February AFRs Issued; Court Adopts Separate Filings Rule for Allocating Tax Refund Between Spouses; Disabled Individuals May Qualify for Earned Income Credit but Many Do Not Claim It; Couple Can't Rely on Cohan Rule for Deduction of Unsubstantiated Expenses ...
Proposed Regs Update Rules for Claiming Dependency Exemption and Other Tax Benefits
The IRS issued proposed regulations which amend the rules relating to the dependency exemption deduction, surviving spouse and head of household filing statuses, the child and dependent care credit, the earned income credit, the standard deduction, joint tax returns, and taxpayer identification numbers for children placed for adoption. In determining a taxpayer's eligibility to claim a dependency exemption, the proposed regulations change the IRS's position regarding the adjusted gross income of a taxpayer filing a joint return for purposes of the tiebreaker rules in Code Sec. 152(c)(4) and the source of support of certain payments that originated as governmental payments. REG-137604-07 (1/19/17).
The Tax Court held that a doctor was correct in recategorizing income from nonpassive to passive and the IRS could not regroup the doctor's plastic surgery activity with his investment in a business entity that rents out surgical space. However, because the issue was not previously raised, the doctor was not entitled to use that recharacterized passive income to offset prior year passive losses. Finally, because the doctor was an investor in the surgical space rental activity and was not involved in the operations of the business, his distributive share of income from that business was not subject to self-employment tax. Hardy v. Comm'r, T.C. Memo. 2017-16.
White House Moratorium on Issuing Regulations Affects Issuance of Proposed Partnership Audit Rules
The White House has ordered a moratorium on regulations, with certain exceptions, and the removal of regulations which have been sent to the Office of the Federal Register but not yet published in the Federal Register. This edict affects proposed regulations on the new partnership audit regime which had been issued by the IRS but not yet published in the Federal Register. White House Memorandum Regarding Regulatory Freeze (1/20/17).
The IRS issued proposed regulations which reflect a change in the IRS's position on the interaction of the Code Sec. 152(c)(4) tiebreaker rules, which goes into effect when two or more people can claim a child as a qualifying child for tax purposes, with the Code Sec. 32 earned income credit rules. Under the revised position, if an individual is not treated as a qualifying child of a taxpayer after applying the tiebreaker rules in Code Sec. 152(c)(4), then the individual will not prevent that taxpayer from qualifying for the childless earned income credit. REG-137604-07 (1/19/17).
The Tax Court held that a married couple that owned an S corporation, which had been administratively dissolved, could not deduct a trust fund liability payment made on behalf of the dissolved corporation. The court found that, while the dissolved corporation filed a return for the year the trust fund liability payment was made and passed through a deduction for the payment to the couple, the corporation did not exist and was not engaged in a trade or business in the year of the payment and, even if it was in existence, no deduction is allowed for trust fund recovery penalties. Brown v. Comm'r, T.C. Memo. 2017-18.
Accountant's Adoption of New Paperless Tax System Justified Client's Form 3115 Filing Extension
The IRS granted an extension of time for a taxpayer to file Form 3115 where the taxpayer missed the filing deadline as a result of the adoption by the taxpayer's accounting firm of a new paperless tax system that caused the firm to overlook certain procedures necessary to timely file the Form 3115. The IRS concluded that the facts constituted "unusual and compelling circumstances" for granting an extension of time. PLR 201702021.
Tax Court Petition Received Eight Days After Deadline Nevertheless Treated as Timely Filed
The Seventh Circuit reversed the Tax Court and held that although the 90-day deadline for filing a Tax Court petition is jurisdictional, the Tax Court could not disregard an agreement between the IRS and the taxpayer that the taxpayer's petition was timely filed. The court rejected the Tax Court's reliance on the date the envelope had entered the Postal Service's tracking system as being indicative of the date the petition was filed. Tilden v. Comm'r, 2017 PTC 17 (7th Cir. 2017).
RV is Dwelling Unit Used as Residence so Business-related Depreciation and Interest Deductions Denied
RV is Dwelling Unit Used as Residence so Business-related Depreciation and Interest Deductions Denied
Proposed Regs Update Rules for Claiming Dependency Exemption and Other Tax Benefits
The IRS issued proposed regulations which amend the rules relating to the dependency exemption deduction, surviving spouse and head of household filing statuses, the child and dependent care credit, the earned income credit, the standard deduction, joint tax returns, and taxpayer identification numbers for children placed for adoption. In determining a taxpayer's eligibility to claim a dependency exemption, the proposed regulations change the IRS's position regarding the adjusted gross income of a taxpayer filing a joint return for purposes of the tiebreaker rules in Code Sec. 152(c)(4) and the source of support of certain payments that originated as governmental payments. REG-137604-07.
Read More...Doctor's Surgery Activities Can't be Grouped with Surgical Rental Business
The Tax Court held that a doctor was correct in recategorizing income from nonpassive to passive and the IRS could not regroup the doctor's plastic surgery activity with his investment in a business entity that rents out surgical space. However, because the issue was not previously raised, the doctor was not entitled to use that recharacterized passive income to offset prior year passive losses. Finally, because the doctor was an investor in the surgical space rental activity and was not involved in the operations of the business, his distributive share of income from that business was not subject to self-employment tax. Hardy v. Comm'r, T.C. Memo. 2017-16.
Facts
Dr. Stephen Hardy is a plastic surgeon who conducts his medical practice through Northwest Plastic Surgery Associates, a single-member professional LLC treated as a partnership. His wife is the chief operating officer. Dr. Hardy performs surgeries in various facilities, one of them being the Missoula Bone & Joint Surgery Center, LLC (MBJ), an LLC formed by a group of practicing physicians for the purpose of operating a surgery center. In 2006, Dr. Hardy purchased a 12.5 percent interest in MBJ for $164,000. MBJ is treated as a partnership for tax purposes and is professionally managed. It hires its own employees and does not share any employees with Northwest Plastic Surgery. MBJ directly bills patients for facility fees and then distributes to each of its members his or her share of the earnings based on the facility fees less expenses. MBJ uses an accounting firm to prepare its taxes and K-1s and does not pay physicians for their medical procedures.
During 2008 through 2010, Dr. Hardy performed approximately 50 percent of his surgeries at his office at Northwest Plastic Surgery Associates, 20 percent at MBJ, and the remainder at other facilities. Dr. Hardy received a distribution from MBJ regardless of whether he performed any surgeries at the surgery center.
For 2006 and 2007, Dr. Hardy and his wife, reported the income from MBJ as nonpassive. Their CPA had determined that such classification was appropriate because the K-1s the Hardys received stated that the income was from a trade or business and the K-1s included self-employment tax. The CPA did not group Dr. Hardy's medical practice activity with his ownership interest in MBJ. For both 2006 and 2007, the Hardys also reported unallowed passive activity losses.
In 2008, after learning that Dr. Hardy was not involved in the management of MBJ and was not liable for the debts of MBJ, the Hardy's CPA determined that the income from MBJ was passive and began reporting it as such. The passive income allowed the Hardys to absorb unrelated passive activity losses. The CPA did not amend the Hardys' returns for 2006 or 2007 because he believed the change would be immaterial. For 2008 and 2009, the Hardys calculated and reported self-employment tax on the income Hardy received from Northwest Plastic Surgery and MBJ. They did not do so for 2010.
The IRS issued a notice of deficiency for 2008 through 2010 recharacterizing the MBJ income as nonpassive and determining deficiencies. The Hardys took their case to the Tax Court.
IRS and Taxpayer Arguments
The IRS argued that the income from Dr. Hardy's medical practice and MBJ should be grouped together as nonpassive income. Before the Tax Court, the IRS inferred that the Hardys had already grouped the ownership interest in MBJ with the medical practice because they had previously reported the income from both activities as nonpassive, thus they were bound to continue reporting the income that way. Alternatively, citing Reg. Sec. 1.469-4(f) and an example contained in that regulation, the IRS argued that it had the authority to regroup Dr. Hardy's activities.
The Hardys argued that Dr. Hardy's ownership interest in MBJ and his medical practice should not be grouped together because they did not constitute an appropriate economic unit as a single activity. Also, they noted, they had not previously grouped the activities together. The Hardys pointed out that the activities are different types of businesses: MBJ is a rental surgical facility and Dr. Hardy's practice is an active medical practice. Additionally, they argued, they did not have a principal purpose of circumventing Code Sec. 469 when they treated the activities as separate because Dr. Hardy did not join MBJ to artificially create a passive activity loss. Rather he had a business purpose for joining MBJ.
Also, at trial, the Hardys argued that they overpaid self-employment tax for 2008 and 2009 because they should not have paid self-employment tax on the MBJ income.
Tax Court's Decision
The Tax Court held that the Hardys' income from MBJ was passive income and that Dr. Hardy's ownership interest in MBJ should not be grouped with his medical practice. The court refused to infer that the Hardys grouped Dr. Hardy's ownership interest in MBJ with his medical practice because, it said, such a grouping was not supported by the evidence. The mere fact that the Hardys reported Dr. Hardy's activities as nonpassive was not enough for the court to conclude that the Hardy's had grouped Dr. Hardy's ownership interest in MBJ with his medical practice.
The court also refused to allow the IRS to regroup Dr. Hardy's activities. The court noted that the IRS can only regroup a taxpayer's activities where -
(1) any of the activities resulting from the taxpayer's grouping are not an appropriate economic unit; and
(2) a principal purpose of the taxpayer's grouping is to circumvent the underlying purposes of Code Sec. 469.
Each requirement must be met, the court observed, in order for the IRS to be able to regroup a taxpayer's activities. In concluding that the IRS did not have a reason to regroup, the court cited TAM 201634022 which had facts similar to the Hardys' situation and which was distinguishable from the example in the regulations that had been cited by the IRS. The court noted that there was more than one reasonable method of grouping Dr. Hardy's activities. While the court found that some facts supported treating Dr. Hardy's ownership interest in MBJ and his medical practice as a single economic unit, the weight of the evidence supported treating them as separate economic units. The court cited the fact that (1) Dr. Hardy was the sole owner of his medical practice and only a minority owner of MBJ; (2) Dr. Hardy actively managed his medical practice but did not have any management responsibilities in MBJ; (3) Dr. Hardy's medical practice and MBJ did not share any building space, employees, billing functions, or accounting services; and (4) Dr. Hardy performed services different from MBJ's services.
The court then addressed the proper amount of the passive activity loss carried over to 2008 from prior years. The court noted that, had the Hardys properly reported the MBJ income as passive for 2006 and 2007 rather than erroneously reporting it as nonpassive, it would have fully absorbed their passive losses and there would have been no passive loss to carryforward to 2008. The court thus held that the Hardys were not entitled to the full passive activity loss deduction carried forward into 2008. The court rejected their argument that, under the doctrine of equitable recoupment, they were entitled to the deduction on the basis that they had not previously argued this defense.
Finally, the Tax Court held that, because Dr. Hardy received his distributions from MBJ as a limited partner acting in his capacity as an investor, he was not liable for self-employment tax on his income from MBJ. In reaching this conclusion, the court cited Renkemeyer, Campbell & Weaver, LLP v. Comm'r, 136 T.C. 137 (2011). The court contrasted Dr. Hardy's limited partnership interest in a surgical facility with a limited partnership interest in a law firm in which the partner was an active participant in the practice.
For a discussion of the grouping rules for purposes of determining passive and nonpassive income, see Parker Tax ¶247,110.
White House Moratorium on Issuing Regulations Affects Issuance of Proposed Partnership Audit Rules
The White House has ordered a moratorium on regulations, with certain exceptions, and the removal of regulations which have been sent to the Office of the Federal Register but not yet published in the Federal Register. This edict affects proposed regulations on the new partnership audit regime which had been issued by the IRS but not yet published in the Federal Register. White House Memorandum Regarding Regulatory Freeze (1/20/17).
On January 20, the White House issued a memorandum to the heads of executive departments and agencies of the United States that instructs them not to send any regulations to the Office of the Federal Register (OFR). The moratorium on regulations excludes regulations that relate to emergency situations or other urgent circumstances relating to health, safety, financial, or national security matters. Further, with respect to regulations that have been sent to the OFR but not published in the Federal Register, departments are required to withdraw such regulations. Several tax regulations are affected by this directive, including 277 pages of proposed regulations (REG-136118-15) on the new partnership audit regime which had been released by the IRS but not officially published in the Federal Register. The new partnership audit regime takes effect in 2018.
Regulations on which the moratorium is imposed can only be issued after they have been reviewed and approved by a department or agency head appointed or designated by the President after noon on January 20, 2017.
In addition, the effective dates of regulations which have been published in the OFR but have not yet taken effect are postponed until 60 days from January 20, i.e., until March 21, 2017, subject to the exceptions noted above. The purpose of the postponement, according to the White House memorandum, is to review the questions of fact, law, and policy that the regulations address. The memorandum asks the heads of executive departments and agencies of the United States to consider proposing for notice and comment a rule to delay the effective date for regulations beyond the March 21 deadline, where appropriate and as permitted by law.
In addition to freezing the proposed regulations on the new partnership audit regime, other affected regulations include the following:
T.D. 9815, REG-135122-16 - provides final, temporary, and proposed regulations which affect nonresident alien individuals and foreign corporations that hold certain financial products providing for payments that are contingent upon, or determined by reference to, U.S. source dividend payments. These rules also provide guidance to withholding agents that are responsible for withholding U.S. tax with respect to a dividend equivalent, as well as certain other parties to Code Sec. 871(m) transactions and their agents.
T.D. 9817 - provides final regulations under Code Sec. 7704(d)(1)(E) relating to the qualifying income exception for publicly traded partnerships to not be treated as corporations for federal income tax purposes.
IRS Changes Position on Claiming Childless EIC; Amended Returns May be in Order
The IRS issued proposed regulations which reflect a change in the IRS's position on the interaction of the Code Sec. 152(c)(4) tiebreaker rules, which goes into effect when two or more people can claim a child as a qualifying child for tax purposes, with the Code Sec. 32 earned income credit rules. Under the revised position, if an individual is not treated as a qualifying child of a taxpayer after applying the tiebreaker rules in Code Sec. 152(c)(4), then the individual will not prevent that taxpayer from qualifying for the childless earned income credit. REG-137604-07 (1/19/17).
Background
Under Code Sec. 32, a taxpayer may claim an earned income credit (EIC) if the taxpayer:
(1) has earned income,
(2) has adjusted gross income not in excess of certain limits,
(3) does not have more than a specified amount of investment income,
(4) is a U.S. citizen or resident for the entire year,
(5) does not file as married filing separately,
(6) has a valid social security number, and
(7) does not claim the foreign earned income exclusion or the foreign housing exclusion or deduction.
The credit is available to taxpayers with a qualifying child or qualifying children, as well as taxpayers without a qualifying child, although different sets of rules apply.
Sometimes an individual meets the tests to be a qualifying child of more than one person. However, only one of these persons can treat the child as a qualifying child for EIC and other child-related tax benefit purposes (such as the child tax credit and the credit for child and dependent care expenses). The other person(s) cannot claim any of these benefits based on the qualifying child. A tiebreaker rules in Code Sec. 152(c)(4) determine who, if anyone, can claim the EIC when an individual is a qualifying child of more than one person.
A taxpayer who does not have a qualifying child for the tax year, but who meets the general requirements to claim the EIC, can claim the "childless EIC" under Code Sec. 32(c)(1)(A) and (B) if the taxpayer (1) is age 25 through 64, or files jointly with someone who meets this age test; (2) lives in the U.S. for more than half the tax year; (3) cannot be claimed as a dependent on another taxpayer's return for the year; and (4) is not a qualifying child of another taxpayer for the year.
Proposed Regulations
Last week, the IRS issued proposed regulations dealing with the dependency exemption deduction, the EIC, and the tiebreaker rules. In the preamble to the proposed regulations, the IRS noted a problem with the tiebreaker rules in Code Sec. 152(c)(4) that determine who is eligible for the EIC where an individual is the qualifying child of more than one person. The problem, the IRS said, can be illustrated by the following example. Two sisters, Betty and Carol, live together and each of them is a low-income taxpayer. Neither has a child and each may claim the childless EIC. Later, Betty has a child and Betty's child meets the definition of a qualifying child for both Betty and Carol. However, under the tiebreaker rules of Code Sec. 152(c)(4), the child is treated as the qualifying child of Betty and Betty may claim the EIC as an eligible individual with a qualifying child.
Although there is no regulatory guidance on this issue, the IRS had taken the position in Publication 596, Earned Income Credit, that if someone meets the definition of a qualifying child for multiple individuals, including the taxpayer, but is not treated as the qualifying child of a particular individual under the tiebreaker rules, the taxpayer is precluded from claiming the childless EIC. Thus, under the current rule, Carol would not be allowed to claim the childless EIC.
The IRS said that allowing Carol to continue to claim the childless EIC after the child is born is both equitable and consistent with the purpose of Code Sec. 32 to assist working low-income taxpayers. As a result, Prop. Reg. Sec. 1.32-2(c)(3) provides that, if an individual is not treated as a qualifying child of a taxpayer after applying the tiebreaker rules of Code Sec. 152(c)(4), then the individual will not prevent that taxpayer from qualifying for the childless EIC.
Effective Date
Prop. Reg. 1.32-2(c)(3) is effective when finalized. However, taxpayers can apply the proposed regulations to any open tax years. Thus, if the proposed regulation applies to a taxpayer who had been denied the EIC as a result of the IRS's previous interpretation of the EIC tiebreaker rules, an amended return may be filed to obtain a refund. Generally, under Code Sec. 6511(a), a claim for refund must be filed within three years of the date the return was filed or two years from the date the tax was paid, whichever is later. If the taxpayer was not required to file a return for the prior year, the claim for refund must be filed within two years of the date the tax to be refunded was paid.
Caution: The White House has issued a moratorium on the implementation of regulations with effective dates after January 20. As a result, it is unclear whether these regulations may be immediately applied.
For further discussion of the rules for claiming the earned income credit, see Parker Tax ¶102,100.
Court Rejects Attempt to Use Dissolved S Corp to Deduct Trust Fund Penalty Taxes
The Tax Court held that a married couple that owned an S corporation, which had been administratively dissolved, could not deduct a trust fund liability payment made on behalf of the dissolved corporation. The court found that, while the dissolved corporation filed a return for the year the trust fund liability payment was made and passed through a deduction for the payment to the couple, the corporation did not exist and was not engaged in a trade or business in the year of the payment and, even if it was in existence, no deduction is allowed for trust fund recovery penalties. Brown v. Comm'r, T.C. Memo. 2017-18.
Facts
Philip Brown and his wife, Amber, owned 100 percent of Quantum Group Inc. (Quantum Inc.) During tax years 2000 through 2002, Quantum Inc. accumulated unpaid payroll tax liabilities, for which trust fund recovery penalties (TFRPs) were assessed. Quantum Inc. did not file any tax returns from 2003 through 2011 and was administratively dissolved by Arizona in 2007 for failing to file required reports. During 2012, Quantum Inc. was not registered as an active entity with any state; nor did it provide any services during 2012 or generate any income.
Philip also founded Quantum Group, LLC (Quantum LLC). The Browns held 100 percent of the membership interests in that entity until 2012, when the company added two additional members, whereupon the Browns' interests were reduced to 87.5 percent. Both Quantum Inc. and Quantum LLC were S corporations.
In 2012, the Browns owed at least $180,911 in trust fund recovery penalties. On December 31, 2012, Quantum LLC sent $215,000 from its bank account to the trust account of the Brown's attorney. The attorney then sent a certified check in that amount to the IRS along with a letter saying that the amount was to be applied to trust fund taxes for Quantum Inc. and any remaining amount should be applied to accrued interest arising from the nonpayment of the certain trust fund taxes. Quantum Inc. filed a tax return for 2012, indicating that it was a cash basis taxpayer and showing no assets, income, or other tax items, with the exception of a deduction of $180,911 for salaries and wages. Quantum Inc. did not issue a Form W-2 to anyone for 2012. According to the Browns, the deduction for salaries and wages reported on Quantum Inc.'s 2012 return was for salary and wage expenses not deducted by Quantum Inc. for tax years 2000 through 2002. The deduction was passed through to the Browns as an ordinary business loss.
The IRS disallowed Quantum Inc.'s 2012 deduction of $180,911 for salaries and wages and also adjusted the Browns' Schedule E income, disallowing their claimed corresponding loss of $180,911 from Quantum Inc.
IRS's Arguments
According to the IRS, the salaries and wages expense reported by Quantum Inc. was nondeductible because the company did not incur or pay any expenses in 2012 while carrying on a trade or business. Additionally, the IRS asserted that the payment of TFRPs is not deductible by the operation of Code Sec. 162(f), which prevents the deduction of payments of fines or similar penalties made to a government for the violation of any law. The IRS also pointed to several Tax Court cases, including Patton v. Comm'r, 71 T.C. 389 (1978), denying deductions for TFRP payments by reason of Code Sec. 162(f).
Taxpayers' Arguments
The Browns claimed that, while Quantum Inc. did not operate for several years and was dissolved in 2007, it still had liabilities for outstanding employment taxes. They alleged that Quantum Inc. was routinely contacted by the IRS with demands for payment. The Browns contended that they contributed $180,911 to Quantum Inc. which the corporation then used to pay the outstanding payroll tax liabilities. According to the Browns, the payment of the outstanding liabilities was deductible by Quantum Inc. as an amount representing the employees' portion of payroll tax withholding, which is deductible by a corporation as an ordinary and necessary business expense.
The Browns pointed out that Code Sec. 162(a) allows a deduction for "ordinary and necessary" business expenses, which requires that such expenses be "appropriate and helpful" but not necessarily unavoidable, habitual, or common. Accordingly, they argued, reasonable direct compensation to employees, including the payment of their payroll taxes, is deductible. This is so, they said, even in the absence of an underlying legal liability on the employer's part to pay such taxes.
The Browns further contended that Quantum Inc. was carrying on a trade or business because it paid payroll tax expenses related to the previous operations of its business, which should be considered a continuation of the corporation's business activities from previous years. According to the Browns, the act of filing a tax return proved that Quantum Inc. was in fact carrying on a trade or business.
Finally, the Browns argued that the employment taxes ostensibly paid by Quantum Inc. were not TFRPs because Quantum Inc. did not owe any TFRPs. The payment of employment taxes by a corporation, the Browns said, was a deductible expense regardless of the fact that an owner of the corporation may get a secondary benefit from the payment of the taxes.
Tax Court's Decision
The Tax Court held that the Browns were not entitled to deduct the payment of the TFRPs by their dissolved S corporation. In so holding, the court listed several reasons. First, the court said, Quantum Inc. was not engaged in a trade or business in 2012. The court rejected the Browns' argument that by filing a tax return, Quantum Inc. proved it was in a trade or business. Second, the court noted, even if Quantum Inc.'s liabilities arose from the conduct of a prior trade or business, it was not entitled to a deduction for 2012 for salaries and wages because by 2012 it was no longer in existence. Third, even if Quantum Inc. did exist in 2012, it was not entitled to the deduction because it did not actually pay the amount in question. Finally, the court said, even if Quantum Inc. existed in 2012 and paid the amount in question, it would not be entitled to the deduction because the payment was for nondeductible TFRPs assessed against the Browns.
For a discussion of the TFRPs, see Parker Tax ¶210,108.
Accountant's Adoption of New Paperless Tax System Justified Client's Form 3115 Filing Extension
The IRS granted an extension of time for a taxpayer to file Form 3115 where the taxpayer missed the filing deadline as a result of the adoption by the taxpayer's accounting firm of a new paperless tax system that caused the firm to overlook certain procedures necessary to timely file the Form 3115. The IRS concluded that the facts constituted "unusual and compelling circumstances" for granting an extension of time. PLR 201702021.
Background
In PLR 201702021, the taxpayer, a construction contractor who was not sophisticated in tax matters, hired an accounting firm (the Firm) to provide tax preparation services. The taxpayer operated his business as an S corporation. Initially, the business capitalized its prepaid insurance expenses and periodically adjusted the deductions as the asset expired. Subsequently, the taxpayer discussed with the Firm the possibility of changing the method of accounting so the business could deduct those expenses in the year they were paid if they met the 12-month rule under Reg. Sec. 1.263(a)-4(f). The change would qualify as an automatic change of accounting method under Rev. Proc. 2015-14 and Rev. Proc. 2015-13.
Observation: A change that qualifies as an automatic change in accounting method does not require payment of a user fee and can be submitted up to the extended filing date of the tax return for the year of change. The latter point enables preparers to correct an accounting method deficiency that is identified during the return preparation process. Otherwise, the Form 3115 must be submitted under nonautomatic consent procedures for the next tax year.
The Firm had adopted a paperless system for filing and storing tax forms and records. The taxpayer's Form 3115, Application for Change in Accounting Method, was prepared and saved in the Firm's electronic files. However, a box was not checked on the internal processing control sheet, which would have alerted the preparer that a Form 3115 should be attached to the return. Therefore, the form was inadvertently omitted from taxpayer's Form 1120S, and the requisite copy was not filed with the IRS as required by Rev. Proc. 2015-13. However, the taxpayer's Form 1120S was prepared and filed consistent with the accounting method change, referenced the (missing) Form 3115, and included the necessary Code Sec. 481(a) adjustment.
For reasons unrelated to this omission, the taxpayer subsequently hired another accounting firm (New Firm). The omission of the Form 3115 was discovered when a member of the New Firm asked the taxpayer for a copy of it. The taxpayer asked the Firm for a copy of the form. At that point, the Firm prepared a private letter ruling requesting an extension of time to file the Form 3115.
Analysis
Reg. Sec. 301.9100-1(c) authorizes the IRS to grant a reasonable extension of time to make certain regulatory elections under the rules in Reg. Secs. 301.9100-2 and 301.9100-3. Reg. Sec. 301.9100-1(b) defines a "regulatory election" in part as an election whose due date is prescribed by a revenue procedure. According to Reg. Sec. 301.9100-3(a), requests for relief under Reg. Sec. 301.9100-3 will be granted when the taxpayer acted reasonably and in good faith, and granting relief would not prejudice the interests of the government. The interests of the government would be prejudiced if granting relief would result in the taxpayer having a lower total tax liability for all tax years affected by the election.
Reg. Sec. 301.9100-3(c)(2) provides special rules for accounting method regulatory elections. Under that regulation, the interests of the government are prejudiced, except in unusual or compelling circumstances, if the accounting method change (1) is subject to the advance consent procedures for method changes; (2) requires a Code Sec. 481(a) adjustment; (3) involves a change from an impermissible method of accounting that is under consideration by an IRS examiner, appeals officer, or federal court; or (4) provides a more favorable method of accounting if the election is made by a certain date or tax year.
Similarly, according to Rev. Proc. 2015-13: "Except in unusual and compelling circumstances, a taxpayer is not eligible for an extension of time to file a Form 3115, and is not eligible to make a late election under section 7.03(3)(d) of Rev. Proc. 2015-13 under [Reg. Secs.] 301.9100-1 and 301.9100-3."
Fortunately for the taxpayer, the IRS found the facts of PLR 201702021 to be unusual and compelling. The IRS noted that the taxpayer engaged the Firm believing its experience with complex tax matters would allow the taxpayer to properly change its method of accounting for prepaid insurance expenses. The taxpayer provided the necessary information to the Firm, which prepared the Form 3115 and Form 1120S as if the change in method had been properly made (i.e., the Form 1120S referenced the Form 3115 and included the necessary Code Sec. 481(a) adjustment).
The IRS concluded that the failure to properly file the Form 3115 was inadvertent and beyond the taxpayer's control. Upon discovery of the error, the Firm promptly requested relief and the relief was requested before the IRS discovered the error. The IRS found that the taxpayer was not using hindsight in requesting relief, and no facts had changed since the original filing deadline. Finally, the IRS observed, the taxpayer would not have a lower total tax liability for all affected tax years if the request for relief was granted. Therefore, the IRS granted an extension of 60 days from the date of the ruling to file the Form 3115.
For discussion of requesting a change in accounting method, including filing Form 3115, see Parker Tax ¶241,590.
Tax Court Petition Received Eight Days After Deadline Nevertheless Treated as Timely Filed
The Seventh Circuit reversed the Tax Court and held that although the 90-day deadline for filing a Tax Court petition is jurisdictional, the Tax Court could not disregard an agreement between the IRS and the taxpayer that the taxpayer's petition was timely filed. The court rejected the Tax Court's reliance on the date the envelope had entered the Postal Service's tracking system as being indicative of the date the petition was filed. Tilden v. Comm'r, 2017 PTC 17 (7th Cir. 2017).
Background
Code Sec. 6213(a) gives a taxpayer 90 days from the date an IRS notice of deficiency is mailed to the taxpayer to file a petition asking the Tax Court to review the notice of deficiency. Robert Tilden received a notice of deficiency that carried an April 21, 2015, deadline for requesting Tax Court review. The Tax Court received the petition on April 29, 2015, and dismissed it as untimely.
While Code Sec. 6213(a) requires Tax Court petitions to be filed within 90 days, Code Sec. 7502(a) makes the date of the postmark dispositive. Code Sec. 7502(b) adds that the timely mailing as timely filing rule applies in the case of postmarks not made by the Postal Service, but only to the extent provided by the regulations. That mattered to Tilden, because his law firm did not put a stamp on the envelope, and the Postal Service did not apply a postmark. Instead the firm's staff purchased postage from Stamps.com, a service that supplies print-at-home postage. The label from Stamps.com was dated April 21, 2015, and a member of the law firm's staff stated that she delivered the envelope to the Postal Service in Salt Lake City, Utah, on that date.
Tilden contended that his petition was timely filed under Reg. Sec. 301.7502-1(c)(1)(iii)(B)(1), which provides that if the postmark on the envelope is made other than by the U.S. Postal Service then:
(1) the postmark so made must bear a legible date on or before the last date, or the last day of the period, prescribed for filing the document or making the payment; and
(2) the document or payment must be received by the agency, officer, or office with which it is required to be filed not later than the time when a document or payment contained in an envelope that is properly addressed, mailed, and sent by the same class of mail would ordinarily be received if it were postmarked at the same point of origin by the U.S. Postal Service on the last date, or the last day of the period, prescribed for filing the document or making the payment.
Before the Tax Court, the IRS accepted Tilden's contention that the envelope was delivered to the Postal Service on April 21, but invoked Reg. Sec. 301.7502-1(c)(1)(iii)(B)(2), which states that if a document or payment described in Reg. Sec. 301.7502-1(c)(1)(iii)(B)(1) is received after the time when a document or payment so mailed and so postmarked by the U.S. Postal Service would ordinarily be received, the document or payment is treated as having been received at the time when a document or payment so mailed and so postmarked would ordinarily be received.
By relying on Reg. Sec. 301.7502-1(c)(1)(iii)(B)(2), the IRS assumed that eight days (April 21 to 29) is more than the Postal Service ordinarily takes to deliver mail from Salt Lake City to Washington, D.C., which would preclude the use of Reg. Sec. 301.7502-1(c)(1)(iii)(B)(1).
The Tax Court conceded that the Postal Service had not placed a postmark on the envelope. It also observed that the envelope had been entered into the Postal Service's tracking system for certified mail on April 23, and the judge thought that was just as good as a postmark, which meant that April 23 was the date of filing. That was two days late, so the Tax Court dismissed the petition.
Seeking reconsideration, Tilden observed that neither he nor the IRS had raised the possibility that tracking data must be treated as a "postmark made by the U.S. Postal Service." The IRS joined Tilden in contending that the Tax Court had been mistaken. Abandoning its earlier position, the IRS asked the Tax Court to apply Reg. Sec. 301.7052-1(c)(1)(iii)(B)(1) and deem both of its subsections satisfied. But the judge denied the motion, stating that because the 90-day limit in Code Sec. 6213(a) is jurisdictional, the court was not obliged to accept the parties' agreement. Tilden appealed to the Seventh Circuit.
Seventh Circuit's Analysis
The Seventh Circuit reversed the Tax Court and held that Tilden's petition was timely filed. As an initial matter, the Seventh Circuit looked at whether Code Secs. 6213 and 7502, and/or Reg. Sec. 301.7502-1, create a "jurisdictional" rule and, citing Guralnik v. Comm'r, 146 T.C. No. 15 (2016), concluded that filing deadlines for petitions seeking Tax Court review are jurisdictional.
However, the Seventh Circuit observed, this does not mean that the Tax Court can disregard the parties' agreement that a petition has been timely filed. Although litigants cannot stipulate to jurisdiction, they can agree on the facts that determine jurisdiction, the court said. According to the court, there was no reason to suspect that Tilden and the IRS colluded to establish the Tax Court's jurisdiction. To the contrary, the IRS initially argued that Tilden's petition was untimely. So, the court said, the Tax Court judge had no good reason to doubt that the envelope was handed to the Postal Service on April 21, 2015. Since the IRS later acknowledged that certified mail can take eight days to reach the Tax Court from Utah, the court found that all requirements for establishing timely filing under Reg. Sec. 301.7502-1(c)(1)(iii)(B)(1) were met.
The Seventh Circuit also doubted the Tax Court's belief that the date an envelope enters the Postal Service's tracking system is a sure indicator of the date the envelope was placed in the mail. The court noted that the IRS acknowledged that the envelope was received by the Postal Service on April 21, but yet the Postal Service's tracking date was April 23.
Although Tilden prevailed on this appeal, the Seventh Circuit was astonished that his law firm waited until the last possible day to mail the petition without an official postmark. A Tax Court petition is not a complicated document, the court observed, and could have been mailed with time to spare. And if Tilden did not hire the law firm until the 90-day period had almost run, why did the firm use a private postmark when an official one would have prevented any controversy? A staff member could have walked the envelope to a post office and asked for hand cancellation, the court noted.
The Seventh Circuit concluded that the law firm took an unnecessary risk with Tilden's money, and its own money "in the malpractice action that was sure to follow if we [the appellate court] had agreed with the Tax Court, by waiting until the last day and then not getting an official postmark or using a delivery service."
For further discussion of filing Tax Court petitions, see Parker Tax ¶263,510.
RV is Dwelling Unit Used as Residence so Business-related Depreciation and Interest Deductions Denied
The Ninth Circuit affirmed a Tax Court decision that a couple couldn't deduct business expenses for their recreational vehicle (RV). Although expenses for the RV were "appropriate and helpful" in selling insurance policies at RV rallies, the RV was a dwelling unit used as a residence and the taxpayers were prohibited by Code Sec. 280A from deducting the expenses. Jackson v. Comm'r, 2017 PTC 11 (9th Cir. 2017).
RV is Dwelling Unit Used as Residence so Business-related Depreciation and Interest Deductions Denied
Dellward Jackson owned and operated an insurance brokerage business, with his spouse also active in the business as an agent and officer. In 2004, the agency began selling recreational vehicle (RV) policies once the Jacksons recognized that traditional auto insurance policies were not well suited for higher end RVs.
The Jackson's interest in RVs did not begin in 2004. They joined their first RV club in 1995. The clubs held rallies about once a month, and during 2004, the Jacksons began attending the rallies not just for pleasure but for business purposes, too. They would set up a table outside their RV or the clubhouse, if the site had one, and attach a banner advertising Dell Jackson Insurance to the RV or table. They would gather information from potential clients, return to their office to generate rate quotes, and bring the policies to the next rally for clients to review and hopefully sign.
On their 2006 tax return, the Jackson's deducted $47,461 for depreciation on their 2004 Winnebago. While they claimed 100% business use for the RV for 2006, the Jacksons admitted at trial that they took two or three personal trips in the RV during the year. In 2007, the couple purchased a new Winnebago, and on their 2007 return, deducted $60,424 for depreciation based on 99.95% business use. They also deducted as a business expense the interest paid to finance the new Winnebago. Because of Mrs. Jackson's health, they took no personal trips during 2007.
In its notice of deficiency, the IRS disallowed the depreciation deductions for both years and also disallowed the 2007 interest expense as a business expense. The Tax Court agreed with the IRS's determinations for both years, and the Jacksons appealed the decision to the Ninth Circuit Court of Appeals.
Analysis
Code Sec. 167(a) authorizes depreciation deductions for property used in a trade or business or held for the production of income and Code Sec. 163(a) allows a deduction for interest paid or accrued on taxpayer debt. However, Code Sec. 262(a) disallows deductions for personal expenses, Code Sec. 163(h) prevents noncorporate taxpayers from deducting personal interest, and Code Sec. 280A prohibits taxpayers from deducting expenses for dwelling units used as a residence unless the expenses are allowable without regard to the taxpayer's business or income-producing activity.
According to the Tax Court, when determining whether property is used in a trade or business or held for the production of income, the proper focus is "whether the acquisition and/or maintenance of the property was primarily associated with profit-motivated purposes." If the expenses are primarily motivated by personal considerations, Code Sec. 262 prohibits a deduction. Where substantial personal and substantial business motives coexist, the court can allocate the expenses between personal and business use.
The Tax Court framed the issue as whether the Jacksons used their RV for business or pleasure when attending the RV rallies. The "social aspect of these rallies" was evident from the fact that the Jacksons attended rallies for at least nine years before using the rallies as a business venue, and continued attending rallies once they sold their insurance business and retired. Nevertheless, it was clear that the Jacksons sold insurance policies during their time at the rallies and their business activities generated not-insignificant revenue ($14,882 in 2006 and $19,446 in 2007) that tripled during the four years after they began soliciting business at the rallies. Accordingly, the court determined that allocating a portion of the depreciation and interest to business use was appropriate.
The Tax Court then considered Code Sec. 280A(a), which disallows deductions for a dwelling unit used during the year as a residence. After concluding that the RV was akin to motor homes held to be dwelling units in Haberkorn v. Comm'r, 75 T.C. 259 (1980) and other cases, the court sought to determine whether it qualified as a residence under Code Sec. 280A(d). Under that provision, a dwelling unit is a residence for the year if used for personal purposes during the year for the greater of 14 days or 10 percent of the number of days during the year the unit is rented at a fair rental. Since the Jacksons did not rent their RV but used it for personal purposes for more than 14 days during the year, Code Sec. 280A prohibited any deductions in 2007.
Code Sec. 280A(c) contains a number of exceptions to the general disallowance rule, including one allowing an allocation of costs to a certain portion of the dwelling unit. But for the exception to apply, a portion of the dwelling unit must be exclusively used on a regular basis as the principal place of business or as a place to meet or deal with customers or clients. Since the Jacksons did not use any portion of their RV exclusively for business, they did not qualify.
Ninth Circuit Affirms Tax Court
In a brief opinion, the appellate court agreed that the deductions were prohibited by Code Sec. 280A, stating that the Tax Court did not clearly err in finding that the Jacksons used their RV for personal purposes for more than 14 days in 2006 and 2007. The Tax Court also did not clearly err in finding Code Sec. 280A(c)(1)(B) inapplicable because the Jackson's RV failed the "exclusively used" test.
Returning to the Tax Court's opinion, the judge acknowledged that the result may seem harsh but reflects Congress' desire to prevent the deduction of personal expenses as business expenses. Code Sec. 280A casts a wide net and sometimes catches taxpayers, like the Jacksons, who had a genuine business purpose. While the use of the RV may have been "appropriate and helpful" in their business, they failed to meet the stringent requirements of Code Sec. 280A.
For more on deductions attributable to the use of a dwelling unit, see Parker Tax ¶86,101.
