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We hope you find our complimentary issue of Parker's Federal Tax Bulletin informative. Parker's Tax Research Library gives you unlimited online access to 147 client letters, 22 volumes of expert analysis, biweekly bulletins via email, Bob Jennings practice aids, time saving election statements and our comprehensive, fully updated primary source library.

Federal Tax Bulletin - Issue 148 - September 5, 2017


Parker's Federal Tax Bulletin
Issue 148     
September 5, 2017     

 

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 1. In This Issue ... 

 

Tax Briefs

Owner of Fast Food Restaurants Can't Revise Merger Transaction After Deal Closes; Big Game Hunter Limited to Using Comparable Sales Valuation Method to Value Trophy Donations; Court Finds Enough Evidence to Estimate Coin Collector's Cost of Goods Sold ...

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IRS Announces Tax Relief for Victims of Hurricane Harvey

The IRS announced that Hurricane Harvey victims in parts of Texas have until January 31, 2018, to file certain individual and business tax returns and make certain tax payments. The IRS also announced that 401(k)s and similar employer-sponsored retirement plans can make loans and hardship distributions to victims of Hurricane Harvey and members of their families. IR-2017-135 (8/28/17); IR-2017-138 (8/30/17); Announcement 2017-11.

Read more ...

Late Filing of Tax Return Precludes Recovery of $32,000 Tax Overpayment

In a case of first impression, the Tax Court held that a taxpayer was not entitled to a refund shown on a late-filed tax return because the three-year lookback period specified in Code Sec. 6512(b)(3) did not apply. The court also held that, because the taxpayer did not file her income tax return before the IRS issued a notice of deficiency and did not pay her tax liability within two years of the mailing of the notice of deficiency, the two-year lookback period likewise did not apply. Borenstein v. Comm'r, 149 T.C. No. 10 (2017).

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Tax Court: Individual's Sale of Personal Residence to Parents was Part Sale, Part Gift

The Tax Court held that an individual's sale of a personal residence to his parents, in which he discharged two mortgages but received no cash or other property, was a sale in part and a gift in part. The individual's amount realized was the amount of the liabilities discharged, and his gain was determined by subtracting from that amount his basis and settlement costs and excluding $250,000 of the gain under Code Sec. 121. Fiscalini v. Comm'r, T.C. Memo. 2017-163.

Read more ...

Taxpayers Had to Repay ACA Advance Premium Tax Credit Due to Increase in Income

The Tax Court held that a married couple who received a Code Sec. 36B advance premium tax credit, which was paid directly to their health insurance provider to reduce their monthly premiums, had to repay the full amount of the credit because an increase in their income made them ineligible for it. However, the Tax Court determined that a penalty for the underpayment did not apply because the couple reported their increase in income to the state insurance exchange, never received a Form 1095-A, Health Insurance Marketplace Statement, and were not the actual recipients of the payments. McGuire v. Comm'r, 149 T.C. No. 9 (2017).

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Gift Tax on Lifetime Gifts Not Includible in Gross Estate Due to Reimbursement Agreements

The Tax Court held that the liability for gift tax on gifts of artwork made within three years of a decedent's death was not includible in the gross estate because the estate would have been entitled to reimbursement from the recipients had it paid the gift taxes. The court also held that the gift recipients could not be apportioned estate tax liability under New Jersey law because they had not received any part of the gross estate and therefore were not transferees to whom estate tax could be apportioned. Sommers v. Comm'r, 149 T.C. No. 8 (2017).

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Tax Court Rejects Insurance Expense Deductions Relating to Microcaptive Transaction

In a case of first impression, the Tax Court held that a couple's businesses could not deduct insurance payments made to a captive insurance company and another company because the companies did not qualify as insurance companies for federal tax purposes. Further, elections made by the captive under Code Sec. 831(b) and Code Sec. 953(d) were invalid and the company is thus treated as a foreign corporation. Avrahami v. Comm'r, 149 T.C. No. 7 (2017)

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Sixth Circuit Rejects FATCA and FBAR Challenges by Senator Rand Paul and Others

The Sixth Circuit upheld a district court ruling that several individuals, including Senator Rand Paul (R-KY), did not have standing to sue the U.S. government to enjoin it from enforcing the Foreign Account Tax Compliance Act (FATCA), the intergovernmental agreements (IGAs) entered into with foreign governments under FATCA, and the foreign bank account reporting (FBAR) requirement under the Bank Secrecy Act. According to the court, none of the individuals had alleged an actual or imminent injury traceable to the U.S. government and redressable by the court. Crawford v. U.S., 2017 PTC 388 (6th Cir. 2017).

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Tax Court Upholds IRS's Adjustments to Cement Company's Depletion Deductions

The Tax Court held that a cement producer that mined calcium carbonate and mixed it with minerals purchased from third parties was entitled to a 14 percent depletion rate for the calcium carbonate, not the 15 percent rate used by the company. The court also held that the purchased minerals were nonmining costs for purposes of calculating the company's gross income. Mitsubishi Cement Corp. v. Comm'r, T.C. Memo. 2017-160.

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 2. Tax Briefs 

 

C Corps

Owner of Fast Food Restaurants Can't Revise Merger Transaction After Deal Closes: In Tseytin v. Comm'r, 2017 PTC 387 (3d Cir. 2017), the Third Circuit affirmed the Tax Court and held that the owner of a number of fast food restaurants that entered into a merger deal could not restructure the transaction to obtain better tax results after the deal closed. The court cited the Danielson rule in holding that, absent proof of mistake, fraud, undue influence, duress, or the like, which would be recognizable under local law in a dispute between the parties to an agreement, a taxpayer generally will be held to the terms or form of an agreement entered into.

 

Deductions

Big Game Hunter Limited to Using Comparable Sales Valuation Method to Value Trophy Donations: In Gardner v. Comm'r, T.C. Memo. 2017-165, the Tax Court held that a big game hunter had to use the comparable sales method to calculate his charitable donation deduction for the contribution of his less desirable hunting trophy specimens to an ecological foundation. The court rejected the taxpayer's theory that replacement cost was more appropriate because the items he donated were pristine specimens of excellent provenance that would be ideal for museum study and research.

Court Finds Enough Evidence to Estimate Coin Collector's Cost of Goods Sold: In Mileham v. Comm'r, T.C. Memo. 2017-168, the Tax Court held that a taxpayer, who bought and sold coins and also participated in exchange transactions for which he prepared handwritten split invoices showing both purchases and sales, did not substantiate his costs of goods sold and did not maintain adequate books and records. However, while the IRS determined the taxpayer's costs of goods sold by effectively disregarding purchases made through the exchange transactions, the court found that there was sufficient evidence to estimate the taxpayer's costs of goods sold by using his markup over cost.

Retired Officer Can't Deduct Losses from Collecting and Selling Law Enforcement Badges: In Grago v. Comm'r, T.C. Summary 2017-67, the Tax Court held that a retired law enforcement officer, who engaged in the activity of collecting and selling law enforcement patches and badges, was not engaged in a trade or business activity during the year at issue because he did not conduct the activity in a businesslike manner and did not engage in the activity with the requisite profit objective. Thus, he was not entitled to deduct losses from the activity for tax purposes.

De Facto Contemporaneous Written Acknowledgment Satisfied Donation Substantiation Rules: In Big River Development, L.P., T.C. Memo. 2017-166, the Tax Court held that a partnership satisfied the substantiation requirements in Code Sec. 170(f)(8) with respect to its donation of a conservation easement and thus was entitled to a charitable deduction for the easement. While the partnership did not receive from the donee organization a timely letter of the sort that normally acts as a contemporaneous written acknowledgment (CWA), the court said that the partnership nevertheless satisfied the statutory substantiation requirements because the deed of easement constituted a de facto CWA.

 

Employee Benefits

IRS Provides Model Amendments for Certain Defined Benefit Plan Documents: In Notice 2017-44, the IRS provides model amendments that a sponsor of a qualified defined benefit plan may use to amend its plan document to offer bifurcated benefit distribution options to participants in accordance with final regulations issued under Code Sec. 417(e). The model amendments are aimed at helping stakeholders in light of the changes to the determination letter program that are set forth in Rev. Proc. 2016-37.

Temporary Nondiscrimination Relief Extended for Closed Defined Benefit Plans: In Notice 2017-45, the IRS extended the temporary nondiscrimination relief for closed defined benefit plans that is provided in Notice 2014-5 by making that relief available for plan years beginning before 2019 if the conditions of Notice 2014-5 are satisfied. The IRS noted that, while proposed regulations relating to nondiscrimination requirements for closed plans were published in January of 2016, the regulations will most likely not be finalized in time for plan sponsors to make plan design decisions based on the final regulations before expiration of the relief provided under Notice 2014-5 (as last extended by Notice 2016-57) and thus it is appropriate to extend the relief provided under Notice 2014-5 for an additional year.

 

Gross Income

South Korean Airline Pilot Not Eligible for Foreign Earned Income Exclusion: In Acone v. Comm'r, T.C. Memo. 2017-162, the Tax Court held that a pilot who worked for a South Korean airline company was not a "qualified individual" for purposes of the foreign earned income exclusion in Code Sec. 911(a) and thus could not exclude amounts from gross income as foreign earned income. The court concluded that the taxpayer was not a "qualified individual" because his "abode" was within the United States for purposes of Code Sec. 911(d)(3) and because he was not a "bona fide resident" of South Korea for purposes of Code Sec. 911(d)(1)(A).

 

Healthcare

National Average Premium Rates Issued for Bronze Level Health Plans: In Rev. Proc. 2017-48, the IRS provides the monthly national average premium for qualified health plans that have a bronze level of coverage and are offered through Exchanges. The procedure, which is effective for tax years ending after December 31, 2016, are used by taxpayers to determine their maximum individual shared responsibility payment under Code Sec. 5000A(c)(1)(B) and Reg. Sec. 1.5000A-4.

 

Penalties

Levy Against Tax Preparer Who Failed to Satisfy Due Diligence Rules Sustained: In Mohamed v. Comm'r, T.C. Summary 2017-69, the Tax Court sustained a proposed levy action against a CPA who operated a tax return preparation business. The levy related to penalties owed by the CPA as a result of his failure to satisfy earned income tax credit due diligence requirements.

 

Procedure

Tenth Circuit Vacates Judgment Allowing IRS to Sell Property Owned by Taxpayer's Corporation: In Geophysical v. U.S., 2017 PTC 384 (10th Cir. 2017), the Tenth Circuit vacated a district court judgment allowing the IRS to enforce a lien, as well as an order permitting the IRS to sell two properties owned by a taxpayer's company in order to satisfy the lien. The court concluded that the district court had granted the judgment without providing the taxpayer and the taxpayer's company an adequate opportunity to respond to the IRS's assertion that the company held title to the properties as the taxpayer's alter ego or nominee.

IRS Not Barred by Statute of Limitations from Enforcing 2002 Assessment Against an Estate: In U.S. v. Est. of Chicorel, 2017 PTC 389 (E.D. Mich. 2017), a district court held that the IRS was not barred by the statute of limitations from enforcing a 2002 assessment against an estate. The court concluded that the government initiated a timely proceeding in court within the meaning of Code Sec. 6502(a) by submitting its proof of claim to a Michigan probate court and the estate's personal representative, and that tolled the statute of limitations with respect to the instant proceeding and, by implication, any subsequent proceeding regardless of how many years later it may be filed.

Court Won't Overturn Jury Verdict Awarding Refund to Taxpayers Who Relied on Tax Advisors: In Ervin v. U.S., 2017 PTC 394 (W.D. Ky. 2017) a district court declined to overturn a jury verdict which found that the taxpayers were entitled to a refund of a valuation misstatement penalty and penalty interest payments paid to the IRS as a result of disallowed tax losses. The court found that the taxpayers had established to the jury's satisfaction a reasonable cause defense in which they claimed to have had relied in good faith upon the advice of competent tax advisors such as the accounting firm of BDO Seidman.

Trustee Was Foundation's Alter Ego and Is Personally Liable for Taxes: In U.S. v. Williams, 2017 PTC 398 (M.D. N.C. 2017), a district court entered a default judgment for the United States against a foundation that sought and received over $600,000 in fraudulent tax refunds, which were then used by the foundation's trustee for personal purposes, such as paying off a car loan and mortgage. The court agreed with the IRS that the trustee was the foundation's alter ego and was personally liable for its tax liabilities.

 

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 3. In-Depth Articles 

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IRS Announces Tax Relief for Victims of Hurricane Harvey

The IRS announced that Hurricane Harvey victims in parts of Texas have until January 31, 2018, to file certain individual and business tax returns and make certain tax payments. The IRS also announced that 401(k)s and similar employer-sponsored retirement plans can make loans and hardship distributions to victims of Hurricane Harvey and members of their families. IR-2017-135 (8/28/17); IR-2017-138 (8/30/17); Announcement 2017-11.

Extensions for Individual and Business Tax Returns and Tax Payments

The IRS is granting automatic extensions of time to file tax forms to individuals and businesses affected by Hurricane Harvey. The IRS announced that hurricane victims in parts of Texas have until January 31, 2018, to file certain individual and business tax returns and make certain tax payments. According to the IRS, the extended deadline applies to individuals with valid extensions that run out on October 16, and businesses with extensions that run out on September 15.

The IRS is offering this expanded relief to any area designated by the Federal Emergency Management Agency (FEMA) as qualifying for individual assistance. Currently, 18 counties are eligible (see list below), but taxpayers in localities added later to the disaster area will automatically receive the same filing and payment relief.

The tax relief postpones various tax filing and payment deadlines that occurred starting on August 23, 2017. As a result, affected individuals and businesses will have until January 31, 2018, to file returns and pay any taxes that were originally due during this period. This includes the September 15, 2017 and January 16, 2018 deadlines for making quarterly estimated tax payments. For individual tax filers, it also includes 2016 income tax returns that received a tax-filing extension until October 16, 2017. The IRS noted, however, that because tax payments related to these 2016 returns were originally due on April 18, 2017, those payments are not eligible for this relief.

A variety of business tax deadlines are also affected including the October 31 deadline for quarterly payroll and excise tax returns. In addition, the IRS is waiving late-deposit penalties for federal payroll and excise tax deposits normally due on or after August 23 and before September 7, if the deposits are made by September 7, 2017.

According to the IRS, it will automatically provide filing and penalty relief to any taxpayer with an IRS address of record located in the disaster area. Thus, taxpayers need not contact the IRS to get this relief. However, if an affected taxpayer receives a late filing or late payment penalty notice from the IRS that has an original or extended filing, payment or deposit due date falling within the postponement period, the taxpayer should call the number on the notice to have the penalty abated.

In addition, the IRS said it will work with any taxpayer who lives outside the disaster area but whose records necessary to meet a deadline occurring during the postponement period are located in the affected area. Taxpayers qualifying for relief who live outside the disaster area need to contact the IRS at 866-562-5227. This also includes workers assisting the relief activities who are affiliated with a recognized government or philanthropic organization.

Individuals and businesses who suffered uninsured or unreimbursed disaster-related losses can choose to claim them on either the return for the year the loss occurred (i.e., the 2017 return normally filed next year), or the return for the prior year (i.e., 2016).

Retirement Plan Rules Relaxed for Hurricane Victims and Their Families

The IRS also announced that 401(k)s and similar employer-sponsored retirement plans can make loans and hardship distributions to victims of Hurricane Harvey and members of their families. Participants in 401(k) plans, employees of public schools and tax-exempt organizations with 403(b) tax-sheltered annuities, as well as state and local government employees with 457(b) deferred-compensation plans may be eligible to take advantage of streamlined loan procedures and liberalized hardship distribution rules. Though IRA participants are barred from taking out loans, they may be eligible to receive distributions under liberalized procedures.

Retirement plans can provide this relief to employees and certain members of their families who live or work in disaster area localities affected by Hurricane Harvey and designated for individual assistance by the Federal Emergency Management Agency (FEMA). Currently, parts of Texas qualify for individual assistance. A list of eligible counties may be found fema.gov/disasters. To qualify for this relief, hardship withdrawals must be made by January 31, 2018.

The IRS is also relaxing procedural and administrative rules that normally apply to retirement plan loans and hardship distributions. As a result, eligible retirement plan participants will be able to access their money more quickly with a minimum of red tape. In addition, the six-month ban on 401(k) and 403(b) contributions that normally affects employees who take hardship distributions will not apply.

This broad-based relief means that a retirement plan can allow a victim of Hurricane Harvey to take a hardship distribution or borrow up to the specified statutory limits from the victim's retirement plan. It also means that a person who lives outside the disaster area can take out a retirement plan loan or hardship distribution and use it to assist a son, daughter, parent, grandparent or other dependent who lived or worked in the disaster area.

Plans will be allowed to make loans or hardship distributions before the plan is formally amended to provide for such features. In addition, the plan can ignore the reasons that normally apply to hardship distributions, thus allowing them, for example, to be used for food and shelter. If a plan requires certain documentation before a distribution is made, the plan can relax this requirement as described in Announcement 2017-11.

The IRS emphasized that the tax treatment of loans and distributions remains unchanged. Ordinarily, retirement plan loan proceeds are tax-free if they are repaid over a period of five years or less. Under current law, hardship distributions are generally taxable and subject to a 10-percent early-withdrawal tax.

Counties Eligible for Relief

Currently, the following Texas counties are eligible for relief: Aransas, Bee, Brazoria, Calhoun, Chambers, Fort Bend, Galveston, Goliad, Harris, Jackson, Kleberg, Liberty, Matagorda, Nueces, Refugio, San Patricio, Victoria and Wharton.

For a discussion of extensions for tax deadlines as a result of disasters, see Parker Tax ¶250,125.

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Late Filing of Tax Return Precludes Recovery of $32,000 Tax Overpayment

In a case of first impression, the Tax Court held that a taxpayer was not entitled to a refund shown on a late-filed tax return because the three-year lookback period specified in Code Sec. 6512(b)(3) did not apply. The court also held that, because the taxpayer did not file her income tax return before the IRS issued a notice of deficiency and did not pay her tax liability within two years of the mailing of the notice of deficiency, the two-year lookback period likewise did not apply. Borenstein v. Comm'r, 149 T.C. No. 10 (2017).

Background

Roberta Borenstein's 2012 tax return was originally due on April 15, 2013. She requested and received a six-month extension of time to file that return. By virtue of that extension, the due date for filing her 2012 return was October 15, 2013. Borenstein made tax payments for 2012 totaling $112,000. Under Code Sec. 6512, all of these payments were deemed made on April 15, 2013. Borenstein did not file a return for 2012 by October 15, 2013, or during the ensuing 22 months.

On June 19, 2015, the IRS issued Borenstein a notice of deficiency for 2012. On August 29, 2015, shortly before filing a petition with the Tax Court, Borenstein filed a delinquent return for 2012 that reported a tax liability of $79,559. Borenstein and the IRS agreed that Borenstein had a deficiency of $79,559 for 2012 and an overpayment of $32,441. Borenstein requested a refund of the $32,441 and, after the IRS rejected her request, she filed a petition with the Tax Court.

Analysis

Under Code Sec. 6512(b)(1), the Tax Court has jurisdiction to determine an overpayment for a year for which the court has also determined a deficiency (or has decided that there is no deficiency). However, Code Sec. 6512(b)(3) places a limit on the amount of credit or refund that may be allowed. That limit is determined by the amount of tax that was paid during one of three "lookback" periods from the date on which the IRS notice of deficiency was mailed.

The question before the Tax Court was whether Borenstein was limited to the two-year lookback period in Code Sec. 6511(a) and Code Sec. 6511(b)(2)(B) or was instead eligible for the three-year lookback period specified in the final sentence of Code Sec. 6512(b)(3). The final sentence of Code Sec. 6512(b)(3) provides that a three-year lookback period applies where "the date of the mailing of the notice of deficiency is during the third year after the due date (with extensions) for filing the return of tax and no return was filed before such date."

According to the IRS, the parenthetical phrase "with extensions" modifies "due date." Thus, the "due date (with extensions) for filing the return of tax" was October 15, 2013, pursuant to the automatic extension Borenstein received to file her 2012 return. The "third year" after that date, the IRS said, began on October 15, 2015, but the notice of deficiency was mailed on June 19, 2015. According to the IRS, that date was during the second year, not during the third year, "after the due date (with extensions) for filing the return." The IRS accordingly argued that the exception set forth in the final sentence of Code Sec. 6512(b)(3) did not apply, with the result that a refund or credit of Borenstein's $32,411 overpayment was barred by the two-year lookback rule generally applicable to nonfilers. Borenstein countered that she was eligible for the three-year lookback period specified in the final sentence of Code Sec. 6512(b)(3) and that she was thus entitled to a refund of $32,441.

Borenstein argued that "with extensions" should be taken instead to modify "the third year," a noun phrase that appears earlier in the sentence. In that event, "the third year" would be determined by reference to the original due date for her return and would be prolonged to include the six-month extension period. Alternatively, Borenstein contended that "with extensions" should be taken to modify "3 years," the last two words in the sentence. In that event, Code Sec. 6512(b)(3) would afford taxpayers a maximum lookback period, not of three years, but of three and one-half years. Under either of these interpretations, Borenstein would get her refund.

The Tax Court held that Borenstein was not eligible for the three-year lookback period because the notice of deficiency was not mailed to her "during the third year after the due date (with extensions) for filing the return of tax." Additionally, the court also held that, because Borenstein did not file her 2012 income tax return before the notice of deficiency was issued and did not pay her tax liability within two years of the mailing of the notice of deficiency, her refund request was outside of the two-year lookback period.

The Tax Court noted that its decision was one of first impression because it was the first time the Tax Court had been called upon to interpret the final sentence of Code Sec. 6512(b)(3) as applied to the fact pattern presented in Borenstein's situation. However, the court noted, statements in prior cases supported (or were at least consistent with) the IRS's position that the parenthetical phrase "with extensions" modifies "due date," the immediately preceding noun. The court also noted that, on two other occasions, it had interpreted the final sentence of Code Sec. 6512(b)(3) as applied to taxpayers who did not secure extensions of time to file and dicta in those cases were consistent with the IRS's position.

For a discussion of the timing of tax refund claims, see Parker Tax ¶261,190.

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Tax Court: Individual's Sale of Personal Residence to Parents was Part Sale, Part Gift

The Tax Court held that an individual's sale of a personal residence to his parents, in which he discharged two mortgages but received no cash or other property, was a sale in part and a gift in part. The individual's amount realized was the amount of the liabilities discharged, and his gain was determined by subtracting from that amount his basis and settlement costs and excluding $250,000 of the gain under Code Sec. 121. Fiscalini v. Comm'r, T.C. Memo. 2017-163.

In 1993, Robert Fiscalini and his parents bought a house in Hollister, CA for approximately $274,000. The parents paid $40,000 and Fiscalini took out a mortgage for the balance. Fiscalini, the owner of a construction company, lived at the property until August 2007. In 2002, he built a swimming pool with equipment used in his business and converted a detached garage into a game room. In 2003, his parents transferred their interest in the house to Fiscalini as a gift. Fiscalini did not give them any cash or other property in return for their interest in the property.

Fiscalini refinanced the property several times. In 2007, he was unable to make his mortgage payments and sold the house to his parents in order to avoid foreclosure. Fiscalini's parents borrowed $682,000 to finance the purchase. Most of the loan was used to discharge Fiscalini's outstanding loan balances totaling approximately $664,000. The closing statements on the sale showed total consideration of $975,000 and a gift of equity to the parents of around $295,000. Settlement costs of almost $17,000 were also incurred. Fiscalini received a Form 1099-S, Proceeds from Real Estate Transactions, showing gross proceeds of $975,000.

Fiscalini did not file a tax return for 2007 because he was unable to pay any tax due for that year. He eventually filed a return for 2007 in 2013 but did not report any gain on the sale of the house. In a notice of deficiency for 2007, the IRS claimed that Fiscalini had $975,000 of long term capital gain from the sale of the house. The notice also said that Fiscalini was liable for penalties under Code Sec. 6651(a)(1) and Code Sec. 6662(a). Fiscalini challenged the notice in the Tax Court.

Fiscalini argued that his gain on the sale was approximately $70,000 after taking into account the exclusion of $250,000 of gain on the sale of a personal residence under Code Sec. 121. He claimed that his basis in the property was approximately $330,000 and his amount realized was around $650,000, which represented the discharge of his liabilities minus settlement costs. In determining his basis, Fiscalini said that his cost basis of $234,000 was increased by $40,000, his parents' basis in the property when they gifted their interest to him in 2003. Fiscalini argued that his basis was also increased by his costs of $50,000 for the swimming pool and other improvements he made. According to Fiscalini, the 2007 transaction with his parents was in part a sale and in part a gift to them. He said the amount of the gift was the difference between the total consideration of $975,000 and his discharged liabilities of $664,000.

The IRS argued that Fiscalini's basis was $234,000 and his amount realized was the $975,000 sale price less the $17,000 in settlement costs. According to the IRS, Fiscalini's basis was not increased when he received the partial interest from his parents; it asserted that coowners of an asset have only a cost basis in the amount each has paid for the asset. As to the amount realized, the IRS said that the $975,000 sale price was the fair market value on the date of the sale, and therefore the amount realized.

In determining Fiscalini's basis in the property, the court held that Fiscalini received a carryover basis of $40,000 in the interest he received from his parents in 2003 which increased his basis to approximately $274,000. The Tax Court did not agree, however, that Fiscalini's basis should be increased by his claimed costs to build a swimming pool and make other improvements because he failed to substantiate those costs.

Turning to the amount realized, the Tax Court agreed with Fiscalini's characterization of the transaction as part sale, part gift. The court noted that Fiscalini received no cash or other property from his parents in the sale, although his mortgages in the amount of around $664,000 were discharged. Fiscalini's amount realized was determined to be approximately $647,000, equal to the liabilities discharged minus the settlement costs.

Subtracting his basis and taking into account the exclusion of $250,000 of gain on a personal residence under Code Sec. 121, the Tax Court concluded that Fiscalini's gain on the sale was approximately $122,000.

The court also found that Fiscalini was liable for penalties under Code Secs. 6651(a)(1) and 6662(a). Fiscalini's inability to pay his taxes in 2007 was not reasonable cause for failure to file a return, according to the Tax Court. The Tax Court also found that when Fiscalini did file a return for 2007, it did not include any gain from the sale, even though he knew that his mortgage loan balances had been discharged. An accuracy related penalty therefore applied because Fiscalini made no attempt to comply with the Code in determining his gain and therefore failed to do what a reasonable person would do under the circumstances. Fiscalini did not have reasonable cause for, or act in good faith with respect to, the underpayment, according to the Tax Court.

For a discussion of the exclusion of gain on the sale of a personal residence, see Parker Tax ¶77,710. For a discussion of the measurement of gain or loss on a sale or exchange, see Parker Tax ¶110,140. For a discussion of the penalty for failure to file a return see Parker Tax ¶262,105.05. For a discussion of the accuracy related penalty for negligence or disregard of rules or regulations, see Parker Tax ¶262,120.05.

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Taxpayers Had to Repay ACA Advance Premium Tax Credit Due to Increase in Income

The Tax Court held that a married couple who received a Code Sec. 36B advance premium tax credit, which was paid directly to their health insurance provider to reduce their monthly premiums, had to repay the full amount of the credit because an increase in their income made them ineligible for it. However, the Tax Court determined that a penalty for the underpayment did not apply because the couple reported their increase in income to the state insurance exchange, never received a Form 1095-A, Health Insurance Marketplace Statement, and were not the actual recipients of the payments. McGuire v. Comm'r, 149 T.C. No. 9 (2017).

Steven and Robin McGuire are a married couple who lived in California during 2014, the year at issue. In 2013, the McGuires applied for and received benefits under the Affordable Care Act (ACA). At that time, Mr. McGuire was earning $800 per week from his parts and service business and Mrs. McGuire was not working. California's health insurance exchange, Covered California, determined that the McGuires qualified for an advance premium tax credit (APTC) of almost $600 per month, or approximately $7,000 for the year. The APTC is a monthly payment directly to a health insurance provider that is based on an advance eligibility determination and is intended to reduce premiums for eligible individuals.

The McGuires signed up for an insurance plan with a monthly premium of around $1,200. Their monthly premium was reduced to around $600 after applying the APTC. Later in 2013, after their eligibility determination, Mrs. McGuire began working at a job that paid her $600 per week. She promptly notified Covered California that the additional income needed to "be included in our annual income." The change was significant because 400 percent of the federal poverty line for a family of two living in California at the time was around $62,000. The additional income was almost certain to put the McGuires over that limit, in which case they would not be entitled to any of the APTC.

Covered California acknowledged the change in income several months later in a June 2014 letter advising the McGuires that they did not qualify for their current health plan because their income was too high. The letter also stated that the McGuires may have to pay back some of the premium assistance when they filed their 2014 tax return. However, the McGuires never received the letter. According to Covered California, it was so busy during its first open enrollment period that it was common for changes to not be implemented. The McGuires made repeated efforts to get Covered California to take into account the change in income but it never did so. The McGuires also attempted to change their address with Covered California after they moved but Covered California did not update their address. As a result, they never received a Form 1095-A, Heath Insurance Marketplace Statement, which is used to calculate the premium tax credit.

The McGuires hired an accountant to prepare their 2014 return. The return reported that they had health insurance throughout the year, but the line for the net premium tax credit was left blank and the McGuires did not report the $7,000 APTC. In 2016, the McGuires received a notice of deficiency disallowing the APTC, which increased their tax liability in the amount of the disallowed credit. An accuracy related penalty was also applied. The McGuires petitioned the Tax Court for review.

The McGuires argued that it was Covered California's responsibility to ensure that clients received only the APTC amount for which they qualified, and that they would have never signed up for medical coverage costing $14,000 per year. They considered themselves to be trapped in a plan they could not afford without the subsidy provided by the ACA and asked the Tax Court to rule fairly and justly.

The Tax Court held that the McGuires owed the IRS the full amount of the $7,000 APTC. The Tax Court reasoned that the McGuires were asking it to provide equitable belief, but that it is not a court of equity and could not ignore the law to achieve an equitable end. It was clear to the Tax Court that the excess ATPC was an increase in the tax imposed under Code Sec. 36B(f)(2)(A). The McGuires received an advance credit for which they did not qualify and were therefore liable for the deficiency.

However, the Tax Court held that because the McGuires had acted reasonably and in good faith with respect to the underpayment, the penalty under Code Sec. 6662 did not apply. The court noted that the McGuires' understatement was substantial because it exceeded the greater of 10 percent of the tax required to be shown on the return or $5,000. However, the Tax Court reasoned that the McGuires never received a Form 1095-A, and although they received a benefit in the form of the APTC, it was the insurance company and not the McGuires that received the payments. The Tax Court found that the McGuires therefore did not have notice that they were receiving taxable income. They reported their changed circumstances to Covered California and relied on it to properly determine and adjust their eligibility for the tax credit. Moreover, the McGuires relied on a qualified tax professional in preparing their return, which in the Tax Court's view also bolstered the reasonable cause and good faith defense. The Tax Court concluded that the McGuires did not know nor should they have known that they had additional income required to be shown on their return, and the penalty for the underpayment therefore did not apply.

For a discussion of the ATPC, see Parker Tax ¶102,630. The accuracy related penalty for underpayment of tax is discussed at Parker Tax ¶262,120.

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Gift Tax on Lifetime Gifts Not Includible in Gross Estate Due to Reimbursement Agreements

The Tax Court held that the liability for gift tax on gifts of artwork made within three years of a decedent's death was not includible in the gross estate because the estate would have been entitled to reimbursement from the recipients had it paid the gift taxes. The court also held that the gift recipients could not be apportioned estate tax liability under New Jersey law because they had not received any part of the gross estate and therefore were not transferees to whom estate tax could be apportioned. Sommers v. Comm'r, 149 T.C. No. 8 (2017).

Background

In 2001, Sheldon Sommers asked his attorneys for advice on making a gift of artwork to his three nieces, his closest living relatives, in a way that would reduce or eliminate any gift tax liability. His attorneys devised a plan to transfer the artwork to a newly formed limited liability company (LLC) and then make gifts of ownership units in the LLC to the nieces. The plan involved making the gifts in two stages, with the first transfer of units in 2001 and the rest in 2002 in order to increase the portions of the gifts that could be covered by the annual gift tax exclusion under Code Sec. 2503(b).

Sommers transferred the artwork to the LLC and executed two sets of agreements with his nieces, the first in December 2001 and the second in January 2002. As a result of a March 2002 appraisal, Sommers' lawyers concluded that dividing the transfers of units would not allow for the complete avoidance of gift tax, so the nieces agreed to pay any gift tax on the 2002 transfers. The gift agreements were amended to provide that the nieces agreed to any gift taxes, penalties and interests that might be assessed. The agreements did not specifically refer to the apportionment of estate tax liability resulting from the gifts.

Sommers executed his last will in April 2002, which directed his ex-wife Bernice to pay all debts, including funeral and estate administration expenses, and bequeathed to her all of his estate remaining after payment of the debts. In June 2002, shortly before remarrying Bernice, Sommers filed a lawsuit challenging the validity of the gifts to his nieces and seeking return of the artwork. A similar action was initiated by Bernice in New Jersey, but the validity of the gifts was upheld.

Sommers died in November 2002. The estate tax return for Sommers' estate reported a gross estate of approximately $3.7 million and, after deductions, a taxable estate of $500. The IRS audited the estate's return and increased the value of the taxable estate to approximately $1.1 million. The increase reflected three adjustments. First, the IRS included in the estate the gift tax on the 2002 gifts because they were made less than three years before Sommers' death. Second, the value of the artwork was excluded from the estate. Third, the marital deduction was reduced by approximately $2 million, reflecting the IRS's determination that the estate tax liability resulting from the gift tax inclusion would have to be paid out of marital assets. The parties stipulated that the 2002 gift tax liability was approximately $273,000, which the nieces then paid. The IRS's final Form 1273, Report of Estate Tax Examination Changes, determined an estate tax deficiency of approximately $220,000, which reduced the marital deduction to just over $1 million. The estate challenged the deficiency assessment in Tax Court.

Issues

The first issue before the Tax Court was the deductibility of the gift tax liability. The estate argued that the gift tax was deductible under Reg. Sec. 20.2053-6(d) and that the nieces' payment of the tax did not affect the deductibility because Sommers was deemed to have paid the gift tax under Code Sec. 2502(d). The IRS countered that the gift tax liability was not deductible because the nieces received nothing additional from the estate and thus did not pay the gift tax in their capacity as beneficiaries. It also argued that a deduction for a liability that did not reduce the net amount passing to Sommers' other heirs would subvert the purpose of Code Sec. 2035.

Next, the estate argued that it was entitled as a matter of law to deduct approximately $1.6 million, the value of Sommers' nonprobate property that Mrs. Sommers received that was exempt from the estate's debts under New Jersey law. The general rule is that the marital deduction does not include any property that would have gone to the spouse but is used to satisfy the estate's debts. The estate argued that all of the debts for which the estate claimed deductions on its estate tax return arose under New Jersey law, and accordingly were subject to the limitations and exemptions set forth in the New Jersey statutes. The IRS responded that the marital share of the estate held the only assets available to pay the debts and expenses for which the estate claimed deductions; therefore, those debts and expenses reduced the marital deduction under Reg. Sec. 20.2056-4.

The third issue was whether any estate tax liability could be apportioned to the nieces. New Jersey law generally provides that transferees of any property included in the "gross tax estate" must be apportioned estate tax unless the testator directs otherwise. The gross tax estate means all property required to be included in computing the estate tax. The estate argued that, because the gifts were included as adjusted taxable gifts under Code Sec. 2001(b), they had to be included in computing the estate tax liability. It also argued that the LLC units were net gifts because the nieces agreed to pay the gift tax, so the nieces received a part of the gross tax estate at least equal to the portion enabling them to pay the gift tax. The nieces, as intervenors, argued that the gift tax clawbacks were not transferees' property under the statute. They also argued apportionment would be inconsistent with Sommers' intent as expressed in the gift agreements.

Analysis

The Tax Court held that the gift tax liability was not deductible under Code Sec. 2053(a) because the estate's payment of the liability would have given rise to a claim for reimbursement from the nieces. According to the Tax Court, under longstanding precedent, a claim against an estate is deductible in computing estate tax liability only to the extent it exceeds any right to reimbursement to which its payment would give rise. The estate was not entitled to a deduction for gift tax liability on the 2002 gifts to the nieces because, had the estate paid the taxes, the nieces would have been required under the gift agreements to reimburse the estate.

Next, the Tax Court held that the marital deduction amount depended on the extent to which nonprobate assets were used to pay estate debts and expenses, which was a question of fact. The Tax Court noted that the estate's claim of a $1.6 million marital deduction was inconsistent with its deduction of $413,000 of debts and expenses. The court reasoned that the debts and expenses reported by the estate would be fully deductible only if voluntarily paid before the due date of the estate tax return out of assets that were exempt from claims against the estate under Code Sec. 2053(c)(2). If Mrs. Sommers voluntarily paid debts or expenses of the estate from exempt property, the estate's allowable marital deduction would be reduced. The Tax Court concluded that either the allowable marital deduction was less than the $1.6 million the estate reported, or the estate was not entitled to deduct in full the debts and expenses. It therefore denied the estate's motion for summary judgment on that issue.

The Tax Court also held that no portion of the estate tax could be apportioned to the nieces because they were not transferees of gross tax estate property. Under New Jersey law, if the units the nieces received in 2002 were included in computing the estate tax liability, then they were part of the gross tax estate and the nieces would be transferees to whom estate tax could be apportioned. The Tax Court found that New Jersey courts had not addressed the extent to which their state's apportionment statute provided for the apportionment of estate tax to recipients of lifetime gifts. After reviewing the decisions of other courts in states with similar apportionment statutes, the Tax Court concluded that there were insufficient policy grounds to extend the statute to such recipients. According to the Tax Court, although the amount of gift tax paid on the LLC units was included in the gross estate, the units themselves were not; there was no property included in the gross estate that the nieces received or from which they otherwise benefited. The units were not part of Sommers' gross tax estate under New Jersey law, and the nieces were therefore not transferees to whom estate tax liability could be apportioned, the Tax Court concluded.

The Tax Court also refused to hold as a matter of law that any estate tax due would not reduce Mrs. Sommers' marital deduction. The court determined that New Jersey law requires estate tax to be apportioned so as to preserve, as much as possible, the benefit of a marital deduction. According to the Tax Court, if Mrs. Sommers used property that otherwise would have been exempt from claims against the estate to pay debts and expenses then she may have been a transferee and subject to apportionment.

For a discussion of the inclusion in the gross estate of gift tax on gifts made within three years of death, see Parker Tax ¶225,320. For a discussion of the effect of a donee's assumption of gift tax liability on the gross estate, see Parker Tax ¶222,765. For a discussion of the estate tax marital deduction see Parker Tax ¶227,110.

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Tax Court Rejects Insurance Expense Deductions Relating to Microcaptive Transaction

In a case of first impression, the Tax Court held that a couple's businesses could not deduct insurance payments made to a captive insurance company and another company because the companies did not qualify as insurance companies for federal tax purposes. Further, elections made by the captive under Code Sec. 831(b) and Code Sec. 953(d) were invalid and the company is thus treated as a foreign corporation. Avrahami v. Comm'r, 149 T.C. No. 7 (2017)

Background

Benyamin and Orna Avrahami own three shopping centers and three successful jewelry stores. In 2007, the Avrahamis business entities were flourishing and they were in need of some business advice. They turned to Craig McEntee, who had been their trusted CPA for about 25 years. Upon McEntee's recommendation, the Avrahamis retained Neil Hiller for some estate-planning services. McEntee also suggested that a captive insurance company might be a good fit for the Avrahamis and recommended that they consult Celia Clark, a founding partner of Clark & Gentry, PLLC. In 2006, Clark helped draft captive-insurance legislation for the dual-island Caribbean nation of Saint Christopher and Nevis (St. Kitts). Clark had more than 75 captive insurance clients in St. Kitts by 2008. Hiller also discussed the captive insurance idea with the Avrahamis and recommended that they hire Clark. In November 2007, the Avrahamis signed a retainer agreement with Clark in which they agreed that Clark and Hiller would act as co-counsel and provide all legal services relating to the start-up of a captive insurance company in exchange for $75,000. This agreement eventually led to the formation in 2007 of the Avrahamis' captive insurance company - Feedback Insurance company, Ltd. (Feedback).

Mrs. Avrahami was Feedback's sole shareholder as well as its treasurer and bookkeeper, though both Avrahamis had signature authority over Feedback's bank account. Feedback applied for and received authorization from St. Kitts to conduct a small group captive insurance business under the St. Kitts 2006 Captive Insurance Companies Act. In 2008, Feedback made two elections. The first was an election under Code Sec. 953(d) to be treated as a domestic corporation for federal income tax purposes. The second was an election to be taxed as a small insurance company under Code Sec. 831(b).

In 2006, the Avrahamis had spent approximately $150,000 insuring their business entities. In 2009, they paid more than $1.1 million for insurance and, in 2010, that amount increased to more than $1.3 million. The Avrahamis made the overwhelming share of these payments to Feedback. Feedback also entered into a cross insurance program to reinsure terrorism insurance for other small captive insurers through a risk-distribution pool set up by Clark exclusively for clients of her firm. Despite the formation of Feedback, each of the Avrahamis' entities continued to buy insurance from third-party commercial carriers. They made no change to coverage under those policies after contracting for insurance with Feedback.

There were no claims made on any of the Feedback policies until the IRS began an audit of the Avrahamis' tax returns and tax returns of entities they owned. With money coming in and none going back out to pay claims, Feedback accumulated a surplus of more than $3.8 million by the end of 2010, $1.7 million of which ended up back in the Avrahamis' bank account. Included in Feedback's surplus was $720,000 that the Avrahamis' jewelry stores paid to an off-shore company, Pan American Reinsurance Company (Pan American), which reinsured a portion of its risk with Feedback. The full $720,000 (which equaled 30 percent of target premiums for 2009 and 2010, the rate necessary to ensure risk is being distributed) then came right back to Feedback. Feedback used its surplus to transfer funds to Mrs. Avrahami and an entity named Belly Button Center, LLC (Belly Button). Belly Button owns approximately 27 acres of land in Arizona, which it purchased using $1.2 million in cash borrowed from Mr. Avrahami and a note payable to the sellers. Belly Button was owned equally by the Avrahamis' three children, none of which had any knowledge of the company. Feedback funneled money to Belly Button in exchange for promissory notes payable to Belly Button.

In 2010, Feedback reported two types of assets on its tax return - more than $1.35 million in cash and $2.53 million in mortgage and real estate loans. The $2.53 million comprised an $830,000 secured promissory note from Belly Button with no payments due until February 2018, a $1.5 million unsecured promissory note from Belly Button due in March 2020, and a $200,000 unsecured note from Belly Button - even though the funds went directly to Mrs. Avrahami - due no earlier than December 2012. In 2010, Belly Button transferred $1.5 million from its bank account into the Avrahamis' bank account, claiming this was a repayment of the $1.2 million loan for the Arizona property. However, these amounts were inconsistently reported on the Feedback and Belly Button returns.

For 2009 and 2010, the Avrahami entities collectively took business expense deductions for insurance premiums of $1,090,000 and $1,170,000, respectively. No claims were filed against Feedback under any of its direct policies in either 2009 or 2010. And no events took place triggering a terrorism claim in either year.

Insurance Arrangements and Sec. 953(d) and Sec. 831(b) Elections

The Supreme Court addressed insurance arrangements in Helvering v. Le Gierse, 312 U.S. 531 (1941). In that case, the Supreme Court listed four nonexclusive criteria that must be met for an arrangement to constitute insurance. According to the Court, the arrangement must:  

(1) involve risk-shifting;  

(2) involve risk-distribution;  

(3) involve insurance risk; and  

(4) meet commonly accepted notions of insurance.

Under Code Sec. 953(d), a foreign corporation that would qualify as an insurance company under subchapter L of the Code if it were a domestic corporation, and that meets certain other requirements, can elect to be treated as a domestic corporation for federal income tax purposes. By making this election, the corporation is not treated as a controlled foreign corporation (CFC) and is not subject to the burdensome requirements that a CFC is subject to, such as filing Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. Failure to file Form 5471 can result in hefty penalties as well as an extension of the statute of limitations in which to assess taxes on the taxpayer.

Code Sec. 831(b) allows qualifying non-life insurance companies whose net written premiums do not exceed $2,200,000 ($1,200,000 before January 1, 2017) to elect to be taxed solely on investment income.

IRS Stepping Up Audits Relating to Microcaptive Insurance Companies

In 2015, in IR-2015-19, the IRS began warning taxpayers about engaging in microcaptive transactions. It characterizes such transactions as transactions of interest under Code Sec. 6011, Code Sec. 6111, and Code Sec. 6112. In Notice 2016-66, the IRS identified the type of transactions it would consider microcaptive transactions and warned persons involved in such transactions that certain responsibilities and penalties may arise from participating in such transactions.

Microcaptive transactions involve a captive insurance company (i.e., a captive), a related insured business, and another insurance company that is generally unrelated to the insured business but related to the promoter of the captive transactions. The captive excludes the premium income from its taxable income by electing under Code Sec. 831(b) to be taxed only on its investment income. The captive uses that premium income for purposes other than administering and paying claims under the insurance contract, generally benefitting the insured or a party related to the insured. For instance, the captive may use premium income to provide a loan to the insured.

As a result of this increased scrutiny of microcaptives by the IRS, the Avrahamis weren't alone in having returns audited because of their interactions with a related microcaptive insurance company. However, the Avrahamis' returns were the first Code Sec. 831(b) case to make it to trial.

IRS and Taxpayers' Positions

The IRS argued that the amounts paid to Feedback and Pan American were not deductible business expenses because the arrangements lacked all four criteria necessary to be considered insurance for federal tax purposes. According to the IRS, (1) several of Feedback's policies included uninsurable risks; (2) Feedback failed to distribute risk because it had an insufficient pool of insureds; (3) no risk was shifted because neither Feedback nor Pan American was financially capable of meeting its obligations; and (4) the arrangements did not embody common notions of insurance because Feedback and Pan American did not operate like insurance companies and their premiums were not determined at arm's length. According to the IRS, the funds transferred out of Feedback that eventually ended up in the Avrahamis' bank account - whether directly or indirectly via Belly Button - constituted ordinary income to them.

The Avrahamis and Feedback, on the other hand, argued that (1) Feedback was a valid insurance company that qualified and properly elected to be taxed under Code Sec. 831(b); (2) all the policies covered insurable risks; (3) all premiums were actuarially determined; and (4) Feedback distributed risk by ensuring at least 30 percent of its premium income came from unrelated parties participating in the Pan American program. As a result, they maintained that the insurance-expense deductions claimed by the various Avrahami entities were proper and all the distributions to Belly Button were valid, documented loans. However, they conceded that the $200,000 distributed directly to Mrs. Avrahami should have been reported and taxed - at qualified dividend rates, they argued - and would have been but for an error by their CPA. The Avrahamis also argued that Feedback distributed risk by participating in the Pan American program and reinsuring third-party risk.

Tax Court's Decision

The Tax Court held that the elections made by Feedback were not valid and the amounts paid to Feedback and Pan American did not constitute insurance premiums for federal income tax purposes and thus were not deductible under Code Sec. 162. The court also concluded that the $200,000 transferred directly from Feedback to Mrs. Avrahami was an ordinary dividend taxed at ordinary income tax rates; however, amounts transferred indirectly from Feedback to the Avrahamis through Belly Button was not taxable to the extent it represented a loan repayment. Any excess over this amount was either taxable interest or ordinary dividends. Finally, because this was the first case to ever address microcaptives and the interplay among Code Sec. 162, Code Sec. 831(b), and Code Sec. 953(d), the court held that the Avrahamis were not liable for the accuracy-related penalties under Code Sec. 6662(a) except in relation to the amounts determined to be ordinary dividends or taxable interest.

In concluding that Feedback did not qualify as an insurance company, the court said Feedback's operations left much to be desired. While noting that Feedback met the minimum capitalization requirements of St. Kitts and that case law implied that this meant it was adequately capitalized, the court also noted that Feedback dealt with claims on an ad hoc basis and invested only in illiquid, long-term loans to related parties and failed to get regulatory approval before transferring funds to them. Additionally, the court observed, the Avrahami entities made no claims whatsoever against Feedback from its inception in 2007 until March 2013 - two months after the IRS began its audits. And even the claims Feedback did receive it dealt with in questionable ways, the court noted. The policies required that Feedback be notified within 30 days of the loss; however, most of the claims were approved despite being filed after 30 days.

Further, the court said, Feedback also made investment choices only an unthinking insurance company would make. By the end of 2010, more than 65 percent of Feedback's assets were tied up in long-term, illiquid, and partially unsecured loans to related parties. And, despite Kittian regulations requiring advance approval for any loan to a parent or affiliated person, such loans weren't disclosed until September 2014. If something catastrophic happened to Belly Button, its ability to repay the loans would be impaired, the court noted, and make Feedback's ability to pay on any claims doubtful. Even if Feedback was organized and regulated as an insurance company, the Tax Court found that it was not operated like one.

In determining whether Pan American was a bona fide insurance company, the court said it wouldn't condemn the entity solely for the atypical fee structure it had; however, the court noted such fee structure came combined with excessive premiums, an ultralow probability of a claim ever being paid, and payments of a circular nature. The court had to make a finding of fact as to whether Pan American was an entity engaged in insurance or was just part of a tax-reduction scheme papered to look like an entity engaged in insurance and concluded that, more likely than not, Pan American was not a bona fide insurance company. According to the court, even though Pan American was regulated under the laws of the Island of Nevis and met that loosely regulated regime's low capitalization requirements, that was not enough. The court concluded that the policies Pan American was issuing were not insurance, which in turn meant Feedback's reinsurance of those same policies did not distribute risk. Therefore, neither through its affiliated entities nor through Pan American did Feedback accomplish sufficient risk distribution for its arrangements to be considered insurance for federal income tax purposes.

For a discussion of insurance expense deductions and captive and microcaptive insurance arrangements, see Parker Tax ¶92,730.

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Sixth Circuit Rejects FATCA and FBAR Challenges by Senator Rand Paul and Others

The Sixth Circuit upheld a district court ruling that several individuals, including Senator Rand Paul (R-KY), did not have standing to sue the U.S. government to enjoin it from enforcing the Foreign Account Tax Compliance Act (FATCA), the intergovernmental agreements (IGAs) entered into with foreign governments under FATCA, and the foreign bank account reporting (FBAR) requirement under the Bank Secrecy Act. According to the court, none of the individuals had alleged an actual or imminent injury traceable to the U.S. government and redressable by the court. Crawford v. U.S., 2017 PTC 388 (6th Cir. 2017).

Background

The Foreign Account Tax Compliance Act (FATCA) was enacted in 2010 to reduce tax evasion by U.S. taxpayers using foreign bank accounts. FATCA imposes account reporting requirements and penalties for noncompliance on individual taxpayers as well as on foreign financial institutions (FFIs). FATCA's individual reporting requirements under Code Sec. 6038D generally apply to U.S. taxpayers with specified foreign assets valued above $50,000, or higher depending on marital status and other factors. FATCA also imposes institutional reporting requirements on FFIs; FFIs must use Form 8966, FATCA Report, to make the required disclosures regarding U.S. taxpayers with foreign accounts. An FFI that fails to meet the reporting requirements is subject to a 30 percent tax on all payments of U.S. source income to the FFI. For account holders who fail to comply with an FFI's information requests, the FFI must withhold 30 percent of payments of interest, dividends and other income; this is referred to as the "passthrough penalty."

To facilitate FFIs' disclosure of account information, the U.S. has reached intergovernmental agreements (IGAs) with over 70 countries. Under the IGAs, either the foreign government agrees to collect the financial information that FATCA would otherwise require FFIs to report, and the foreign government itself reports the information directly to the IRS, or FFIs report the required information directly to the IRS, and the foreign government agrees to modify its laws to allow FFIs to comply with FATCA.

Separately from FATCA, the Bank Secrecy Act imposes a foreign bank account reporting (FBAR) requirement on Americans living abroad who have foreign account balances over $10,000. The FBAR requirement is satisfied by filing FinCEN Form 114. Willful failure to file an FBAR results in a penalty equal to the greater of $100,000 or 50 percent of the value of the reportable account. Absent a showing of willfulness, the ordinary penalty is $10,000 per violation.

In 2015, a group of individuals sued to enjoin the U.S. government from enforcing FATCA, the IGAs, and the FBAR. The group included Mark Crawford, an American citizen living in Albania and the owner of Aksioner, an Albanian brokerage firm that is a partner of Saxo Bank in Copenhagen. He claimed that Saxo Bank did not allow Aksioner to accept U.S. citizens as clients because the bank did not want to assume FATCA responsibilities. Crawford also said that because of FATCA, Aksioner denied Crawford's own application for a brokerage account, and that FATCA forced him to turn away prospective American clients living in Albania.

The group also included Senator Rand Paul, who claimed he was denied the opportunity to vote against the FATCA IGAs, but did not otherwise challenge FATCA or the FBAR. Other individuals were current and former U.S. citizens who shared joint bank accounts with their non-U.S. citizen spouses and who claimed that FATCA would result in the disclosure of their spouses' private financial information. Another individual claimed he had a college savings account for his daughter at a Swiss bank and did not want to transfer the account to his daughter for fear that the FBAR penalty would be imposed if the IRS determined that there had been a willful failure to file an FBAR. Marc Zell, an American and Israeli citizen living in Israel, said that because of FATCA, his law firm had been required by Israeli banks to complete IRS withholding forms in order to open trust accounts for both U.S. and non-U.S. clients. Zell claimed that Israeli banks required the forms regardless of whether the beneficiary was a U.S. person and, as a result, Zell had to close accounts in some cases and could not open trust accounts in others. Zell also claimed an Israeli bank had requested that he transfer certain client securities elsewhere because he and the beneficiary are U.S. citizens. Zell said that he had lost several clients as a result of the FATCA reporting requirements.

The lawsuit alleged several Constitutional violations resulting from FATCA, the IGAs, and the FBAR. According to the complaint, the IGAs were not authorized by Congress through the ordinary legislative process and therefore exceeded the President's authority. With respect to the various individual reporting requirements, the complaint argued that U.S. citizens living abroad were being treated differently from those living in the U.S. in violation of their equal protection rights. The lawsuit alleged that the FFI, passthrough, and FBAR willfulness penalties were unconstitutional because they constituted excessive fines. The individuals claimed that the institutional reporting requirements under FATCA and the IGAs constituted a warrantless search in violation of the Fourth Amendment right to privacy. The individuals moved to amend their complaint to add three other individuals and to include statements that some of the individuals' bank balances exceeded the FATCA or FBAR threshold amounts. None of the original or proposed additional individuals alleged that they faced direct consequences such as the imposition or threatened imposition of a penalty for noncompliance with FATCA, the IGAs, or the FBAR.

The district court denied the motion for a preliminary injunction, holding that the individuals were not likely to succeed on the merits either because they lacked standing or because their allegations failed as a matter of law. The district court granted the government's motion to dismiss for lack of standing, and declined to consider the motion for leave to amend their complaint. The individuals appealed to the Sixth Circuit.

Analysis

On appeal, the Sixth Circuit affirmed the district court's ruling that none of the individuals had standing and that the lack of standing would not have been cured had leave been granted to amend the complaint. The Sixth Circuit held that there were no allegations of either an actual injury that was fairly traceable to FATCA or an imminent threat of prosecution from noncompliance with FATCA. There had been no actual enforcement of FATCA, such as a demand for compliance with the individual reporting requirement, and no imposition of a penalty for noncompliance. Moreover, none of the individuals claimed to hold enough foreign assets to be subject to the individual reporting requirement. As a result, the court held that there was no credible threat of either prosecution for failing to comply or the imposition of a passthrough penalty by an FFI. The individuals all lacked standing to challenge the FFI penalty, which would require either that the foreign banks themselves brought a suit or that the individuals had third party standing, which the Sixth Circuit determined they did not.

The court noted that Zell claimed to have signatory authority over accounts with an aggregate balance of greater than $200,000 in 2014, which would subject him to FATCA individual reporting. However, the court reasoned that although the Israeli IGA imposes a reporting requirement on trust accounts, FATCA itself did not apply to accounts held entirely for the benefit of non-U.S. persons. Further, although the IGA was in force in Israel as of August 2016, it was not in effect when the complaint was filed or when leave was sought to amend the complaint.

The court held that the individuals' alleged harms arising from FATCA apart from its individual reporting requirement or the passthrough penalty were not fairly traceable to FATCA. For example, Crawford's claim that Saxo Bank would not allow Crawford to accept U.S. clients was the result of Saxo Bank's own independent actions, not FATCA. Likewise, the court held that claims that the private financial information of non-U.S. citizens was disclosed to the IRS was not because of FATCA. Thus, any resulting injury could not be fairly traced to FATCA. Zell's claim that Israeli banks told him to move securities elsewhere and to complete IRS forms for his clients was the due to the banks' voluntary choice.

The Sixth Circuit also held that none of the individuals had standing to challenge the IGAs. Senator Paul claimed he had been harmed by not having the opportunity to exercise his constitutional right as a Senator to vote against the IGAs, but the court found that any incursion on his political power was neither a concrete injury like the loss of a private right nor a particularized grievance. Senator Paul, the court noted, had not claimed that his vote on its own would have been sufficient to forestall the IGAs. Senator Paul's proper remedy was to seek repeal or amendment of FATCA, according to the Sixth Circuit.

The Sixth Circuit also held that no individual had standing to challenge the FBAR. Most of the individuals claimed to have foreign account balances over $10,000, and were therefore subject to the FBAR requirement, but no one alleged both an intent to violate the FBAR and a credible threat of a penalty. Further, there were no allegations of any actual injury arising from the FBAR other than one person's claim that she wanted a college savings account placed in her name but her father did not want to transfer the account for fear that it would trigger an FBAR penalty. The court reasoned that this injury was traceable not to the FBAR but to the father's personal choice not to transfer the account.

Finally, the Sixth Circuit held that the district court properly denied the motion for leave to amend the complaint. According to the Sixth Circuit, the district court thoroughly reviewed all of the proposed new parties and claims in the amended complaint and properly held that leave to amend would be futile because there would still be no one with standing to bring any of the claims in the proposed amended complaint.

For a discussion of the FBAR, see Parker Tax ¶203,170. For a discussion of FATCA, see Parker Tax ¶203,180.

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Tax Court Upholds IRS's Adjustments to Cement Company's Depletion Deductions

The Tax Court held that a cement producer that mined calcium carbonate and mixed it with minerals purchased from third parties was entitled to a 14 percent depletion rate for the calcium carbonate, not the 15 percent rate used by the company. The court also held that the purchased minerals were nonmining costs for purposes of calculating the company's gross income. Mitsubishi Cement Corp. v. Comm'r, T.C. Memo. 2017-160.

Mitsubishi Cement, a Delaware corporation that has its principal place of business in Nevada, mines calcium carbonates in the process of its primary business activity of producing finished cement. It also purchases from third parties other minerals needed for the production of cement. The purchased minerals are added to the mined calcium carbonates before the mixture is introduced into a preheating tower. Mitsubishi Cement's direct mining costs for 2011 and 2012, the years at issue, were around $9.4 million and $10 million, respectively. Mitsubishi Cement claimed depletion deductions under Code Sec. 611 of approximately $1.3 million for 2011 and $1.8 million for 2012 using the percentage depletion method in Code Sec. 613. The company calculated its gross income from mining using the proportionate profits method of Reg. Sec. 1.613-4(d)(4) and used a percentage depletion rate of 15 percent under Reg. Sec. 1.613-2(a)(3).

In 2015, the IRS sent a notice of deficiency disallowing a portion of the depletion deductions for 2011 and 2012. The IRS said that the correct percentage depletion rate was 14 percent under Code Sec. 613(b)(7). It also claimed that in determining the depletion deduction, Mitsubishi Cement had incorrectly computed its gross income from mining by including the costs of minerals purchased from third parties in calculating its mining costs.

The depletion deduction for mining is calculated under Code Sec. 613 as a percentage of the mine's gross income. The percentage depletion rates for specific minerals are listed in Code Sec. 613(b), and these rates are applied to the taxpayer's gross income from mining to determine the depletion allowance. Code Sec. 613(b)(7) provides that the rate for calcium carbonate is 14 percent. However, Reg. Sec. 1.613-2(a)(3) provides that 15 percent is the applicable rate for calcium carbonate. In calculating gross income, a mining company that also has nonmining activities (for example, the manufacture of finished products) must separate its income from the mining and nonmining activities and apply the depletion rate only to the mining gross income. Under the proportionate profits method, the taxpayer determines the ratio of its mining costs to its total costs incurred to produce its first marketable product, then applies this ratio to its total gross sales to determine the gross income from mining. The depletion percentage rate is then applied to the mining gross income amount to determine the depletion allowance.

In applying the 15 percent rate in the regulations instead of the 14 percent rate in Code Sec. 613(b), Mitsubishi Cement argued that the regulation is an agency pronouncement that should be deemed a concession or stipulation by the IRS. With respect to the calculation of its mining costs, the company argued that the costs of third party minerals should be included because they qualified as a treatment process applied to the calcium carbonate that the company mined. Mitsubishi Cement argued that, if the purchased minerals were not mining costs, they should be considered "nominating costs" under Reg. Sec. 1.613-4(d)(3)(ii) and excluded entirely from the proportionate profits formula.

The Tax Court rejected Mitsubishi Cement's arguments and held that the 14 percent depletion rate applied and that the cost of purchased minerals was a nonmining cost that should be included in Mitsubishi Cement's total costs. Regarding the depletion percentage rate, the Tax Court resolved the conflict between the regulations and the statute by noting that the regulation was drafted in 1960, when the statutory rate was 15 percent. In 1969, Congress amended Code Sec. 613 to reduce the applicable rate to 14 percent. According to the Tax Court, the regulation was effectively superseded and made obsolete by the statutory change and could not be regarded as an implementing regulation. The court further observed that in any event, an agency's interpretation of a statute cannot supersede the language chosen by Congress.

In determining that the cost of purchasing minerals from third parties was a nonmining cost, the Tax Court noted that under Reg. Sec. 1.611-1(b)(1), a depletion deduction is permitted only to the taxpayer who has an economic interest in the mineral in its unmined state. According to the court, a taxpayer that purchases a mineral mined or otherwise produced by another may gain some economic advantage in the mineral but has no depletable interest in it. Moreover, the regulations concerning the calculation of mining gross income for percentage depletion purposes specifically provide that mining does not include purchasing minerals from another, and that the application of processes to purchased minerals does not constitute mining. The fact that the third party minerals are added to the calcium carbonates early in the process of making cement ignored the fact that Mitsubishi Cement never had a depletable interest in the purchased minerals, according to the court. In any case, depletion allowances must be calculated separately for individual mineral properties combined in a mixture, in the court's view.

The Tax Court also rejected Mitsubishi Cement's argument that the purchased minerals qualified as "nominating costs" under Reg. Sec. 1.613-4(d)(3)(ii). The Tax Court determined that "nominating" is a typographical error, as it is not defined in the context of the depletion Code sections and appears nowhere else in Reg. Sec. 1.613-4, and is simply a misspelling of "nonmining." The costs of the purchased minerals were nonmining costs paid to produce Mitsubishi Cement's first marketable product. As such, these costs had to be included as part of the total costs in computing Mitsubishi Cement's gross income from mining under the proportionate profits method.

For a discussion of percentage depletion for mines and other natural deposits, see Parker Tax ¶95,335.

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