Student's Light Course Load Precluded Education Credit; 2016 Inflation Adjustment Factor for Section 45Q Credit Issued; Cattle Activity Losses Attributed to Corporation, Not Owners; Expenses to Travel Cross-State for Work Weren't Deductible ...
IRS Rejects LLC Member's Argument That Income Attributable to Capital Isn't Self-Employment Income
The IRS Office of Chief Counsel (IRS) advised that the manager and president of a limited liability company (LLC) that operated franchise restaurants was not a limited partner and thus was subject to self-employment tax on his distributive share of the LLC's income as well as the guaranteed payments he received from the LLC. The IRS rejected the LLC's position that the individual's income should be bifurcated for self-employment tax purposes between income attributable to capital invested, and compensation for services rendered. CCA 201640014.
The IRS has issued final regulations under Code Sec. 707 and Code Sec. 752 regarding disguised sales of partnership property. In addition, the IRS has issued temporary and proposed regulations concerning how partnership liabilities are allocated for purposes of the disguised sale rules, and when certain liabilities are disregarded or treated as recourse liabilities. The final and temporary regulations are generally effective on October 5, 2016, and taxpayers may rely on the proposed regulations until finalized. T.D. 9787 (10/5/16); T.D. 9788 (10/5/16); REG-122855-15 (10/5/16).
The IRS has updated its procedures for disregarding and treating as void a qualified terminable interest property (QTIP) election that does not reduce an estate's tax liability. The IRS notes that while initial guidance assumed executors would not purposefully make an unnecessary QTIP election, such elections could be used to increase the deceased spouse unused exclusion (DSUE) amount eligible for portability. The new procedures generally allow a surviving spouse to void an unnecessary QTIP election as long as no DSUE portability election has been made. Rev. Proc. 2016-49.
IRS Finalizes Regulations on Internal Use Software for Purposes of the Research Credit
The IRS has finalized regulations clarifying the meaning of "internal use software" for purposes of the Code Sec. 41 research credit. Generally, unless such software meets a three part "high threshold of innovation test," development costs do not qualify for the credit. However, the final regulations provide a safe-harbor for expenditures related to software that is developed for both internal and third-party use (dual use software). The regulations are effective October 4, 2016. T.D. 9786 (10/4/16).
The Tax Court, in an issue of first impression, held that an estate was entitled to a theft loss deduction for a loss the decedent's LLC incurred when its account with Madoff Investment Securities became worthless. The court pointed out that the estate lost value because its interest in the LLC had been reduced to zero as a result of the Madoff Ponzi scheme. Est. of Heller v. Comm'r, 147 T.C. No. 11 (2016).
The IRS has provided the 2016-2017 special per diem rates for taxpayers to use in substantiating the amount of ordinary and necessary business expenses incurred while traveling away from home. Notice 2016-58.
An estate could not recover more than $1.2 million in penalties and interest paid as a result of the late filing of its federal estate tax return, even where the executor was a high-school educated homemaker and her legal counsel was incompetent. The Sixth Circuit held that, although the circumstances in the case were unfortunate, case law makes it clear that the duties to file a tax return and pay taxes are non-delegable and mere good-faith reliance does not constitute reasonable cause to avoid late filing penalties. Specht v. U.S., 2016 PTC 363 (6th Cir. 2016).
Drought-Stricken Farmers and Ranchers Have More Time to Replace Livestock; Counties in 38 States Affected
The IRS has provided guidance regarding an extension of the replacement period under Code Sec. 1033(e) for livestock sold on account of drought in specified U.S. counties. Notice 2016-60.
IRS Rejects LLC Member's Argument That Income Attributable to Capital Isn't Self-Employment Income
The IRS Office of Chief Counsel (IRS) advised that the manager and president of a limited liability company (LLC) that operated franchise restaurants was not a limited partner and thus was subject to self-employment tax on his distributive share of the LLC's income as well as the guaranteed payments he received from the LLC. The IRS rejected the LLC's position that the individual's income should be bifurcated for self-employment tax purposes between income attributable to capital invested, and compensation for services rendered. CCA 201640014.
Background
An individual purchased franchise restaurants and contributed the restaurants to a limited liability company (LLC) taxed as a partnership for federal tax purposes. During the years at issue, the partnership's gross receipts and net ordinary business income were almost entirely attributable to food sales. The franchisee owns a majority interest in the partnership.
The franchise agreements require the franchisee to personally devote full time and best efforts to operating the restaurants. The partnership's operating agreement provides that the franchisee is the partnership's operating manager, president, and CEO and must conduct its day-to-day business affairs. In particular, the franchisee has authority to manage the partnership, make all decisions, and do anything reasonably necessary in light of its business and objectives. The franchisee has ultimate responsibility for hiring, firing, and overseeing all the partnership's employees, including members of the executive management team.
Self-Employment Tax Rules Applicable to Partnerships
Code Sec. 1402(b) generally provides that the term "self-employment income" means the net earnings from self-employment derived by an individual during any tax year. The term "net earnings from self-employment" is defined in Code Sec. 1402(a) as the gross income derived by an individual from any trade or business carried on by such individual, less certain deductions which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in Code Sec. 702(a)(8) from any trade or business carried on by a partnership of which he is a member, with certain enumerated exclusions. Code Sec. 702(a)(8) provides that in determining a partner's income tax, each partner must take into account separately his distributive share of the partnership's taxable income or loss, exclusive of items requiring separate computation.
Code Sec. 1402(a)(13) excludes from self-employment income the distributive share of any item of income or loss of a limited partner other than guaranteed payments described in Code Sec. 707(c) made to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.
Observation: Code Sec. 1402(a)(13) was originally enacted as Code Section 1402(a)(12) in 1977 before entities such as LLCs were widely used. The applicable statute did not, and still does not, define a "limited partner." At the time of the statute's enactment, the Revised Uniform Limited Partnership Act of 1976 provided that a "limited partner" would lose his limited liability protection if, in addition to the exercise of his rights and powers as a limited partner, he took part in the control of the business.
Partnership's Position
The partnership treated the franchisee as a limited partner for purposes of Code Sec. 1402(a)(13), and included only the guaranteed payments in the franchisee's net earnings from self-employment, not his full distributive share. The partnership argued that the franchisee's income from the partnership should be bifurcated for self-employment tax purposes between the franchisee's (1) income attributable to capital invested or the efforts of others, which is not subject to self-employment tax, and (2) compensation for services rendered, which is subject to self-employment tax. According to the partnership, as a retail operation, the partnership requires capital investment for buildings, equipment, working capital and employees and, in fact, the partnership and the franchisee made significant capital outlays to acquire and maintain the restaurants. The partnership said that it derives its income from the preparation and sale of food products by its employees, not the personal services of the franchisee.
IRS Chief Counsel's Advice
The IRS Office of Chief Counsel (IRS) advised that the franchisee is not a limited partner within the meaning of Code Sec. 1402(a)(13) and thus is subject to self-employment tax on his distributive share from the partnership. In reaching its conclusion, the IRS looked at the Tax Court's decision in Renkemeyer, Campbell, and Weaver LLP v. Comm'r, 136 T.C. 137 (2011), where the Tax Court held that that practicing lawyers in a law firm organized as a Kansas limited liability partnership (LLP) were not limited partners within the meaning of Code Sec. 1402(a)(13) and thus were subject to self-employment taxes. In that decision, the Tax Court discussed Kansas state law under which an LLP is considered a general partnership and discussed the ordinary meaning of the term "limited partnership." The court opined that a limited partnership has two fundamental classes of partners: general and limited. General partners, the court said, typically have management power and unlimited personal liability. On the other hand, limited partners lack management powers but enjoy immunity from liability for debts of the partnership. According to the Tax Court, it is generally understood that a limited partner can lose his limited liability protection were he to engage in the business operations of the partnership. Consequently, the interest of a limited partner in a limited partnership is generally akin to that of a passive investor.
According to the IRS, the insight provided by the Tax Court reveals that the intent of Code Sec. 1402(a)(13) is to ensure that individuals who merely invest in a partnership and who are not actively participating in the partnership's business operations (which was the archetype of limited partners at the time) do not receive credits toward social security coverage. The legislative history of Code Sec. 1402(a)(13), the IRS said, does not support a holding that Congress contemplated excluding partners who performed services for a partnership in their capacity as partners (i.e., acting in the manner of self-employed persons), from liability for self-employment taxes.
For a discussion of the self-employment tax liability of LLC members, see Parker Tax ¶29,535.
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IRS Revamps Partnership Disguised Sale Rules and Partnership Liability Regs
The IRS has issued final regulations under Code Sec. 707 and Code Sec. 752 regarding disguised sales of partnership property. In addition, the IRS has issued temporary and proposed regulations concerning how partnership liabilities are allocated for purposes of the disguised sale rules, and when certain liabilities are disregarded or treated as recourse liabilities. The final and temporary regulations are generally effective on October 5, 2016, and taxpayers may rely on the proposed regulations until finalized. T.D. 9787 (10/5/16); T.D. 9788 (10/5/16); REG-122855-15 (10/5/16).
Background
Code Sec. 707 and related regulations provide rules concerning "disguised sales" of property to or by a partnership. A disguised sale can occur when there is a transfer of property by a partner to a partnership followed by a transfer of money or other consideration from the partnership to the partner. Such a transfer is considered a disguised sale if the transfer to the partners would not have been made but for the transfer of property to the partnership and, for non-simultaneous transfers, the subsequent transfer is not dependent on the entrepreneurial risks of the partnership.
Certain transactions involving partnership liabilities, however, are not classified as disguised sales. For example, if a partner transfers property to a partnership, the partnership incurs a liability and all or a portion of the proceeds of that liability are traceable to a transfer of money or other consideration to the partner, the transfer of money or other consideration is taken into account for purposes of the disguised sale rules only to the extent that the amount of money or the fair market value of other consideration exceeds the partner's allocable share of the partnership liability (i.e., the debt-financed distribution exception). The disguised sale rules also generally exclude certain types of liabilities from disguised sale treatment. Generally, a partnership's assumption of a qualified liability, or a partnership's taking property subject to a qualified liability, in connection with a transfer of property by a partner to the partnership is not treated as part of a disguised sale.
In determining a partner's share of a partnership liability for disguised sale purposes, regulations provide separate rules for a partnership's recourse liability and a partnership's nonrecourse liability. Generally, a partner's share of a partnership's recourse liability equals the partner's share of the liability under Code Sec. 752 and the related regulations. A partner's share of a partnership's nonrecourse liability is determined by applying the same percentage used to determine the partner's share of the excess nonrecourse liabilities, which are generally determined in accordance with the partner's share of partnership profits.
In T.D. 9787, the IRS issued final regulations under Code Sec. 707 and Code Sec. 752 that substantially adopt proposed regulations (REG-119305-11) published in January 2014 (2014 proposed regulations). The final regulations provide guidance under Code Sec. 707, relating to disguised sales of property to or by a partnership, and under Code Sec. 752, relating to allocations of excess nonrecourse liabilities of a partnership to partners for disguised sale purposes. The IRS has also issued, in T.D. 9788, temporary regulations concerning how liabilities are allocated for purposes of Code Sec. 707 and when certain obligations are recognized for purposes of determining whether a liability is a recourse partnership liability under Code Sec. 752. The temporary regulations also provide guidance on the treatment of "bottom dollar payment obligations."
Finally, the IRS withdrew a portion of the 2014 proposed regulations to the extent not adopted by the final regulations, and has published new proposed regulations (REG-122855-15) under Code Sec. 752 (2016 proposed regulations). The new proposed regulations address when certain obligations to restore a deficit balance in a partner's capital account are disregarded under Code Sec. 704 and when partnership liabilities are treated as recourse liabilities under Code Sec. 752.
An in-depth discussion of the final, temporary, and proposed regulations follows.
I. Final Regulations
Preformation Capital Expenditures and Capital Expenditure Qualified Liabilities
The regulations under Code Sec. 707 provide several exceptions to a transaction being labeled a disguised sale, such as the exception for reimbursements of preformation expenditures in Reg. Sec. 1.707-4(d). Under that exception, transfers of money or other consideration from a partnership to reimburse a partner for certain capital expenditures and costs incurred by the partner (preformation capital expenditures) were not considered disguised sales. The exception generally applies only to the extent the reimbursed expenditures do not exceed 20 percent of the fair market value (FMV) of the transferred property (i.e., the 20 percent limitation). This limitation does not apply where the FMV of the property does not exceed 120 percent of the partner's adjusted basis in that property when it is transferred (i.e., the 120 percent test).
The 2014 proposed regulations provided that the determination of whether the 20 percent limitation and the 120 percent test applied to reimbursements of capital expenditures was made, in the case of multiple property transfers, separately for each property that qualified for the exception (property-by-property rule). Practitioners generally supported the property-by-property rule but noted that in some circumstances the approach could be burdensome and recommended limited aggregation of certain property. Read more...
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IRS Updates Guidance on Unnecessary QTIP Elections to Address DSUE Portability
The IRS has updated its procedures for disregarding and treating as void a qualified terminable interest property (QTIP) election that does not reduce an estate's tax liability. The IRS notes that while initial guidance assumed executors would not purposefully make an unnecessary QTIP election, such elections could be used to increase the deceased spouse unused exclusion (DSUE) amount eligible for portability. The new procedures generally allow a surviving spouse to void an unnecessary QTIP election as long as no DSUE portability election has been made. Rev. Proc. 2016-49.
Background
Under Code Sec. 2056(b)(7), a decedent's gross estate is reduced by the value of qualified terminable interest property. Qualified terminable interest property (QTIP) is property that passes from the decedent to the surviving spouse, where the surviving spouse has a qualifying income interest for life in the property and the executor has made a QTIP election on the estate tax return.
In Rev. Proc. 2001-38, the IRS provided relief for surviving spouses and their estates in situations where a predeceased spouse's estate made a QTIP election that did not reduce the estate tax liability of the estate (unnecessary QTIP election). Generally, the value of property for which a QTIP election was made is included in the surviving spouse's gross estate, the inter vivos disposition of an interest in the property is subject to gift tax, and in the absence of a "reverse QTIP" election, the surviving spouse will be treated as the transferor of the property for generation-skipping transfer tax purposes. As such, prior to the issuance of Rev. Proc. 2001-38, an unnecessary QTIP election produced adverse tax consequences and no benefit for taxpayers. Rev. Proc. 2001-38 provided relief by treating the unnecessary QTIP election as a nullity for federal estate, gift, and generation-skipping transfer tax purposes.
The IRS stated that Rev. Proc. 2001-38 was premised on the belief that an executor would never purposefully make an unnecessary QTIP election. However, the IRS noted that with the 2010 amendments to Code Sec. 2010(c) and Code Sec. 2505(a) providing portability elections for the deceased spouse's unused exclusion (DSUE) amount, an executor of a deceased spouse's estate may wish to elect QTIP treatment for property even where the election is not necessary to reduce the estate tax liability. A QTIP election would reduce the amount of the taxable estate, resulting in less use of the decedent's applicable credit amount and producing a greater DSUE amount than would otherwise exist. An increased DSUE amount available to the surviving spouse increases the applicable credit amount available to the surviving spouse to wholly or partially offset the surviving spouse's gift or estate tax liability that is attributable to the QTIP or any other property.
In Rev. Proc. 2016-49, the IRS has updated the procedures by which it will disregard an unnecessary QTIP election and treat such election as null and void, but only for estates in which the executor neither made nor was considered to have made the portability election. The relief provided in the revenue procedure is effective as of September 27, 2016.
New Guidance Treats Unnecessary QTIP Elections as Void, Provided No DSUE Portability Election is Made
Rev. Proc. 2016-49 treats as void QTIP elections made in cases where all of the following requirements are satisfied:
(1) The estate's federal estate tax liability was zero, regardless of the QTIP election, based on values as finally determined for federal estate tax purposes, thus making the QTIP election unnecessary to reduce the federal estate tax liability;
(2) The executor of the estate neither made nor was considered to have made the DSUE portability election; and
(3) Certain procedural requirements are satisfied.
QTIP elections made to treat property as QTIP are not treated as void in cases where:
(1) A partial QTIP election was required with respect to a trust to reduce the estate tax liability and the executor made the election with respect to more trust property than was necessary to reduce the estate tax liability to zero;
(2) A QTIP election was stated in terms of a formula designed to reduce the estate tax to zero;
(3) The QTIP election was a protective election under Reg. Sec. 20.2056(b)-7(c);
(4) The executor of the estate made a DSUE portability election, even if the decedent's DSUE amount was zero; or
(5) The procedural requirements are not satisfied.
Procedural Requirements for Relief to Treat QTIP Election as Void
In order to be eligible for relief under Rev. Proc. 2016-49, the taxpayer must identify the QTIP election and provide an explanation of why the election should be treated as void. The explanation should include all the relevant facts, including the value of the predeceased spouse's taxable estate without regard to the allowance of the marital deduction for the QTIP at issue compared to the applicable exclusion amount in effect for the year of the predeceased spouse's death. The explanation should state that the portability election was not made in the predeceased spouse's estate and include the relevant facts to support this statement.
The taxpayer must provide sufficient evidence to establish that the QTIP election was not necessary to reduce the estate tax liability to zero and that the executor opted not to elect portability of the DSUE amount. Such evidence may include a copy of the predeceased spouse's estate tax return filed with the IRS. If the executor of the predeceased spouse's estate was not considered to have made a portability election because of a late filing of that return, evidence may consist of the account transcript reflecting the date the estate tax return was filed.
The procedural requirements of Rev. Proc. 2016-49 are satisfied by submitting the above information in connection with:
- a supplemental Form 706 filed for the estate of the predeceased spouse;
- a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, filed by the surviving spouse; or
- a Form 706 filed for the estate of the surviving spouse.
The taxpayer must notify the IRS that a QTIP election is eligible for relief under Rev. Proc. 2016-49 by entering at the top of the Form 706 or Form 709 the notation "Filed pursuant to Revenue Procedure 2016-49."
These procedures must be used in lieu of requesting a letter ruling; accordingly, user fees do not apply to corrective action under this revenue procedure.
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IRS Finalizes Regulations on Internal Use Software for Purposes of the Research Credit
The IRS has finalized regulations clarifying the meaning of "internal use software" for purposes of the Code Sec. 41 research credit. Generally, unless such software meets a three part "high threshold of innovation test," development costs do not qualify for the credit. However, the final regulations provide a safe-harbor for expenditures related to software that is developed for both internal and third-party use (dual use software). The regulations are effective October 4, 2016. T.D. 9786 (10/4/16).
Background
Under Code Sec. 41, taxpayers may take a credit for increasing expenditures on qualified research activities (research credit). Computer software that is developed by (or for the benefit of) the taxpayer primarily for its own internal use (internal use software) is generally excluded from the research credit pursuant to Code Sec. 41(d)(4)(E). Internal use software may, however, be eligible for the credit if the research undertaken to create the software meets a three-part "high threshold of innovation" test.
Determining whether software falls within the "internal use" definition and (if so) whether it passes the high threshold of innovation test has been a persistent source of controversy since the research credit was added to the Code in 1986. Two previous sets of proposed regulations released in 1997 and 2001 respectively had done little to settle the matter. On January 20, 2015, the IRS released a new set of proposed regulations to address the uncertainty surrounding internal use software. These new proposed regulations have been finalized, with some modifications made in response to practitioner comments.
Definition of Internal Use Software
The final regulations provide that software is developed for internal use if the software is developed by the taxpayer for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. "General and administrative functions" are limited to financial management, human resource management, and support services functions. Financial management functions involve the financial management of the taxpayer and the supporting recordkeeping. Human resource management functions assist in managing the taxpayer's workforce. Support services functions support the day-to-day operations of the taxpayer, such as data processing or facilities services. Such functions generally fall within the realm of those commonly thought of as back-office operations.
Observation: The IRS noted that the characterization of a function as back-office may depend on the taxpayer's industry. For example, tax preparation software used in the tax services industry is not used in a general and administrative function, whereas the same software used in other industries would be considered as being used for general and administrative purposes.
In addition, the final regulations provide that whether or not software is developed primarily for internal use depends on the intent of the taxpayer at the beginning of the software development. However, if the taxpayer later makes improvements to the existing software, those improvements will be considered separate from the existing software and the internal use software rules will be applied to the improvements.
Non-Internal Use Software
The proposed regulations provided that software is not developed primarily for internal use if it is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties, or if it is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system.
Example: A manufacturer of various products develops software for a website that allows third parties to order products and track the status of their orders online. Under these facts, the software is not developed primarily for internal use because the software allows third parties to initiate functions or review data as provided.
After consideration of practitioner comments, the final regulations clarify that software is not developed primarily for the taxpayer's internal use if it is not developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business. In addition, software that is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties and software that is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system are examples of software that is not developed primarily for the taxpayer's internal use.
Safe Harbor for Certain Dual Function Software
The final regulations provide that software developed both for use in the taxpayer's general and administrative functions and for use by or with third-parties (dual function software) is presumed to be developed primarily for a taxpayer's internal use. However, this presumption does not apply if a taxpayer can identify a subset of elements of the dual function software that only enables a taxpayer to interact with third parties or to allow third parties to initiate functions or review data (third party subset). Such third party subsets are not considered developed primarily for internal use.
Example: A taxpayer develops computer software that the taxpayer uses in general and administrative functions that support the conduct of the taxpayer's trade or business and that allows third parties to initiate functions. The taxpayer is able to identify the third party subset and the taxpayer incurs $50,000 of research expenditures for the computer software, 50 percent of which is allocable to the third party subset. Under these facts, the computer software developed by the taxpayer is dual function computer software. Because the taxpayer is able to identify the third party subset, such third party subset is not presumed to be internal use software.
The final regulations incorporate a safe harbor for expenditures related to dual function software if, after the taxpayer has identified any third party subsets, there remains dual function software or a subset of elements of dual function software (dual function subset). The safe harbor allows a taxpayer to include 25 percent of the qualified research expenditures of the dual function subset in computing the amount of the taxpayer's credit, provided that the taxpayer's research activities related to the dual function subset constitute qualified research and the use of the dual function subset by third parties or by the taxpayer to interact with third parties is reasonably anticipated to constitute at least 10 percent of the dual function subset's use.
Final Regulations Modify High Threshold of Innovation Test and Application
The proposed regulations provided that certain internal use software is eligible for the research credit if the software satisfies the high threshold of innovation test, the three parts of which are:
(1) software is innovative, meaning that that the software would result in a reduction in cost or improvement in speed or other measurable improvement, that is substantial and economically significant, if the development is or would have been successful;
(2) software development involves significant economic risk, meaning that the taxpayer commits substantial resources to the development and there is a substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period; and
(3) software is not commercially available for use by the taxpayer, meaning in that the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the innovation and significant economic risk requirements.
The proposed regulations further provided that, for purposes of the significant economic risk test, substantial uncertainty exists if, at the beginning of the taxpayer's activities, the information available to the taxpayer does not establish the capability or method for developing or improving the software.
Practitioners requested that the final regulations include design uncertainty in the definition of technical risk for purposes of meeting the significant economic risk. Practitioners also raised concerns that the statute and regulations do not define the concepts of capability, methodology, and design uncertainty. The IRS noted that while there may be design uncertainty in the development of internal use software, substantial uncertainty generally exists only when there is also uncertainty in regard to the capability or method of achieving the intended result. The IRS said that the appropriate design uncertainty of internal use software may be inextricably linked to substantial uncertainty regarding capability or method, but that it is difficult to delineate the types of technical uncertainties and that the focus of the significant economic risk test should be on the level of uncertainty that exists and not the types of uncertainty. For those reasons, the final regulations remove the references to capability and method uncertainty, but otherwise retain the high threshold of innovation test under the proposed regulations.
The final regulations also clarify that the high threshold of innovation test does not apply to:
(1) software developed for use in an activity that constitutes qualified research;
(2) software developed for use in a production process to which the requirements of Code Sec. 41(d)(1) are met; and
(3) a new or improved package of software and hardware developed together by the taxpayer as a single product.
Accordingly, under the final regulations, the high threshold of innovation test applies only to the software developed for use in general and administrative functions that facilitate or support the conduct of the taxpayer's trade or business, and to dual function software.
Effective Date
The final regulations are prospective, and generally apply to tax years beginning on or after October 4, 2016. However, the IRS stated that software not developed for internal use under the final regulations may or may not have been internal use software under prior law.
For tax years ending before January 20, 2015, taxpayers may choose to follow either the rules in final regulations (T.D. 8930) published on January 3, 2001 or the rules contained in proposed regulations (REG-112991-01) published on December 26, 2001. In addition, for any tax year that both ends on or after January 20, 2015 - the date the 2015 proposed regulations (REG-153656-03) were published - and begins before October 4, 2016, the IRS will not challenge return positions consistent either with the 2015 proposed regulations or the final regulations.
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Estate Could Deduct Theft Loss Decedent's LLC Suffered in Madoff Ponzi Scheme
The Tax Court, in an issue of first impression, held that an estate was entitled to a theft loss deduction for a loss the decedent's LLC incurred when its account with Madoff Investment Securities became worthless. The court pointed out that the estate lost value because its interest in the LLC had been reduced to zero as a result of the Madoff Ponzi scheme. Est. of Heller v. Comm'r, 147 T.C. No. 11 (2016).
Background
At the time of his death in January 2008, James Heller owned a 99 percent interest in James Heller Family, LLC (JHF). His daughter and son each held an equal share of the remaining interest in JHF. Harry Falk managed JHF, the only asset of which was an account (JHF Madoff account) with Bernard L. Madoff Investment Securities, LLC (Madoff Securities). Following Heller's death, his son, daughter, and Falk were appointed co-executors of his estate. Between March and November 2008, Falk withdrew $11,500,000 from the JHF Madoff account and distributed it according to JHF's ownership interests. The estate's share, $11,385,000, was used to pay its taxes and administrative expenses.
In December 2008, Bernard Madoff, the chairman of Madoff Securities, was arrested, and the Securities and Exchange Commission issued a press release to alert the public that it had charged him with securities fraud relating to a multibillion-dollar Ponzi scheme. In perpetuating the scheme, Madoff and his associates fabricated monthly and quarterly statements and sent them to Madoff Securities' clients. Madoff, in March 2009, admitted that he had perpetrated a Ponzi scheme through Madoff Securities and pled guilty to various federal crimes, including securities fraud, investment adviser fraud, money laundering, and perjury. As a result of the Ponzi scheme, JHF's interest in the JHF Madoff account and the estate's interest in JHF became worthless.
In April 2009, the estate filed its Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, reporting a $26,296,807 gross estate, which included the date-of-death value of Heller's interest in JHF ($16,560,990). The estate also claimed a $5,175,990 theft loss deduction relating to the Ponzi scheme, reflecting the difference between the estate's interest in JHF and its share of the amounts withdrawn from the JHF Madoff account in 2008. Following an audit, the IRS determined that the estate was not entitled to the theft loss deduction because it did not incur a theft loss during its settlement. According to the IRS, under state law, it was the LLC and not the estate that was the theft victim.
Analysis
Code Sec. 2054 provides that, in general, an estate is entitled to deductions relating to losses incurred during the settlement of the estate "arising" from theft.
The Tax Court noted that whether an estate is entitled to a Code Sec. 2054 theft loss deduction relating to property held by an LLC in which the estate has an interest was an issue of first impression. Because neither the regulations nor the legislative history relating to Code Sec. 2054 or its predecessors addressed the issue, the court stated that its analysis would begin and end with the statute.
The estate tax is imposed on the value of property transferred to beneficiaries and in that context, the court said, a loss refers to a reduction of the value of property held by an estate. The court pointed out that while JHF lost its sole asset as a result of the Ponzi scheme, the estate, during its settlement, also incurred a loss because the value of its interest in JHF decreased from $5,175,990 to zero.
The court disagreed with the IRS's argument that it was JHF and not the estate that suffered the theft loss. Code Sec. 2054, the court noted, allows for a broader nexus between the theft and the incurred loss than did the IRS's narrow interpretation. Citing the Merriam-Webster's Collegiate Dictionary, the court noted that "arise" is generally defined as "to originate from a source." Pursuant to the phrase "arising from" in Code Sec. 2054, the court said, the estate was entitled to a deduction if there was a sufficient nexus between the theft and the estate's loss. The court found the nexus between the theft and the value of the estate's JHF interest sufficient, noting that the loss suffered by the estate related directly to its JHF interest, the worthlessness of which arose from the theft.
The court stated that its conclusion was in accordance with, and buttressed by, the purpose of the estate tax. Estate tax deductions are designed to ensure that the estate tax is imposed on the net estate, which the court pointed out is the value of what passes from the decedent to the beneficiaries. The court noted that the theft extinguished the value of the estate's JHF interest, thereby diminishing the value of property available to Heller's heirs. Thus, the court determined that the estate's entitlement to a Code Sec. 2054 deduction was consistent with the overall statutory scheme of the estate tax.
For a discussion of deductions against the estate for losses, expenses, debts, and taxes, see Parker Tax ¶227,501.
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IRS Updates Per Diem Rates for Travel Away From Home
The IRS has provided the 2016-2017 special per diem rates for taxpayers to use in substantiating the amount of ordinary and necessary business expenses incurred while traveling away from home. Notice 2016-58.
In Notice 2016-58, the IRS issued the annual update on special per diem rates used in substantiating the amount of ordinary and necessary business expenses incurred while traveling away from home. Specifically, the notice provides: (1) the special transportation industry meal and incidental expenses rates (M&IE rates), (2) the rate for the incidental expenses only deduction, and (3) the rates and lists of high-cost localities for purposes of the high-low substantiation method.
Taxpayers using the rates and the list of high-cost localities provided in Notice 2016-58 must comply with Rev. Proc. 2011-47, which provides rules for using a per diem rate to substantiate, under Code Sec. 274(d) and Reg. Sec. 1.274-5, the amount of ordinary and necessary business expenses paid or incurred while traveling away from home.
For purposes of the high-low substantiation method, the per diem rates are $282 for travel to any high-cost locality and $189 for travel to any other locality within the continental U.S. (up from $275 and $185, respectively). The amount of the $282 high rate and $189 low rate that is treated as paid for meals for purposes of Code Sec. 274(n) is $68 for travel to any high-cost locality and $57 for travel to any other locality within the continental U.S.
The per diem rates for the meal and incidental expenses only substantiation method are $68 for travel to any high-cost locality and $57 for travel to any other locality within the continental U.S. (same as last year).
Notice 2016-58 is effective for per diem allowances for lodging, meal and incidental expenses, or for meal and incidental expenses only that are paid to any employee on or after October 1, 2016, for travel away from home on or after October 1, 2016. Rates for the period of October 1, 2015 through September 30, 2016, can be found in Notice 2015-63.
For a discussion of the substantiation rules for expenses incurred while traveling away from home, see Parker Tax ¶91,130.
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Incompetent Legal Counsel Doesn't Excuse Estate from Late Filing Penalties
An estate could not recover more than $1.2 million in penalties and interest paid as a result of the late filing of its federal estate tax return, even where the executor was a high-school educated homemaker and her legal counsel was incompetent. The Sixth Circuit held that, although the circumstances in the case were unfortunate, case law makes it clear that the duties to file a tax return and pay taxes are non-delegable and mere good-faith reliance does not constitute reasonable cause to avoid late filing penalties. Specht v. U.S., 2016 PTC 363 (6th Cir. 2016).
Background
Virginia Escher died on December 30, 2008, and her estate was worth approximately $12.5 million. Escher's cousin, Janice Specht, was asked to be the executor of the estate. Specht, then 73, was a high-school-educated homemaker who had never served as an executor, never owned stock, and had never been in an attorney's office. Specht selected Escher's attorney, Mary Backsman, to assist her. Backsman had over 50 years of experience in estate planning, but unbeknownst to Specht, was privately battling brain cancer. In January 2009, Backsman informed Specht that the estate owed approximately $6 million in federal estate taxes, and that the estate would need to liquidate its shares in United Parcel Service, Inc. (UPS) in order to pay the liability. Backsman informed Specht that the estate taxes were due nine months following Escher's death, on September 30, 2009. Backsman also suggested that her law firm could pay the liability on the estate's behalf and seek reimbursement later.
Whenever Specht asked about the filing of the tax return and payment, Backsman assured her that an extension had been obtained. However, Specht did not ask for proof that an extension had been obtained, and Backsman's assurances turned out to be false; she had not in fact even requested an extension. Before the IRS filing deadline, Specht received four notices from the probate court informing her that the estate had missed probate deadlines. She responded to the notices by calling Backsman and asking why the deadlines had been missed. Specht then unquestioningly accepted Backsman's repeated response that she had obtained an extension and was handling the matter. The September 30, 2009, estate filing deadline came and passed without the estate filing its tax return and paying the federal estate tax.
In July 2010, Specht received a call from friends of Escher who had also hired Backsman as an attorney for a family member's estate. They warned Specht that Backsman was incompetent, and told Specht they were seeking to have Backsman removed as co-executor of their family member's estate. Specht scheduled a meeting with Backsman and again accepted Backsman's representation that the execution of the estate was going smoothly. However, after receiving notices from the state of Ohio saying that the estate was delinquent in filing its Ohio estate tax return, Specht fired Backsman and hired another attorney. That attorney liquidated the UPS stock and filed the estate's federal tax return in January of 2011, paying the tax liability and interest due.
The IRS assessed penalties against the estate for failing to meet the September 30, 2009, deadline, which the estate paid. The estate had also paid penalties to the Ohio Department of Taxation; however, the state fully refunded those penalties due to the hardship caused by Backsman's representation. The estate settled a malpractice action against Backsman in 2012, and Backsman surrendered her law license.
Suit Against the IRS in District Court
Code Sec. 6651(a)(1) and (2) provide for the assessment of penalties for failure to file a tax return and failure to pay a tax liability. These penalties are mandatory unless the failure is due to reasonable cause and not due to willful neglect. To escape the penalty, the taxpayer must prove both (1) that the failure did not result from willful neglect, and (2) that the failure was due to reasonable cause.
Specht and a co-fiduciary filed suit against the IRS in a district court seeking to recover the almost $1.2 million in penalties and interest on the penalties that the estate paid. The district court held for the IRS, concluding that Specht's reliance on Backsman to file the tax return and pay the tax liability was not a reasonable cause for the missed deadline. The district court also found that Specht's failure to supervise Backsman, despite the many warning signs of Backsman's deficient performance, constituted willful neglect of her duty to file the tax return and tax payment.
Specht and the co-fiduciary appealed to the Sixth Circuit, arguing that in light of Specht's age, education, and inexperience, her reliance on Backsman to file the tax return and pay the tax liability was a reasonable cause for the estate's failure to meet the deadline. The estate also argued that Specht's continued reliance on Backsman throughout the process did not constitute willful neglect of her duty to file the tax return and pay the tax liability.
Sixth Circuit Sides With IRS
The IRS, citing the Supreme Court's decision in U.S. v. Boyle, 469 U.S. 241 (1985), maintained that courts have recognized a non-delegable nature of the duty to make timely filings of tax returns and have held that reliance on counsel is not sufficient to constitute reasonable cause for the failure to file a return or pay a tax. The estate attempted to distinguish Boyle on the basis that Specht was unqualified to be an executor, and her reliance on Backsman was thus more reasonable than the taxpayer's reliance in Boyle and the taxpayers' reliance in cases following Boyle.
The Sixth Circuit affirmed the district court and held that the estate showed neither reasonable cause nor an absence of willful neglect to excuse the late filing and payment. To be sure, the court said, the Boyle Court left open the possibility that an executor's qualifications might impact the reasonableness analysis, and Justice Brennan's concurrence in the case cited taxpayers suffering from "senility, mental retardation or other causes" as examples of exceptional cases that might render an individual unable to comply with the statutory deadlines. But, the Court observed, the overwhelming majority of individuals are capable of complying with the deadlines.
Practice Tip: For tax practitioners with clients serving as executors or fiduciaries of estates or trusts, it's important to emphasize to them that penalties for late filings cannot be avoided by simply relying on others. They may want to ask those charged with preparing returns or legal filings, which could generate penalties if not timely filed, what back up plans are in place in case they are incapacitated and cannot perform their duties.
For a discussion of the abatement of penalties for failing to file a timely return and pay the tax due on time, see Parker ¶262,127.
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Drought-Stricken Farmers and Ranchers Have More Time to Replace Livestock; Counties in 38 States Affected
The IRS has provided guidance regarding an extension of the replacement period under Code Sec. 1033(e) for livestock sold on account of drought in specified U.S. counties. Notice 2016-60.
Under Code Sec. 1033(e)(2), farmers and ranchers who, due to drought, sell more livestock than they normally would may defer tax on the extra gains from those sales. To qualify, the livestock generally must be replaced within a four-year period. The IRS is authorized to extend this period if the drought continues.
Notice 2006-82 provides for extensions of the replacement period. If a sale or exchange of livestock is treated as an involuntary conversion on account of drought, the taxpayer's replacement period is extended until the end of the taxpayer's first tax year ending after the first drought-free year for the applicable region. For this purpose, the first drought-free year for the applicable region is the first 12-month period that:
(1) ends August 31;
(2) ends in or after the last year of the taxpayer's four-year replacement period determined under Code Sec. 1033(e)(2)(A); and
(3) does not include any weekly period for which exceptional, extreme, or severe drought is reported for any location in the applicable region.
The applicable region is the county that experienced the drought conditions on account of which the livestock was sold or exchanged and all counties that are contiguous to that county. A taxpayer may determine whether exceptional, extreme, or severe drought is reported for any location in the applicable region by reference to U.S. Drought Monitor maps that are produced on a weekly basis by the National Drought Mitigation Center.
In the appendix of Notice 2016-60, the IRS lists the counties for which exceptional, extreme, or severe drought was reported during the 12-month period ending August 31, 2016. For a taxpayer who qualified for a four-year replacement period for livestock sold or exchanged on account of drought and whose replacement period is scheduled to expire at the end of 2016 (or, in the case of a fiscal year taxpayer, at the end of the tax year that includes August 31, 2016), the replacement period is extended under Code Sec. 1033(e)(2) and Notice 2006-82 if the applicable region includes any county on this list. This extension will continue until the end of the taxpayer's first tax year ending after a drought-free year for the applicable region.
For a discussion of the postponement of gain on livestock resulting from weather-related events, see Parker Tax ¶161,570.
