Proposed Partnership Regs Would Change Rules on Disguised Sales and Allocation of Liabilities

On January 29, the IRS issued lengthy proposed regulations on disguised sales of property to or by a partnership, as well as proposed regulations dealing with the treatment of partnership liabilities. The aim of the proposed regulations is to address certain deficiencies and technical ambiguities in the current regulations and issues in determining a partner's share of liabilities under Code Sec. 752. The proposed regulations affect partnerships and their partners and, if adopted, would substantially affect the tax treatment of many partnership transactions. The regulations, issued in REG-119305-11 (1/30/11), are not effective until finalized.

Proposed Changes to the Recourse Liability Rules

Under Reg. Sec. 1.752-2, a partner's share of a recourse partnership liability equals the portion of the liability, if any, for which the partner or related person bears the economic risk of loss. A partner generally bears the economic risk of loss for a partnership liability to the extent the partner, or a related person, would be obligated to make a payment if the partnership's assets were worthless and the liability became due and payable. Subject to an anti-abuse rule and the disregarded entity net value requirement, Reg. Sec. 1.752-2(b)(6) assumes that all partners and related persons will actually satisfy their payment obligations, irrespective of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation (i.e., the satisfaction presumption). Thus, for purposes of allocating partnership liabilities, Reg. Sec. 1.752-2 adopts an ultimate liability test under a worst-case scenario. Under this test, the regulations would generally allocate an otherwise nonrecourse liability of the partnership to a partner that guarantees the liability even if the lender and the partnership reasonably anticipate that the partnership will be able to satisfy the liability with either partnership profits or capital.

The IRS believes that the approach of the existing regulations is not appropriate given that, in most cases, a partnership will satisfy its liabilities with partnership profits, the partnership's assets do not become worthless, and the payment obligations of partners or related persons are not called upon. The concern is that some partners or related persons have entered into payment obligations that are not commercial solely to achieve an allocation of a partnership liability to such partner.

Certain Factors Must Be Present for Liabilities To Be Recognized

As a result, the proposed regulations provide a rule that obligations to make a payment with respect to a partnership liability (excluding those imposed by state law) will not be recognized for purposes of Code Sec. 752 unless certain factors are present. According to the IRS, these factors, if satisfied, will establish that the terms of the payment obligation are commercially reasonable and are not designed solely to obtain tax benefits. Specifically, the rule requires a partner or related person to maintain a commercially reasonable net worth during the term of the payment obligation or be subject to commercially reasonable restrictions on asset transfers for inadequate consideration. In addition, the partner or related person must provide commercially reasonable documentation regarding its financial condition and receive arm's-length consideration for assuming the payment obligation. The rule also requires that the payment obligation's term must not end before the term of the partnership liability and that the primary obligor or any other obligor must not be required to hold money or other liquid assets in an amount that exceeds the reasonable needs of such obligor. The rule would also prevent certain so-called bottom-dollar guarantees from being recognized for purposes of Code Sec. 752.

Observation: A bottom-dollar guarantee is a guarantee of the last dollar of debt. It usually provides that the guarantor is not obligated to make any payments until all attempts at collection have failed to produce repayment to the lender of a specified amount.

Because the IRS feels that because certain partners or related persons might attempt to use certain structures or arrangements to circumvent the rules included in the proposed regulations with respect to bottom-dollar guarantees, the IRS has also revised the anti-abuse rule in Reg. Sec. 1.752-2(j) to address the use of intermediaries, tiered partnerships, or similar arrangements to avoid the bottom-dollar guarantee rules.

Prop. Regs Extend Net Value Requirement

The IRS noted that the satisfaction presumption does not apply to disregarded entities and believes that rule should be extended to other circumstances. Thus, the proposed regulations turn off the satisfaction presumption by extending the net value requirement of Reg. Sec. 1.752-2(k) to all partners or related persons, including grantor trusts, other than individuals and decedents' estates for payment obligations associated with liabilities that are not trade payables. The net value requirement of Reg. Sec. 1.752-2(k) provides that, in determining the extent to which a partner bears the economic risk of loss for a partnership liability, a payment obligation of a disregarded entity is taken into account only to the extent of the net value of the disregarded entity as of the allocation date.

In situations in which the satisfaction presumption is turned off, the proposed regulations provide that the partner's or related person's payment obligation is recognized only to the extent of the partner's or related person's net value as of the allocation date. A partner or related person that is not a disregarded entity is treated as a disregarded entity for purposes of determining net value.

Observation: The IRS considered further extending the net value requirement to partners and related persons that are individuals and decedent's estates, but decided not to require such persons to comply with the net value requirement because of the nature of personal guarantees. However, applying this less restrictive standard to individuals and decedent's estates may disadvantage other entities that enter into partnerships with individuals or decedents' estates. Thus, the IRS is requesting comments on whether the final regulations should extend the net value requirement to all partners and related persons.

Payment Obligations Reduced by Any Reimbursement Right

In determining the amount of any obligation of a partner to make a payment to a creditor or a contribution to the partnership with respect to a partnership liability, Reg. Sec. 1.752-2(b)(1) reduces the partner's payment obligation by the amount of any reimbursement that the partner would be entitled to receive from another partner, a person related to another partner, or the partnership. After considering whether a right to be reimbursed for a payment or contribution by an unrelated person (for example, under an indemnification agreement from a third party) should be taken into account in the same manner, the IRS has concluded that any source of reimbursement that effectively eliminates a partner's payment risk should cause a payment obligation to be disregarded. Therefore, the proposed regulations provide that a partner's payment obligation is reduced by the amount of any right to reimbursement from any person.

Proposed Changes to Nonrecourse Liability Rules

Reg. Sec. 1.752-3 contains rules for determining a partner's share of a nonrecourse liability of a partnership, including the partner's share of excess nonrecourse liabilities under Reg. Sec. 1.752-3(a)(3). Various methods may be used to determine a partner's share of the excess nonrecourse liabilities. Under one method, a partner's share of excess nonrecourse liabilities is determined in accordance with the partner's share of partnership profits. For this purpose, the partnership agreement may specify the partners' interests in partnership profits so long as the interests so specified are reasonably consistent with allocations (that have substantial economic effect under the Code Sec. 704(b) regulations) of some other significant item of partnership income or gain (i.e., the significant item method). Alternatively, excess nonrecourse liabilities may be allocated among the partners in the manner that deductions attributable to those liabilities are reasonably expected to be allocated (i.e., the alternative method). Similar to the significant item method, a partnership agreement is allowed to allocate nonrecourse deductions in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liability.

Significant Item Method and Alternative Method Not Appropriate for Allocating Excess Nonrecourse Liabilities

According to the IRS, the allocation of excess nonrecourse liabilities in accordance with the significant item method and the alternative method may not properly reflect a partner's share of partnership profits that are generally used to repay such liabilities because the allocation of the significant item may not necessarily reflect the overall economic arrangement of the partners. Therefore, the proposed regulations remove the significant item method and the alternative method from Reg. Sec. 1.752-3(a)(3).

Liquidation Value Percentage Would Determine Partner's Interest in Profits

The IRS noted the difficulty in determining a partner's interest in partnership profits in other than very simple partnerships and concluded that an appropriate proxy of a partner's interest in partnership profits, and one that can provide the needed certainty, is a partner's liquidation value percentage. Thus, in order to have a bright-line measure of a partner's interest in partnership profits, the proposed regulations adopt a liquidation value percentage approach. Thus, a partner's liquidation percentage, determined upon formation of the partnership and redetermined upon the most recent occurrence of an event described in Reg. Sec. 1.704-1(b)(2)(iv)(f)(5) (i.e., revaluations made principally for a substantial non-tax business purpose), whether or not the capital accounts of the partners are adjusted, would be used to determine a partner's interest in partnership profits. A partner's liquidation value percentage is the ratio (expressed as a percentage) of the liquidation value of the partner's interest in the partnership to the liquidation value of all of the partners' interests in the partnership.

Observation: According to the IRS, the liquidation value approach may not precisely measure a partner's interest in partnership profits, but the IRS believes that the approach is a better proxy than the significant item and alternative methods and is still administrable. The IRS is asking practitioners for comments on other methods that reasonably measure a partner's interest in partnership profits that are not overly burdensome. In addition, the IRS is requesting comments on whether exceptions should be provided to exclude certain events from triggering a redetermination of the partners' liquidation values.

Proposed Changes to Disguised Sale Rules

In 1992, the IRS issued final regulations under Code Sec. 707(a)(2) relating to disguised sales of property to and by partnerships. No major changes have been made to the rules since then.

Reg. Sec. 1.707-3 generally provides that a transfer of property by a partner to a partnership followed by a transfer of money or other consideration from the partnership to the partner is treated as a sale of property by the partner to the partnership if, based on all the facts and circumstances, the transfer of money or other consideration would not have been made but for the transfer of the property and, for non-simultaneous transfers, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership.

The IRS noted that there are certain deficiencies and technical ambiguities in the existing regulations under Reg. Secs. 1.707-3, 1.707-4, and 1.707-5, and that it is seeking to fix these items with the proposed regulations.

New Ordering Rule Would Apply Debt-Financed Distribution Exception First

There are several exceptions to the disguised sale rules. One of the exceptions is Reg. Sec. 1.707-5(b), which generally provides that a distribution of money to a partner is not taken into account for purposes of the disguised sale rules to the extent the distribution is traceable to a partnership borrowing and the amount of the distribution does not exceed the partner's allocable share of the liability incurred to fund the distribution. This is known as the debt-financed distribution exception. Under a special rule in the existing regulations, if a partnership transfers to more than one partner pursuant to a plan all or a portion of the proceeds of one or more liabilities, the debt-financed distribution exception is applied by treating all the liabilities incurred pursuant to the plan as one liability. Thus, partners who are allocated shares of multiple liabilities are treated as being allocated a share of a single liability, to which any distributee partner's distribution of debt proceeds relates, rather than a share of each separate liability.

According to the IRS, there is uncertainty as to whether the amount of money transferred to a partner that is traceable to a partnership liability is reduced by any portion of the amount that is also excluded from disguised sale treatment under one or more of the other exceptions in Reg. Sec. 1.707-4 (e.g., because the transfer of money is also properly treated as a reasonable guaranteed payment). Thus, the proposed regulations provide that treatment of a transfer should first be determined under the debt-financed distribution exception, and any amount not excluded under that exception should be tested to see if such amount would be excluded under a different exception in Reg. Sec. 1.707-4. This ordering rule, the IRS said, will ensures that the application of one of the exceptions in Reg. Sec. 1.707-4 does not minimize the application of the debt-financed distribution exception.

Changes Made to Exception for Preformation Capital Expenditures

Currently, Reg. Sec. 1.707-4(d) provides an additional exception to the disguised sale rules for reimbursements of preformation expenditures. Under that exception, transfers to reimburse a partner for certain capital expenditures and costs incurred are not treated as part of a sale of property (i.e., the exception for preformation capital expenditures). The proposed regulations amend the exception for preformation capital expenditures to address three issues. First, the proposed regulations provide how the exception for preformation capital expenditures applies in the case of multiple property transfers. The exception generally applies only to the extent the reimbursed capital expenditures do not exceed 20 percent of the fair market value of such property at the time of the contribution. This fair market value limitation, however, does not apply if the fair market value of the contributed property does not exceed 120 percent of the partner's adjusted basis in the contributed property at the time of the contribution. The provision applies to the single property for which the expenditures were made. Accordingly, in the case of multiple property contributions, the proposed regulations provide that the determination of whether the fair market value limitation and the exception to the fair market value limitation apply to reimbursements of capital expenditures is made separately for each property that qualifies for the exception. Second, the proposed regulations clarify the scope of the term "capital expenditures," and lastly, the proposed regulations provide a rule coordinating the exception for preformation capital expenditures and the rules regarding liabilities traceable to capital expenditures.

Addition of a New Qualified Liability Type

Reg. Sec. 1.707-5(a)(6) provides four types of liabilities that are qualified liabilities that are generally excluded from disguised sale treatment. With respect to two of the types of liabilities, there is a requirement that the liabilities encumber the transferred property. That requirement exists where a liability is incurred in the ordinary course of the trade or business in which property transferred to the partnership was used or held, but only if all the assets that are material to that trade or business are transferred to the partnership (i.e., ordinary course qualified liability). According to the IRS, the requirement that the liability encumber the transferred property is not necessary to carry out the purposes of the disguised sale rules when a liability was incurred in connection with the conduct of a trade or business, provided the liability was not incurred in anticipation of the transfer and all the assets material to that trade or business are transferred to the partnership. Accordingly, the proposed regulations add an additional definition of qualified liability to account for this type of liability.

Netting Rules Apply to Disguised Sales

Reg. Sec. 1.752-1(f) provides for netting of increases and decreases in a partner's share of liabilities resulting from a single transaction. Under that rule, increases and decreases in partnership liabilities associated with a merger or consolidation are netted by the partners in the terminating partnership and the resulting partnership to determine the effect of a merger under Code Sec. 752. The IRS believes that similar netting rules should apply with respect to the disguised sale rules and, accordingly, the proposed regulations extend the principles of Reg. Sec. 1.752-1(f) to determine the effect of the merger under the disguised sale rules.

New Rules for Tiered Partnerships

The proposed regulations add additional rules regarding tiered partnerships. First, they clarify that the debt-financed distribution exception applies in a tiered partnership setting. Second, the proposed regulations provide rules regarding the characterization of liabilities attributable to a contributed partnership interest. Currently, a partner that contributes an interest in a partnership (lower-tier partnership) to another partnership (upper-tier partnership) must take into account its share of liabilities from the lower-tier partnership. The IRS believes it is appropriate to treat the lower-tier partnership as an aggregate for purposes of determining whether the upper-tier partnership's share of the liabilities of the lower-tier partnership are qualified liabilities. Thus, the proposed regulations provide that a contributing partner's share of liabilities from a lower-tier partnership is treated as qualified liabilities to the extent the liability would be a qualified liability had the liability been assumed or taken subject to by the upper-tier partnership in connection with a transfer of all of the lower-tier partnership's property to the upper-tier partnership by the lower-tier partnership.

Clarification of Anticipated Reduction Rule

Under the existing disguised sale rules, a partner's share of a liability assumed or taken subject to by a partnership is determined by taking into account certain subsequent reductions in the partner's share of the liability. Specifically, a subsequent reduction in a partner's share of a liability is taken into account if (1) at the time the partnership incurs, assumes, or takes property subject to the liability, it is anticipated that the partner's share of the liability will be subsequently reduced; and (2) the reduction is part of a plan that has as one of its principal purposes minimizing the extent to which the distribution or assumption of, or taking property subject to, the liability is treated as part of a sale (the anticipated reduction rule). According to the IRS, practitioners are uncertain as to when a reduction is anticipatory because it is generally anticipated that all liabilities will be repaid.

Under the proposed regulations, a reduction that is subject to the entrepreneurial risks of partnership operations is not an anticipated reduction. The proposed regulations also provide that, if within two years of the partnership incurring, assuming, or taking property subject to the liability, a partner's share of the liability is reduced due to a decrease in the partner's or a related person's net value, then the reduction will be presumed to be anticipated, unless the facts and circumstances clearly establish that the decrease in the net value was not anticipated. Any such reduction must be disclosed.

Effective Date and Transition Rules

The proposed regulations are not effective until finalized. In addition, the proposed regulations provide transitional relief for any partner whose allocable share of partnership liabilities under Reg. Sec. 1.752-2 exceeds its adjusted basis in its partnership interest on the date the proposed regulations are finalized. Under this transitional relief, the partner can continue to apply the existing regulations under Reg. Sec. 1.752-2 for a seven-year period to the extent the partner's allocable share of partnership liabilities exceeds the partner's adjusted basis in its partnership interest on the date the proposed regulations are finalized. The amount of partnership liabilities subject to transitional relief will be reduced for certain reductions in the amount of liabilities allocated to that partner under the transition rules and, upon the sale of any partnership property, for any excess of tax gain (including Code Sec. 704(c) gain) allocated to the partner less the partner's share of amount realized.

[Return to Table of Contents]

Final Regs Delay Implementation of Employer-Mandate for Some Medium-Sized Businesses

Late Monday, the IRS issued final regulations (T.D. 9655 (2/12/14)) implementing the shared responsibility provisions for employee health coverage required under Code Sec. 4980H, as enacted by the Affordable Care Act.

Under the employer shared responsibility provisions, if employers to whom the rules apply do not offer affordable health coverage that provides a minimum level of coverage to their full-time employees (and their dependents), the employer may be subject to an employer shared responsibility payment if at least one of its full-time employees receives a premium tax credit for purchasing individual coverage on one of the new Affordable Insurance Exchanges, also called a Health Insurance Marketplace.

The employer shared responsibility provisions apply to employers that have 50 or more full-time employees. According to a Treasury Department fact sheet, approximately 96 percent of employers are small businesses that have fewer than 50 workers and thus are exempt from the employer shared responsibility provisions. The final regulations provide that to avoid having to pay a penalty for failing to offer health coverage, employers subject to the rules need to offer coverage to 70 percent of their full-time employees in 2015 and 95 percent in 2016 and beyond.

In what is good news for businesses with 50 or more full-time employees but less than 100 of such employees, compliance with the final regulations was postponed by one year. Under the final regulations, the employer responsibility provision will generally apply to larger firms with 100 or more full-time employees starting in 2015, and to employers with 50 or more but fewer than 100 full-time employees starting in 2016.

Observation: The IRS said it will issue final regulations shortly that aim to substantially simplify and streamline the employer reporting requirements.

Regs Clarify the Definition of Full-time Employees

The final regulations provide clarifications of whether employees of certain types, or in certain occupations and professions, are considered full-time, including:

• Volunteers: Hours contributed by bona fide volunteers for a government or tax-exempt entity, such as volunteer firefighters and emergency responders, will not cause them to be considered full-time employees.
• Educational employees: Teachers and other educational employees will not be treated as part-time for the year simply because their school is closed or operating on a limited schedule during the summer.
• Seasonal employees: Those in positions for which the customary annual employment is six months or less generally will not be considered full-time employees.
• Student work-study programs: Service performed by students under federal or state-sponsored work-study programs will not be counted in determining whether they are full-time employees.
• Adjunct faculty: The final regulations provide as a general rule that employers of adjunct faculty are to use a method of crediting hours of service for those employees that is reasonable in the circumstances and consistent with the employer responsibility provisions. However, to accommodate the need for a "bright line" approach suggested by practitioners, the final regulations expressly allow crediting an adjunct faculty member with 2.25 hours of service per week for each hour of teaching or classroom time as a reasonable method.

Optional Look-Back Measurement for Determining if an Employee Is Full-Time

Like the proposed regulations, the final rules allow employers to use an optional look-back measurement method to make it easier to determine whether employees with varying hours and seasonal employees are full-time. Under this measurement, employers may determine the status of an employee as a full-time employee during a subsequent period (referred to as the stability period), based on the hours of service of the employee in a prior period (referred to as the measurement period). Also as in the proposed regulations, the final regulations provide a method under which special unpaid leave and employment break periods during a measurement period are not treated as a period during which zero hours of service are credited when applying the look-back measurement method.

Affordability Safe Harbors

Like the proposed regulations, the final rules provide safe harbors that make it easy for employers to determine whether the coverage they offer is affordable to employees. These safe harbors permit employers to use the wages they pay, their employees' hourly rates, or the federal poverty level in determining whether employer coverage is affordable under the ACA.

Transition Rules Extended to 2015

Limited transition rules that applied to 2014 under the proposed regulations have been extended under the final regulations to 2015, including:

(1) Employers first subject to shared responsibility provision: Employers can determine whether they had at least 100 full-time or full-time equivalent employees in the previous year by reference to a period of at least six consecutive months, instead of a full year. This will help facilitate compliance for employers that are subject to the employer shared responsibility provision for the first time.

(2) Non-calendar-year plans: Employers with plan years that do not start on January 1 will be able to begin compliance with employer responsibility at the start of their plan years in 2015 rather than on January 1, 2015, and the conditions for this relief are expanded to include more plan sponsors.

(3) Dependent coverage: The policy that employers offer coverage to their full-time employees' dependents will not apply in 2015 to employers that are taking steps to arrange for such coverage to begin in 2016.

(4) On a one-time basis, in 2014 preparing for 2015, plans may use a measurement period of six months even with respect to a stability period the time during which an employee with variable hours must be offered coverage of up to 12 months.

Observation: The IRS noted that as these limited transition rules take effect, it will consider whether it is necessary to further extend any of them beyond 2015.

[Return to Table of Contents]

D.C. Circuit Affirms Loving Decision; IRS Can't Regulate Unlicensed Tax Preparers

On February 11, in a decision that will be a disappointment to many CPAs and enrolled agents, the U.S. Court of Appeals for the District of Columbia Circuit affirmed a district court's holding that the IRS does not have the authority to regulate tax return preparers. In Loving v. IRS, 2014 PTC 73 (D.C. Cir. 2/11/14), the D.C. Circuit concluded that the IRS's authority to regulate the practice of representatives of persons before the Treasury Department did not encompass the authority to regulate tax-return preparers.

Observation: The IRS has several choices now. It could do nothing, which is unlikely. Or it could appeal to the Supreme Court. But the most likely scenario would be for it to appeal to Congress to legislatively overturn the Loving decision.  

The regulations had been seen by CPAs and enrolled agents as a way to level the playing field. Without the regulations, they are at a clear disadvantage because they are required to comply with competency and quality control regulations under IRS Circular 230, while unlicensed tax return preparers are not.

Background

In 2011, the IRS began requiring all tax return preparers to have a preparer tax identification number (PTIN). Additionally, the IRS issued regulations requiring preparers to pass a qualifying exam, pay annual fees, and complete 15 hours of continuing-education courses each year. The regulations exempted certain tax return preparers, such as attorneys, CPAs, and enrolled agents, from the testing requirements because they have their own testing requirements. According to the IRS, it has authority to issue such regulations under Section 330 of Title 31. That provision, enacted by Congress, authorizes the Secretary of the Treasury and by extension, the IRS, a subordinate agency within the Treasury Department to regulate the practice of representatives of persons before the Department of the Treasury.

In 2012, three independent tax-return preparers brought a suit against the IRS in the U.S. District Court for the District of Columbia, arguing that the IRS exceeded its authority in issuing the return-preparer regulations. On January 18, 2013, in Loving v. IRS, 2013 PTC 10 (D.C. D.C. 1/18/13), the district court agreed and held that the regulations were invalid and that the IRS could not enforce them.

The IRS appealed to the D.C. Circuit and, in an unusual move, five former IRS Commissioners, appointed by Democratic and Republican presidents, came together to file an amicus brief (2013 PTC 64) before the D.C. Circuit Court. In that brief, the former Commissioners strongly disagreed with the D.C. district court's decision.

D.C. Circuit's Analysis

The D.C. Circuit began its analysis by noting that the crux of this case was whether the IRS's authority to regulate the practice of representatives of persons before the Department of the Treasury encompasses the authority to regulate tax-return preparers. According the court, there were at least six reasons why this was not so.

First, the court said, was the meaning of the key statutory term "representatives." The court dismissed the IRS's assertion that there "can be no serious dispute that paid tax-return preparers are representatives of persons." The court noted that the IRS never explained how a tax return preparer represents a taxpayer. The term "representative" is traditionally and commonly defined as an agent with authority to bind others, a description that the court said did not fit tax-return preparers.

Second was the meaning of the phrase "practice . . . before the Department of the Treasury." According to the court, while the IRS has long regulated service professionals such as attorneys and accountants who appear as representatives of taxpayers in adversarial tax proceedings before the IRS, the new regulations expanded the definition of "practice" to cover tax-return preparers. To be sure, the court observed, preparing and signing tax returns could be considered a "practice" of sorts, particularly if the tax-return preparer is providing advice or making judgment calls about a taxpayer's liability. But, the court said, Section 330 does not regulate the act of "practice" in the abstract. The statute instead addresses "practice . . . before the Department of the Treasury."

Third was the history of Section 330. The original language of the provision, the court noted, plainly would not encompass tax-return preparers. Even after tax-return preparation became a significant industry, Congress did not broaden the language. The fact that Congress used the words "agents," "attorneys," "claimants," "otherwise," and "presentation of their cases" in the original version of the statute, the court said, and the fact that Congress then expressly stated in the statute itself that it intended no change in meaning when it streamlined the statute in 1982, further indicated to the court that the statute contemplates representation in a contested proceeding, not simply assistance in preparing a tax return.

Fourth was the broader statutory framework. The court noted that it is a fundamental canon of statutory construction that the words of a statute must be read in their context and with a view to their place in the overall statutory scheme. Yet, the court observed, accepting the IRS's view of Section 330(a)(1) would effectively gut Congress's carefully articulated existing system for regulating tax-return preparers.

Fifth was the nature and scope of the authority being claimed by the IRS. The Supreme Court has stated that courts should not lightly presume congressional intent to implicitly delegate decisions of major economic or political significance to agencies. According to the court, if it were to accept the IRS's interpretation of Section 330, the IRS would be empowered for the first time to regulate hundreds of thousands of individuals in the multi-billion-dollar tax-preparation industry. Yet, the court observed, nothing in the statute's text or the legislative record contemplates that vast expansion of the IRS's authority.

The sixth and final reason the court gave for affirming the lower court's decision was the IRS's past approach to this statute. Until 2011, the IRS never interpreted the statute to give it authority to regulate tax-return preparers. Nor did the IRS ever suggest that it possessed this authority but simply chose, in its discretion, not to exercise it. The IRS is free to change (or refine) its interpretation of a statute it administers, the court stated. But the interpretation, whether old or new, must be consistent with the statute. And in the circumstances of this case, the court found it rather telling that the IRS had never before maintained that it possessed this authority.

[Return to Table of Contents]

IRS Provides Safe Harbor for Debt Secured by an Interest in a Disregarded Entity

Cancellation of a debt generally results in taxable income. Often, debt is discharged because the taxpayer doesn't have the money to pay the debt. The additional income to the taxpayer is problematic because the taxpayer usually doesn't have the money to pay the taxes on the income either.

Special rules apply, however, to the discharge of qualified real property business indebtedness (QRPBI). The discharge of QRPBI can be excluded from income if the debt was incurred or assumed by the taxpayer in connection with real property used in a trade or business and the debt was secured by such real property. This exception is especially useful in times of declining property values, where a taxpayer may find himself underwater with respect to real property used in the taxpayer's business.

An issue practitioners have faced with respect to clients seeking to use this exception is the fact that neither the Code nor the legislative history define what is meant by "secured by such real property." Often, for liability reasons or at the request of lenders, a taxpayer will set up a single-member LLC (SMLLC) to hold real property used in a trade or business. The question practitioners were confronted with was whether debt obtained to purchase the property and secured by an interest in an SMLLC was "debt secured by such real property." In Rev. Proc. 2014-20, the IRS answered "yes," as long as certain conditions are met.

Rules for Excluding Discharge of QRPBI from Income

Under Code Sec. 108(a)(1)(D), income from the discharge of debt is excluded from gross income if, in the case of a taxpayer other than a C corporation, the debt discharged is QRPBI. Code Sec. 108(c)(3) provides that, to qualify as QRPBI, the debt must be incurred or assumed by the taxpayer in connection with real property used in a trade or business and be secured by such real property. In addition, the taxpayer must make an election to treat the debt as QRPBI. Qualified farm indebtedness does not qualify as QRPBI.

QRPBI must be debt that was incurred or assumed before January 1, 1993, or if the debt was incurred or assumed on or after January 1, 1993, it must be qualified acquisition indebtedness. Qualified acquisition indebtedness is debt incurred or assumed to acquire, construct, reconstruct, or substantially improve real property used in a trade or business. QRPBI also includes debt resulting from the refinancing of debt, but only to the extent it does not exceed the amount of debt being refinanced.

The amount of the exclusion is subject to two limitations:

(1) a limitation based on the fair market value of the real property securing the debt, and

(2) an overall limitation based on the adjusted bases of all depreciable real property held by the taxpayer.

Under the first limitation, the amount of the exclusion is limited to the excess of: (1) the outstanding principal amount of the debt, over (2) the net fair market value of the real property securing the debt.

Both amounts are measured immediately before the discharge. The net fair market value of the real property securing the debt is its fair market value, reduced by the outstanding principal amount of any other qualified real property business debt that is secured by it immediately before and after the discharge.

Under the second limitation, the amount of the exclusion is limited to the aggregate adjusted bases of depreciable real property held by the taxpayer immediately before the discharge (other than depreciable real property acquired in contemplation of the discharge), reduced by the sum of: (1) any depreciation claimed for the year of the discharge; and (2) any reductions to the adjusted bases of depreciable real property for the year of the discharge.

This exclusion does not apply to a cancellation of debt in a title 11 bankruptcy case or to the extent the taxpayer was insolvent immediately before the cancellation. If qualified real property business debt is canceled in a title 11 bankruptcy case, the taxpayer must apply the bankruptcy exclusion rather than the exclusion for canceled qualified real property business debt. If the taxpayer was insolvent immediately before the cancellation of QRPBI, the taxpayer must apply the insolvency exclusion before applying the exclusion for canceled qualified real property business debt.

As noted above, to qualify for this exclusion, the debt must be secured by the real property upon which the debt is incurred. Neither the Code nor the legislative history contains any explanation of, or definition for, the term "secured by such real property."

Rev. Proc. 2014-20

According to the IRS, while mortgages are commonly used by lenders to secure an interest in real estate, there is no suggestion in the legislative history that mortgages are the exclusive form of security for purposes of the exclusion from income of the discharge of QRPBI. The fact that the Code does not limit the security interest to a mortgage, the IRS said, indicates an intent to include a broader range of security interests. As a result, the IRS issued Rev. Proc. 2014-20 to provide taxpayers with a safe harbor under which debt that is secured by a 100 percent ownership interest in a disregarded entity holding real property will be treated as debt that is secured by real property for purposes of cancellation-of-debt rules for QRPBI. 

Observation: A taxpayer that does not meet the requirements of this safe harbor is not precluded from arguing, based on facts and circumstances, that its debt satisfies the "secured by" requirement.

Taxpayers, other than C corporations, may avail themselves of the safe harbor in Rev. Proc. 2014-20 if they meets all of the following requirements:

(1) The taxpayer or a wholly owned disregarded entity of the taxpayer (i.e., the borrower) incurs indebtedness.

(2) The borrower directly or indirectly owns 100 percent of the ownership interest in a separate disregarded entity owning real property (i.e., the property owner). The borrower cannot be the same entity as the disregarded entity.

(3) The borrower pledges to the lender a first priority security interest in the borrower's ownership interest in the disregarded entity. Any further encumbrance on the pledged ownership interest must be subordinate to the lender's security interest in the disregarded entity.

(4) At least 90 percent of the fair market value of the total assets (immediately before the discharge) directly owned by the disregarded entity must be real property used in a trade or business, and any other assets held by the disregarded entity must be incidental to the acquisition, ownership, and operation of the real property by the disregarded entity.

(5) Upon the default and foreclosure on the debt, the lender will replace the borrower as the sole member of disregarded entity.

Debt that satisfies these requirements will be treated as debt secured by real property for purposes of the exclusion from income of discharged QRPBI.

Effective Date

Rev. Proc. 2014-20 is effective for taxpayers who make an election to exclude the discharge of QRPBI from income on or after February 5, 2014.

[Return to Table of Contents]

Taxpayer's Job Was Temporary and His Tax Home Was Missouri, Not Florida

The fact that a Florida taxpayer's apartment lease in Missouri was scheduled to expire in less than a year, along with the fact that he negotiated an addendum for possibly terminating the lease earlier, indicated to the court that the taxpayer's job in Missouri was temporary and not indefinite; thus, Missouri was not his tax home, and his unreimbursed business expenses were deductible. Snellman v. Comm'r, T.C. Summary 2014-10 (2/3/14).

Roj Snellman was unemployed during the first several months of 2009. In May, he began work as a project manager for U.S. Fidelis, Inc. in Wentzville, Missouri. Fidelis hired Roj to manage the development of an automated interactive system to track its customers' credit card payments. Fidelis informed Roj that he would be paid an annual salary of $90,000, but expected the credit card project to be completed no later than December 31, 2009, and Roj's employment would end at that time. A Fidelis representative told Roj that he would not be reimbursed for expenses related to his employment.

On May 24, 2009, Roj drove from his home in Florida to Missouri. He stayed in a hotel in Missouri from May 25 to June 10, 2009. On June 11, 2009, Roj signed a lease agreement to rent an apartment in St. Charles, Missouri, for $525 per month through December 31, 2009. The apartment was approximately 18 miles from Fidelis' offices. Roj negotiated an addendum to the lease agreement that stated that if he lost his job with Fidelis and provided the landlord with 30 days' written notice, he would be able to terminate the lease without having to pay a "lease break fee." Fidelis began to experience financial difficulties, and Roj's job ended abruptly on November 2, 2009. After collecting his final paycheck, Roj drove back to Florida on November 18.

For 2009, Roj filed a joint tax return with his wife, Patricia. They attached Schedule A and Form 2106-EZ, Unreimbursed Employee Business Expenses, to the return. Roj reported that he drove his vehicle 7,381 miles in connection with his Fidelis job and, applying the standard mileage rate of 55 cents per mile, he reported total vehicle expenses of $4,060. He also reported expenses for travel while away from home of $27,200. He derived this amount by multiplying 160 days (the total number of days he spent in Missouri) by a per diem rate of $170 for meals, incidental expenses, and lodging. The IRS disallowed the deductions for lack of substantiation and on the ground the expenses were not ordinary and necessary business expenses. According to the IRS, Wentzville, Missouri, was Roj's tax home, and thus he could not deduct expenses relating to his job in Wentzille. The IRS also said that the Snellmans failed to properly compute the deduction for meal expenses in accordance with Code Sec. 274(n), and that they were not entitled to compute the amount of any lodging deduction on a per diem basis.

Code Sec. 162(a)(2) allows a taxpayer to deduct travel expenses, including expenditures for meals and lodging, if the expenses are reasonable and necessary, incurred while away from home, and made in pursuit of a trade or business. Although the term "home" (or "tax home") in Code Sec. 162(a)(2) normally means a taxpayer's principal place of employment (and not the taxpayer's personal residence), there is an exception to this rule when a taxpayer accepts a job away from his or her personal residence and the job is temporary rather than indefinite. A job is considered temporary if it is expected to last for only a short period. Cod Sec. 162(a) provides that a taxpayer will not be considered as temporarily away from home during any period of employment if such period exceeds one year.

Observation: The purpose underlying this exception is to relieve the taxpayer of the burden of duplicate living expenses while at a temporary employment location, since it would be unreasonable to expect him to move his residence under such circumstances.

At trial, Roj presented a mileage log that he admitted assembling after receiving the IRS notice of deficiency.

The Tax Court held that Florida was Roj's tax home, not Missouri. According to the court, this determination was supported by the fact that Roj's apartment lease was scheduled to expire on December 31 and that he negotiated an addendum for terminating the lease on short notice. Because the mileage log failed to meet the strict substantiation requirements of Code Sec. 274(d), the court found it of little value. However, the court noted, there was no doubt that Roj drove from Florida and back in May and November of 2009 and it thus allowed a deduction for vehicle expenses of $1,215 (before the 2 percent floor) to account for the travel cost of transportation to and from Missouri.

With respect to the per diem expenses, the court concluded that Roj spent 137 days in Missouri for business purposes and was entitled to deduct $59 per day for meal and entertainment expenses. The court then applied the 50 percent reduction provided for in Code Sec. 274(n). With respect to Roj's lodging expenses, the court noted that lodging expenses paid or incurred by an employee while away from home are not eligible to be computed on the basis of a per diem allowance. Because Roj could not substantiate the amount spent on the hotel he stayed in before he obtained the leased apartment, no deduction was allowed for the hotel. However, even though Roj did not have canceled checks or receipts showing that he actually paid the $525 monthly rent for the full term of the lease, the court said his testimony regarding his living arrangements was forthright and credible. Consequently, the court concluded that the Snellmans could deduct lodging expenses of $2,975, comprising a pro rata share of the monthly rental charge for June and full monthly charges for July through November.

For a discussion of the requirements for deducting expenses for travel away from home, see Parker Tax, ¶91,105.

[Return to Table of Contents]

"Gentlemen's Club" Owner Liable for Penalties for Filing False Returns

An owner of a strip club who admittedly filed false corporate tax returns was liable for the 75 percent fraud penalty because his conduct of transferring large amounts of cash from the company to his personal bank account and maintaining two sets of sales ledgers to conceal the company's actual receipts established the requisite fraudulent intent. Potter v. Comm'r., T.C. Memo. 2014-18 (1/27/14).

John Potter owned and operated Potter's Pub, Inc. in Jackson, Michigan. Potter's Pub was a cash-based business that sold food and beverages, charged a cover charge, collected receipts from a juke box and from renting pool tables, and collected money from its dancers for the privilege of "dancing." As president, John signed and filed the company's Forms 1120, U.S. Corporation Income Tax Return. Those returns reported losses for years 2002 and 2003 and zero taxable income for 2004 and 2005. John filed individual tax returns, but his returns for 2002 and 2003 were untimely. John reported no wages, dividends, or other income from Potter's Pub for any of the years at issue.

In December 2006, undercover IRS agents posing as buyers interested in acquiring Potter's Pub met with John. John assured the agents that Potter's Pub was much more profitable than it appeared. He explained that he deposited in the corporate account only enough of the business revenues to cover the company's expenses and that he wired the balance of the revenue to his personal bank account in Florida. These wire transfers were structured in amounts less than $10,000 to avoid reporting obligations by the bank to the IRS. In reality, John told the agents, Potter's Pub grossed more than $1 million annually and he took home between $400,000 and $520,000 each year. John showed the agents clandestine sales ledgers for 2003 and 2004 that supported the gross receipts he claimed, acknowledging that it might have been unwise to maintain documentary evidence of his skimming. During a subsequent search of Potter's Pub, IRS agents seized upwards of $200,000 in cash and obtained the set of clandestine sales ledgers. The ledgers confirmed that Potter's Pub's annual receipts for 2002-05 were vastly in excess of the amounts that John had reported to the IRS. The difference between its actual gross receipts and the gross receipts reported on the company's Forms 1120 for those years exceeded $2 million. After the search of Potter's Pub, when he knew he was under criminal investigation, John provided his accountant with additional bank account information for the 2003-05 tax years. His accountant used this information to file amended federal income tax returns for those years, both for Potter's Pub and for John. The IRS determined that John was liable for the 75 percent fraud penalty and for additions to tax for failure to timely file returns.

John tried to avoid the fraud penalty by arguing that he lacked fraudulent intent because he was unsophisticated and needed to hire tax professionals to prepare and file his individual and corporate tax returns.

The Tax Court held that John's underpayments of tax were attributable to fraud and, thus, he was liable for the fraud penalty. The existence of fraudulent intent is a question of fact. The court noted that, in Spies v. U.S., 317 U.S. 492 (1943), the Supreme Court set forth the following circumstances that tend to indicate fraud: (1) understating income; (2) maintaining inadequate records; (3) concealing income or assets; (4) providing incomplete or misleading information; (5) filing false income tax returns; and (6) extensive dealings in cash. In this case, the court said, John admitted in his guilty plea that he intentionally underreported the company's income for multiple years to evade the corporate-level income tax. He maintained two sets of sales ledgers that were designed to conceal the cash he was transferring into his personal bank account, and he kept the transfers below $10,000 to avoid bank reporting to the IRS.

With respect to John's argument that he was unsophisticated and thus lacked fraudulent intent, the court noted that he was sophisticated enough to structure his wire transfers in amounts under $10,000 and preparing clandestine sales ledgers for tax professionals.

For a discussion of the fraud penalty on underpayments of tax, see Parker Tax ¶262,125.

[Return to Table of Contents]

Calling Tuition Repayment "Settlement Damages" Doesn't Make It Deductible

A physician could not deduct medical school tuition he had to repay because the circumstances under which he received the original payment were of a personal nature. Dargie v. U.S., 2014 PTC 69 (6th Cir. 2/5/14).

In 1993, Tripp Dargie enrolled as a student at the University of Tennessee College of Medicine (UT). In 1994, he entered into an agreement with UT and Middle Tennessee Medical Center (MTMC) that provided that MTMC would pay his tuition, fees, and other reasonable expenses for attending UT. After graduation and the completion of his residency, Dr. Dargie was required to repay MTMC's grant by either (1) working as a doctor in the medically underserved community of Murfreesboro, Tennessee, for four years or (2) repaying two times the uncredited amount of all conditional award payments he received or a lesser amount agreed to by UT. During his time in medical school, MTMC paid UT $73,000 on Dr. Dargie's behalf as part of the agreement.

After completing his medical training in 2001, Dr. Dargie decided not to work as a doctor in Murfreesboro. Instead, he chose to practice in Germantown, Tennessee, near Memphis. In 2002, for not fulfilling his service obligation, Dr. Dargie repaid $121,440 a sum equal to the $73,000 principal he had received plus interest.

In 2005, Dr. Dargie and his wife filed an amended tax return for 2002, claiming they had inadvertently omitted an ordinary and necessary business expense on their Schedule C for the full amount of the $121,440 repayment. The Dargies sought to recover a recalculated refund of $30,304 plus interest. The IRS disallowed the deduction and the Dargies initiated a refund suit claiming the IRS had erred in its decision.

A district court found for the IRS, concluding that Dr. Dargie's repayment of the funds was a personal expense, and no deduction was allowed under Code Sec. 265(a)(1) because the repaid amount was allocable to income the Dargies had received tax free. The Dargies appealed.

Before the Sixth Circuit, the Dargies argued that the $121,440 amount sent UT in 2002 was a damages payment for Dr. Dargie's breaching the agreement with MTMC to work in Murfreesboro after his medical training. Consequently, he argued that the payment was an ordinary and necessary business expense permitted under Code Sec. 162(a) because it enabled him to pursue his for-profit medical practice in a different area of the state. The IRS countered that the payment to UT did not qualify as a deduction because educational expenses that allow an individual to meet the minimum requirements for practicing a given profession are personal.

The Sixth Circuit affirmed the district court's decision and held that the repayment by Dr. Dargie was not deductible. The court noted that, to determine whether an expense is a nondeductible personal expense or a deductible business expense, courts look to the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer. Thus, the court stated, the circumstances under which Dr. Dargie received the money determine its business or personal characterization, not the circumstances under which he repaid it. Dr. Dargie, the court observed, did not dispute that MTMC paid for his medical education and that education enabled him to meet the prerequisites for working as a physician. Moreover, Reg. Sec. 1.162-5(b)(2) specifically categorizes as nondeductible expenditures made by an individual for education that is required of him in order to meet the minimum educational requirements for qualification in his employment or other trade or business.

For a discussion of the deductibility of work-related educational expenses, see Parker Tax ¶85,110.

[Return to Table of Contents]

Construction Support Payments to Retailers Don't Have to be Capitalized

Construction support payments made by a company to its retailers were not required to be capitalized because they did not create a financial interest, did not create a capitalizable contract right, and did not result in an improvement to real property owned by another that could reasonably be expected to produce significant economic benefits for the taxpayer. CCA 201405014.

A company produces certain products that it distributes through a network of dedicated retailers. The company has a standing offer for its retailers to enter an agreement to maintain retail space that conforms to the company's design requirements. The agreement provides that the company will provide a certain amount of construction support payments to retailers of the company's products, with a percentage paid upon groundbreaking or the beginning of the renovation construction and a percentage paid upon the beginning of operations of a facility for the company's products. The agreement provides that repayment of all the construction support payments to the company is required immediately if, within 15 years of beginning operations as a facility, the retailer seeks the company's approval to no longer conform to the requirements of a facility, or no longer sells and maintains a full line of the company's products, and/or no longer provides servicing at the facility.

The retailer is required to incorporate seven critical image elements in the facility, including:

(1) an elevated glass display several feet off the ground;

(2) an area with information and brochures;

(3) a display platform one foot to two feet off the ground;

(4) an area with a coffee machine and doughnuts;

(5) a greeter station with a computer;

(6) key colors and materials; and

(7) key signage - product signage and slogan signage.

Depending on the location of the retailer, the signage could include signs in the building, on the building and/or on posts. The agreement does not obligate the retailer to purchase any specific quantity of the company's products, and does not confer with any right other than the right to require the retailer to conform its premises to the facility design.

In Indopco, Inc. v. Comm'r, 503 U.S. 79, 86 (1991), the Supreme Court established the test for capitalization as being whether an expense results in a significant future benefit. The capitalization of intangibles is governed by Reg. Sec. 1.263(a)-4 and Reg. Sec. 1.263(a)-5 which define the exclusive scope of the significant future benefit test, generally by providing specific categories of intangible assets for which capitalization is required. Reg. Sec. 1.263(a)-4 provides rules for applying the capitalization rules to amounts paid to acquire or create intangibles. Reg. Sec. 1.263(a)-4(b)(1) provides that except as otherwise provided, a taxpayer must capitalize an amount paid to: (1) acquire an intangible; (2) create an intangible described in Reg. Sec. 1.263(a)-4(d); (3) create or enhance a separate and distinct intangible asset within the meaning of Reg. Sec. 1.263(a)-4(b)(3); (4) create or enhance a future benefit identified in IRS guidance as an intangible for which capitalization is required; and (5) facilitate the acquisition or creation of an intangible.

In general, advertising and marketing expenses are deductible because they do not fall within a category required to be capitalized. Generally, the future benefit from advertising is considered to be too ephemeral to be a significant future benefit.

The Office of Chief Counsel concluded that the construction support payments did not create or enhance a separate and distinct intangible asset because the company's rights have no value apart from the promotion of the company's product line. The Chief Counsel's Office then examined whether the created intangible was required to be capitalized because it created a financial interest, created a contract right that was required to capitalized, or was an improvement to real property owned by another that could reasonably be expected to produce significant economic benefits for the taxpayer. No other category of expenditure was relevant, the Chief Counsel's Office noted.

The Chief Counsel's Office noted that while the retailers are required to sell and maintain a full line of the company's products and provide servicing at the facility, the retailers are not required to purchase any specific amount of products from the company during the term of the agreement, the price of the product is not fixed at the time of the agreement, and the company does not have the right to provide any specific quantity of products to the retailers. Under these circumstances, the Chief Counsel's Office found that the agreement did not constitute a forward contract or option and, thus, the amounts were not paid to create a capitalizable financial interest under Reg. Sec. 1.263(a)-4(d)(2).

Further, the Chief Counsel's Office stated, because the agreement provides that the retailers must sell a full line of the company's products and provide servicing for the products but does not obligate the retailer to purchase any specific quantity of products or services from the company, these amounts are not paid to create a contract right under Reg. Sec. 1.263(a)-4(d)(6).

Finally, the Chief Counsel's Office noted that, for purposes of capitalizing real property, such property includes property that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time, such as roads, bridges, tunnels, pavements, wharves and docks, breakwaters and sea walls, elevators, power generation and transmission facilities, and pollution control facilities. The seven critical image elements that are required to be incorporated in the facility design, the Chief Counsel's Office stated, did not appear to fall under the definition of real property under Reg. Sec. 1.263(a)-4(d)(8)(iii), as they would not remain affixed for an indefinite period of time. Rather the seven critical image elements appeared to the Chief Counsel's Office to support the company's marketing efforts and to standardize the appearance of the company's retailers. While some renovation may be required, and the retailers may be required to capitalize some of these costs as purchases of or improvements to tangible property, the Chief Counsel's Office did not believe that the taxpayer's payments to support these cosmetic renovations constituted amounts paid to improve real property owned by another under Reg. Sec. 1.263(a)-4(d)(8)(iii), since the improvements were not permanent structural changes, and the benefit the company derived was akin to the benefit provided by advertising. Therefore, the construction support payments made by the company to its retailers were not required to be capitalized.

For a discussion of the capitalization of intangibles, see Parker Tax, ¶99,580.

[Return to Table of Contents]

Assets Held by Trust, as Taxpayer's Alter Ego, Were Subject to Collection for Tax Debts

A trust created by a businessman was his alter ego and, consequently, the assets and funds held by the trust were subject to collection by the government as a result of tax judgments and tax liens against the taxpayer. Acheff v. Lazare, 2014 PTC 50 (D. N.Mex. 1/29/14).

Jon Edelman was a businessman who specialized in tax shelters and tax deferral techniques. In 1984, Jon purchased a 55-foot yacht and took title in the name of an Oregon corporation of which he was president. Jon and his wife, Barbara, also purchased a 30-acre property in Taos, New Mexico from William Acheff. Subsequently, Jon was convicted of federal income tax fraud and sentenced to prison. While his criminal case was pending, he transferred title to the yacht, named "Elusive," to a Cayman Islands company, which was solely owned by Barbara. He also created a trust in Liechtenstein (the Delos trust), designating himself and his family as beneficiaries. A Liechtenstein company was named as trustee.

In 1993, shortly after he began to serve his prison sentence, Jon escaped and, for more than two years, lived on the yacht with his family, moving among several nations in the South Pacific. While Jon was a fugitive, the Taos property went into default and was repurchased by William while it was in foreclosure. Jon was recaptured and sent back to prison in 1995. While in prison, Jon contacted William about repurchasing the property. William agreed to sell the property back to Jon under sale terms that included a $1 million down payment, semi-annual interest payments for five years, and a balloon payment at the end of five years. A second trust created by Jon under the laws of New York, the Edelman trust, was the buyer for the property, and the Delos trust paid the down payment as a loan to the New York trust. In 1999, Jon was released from prison and lived on the Taos property for the next 12 years. Also in 1999, he and Barbara were divorced and her share of the company that owned the yacht was transferred to the Delos trust as part of the divorce.

From 2001 to 2005, the Delos trust transferred payments to the New York trust for the semi-annual interest payments on the Taos property, which would in turn pay William by check. William and the trustee of the New York trust, Peter Lazare, a long-time friend of Jon's, agreed to a loan modification that continued the interest-only payments and delayed the balloon payment. After several loan modifications, William filed suit in 2012 to collect on the defaulted promissory note and foreclose the mortgage. The government was added as a defendant, since it held two judgments against Jon for delinquent federal income taxes exceeding $334 million. The government filed a counterclaim, seeking to enforce its tax judgments and liens against the Taos property, the New York trust, and the yacht. The court ruled that William's mortgage on the Taos property was senior to the government's tax liens and issued a preliminary injunction enjoining the trustee of the New York trust from liquidating or distributing the New York trust assets.

Under Code Sec. 6321, if a taxpayer that is liable for any tax neglects or refuses to pay such tax after a demand is made, the tax (including any interest and penalties, together with any costs that may accrue in addition thereto) becomes a lien in favor of the government upon all property and rights to property, whether real or personal, belonging to the taxpayer.

Observation: The government can collect on tax liens from a taxpayer who holds property in the name of another entity on either of two theories, the "nominee" theory and the "alter ego" theory. While related, the concepts of nominee and alter ego are independent grounds for attaching the property of a third party in satisfaction of a delinquent taxpayer's liability. A nominee theory involves the determination of the true beneficial ownership of property, while an alter ego theory focuses more on those facts associated with a "piercing of the corporate veil" analysis.

A district court held that the Delos trust was the alter ego of Jon, and its assets were subject to collection by the government. The court cited G.M. Leasing Corp. v. U.S., 429 U.S. 338 (1977), which found that property held by the alter ego of a taxpayer is regarded as the taxpayer's property and is subject to the government's judgments and collection attempts. The court noted that Jon personally used the funds from the Delos trust during a time period when the government had several tax judgments against him and liens against his property. According to the court, Jon exerted near-complete control over the Delos trust and how the funds were spent. The trust was used as an overseas safe haven for Jon's money, and he simply withdrew funds on an as-needed basis.

Although Jon routed the money from the trust through various sources in an attempt to avoid seizure of the funds to satisfy his tax debt, the government was able to identify many transactions originating in the Delos trust that directly benefited Jon.

The court also determined that the appropriate remedy for Jon's unlawful use of the Delos trust as his alter ego was to impose a constructive trust on the Edelman trust for $1.6 million. Thus, the government may seize and foreclose on any assets in the New York trust up to the $1.6 million constructive trust amount. The government could also seize and collect against the New Mexico property, subject to any superior encumbrances, including William's.

Finally, the court found that the government was entitled to a permanent injunction against the Edelman trust for the amount of the constructive trust. The government established that irreparable harm was likely unless the permanent injunction was issued, since Jon avoided paying his federal tax debt for over two decades and depletion of the trust assets would prevent the government from any meaningful recovery. Also, the balance of equities favored preserving the government's ability to collect Jon's tax debt over the interests of Jon's adult children, the trust's other beneficiaries. Moreover, the permanent injunction was in the public interest by preserving assets that are subject to Jon's federal tax obligation that he actively avoided for many years, the court concluded.

For a discussion of tax liens, see Parker Tax ¶260,530.

[Return to Table of Contents]

Tax Court Had Jurisdiction to Review Denial of Interest Suspension

Letters 3477 sent by the IRS to a married couple denying their claim for suspension of interest on accruing tax liabilities were subject to review by the Tax Court, even though the couple's concurrent claims for abatement of interest attributable to unreasonable errors and delays by the IRS were still pending. Corbalis v. Comm'r., 142 T.C. No. 2 (1/27/14).

Following an audit of Charles and Linda Corbalis for the years 1999 through 2004, the IRS disallowed a loss carried back from 2001which resulted in the assessment of tax deficiencies. The couple requested an abatement of the interest accruing on those liabilities due to unreasonable errors and delays by the IRS. The IRS sent the couple four separate Letters 2289, Full Disallowance on Interest Abatement Claims, disallowing their claims because the claims did not apply to the liability reported on their returns. The IRS also sent separate Letters 3477, Letter to Address any IRC 6404(g) Interest Suspension Provisions, stating that interest suspension did not apply to the tax years in issue, the Corbalises did not have appeal rights, and they could not petition the Tax Court for judicial review regarding the letters. Charles and Linda subsequently filed a petition seeking judicial review of the Letters 3477.

Code Sec. 6404(e) provides for the abatement of interest attributable to unreasonable errors and delays by the IRS. Code Sec. 6404(g), which is effective for tax years ending after July 22, 1998, suspends the accrual of certain penalties and interest after a defined period after the filing of the tax return if the IRS has not sent the taxpayer a notice specifically stating the taxpayer's liability and the basis for the liability within the specified period. If certain requirements are met, Code Sec. 6404(h) provides for the review of a final determination by the IRS regarding the denial of an interest abatement request.

Besides the claim under Code Sec. 6404(g), the Corbalises also filed a claim for interest abatement under Code Sec. 6404(e) and no determination had been made by the IRS with respect to that claim.

The IRS argued that Code Sec. 6404(h) did not apply to the Corbalises' claims under Code Sec. 6404(g) because their claim involved the suspension of interest and not the abatement of interest. The Tax Court did not have jurisdiction to review the denial of an interest suspension claim, the IRS said. The IRS also argued that, because the Corbalises still had a claim for abatement under Code Sec. 6404(e) outstanding, Tax Court review was premature.

Charles and Linda argued that Code Sec. 6404 deals with abatement, of which suspension is a category and a claim that interest should have been suspended for a period was the equivalent to a claim for abatement of interest that had been assessed for that period. Thus, the denial was subject to review by the Tax Court.

The Tax Court held that the Charles and Linda were entitled to judicial review of their claims for interest suspension. In rejecting the IRS argument that the court only had jurisdiction over abatement of interest claims, the court explained that relief provisions of Code Sec. 6404 were for taxpayers who were affected by errors or omissions of the IRS, and the grant of jurisdiction to the Tax Court covered the suspension of interest.

The court also found that the Letters 3477, which denied the couple's claim to interest suspension and disallowed the right to judicial review, were final determinations for jurisdictional purposes. The court said that the IRS denial of the Corbalises' interest suspension claim and disavowal of judicial review, if upheld, would leave the couple with no further recourse, which is a final determination. Although the contemporaneous Letters 2289 anticipated further proceedings with respect to the claim for abatement for unreasonable errors and delay by the IRS, the claim was severable, the court noted.

For a discussion of the abatement of interest, see Parker Tax ¶261,570.