Federal Tax Bulletin - Issue 126 - October 21, 2016

2016 Year-End Tax Planning for Individuals

The first installment of Parker's annual two-part series on year-end tax planning recaps 2016's major changes affecting individual taxpayers, and strategies clients can use to minimize their 2016 tax bill. The online version of the article includes links to sample year-end client letters for individuals and businesses.

Introduction

For tax returns preparers looking to take their minds off the 24/7 election news coverage, year-end tax planning may be just the ticket. While there are several tax proposals before Congress and it's possible that some of the low-cost tax extenders not made permanent by prior year's legislation will be extended, no significant legislative proposals are expected to pass before the end of the year. As discussed below, there are some changes for 2016 that you should be aware of, as well as some expiring tax provisions that your clients may be able to take advantage of.

CLIENT LETTERS for both individuals and businesses are available online now:

Practice Aid: See ¶320,129, for a comprehensive year-end letter for individuals. For a comprehensive year-end planning letter for businesses, see ¶320,128.

As with every year, the tax brackets have increased slightly as they are adjusted for inflation. For 2016, the top tax rate of 39.6 percent will apply to incomes over $415,050 (single), $466,950 (married filing jointly and surviving spouse), $233,475 (married filing separately), and $441,000 (heads of households). However, high-income taxpayers are also subject to the 3.8 percent net investment income tax and/or the .9 percent Medicare surtax. For taxpayers subject to one or both of these additional taxes, there are certain actions that can be taken which may mitigate the damage of these additional taxes.

The due date for filing 2016 tax returns is Tuesday, April 18, 2017, because April 15 is a Saturday, and Monday April 17 is Emancipation Day in Washington, D.C. Thus, the tax deadline is extended to the next business day.

Finally, under a new law that goes into effect this tax season, the IRS is prohibited from issuing any refunds before February 15 for returns claiming the earned income tax credit (EITC) and/or the additional child tax credit (ACTC). The refund delay is aimed at allowing the IRS additional time to process such returns and prevent revenue loss due to identity theft and refund fraud relating to fabricated wages and withholdings. The IRS will hold the entire refund. Under the new law, the IRS cannot release the part of the refund that is not associated with the EITC or the ACTC.

I. Changes for 2016 Returns

Obamacare Penalties Increase

Under Obamacare, there is a penalty for failing to have health insurance. The monthly penalty amount is equal to 1/12 of the greater of: (1) a flat dollar amount; or (2) a percentage of the taxpayer's income. The flat dollar amount is equal to the lesser of: (1) the sum of the applicable dollar amounts for all individuals with respect to whom the failure occurred, or (2) 300 percent of the applicable dollar amount. For 2016, the applicable dollar amount is $695, up from $325 in 2015. The percentage of the taxpayer's income is equal to a specified percentage of the excess of his or her household income over his or her filing threshold amount. The specified percentage in 2016 is 2.5 percent, up from 2 percent in 2015. For purposes of this rule, household income is the aggregate modified adjusted gross incomes of the taxpayer and all dependents who are required to file tax returns for the tax year. See Parker Tax ¶190,140.

Increases in Personal Exemptions and Head-of-Household Standard Deduction

Personal exemptions increased by $50 in 2016 to $4,050. However, the amount of the exemption is reduced by 2 percent for each $2,500 ($1,250 for married filing separately), or fraction thereof, by which the taxpayer's AGI exceeds a certain threshold. The threshold amounts, which have been inflation-adjusted for 2016, are (1) $259,400 in the case of a single individual; (2) $285,350 in the case of a head of household; (3) $311,300 in the case of a joint return or a surviving spouse; and (4) $155,650 in the case of a married individual filing a separate return.

Because inflation rates have continued to be low, the only change to the standard deduction was a $50 increase to $9,300 for head-of-households. For married individuals, unmarried individuals (other than surviving spouses and heads of households), and married individuals filing separately, the standard deduction amounts remain at $12,600, $6,300, and $6,300, respectively. See Parker Tax ¶10,705.

Alternative Minimum Tax Exemption Boosted

The alternative minimum tax (AMT) exemption has been increased in varying amounts between $100 and $400, depending on a taxpayer's filing status. The exemptions for 2016 are (1) in the case of a joint return or a surviving spouse, $83,800 (up from $83,400); (2) in the case of an individual who is unmarried and not a surviving spouse, $53,900 (up from $53,600); (3) in the case of a married individual filing a separate return, $41,900 (up from $41,700); and (4) in the case of an estate or trust, $23,900 (up from $23,800). See Parker Tax ¶12,120. Read more...

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New Overtime Rules Go Into Effect December 1st; What Tax Practitioners Need to Know

On December 1, 2016, final regulations updating overtime rules go into effect. The new rules, estimated to affect over 4.2 million workers, double the salary threshold at which a white color worker can be classified as an "exempt employee" not entitled to overtime pay. The regulations also increase the salary threshold for highly compensated employees, who are subject to looser exemption criteria. The rules defining the types of employees who can qualify for exemption remain unchanged. RIN 1235-AA11.

Background

Federal overtime rules are contained in the Fair Labor Standards Act (FLSA). The FLSA covers more than 135 million workers at 7.3 million businesses nationwide. Unless exempt, employees covered by the FLSA must receive overtime pay (generally time and one-half) when they work more than 40 hours in a workweek.

Observation: Federal overtime rules exist side by side with state overtime rules, which are often identical. Where federal and state rules diverge, employers must comply with whichever rules are stricter.

Generally, the FLSA applies to employees of enterprises that have an annual gross sales of $500,000 or more, and to employees individually covered by the law because they are engaged in interstate commerce or in the production of goods for commerce. In addition, employees of the following types of entities are covered by the FLSA regardless of gross sales: hospitals; businesses providing medical or nursing care for residents; schools (whether operated for profit or not-for-profit); and public agencies.

While the FLSA overtime rules apply to most hourly and salaried workers, they do not apply to executive, administrative, and professional (EAP) employees meeting certain criteria. The EAP exemption applies to workers who pass three tests:

(1) the employee must be paid a predetermined and fixed salary that is not subject to reduction because of variations in the quality or quantity of work performed ("salary basis test");

(2) the amount of salary paid must meet a minimum specified amount ("salary level test"); and

(3) the employee's job duties must primarily involve executive, administrative, or professional duties as defined by the regulations ("duties test").

Highly compensated employees (HCE) are subject to the same exemption criteria, but with a higher salary threshold and a looser version of the duties test, referred to as the "minimal duties test."

Key Changes in the New Overtime Rules

Salary Threshold for the Standard EAP Exemption Has Doubled. The biggest change in the new rules is the increase in the threshold for passing the salary level test. The regulations increase the minimum specified salary from $23,660 to $47,476 (or $455 a week to $913 a week). Under the new rules, employees with annual salaries of less than $47,476 cannot be considered exempt employees, regardless of their job responsibilities.

Salary Threshold for Highly Compensated Employees Has Increased. The new rules also increase the salary threshold for HCEs (who are subject to a relaxed version of the duties test) from $100,000 to $134,004 a year. Adjusting for wage inflation, this change effectively resets the HCE threshold to where it was in 2004, the last time it was changed.

Compliance Tip: Employers should take care not to round down to the nearest thousand in setting a salary right at the HCE threshold. An employee with an annual salary of $134,000 will fall four dollars short and will not be classified as an HCE under the new rules.

Thresholds will be Updated Automatically Every Three Years. Under the new rules, both of the above salary thresholds will be automatically adjusted for wage inflation every three years, beginning January 1, 2020. The standard and HCE thresholds are projected to increase to $51,168 and $147,524 respectively in 2020. The Department of Labor will post new salary levels 150 days in advance of their effective date, beginning August 1, 2019.

Incentive Payments May Satisfy Part of Standard Salary Level Amount. For the first time, employers can use nondiscretionary bonuses and incentive payments (including commissions) to satisfy up to 10 percent of the salary level amount in order to reach the threshold for the standard EAP exemption (i.e., up to $91 of the $913 per week threshold), provided these payments are made on a quarterly or more frequent basis. Before the new overtime rules, the entire salary level had to be paid in each pay period.

"Salary Basis" and "Duties" Tests Remain Unchanged

Neither the rules for what constitutes a bona fide salary arrangement (salary basis test), nor the rules governing what types of employees fall into the "executive, administrative, or professional" category (duties test) were changed by the new regulations.

Salary Basis Test. To meet the salary basis test, an employee must regularly receive a predetermined amount of money each pay period on a weekly, or less frequent, basis. The predetermined amount cannot be reduced because of variations in the quality or quantity of the employee's work; however, deductions from pay are permissible for certain limited reasons. Generally, an exempt employee must receive the full salary for any week in which the employee performs any work, regardless of the number of days or hours worked. Exempt employees do not need to be paid for any workweek in which they perform no work.

As noted above, the final rules provide that employers can use nondiscretionary bonuses and incentive payments (including commissions) to satisfy up to 10 percent of the standard salary level amount.

Administrative, professional, and computer employees may be paid on a "fee basis" rather than on a salary basis. If the employee is paid an agreed sum for a single job, regardless of the time required for its completion, the employee will be considered to be paid on a "fee basis." A fee payment is generally paid for a unique job, rather than for a series of jobs repeated a number of times and for which identical payments repeatedly are made. To determine whether the fee payment meets the minimum salary level requirement, the test is to consider the time worked on the job and determine whether the payment is at a rate that would amount to at least $913 per week if the employee worked 40 hours.

Duties Test. To qualify for any of the white collar exemptions (commonly known as "executive, administrative, and professional" or "EAP" exemptions), employees must meet certain tests regarding their job duties. The regulations establish separate duties requirements for executive, administrative, professional, outside sales, and computer employees, respectively. The following link provides a detailed explanation of the duties requirements for various types of employees that may qualify for EAP exemption: Federal Overtime Rules - Duties Tests for Various Professions.

Under the standard duties test, an employee's primary duty must be that of an exempt executive, administrative or professional employee. "Primary duty" means the principal, main, major, or most important duty that the employee performs. The determination of an employee's primary duty must be based on all the facts in a particular case, with the major emphasis on the character of the employee's job as a whole.

Employees can also qualify for exemption under the special rule for HCEs, which pairs a more relaxed duties test with the higher HCE total annual compensation requirement. Under the HCE duties test, the employee's primary duty must still consist of office or non-manual work, but the employee need only "customarily and regularly" perform one of the exempt duties of a bona fide executive, administrative, or professional employee.

Options for Compliance

Employers have several options for responding to the changes in the new overtime rules. Organizations may ensure compliance for those employees affected by the rules by providing pay raises that increase workers' salaries to the new threshold, spreading employment by reducing or eliminating work hours of individual employees working over 40 hours per week for which no overtime is being paid, or paying overtime. The rules does not require employers to convert a salaried worker making less than the new salary threshold to hourly status: employers can pay non-exempt employees on a salary basis and pay overtime for hours worked beyond 40 in a week.

Compliance Tip: The new rules go into effect on a Thursday, creating a situation where an employee may be exempt for half of the week, and non-exempt for the other half. To sidestep the administrative complexity of a midweek switch, employers may want to consider making any changes required to comply with the new rules at the beginning of the workweek that includes December 1 (e.g., Monday, November 28 for employers with Monday-Sunday workweeks).

Employers may use any method they choose for tracking and recording hours, as long as they are complete and accurate. The method for compliance, which is entirely within each employer's discretion, will likely depend on the circumstances of that organization's workforce, including how much employees currently earn and how often employees work overtime, and may include a combination of responses, such as paying overtime and adjusting employees' hours and schedules.

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Social Security Wage Base to Increase Sharply in 2017

After leaving the Old-Age, Survivors and Disability Insurance (OASDI) wage base unchanged in 2016, the Social Security Administration (SSA) has announced an increase from $118,500 to $127,200 for 2017. The 7.34 percent increase is based on the increase in average wages. SSA 2017 Fact Sheet.

Observation: This $8,700 increase to the wage base is the largest year-over-year dollar increase since indexing began; the percentage increase is the largest since 1983.

For employees, the Social Security tax rate remains at 6.20 percent on earnings up to the wage base. For 2017, an employee with earnings equal to or exceeding the wage base will pay a maximum of $7,886.40 in Social Security taxes, an increase of $539.40 from last year's maximum.

For self-employed individuals, the OASDI tax rate for self-employment income equal to or exceeding the wage base remains at 12.40 percent. For 2017, a taxpayer with self-employment income equal to or exceeding the wage base will pay a maximum OASDI tax of $15,772.80, an increase of $1,078.80 from last year's maximum.

The SSA noted that, of the estimated 173 million workers who will pay Social Security taxes in 2017, about 12 million will pay more because of the increase in the taxable maximum.

The SSA also announced that, based on the increase in the Consumer Price Index (CPI-W) from the third quarter of 2014 through the third quarter of 2016, Social Security and Supplemental Security Income (SSI) beneficiaries will receive a 0.3 percent cost of living adjustment (COLA) for 2017.

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Trust Can't Deduct Charitable Contributions Where Will Did Not Explicitly Allow Them

The Tax Court held that charitable contributions made by a trust were not deductible because they were not made pursuant to the will that established the trust. The court stated that if the decedent had intended to give his trustees authority in his will to make charitable contributions, he could have added language to that effect, and disagreed that the will contained a "latent ambiguity" allowing the contributions. Harvey C. Hubbell Trust v. Comm'r, T.C. Summary 2016-67.

Background

The Harvey C. Hubbell Trust is a testamentary trust created under the last will and testament of Harvey C. Hubbell. Hubbell died in 1957 and, following the final distribution of his estate in 1960, the trust came into existence. The trust provides for fixed payments to certain individuals for their life and directs the trustees to make the payments out of net income if available, otherwise out of principal. The trust document also provides that the trust "shall terminate upon the death of the last person receiving benefits therefrom, except that if in the judgment of the then Trustees it is advisable to continue the trust, it may be continued for not longer than ten (10) years after such death. All unused income and the remainder of the principal shall be used and distributed, in such proportion as the Trustees deem best, for such purpose or purposes, to be selected by them as the time of each distribution, as will make such uses and distributions exempt from Ohio inheritance and Federal estate taxes and for no other purpose."

Mr. Hubbell's will appointed three individuals to be the executors and trustees. They were given broad powers to manage Mr. Hubbell's estate and the trust. From 1960 to 2009, the trustees managed the assets of the trust, paid fees and expenses, and from the net income of the trust they made the required beneficiary distributions. From time to time, the trustees also caused the trust to make charitable contributions as defined by Code Sec. 170(c). Between 1985 and 2008, more than $1 million in charitable contributions were made by the trust. On its 2009 Form 1041, the trust took a charitable contribution deduction of $64,279. The IRS disallowed the deduction.

IRS's Position

While conceding that the contributions were made for a purpose specified in Code Sec. 170(c), the IRS nonetheless disallowed the trust's charitable contribution deduction because it was not made "pursuant to the terms of the governing instrument" as required by Code Sec. 642(c)(1). The IRS noted that no provision of the will authorized the trustees to make charitable contributions for 2009 or for any other year. Thus, the IRS argued, the charitable contributions made during 2009 were not deductible under Code Sec. 642(c)(1).

Trust's Position

The trust asserted that the Tax Court could go beyond the provisions of the will to determine Mr. Hubbell's intent because there was a latent ambiguity in the will. Case law defines a "latent ambiguity" as a defect which does not appear on the face of language used or an instrument being considered. It arises when language is clear and intelligible and suggests only a single meaning, but some intrinsic fact or some extraneous evidence creates a necessity for interpretation or a choice between two or more possible meanings (for example, where the words apply equally well to two or more different subjects or things).

The trust argued that, to the extent the language of the will was not clear in explicitly authorizing charitable gifts, it contained a latent ambiguity. The trust further argued that the latent ambiguity was revealed by the fact that the trustees of the trust, including his attorney, had consistently exercised their duties with the understanding that the will authorized them to make charitable gifts. As a result, the trust said, the Tax Court could use extrinsic evidence to resolve the latent ambiguity in the will and to find that Mr. Hubbell intended his trustees to make the charitable contributions that were made during 2009.

Tax Court's Analysis

The Tax Court noted that, in order for the trust to be entitled to the charitable contribution deduction, it had to do three things:  

(1) identify the "governing instrument";  

(2) show that the charitable contributions were paid "pursuant to" the terms of that instrument as required by Code Sec. 642(c)(1); and  

(3) demonstrate that each contribution was paid for a charitable purpose under Code Sec. 170(c).  

Because the parties agreed that the will was the governing instrument and that the contributions were paid for a charitable purpose under Code Sec. 170(c), the trust only had to show that the charitable contributions were made "pursuant to" the terms of the will, as required by Code Sec. 642(c)(1).

The Tax Court held that the charitable contributions made by the trust in 2009 were not deductible because they were not made pursuant to the will. The court rejected the trust's argument that there was ambiguity in the will. In essence, the court said, the trust was arguing that the terms of the will, which stated in effect that charitable gifts could not be made before the death of the last annuitant, were ambiguous because they did not explicitly state the opposite - that charitable gifts could be made before the death of the last annuitant. The court observed that, after the death of all annuitants, the will authorized the unused income and the remainder of principal to be used and distributed for a purpose "exempt from Ohio inheritance and Federal estate taxes and for no other purpose." The court concluded that, if Hubbell had intended to give his trustees authority in his will to make charitable contributions, he could easily have done so. The court said it was hard to believe that his failure to grant authority to his trustees to make charitable contributions before the death of the last annuitant was not intentional.

In reaching its conclusion, the court also cited the Supreme Court's decision in Old Colony Trust Co. v. Comm'r, 301 U.S. 379 (1937), in which the Court held that a trust is not entitled to a charitable contribution deduction when the fiduciary, acting without any authority under the trust instrument, distributes trust assets to charity. The trust instrument must authorize the fiduciary to make charitable contributions, in order for a court to find that the charitable contributions were made "pursuant to" the terms of the trust instrument.

For a discussion of the requirements a trust must meet to deduct a charitable contribution, see Parker Tax ¶53,110.

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Loss from Sale of Equipment Used to Generate DPGR Didn't Affect QPAI

The IRS Office of Chief Counsel concluded that even though equipment a taxpayer used to produce qualified production property (QPP) generated domestic production gross receipts (DPGR), the equipment itself was not QPP and thus a loss on its sale did not reduce the taxpayer's qualified production activities income (QPAI) for purposes of calculating the Code Sec. 199 deduction. CCA 201642033.

Under the facts of CCA 201642033, a taxpayer purchased equipment and solely used it for three years to produce qualified production property (QPP), the sales of which generated domestic production gross receipts (DPGR). Depreciation of the cost of the equipment was capitalized to the QPP. In the third year, the taxpayer sold the equipment for less than the property's adjusted basis at the time of the sale, generating a loss.

Senior counsel for the IRS requested advice from the IRS Office of Chief Counsel (IRS) on whether the loss on the sale of the equipment reduced the taxpayer's qualified production activities income (QPAI).

The domestic production activities deduction (DPAD) under Code Sec. 199 is, in general, equal to 9 percent of the lesser of a taxpayer's QPAI or taxable income. The QPAI of a taxpayer is equal to its domestic production gross receipts (DPGR) less certain expenses, losses, or deductions allocable to that DPGR, including the costs of goods sold (COGS). Code Sec. 199(c)(4)(A)(i)(I) defines DPGR, in part, as the gross receipts of the taxpayer that are derived from any lease, rental, license, sale, exchange, or other disposition of QPP which was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or significant part within the U.S.

The IRS noted that pursuant to Reg. Sec. 1.199-4(b)(1), the taxpayer's costs of goods sold included the adjusted basis of the taxpayer's equipment when it was sold. However, the IRS concluded that even though the equipment was used to produce QPP and the gross receipts from sales of that QPP were DPGR, the taxpayer's gross receipts from the sale of the equipment were non-DPGR because the equipment was not QPP that was MPGE by the taxpayer. Accordingly, the IRS advised that the COGS from the sale would be allocated solely to the taxpayer's non-DPGR and that therefore the loss will not reduce the taxpayer's QPAI for purposes of calculating the domestic production activities deduction.

For a discussion of domestic production gross receipts, see Parker Tax ¶96,110.

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Temp Regs Allow More Time to Make Disaster Loss Elections

The IRS has issued temporary regulations, effective immediately, that extend the time available for taxpayers to make a Code Sec. 165(i) election to treat a loss from a federally declared disaster as sustained in the year preceding the disaster. The due date is now six months after the due date for filing the return for the disaster year. In addition, the IRS has issued a revenue procedure specifying how taxpayers must make the election. T.D. 9789 (10/14/16); Rev. Proc. 2016-53.

Background

Under Code Sec. 165, a loss from a federally declared disaster is a form of casualty loss. A casualty loss is generally allowed as a deduction only for the tax year in which the loss is sustained (disaster year). Code Sec. 165(i) provides an exception to the general timing rule by allowing a taxpayer to elect to treat an allowable loss as sustained in the tax year immediately prior to the tax year in which the disaster occurred. Taxpayers typically have until the unextended due date of the return for the disaster year to make the Code Sec. 165(i) election.

For purposes of Code Sec. 165(i), a federally declared disaster is any disaster subsequently determined by the President of the United States to warrant assistance by the federal government under the Robert T. Stafford Disaster Relief and Emergency Assistance Act. A disaster area is the area that is determined to be eligible for assistance pursuant to the Presidential declaration.

Observation: An up-to-date list of tax relief available for various disasters, including Hurricane Matthew which recently affected much of Florida and North Carolina, is available on the IRS's website.

Temporary Regulations Increase Time Available to Make Section 165(i) Election

The IRS has issued temporary regulations that provide that the due date for making the Code Sec. 165(i) election is six months after the due date for filing the taxpayer's federal income tax return for the disaster year (determined without regard to any extension of time to file). In addition, the temporary regulations extend the period of time for revoking a Code Sec. 165(i) election to 90 days after the due date for making the election.

The temporary regulations are effective immediately.

Procedures for Making a Section 165(i) Election

Contemporaneously with the temporary regulations, the IRS has issued Rev. Proc. 2016-53, which specifies how a taxpayer makes a Code Sec. 165(i) election.

A taxpayer makes a Code Sec. 165(i) election by deducting the disaster loss on either an original federal tax return or an amended federal tax return for the preceding year. A taxpayer must include with the original federal tax return or amended federal tax return, an election statement indicating the taxpayer is making the election.

The election statement must contain the following information:

(1) The name or a description of the disaster and date or dates of the disaster which gave rise to the loss.

(2) The address, including the city, town, county, parish, state, and zip code, where the damaged or destroyed property was located at the time of the disaster.

For an election made on an original federal tax return, a taxpayer must provide the above information on Lines 1 or 19 (as applicable) of Form 4684, Casualties and Thefts. A taxpayer filing an original federal tax return electronically may attach a statement as a PDF document if there is insufficient space on Lines 1 or 19 of the Form 4684.

For an election made on an amended federal tax return, a taxpayer can provide the required information by any reasonable means, including by writing the name or a description of the disaster, the state in which the damaged or destroyed property was located at the time of the disaster, and "Section 165(i) Election" on the top of the Form 4684 and providing the rest of the information required by Rev. Proc. 2016-53 in either the Explanation of Changes section in Form 1040X, Form 1120X, or other appropriate form, or directly on the Form 4684.

Generally, a taxpayer cannot make a Code Sec. 165(i) election for a disaster loss if the loss has already been claimed as a deduction for the disaster year. However, if a taxpayer has claimed a deduction for a disaster loss in the disaster year and the taxpayer instead wants to make a Code Sec. 165(i) election with respect to such loss, the taxpayer must file an amended return to remove the previously deducted loss. The amended return must be filed on or before the date that the taxpayer files the return or amended return for the preceding year that includes the Code Sec. 165(i) election. Similarly, a taxpayer cannot revoke a previously made Code Sec. 165(i) election and deduct the loss in the disaster year unless the taxpayer first files an amended return to remove the loss for the preceding year.

For a discussion of losses due to federally declared disasters, see Parker Tax ¶84,545.

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Investigation of Father's Mysterious Death Was a Hobby, Not a Business

The Tax Court determined that a taxpayer's investigation of his father's alleged suicide, later discovered to be a murder, was not engaged in for profit. Although the taxpayer believed he might be able to eventually adapt his investigation into a book or movie, the court found his efforts were the product of a personal desire to uncover the cause of his father's death, not an attempt to develop a business. Vest v. Comm'r, T.C. Memo. 2016-187.

Background

In 1946, when Herb Vest was two years old, his father was found hanging by the neck in the bathroom of his shop in Gainesville, Texas. The death was originally ruled a suicide, but in 2003 Vest received an anonymous letter asserting that unidentified residents of Gainesville had murdered his father and staged it to look like a suicide. Having realized a large gain on the sale of his financial services business in 2001, Vest had the means to devote significant time and resources to investigating the circumstances of his father's death.

Beginning in 2003, Vest caused partnerships he controlled to pay at least $6.4 million to private investigators, forensic experts, morticians, and writers to assist him in solving the mystery of his father's death and reporting the results. In January 2006, one of his investigators wrote a report concluding that his father's death had in fact been a homicide. The report found, however, that no plausible suspects among Gainesville residents could be identified, that no further leads existed, and that additional time spent investigating the homicide would not prove fruitful. Undeterred, Vest continued his investigation, shifting his focus to the possibility that his father had been killed by government agents in the wake of World War II. He spent considerable effort gathering information, and believed that the story of his father's death could be successfully adapted into a book or a movie.

In November 2007, Vest hired a writer to draft a manuscript, and nine months later received a 96-page partial draft describing the known circumstances of his father's death. This draft was never completed. During this period, Vest also worked with a public relations firm to publicize his story and look for a buyer interested in commercializing it. There was apparently some interest; his father's death was the subject of one episode of a television show. Although this episode generated some publicity, it produced no revenue.

Vest conducted his investigative activities through various partnerships that he controlled. Between 2008 and 2010, the Harold E. Vest, H.W. Powers & Son LLC (HVPS), which Vest owned 100 percent directly or via passthrough partners, was principally engaged in investigating the circumstances of Vest's father's death. HVPS reported aggregate losses of approximately $3.8 million from these activities. By the end of 2010, Vest had been investigating his father's death for eight years. As of that time, his activities had not generated a single dollar of revenue and he had no reasonable prospect of generating future income.

The IRS examined HVPS' returns for 2008 to 2010 and disallowed the deductions relating to Vest's homicide-related investigative activity on the ground that the activity was "not engaged in for profit."

Analysis

Code Sec. 183(b) limits the deductions relating to an activity not engaged in for profit. Reg. Sec. 1.183-2(b) provides a nonexclusive list of nine factors relevant in ascertaining whether a taxpayer conducts an activity with the intent to earn a profit. The factors listed are: (1) the way the taxpayer conducts the activity; (2) expertise of the taxpayer or his advisers; (3) time and effort the taxpayer spends in carrying on the activity; (4) expectation that assets used in the activity may appreciate in value; (5) taxpayer's success in carrying on other similar or dissimilar activities; (6) taxpayer's history of income or losses with respect to the activity; (7) amount of occasional profits earned, if any; (8) taxpayer's financial status; and (9) elements of personal pleasure or recreation.

The Tax Court determined that none of the regulatory factors weighed meaningfully in Vest's favor.

The court observed that Vest had no professional training or experience in writing, publishing, or media and had no budget or business plan for his activity, which indicated that he did not conduct his activity in a businesslike manner (factor 1). Although he hired multiple investigators (factor 2) and devoted many hours to the project (factor 3), the court said, he showed little interest in actually making it profitable. The court stated that while Vest had earlier been successful in his financial planning business, those accomplishments were not a good predictor of success as an author, book publisher, or producer (factor 5).

The court noted that Vest did not generate a single dollar of revenue from this activity in any year from 2003 through 2010 (factor 7). Over that time, the court said, Vest's reported losses were continuous and substantial, strongly suggesting that he did not engage in this activity to make a profit (factor 6). Vest did not adjust the scale or direction of his activities as a profit-maximizing person would do, the court said, noting that after his investigator in 2006 found the anonymous letter to be a dead end, Vest did not curtail his expenditures or abandon the project to cut losses. In addition, the court determined Vest had no expectation that assets used would appreciate in value (factor 4), noting the investigations had no meaningful assets apart from the research he accumulated and the incomplete 96-page manuscript, which remained an incomplete draft.

The court observed that after the sale of his business in 2003, Vest had significant financial resources and leisure time available (factor 8) and had strong personal motives for conducting his activity (factor 9). The court noted that Vest clearly found the mystery surrounding his father's death to be very engaging, as he expended significant financial resources pursuing multiple theories.

The Tax Court concluded that Vest did not engage in the investigation of his father's death with the primary and genuine purpose of making a profit, and sustained the IRS's disallowance of his deductions.

For a discussion of the determination of whether an activity is engaged in for profit, see Parker Tax ¶97,505.

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IRS Limits Application of Debt/Equity Regs, Expands Exceptions for Ordinary Business Transactions

The IRS has issued final and temporary regulations under Code Sec. 385 that make substantial changes to controversial proposed regulations that addressed the characterization of debt and equity in an attempt to combat earnings stripping following a corporate inversion. The final regulations, which apply to debt instruments issued on or after January 1, 2018, generally exempt foreign taxpayers, S corporations, and some RICs and REITs from the new rules, relax documentation requirements, and limit the scope of the new rules in order to reduce the impact on ordinary business transactions. T.D. 9790 (10/21/16).

Background

Corporate inversions are seen as a problem for the U.S. tax system because they are generally entered into for tax avoidance purposes. A corporate inversion is a transaction in which a multinational group with a U.S. parent changes its tax residence to reduce or avoid paying U.S. taxes. Specifically, a group with a U.S. parent engages in an inversion when it acquires a smaller foreign company and then locates the tax residence of the merged group outside the U.S., typically in a low-tax country. After a corporate inversion, multinational corporations often use a tactic called "earnings stripping" to minimize U.S. taxes by paying deductible interest to their new foreign parent or one of its foreign affiliates in a low-tax country. For example, following an inversion or foreign takeover, a U.S. subsidiary can issue its own debt to its foreign parent as a dividend distribution. The foreign parent, in turn, can transfer this debt to a low-tax foreign affiliate. The U.S. subsidiary can then deduct the resulting interest expense on its U.S. income tax return at a significantly higher tax rate than is paid on the interest received by the related foreign affiliate. The related foreign affiliate can also use various strategies to avoid paying any tax at all on the associated interest income. The IRS stated that, when available, these tax savings incentivize firms with a foreign parent to load up their U.S. subsidiaries with related-party debt.

In April, the IRS issued proposed regulations (REG-108060-15 (4/8/16)) which targeted earnings stripping transactions. The proposed regulations generally made it more difficult for groups with a foreign parent to quickly load up their U.S. subsidiaries with related party debt following an inversion or foreign takeover, by treating as stock instruments issued to a related corporation through dividends or certain economically similar transactions. In addition, the proposed regulations provided that the IRS, on audit, could divide a purported debt instrument into part debt and part stock (bifurcation rule).

The proposed regulations were met with immense backlash from Congressional lawmakers and businesses concerned that the proposed regulations would impose compliance burdens and result in collateral consequences that were not justified by the stated policy objectives. In response to these concerns, the IRS has issued final and temporary regulations that substantially revise the proposed regulations.

Final Regs Exempt Foreign Issuers, S Corps, RICs, and REITs, Remove Bifurcation Rule

The proposed regulations generally applied to "expanded groups," which were defined by reference to Code Sec. 1504(a) "affiliated groups" but broadened to include foreign and tax-exempt corporations, as well as corporations held indirectly, for example, through partnerships. Practitioners expressed concerns regarding the complexity of applying the proposed regulations to foreign borrowers. In addition, practitioners requested that S corporations, regulated investment companies (RICs), and real estate investment trusts (REITs) be excluded from the definition of an expanded group, noting that these entities are similar to non-controlled partnerships (which the proposed regulations would not have included in an expanded group), and that recharacterization of an instrument issued by these entities could affect its tax status.

In response to practitioner concerns, the final regulations apply only to instruments issued by members of an expanded group that are domestic corporations. In addition, the final regulations exempt from the definition of an "expanded group" S corporations and RICs or REITs that are not controlled by members of an expanded group. Thus, the final regulations do not apply to foreign issuers, S corporations, and non-controlled RICs and REITs.

The final regulations also do not include the general bifurcation rule from the proposed regulations. The IRS noted that this rule was broadly applicable and not subject to the same threshold rules as most of the regulations' other provisions. Practitioners had expressed concerns about a lack of specificity in application and corresponding unintended collateral consequences. For example, one concern was that this provision could have unintended and disqualifying effects on an entity's tax status, such as for an S corporation or a REIT. The IRS stated it is continuing to study comments received on the proposed bifurcation rule.

Final Regulations Relax Documentation Requirements

Under the proposed regulations, companies were required to undertake certain due diligence procedures and complete documentation up front to establish that a financial instrument is really debt. Specifically, the proposed regulations required key information be documented, including a binding obligation for an issuer to repay the principal amount borrowed, creditor's rights, a reasonable expectation of repayment, and evidence of an ongoing debtor-creditor relationship. Prop. Reg. Sec. 1.385-2 provided that the absence of timely preparation of documentation and financial analysis evidencing these four essential characteristics of indebtedness would be a dispositive factor requiring a purported debt instrument to be treated as stock for federal tax purposes.

The final regulations eliminate the timely document preparation requirement, and instead treat documentation and financial analysis as timely prepared if it is prepared by the time that the issuer's federal income tax return is filed (taking into account all applicable extensions). The final regulations also provide that, if an expanded group is otherwise generally compliant with the documentation requirements, then a rebuttable presumption, rather than per se recharacterization as stock, applies in the event of a documentation failure with respect to a purported debt instrument.

In addition, the final regulations apply only to debt instruments issued on or after January 1, 2018.

Final and Temp Regs Make Significant Changes Regarding Distributions of Debt Instruments and Similar Transactions

Under the proposed regulations, if the application of Prop. Reg. Sec. 1.385-2 and general federal income tax principles otherwise would result in treating an interest issued to a related party as indebtedness for federal tax purposes, Prop. Reg. Sec. 1.385-3 provided additional rules that would treat the interest, in whole or in part, as stock for federal tax purposes if it was issued in a distribution or other transaction that was identified as frequently having only limited non-tax effect (the general rule), or was issued to fund such a transaction (the funding rule).

The final and temporary regulations under Reg. Sec. 1.385-3 generally retain these rules that recharacterize purported debt of U.S. issuers as equity if the interest is among highly related parties and does not finance new investment, but make significant modifications and provide various exceptions and exclusions in order to exempt most ordinary course transactions and certain common commercial lending practices from being subject to the rules.

Specifically, the final and temporary regulations provide that, when applying the Reg. Sec. 1.385-3 rules, an expanded earnings and profits (E&P) exception takes into account a corporation's E&P accumulated after April 4, 2016, as opposed to limiting distributions to the amount of E&P generated each year (as under the proposed regulations). However, the accumulated E&P available under this exception to offset distributions or acquisitions for purposes of applying the Reg. Sec. 1.385-3 rules resets to zero when there is a change in control of the issuer due, for example, to the issuer being acquired by an unrelated party.

In addition, Reg. Sec. 1.385-3 does not apply to cash pool borrowing and other short-term debt. The exception for short-term debt allows companies to efficiently transfer cash around an affiliated group in order to meet the day-to-day global cash needs of the business without resorting to third-party borrowing in order to avoid Reg. Sec. 1.385-3.

The final and temporary regulations also provide an exception for the first $50 million of debt that would otherwise be recharacterized as stock. Under the threshold exception in Reg. Sec. 1.385-3(c)(4), immediately after debt would be treated as stock, to the extent that the aggregate adjusted issue price of that debt exceeds $50 million, only the amount of the debt in excess of $50 million will be treated as stock.

In addition, the final and temporary regulations make the following changes:

• Exclusion of debt instruments issued by regulated financial groups and insurance entities - The final and temporary regulations do not apply to debt instruments issued by certain specified financial entities, financial groups, and insurance companies that are subject to a specified degree of regulatory oversight regarding their capital structure.
• Limiting certain "cascading" recharacterizations - The final and temporary regulations narrow the application of the funding rule by preventing, in certain circumstances, the so-called "cascading" consequence of recharacterizing a debt instrument as stock.
• Credit for certain capital contributions - The final and temporary regulations provide an exception pursuant to which certain contributions of property are "netted" against distributions and transactions with similar economic effect.
• Exception for equity compensation - The final and temporary regulations provide an exception for the acquisition of stock delivered to employees, directors, and independent contractors as consideration for the provision of services.

The final and temporary regulations also provide that any debt instrument that is subject to recharacterization but that is issued on or before January 19, 2017, will not be recharacterized until immediately after that date.

Effective Date and Transition Rules

The final and temporary regulations generally apply to tax years ending on or after January 19, 2017. In addition, the final regulations under Reg. Sec. 1.385-2 do not apply to interests issued or deemed issued before January 1, 2018. Reg. Sec. 1.385-3 and Reg. Sec. 1.385-3T grandfather debt instruments issued before April 5, 2016.

The final regulations under Reg. Sec. 1.385-3 provide a transition period under which any debt instrument that would be treated as stock by reason of the application of the final and temporary regulations on or before January 19, 2017 (the final transition period) is not treated as stock, but rather the covered debt instrument is deemed to be exchanged for stock immediately after that date, but only to the extent that the debt instrument is held by a member of the issuer's expanded group immediately after that date (final transition period rule). Thus, the final transition period rule addresses both debt instruments that would have been recharacterized before the final and temporary regulations become applicable (that is, because the recharacterization would have occurred during a taxable year ending before January 19, 2017), as well as other debt instruments that would be treated as stock on or before that date.