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Parker's Federal Tax Bulletin - Tax and Accounting Research Articles

              

Parker's Federal Tax Bulletin
Issue 84     
March 13, 2015     

 

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 1. In This Issue ... 

 

Tax Briefs

IRS Updates Address for Ogden Copy of Form 3115; IRS Issues Final Regs on Electing Alternative Simplified Credit; IRS Advises Student on the American Opportunity Tax Credit; No Exclusion from Sale of Home Where Taxpayers Only Maintained an Office ...

Read more ...

IRS Releases Detailed FAQ Explaining Repair Regulations

Last week, the IRS released a clear and detailed FAQ explaining key aspects of the new tangible property regulations (a.k.a., the "repair regulations"). IRS FAQ - Tangible Property Regulations (3/5/15).

Read more ...

Eight Circuit Rejects Like-Kind-Exchange Structured to Avoid Related Party Restrictions

The Eighth Circuit found that a construction equipment seller entered into like-kind-exchanges involving unnecessary intermediaries to avoid related party restrictions. The court upheld a district court determination disallowing nonrecognition treatment. North Central Rental & Leasing, LLC v. U.S., 2015 PTC 67 (8th Cir. 2015)

Read more ...

Bartender's Meticulous Records Defeat IRS's Claim of Unreported Tip Income

The Tax Court held that a Las Vegas bartender, audited after he stopped participating in an IRS tip compliance program, had fully reported his tip income. The court concluded that the taxpayer's records reflected his income earned from tips more accurately than the IRS's reconstruction formula did. Sabolic v. Comm'r, T.C. Memo. 2015-32.

Read more ...

IRS Issues Proposed Rules on Winnings from Electronic Slot Machines

The IRS has issued updated guidance, in a proposed revenue procedure and proposed regulations, on how taxpayers calculate their wagering gains or losses from electronic slot machines and the thresholds for when gambling establishments must report winnings from electronic slot machines. Notice 2015-21; REG-132253-11 (3/4/15).

Read more ...

Abandonment of Securities Not an Abandonment of Contractual Rights; Fifth Circuit Allows a Nearly $100 Million Ordinary Loss

The Fifth Circuit reversed the Tax Court, finding that Code Sec. 1234A only applies to the abandonment of contractual rights, as opposed to rights inherent in assets like securities. By allowing a $98.6 million ordinary loss, the court validated the taxpayer's decision to decline a $20 million purchase offer in favor of a $30 million tax savings. Pilgrim's Pride v. Comm'r, 2015 PTC 61 (5th Cir. 2015).

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Dude Ranch Shareholders Liable for Unpaid Corporate Taxes after Liquidation Scheme Collapses

The Seventh Circuit affirmed a Tax Court decision holding former dude ranch shareholders liable as transferees for unpaid taxes left over from participation in an intricate tax-avoidance scheme pitched to them as an alternative to a standard liquidation. Feldman v. Comm'r, 2015 PTC 58 (7th Cir. 2015).

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Portions of Refundable State Tax "Credits" Were Includable in Federal Income

[The Tax Court held that taxpayers had to include in income portions of refundable state tax "credits" received from participating in a New York economic development program. The court found that, contrary to the state's characterization, the refundable credits were effectively taxable subsidies. Maines v. Comm'r, 144 T.C. No. 8 (3/11/15)

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IRS Proposes "Next Day Rule" for Changes in Consolidated Group Membership

The IRS has issued proposed amendments to the consolidated return regulations, revising the rules for reporting certain items of income and deduction that are reportable on the day a corporation joins or leaves a consolidated group. The proposed regulations would affect these corporations and the consolidated groups that they join or leave. REG-100400-14 (3/6/15).

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 2. Tax Briefs 

 

Accounting Methods

IRS Updates Address for Ogden Copy of Form 3115: In an IRS Press Release (02/20/2015), the IRS alerted taxpayers to a change in address for the copy of Form 3115, Application for Change of Accounting Method sent to Ogden, Utah. Taxpayers should now send a copy of their Form 3115 to: Internal Revenue Service, 1973 Rulon White Blvd., Mail Stop 4917, Ogden, UT, 84201-1000.

 

Credits

IRS Issues Final Regs on Electing Alternative Simplified Credit: In T.D. 9712 (2/27/15), the IRS issued final regulations related to the timing and manner of electing the alternative simplified credit (ASC) under Code Sec. 41(c)(5). Under the final regulations, taxpayers may make an ASC election on an amended return if the taxpayer had not previously claimed a Code Sec. 41 credit for that year. In addition, the final regulations provide that a taxpayer that is a member of a controlled group may not make an ASC election for that year on an amended return if any member of the controlled group claimed the research credit using a method other than the ASC. The final regulations affect certain taxpayers claiming credits under Code Sec. 41.

IRS Advises Student on the American Opportunity Tax Credit: In CCA 201509030, a student requested information on when a portion of the American Opportunity Tax Credit (AOTC) is refundable. The IRS Office of Chief Counsel advised that the student would not be entitled to the refundable portion of the AOTC if the individual was a "child," as described by Code Sec. 1(g). Otherwise, Code Sec. 25A(i)(5) allows a 40 percent refund of the AOTC claimed with respect to qualified educational expenses.

 

Deductions

No Exclusion from Sale of Home Where Taxpayers Only Maintained an Office: In Villegas v. Comm'r, T.C. Memo. 2015-33, taxpayers sold the group home they ran for the benefit of developmentally disabled individuals, claiming it was their principal residence and excluding the gain under Code Sec. 121. However, the taxpayers never resided at the group home; three of the bedrooms were used by clients, with the fourth serving as an office, and employees testified that they never saw the owners live at the address. The court found that the group home was not the taxpayer's principle residence and disallowed the income exclusion.

Expenses Related to Taxpayer's Uncompensated IT Services Not Deductible: In Shah v. Comm'r, T.C. Memo. 2015-31, an information technology (IT) consultant taxpayer claimed deductions for expenses incurred in providing complimentary computer services for friends and family remotely from his home. Because the taxpayer never sought, nor received, compensation for these services, the Tax Court determined he did not engage in the activity for profit as required by Code Sec. 183(a) and denied the deductions as personal expenses under Code Sec. 262(a).

 

Educational Savings Plans

IRS to Issue Proposed Regulations on ABLE Accounts: In Notice 2015-18, the IRS announced that it anticipates issuing proposed regulations that will provide that the designated beneficiary of an ABLE account is the owner of the account. The notice also provides that, where the designated beneficiary does not have signature authority over an ABLE account, the person with signature authority may neither have nor acquire any beneficial interest in the account and must administer the account for the benefit of the designated beneficiary. New section 529A establishes the ABLE account program, under which contributions may be made to an ABLE account created to meet the qualified disability expenses of a designated beneficiary.

 

Healthcare Taxes

IRS Corrects Final Regs Affecting Charitable Hospital Orgs: In T.D. 9708 (3/11/15), the IRS issued corrections to the final regulations providing guidance on the requirements for charitable hospital organizations relating to financial assistance and emergency medical care policies, charges for certain care provided to individuals eligible for financial assistance, and billing and collections. The regulations reflect changes to the law made by the Patient Protection and Affordable Care Act of 2010.

 

Innocent Spouse Relief

No Innocent Spouse Relief: In Panetta v. Comm'r, T.C. Summary 2015-16, the Tax Court determined a taxpayer was not entitled to innocent spouse relief from deficiencies stemming from her business. Before her divorce, the taxpayer had opened a mobile food truck specializing in deserts; she would provide her then-husband with information on the expenses and income of the business, and he was responsible for filing the tax returns. Although the taxpayer never reviewed the returns, the court determined that as she knew she had incurred reported expenses and the deficiencies were attributable to her business, she was not entitled to innocent spouse relief from the liabilities stated on her joint return.

 

Retirement Plans

Banking Error Saves Taxpayer from Early Distribution Penalty: In PLR 201510060, the IRS ruled that two unrequested payments from a taxpayer's IRA were not subject to the 10 percent additional tax on early distributions. When a new entity assumed control of the IRA, it inadvertently started making additional payments from the account. The IRS ruled that because those payments were due to a bank error, they were not considered a modification of a series of substantially equal periodic payments under Code Sec. 72(t)(4) and, therefore would not be subject to the 10 percent additional tax on early distributions under Code Sec. 72(t)(1).

 

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 3. In-Depth Articles 

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IRS Releases Detailed FAQ Explaining Repair Regulations

Last week, the IRS released a clear and detailed FAQ explaining key aspects of the new tangible property regulations (a.k.a., the "repair regulations"). IRS FAQ - Tangible Property Regulations (3/5/15).

Although the IRS's question-and-answer style guidance covers quite a bit of ground, most falls into four categories:

  • De minimis safe harbor election
  • Rules for the treatment of materials and supplies costs
  • Distinguishing capital improvements from deductible repairs
  • When and how to apply the new regulations

The following are lightly paraphrased excerpts from the IRS FAQ. As is typical for IRS guidance of this type, the FAQ omits citations to the regulations. As a convenience to subscribers who wish to dig deeper into the rules, we've provided cites as well as links to relevant Parker analysis sections and practice aids. For completeness, we've included Parker observations and cautionary warnings where appropriate.

De Minimis Safe Harbor Election

Under the final tangible property regulations, taxpayers may elect to apply a de minimis safe harbor to amounts paid to acquire or produce tangible property to the extent such amounts are deducted for financial accounting purposes or in keeping books and records. If a taxpayer has an applicable financial statement (AFS), he or she may use this safe harbor to deduct amounts paid for tangible property up to $5,000 per invoice or item. If a taxpayer does not have an AFS, he or she may use the safe harbor to deduct amounts up to $500 per invoice or item.

Parker Observation: Under the prior regulations, there was no de minimis safe harbor exception to capitalization; taxpayers were required to determine whether each expenditure for tangible property, regardless of amount, was required to be capitalized.

These limitations are for purposes of determining whether particular expenses qualify under the safe harbor; they aren't intended as a ceiling on the amount a taxpayer can deduct as business expenses.

The de minimis safe harbor election eliminates the burden of determining whether every small-dollar expenditure for the acquisition or production of property is properly deductible or capitalizable. If a taxpayer elects to use the de minimis safe harbor, he or she doesn't have to capitalize the cost of qualifying de minimis acquisitions or improvements. However, de minimis amounts paid for tangible property may be subject to capitalization under Code Section 263A, if the amounts include the direct or allocable indirect costs of other property produced or acquired for resale. For example, taxpayers must capitalize all the direct and allocable indirect costs of constructing a new building.  

Parker Caution: The de minimis safe harbor does not apply to: (1) amounts paid for property that is or is intended to be included in inventory property; (2) amounts paid for land; (3) amounts paid for rotable, temporary, and standby emergency spare parts that the taxpayer elects to capitalize and depreciate under Reg. Sec. 1.162-3(d); and (4) amounts paid for rotable and temporary spare parts that the taxpayer accounts for under the optional method of accounting for rotable parts pursuant to Reg. Sec. 1.162-3(e).

[Parker ¶242,715.20; Reg. Sec. 1.263(a)-1(f)]

If a taxpayer elects to use the de minimis safe harbor, do they have to capitalize all expenses that exceed the $500 or $5,000 limitations?

No. Amounts paid for the acquisition or production of tangible property that exceed the safe harbor limitations aren't subject to the de minimis safe harbor election. Such amounts are treated under the normal rules that apply. For example, amounts paid for repairs or maintenance are currently deductible (assuming other applicable requirements are met), even if the amounts exceed the $500 or $5,000 limitations.

Are there financial statements other than those required to be filed with the SEC that qualify as an AFS, permitting a taxpayer to apply the $5,000 de minimis limitation?

An AFS includes a financial statement required to be filed with the SEC, as well as other types of certified audited financial statements accompanied by a CPA report, including a financial statement provided for a loan, reporting to shareholders, or for other non-tax purposes. An AFS also includes a financial statement required to be provided to a federal or state government or agency other than the IRS or the SEC. [Parker ¶242,715.20[a]; Reg. Sec. 1.263(a)-1(f)(1)(i)]

What are the requirements for taxpayers without an AFS?

If a taxpayer does not have an AFS, he or she is not required to have written accounting procedures; however, he or she must expense amounts on his or her books and records for the year in accordance with a consistent accounting procedure or policy existing at the beginning of the year to qualify for the de minimis safe harbor election.

If a taxpayer does not have an AFS, but has a policy for his or her books and records of deducting amounts more than $500, the taxpayer may properly deduct these amounts for federal tax purposes, as long as he or she can show that the reporting policy clearly reflects income.

In these situations, taxpayers may want to elect the de minimis safe harbor for items costing $500 or less to assure that the deduction of the items costing $500 or less will not be questioned by the IRS.

How do taxpayers elect to use the de minimis safe harbor?

Taxpayers should attach a statement titled "Section 1.263(a)-1(f) de minimis safe harbor election" to the timely filed original federal tax return including extensions for the year in which the de minimis amounts are paid. The statement should include the name, address, and Taxpayer Identification Number of the taxpayer, as well as a statement that the taxpayer is making the de minimis safe harbor election. Under the election, taxpayers must apply the de minimis safe harbor to all expenditures meeting the criteria for the election in that year. [Parker ¶242,715.20[d]; Reg. Sec. 1.263(a)-1(f)(5)]

Practice Aid: See Parker ¶320,216 for a sample de minimis safe harbor election statement.

An annual election is not a change in method of accounting. Therefore, taxpayers should not file Form 3115, Application for Change in Method of Accounting, to use the de minimis safe harbor for a particular tax year, and should not file a Form 3115 to change the amount deducted under the taxpayer's book policy. Similarly, taxpayers should not file a Form 3115 to stop applying the de minimis safe harbor for a subsequent tax year.

How does the de minimis safe harbor affect the deductions typically taken for materials and supplies or repairs and maintenance?

In general, when a taxpayer elects the de minimis safe harbor, materials and supplies that also qualify under the de minimis safe harbor are treated as de minimis costs and are not treated as materials and supplies. However, the de minimis safe harbor doesn't change a taxpayer's ability to deduct costs for materials and supplies, incidental or nonincidental, that don't qualify under the de minimis safe harbor.

Similarly, the de minimis safe harbor doesn't change a taxpayer's ability to deduct repair and maintenance costs that don't qualify under the de minimis safe harbor, e.g., costs that exceed the safe harbor threshold. Therefore, for costs that don't qualify under the de minimis safe harbor, taxpayers apply the general rules for identifying and deducting repair and maintenance costs, incidental supplies, and nonincidental materials and supplies.

[Parker ¶242,715.20; Reg. Sec. 1.263(a)-1(f)(3)(iv)]

Rules for Treatment of Materials and Supplies Costs

What is included in the definition of materials and supplies?

Materials and supplies are tangible, non-inventory property used and consumed in a taxpayer's operations including:

Acquired components - Costs of components acquired to maintain, repair, or improve tangible property owned, leased, or serviced by the taxpayer and that's not acquired as part of a larger item of tangible property;

Consumables - Costs of fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in operations;

12 month property - Costs of tangible property that has an economic useful life of 12 months or less, beginning when the property is used or consumed;

$200 property - Costs of tangible property that has an acquisition cost or production cost of $200 or less.

The property need only fit into one of the above categories to qualify as a material or supply.

[Parker ¶242,705; Reg. Sec. 1.162-3(c)(1)]

When can a taxpayer deduct the costs of materials and supplies?

As under prior rules, taxpayers may deduct the costs of incidental and nonincidental materials and supplies in the following manner:

Incidental materials and supplies - If the materials and supplies are incidental, i.e., of minor or secondary importance, carried on hand without keeping a record of consumption, and no beginning and ending inventories are recorded (e.g., pens, paper, staplers, toner, trash baskets) then taxpayers deduct the materials and supplies costs in the year in which the amounts are paid or incurred, provided taxable income is clearly reflected.

Nonincidental materials and supplies - If the materials and supplies are not incidental, then taxpayers deduct the materials and supplies costs in the year in which the materials and supplies are first used or consumed. For example, a taxpayer could deduct certain expendable spare parts in a trucking business for which records of consumption are kept and inventories are recorded in the year the part is removed from storage and installed in one of the trucks. However, an otherwise deductible material or supply cost could be subject to capitalization under Code Sec. 263(a) if the material or supply is used to improve property, or under Code Sec. 263A if the material or supply is incorporated into property produced or acquired for resale.

Application with de minimis safe harbor - If a taxpayer elects to use the de minimis safe harbor and any materials and supplies also qualify for the safe harbor, taxpayers must deduct amounts paid for these materials or supplies under the safe harbor in the year the amounts are paid or incurred. Such amounts are not treated as amounts paid for materials and supplies and may be deducted as business expenses in the year they are paid or incurred.

[Parker ¶242,705; Reg. Secs. 1.162-3(a)]

What must taxpayers do to apply the final regulations to materials and supplies?

Because the final regulations governing the treatment of materials and supplies are based primarily on prior law, taxpayers previously in compliance with the rules generally will still be in compliance and generally no action will be required to continue to apply these rules on a prospective basis.

Distinguishing Capital Improvements from Deductible Repairs

Have the final regulations changed the rules for determining whether an expenditure is a deductible repair or a capital improvement?

The final regulations synthesize existing case law and prior administrative rules into a framework to help taxpayers determine whether a cost is deductible as a repair and maintenance expense or must be capitalized because it's an improvement. If the amounts are not paid or incurred for an improvement to tangible property as determined under the final regulations, then the amounts generally are deductible as repairs and maintenance.

Whether a cost is for repair or an improvement will always require reviewing facts and circumstances, as required under prior rules. This facts and circumstances analysis is described in more detail below. The final regulations do not eliminate the requirements of Code Sec. 263(a), which generally provides that taxpayers must capitalize the direct and allocable indirect costs of producing real or tangible personal property and acquiring property for resale.

In addition, the final regulations provide several simplifying safe harbors and elections to ease compliance with these rules.

[Parker ¶99,520; T.D. 9636]

Two-Step Facts and Circumstances Analysis for Distinguishing Capital Improvements from Deductible Repairs

Step 1 - What is the unit of property?

For buildings, the unit of property is generally the entire building including its structural components. However, under the final regulations and for these purposes only, the improvement analysis applies to the building structure and each of the key building systems. The key building systems are the plumbing system, electrical system, HVAC system, elevator system, escalator system, fire protection and alarm system, gas distribution system, and the security system. Lessees of portions of buildings apply the analysis to the portion of the building structure and portion of each building system subject to the lease. Lessors of an entire building apply the improvement rules to the entire building structure and each of the key building systems.

For non-buildings, the unit of property is, and the analysis applies to, all components that are functionally interdependent. Components of property are functionally interdependent if taxpayers cannot place in service one component of property without placing in service another component of property.

For plant property (e.g. a manufacturing plant, generation plant, etc.), the unit of property is, and the analysis applies to, each component or group of components within the plant that performs a discrete and major function or operation.

For network assets (e.g., railroad track, oil and gas pipelines, etc.), the particular facts and circumstances or industry guidance from the IRS determines the unit of property and the application of the improvement analysis.

Step 2 - Is there an improvement to the unit of property identified in Step 1?

A unit of tangible property is improved only if the amounts paid are:

(1) For a betterment to the unit of property; or

(2) To restore the unit of property; or

(3) To adapt the unit of property to a new or different use.

What is a betterment?

Betterments include:

  • Amounts paid to fix a material condition or material defect that existed before the acquisition or arose during production of the unit of property; or
  • Amounts paid for a material addition, including a physical enlargement, expansion, extension, or addition of a major component, to the property or a material increase in capacity, including additional cubic or linear space, of the unit of property; or
  • Amounts paid that are reasonably expected to materially increase productivity, efficiency, strength, quality, or output of the unit of property where applicable.

Parker Observation: In recognition of the fact that taxpayers may apply different standards for capitalizing amounts on their applicable financial statements and such standards may not be controlling for whether the activities are betterments for federal tax purposes, the final regulations do not include the taxpayer's treatment of the expenditure on its financial statement as a factor to be considered in performing a betterment analysis.

[Parker ¶99,560.35; Reg. Sec. 1.263(a)-3(j)]

What are amounts to restore a unit of property?

Restorations include:

Replacement of a major component or substantial structural part - Amounts paid for the replacement of a part or combination of parts that make up a major component or a substantial structural part of the unit of property; or

Recognition of gains or losses and basis adjustments - Taxpayer has taken into account or adjusted the basis of the unit of property or component of the unit of property, including: (a) deducted loss; (b) sale or exchange; or (c) casualty loss or event

Deterioration to state of disrepair - Amount paid to return the unit of property to its ordinarily efficient operating condition, if the unit of property has deteriorated to a state of disrepair and is no longer functional for its intended use; or

Rebuilding to like-new condition - Amounts paid for the rebuilding of the unit of property to a like-new condition after the end of its class life.

Parker Observation: A taxpayer does not have to treat as a restoration amounts paid under restoration standard (1) or (2) above if the unit of property has been fully depreciated and the loss is attributable only to remaining salvage value as computed for federal income tax purposes.

[Parker ¶99,560.40; Reg. Sec. 1.263(a)-3(k)]

What adapts a unit of property to a new or different use?

In general, an amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer's intended ordinary use of the unit of property at the time originally placed in service by the taxpayer.

[Parker ¶99,560.45; Reg. Sec. 1.263(a)-3(l)]

Alternatives to Facts and Circumstances Analysis: Elections and Safe Harbors

Simplifying alternatives to the facts and circumstances analysis include:

(1) Safe Harbor Election for Small Taxpayers;

(2) Safe Harbor for Routine Maintenance; and

(3) Election to Capitalize Repair and Maintenance Costs.

Safe Harbor Election for Small Taxpayers

Taxpayers are not required to capitalize as an improvement, and therefore may deduct, the costs of work performed on owned or leased buildings, e.g., repairs, maintenance, improvements or similar costs, that fall into the safe harbor election for small taxpayers. The requirements of the safe harbor election for small taxpayers are:

(1) Average annual gross receipts less than $10 million; and

(2) Owns or leases building property with an unadjusted basis of less than $1 million; and

(3) The total amount paid during the year for repairs, maintenance, improvements, or similar activities performed on such building property doesn't exceed the lesser of: (a) two percent of the unadjusted basis of the eligible building property; or (b) $10,000.

Taxpayers make the election to use the safe harbor for each year in which qualifying amounts are incurred. The election is made by attaching a statement to the taxpayer's income tax return for the year.

Practice Aid: See Parker ¶320,212 for a sample small taxpayer safe harbor election statement.

An annual election is not a change in method of accounting. Therefore, taxpayers shouldn't file Form 3115, Application for Change in Method of Accounting, to make this election or to stop applying the safe harbor in a subsequent year.

[Parker ¶99,560.25; Reg. Sec. 1.263(a)-3(h)]

Safe Harbor for Routine Maintenance

Taxpayers are not required to capitalize as an improvement, and therefore may deduct, amounts that meet all of the following criteria:

(1) Amounts paid for recurring activities that the taxpayer expects to perform;

(2) As a result of the use of the property in a trade or business;

(3) To keep the property in its ordinarily efficient operating condition; and

(4) The taxpayers reasonably expects, at the time the property is placed in service, to perform the activities: (a) For building structures and building systems, more than once during the 10-year period beginning when placed in service, or (b) For property other than buildings, more than once during the class life of the unit of property.

If the amount doesn't meet all of the requirements for the routine maintenance safe harbor, the taxpayer may still deduct the amount if the amount is not for an improvement under the facts and circumstances analysis.

Parker Observation: Unlike the small taxpayer safe harbor (discussed above), the safe harbor for routine maintenance does not require filing an election statement.

The routine maintenance safe harbor DOES NOT apply to amounts paid for betterments. However, it DOES apply to certain restorations that would otherwise be improvements, including when a taxpayer pay amounts to replace a major component or substantial structural part of a unit of property.

Because the final regulations are based primarily on prior law, taxpayers who were previously in compliance with the rules generally will be in compliance with the final regulations and generally no action is required. If a taxpayer is not in compliance or otherwise wants to change his or her method of accounting to use the safe harbor for routine maintenance, the taxpayer should file Form 3115, Application for Change in Accounting Method, and compute a Code Sec. 481(a) adjustment.

[Parker ¶99,560.30; Reg. Sec. 1.263(a)-3(i)]

Election to Capitalize Repair and Maintenance Costs

To reduce the difficulty with applying the facts and circumstances analysis to identify the tax treatment of costs and to recognize simpler administration by permitting taxpayers to follow financial accounting policies for federal tax purposes, the final regulations include an election to capitalize repair and maintenance expenses as improvements, if the taxpayer treats such costs as capital expenditures for financial accounting purposes.

A taxpayer may elect to treat repair and maintenance costs paid during the year as amounts paid to improve property if he or she:

(1) Pays these amounts in carrying on a trade or business;

(2) Treats these amounts as capital expenditures on his or her books and records regularly used in computing income; and

(3) Makes the election to capitalize for each year in which qualifying amounts are incurred by attaching a statement to a timely filed original federal tax return including extensions for the year that the amounts are paid.

If a taxpayer makes the election to capitalize repair and maintenance expenses, he or she must apply the election to all amounts paid for repair and maintenance that are treated as capital expenditures on the books and records in that year.

Practice Aid: See Parker ¶320,214 for a sample election statement that can be used when electing to capitalize repair and maintenance costs.

An annual election is not a change in method of accounting. Therefore, taxpayers shouldn't file Form 3115, Application for Change in Method of Accounting, to make this election or to stop capitalizing repairs and maintenance costs for a subsequent year.

[Parker ¶99,560.55; Reg. Sec. 1.263(a)-3(n)]

When and How to Apply the New Regulations

What is the effective date?

Generally, the final regulations apply to years beginning on or after Jan. 1, 2014, or in certain circumstances, apply to costs paid or incurred in years beginning on or after Jan. 1, 2014. [Parker ¶99,520; Reg. Sec. 1.263(a)-2(j)(1)].

How do the repair regulations coordinate with other Code provisions?

Nothing in the final repair regulations changes the treatment of any amount that is specifically provided for under any provision of the IRC or the Treasury regulations other than section 162(a) or section 212. For example, the final regulations do not eliminate the requirements of section 263(a), which generally provides that taxpayers must capitalize the direct and allocable indirect costs of producing real or tangible personal property and acquiring property for resale.

How does a taxpayer change a method of accounting to use the final regulations?

Under the Code, a change in method of accounting includes a change in the treatment of an item affecting the timing for including the item in income or taking the item as a deduction. For example, a change in a method of accounting occurs if a taxpayer has been capitalizing certain amounts that were characterized as improvements and would like to currently deduct the amounts as repairs and maintenance costs pursuant to the final regulations.

Taxpayers must get consent from the IRS to change a current accounting method to a new accounting method. The IRS provides automatic consent procedures for those who want to change to a method of accounting permitted under the final regulations.

Generally, taxpayers receive automatic consent to change a method of accounting by completing and filing Form 3115, Application for Change in Accounting Method, and including it with a timely filed original federal tax return for the year of change. Taxpayers also mail a duplicate copy of the Form 3115 to Ogden, Utah. The Form 3115 will identify the taxpayer, describe the methods that are being changed, identify the type of property involved in the change, and include a Code Sec. 481(a) adjustment, if applicable.

The Code Sec. 481(a) adjustment takes into account how taxpayers treated certain expenditures in years before the effective date of the final regulations to avoid duplication or omission of amounts in taxable income. For detailed instructions for filing applications for changes in methods of accounting under the tangibles regulations, see Rev. Proc. 2015-13, and sections 6.37-6.40 and 10.11 of Rev. Proc. 2015-14.

[Parker ¶99,540.05; Reg. Sec. 1.263(a)-1(g); Rev. Proc. 2015-14]

Simplified Procedures for Small Business Taxpayers (RP 2015-20 Relief)

The final section of the IRS's FAQ is devoted to a lengthy discussion of relief granted to small business taxpayers under Rev. Proc. 2015-20.

In a nutshell: the revenue procedure waives the requirement for small businesses to file a Form 3115, Application for Change in Accounting Method, and instead allows them to opt for a simplified procedure for changing accounting methods under the final repair regulations. Such changes can be made on a prospective basis for tax years beginning in 2014 (a.k.a. "the cut-off method"), thereby eliminating the need to make a Code Sec. 481(a) adjustment with respect to prior tax years. For purposes of Rev. Proc. 2015-20, a "small business" is defined as one with total assets of less than $10 million or average annual gross receipts of $10 million or less for the prior three tax years.

For an article on the simplified procedures for small business taxpayers covering the same ground as the IRS's FAQ, see the February 27, 2015 issue of Parker's Federal Tax Bulletin. For a quick reference guide, see Parker ¶360,240; for in-depth analysis, see ¶241,591.

[Return to Table of Contents]

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Eight Circuit Rejects Like-Kind-Exchanges Structured to Avoid Related Party Restrictions

The Eighth Circuit found that a construction equipment seller entered into like-kind-exchanges involving unnecessary intermediaries to avoid related party restrictions. The court upheld a district court determination disallowing nonrecognition treatment. North Central Rental & Leasing, LLC v. U.S., 2015 PTC 67 (8th Cir. 2015)

Background

Butler Machinery Company ("Butler Machinery") sells agricultural, mining, and construction equipment for manufacturers, primarily Caterpillar, Inc. ("Caterpillar"). In 2002, Butler Machinery formed subsidiary North Central Rental & Leasing, LLC ("North Central") to take over rental and leasing operations. Although considered separate entities, Butler Machinery and North Central are closely related and are ultimately controlled by Daniel Butler and his family.

Less than two months after formation, North Central instituted a like-kind-exchange (LKE) program. Under that program, North Central sold its used equipment to third parties, and the third parties paid the sales proceeds to a qualified intermediary, Accruit, LLC ("Accruit"). Accruit forwarded the sales proceeds to Butler Machinery, and the proceeds went into Butler Machinery's main bank account. At about the same time, Butler Machinery purchased new Caterpillar equipment for North Central and then transferred the equipment to North Central via Accruit. Butler Machinery charged North Central the same amount that it paid for the equipment. The LKE program allowed North Central to trade used equipment for new equipment and, in the process, defer tax recognition of any gains or losses from the transactions.

Butler Machinery's use of LKE transactions facilitated favorable financing terms under which Butler Machinery was given up to six months from the date of the invoice to pay Caterpillar for North Central's new equipment, essentially giving Butler Machinery an interest-free loan for up to six months.

From 2004 to 2007 North Central claimed nonrecognition treatment of gains from 398 LKE transactions pursuant to Code Sec. 1031. These transactions frequently resulted in significant sales proceeds which would be placed in Butler Machinery's accounts, giving it unfettered access to the funds until the payments to Caterpillar became due.

The IRS determined that North Central structured the transactions to avoid the related-party exchange restrictions under Code Sec. 1031(f), and disallowed nonrecognition treatment. In response, North Central brought suit in the District Court of North Dakota, alleging the LKE transactions were entitled to nonrecognition treatment. After the district court sided with the IRS, North Central appealed to the Eighth Circuit Court.

Analysis

Under Code Sec. 1031(a), no gain or loss is recognized on the exchange of property held for the productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment ("like-kind exchange"). However, Code Sec. 1031(f) generally prohibits this nonrecognition treatment where a taxpayer exchanges like-kind property with a related person, and either party disposes of the exchanged property within two years of the exchange. In addition, Code Sec. 1031(f)(4) broadly prohibits nonrecognition treatment for any exchange which is part of a transaction (or a series of transactions) structured to avoid the purposes of Code Sec. 1031(f).

The Eighth Circuit drew attention to the comparative complexity of the transactions, noting that prior cases in both the Eleventh Circuit and the Ninth Circuit had determined that LKEs were structured to avoid the purposes of Code Sec. 1031(f) in part because of their unnecessary complexity and unnecessary parties involved in the transaction. Each of the transactions involved an intricate interplay between at least five parties: North Central, Accruit, Butler Machinery, Caterpillar, and the third party who bought North Central's used equipment. Although North Central, Caterpillar, and the third-party customer were indisputably necessary for the sales and purchase transactions to occur, the court believed Butler Machinery and Accruit were not.

The court questioned why Butler Machinery was involved in the transactions at all as North Central had acknowledged that Butler Machinery functioned as a passthrough for both the cash and the property. North Central proffered several alternative reasons for Butler Machinery's involvement, including that it made the transactions administratively easier and more efficient.

However, the court dismissed those arguments, noting that North Central could have placed the orders with Caterpillar directly; injecting Butler Machinery into the transactions added unnecessary inefficiencies and complexities, including additional transfers of payment and property. Instead, the court believed the more plausible explanation for Butler Machinery's involvement was that it financially benefitted from what amounted to six-month, interest-free loans under the financing terms.

The court found Butler Machinery was not necessary to the transactions yet possessed significant, unearmarked cash proceeds as a result of the transactions.

The court found that Accruit was also an unnecessary party as Butler Machinery and North Central could have exchanged property directly with each other. This unnecessary layer of complexity supported finding that the exchanges were structured to sidestep Code Sec. 1031(f), because if Butler Machinery and North Central exchanged the property directly with each other, they, as related parties, would have to hold the exchanged-for property for two years before the exchanges could qualify for nonrecognition treatment.

Because North Central could have achieved the same property dispositions via a much simpler method, the Circuit Court believed the transactions took their peculiar structure for no purpose other than to avoid Code Sec. 1031(f) and upheld the district court's determination, denying like- kind-exchange treatment for the transactions.

For a discussion of like-kind-exchanges, see Parker Tax ¶113,100.

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Bartender's Meticulous Records Defeat IRS's Claim of Unreported Tip Income

The Tax Court held that a Las Vegas bartender, audited after he stopped participating in an IRS tip compliance program, had fully reported his tip income. The court concluded that the taxpayer's records reflected his income earned from tips more accurately than the IRS's reconstruction formula did. Sabolic v. Comm'r, T.C. Memo. 2015-32.

Background

Alan Sabolic, a bartender with over 20 years of experience, worked at the Zuri Lounge at the MGM Grand Hotel and Casino (MGM Grand). During 2009 to 2011, Sabolic chose not to participate in the IRS's Gaming Industry Tip Compliance Agreement Program (GITCA Program). GITCA sets an automatic tip rate for participating employees used to calculate taxable tip income. Sabolic had participated in the GITCA Program for over 20 years, but opted out of the program citing concerns that the automatic tip rate was too high and did not reflect the poor economic conditions.

Since Sabolic opted out of the program, he was required to self-report his cash tips to MGM Grand and keep personal records of how much he received in tips. At the end of each shift, he would add together his tips and enter the total into the MGM Grand's system, tip-out the barbacks, and give the cashiers the loose change he would receive with cash tips. He also kept a daily personal tip log, recording the total on a slip of paper. Sabolic reported income from tips of $18,110, $23,941, and $21,926 for tax years 2009 to 2011, respectively, and also claimed deductions for the tip outs.

The IRS contended Sabolic's logs were inadequate and determined deficiencies for 2009 to 2011. In calculating the amount owed, the IRS reconstructed Sabolic's tips based on sales records, reduced by 10 percent to account for the tip outs to the barbacks. The IRS determined that Sabolic had underreported his tip income by $19,729, $19,000, and $20,284 for 2009 to 2011.

Sabolic challenged that determination, arguing the IRS's reconstruction did not accurately reflect his tip income and petitioned the Tax Court.

Analysis

Tips constitute compensation for services and are includable in gross income (Reg. Sec. 1.61-2(a)(1)). When a taxpayer receives tips daily, he or she is required to keep an accurate and contemporaneous record of such income (Reg. Sec. 31.6053-4(a)(1)). When a taxpayer's records are inadequate or incomplete, the IRS can reconstruct the employee's tip income in any manner that clearly reflects income. The IRS has great latitude in choosing the method of reconstruction, and the method chosen need only be reasonable in light of all of the surrounding facts and circumstances (Schroeder v. Comm'r, 40 T.C. 30 (1963)).

The IRS asserted multiple arguments designed to establish that Sabolic's logs were inadequate.

First, the IRS pointed to the fact that the logs were recorded in whole numbers, arguing that Sabolic was not tipped in exact dollar amounts. The court did not believe this made the records inadequate, noting Sabolic's explanation that the whole numbers reflected the fact he gave change he received to cashiers.

Second, the IRS argued that the daily tip logs were inadequate because Sabolic did not keep track of how much he actually tipped out the barbacks at the end of each shift. The court found that, while ideally Sabolic should have kept track of the exact amounts he tipped the barbacks, his testimony that he always tipped them between 10 percent and 20 percent and the fact the IRS allowed Sabolic a 10 percent reduction for tip outs defeated the IRS's assertion.

Third, the IRS claimed the logs were inadequate because they appeared to be missing days. The court, however, found that vacations, flexible work days, and frequent system outages adequately explained why the records appeared to be incomplete.

Finally, the IRS contended that the logs were inadequate because they did not precisely match up with the information on Sabolic's Forms W-2. The court disagreed, reasoning that while the information did not precisely match, timing differences in the pay period and malfunctions in the MGM Grand System that tracked tips likely accounted for the discrepancies.

The court noted that while in general the IRS's method of reconstructing taxpayers' tip income was reasonable, there was no evidence of a discrepancy in Sabolic's records that would result in the unreported income reflected in the IRS's calculations. Thus, in this case, the IRS's method was not an accurate reflection of Sabolic's income.

Because the court concluded the IRS's method did not reflect Sabolic's income as accurately as Sabolic's own daily records, the court ruled Sabolic was in compliance with the requirements of Reg. Sec. 31.6053-4(a)(1) and found Sabolic fully reported his tip income on his 2009 to 2011 tax returns.

For a discussion of employee tip recordkeeping and reporting requirements, see Parker Tax ¶124,105.

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IRS Issues Proposed Rules on Winnings from Electronic Slot Machines

The IRS has issued updated guidance, in a proposed revenue procedure and proposed regulations, on how taxpayers calculate their wagering gains or losses from electronic slot machines and the thresholds for when gambling establishments must report winnings from electronic slot machines. Notice 2015-21; REG-132253-11 (3/4/15).

Determining Gains and Losses from Electronic Slots

In recent years, controversy between taxpayers and the IRS over determining wagering gains or losses from slot machine play has been complicated by changes in gambling technology. The increased use of electronic gambling, with the development of player's cards and tickets, has curtailed the redemption of tokens by slot machine players, normally the preferred method of tracking gains or losses. To reduce the burden on taxpayers, the proposed revenue procedure in Notice 2015-21 provides an optional safe harbor method for determining what constitutes a "session of play" for purposes of calculating wagering gains or losses from electronically tracked slot machine play.

In general, gains from wagering transactions are included in gross income (Rev. Rul. 54-339), and gains from a slot machine wagering transaction are determined on a session-by-session basis (Shollenberger v. Comm'r, T.C. Memo. 2009-306). Under Code Sec. 165(d), losses from wagering transactions are allowed only to the extent of the gains from such transactions.

Under the proposed safe harbor, a "session of play" begins when a patron places the first wager and ends when the same patron completes his or her last wager before the end of the same day. A taxpayer recognizes a wagering gain if, at the end of a single session of play, the total dollar amount of payouts from electronically tracked slot machine play during that session exceeds the total dollar amount of wagers placed by the taxpayer on electronically tracked slot machine play during that session. Conversely, a taxpayer recognizes a wagering loss if wagers exceed payouts at the end of a session of play.

A taxpayer must use the same session of play if the taxpayer stops and then resumes electronically tracked slot machine play within a single gaming establishment during the same calendar day. However, a separate session of play will begin if the taxpayer moves to a different establishment, or if the taxpayer uses a non-electronic slot machine. Additionally, if a continuous session extends from one day to the next (i.e. begins before midnight and ends after midnight), a separate session of play will begin at midnight.

Example: Taxpayer engages in electronically tracked slot machine play at Lucky Casino from 3:00 pm to 6:00 pm, and then moves to a different establishment, Happy Casino, to play slots from 7:00 pm to 9:00 pm before returning to Lucky Casino for more electronic slot play from 10:00 pm to 2:00 am the next day. Taxpayer will have three distinct sessions of play: one session encompassing his time at Lucky Casino from 3:00 pm to 6:00 pm and 10:00 pm to 11:59 pm, a second session at Lucky Casino for 12:00 am to 2:00 am, and a session encompassing his time at Happy Casino from 7:00 pm to 9:00 pm.

A taxpayer must calculate his or her wagering gains or losses separately for each session of play, and may not net the sessions together.

Taxpayers may not rely on the safe harbor in the proposed revenue procedure until it is finalized.

Reporting Winnings from Electronic Slots

On the other end of the spectrum, and in conjunction with Notice 2015-21, the IRS issued proposed regulations in REG-132253-11updating and simplifying badly outdated reporting requirements to account for how gambling establishments report payouts from electronically tracked slot machines. The updated requirements are proposed to be set forth in new Reg. Sec. 1.6041-10, which would replace the current regulations in Sec. 7.6041-1 of the Temporary Income Tax Regulations under the Tax Reform Act of 1976.

The current regulations governing information reporting of winnings from bingo, keno, and slot machine play were published in 1977. There have been significant advances in gaming industry technology since then, such as electronic slot machines and other mechanisms that permit electronic tracking of wagers and/or winnings. The proposed regulations will be effective when finalized.

The proposed regulations contain the same reporting threshold requirements for winnings from bingo, keno and non-electronically tracked slot machine play. However, the proposed regulations include new rules for determining the reporting threshold for electronically tracked slot machine play. The changes are intended in part to facilitate reporting that more closely reflects the gross income that will be reported by payees on their individual income tax returns, pursuant to Notice 2015-21.

Under these new rules, gambling winnings for electronically tracked slot machine play must be reported when two criteria are met: (1) the total amount of winnings earned from electronically tracked slot machine play during a single session netted against the total amount of wagers placed on electronically tracked slot machines during the same session is $1,200 or more; and (2) at least one single win during the session (without regard to the amount wagered) equals or exceeds $1,200. The first criterion helps to implement the safe harbor for computing gross income attributable to electronically tracked slot machine play described in Notice 2015-21. The second criterion is intended to be consistent with the casino industry's current practice of gathering payee information when a player wins a single jackpot that satisfies the reporting threshold.

Under this rule, reporting with respect to electronically tracked slot machine play is not required if no single win (without reduction for the amount of the wager) meets the $1,200 reporting threshold or if the net amount of winnings reduced by the amount of all wagers is less than $1,200. However, if the $1,200 reporting threshold for a single win is satisfied and all winnings from electronically tracked slot machine play during a session netted against all wagers during that session are $1,200 or more, gambling winnings for the session must be reported on a Form W-2G.

For a discussion of income from gambling, see Parker Tax ¶85,120.25. For a client letter explaining the reporting of gaming income, see ¶320,770.

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Abandonment of Securities Not an Abandonment of Contractual Rights; Fifth Circuit Allows a Nearly $100 Million Ordinary Loss

The Fifth Circuit reversed the Tax Court, finding that Code Sec. 1234A only applies to the abandonment of contractual rights, as opposed to rights inherent in assets like securities. By allowing a $98.6 million ordinary loss, the court validated the taxpayer's decision to decline a $20 million purchase offer in favor of a $30 million tax savings. Pilgrim's Pride v. Comm'r, 2015 PTC 61 (5th Cir. 2015).

Background

Pilgrim's Pride Corporation is the successor-in-interest to Gold Kist, Inc., an association taxed as a nonexempt cooperative. In the late 1990's, Gold Kist was contractually obligated to purchase, and did purchase, securities from Southern States Cooperative, Inc., and Southern States Capital Trust I (Southern States). The purchase price was $98.6 million. The securities were capital assets of Gold Kist.

In 2004, Southern States offered to redeem the securities for $20 million. Instead of accepting the offer, Gold Kist's board of directors decided to surrender the securities to Southern States for no consideration, reasoning a $98.6 million ordinary loss would produce greater tax savings than the $20 million offered by Southern States. On its 2004 federal income tax return, Gold Kist reported a $98.6 million ordinary abandonment loss deduction under Code Sec. 165(a) and Reg. Sec. 1.165-2(a).

Five years later, while Pilgrim's Pride was in bankruptcy, the IRS issued a deficiency notice to Pilgrim's Pride with respect to Gold Kist's 2004 tax year asserting that Gold Kist's loss from the abandonment of the Securities was a capital loss, rather than an ordinary loss, creating a tax deficiency of nearly $30 million. The IRS argued that Code Sec. 1234A(1) applied and rendered the abandonment a deemed sale or exchange of capital assets subject to capital loss treatment.

The Tax Court agreed with the IRS, holding that the securities were intangible property comprising rights that Gold Kist had in the management, profits, and assets of Southern States which terminated when Gold Kist surrendered the securities. Pilgrim's Pride appealed to the Fifth Circuit, challenging the IRS' determination that Gold Kist's abandonment generated a capital loss and arguing that Code Sec. 1234A was inapplicable.

Analysis

Under Code Sec. 165(a) and Reg. Sec. 1.165-2(a), an abandonment loss deduction can be taken for a loss incurred and arising from the sudden termination of the usefulness in a business or transaction of nondepreciable property. The loss is allowable where a business or transaction is discontinued or where such property is permanently discarded from use. The loss is taken as a deduction for the tax year in which the loss is actually sustained. However, under Reg. Sec. 1.165-2(b), an abandonment loss cannot be claimed on a sale or exchange of property. Under Code Sec. 165(f), losses from sales or exchanges of capital assets are subject to the limitations on capital losses. Further, Code Sec. 1234A(1) requires gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right with respect to property that is (or on acquisition would be) a capital asset in the hands of a taxpayer to be treated as gain or loss from the sale of a capital asset.

The Fifth Circuit noted that, by its plain terms, Code Sec. 1234A(1) applies to the termination of rights or obligations with respect to capital assets (e.g. derivative or contractual rights to buy or sell capital assets), not to the termination of ownership of the capital asset itself.

The IRS asserted that Code Sec. 1234A(1) also indirectly applies to the abandonment of a capital asset because such abandonment involves the termination of certain rights and obligations inherent in those assets. Thus, the IRS claimed, when Pilgrim's Pride abandoned the securities it abandoned the rights in the securities, meaning it should be treated as a capital loss pursuant to Code Sec. 1234A(1).

The court disagreed, stating that the IRS's position was essentially that Congress, rather than simply stating that the abandonment of a capital asset results in capital loss, chose to legislate that result by reference to the termination of rights and obligations "inherent in" capital assets. The court assumed that the ordinary meaning of Code Sec. 1234A accurately expressed its legislative purpose, noting that interpreting the section as the IRS argued would render Code Sec. 1234A(2) superfluous. Thus, the court found Pilgrim's Pride had abandoned the securities themselves, not a right or obligation with respect to the securities within the meaning of Code Sec. 1234A(1).

As an alternative argument, the IRS claimed that Code Sec. 165(g) required the abandonment of securities to be treated as a capital loss resulting from worthless securities. Although the securities were worth at least $20 million when Pilgrim's Pride abandoned them, the IRS argued that they were "worthless" because they were useless to Pilgrim's Pride.

The court found that this argument conflicted with prior precedent, as the Fifth Circuit had previously held in Echols v. Comm'r, 950 F.2d 209 (5th Cir. 1991) that property cannot be treated as worthless for tax loss purposes if it objectively has substantial value. Since the abandoned securities had a value of at least $20 million, they were not objectively worthless, and thus the court held Code Sec. 165(g) did not apply.

Because the court determined Code Sec. 1234A(1) only applies to the termination of contractual or derivative rights, and not to the abandonment of capital assets, the Fifth Circuit reversed the judgment of the Tax Court and allowed Pilgrim's Pride to claim a $96.8 million ordinary loss.

Caution: While the holding in this case may seem like a windfall for taxpayers looking to abandon securities to generate an ordinary tax loss, the regulations under Code Sec. 165(g) were amended in 2008 to provide that abandonment of securities generate capital losses (Reg. Sec. 1.165-5(i)).

For a discussion of abandonment losses, see Parker Tax ¶114,510.

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Dude Ranch Shareholders Liable for Unpaid Corporate Taxes after Liquidation Scheme Collapses

The Seventh Circuit affirmed a Tax Court decision holding former dude ranch shareholders liable as transferees for unpaid taxes left over from participation in an intricate tax-avoidance scheme pitched to them as an alternative to a standard liquidation. Feldman v. Comm'r, 2015 PTC 58 (7th Cir. 2015).

Background

William Feldman founded Woodside Ranch in the 1920s and over time the ranch came to offer a wide array of outdoor recreational activities. The ranch was incorporated in 1952 as Woodside Ranch Resort, Inc. ("Woodside") and was owned and operated by the descendants of the founder until its sale in 2002.

By the late 1990s, the ranch was facing a number of challenges to its ongoing viability as due to competition from nearby casinos and water parks. The ten shareholders, all descendants of the founder, decided to sell the ranch to a third party who they hoped would continue to operate the ranch. Although the shareholders proposed a stock sale, the buyer insisted on an asset sale and the shareholders acquiesced. The asset sale netted the shareholders $2.3 million, resulting in a taxable capital gain of $1.8 million (on a basis of $510,000) and triggering tax liabilities of approximately $750,000.

While the asset sale was pending, Woodside's accountant and financial advisor introduced the shareholders to Honora Shapiro, a 50 percent owner of Midcoast Acquisition Corp. ("Midcoast"), a firm specializing in tax shelters. The shareholders jumped at the opportunity to reduce their tax liability, and in June of 2002 Midcoast sent a letter of intent offering to buy Woodside's stock for its liquidation value (about $1.4 million) plus a premium of about $225,000.

The closing involved a number of steps in quick succession, taking place in a single day in July of 2002. First, Woodside redeemed 20 percent of its stock directly from the shareholders, leaving it with $1.83 million in cash, and the still-unpaid tax liabilities. The parties then executed the share purchase agreement and the funds were then wired into and out of a trust account. At 12:09 p.m., Woodside's cash reserves of $1.83 million were transferred into the trust account. Then, at 1:34 p.m., Shapiro transferred $1.4 million into the trust account, purportedly as a loan to Midcoast to fund the transaction, although there was no promissory note or other writing evidencing a loan. At 3:35 p.m., $1,344,451 was wired to Woodsedge LLC, an entity set up to receive the proceeds of the stock sale, as payment to the shareholders. One minute later, at 3:36 p.m., $1.4 million was returned to Shapiro, repaying the undocumented "loan."

After the stock sale, Woodside had $452,729 cash on hand along with the tax liabilities from the initial asset sale. A few days later, Woodsedge LLC, which was holding the proceeds of the redemption and stock sale, disbursed approximately $1.2 million to the shareholders. Woodside never paid federal taxes on the capital gain from the asset sale; its 2003 tax return claimed a net operating loss carried back to 2002, reducing Woodside's 2002 federal tax liability to zero.

In 2008 the IRS sent notices to the former shareholders assessing transferee liability for Woodside's unpaid taxes and penalties under Code Sec. 6901.

At trial before the tax court, the shareholders conceded that the tax shelter was illegal, but contested transferee liability. In a comprehensive opinion, the tax court ruled in the IRS's favor, holding that the stock sale was in substance a liquidation with no purpose other than tax avoidance, making the shareholders liable for the unpaid tax debt as transferees of Woodside under Code Sec. 6901 and Wisconsin law. The shareholders then appealed to the Seventh Circuit.

Analysis

Code Sec. 6901 authorizes the IRS to proceed against the transferees of delinquent taxpayers to collect unpaid tax debts. In order to do so, the IRS must first establish that the target for collection is a "transferee" of the delinquent taxpayer within the meaning of Code Sec. 6901; next, the IRS must show that the transferee is liable for the transferor's debts under state law (Comm'r v. Stern, 357 U.S. 39 (1958)). The term "transferee" is defined broadly to include any donee, heir, legatee, devisee, or distributee (Code Sec. 6901(h)).

The Circuit Court reviewed the Tax Court's decision for error. The tax court had found that the stock sale was structured to avoid the tax consequences of Woodside's asset sale, which the shareholders would have had to absorb had they pursued a standard liquidation. Formally, the shareholders sold their Woodside stock to Midcoast, which purported to fund the transaction via a loan from Honora Shapiro.

The tax court looked past these formalities to the substance of the transaction, recasting it as a liquidation, and found that Midcoast did not actually pay the shareholders for their stock; instead, each shareholder received a pro rata distribution of Woodside's cash on hand (which came from the proceeds of the asset sale) making them "transferees" under Code Sec. 6901(h). The circuit court found nothing wrong with this recharacterization by the tax court, noting it has long been established that courts may look past the form of a transaction to its substance to determine how the transaction should be treated for tax purposes.

Accordingly, the circuit court agreed with the tax court's conclusion that the transaction was a de facto liquidation. Woodside carried on no business activity, its only asset was cash from the initial asset sale, and the shareholders had planned to liquidate. The circuit court reasoned that the $1.4 million loan from Shapiro was a sham, because if it was removed from the transaction, nothing of consequence would change. What remained after disregarding the sham loan was a transfer of cash from Woodside to the trust account and then to an LLC owned by the shareholders established for the sole purpose of receiving the proceeds of the transaction. The circuit court noted that, in reality, the only money that changed hands was Woodside's cash reserves. On those facts the circuit court found it was entirely reasonable for the tax court to conclude that this was a liquidation cloaked in the trappings of a stock sale.

Having received Woodside's cash in a de facto liquidation, the circuit court agreed with the tax court, holding the shareholders were transferees under Code Sec. 6901. In addition, the circuit court found the shareholders were liable for Woodside's tax debts under Wisconsin state law, and sustained the tax court's determination of transferee liability under Code Sec. 6901.

For a discussion of transferee liability, see Parker Tax ¶262,530.

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Portions of Refundable State Tax "Credits" Were Includable in Federal Income

[The Tax Court held that taxpayers had to include in income portions of refundable state tax "credits" received from participating in a New York economic development program. The court found that, contrary to the state's characterization, the refundable credits were effectively taxable subsidies. Maines v. Comm'r, 144 T.C. No. 8 (3/11/15)

Background

The New York Empire Zones Program (EZ Program) provides incentives for businesses to stimulate private investment and business development, and tries to create jobs in impoverished areas in New York State. David and Tami Maines received these incentive payments from their participation in the EZ Program between 2005 and 2007 through their two passthrough entities, Endicott Interconnect Technologies, Inc., and Huron Real Estate Associates.

New York calls these payments "credits" and treats them as refunds for "overpayments" of state tax. All the credits required the Maines to make some amount of business expenditure or investment in targeted areas within the state. One of the credits, the QEZE Real Property Tax Credit, is limited to the amount of past real property tax actually paid. The other two credits, the EZ Investment Credit and the EZ Wage Credit, are not limited to past tax actually paid. All the credits first reduce a taxpayer's state income-tax liability; any excess credits may be carried forward to future years or partially refunded.

For 2005 to 2007, the Maines eliminated their state income-tax liability primarily through the use of other nonrefundable state credits. Because the Maines had little to no state income-tax liability in these years for the credits to offset, the refundable credits under the EZ program led to large "refund" payments from New York, which the Maines did not include on their federal income tax returns.

The IRS assessed deficiencies for 2005 to 2007, arguing that the refundable credits were, in substance, cash subsidies constituting taxable income, and the Maines challenged this determination in the Tax Court.

Analysis

State tax refunds are not income unless the taxpayer claimed a deduction for them, for example, by itemizing for the previous year (Tempel v. Comm'r, 136 T.C. 341 (2011)). Likewise, under the tax-benefit rule, a taxpayer is allowed to exclude a refund from his income only if he never got the benefit of a corresponding deduction for an earlier year (Hillsboro Nat'l Bank v. Comm'r, 460 U.S. 370 (1983)).

The Maines claimed they took no deduction on their federal income-tax returns for 2005 to 2007 for state income tax paid in the preceding years, arguing their refunds should not be included in their income under the tax benefit rule. They pointed out that their credits under the EZ Program were defined by New York state law to be "overpayments" of state income tax.

However, the Tax Court noted that the state-law label of the credits as "overpayments" of past tax was not controlling for Federal tax purposes; if that were true, a state could undermine federal tax law simply by including certain descriptive language in its statute. The court quoted Abraham Lincoln, reasoning that under the Maines' logic, "if New York called a tail a leg, we'd have to conclude that a dog has five legs in New York as a matter of federal law." Instead, the court looked to the nature of the credits to determine whether they were non-taxable refunds of overpaid state taxes.

The court observed that to qualify for the EZ Investment Credit and the EZ Wage Credit, taxpayers must own a business with property in a designated Empire Zone and have full-time employees receiving qualified EZ wages. Neither of the credits depended on a refund of previously paid state taxes deducted under federal law and instead were essentially cash subsidies from the state to incentivize taxpayers.

The court held that the portions of the EZ Investment Credits and the EZ Wage Credits that actually reduced the Maines' state-tax liabilities were not taxable income. However, any excess portions of the credits that were refundable were taxable income.

In contrast, the court noted that taxpayers receive a QEZE Real Property Tax Credit only if their business pays eligible real-property taxes, and the amount of the credit cannot exceed the amount of those taxes actually paid. Thus the refundable portion of the credit could be treated like a refund of past overpayments.

The court held the portions of the QEZE credit payments that only reduced the Maines' state-tax liabilities were not taxable income. However, the refundable portions of the credit were includible in the Maines' gross income under the tax-benefit rule to the extent that they had taken previous deductions for property-tax payments.

For a discussion on the recovery of tax benefit items, including state tax credits, see Parker ¶76,900.

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IRS Proposes "Next Day Rule" for Changes in Consolidated Group Membership

The IRS has issued proposed amendments to the consolidated return regulations, revising the rules for reporting certain items of income and deduction that are reportable on the day a corporation joins or leaves a consolidated group. The proposed regulations would affect these corporations and the consolidated groups that they join or leave. REG-100400-14 (3/6/15).

Background

The proposed regulations provide guidance under Reg. Sec. 1.1502-76, which prescribes rules for determining when items of income, gain, deduction, loss, and credit (tax items) of a corporation that joins in filing a consolidated return are included. Reg. Sec. 1.1502-76(b) provides, in part, that if a corporation becomes or ceases to be a member of a consolidated group during a consolidated return year, that corporation must include in the consolidated return its tax items for the period during which it is a member. The corporation also must file a separate return (including a consolidated return of another group) that includes its items for the period during which it is not a member.

Under the end of the day rule of Reg. Sec. 1.1502-76(b)(1)(ii)(A)(1) in the current regulations, a corporation is treated as becoming or ceasing to be a member of a consolidated group at the end of the day of the corporation's change in status, and the corporation's tax items that are reportable on that day generally are included in the tax return for the tax year that ends as a result of the corporation's change in status.

There are two exceptions to the current end of the day rule. The first exception, in Reg. Sec. 1.1502-76(b)(1)(ii)(A)(2) (S corporation exception), provides that if a corporation is an S corporation immediately before becoming a member of a consolidated group, the corporation becomes a member of the group at the beginning of the day the termination of its S corporation election is effective, and its tax year ends for all federal income tax purposes at the end of the preceding day.

The second exception, in Reg. Sec. 1.1502-76(b)(1)(ii)(B) (current next day rule), provides that if a transaction occurs on the day of the corporation's change in status that is properly allocable to the portion of the corporation's day after the event resulting in the change, the corporation and certain related persons must treat the transaction as occurring at the beginning of the following day for all federal income tax purposes.

Proposed Next Day Rule

The IRS has determined that changes should be made to Reg. Sec. 1.1502-76(b) due to uncertainty regarding the appropriate application of the current next day rule. To provide certainty, the proposed regulations clarify the period in which a corporation must report certain tax items by replacing the current next day rule with a new exception to the end of the day rule (proposed next day rule) that is more narrowly tailored to clearly reflect taxable income and prevent certain post-closing actions from adversely impacting the corporation's tax return. The proposed next day rule applies only to "extraordinary items" (as defined in Prop. Reg. Sec. 1.1502-76(b)(2)(ii)(C)) that result from transactions occurring on the day of the corporation's change in status, but after the event causing the change, and that would be taken into account by the corporation on that day.

The proposed next day rule requires those extraordinary items to be allocated to the corporation's tax return for the period beginning the next day. The proposed next day rule is expressly inapplicable to any extraordinary item that arises simultaneously with the event that causes the corporation's change in status.

The proposed regulations further clarify that fees for services rendered in connection with a corporation's change in status are an extraordinary item if they constitute a "compensation-related deduction." The proposed regulations also clarify that the anti-avoidance rule in Reg. Sec. 1.1502-76(b)(3) may apply to situations in which a person modifies an existing contract or other agreement in anticipation of a corporation's change in status.

The proposed regulations also add a rule (previous day rule) to clarify the application of the S-corporation exception. In addition, the proposed regulations limit the scope of the end of the day rule, the next day rule, the S corporation exception, and the previous day rule to determining the period in which a corporation must report certain tax items and determining the treatment of an asset or a tax item for purposes of Code Secs. 382(h) and 1374.

Additionally, the proposed regulations provide that short taxable years resulting from intercompany transactions to which Code Sec. 381(a) applies are not taken into account in determining the carryover period for a tax item of the distributor or transferor member in the intercompany Code Sec. 381 transaction or for purposes of Code Sec. 481(a). Furthermore, the proposed regulations provide that the due date for filing a corporation's separate return for the taxable year that ends as a result of the corporation becoming a member is not accelerated if the corporation ceases to exist in the same consolidated return year.

The proposed regulations make several other conforming and non-substantive changes to the current regulations, along with adding several examples to illustrate the proposed rules. The IRS notes that neither the current regulations nor the proposed regulations are intended to supersede general rules in the Code and regulations concerning whether an item is otherwise includible or deductible.

The proposed regulations are not effective until finalized.

For a discussion of consolidated income tax returns for corporations, see Parker Tax ¶42,120.

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