the bettor, the court said, it cannot qualify as the bettor's deductible nongambling business expense under Mayo. Thus, the court held that Shiraz was not entitled to a passthrough deduction of such expenses under Code Sec. 162, Code Sec. 165, or Code Sec. 212.

With respect to Shiraz's argument regarding the constitutionality of Code Sec. 165(d), the court agreed with the IRS that its decision in Valenti was dispositive of Shiraz's equal protection claim. The lessening in recent time of the historical moral opposition to gambling, the court stated, does not undercut the rational basis for treating professional gambling losses differently from other business-related losses. The basis for enacting the former version of Code Sec. 165(d) was to force taxpayers to report their gambling gains if they wanted to deduct their gambling losses. According to the Tax Court, this constitutes a rational basis for the continued application of Code Sec. 165(d) to gambling losses.

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Failure to File Joint Return Precludes Rental Loss Deductions

The passive activity loss rules of Code Sec. 469, as many practitioners know first hand, are not the model of clarity. The regulations under Code Sec. 469 include final regulations, temporary regulations, and proposed regulations, some of which are 20 years old. Included in those regulations is a spousal attribution rule that allows one spouse's material participation to be attributed to the other spouse in determining whether an individual has materially participated in an activity that produces passive income, such as a rental real estate activity. However, as one taxpayer recently found out, to fully take advantage of this rule, a joint return must filed. In Oderio v. Comm'r, T.C. Memo. 2014-39 (3/10/14), a landlord was precluded from deducting rental losses because she did not file a joint return with her husband. The Tax Court's decision is instructive in that it clarifies the interaction of various regulations that dictate how the spousal attribution rules under Code Sec. 469 are applied.

Facts

During 2008, Julie Oderio was married to and lived with Jason Oderio. Julie worked full time as an employee for RREEF, a real estate investment company. Also in 2008, Julie owned rental property in San Jose, California. For 2008, Julie filed her tax return as married filing separately. On that return, she deducted almost $30,000 in rental losses with respect to her rental property. The IRS disallowed the deduction.

Rules for Deducting Rental Losses

Under Code Sec. 469, taxpayers cannot generally deduct passive activity losses. A passive activity loss is defined as the excess of the aggregate losses from all passive activities for the year over the aggregate income from all passive activities for the year. A passive activity is any trade or business in which the taxpayer does not materially participate.

Under Code Sec. 469(c)(2), rental activities are generally treated as per se passive, regardless of whether the taxpayer materially participates. However, Code Sec. 469(c)(7)(B) provides an exception for real estate professionals. To qualify, a taxpayer must meet two requirements: (1) more than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates. The flush language of Code Sec. 469(c)(7)(B) provides that, in the case of a joint return, these requirements are satisfied if and only if either spouse separately satisfies the requirements. For purposes of this provision, Code Sec. 469(c)(7)(B) provides that activities in which a spouse materially participates are determined under Code Sec. 469(h). Code Sec. 469(h), in turn, provides that in determining whether a taxpayer materially participates, the participation of the spouse of the taxpayer is taken into account. However, this is not the only provision where spousal attribution is mentioned.

Reg. Sec. 1.469-9, titled "Rules for certain rental real estate activities," provides guidance to taxpayers engaged in certain real property trades or businesses on how to apply the exception in Code Sec. 469(c)(7) to their rental real estate activities.

Reg. Sec. 1.469-9(c)(4) provides that spouses filing a joint return are qualifying taxpayers only if one spouse separately satisfies both requirements of Code Sec. 469(c)(7)(B). The regulation further provides that, "in determining the real property trades or businesses in which a married taxpayer materially participates (but not for any other purpose under this paragraph (c)), work performed by the taxpayer's spouse in a trade or business is treated as work performed by the taxpayer under Reg. Sec. 1.469-5T(f)(3), regardless of whether the spouses file a joint return for the year."

Reg. Sec. 1.469-5T(f)(3) treats the participation of a taxpayer's spouse in an activity as participation by the taxpayer for purposes of Code Sec. 469 and its regulations without regard to whether the spouses file a joint return.

Taxpayer's Argument

Julie admitted that she did not separately satisfy the requirements of Code Sec. 469(c)(7)(B) for determining whether she materially participated in her rental real estate activity. However, she argued that her husband, Jason, did satisfy those requirements and, therefore, she satisfied them also by virtue of the spousal attribution rule. In making this argument, Julie relied on Reg. Sec. 1.469-9(c)(4) and Reg. Sec. 1.469-5T(f)(3). She contended that, under those regulations, Jason's efforts were attributable to her for purposes of satisfying the material participation requirements of Code Sec. 469(c)(7)(B), regardless of whether she and Jason filed a joint return.

Observation: The facts in the court decision did not describe Jason's activities with respect to the rental real estate.

IRS's Argument

The IRS argued that because Julie did not file a joint return with her husband, she did not satisfy the Code Sec. 469(c)(7)(B) requirements through her husband and must separately satisfy them herself.

The Tax Court's Analysis

The Tax Court sided with the IRS and held that Julie could not deduct her rental real estate losses because she did not file a joint return. According to the court, she could not satisfy the Code Sec. 469(c)(7)(B) requirements through her husband and instead had to separately satisfy them herself.

With respect to Julie's arguments, the court noted that Reg. Sec. 1.469-5T(f)(3) treats the participation of a taxpayer's spouse in an activity as participation by the taxpayer for purposes of Code Sec. 469 and its regulations without regard to whether the spouses file a joint return. However, the court observed, Reg. Sec. 1.469-9(c)(4) clarifies the scope of attribution as it relates to satisfying the requirements of Code Sec. 469(c)(7)(B) and provides, in pertinent part, that spouses filing a joint return are qualifying taxpayers only if one spouse separately satisfies both requirements of Code Sec. 469(c)(7)(B).

The Tax Court said that, in determining the real property trades or businesses in which a married taxpayer materially participates (but not for any other purpose), work performed by the taxpayer's spouse in a trade or business is treated as work performed by the taxpayer, regardless of whether the spouses file a joint return for the year. The rental real estate activity of a "qualifying taxpayer" under Reg. Sec. 1.469-9, the court stated, is exempt from per se passive activity loss treatment. According to the court, the parenthetical "(but not for any other purpose under this paragraph(c))" limits the use of spousal attribution under Reg. Sec. 1.469-5T(f)(3), for purposes of satisfying the Code Sec. 469(c)(7)(B) requirements, to the material participation requirements of that section.

In conclusion, the court stated that, while the regulations Julie cited do allow for spousal attribution with respect to the material participation requirements of Code Sec. 469(c)(7)(B), they do not allow for spousal attribution for purposes of meeting its other requirements, namely, that a taxpayer perform more than one half of his or her personal services and more than 750 hours in real estate trades or businesses.

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Husband Cannot Change to Head of Household Filing Status on Amended Return

A husband who filed an amended income tax return, after the time for filing a return for the tax year at issue had passed, could not change his filing status from married filing jointly to head of household on the amended return. CCM 201411017.

The facts in CCM 201411017 indicate that a husband and wife filed a joint income tax return. Later, after the time for filing a return for the year at issue had expired, but before the end of the end of the statute of limitations for that year, the husband filed an amended income tax return reporting additional income tax due. On that return, the husband claimed head of household filing status. -----

The issues presented to the Chief Counsel's Office were (1) whether a spouse may change his or her filing status from married filing jointly to head of household on an amended return after a valid joint return has been filed and the time to file has expired; and (2) whether an assessment of additional tax reported on an amended return that only one spouse signed and agreed to file is valid against either spouse, and if not, whether the assessment must be abated.

Citing Reg. Sec. 1.6013-1(a)(1) and Ladden v. Comm'r, 38 T.C. 530 (1962), the Chief Counsel's Office advised that an election to file a joint income tax return is irrevocable after the time to file has expired. Thus, because the husband in this situation filed the amended return after the time for filing a return for the tax year at issue had passed, and assuming the election to file a joint return was valid, the husband could not change his filing status to head of household on an amended return.

With respect to the second issue, the Chief Counsel's Office noted that Code Sec. 6201(a)(1) requires the IRS to assess all taxes determined by the taxpayer as to which returns are filed. Because the husband filed an amended return that reported additional income tax due and the IRS made an assessment of additional tax on the amended return before the expiration of the statute of limitations period on the original return, the assessment against the husband is valid. Further, while Code Sec. 6404(a) allows the IRS to abate the unpaid portion of an assessment that is excessive, that is assessed after the limitations period or that is erroneously or illegally assessed, the assessment based on the husband's amended return was valid and the IRS lacks the authority to abate the assessment.

For a discussion of filing a separate return after a joint return has been filed, see Parker Tax ¶250,115.

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Payments for Providing Business Methodology Were Ordinary Income

Payments received by a sales manager for developing a client engagement methodology for his former employer were ordinary income and not capital gain because the transfer of the methodology without the transfer of all substantial rights of value in the methodology did not amount to a sale of a capital asset. Kamieneski v. Comm'r., T.C. Summary 2014-22 (3/11/14).

Scott Kamieneski, an experienced sales manager, worked for Symcon Global Technologies (SGT) from 2005 to 2008. Shortly after leaving SGT, he contacted SGT to explore a possible business arrangement and offered to develop an improved client engagement methodology. SGT expressed an interest in the client methodology and Scott went ahead with the development of the methodology. Upon completion of the client methodology, Scott and SGT entered into an agreement under which Scott would be paid the sum of $22,500 in six installments in 2008 and 2009 in return for providing the client methodology for SGT. The agreement, in part, stated that Scott had created a product for SGT in the form of goodwill. The client methodology developed by Scott was designed to assist small to medium-sized businesses to implement excellence by taking a comprehensive, strategic approach to the life cycle of a business or product. Scott did not apply for a copyright or patent for the methodology and received payments totaling $11,250 in 2009 pursuant to the agreement.

Scott and his wife, Eresia, timely filed their 2009 joint federal income tax return, but did not report the $11,250. After examining the couple's return, the IRS issued a notice of deficiency, characterizing the $11,250 as nonemployee compensation taxable as ordinary income.

Code Sec. 61 provides that the term "ordinary income" includes any gain from the sale or exchange of property that is not a capital asset. Capital gain will result from gain on the sale or exchange of a capital asset under Code Sec. 1222.

Scott and Eresia admitted receiving the $11,250 but argued that it was capital gain and not ordinary income.

The Tax Court held that providing the client methodology to SGT did not amount to a sale and, thus, the payments Scott received from SGT were ordinary income. For a property transaction to receive capital gain treatment, the court noted, the property involved must have been sold or exchanged. The court looked to the terms of the agreement between Scott and SGT to determine if there was a transfer to SGT of all substantial rights of value in the client methodology, which would indicate a sale. The court observed that the agreement did not prevent Scott from disclosing the methodology to other persons or entities and did not confer to SGT exclusivity in the methodology.

In rejecting Scott's contention that SGT paid for "goodwill" and that goodwill conferred exclusivity, the court noted that it was not credible that Scott, an experienced professional, would believe that the provision of goodwill granted SGT exclusivity. If SGT had sought exclusive rights in the methodology, it was unlikely that the company would have used such an ambiguous term to obtain those rights. Since Scott did not show that he surrendered all substantial rights of value in the client methodology, the transfer of the methodology to SGT was not a sale for tax purposes, the court concluded.

For a discussion of the sale or exchange requirement with respect to property transactions, see Parker Tax ¶111,100.

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Payments under Stock Swap Agreement Are Deductible in Year of Payment

Characterizing payments made under a swap agreement as an adjustment to the sales price was more appropriate than characterizing the payments as nonperiodic payments amortizable over the life of the agreement. CCA 201411032.

Under the facts in CCA 201411032, a taxpayer sold stock of a third-party to a buyer for an agreed upon amount. The transfer of the stock was restricted and convertible into another class of stock, publicly traded and issued by the same third-party, upon the conclusion of certain contingencies outside the control of the taxpayer and the buyer. Simultaneous with the stock sale, the taxpayer and the buyer entered into an agreement, labeled as a share swap, under which the taxpayer agreed to make certain payments, at any time, related primarily to the decline in the conversion rate of the restricted stock into the publicly traded stock. Under the agreement, the taxpayer generally was also entitled to receive payments at any time if there was an increase in the conversion rate of the restricted stock into the publicly traded stock.

The Chief Counsel's Office noted that no information was provided to the IRS which indicated that the parties to the agreement reasonably expected that any such payments would ever be made. The terms of the stock sale and the agreement were negotiated together, and the stock sale price would have been substantially lower if the taxpayer had not agreed to enter into the agreement. The taxpayer subsequently made substantial payments under agreement, deducting the full amounts as capital losses in the years they were paid. Finally, the taxpayer never received any payments under the agreement.

The issue before the Chief Counsel's Office was whether the amounts paid by the taxpayer to the buyer under the agreement were properly characterized as an adjustment to the sale price and thus fully deductible in the year of the payments as capital losses, or whether such payments were treated as a nonperiodic payments amortizable over the life of the agreement.

The Chief Counsel's Office concluded that characterizing the payments an adjustment to the sales price was a more appropriate treatment.

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Chief Counsel's Office Clarifies Rules for Grouping Activities under Passive Loss Rules

A taxpayer must have an ownership interest in each separate activity before those activities may be grouped together and treated as one activity for purposes of Code Sec. 469; a trade or business activity cannot become an "activity of the taxpayer" simply by virtue of being grouped with another activity of the taxpayer in which the taxpayer owns an interest. CCA 201411025.

Under the facts in CCA 201411025, a taxpayer owns interests in two activities. He also works full time as an employee of a closely held C corporation in which he does not own an interest. Citing Reg. Sec. 1.469-4(d)(5)(ii), the taxpayer argued to the IRS Chief Counsel's Office that he should be able to group his two activities with the activity of the closely held C corporation to determine whether he materially participates in his own activities for purposes of the passive activity loss rules of Code Sec. 469.

The Chief Counsel's Office advised that, for purposes of Code Sec. 469, the activities of a taxpayer include only activities in which the taxpayer has an ownership interest. A taxpayer's activities include those conducted through C corporations that are subject to Code Sec. 469, S corporations, and partnerships. Under Reg. Sec. 1.469-4(d)(5)(ii), an activity that the taxpayer conducts through a C corporation subject to Code Sec. 469 may be grouped with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially or significantly participates in the other activity.

To be "an activity of the taxpayer," the Chief Counsel's Office stated, the taxpayer must have an ownership interest in the trade or business activity or rental activity. Similarly, for a taxpayer to "conduct" an activity, the taxpayer must have an ownership interest in the activity. The grouping rules of Reg. Sec. 1.469-4, the Chief Counsel's Office noted, may only be used to group together activities that are already "activities of the taxpayer," meaning that the taxpayer must have an ownership interest in each separate activity before those activities can be grouped together and treated as one activity for purposes of Code Sec. 469. A trade or business activity cannot become an "activity of the taxpayer" simply by virtue of being grouped with another activity of the taxpayer in which the taxpayer owns an interest.

Accordingly, in the instant case, the Chief Counsel's Office stated that the taxpayer cannot group the trade or business activity of the closely held C corporation with any of the taxpayer's own activities because the taxpayer does not have an ownership interest in the corporation. In this case, the corporation is simply the taxpayer's employer, and nothing else. In addition, the Chief Counsel's Office stated, this would raise the issue of whether the business activity of the corporation and the taxpayer's own activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of Code Sec. 469.

The Chief Counsel's Office said it believed that the business activity of the corporation and the taxpayer's own activities would not constitute an appropriate economic unit for the measurement of gain and loss for purposes of Code Sec. 469 as a matter of law. Any trade or business activity or rental activity that is conducted through an entity, whether it is an S corporation, partnership, or closely held C corporation, the Chief Counsel's Office stated, is not relevant to the measurement of gain or loss of a taxpayer for purposes of Code Sec. 469 if the taxpayer does not possess an ownership interest in the entity.

Moreover, the Chief Counsel's Office stated, it would not make sense if a taxpayer could "group" the business activity of his employer with his own activities to determine material participation in his own activities simply because the taxpayer's employer happened to be a closely held C corporation (rather than another type of entity). The Chief Counsel's Office did not believe that the purpose of Reg. Sec. 1.469-4(d)(5)(ii) was to give a special advantage to non-owner employees of closely held C corporations and said that Reg. Sec. 1.469-5(f)(1) provided support for this position.

Reg. Sec. 1.469-5(f)(1) provides that, with certain exceptions not relevant in this situation, any work done by an individual (without regard to the capacity in which the individual does the work) in connection with an activity in which the individual owns an interest at the time the work is done is treated as "participation" of the individual in the activity. Only an individual's "participation" in an activity, as defined in Reg. Sec. 1.469-5(f)(1), the Chief Counsel's Office stated, will count towards meeting any of the safe-harbor tests for material participation under Reg. Sec. 1.469-5T(a).

According to the Chief Counsel's Office, because the taxpayer in this case did not have an ownership interest in the closely held C corporation at the time his work was performed, the work does not count as "participation" in the taxpayer's activities within the meaning of Reg. Sec. 1.469-5(f)(1). Accordingly, any work performed by the taxpayer for the corporation as a non-owner employee (assuming the work was not performed "in connection" with the conduct of the taxpayer's own activities) would not count towards meeting the tests for material participation in the taxpayer's own activities.

Practice Tip: If an individual taxpayer performs work through a closely held C corporation (or through any other type of entity) as an employee (or in any other capacity), and the work was performed "in connection" with the taxpayer's own activities (within the meaning of Reg. Sec. 1.469-5(f)(1)), that work might count towards material participation in the individual taxpayer's own activities. This would be true regardless of whether the taxpayer grouped (or could have grouped) his own activities with the corporation's activity pursuant to Reg. Sec. 1.469-4(d)(5)(ii). For example, under Reg. Sec. 1.469-9(e)(3)(ii), if a taxpayer manages his own properties through a separate property management company, his own work in managing his own properties through the company may count as participation with respect to those properties. The question of whether the work is properly treated as performed "in connection" with an activity in which the taxpayer owns an interest is a factual issue, and the burden of proof generally is on the taxpayer to substantiate that issue.

For a discussion of the rules for determining material participation with respect to a trade or business, see Parker Tax ¶247,115.

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Conservation Easements Were Properly Valued for Charitable Deduction; State Tax Credits Sale Proceeds Were Short Term Capital Gain

The value of conservation easements donated by a group of investors in property near a gravel mining operation was properly determined by an expert appraiser who took into account the property's current use for agriculture and its remote likelihood of development for gravel mining; proceeds from the sale of state tax credits received by the investors as a result of the donations were reportable as short-term capital gain. Esgar Corporation v. Comm'r., 2014 PTC 122 (10th Cir. 3/7/14).

Investors Esgar Corporation, Delmar and Patricia Holmes, and George and Georgetta Tempel acquired undivided interests in 2,200 acres of land that they held in a partnership. In 1999, the partnership leased around 1,500 acres of the property to a company to operate a gravel mine. In 2004, the partnership transferred a portion of the unleased acres to Esgar, the Holmes, and the Tempels individually. The investors then granted a perpetual conservation easement over their respective properties to an organization that would preserve the natural condition of the land and protect its biological, ecological, and environmental characteristics. The grant specifically prohibited the mining of gravel or minerals on the properties.

The investors claimed charitable deductions on their respective 2004 returns for qualified conservation contributions and hired an appraiser to value their contributions. In determining the value of the easements, the appraiser concluded that the properties would have realized their greatest potential as a gravel mining operation. Esgar, the Holmes and Tempels claimed those amounts as charitable contributions on their respective 2004 returns, carrying forward unused contributions to their 2005 and 2006 returns. As a result of the donations, they received transferable tax credits from the state that they sold to third parties within two weeks of receiving the credits. The investors reported the sale proceeds as income, although characterizing the income differently. After examining the investors' returns, the IRS determined that the conservation easements were in fact valueless and that the sale proceeds from the state tax credits were reportable as ordinary income. The IRS issued deficiency notices for the 2004, 2005, and 2006 tax years.

The issue before the Tax Court was the value of the conservation easement. Finding for the IRS, the Tax Court ruled that agriculture was the properties' highest and best use and valued the easements accordingly. The Tax Court also held that the income resulting from the sale of the state tax credits should be reported as short-term capital gains and not long-term capital gains as some of the investors had reported. The investors appealed.

Code Sec. 170 allows a charitable deduction for partial interest contributions where the interest donated is a qualified conservation easement that meets certain requirements. Reg. Sec. 1.170A-14 states that the value of a conservation easement is the fair market value of the perpetual conservation restriction at the time of the contribution.

The investors argued that: (1) the Tax Court erred by adopting the properties' current use as its highest and best use rather than taking a "development-based approach"; and (2) the Tax Court erred by citing eminent domain principles in reaching its valuation determination. Thus, the investors argued, the conservation easements had a higher value than what the Tax Court held.

The Tenth Circuit affirmed the Tax Court, concluding that there was substantial evidence on which the Tax Court based its conclusion. The IRS presented expert testimony by an experienced appraiser who opined that the properties' highest and best use was agriculture. The expert noted that, although it would be physically possible to mine the properties, there was no demand for such use in the reasonably foreseeable future.

The Tenth Circuit also found that the Tax Court applied the proper valuation methodology for the conservation easements. Taking into account the properties' current use and that the likelihood of development for gravel mining was remote, it was reasonable for the Tax Court to conclude that agriculture was the properties' highest and best use. Moreover, the court rejected the investors' argument that eminent domain principles - standards used to value property to determine just compensation - were inapplicable in valuing conservation easements. Just-compensation and conservation easement valuations require identical findings, and there was no material difference in the context of determining a property's highest and best use, the court noted.

Finally, the Tax Court correctly found that the state tax credits were capital assets and that their holding periods did not qualify for long-term capital gain treatment. The investors cited no authority for their contention that long-term treatment was appropriate because they had held the underlying real properties for more than one year. Further, the tax credits did not replace the value of the donated easements through a like-kind exchange, hence no tacking of holding periods was allowed, the court concluded.

For a discussion of the rules for contributions of partial interests in property, see Parker Tax ¶84,155.

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State Law Limiting Duration of Easements Precludes Charitable Deduction

Because North Dakota law prohibited real property easements from being granted in perpetuity, the taxpayer could not take charitable contribution deductions for donations of conservation easements. Wachter v. Comm'r, 142 T.C. No. 7 (3/11/14).

Michael, Patrick, and Louise Wachter held varying interests in WW Ranch, a partnership, and Wind River Properties, LLC. In 2003, under a government land protection program, the U.S. Department of Agriculture and American Foundation for Wildlife (AFW) entered into a cooperative agreement to buy conservation easements on land in North Dakota owned by WW Ranch. Under the program, the government would reimburse AFW for up to half of the easement purchase price. The agreement required that the easement run in perpetuity or for a minimum of 30 years where state law prohibited permanent easements. The agreement also allowed the landowner to donate up to 25 percent of the appraised fair market value of the easement and such donation would be considered part of AFW's contribution to the purchase price. For the years at issue, North Dakota law provided that the duration of an easement on the use of real property must be specifically set out, and in no case could the duration of any interest in real property exceed 99 years.

As part of the conservation easement sales, in 2004, Michael and Patrick, on behalf of Wind River, signed an agreement with the North Dakota Natural Resource Trust (NRT) to donate $170,000 to NRT. NRT sent a letter to Michael and Patrick d/b/a WW Ranch acknowledging the cash gift and stating that NRT provided no goods or services in exchange for the donation. In 2005 and 2006, the Wachters donated $170,000 and $144,000, respectively, to NRT and received letters acknowledging the cash gifts and stating that NRT provided no goods or services in exchange for the donations. On its 2004, 2005, and 2006 partnership returns, WW Ranch reported the sales of conservation easements as charitable contributions of $349,000, $247,000, and $162,000, respectively. For each sale, two appraisals of the contributed property were obtained. Each appraisal valued the property according to a different land use and the Wachters used the difference as the value of the conservation easements and, thus, the amount of their noncash charitable contributions. The Wachters reported the cash and noncash charitable contributions on their individual federal income tax returns. The IRS issued notices of deficiencies to the Wachters, disallowing the charitable contribution deductions related to WW Ranch and Wind River.

Generally, no charitable contribution deduction is allowed for a gift of property consisting of less than the donor's entire interest in that property. However, there is an exception in Code Sec. 170(f)(3)(B)(iii) for a "qualified conservation contribution." Under Code Sec. 170(h)(1) and Reg. Sec. 1.170A-14(a), a contribution of real property is a qualified conservation contribution if (1) the real property is a "qualified real property interest," (2) the contribution is made to a "qualified organization," and (3) the contribution is "exclusively for conservation purposes." Under Code Sec. 170(h), a qualified real property interest means a restriction, granted in perpetuity, on the use that may be made of the real property. Reg. Sec.1.170A-14(g)(3) provides that a deduction is not disallowed if the donated interest may be defeated by a remote future event.

The IRS argued that the North Dakota law restricting easements to 99 years prevents conservation easements from being qualified real property interests and prevents conservation easements from being exclusively for conservation purposes.

The Wachters argued that the state law limitation on the duration of property easements was the equivalent of a remote future event or retention of a negligible interest that did not preclude the conservation easements from being qualified real property interests or contributions exclusively for conservation purposes.

The Tax Court held that the Wachters could not take charitable contribution deductions for the donations of the conservation easements. The court cited the Supreme Court's decision in U.S. v. National Bank of Commerce, 472 U.S. 713 (1985), which found that state law determines the nature of property rights and federal law determines the appropriate tax treatment of those rights. Because North Dakota law limits the duration of an easement to 99 years, the Tax Court said, this precludes a North Dakota conservation easement from qualifying as being granted "in perpetuity."

For a discussion of the deductibility of conservation easements, see Parker Tax ¶84,155.

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Fifth Circuit Reverses Tax Court; Nonqualified Stock Options Were Taxable Compensation to Railroad Employees

Nonqualified stock options offered to employees of a rail carrier as part of a compensation package were properly taxed as compensation under the Railroad Retirement Tax Act; however, the case was remanded to determine whether moving expense benefits paid by the rail carrier qualified as taxable compensation or were properly excluded as a travel expense. BNSF Railway Company v. U.S., 2014 PTC 134 (5th Cir. 3/13/14).

The BNSF Railway, formed in 1996 by a merger of three rail carriers, is a rail carrier that operates an international railroad system throughout the western United States and Canada. As a rail carrier, BNSF and its employees are subject to the Railroad Retirement Tax Act (RRTA). From 1993 to 1998, BNSF and its predecessor rail carriers offered salaried employees and executives a combination of incentive stock options (ISOs) and nonqualified stock options (NQSOs). The stated purpose of the stock option plans was to provide employees with a competitive compensation package.

BNSF awarded stock options annually as compensation for services rendered by employees and for job performance. For the years at issue, BNSF and its employees paid over $16 million in RRTA taxes on exercised NQSOs. In addition, BNSF also paid taxes on moving expense benefits provided to employees who were required to relocate as a result of the merger. Typically, BNSF paid moving expenses in one of two ways: (1) by direct payment to the service providers, or (2) by a lump-sum payment to employees, who could generally keep any excess payment over expenses actually incurred and who were not required to provide substantiation. BNSF generally paid employees a "tax gross-up" to cover additional tax due on these moving expense benefits.

BNSF filed refund claims for the employer and employee portions of the RRTA taxes paid on the NQSOs and the moving expenses. The district court granted BNSF's motion for summary judgment, holding that the NQSOs were not compensation for purposes of the RRTA and that the moving expenses were properly excluded from income under the RRTA.

Code Sec. 3121 provides that the term "wages" means all remuneration for employment, including the cash value of all remuneration, including benefits, paid in any medium other than cash. Under Reg. Sec. 31.3231(e)-1, compensation has the same meaning as the term "wages" in Code Sec. 3121, except as specifically limited in the RRTA and the related regulations. For RRTA purposes, Code Sec. 3231(e)(1) defines compensation as "any form of money remuneration paid to an individual for services rendered as an employee to one or more employers," subject to certain enumerated exceptions. Under Code Sec. 3231(e)(5), the term "compensation" does not include any benefit provided to or on behalf of an employee if at the time that benefit is provided it is reasonable to believe that the employee will be able to exclude that benefit from income under Code Secs. 74(c), 108(f)(4), 117, or 132

BNSF argued that the NQSOs did not qualify as money because they were not cash or other medium of exchange for employment, and therefore, were not compensation under the RRTA. BNSF also claimed that the moving expenses were not provided as compensation for employees' services to BNSF, but instead were provided as a means of retaining qualified and knowledgeable employees. BNSF considered the moving expenses to be excludible moving expense payments and reimbursements under Code Sec. 217.

The IRS contended that the NQSOs were compensation because they qualified as wages under the Federal Insurance Contributions Act (FICA). In addition, the IRS said that the moving expenses did not qualify as benefits excludible from compensation.

The Fifth Circuit reversed the Tax Court and held that the NQSOs are includible as compensation under the RRTA. Under Tier 1 of the RRTA, a tax is imposed on an applicable percentage of an employee's compensation for services. The court cited the Supreme Court's decision in Chevron USA, Inc. v. Nat'l Resources Def. Council, Inc., 467 U.S. 837 (1983), which held that, where a statute is silent with respect to a specific issue, the IRS regulations receive deference on a permissible construction of the statute. In this case, the terms "compensation" and "any form of money remuneration" were inherently ambiguous, the Fifth Circuit concluded. Although RRTA compensation may exclude certain in-kind benefits, the court said it was reasonable to construe that NQSOs were properly included as compensation under the RRTA as interpreted by Reg. Sec. 31.3231(e)-1.

However, the court remanded the case to the district court to determine whether the moving expense benefits were properly excluded under Code Sec. 3231(e)(5). Because the benefits were paid in various ways, a determination on an expense-by-expense basis was needed to determine whether such benefits qualified as compensation under the RRTA or were properly excluded as a travel expense.

For a discussion of wages payments subject to withholding, see Parker Tax ¶212,110.

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