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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 149 - September 18, 2017


Parker's Federal Tax Bulletin
Issue 149     
September 18, 2017     

 

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 1. In This Issue ... 

 

Tax Briefs

IRS Publishes Reference Price and Credit Amount for Determining Section 45I Credit; Losses Relating to Child's Pageant Activity Aren't Deductible; No Educational Credit Allowed for Tuition to "Canine Clippers" Trade School ...

Read more ...

IRS Grants Tax Relief to Hurricane Victims; Retirement Plan Rules Relaxed

The IRS announced that Hurricane Irma victims 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 Irma and members of their families. IR-2017-150; Announcement 2017-13.

Read more ...

Obamacare Repeal Is Back: Senate Gears up for Final 2017 Repeal Push

Over the past two weeks, momentum has been building among Senate Republicans to make a final attempt to repeal the Affordable Care Act ("Obamacare") before the federal government's fiscal year ends on September 30 (realistically, the last day in 2017 the Senate could pass a bill on a party-line vote). The bill under consideration, Graham-Cassidy, would retain many of Obamacare's taxes and regulations, but would radically restructure its premium subsidies. Graham-Cassidy is generally considered to be the only viable Senate healthcare proposal left standing after the chamber voted down three other bills in July.

Read more ...

IRS Offers Relief for Partnerships and REMICS That Missed New Return Due Dates

The IRS is providing penalty relief to partnerships and real estate mortgage investment conduits (REMICs) that filed certain untimely returns or untimely requests for extension of time to file those returns as a result of changes to tax return due dates that were made by the Surface Transportation Act of 2015. The relief is granted automatically for penalties for failure to timely file Forms 1065, 1065-B, 8804, 8805, 1066, and any other returns, such as Form 5471, for which the due date is tied to the due date of Form 1065 or Form 1065-B. Notice 2017-47.

Read more ...

District Court Denies Deductions for Losses from Bad Real Estate Deal

A district court held that a couple who invested in a real estate development that later turned out to be fraudulent were not entitled to refunds for losses sustained directly and through a partnership. According to the court, the couple did not meet the deductibility requirements provided in Rev. Proc. 2009-20, failed to show that there was no reasonable expectation of recovery in the year the losses were discovered, and did not satisfy the procedural requirements to bring a refund action for the partnership losses. Hamilton v. U.S., 2017 PTC 415 (N.D. Ind. 2017).

Read more ...

IRS Validly Examined Predeceased Spouse's Return to Determine DSUE

The Tax Court held that during the audit of an estate, the IRS validly examined a predeceased spouse's estate tax return in order to adjust the amount of the deceased spousal unused exclusion (DSUE). A Letter 627, Estate Tax Closing Document, notifying the predeceased spouse's estate that its return had been accepted as filed did not constitute a closing agreement or estop the IRS from examining the predeceased spouse's return, and the examination was not an impermissible second examination. Estate of Sower v. Comm'r, 149 T.C. No. 11 (2017).

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IRS Barred by Statute of Limitations from Assessing Tax and Penalties Nine Years after Merger

The Tax Court held that the IRS was barred by the statute of limitations from assessing tax and penalties on a corporation that was merged into a new corporation almost nine years before the notice of deficiency was issued. The Tax Court found that under Beard v. Comm'r, 82 T.C. 766 (1984), the surviving corporation's return for the year at issue qualified as a return for the merged corporation's short tax year, thus triggering the three year period of limitations for assessments. New Capital Fire, Inc. v. Comm'r, T.C. Memo. 2017-177.

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IRS Addresses Tax Treatment of Employer Programs to Aid Hurricane Victims

The IRS issued guidance on the tax treatment of leave-based donation programs aimed at aiding victims of Hurricane Harvey, Tropical Storm Harvey, Hurricane Irma, and Tropical Storm Irma. Notice 2017-48; Notice 2017-52.

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Sovereign Immunity Did Not Bar Bankruptcy Trustee's Action to Avoid Debtor's Fraudulent Tax Payments

The Ninth Circuit Court held that sovereign immunity did not preclude a bankruptcy trustee from bringing an action under a state fraudulent transfer statute to avoid an S corporation debtor's payment of federal income taxes on its shareholders' behalf. In reaching the decision, the Ninth Circuit declined to follow In re Equipment Acquisition Resources, Inc., 2014 PTC 70 (7th Cir. 2014), where the Seventh Circuit reached the opposite conclusion in holding that the waiver of sovereign immunity in the Bankruptcy Code did not extend to a derivative state law claim. In re DBSI, Inc., 2017 PTC 404 (9th Cir. 2017).

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Owner of Fast Food Restaurants Can't Revise Merger Transaction After Deal Closes

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. Tseytin v. Comm'r, 2017 PTC 387 (3d Cir. 2017).

Read more ...

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 2. Tax Briefs 

 

Credits

IRS Publishes Reference Price and Credit Amount for Determining Section 45I Credit: In Notice 2017-51, the IRS provides the applicable reference price for qualified natural gas production from qualified marginal wells during tax years beginning in calendar year 2016 for the purpose of determining the marginal well production credit (MWC) under Code Sec. 45I. The notice also provides the credit amount used for purposes of determining the MWC for tax years beginning in calendar year 2016.

 

Deductions

Losses Relating to Child's Pageant Activity Aren't Deductible: In Lopez v. Comm'r, T.C. Memo. 2017-171, the Tax Court held that a couple could not deduct losses attributable to their child's pageant activity because the prize winnings earned by the child were includible in her gross income and only she could deduct expenses related to that income. However, because the couple hired an accountant to help with their returns, they had reasonable cause and acted in good faith with respect to their deductions and, thus, were not liable for the accuracy-related penalties.

No Educational Credit Allowed for Tuition to "Canine Clippers" Trade School: In Martin v. Comm'r, T.C. Summary 2017-73, the Tax Court held that a couple was not entitled to an education credit for amounts paid for their daughter's tuition where they produced no evidence showing that the daughter (1) was enrolled in college at least half time, or (2) was enrolled at a particular college for at least one academic period. The court also said the couple failed to show, with respect to their daughter's attendance at a trade school called "Canine Clippers," that Canine Clippers was an eligible educational institution.

Scientist Failed to Meet Requirements Necessary to Deduct $8.55 Million as Partially Worthless Bad Debt: In Rutter v. Comm'r, T.C. Memo. 2017-174, the Tax Court held that the IRS did not abuse its discretion in determining that a world-renowned scientist in the field of biotechnology was not entitled to a deduction of $8.55 million for a partially worthless debt for 2009. The court concluded that, even if the taxpayer established that his advances to a company behind which he was the driving force constituted debt, and that this debt was a business debt, he did not meet the requirements in Code Sec. 166(a)(2) and Reg. Sec. 1.166-3(a)(2)(iii) for deducting a partially worthless bad debt.

 

Employee Benefits

IRS Provides Hurricane Relief in Connection with Certain Employee Benefit Plans: In Notice 2017-49, the IRS, the Department of Labor's Employee Benefits Security Administration (EBSA), and the Pension Benefit Guaranty Corporation (PBGC) are providing relief in connection with certain employee benefit plans because of damage caused by Hurricane Harvey and Hurricane Irma. The relief includes a relaxation of the rules for the dates by which contributions to such plans must be made.

 

Penalties

IRS Waives Diesel Fuel Penalty in Texas and Florida: In IR-2017-142 and IR-2017-149, the IRS announced that, in response to shortages of undyed diesel fuel caused by Hurricane Harvey and Hurricane Irma, respectively, it is waiving the penalty when dyed diesel fuel is sold for use or used on the highway in the state of Texas. The relief is effective as of August 25, 2017, for Hurricane Harvey and September 6, 2017, for Hurricane Irma.

 

Procedure

Court Rejects Request to Close Down Dentist's Practice Over Unpaid Taxes: In U.S. v. Moore, DMD PA, 2017 PTC 401 (D. N.J. 2017), a district court denied a request by the government for injunctive relief aimed at closing down the practice of a dentist who owed income and employment taxes, saying the request was overly broad and premature, and would cut off the dentist's only real chance to repay his and the practice's liabilities. The court found that, even though the government had demonstrated the dentist's history of noncompliance, it had not demonstrated that his conduct warranted the proposed injunction.

Third Circuit Erred in Concluding Company Couldn't Establish Negligence Against CPA Firm: In DDRA Capital, Inc. v. KPMG, LLP, 2017 PTC 408 (3d Cir. 2017), the Third Circuit held that a district court erred in concluding that a corporation could not establish proximate cause for purposes of negligence claims against an accounting firm, which the corporation said had directed it into a transaction known as Short Option Strategy (SOS) that the accounting firm knew was illegal. The corporation argued that, but for misrepresentations by the firm and one of its partners that the SOS transaction was legal and would survive IRS scrutiny, they would have pursued other tax strategies for which they would have paid no penalties or interest, no fee to the accounting firm, and possibly less in taxes.

Ninth Circuit Affirms 30-Month Sentence of Former IRS Agent Who Solicited Bribes: In U.S. v. Hurley, 2017 PTC 409 (9th Cir. 2017), the Ninth Circuit affirmed the conviction and 30-month prison sentence of a former IRS agent, who was found guilty of soliciting and receiving bribes and illegal gratuities from an individual he was auditing. According to the court, a rational jury could find that the payments received by the former IRS agent from the individual he was auditing influenced the official act of the tax audit and induced the agent to violate his official duties.

Court Did Not Err in Accepting Schizophrenic's Guilty Plea: In U.S. v. Anderson, 2017 PTC 416 (11th Cir. 2017), the Eleventh Circuit held that a district court did not err by accepting a guilty plea from individual who suffers from schizophrenia, but controls it with medication. The individual had admitted in writing that he cashed thousands of fraudulently obtained tax refund checks in amounts totaling over $7 million dollars, had received approximately 20 percent of the face value of the checks, and had spent the money buying real property and multiple luxury cars.

Related Entities Must All Pay 15 Percent of Penalty In Order for Court to Hear Their Case: In DAC Management, LLC v. U.S., 2017 PTC 419 (N.D. Ill. 2017), a district court granted an IRS motion to dismiss two cases in which taxpayers were seeking a determination that they were not liable for civil penalties assessed against them under Code Sec. 6700. The court held that, while the law requiring an individual and the entities he owns to all pay the exact same penalty on the exact same income as a precondition to challenging the assessment of a Code Sec. 6700 penalty may well be unlawful, because all the entities involved in the case did not pay the required 15 percent of the penalties assessed against them, the court lacked jurisdiction to hear the case.

IRS Issues Quarterly Interest Rates for Tax Overpayments and Underpayments: In Rev. Rul. 2017-18, the IRS issued the rates for interest on tax overpayments and underpayments for the fourth calendar quarter of 2017, beginning October 1, 2017. The interest rates will be 4 percent for overpayments (3 percent in the case of a corporation), 4 percent for underpayments, 1 and one-half percent for the portion of a corporate overpayment exceeding $10,000, and 6 percent for large corporate underpayments.

Chief Counsel's Office Discusses Representations Covered by POAs: In CCM 201736012, the Office of Chief Counsel advised that a Form 2848, Power of Attorney and Declaration of Representative, which lists only a specific tax return, does not cover representation for penalties, payments, and interest relating to other returns, regardless of whether other returns are attached to the return specified in the Form 2848. Further, Forms 2848 that only list a specific return cover representation for penalties, payments, and interest related only to that specific tax return, and not to other returns that may be filed separately.

 

Tax Accounting

IRS Provides Safe Harbor for Accounting Practice Used by Regulated Utilities: In Rev. Proc. 2017-47, the IRS provides a safe harbor concerning inadvertent or unintentional uses of a practice or procedure that is inconsistent with Code Sec. 50(d)(2) and Code Sec. 168(i)(9), which require regulated utilities to use the Normalization Rules. If the safe harbor applies, the IRS will not assert that a taxpayer's inadvertent or unintentional use of a practice or procedure that is inconsistent with Code Sec. 50(d)(2) and Code Sec. 168(i)(9) constitutes a violation of the Normalization Rules.

 

Tax-Exempt Organizations

IRS Issues Guidance for Tax Practitioners Preparing Written Advice Relating to Private Foundations: In Rev. Proc. 2017-53, the IRS provides guidelines that qualified tax practitioners may use for preparing written advice on which a private foundation or sponsoring organizations of donor advised funds ordinarily may rely in making a good faith determination that a grantee is a qualifying public charity in order that the grant will be considered a qualifying distribution that does not require expenditure responsibility in order to not be a taxable expenditure.. The procedure modifies and supersedes Rev. Proc. 92-94.

 

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 3. In-Depth Articles 

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IRS Grants Tax Relief to Hurricane Victims; Retirement Plan Rules Relaxed

The IRS announced that Hurricane Irma victims 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 Irma and members of their families. IR-2017-150; Announcement 2017-13.

Practice Aid: See ¶320,097, for a sample client letter explaining Hurricane Irma tax relief. For a similar letter explaining Hurricane Harvey relief, see ¶320,098.

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 Irma. 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. The tax relief granted by the IRS includes an additional filing extension for taxpayers 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. As of press time, this relief covers all 67 Florida counties, the islands of St. John and St. Thomas in the U.S. Virgin Islands, and the municipalities of Culebra, Vieques, Canovanas and Loiza in Puerto Rico.

Taxpayers in other localities added later to the disaster area listing will automatically receive the same filing and payment relief. The list of eligible localities is available on the disaster relief page on IRS.gov/newsroom/help-for-victims-of-hurricane-irma.

The tax relief postpones various tax filing and payment deadlines that occurred starting on September 4, 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. Businesses with extensions also have the additional time including, among others, calendar-year partnerships whose 2016 extensions run out on September 15, 2017, and calendar-year tax-exempt organizations whose 2016 extensions run out on November 15, 2017. The disaster relief page has details on other returns, payments and tax-related actions qualifying for the additional time.

In addition, the IRS is waiving late-deposit penalties for federal payroll and excise tax deposits normally due during the first 15 days of the disaster period. Different time periods apply to the various jurisdictions. The time periods for each jurisdiction may be found on the IRS's disaster relief page at irs.gov

The IRS automatically provides 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.

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 Irma 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 Irma and designated for individual assistance by the Federal Emergency Management Agency (FEMA). 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 Irma 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 2017-13.

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.

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

[Return to Table of Contents]

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Obamacare Repeal Is Back: Senate Gears up for Final 2017 Repeal Push

Over the past two weeks, momentum has been building among Senate Republicans to make a final attempt to repeal the Affordable Care Act ("Obamacare") before the federal government's fiscal year ends on September 30 (realistically, the last day in 2017 the Senate could pass a bill on a party-line vote). The bill under consideration, Graham-Cassidy, would retain many of Obamacare's taxes and regulations, but would radically restructure its premium subsidies. Graham-Cassidy is generally considered to be the only viable Senate healthcare proposal left standing after the chamber voted down three other bills in July.

Like the healthcare bill that passed the House in May (AHCA; "House bill"), Graham-Cassidy eliminates the individual and employer mandates, repeals the medical device tax, and delays implementation of the "Cadillac tax" on high-cost employer-sponsored health plans until 2026.

Observation: Unlike the House bill, which replaces the individual mandate with a 30 percent health insurance premium surcharge on individuals who allow their coverage to lapse, Graham-Cassidy does not provide any incentives for individuals to maintain continuous coverage. The omission is similar to the one in the Better Care Reconciliation Act (BRCA), the since-defeated Senate healthcare introduced last June. Senate leadership dealt with the earlier omission by adding provisions to the BRCA requiring individuals to wait six months to obtain new health insurance after a coverage lapse. There's no indication that a similar change to Graham-Cassidy is in the offing.

Similar to the House bill, the Graham-Cassidy bill ostensibly retains Obamacare's insurance regulations, including standards for "essential health benefits" that insurers must cover and protections for individuals with preexisting conditions - but potentially undermines them by making it easier for states to obtain waivers. Other features common to the House and the Graham-Cassidy bills include provisions that would allow insurers to charge older individuals five times more than younger ones (compared with three times under current law), and sharp reductions in Medicaid funding beginning in 2020.

Where the two bills depart the most sharply is in their handling of Obamacare's key funding sources, and in how they subsidize the purchase of health insurance on the individual market.

The House bill would repeal the net investment income tax (NIIT) and the 0.9% additional Medicare tax in 2017 and 2023, respectively. Graham-Cassidy would keep both taxes.

Both bills would retain Obamacare's means-tested premium tax credit through 2019 with minor adjustments. After that, the House bill would replace it with a new, less generous, age-based credit. Graham-Cassidy, by contrast, would eliminate the federal credit altogether, and replace it with a seven-year block grant program. The program would allow states to implement their own subsidies by using the federal funds for any combination of six approved purposes, ranging from establishment of high-risk pools and/or reinsurance programs, to providing direct assistance to people purchasing health insurance on the individual market.

The Congressional Budget Office (CBO) has not yet scored the Senate's healthcare plan. An estimate is expected the week of September 25.

It's too soon to know whether Senate Republicans will have the 50 votes they'll need to pass the bill, after falling one short on the "skinny repeal" bill in July. Of the three Republicans who helped send that measure to defeat, Susan Collins (R-ME) and Lisa Murkowski (R-AK) have yet to state their position on Graham-Cassidy; John McCain (R-AZ), a close friend of bill sponsor Lindsey Graham, has voiced tentative support. Rand Paul (R-KY), who voted for skinny repeal but against BCRA, has said that he's a hard "no".

Senate leadership has indicated that they will only bring the matter to a vote if they have the votes to win passage.

[Return to Table of Contents]

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IRS Offers Relief for Partnerships, REMICS, and Partners That Missed New Return Due Dates

The IRS is providing penalty relief to partnerships and real estate mortgage investment conduits (REMICs) that filed certain untimely returns or untimely requests for extension of time to file those returns as a result of changes to tax return due dates that were made by the Surface Transportation Act of 2015. The relief is granted automatically for penalties for failure to timely file Forms 1065, 1065-B, 8804, 8805, 1066, and any other returns, such as Form 5471, for which the due date is tied to the due date of Form 1065 or Form 1065-B. Notice 2017-47.

Background

The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (the Surface Transportation Act) amended Code Sec. 6072 and changed the date by which a partnership must file its annual return. The due date for filing partnership and real estate mortgage investment conduit (REMIC) tax returns changed from the 15th day of the fourth month following the close of the tax year (i.e., April 15 for calendar-year taxpayers) to the 15th day of the third month following the close of the tax year (i.e., March 15 for calendar-year taxpayers). The new due date applies to the returns of partnerships and REMICs for tax years beginning after December 31, 2015.

Partnerships filing Form 1065, U.S. Return of Partnership Income, and Form 1065 B, U.S. Return of Income for Electing Large Partnerships, as well as REMICs filing Form 1066, U.S. Real Estate Mortgage Investment Conduit (REMIC) Income Tax Return, are affected by the Surface Transportation Act amendment. The partnerships may also file Form 8804, Annual Return for Partnership Withholding Tax (Section 1446), and Form 8805, Foreign Partner's Information Statement of Section 1446 Withholding Tax, which are generally due to the IRS on the same date as the partnership's Form 1065 or Form 1065-B. Filers of Form 1065 must furnish their partners with Schedules K-1, Partner's Share of Income, Deductions, Credits, etc., by the due date of the Form 1065, and filers of Form 1065-B must furnish their partners with Schedules K-1 by the first March 15 following the close of the partnership's tax year. Filers of Form 8804 that are required to file Forms 8805 must also furnish their partners with their respective copies of Forms 8805 by the due date of the Form 8804. Some partnerships must also file additional returns, such as Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, by the due date of the Form 1065 or Form 1065-B.

Partnerships and REMICs can obtain a six-month extension of time to file Form 1065, Form 1065 B, Form 8804, and Form 1066 by filing Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns, by the statutory due date of those returns. Partnerships that receive an extension of time to file Form 1065 receive a concurrent extension of time to furnish their partners with Schedules K-1. Also, partnerships that receive an extension of time to file Form 8804 receive concurrent extensions of time to file Forms 8805 and to furnish respective copies of the Forms 8805 to their partners. The six-month extension may apply to additional returns that partnerships may be required to file by the due date of their Forms 1065 or 1065-B, but it does not affect the due date for partnerships filing Form 1065-B to furnish their partners with Schedules K-1

Partnerships and REMICs that fail to timely meet their obligations to file and furnish returns are subject to penalties. Partnerships and REMICs that fail to file Form 1065, Form 1065-B, Form 8804, or Form 1066 by the due date (with regard to extensions) are subject to penalty under Code Sec. 6698 or Code Sec. 6651. Partnerships that fail to file Forms 8805 by the due date (with regard to extensions) are subject to penalty under Code Sec. 6721. Partnerships that fail to furnish Schedules K 1 or the partner copies of Forms 8805 by the due date are subject to penalty under Code Sec. 6722. Partnerships that fail to file Form 5471 by the due date are subject to penalty under Code Sec. 6038 or Code Sec. 6679. Partnerships that fail to file additional returns that they are required to file by the due date of their Forms 1065 or 1065-B may also be subject to other penalties.

Issue

Many partnerships and REMICs filed the returns discussed above or Form 7004 for the first tax year beginning after December 31, 2015, by the date previously required by Code Sec. 6072; thus, the returns were filed late. If not for the Surface Transportation Act, these returns and requests for extension of time to file would have been timely.

IRS Relief

The IRS will grant relief from the penalties described above for any return described above for the first tax year of any partnership that began after December 31, 2015, if the following conditions are satisfied:

(1) the partnership or REMIC filed the Form 1065, 1065-B, 8804, 8805, 5471, or other return required to be filed with the IRS and furnished copies (or Schedules K-1) to the partners (as appropriate) by the date that would have been timely under Code Sec. 6072 before amendment by the Surface Transportation Act (April 18, 2017, for calendar-year taxpayers, because April 15 was a Saturday and April 17 was a legal holiday in the District of Columbia), or

(2) the partnership or REMIC filed Form 7004 to request an extension of time to file by the date that would have been timely under Code Sec. 6072 before amendment by the Surface Transportation Act and files the return with the IRS and furnishes copies (or Schedules K-1) to the partners (as appropriate) by the fifteenth day of the ninth month after the close of the partnership's taxable year (September 15, 2017, for calendar-year taxpayers). If the partnership files Form 1065-B and was required to furnish Schedules K-1 to the partners by March 15, 2017, it must have done so to qualify for relief.

The relief under Notice 2017-47 is granted automatically for penalties for failure to timely file Forms 1065, 1065-B, 8804, 8805, 1066, and any other returns, such as Form 5471, for which the due date is tied to the due date of Form 1065 or Form 1065-B. Partnerships and REMICs that qualify for relief and have already been assessed penalties can expect to receive a letter within the next several months notifying them that the penalties have been abated.

For reconsideration of a penalty covered by Notice 2017-47 that has not been abated by February 28, 2018, taxpayers should contact the number listed in the letter that notified the taxpayer of the penalty or call (800) 829-1040 and ask for relief under Notice 2017-47. Taxpayers who qualify for relief under Notice 2017-47 will not be treated as having received a first-time abatement under the IRS's administrative penalty waiver program.

For a discussion of the due dates for partnership and REMIC tax returns and the penalties for late filing of those returns, see Parker Tax ¶28,550 and ¶49,135, respectively.

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District Court Denies Deductions for Losses from Bad Real Estate Deal

A district court held that a couple who invested in a real estate development that later turned out to be fraudulent were not entitled to refunds for losses sustained directly and through a partnership. According to the court, the couple did not meet the deductibility requirements provided in Rev. Proc. 2009-20, failed to show that there was no reasonable expectation of recovery in the year the losses were discovered, and did not satisfy the procedural requirements to bring a refund action for the partnership losses. Hamilton v. U.S., 2017 PTC 415 (N.D. Ind. 2017).

Facts

Robert Hamilton and his wife, Joan, were approached in 2006 with a real estate investment opportunity in North Carolina called the Grandfather Vista Development. The couple were told that for $500,000, they could buy a 10 acre lot and simultaneously enter into a buyback agreement effective one year after the purchase, by which the developers would repurchase the lot for $625,000. The developers personally guaranteed the buyback agreement, and represented to the Hamiltons that they had over $100 million in net worth. In other words, they portrayed the investment as nearly risk free.

The Hamiltons made a $25,000 down payment on one 10 acre lot referred to as Lot 86. The rest of the purchase price was financed through a bank, which disbursed the proceeds directly to the developers. At closing, the developers paid the Hamiltons $38,000 for the first year's interest on the loan. A short time after buying Lot 86, the Hamiltons purchased a second, smaller parcel in the development. This lot was represented to be a retail lot that would be developed after the commercial development was completed. For this purchase, the Hamiltons invested through a partnership called H-Cubed Enterprises, LLC. The two members of H-Cubed were an entity owned by the Hamiltons and an entity owned by their in-laws, Gregory and Cynthia Hellmann. H-Cubed bought Lot 135 for $275,000. The entire amount was financed, so the Hamiltons paid nothing at closing, but they signed notes personally guaranteeing the loan.

The developer failed to follow through on the buyback agreements and the property was never developed. The lots, which could not be developed individually, ended up being worth very little. The Hamiltons were thus left with large loans that were secured by property of little value. The Hamiltons stated that they discovered the fraudulent nature of the project in 2008. That same year, the state shut down the Grandfather Vista development. In December 2008, the Hamiltons and other purchasers filed suit against the developers and the banks that financed the loans. They also joined at least two adversary proceedings in bankruptcy court against some of the developers. Ultimately, the Hamiltons declared bankruptcy, through which they discharged their loan obligations arising from these investments. The Hamiltons ended up with outright ownership in Lot 86 and transferred their interest in Lot 135 to the Hellmanns.

In 2011, the Hamiltons met with an accountant to address the tax implications of their investment losses. They filed amended returns for 2008 to claim their losses as theft losses. The Hamiltons calculated their total investments in the properties, including the amounts they borrowed but never had to pay back, and claimed 75 percent of those amounts as theft loss deductions pursuant to Rev. Proc. 2009-20, which generally permits a 75 percent deduction for certain theft losses from Ponzi schemes. They claimed a loss on Lot 86 of approximately $361,000. With respect to Lot 135, the Hamiltons claimed a loss of $103,000, equal to half of the approximately $206,000 loss that H-Cubed identified on its return as a theft loss. The partnership losses were different from what the Hamiltons and H-Cubed had reported on their initial returns, so they filed amended returns to reflect those changes, but did not file an administrative adjustment request (AAR). An AAR is the process for amending the reporting of partnership items on a previous return.

For 2008, the Hamiltons sought a refund of $21,000, and sought to carryback loss deductions of $76,000 to 2005. The IRS disallowed the loss deductions and denied the Hamiltons' refund claim. According to the IRS, (1) 2008 was not the proper year to take the deductions for the Lot 86 losses, and (2) the district court did not have jurisdiction to consider the refund claims related to the partnership losses on Lot 135. The Hamiltons then filed a refund action in a district court.

Under Code Sec. 165, theft losses are generally deductible in the year the theft is discovered, but not if the taxpayer has a claim for reimbursement with a reasonable prospect of recovery. A good faith effort to recover the loss, such as a lawsuit, generally delays the deduction to a later year. For Ponzi scheme losses, Rev. Proc. 2009-20 provides a safe harbor procedure that allows a deduction of 75 percent of a loss in the year that criminal charges are filed against the lead figure in the scheme, if certain requirements are met. One of those requirements is that there must be a qualified loss in a qualified investment, as those terms are described in Rev. Proc. 2009-20.

Partnership losses are covered by the Tax Equity and Fiscal Responsibility Act (TEFRA), which requires that all adjustments to partners' tax liabilities and any challenges to these adjustments be determined by the IRS in a single partnership administrative proceeding. TEFRA limits the jurisdiction of district courts to hear an action for a refund involving partnership items. District courts have jurisdiction over refund actions for partnership items only if (1) the refund claim is based on a computational error, or (2) the partner's AAR is rejected by the IRS.

District Court's Analysis

The district court held that the Hamiltons were not entitled to any of the refunds they sought. With respect to Lot 86, the court determined that (1) the Hamiltons were not entitled to relief under Rev. Proc. 2009-20, and (2) they failed to show that there was no reasonable expectation of recovery in 2008. The Hamiltons did not meet the requirements under Rev. Proc. 2009-20, the court said, because they did not provide any evidence that they had a qualified loss from a qualified investment. The court found that although state authorities had shut down the Grandfather Vista project in 2008, there was no evidence that criminal charges were brought as a result of the conduct that caused the Hamiltons' loss. Thus, the loss suffered by the Hamiltons was not a qualified loss, the court found. Moreover, the court observed, the Hamiltons failed to establish that their investment was a qualified investment because any amount that was borrowed and not repaid could not have been borrowed from a party that was part of the fraud. The court found that the Hamiltons failed to show that the bank from which they borrowed the investment funds was not part of the fraud, so their investment was not a qualified investment.

The Hamiltons also did not meet the requirements for a theft loss under Code Sec. 165, in the court's view, because they filed suit in December 2008 against the developers and banks involved in their purchase of Lot 86 and continued to pursue that and other actions for several years. According to the court, the Hamiltons made no attempt to prove that these proceedings offered no reasonable prospect of recovery. The court noted that, in a year where the prospect of recovery is simply unknowable, a theft loss deduction is inappropriate.

For the losses on Lot 135 that the Hamiltons incurred through H-Cubed, the district court determined that it did not have jurisdiction to consider the refund because the Hamiltons did not demonstrate either a computational error or that their AAR was denied. The court found that there was no question that the theft loss deduction for the loss incurred through H-Cubed was a partnership item, and as such, the refund claim had to be resolved through TEFRA procedures. The court rejected the Hamiltons' contention that the amended return of H-Cubed was functionally equivalent to an AAR, holding that even if it were, a partnership's AAR does not confer jurisdiction on the district court. Only a partner's AAR, which is rejected by the IRS, gives rise to jurisdiction over a refund action.

For a discussion of the theft loss deduction, see Parker Tax ¶98,110. The TEFRA procedures are discussed at Parker Tax ¶28,505.

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IRS Validly Examined Predeceased Spouse's Return to Determine DSUE

The Tax Court held that during the audit of an estate, the IRS validly examined a predeceased spouse's estate tax return in order to adjust the amount of the deceased spousal unused exclusion (DSUE). A Letter 627, Estate Tax Closing Document, notifying the predeceased spouse's estate that its return had been accepted as filed did not constitute a closing agreement or estop the IRS from examining the predeceased spouse's return, and the examination was not an impermissible second examination. Estate of Sower v. Comm'r, 149 T.C. No. 11 (2017).

Minnie Sower was the surviving spouse of Frank Sower, who died in 2012. From 2003 to 2005, Mr. and Mrs. Sower each gave approximately $997,000 in taxable gifts, which they reported on gift tax returns. When Mr. Sower died, his estate filed a return reporting no estate tax liability and zero in taxable gifts. Mr. Sower's estate reported a deceased spousal unused exclusion (DSUE) of approximately $1.2 million and elected portability of the DSUE to allow Mrs. Sower to use it. In 2013, the IRS issued an initial Letter 627, Estate Tax Closing Document (ETCD), to Mr. Sower's estate showing no tax liability. It stated that the return had been accepted as filed and that the IRS would not reopen or examine the return unless it was notified of changes or there was evidence of wrongdoing or error.

Mrs. Sower died in 2013. Her estate filed a return claiming the DSUE from her husband's estate. Like Mr. Sower's estate, Mrs. Sower's estate did not include the lifetime taxable gifts on the return. However, rather than reporting zero in gifts as on Mr. Sower's estate return, Mrs. Sower's estate's return left the entry blank.

The IRS audited Mrs. Sower's estate tax return beginning in February 2015. In connection with that examination, it also opened an examination of the return filed by Mr. Sower's estate to determine the proper DSUE amount available to Mrs. Sower's estate. In March 2015, an IRS attorney sent the executors of Mr. Sower's estate a letter and a draft revised report showing an adjustment to the amount of Mr. Sower's lifetime taxable gifts. In July 2015, the IRS issued a second ETCD to Mr. Sower's estate, which was in substance identical to that of the first ETCD sent in 2013. The IRS did not request any additional information from, or determine any additional liability for, Mr. Sower's estate.

After examining the return for Mr. Sower's estate, the IRS reduced the DSUE available to Mrs. Sower's estate to approximately $282,000. Mrs. Sower's taxable estate was also adjusted by the amount of her lifetime taxable gifts. The adjustments increased the estate tax liability for Mrs. Sower's estate by around $788,000, and in December 2015, the IRS sent the estate a notice of deficiency for that amount. Mrs. Sower's estate filed a Tax Court petition disputing the full amount of additional estate tax.

Before the Tax Court, Mrs. Sower's estate made four arguments. First, the estate said that the first ETCD should be treated as a closing agreement under Code Sec. 7121 and that the IRS should be estopped from reopening the estate. Second, it argued that the examination that occurred after the IRS had sent the first ETCD was an improper second examination. Third, the estate said that the effective date of Code Sec. 2010(c)(5)(B), which addresses the statute of limitations period relating to an audit of a DSUE amount, and the text of the regulations precluded the IRS from adjusting the DSUE amount for gifts made before 2010. Fourth, the estate argued that the IRS's application of Code Sec. 2010(c)(5)(B) in this case was contrary to Congress's intent to permit portability and was a due process violation because it overrode the statute of limitations on assessments.

The Tax Court rejected all of the estate's arguments. First, it determined that the original ETCD was not a closing agreement under Code Sec. 7121 because, under the regulations, only Form 866, Agreement as to Final Determination of Tax Liability, and Form 906, Closing Agreement on Final Determination Covering Specific Matters, qualify as closing agreements. The court noted that in rare cases, courts have bound the IRS to an agreement not executed on a Form 866 or Form 906, but only where there was evidence of negotiation and an offer and acceptance. In this case, the Tax Court found no such evidence. The estoppel argument failed because the Tax Court found that the estate established none of the necessary elements for an estoppel claim. To prevail on an estoppel claim against the IRS, a taxpayer must show four essential elements:  

(1) a false representation or wrongful misleading silence;  

(2) an error in a statement of fact and not in an opinion or statement of law;  

(3) a taxpayer ignorant of the true facts; and  

(4) a taxpayer that is adversely affected by the acts or statements of the person against whom an estoppel is being claimed (for example, by having to pay a tax twice).  

The Tax Court found that there was no false statement of fact because the issues in the case were questions of law and the facts were known by both parties. Further, the estate was not at risk of double taxation, and there were no facts showing that it acting in reliance on the first ETCD.

The Tax Court also did not agree that the IRS had conducted an impermissible second examination of the return filed by Mr. Sower's estate. The court cited the general rule that the IRS does not conduct a second examination when it does not obtain any new information. As the IRS did not request any additional information from Mr. Sower's estate, there was no second examination. The Tax Court further reasoned that only the examined party is protected from second examinations. Therefore, according to the Tax Court, even if there had been a second examination, it was not a second examination of the return of Mrs. Sower's estate.

The Tax Court rejected the estate's argument regarding the effective date of Code Sec. 2010(c)(5)(B), which authorizes the IRS to examine a deceased spouse's return after the statute of limitations has run in order to determine the DSUE amount. First, the estate argued that the IRS did not have the power to examine the return of Mr. Sower's estate a second time because the DSUE was not applied to a taxable gift transfer. The estate also said that because the gifts at issue in the case were given before the effective date of Code Sec. 2010(c)(5)(B), the IRS could not make adjustments to the DSUE as a result of those gifts. The Tax Court held that it was irrelevant whether the DSUE was applied to a taxable gift transfer because the DSUE was applied to the transfer of the estate, which was all that was required by the statute. The Tax Court further found that Code Sec. 2010(c)(5)(B) applies to decedents dying after December 31, 2010, which was true of both Mr. and Mrs. Sower. The fact that the gifts were made before that date had no relevance, according to the Tax Court.

Finally, the Tax Court rejected the estate's Congressional intent and due process arguments. The Tax Court reasoned that Congress adopted Code Sec. 2010(c)(5)(B) with the explicit purpose empowering the IRS to examine a predeceased spouse's return outside of the period of limitations in order to adjust the DSUE amount. This was a clear indication, in the Tax Court's view, that the IRS's exercise of this power with respect to Mr. Sower's return was not a violation of Congressional intent. Nor was there a due process violation because the statute of limitations was not subverted by Code Sec. 2010(c)(5)(B), according to the Tax Court. The statute does not give the IRS the power to assess any tax against the estate of the predeceased spouse outside the statute of limitations, and the regulations specifically provide that beyond adjusting the DSUE amount, the IRS can assess additional tax only if it is within the statute of limitations. Because the IRS did not assess any tax against Mr. Sower's estate, and the DSUE adjustment was not an assessment of tax against Mr. Sower's estate, the statute of limitations for assessment was not implicated.

For a discussion of the DSUE, see Parker Tax ¶227,200.

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IRS Barred by Statute of Limitations from Assessing Tax and Penalties Nine Years after Merger

The Tax Court held that the IRS was barred by the statute of limitations from assessing tax and penalties on a corporation that was merged into a new corporation almost nine years before the notice of deficiency was issued. The Tax Court found that under Beard v. Comm'r, 82 T.C. 766 (1984), the surviving corporation's return for the year at issue qualified as a return for the merged corporation's short tax year, thus triggering the three year period of limitations for assessments. New Capital Fire, Inc. v. Comm'r, T.C. Memo. 2017-177.

In 2002, Capital Fire Insurance Co. (Old Capital) merged into New Capital Fire, Inc. (New Capital) with New Capital surviving. The merger was designed to be a tax free reorganization under Code Sec. 368(a)(1)(F). Old Capital did not file a tax return for 2002. In 2003, New Capital filed a 2002 return which included a pro forma Form 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return, for Old Capital's tax year 2002. The pro forma return reported Old Capital's employer identification number (EIN), as well as its income, deductions, and credits for the short tax year ending on the date of the merger. Included with the return was a statement notifying the IRS that the merger had occurred and stating that the operations of Old Capital were included in the return on Form 1120-PC. New Capital reported Old Capital's tax payments and checked the box stating that it was Old Capital's final return. The return was signed under penalties of perjury.

In 2012, the IRS issued a notice of deficiency to Old Capital in which it determined that Old Capital was required to file a return for its 2002 short tax year because the merger failed to meet the Code Sec. 368(a)(1)(F) requirements. The notice was issued nearly nine years after New Capital filed its 2002 return. In sending the notice after the statute of limitations had expired, the IRS relied on the exception to the statute of limitations on assessments in Code Sec. 6501(c)(3), which provides that a tax may be assessed at any time if the taxpayer fails to file a return. The IRS argued that there were two separate taxpayers, Old Capital and New Capital, which were each required to file returns. According to the IRS, Old Capital did not file a return for 2002, and New Capital's return did not qualify as a valid return for Old Capital's short tax year.

The Tax Court rejected the IRS's arguments and held that New Capital's 2002 return was sufficient to trigger the running of the three year statute of limitations on assessment for Old Capital's 2002 tax year. The Tax Court applied the test in Beard v. Comm'r, 82 T.C. 766 (1984), which says that a document qualifies as a return and starts the running of the limitations period if it (1) contains sufficient data to calculate the tax liability; (2) purports to be a return; (3) is an honest and reasonable attempt to comply with the tax law; and (4) is signed under penalties of perjury.

The Tax Court noted that New Capital claimed to be a continuation of Old Capital on its 2002 return. New Capital included a pro forma return for Old Capital that gave the old company's name as well as its income, deductions, and credits. Based on these facts, the Tax Court determined that New Capital's return contained sufficient information to calculate Old Capital's tax liability. The New Capital return also clearly purported to be a return of Old Capital, according to the Tax Court, because it reported Old Capital's tax payments, listed Old Capital's EIN, and the box was checked indicating that it was Old Capital's final return.

The Tax Court rejected the IRS's argument that New Capital's 2002 return was purposefully misleading and therefore failed the third prong of the Beard test. According to the Tax Court, even if the return was purposefully misleading, that alone would not render it a nullity. The Tax Court noted that New Capital's return included Old Capital's income for 2002 up to the effective date of the merger. The Tax Court also noted that the IRS had not alleged a fraudulent intent on New Capital's part to evade Old Capital's tax liability. It was the IRS's duty, in the Tax Court's view, to determine whether New Capital's return was erroneous within the three year statute of limitations period under Code Sec. 6501(a). Because the Tax Court determined that New Capital's return satisfied the Beard test, the exception for failure to file under Code Sec. 6501(c)(3) did not apply, and the assessment of the deficiency was therefore barred by the statute of limitations.

For a discussion of the statute of limitations on assessments, see Parker Tax ¶260,130.

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IRS Addresses Tax Treatment of Employer Programs to Aid Hurricane Victims

The IRS issued guidance on the tax treatment of leave-based donation programs aimed at aiding victims of Hurricane Harvey, Tropical Storm Harvey, Hurricane Irma, and Tropical Storm Irma. Notice 2017-48; Notice 2017-52.

In response to the need for charitable relief for recent hurricane victims, some employers have adopted or are considering adopting leave-based donation programs. Under leave-based donation programs, employees can elect to forgo vacation, sick, or personal leave in exchange for cash payments that the employer makes to charitable organizations described in Code Sec. 170(c).

In Notice 2017-48 and Notice 2017-52, the IRS explains the income and employment tax treatment of cash payments made by employers under leave-based donation programs for the relief of victims of Hurricane Harvey, Tropical Storm Harvey, Hurricane Irma, and Tropical Storm Irma.

The guidance provides that the IRS will not assert that cash payments an employer makes to Code Sec. 170(c) organizations in exchange for vacation, sick, or personal leave that its employees elect to forgo constitute gross income or wages of the employees if the payments are:

(1) made to the Code Sec. 170(c) organizations for the relief of victims of Hurricane Harvey, Tropical Storm Harvey, Hurricane Irma, and Tropical Storm Irma; and

(2) paid to the Code Sec. 170(c) organizations before January 1, 2019.

Additionally, the IRS will not assert that the opportunity to make such an election results in constructive receipt of gross income or wages for employees. Electing employees may not claim a charitable contribution deduction under Code Sec. 170 with respect to the value of forgone leave excluded from compensation and wages. The IRS will not assert that an employer is permitted to deduct these cash payments exclusively under the rules of Code Sec. 170 rather than the rules of Code Sec. 162.

Compliance Tip: Cash payments to which the notices apply need not be included in Box 1, Box 3 (if applicable), or Box 5 of the Form W-2.

In an earlier pronouncement, Notice 2006-59, the IRS provided guidance on the federal tax consequences of certain leave-sharing plans that permit employees to deposit leave in an employer-sponsored leave bank for use by other employees who have been adversely affected by a major disaster. The notice states that IRS will not assert that a leave donor who deposits leave in an employer-sponsored leave bank under a major disaster leave-sharing plan realizes income or has wages, compensation, or rail wages with respect to the deposited leave, provided that the plan treats payments made by the employer to the leave recipient as "wages" for employment and income tax withholding purposes, and as "compensation" for railroad-wage reporting purposes, unless excludible under a specific provision of the Code.

In addition, under Code Sec. 139, individuals can to exclude from gross income any amount received by an individual as a qualified disaster relief payment.

For a discussion of the tax treatment of disaster relief payments, see Parker Tax ¶79,300.

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Sovereign Immunity Did Not Bar Bankruptcy Trustee's Action to Avoid Debtor's Fraudulent Tax Payments

The Ninth Circuit Court held that sovereign immunity did not preclude a bankruptcy trustee from bringing an action under a state fraudulent transfer statute to avoid an S corporation debtor's payment of federal income taxes on its shareholders' behalf. In reaching the decision, the Ninth Circuit declined to follow In re Equipment Acquisition Resources, Inc., 2014 PTC 70 (7th Cir. 2014), where the Seventh Circuit reached the opposite conclusion in holding that the waiver of sovereign immunity in the Bankruptcy Code did not extend to a derivative state law claim. In re DBSI, Inc., 2017 PTC 404 (9th Cir. 2017).

DBSI, Inc. was a commercial real estate developer. It was involved in an illegal Ponzi scheme through which, in its last two years of operation, it purportedly lost $3 million per month and used new investor funds to meet existing obligations. Several of the company's insiders were indicted in May 2013 and later convicted of various fraud crimes.

As an S corporation, DBSI made tax payments on behalf of its shareholders. Between 2005 and 2008, DBSI paid the IRS approximately $17 million in income taxes on behalf of its shareholders. Most of the payments were made on behalf of Doug Swenson and Thomas Var Reeve, two of DBSI's largest shareholders. The IRS ultimately refunded approximately $3.6 million to Swenson and Reeve in claimed overpayments of their individual tax liabilities.

DBSI filed for bankruptcy in 2008. In 2010, a plan of liquidation was confirmed and James Zazzali was appointed as trustee. Under 11 U.S.C. Sec. 544(b)(1), a trustee can avoid any transfer by a debtor if the transfer is voidable under state law by an unsecured creditor. In an avoidance action, the trustee takes the shoes of an unsecured creditor in determining whether the transfer can be avoided; any reason that might prevent such a creditor, including the statute of limitations, estoppel, waiver, or any other defense, also applies to the trustee. The waiver of sovereign immunity in 11 U.S.C. Sec. 106(a)(1) applies for any governmental unit, including the IRS, with respect to Sec. 544(b)(1).

Zazzali sought to avoid the tax payment as a fraudulent transfer under Sec. 544(b)(1) and Idaho's Uniform Fraudulent Transfer Act (UFTA). He brought an adversary proceeding to recover the allegedly fraudulent transfers, including the $17 million in payments to the IRS, on behalf of shareholders. The government argued that Congress had not abrogated sovereign immunity with respect to the Sec. 544(b)(1) underlying state law cause of action, and therefore, there was no unsecured creditor who could sue the government under Idaho's UFTA.

A bankruptcy court concluded that Sec. 106(a)(1)'s waiver of sovereign immunity permitted the Zazzali's suit to proceed. The government appealed the bankruptcy court's ruling to the district court. While the government's appeal was pending, the Seventh Circuit decided In re Equipment Acquisition Resources, Inc., 2014 PTC 70 (7th Cir. 2014), which analyzed the identical issue before the district court. The Seventh Circuit came to the opposite conclusion as the bankruptcy court, and held that Sec. 106(a)(1)'s waiver of sovereign immunity does not extend to Sec. 544(b)(1)'s derivative state law claim. Nonetheless, the district court was unpersuaded by the Seventh Circuit's reasoning, and affirmed the bankruptcy court's ruling. Thus, the district court ruled in favor of Zazzali and avoided approximately $13.4 million, equal to the tax payments less the amount that had been refunded to Swenson and Reeve. The IRS appealed to the Ninth Circuit.

The Ninth Circuit affirmed the district court's decision, holding that the waiver of sovereign immunity in Sec. 106(a)(1) applied to the trustee's claim under Sec. 544(b)(1). First, the court looked at the plain language of the statute and concluded that the effect of Sec. 106(a)(1) is to completely abolish sovereign immunity with respect to Sec. 544. Second, the court noted that Sec. 106(a)(1) was enacted after Sec. 544(b)(1). In the court's view, when Congress waived sovereign immunity with respect to Sec. 544, it understood that Sec. 544(b)(1) codified a trustee's powers to invoke state law. According to the court, Congress knowingly included state law causes of action within the category of suits to which a sovereign immunity defense could no longer be asserted. Third, the court reasoned that the IRS's argument would essentially nullify Sec. 106(a)(1). Concluding that the IRS was asking it to construe Sec. 106(a)(1) in a way that would ignore its plain text, the Ninth Circuit declined to adopt such a reading of the statute.

The Ninth Circuit recognized that its decision conflicted with the Seventh Circuit's opinion in In re Equipment Acquisition Resources, Inc. The Ninth Circuit then discussed its reasons for disagreeing with that decision. The Seventh Circuit applied a two-step analysis to determine (1) whether there was a waiver of sovereign immunity, and (2) whether the substantive law provided an avenue for relief. The Seventh Circuit acknowledged that Sec. 106(a)(1) clearly provided a waiver of immunity. However, the Seventh Circuit determined that the applicable Illinois fraudulent transfer law did not provide an avenue for relief because any unsecured creditor attempting to bring such a claim against the IRS in Illinois would be barred by the government's sovereign immunity. The Seventh Circuit concluded that Sec. 106(a)(1) did not alter the substantive requirements of Sec. 544(b) merely by stating that the federal government's authority was abrogated "with respect to" that provision.

The Ninth Circuit focused on the second prong of the Seventh Circuit's analysis and considered whether Sec. 544(b)(1) and Idaho's fraudulent transfer statute provided an avenue for relief. The Ninth Circuit gave two reasons why both the Bankruptcy Code and Idaho law envisioned the government as a potential defendant. First, the fact that Congress enacted the Sec. 106(a)(1) waiver of immunity logically meant that both Sec. 544(b)(1) and the derivative state law provided a substantive cause of action against the government. It would make no sense, the court reasoned, for Congress to waive sovereign immunity as to a claim which could not be brought against the government. Second, under both the Bankruptcy Code and Idaho law, debtors and creditors are defined to include the government. These statutory definitions further demonstrated to the Ninth Circuit that Sec. 544(b)(1) and the derivative law on which it relies contemplate suits against the government. The Ninth Circuit concluded that under the Seventh Circuit's approach, a substantive cause of action against the government would exist only if Congress also waived sovereign immunity with respect to the particular applicable law under Sec. 544(b)(1). The Ninth Circuit found that to impose such a requirement would be contrary to the plain text of Sec. 106(a)(1).

Additionally, with respect to Constitutional concerns raised by the Seventh Circuit's decision, the Ninth Circuit disagreed with the suggestion that a state law claim would potentially run afoul of the Appropriations Clause and the Supremacy Clause. Finally, the Ninth Circuit offered additional supporting reasons for its decision based on principles of equity and the policy of the Bankruptcy Code.

For a discussion of bankruptcy estates, see Parker Tax ¶16,101.

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Owner of Fast Food Restaurants Can't Revise Merger Transaction After Deal Closes

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. Tseytin v. Comm'r, 2017 PTC 387 (3d Cir. 2017).

Facts

Michael Tseytin was the primary shareholder in a New Jersey corporation, U.S. Strategies, Inc. (USSI), whose business involved owning and operating two Russian LLCs that in turn owned and operated most of Russia's Kentucky Fried Chicken (KFC) and Pizza Hut restaurants. Tseytin owned 75 percent of USSI's shares. The remaining 25 percent was owned by a company named Archer Consulting Corporation.

The two corporations wanted to enter into a merger with AmRest Holdings, NV, a Netherlands corporation also involved in the fast-food business. It owned KFCs, Pizza Huts, and other fast-food restaurants in Eastern Europe, Central Europe, Germany, France, and Spain. In May 2007, all the relevant players substantively agreed to the merger in two separate written agreements. The first agreement was between Tseytin and Archer, wherein Tseytin agreed to purchase for his own account Archer's 25 percent stake in USSI. At closing on June 14 at Archer's offices in Moscow, Archer was to transfer the shares to Tseytin and then, at some time in the next month, Tseytin would make a "deferred" purchase payment to Archer, prior to July 31st.

The second agreement (the Merger Agreement), was signed by Tseytin, USSI, and AmRest - but not Archer - and stated that at closing in Warsaw the following would occur: (1) Tseytin would ensure that he was the "record" owner of 100 percent of the USSI stock, "free and clear of any restrictions"; (2) Tseytin would transfer 100 percent of USSI's shares to AmRest; and (3) AmRest would transfer cash and AmRest stock to Tseytin as compensation.

The transaction went through as planned. On June 14, Tseytin and Archer closed on their agreement and Archer transferred its USSI stock to Tseytin. On July 2, the USSI - AmRest merger closed, and Tseytin transferred all the USSI stock to AmRest. On July 3, AmRest sent Tseytin $23,099,420 in cash and $30,791,390 in AmRest stock, for a total of nearly $54 million for all USSI shares. Then on July 5, Tseytin paid Archer $14 million for its 25 percent stake in USSI.

In two tax filings for the 2007 tax year, Tseytin took two different approaches to the transaction. In his original return, Tseytin reported tax liability of approximately $3,781,000 and paid that amount to the IRS. But, in 2009, he amended his return and reported a lower amount of liability, approximately $2,577,000, and requested a refund for the difference.

On audit and in a notice of deficiency, the IRS treated the Archer and non-Archer shares of USSI stock as owned by Tseytin and as separate blocks of stock with identifiable and different cost bases (as did Tseytin on his amended return). The IRS calculated the taxable amount or portion of the $23,099,420 total cash received on the merger using the total $54 million merger consideration - not just the $23,099,420 total cash received (as Tseytin had done on his amended return). As a result of the IRS's calculations, the amount of Tseytin's long-term capital gain realized on the transfer of the non-Archer shares increased to approximately $40,418,000 and the entire $17,324,565 (i.e., 75% of the total cash received allocable to the non-Archer shares ($23,099,420)) was charged or taxed to Tseytin as long-term capital gain.

Relying on the loss disallowance rule of Code Sec. 356(c), the IRS did not allow a $527,297 short-term capital loss realized on the Archer shares to reduce or to be netted against the $40,418,000 long-term capital gain realized on the non-Archer shares or to reduce the $17,324,565 portion of the cash boot to be recognized and taxed. Code Sec. 356 (c) provides that if (1) Code Sec. 354 would apply to an exchange or Code Sec. 355 would apply to an exchange or distribution, but for the fact that (2) the property received in the exchange or distribution consists not only of property permitted by Code Sec. 354 or Code Sec. 355 to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange or distribution is recognized. As a result of the IRS calculations, the IRS determined that Tseytin had a total 2007 federal income tax liability of $3,811,000 - a deficiency of $30,478 and a $6,095 accuracy-related penalty under Code Sec. 6662(a). Tseytin disagreed with these calculations and petitioned the Tax Court.

Tax Court's Decision

Before the Tax Court, Tseytin acknowledged that on his original 2007 federal income tax return the 1,000 shares of USSI stock were incorrectly treated as a single block of stock, and he agreed that (as reflected on his amended return) those shares of stock consisted of two separate blocks of stock.

With regard to the Archer shares, Tseytin made two arguments. First, in transferring the Archer shares to AmRest, Tseytin said he acted only as a nominee or agent for Archer, that he never owned the Archer shares, and that the Tax Court should treat the Archer shares as either sold directly by Archer to AmRest or as redeemed by USSI or by AmRest from Archer. According to his argument, Tseytin would treat $14 million (the amount paid to Archer for the Archer shares) of the $23,099,420 total cash consideration received from AmRest as not received by him, but rather as received by and taxable to Archer.

Second, in the alternative and if he was to be treated as the owner of the Archer shares on their transfer to AmRest, Tseytin argued that he should be allowed to subtract the $527,297 short-term capital loss realized on the transfer of the Archer shares from the $17,324,565 long-term gain to be recognized and taxed as cash boot.

The Tax Court rejected Tseytin's argument and held for the IRS. In so doing, the court invoked the Danielson rule (Comm'r v. Danielson, 378 F.2d 771 (3d Cir. 1967), vacating and remanding 44 T.C. 549 (1965)), which stands for the proposition 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.

Tseytin appealed to the Third Circuit, raising two main issues with respect to his tax liability: (1) whether he owed tax for income he allegedly derived from Archer's shares, and (2) whether his "losses" could be subtracted from his overall gains.

Third Circuit Finds No Exception to Danielson Rule

The Third Circuit, also citing the Danielson rule, affirmed the Tax Court's decision and upheld the deficiency assessment by the IRS. The court noted that none of the Danielson exceptions applied. Tseytin was not arguing that he was defrauded into the transaction, for example. The contracts signed by the parties, the court observed, stated in explicit terms that Tseytin acquired ownership of Archer's stock (i.e., he purchased it for his own account before selling it to AmRest), and even though the shares were in his hands for only a brief period of time, he was the "record" owner, "free and clear of any restrictions." These terms, the court said, could hardly be clearer and, under Danielson, that was the end of the matter; no exception applied, the general rule governed, and, the court stated, Tseytin must bear the tax liability associated with owning all the USSI shares.

The court noted that Tseytin could have hypothetically structured the deal so that he never acquired formal ownership of Archer's shares. But because he did not, he can not benefit from an alternative route after the transaction. According to the court, Tseytin must bear the tax consequences of his business decisions, and his two blocks of stock were required to be analyzed as separate units and Code Sec. 356 applied.

For a discussion of the Danielson rule as it relates to the sale of a business, see Parker Tax ¶118,110.

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