Federal Tax Bulletin - Issue 92 - July 2, 2015

Supreme Court Upholds Premium Tax Credits to Individuals in States with Federal Exchanges

On June 25, in King v. Burwell, 2015 PTC 210 (S. Ct. 2015), the Supreme Court upheld the use of tax credits for health insurance purchased on any Exchange created under The Patient Protection and Affordable Care Act (ACA), be it federal or state. In one of the most serious challenges to the ACA to date, the Court, in a 6-3 decision, reasoned that the statute's context and structure compelled this conclusion.

Background

President Obama's signature health care legislation, sometimes referred to as "Obamacare," adopts a series of interlocking reforms designed to expand coverage in the individual health insurance market. First, the ACA bars insurers from taking a person's health into account when deciding whether to sell health insurance or how much to charge. Second, it generally requires each person to maintain insurance coverage or make a payment to the IRS. And third, under Code Sec. 36B, the ACA gives refundable tax credits to individuals with household incomes between 100 percent and 400 percent of the federal poverty line in order to make the insurance more affordable. The requirement to maintain insurance coverage applies only when the cost of buying health insurance, minus the amount of the tax credits, is less than 8 percent of an individual's income.

In addition to those reforms, the ACA requires the creaof an "Exchange" in each state, which is essentially a marketthat allows people to compare and purchase insurplans. The law gives each state the opportunity to establish its own Exchange, but provides that the federal government will establish "such Exchange" through the Department of Health and Human Services (HHS) if the state does not.

Under Code Sec. 36B, the amount of a taxpayer's tax credit depends in part on whether the taxpayer has enrolled in an insurance plan through "an Exchange established by the State under section 1311 of the Patient Protection and Affordable Care Act." In 2013, the IRS issued Reg. Sec. 1.36B-2, which provides that a taxpayer is eligible for a tax credit if the taxpayer is enrolled in an insurance plan through "an Exchange," which the regulation defines as an Exchange serving the individual market regardless of whether the Exchange was established and operated by a state or by the federal government through HHS. When the regulation was issued, 16 states and the District of Columhad established their own Exchanges; the other 34 states elected to have HHS do so.

King v. Burwell

David King is a resident of Virginia. He and three other Virginia residents did not want to pur-chase health insurance. Virginia did not establish its own Exchange; thus, it was covered by the Federal Exchange program. Under Reg. Sec. 1.36B-2, Virginia's Exchange qualified as an Exchange established by a state, so that King and the others were eligible to receive tax credits. That would make the cost of buying insurance less than 8 percent of their income, which would subject them to the ACA's coverage requirement. Therefore, Reg. Sec. 1.36B-2 required King and the others to either buy health insurance they did not want, or make a payment to the IRS. They filed suit in district court challenging the validity of Reg. Sec. 1.36B-2. The district court dismissed the suit, holding that the statute unambiguously made tax credits available to individuals enrolled through a Federal Exchange.

The taxpayers appealed and the Fourth Circuit, in King v. Burwell, 2014 PTC 364 (4th Cir. 2014), affirmed the district court. The court found the statutory language ambiguous and subject to multiple interpretations. As a result, under Chevron U. S. A. Inc. v. Natural Resources Defense Council, Inc., 467 U. S. 837 (1984), the court concluded that deference should be given to the IRS guidance under Code Sec 36B as a permissible exercise of the agency's discretion. Under the Chevron analysis, a court applies a two-step framework in which it asks whether a statute is ambiguous and, if so, whether an agency's interpretation of the statute is reasonable. In this case, the Fourth Circuit found the IRS's interpretation of Code Sec. 36B under Reg. Sec. 1.36B-2 to be reasonable.

The same day that the Fourth Circuit issued its decithe D.C. Circuit vacated Reg. Sec. 1.36B-2 in Halbig v. Burwell, 2014 PTC 456 (D.C. Cir. 2014), holding that the ACA "unambiguously restricts" the tax credits to State Exchanges.

The appellate decisions came down along party lines. The Fourth Circuit opinion was approved 3-0, with all judges having been appointed by a Democratic President. The D.C. Circuit opinion was approved by a 2-1 vote, with the dissenting vote cast by the lone Democrat. The taxpayers in King v. Burwell petitioned the U.S. Supreme Court to review the case and the Court granted certiorari.

Taxpayer and IRS Positions

The heart of the case centered on the dispute over whether Code Sec. 36B authorizes tax credits for individuals who enroll in an insurance plan through a Federal Exchange. King and the other taxpayers argued that a Federal Exchange is not "an Exchange established by the State" as provided by the statute. The phrase "established by the State" would be superfluous, they contended, if Congress meant to extend tax credits to both State and Federal Exchanges. Thus, they said, Reg. Sec. 1.36B-2 contradicts Code Sec. 36B and is invalid.

The IRS countered that Reg. Sec. 1.36B-2 is lawful because the phrase "an Exchange established by the State" should be read to include Federal Exchanges.

High Court Rejects Chevron Analysis

In an opinion written by Chief Justice Roberts, the Supreme Court began its analysis by determining whether or not the two-step framework in Chevron applied. Chevron, the Court observed, is premised on the theory that a statute's ambiguity constitutes an implicit delegation from Conto the agency to fill in the statutory gaps. However, the Court found that Chevron did not provide the appropriate framework in this case.

The tax credits are one of the ACA's key reforms, the Court noted, and whether they are available on Federal Exchanges is a question of deep economic and political significance. The Court reasoned that had Congress wished to assign this question to an agency, it would have done so expressly. The Court found it unlikely that Congress would have delegated this decision to the IRS, which has no expertise in crafting health insurance policy. Thus, the Court concluded that Chevron was inapplicable in this case. Rather, the court said, its task was to decide the correct reading of Code Sec. 36B and in doing so, the words had to be read in their context and with a view to their place in the overall statutory scheme.

Observation: Because the Supreme Court concluded that Congress intended for premium tax credits to be available on federal exchanges and did not intend to give the IRS discretion in the matter, the IRS will not be able to reverse its position on the issue under future administrations unless the underlying statute is changed or the Supreme Court reverses itself.

Court Looks to Act's Context and Structure

The Court agreed with the Fourth Circuit that, when read in context, the phrase "an Exchange established by the State under section 1311 of the Patient Protection Affordable Care Act" is ambiguous and could either be limited in its reach to State Exchanges or it could refer to all Exchanges. The Court focused on what happens if a state chooses not to establish an Exchange. In that case, the court noted, the ACA directs the Secretary of HHS to establish "such Exchange." The Court found that by using the words "such Exchange," the statute indicates that State and Federal Exchanges should be the same. But State and Federal Exchanges would differ in a fundamental way, the Court observed, if tax credits were available only on State Exchanges because insurance under a State Exchange would be more affordable as a result. The Court noted that another provision in the statute requires that all Exchanges create outreach programs to distribute information on the tax credits. This provision would make little sense, the Court said, if tax credits were not available on Federal Exchanges.

The Court looked to the broader structure of the ACA to determine whether one of Code Sec. 36B's permissible meanings produced a substantive effect that was compatible with the rest of the law. The Court noted that, under the taxpayers' reading of the statute, the ACA would not work in a state with a Federal Exchange because one of its three major reforms - the tax credits - would not apply. And a second major reform - the coverage requirement - would not apply in a meaningful way because so many individuals would be exempt from the requirement without the tax credits. The Court found that the combination of no tax credits and an ineffective coverage requirement could well push a state's individual insurance market into a death spiral. The Court said it was implausible that Congress meant the ACA to operate in such a manner.

Finally, the Court said that the structure of Code Sec. 36B itself suggested that tax credits were not limited to State Exchanges. Together, Code Sec. 36B(a), which allows tax credits for any "applicable taxpayer," and Code Sec. 36B(c)(1), which defines that term as someone with a household income between 100 percent and 400 percent of the federal poverty line, appeared to make anyone in the specified income range eligible for a tax credit. The Court rejected the taxpayers' interpretation of that provision as being limited to states that had set up a State Exchange.

Observation: In 2014, approximately 87 percent of people who bought insurance on a Federal Exchange did so with tax credits. If the tax credits did not apply, virtually all of those people would become exempt from the coverage requirement, and one study predicted that premiums would increase by 47 percent and enrollment would decrease by 70 percent.

The Court concluded that, while the taxpayers' arguments were strong, the ACA's context and structure compelled the conclusion that Code Sec. 36B allows tax credits for insurance purchased on any Exchange created under the statute. Those credits are necessary, the Court said, for the Federal Exchanges to function like their State Exchange counterparts and avoid the type of result that Congress plainly meant to avoid.

Justice Scalia's Dissent

Justices Scalia, Thomas, and Alito filed a dissenting opinion, written by Justice Scalia. The Justices criticized the Majority's holding that when the ACA says "Exchange established by the State" it means "Exchange established by the State or the Federal Government," calling such a reading "absurd." According to the Justices, words no longer have meaning if an Exchange that is not established by a state is considered established by the state. Under all the usual rules of interpretation, the Justices said, the IRS should lose this case. But, the Justices lamented, normal rules of interpretation yielded to the overriding principle of the present Court: The Affordable Care Act must be saved.

The Justices accused the majority of rewriting the law and coming up with argument after "feeble argument" to support its contrary interpretation of the phrase "Exchange established by the State." With respect to the Majority's observation that the law would make little sense if no tax credits were available on Federal Exchanges, the Justices said that even if this were true, it would show only oddity, not ambiguity. According to the Justices, laws often include unusual or mismatched provisions, and they noted it would be amazing if the provisions of the 900 page statute all lined up perfectly with each other. The dissenting Justices stated it is entirely natural for slight mismatches to occur when lawmakers draft a single statutory provision to cover different kinds of situations. Reading the ACA as a whole, the Justices concluded, leaves no doubt about the matter: "Exchange established by the State" means what it looks like it means.

Significance of Supreme Court Decision for the Future of ACA

Having survived what may be its last major challenge in the courts, the ACA's implementation is expected to continue uninterrupted through the 2016 election. Key pieces that are still being phased in include the employer mandate (effective for employers with 100 or more employees in 2015 and for employers with 50-99 employees in 2016) and various reporting requirements that had been temporarily delayed by the IRS.

The next existential challenge for the ACA will likely come in the political arena, as numerous Republican presidential candidates and party leaders have vowed to make repeal a central issue in the 2016 elections.

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Losses in Pump-and-Dump Stock Scheme Are Capital, Not Theft, Losses

Because there was no direct transfer of money from the taxpayers to the individuals operating a pump-and-dump stock scheme, or to such individuals' corporate alter egos, the taxpayers were limited to a capital loss, rather than theft loss, deduction. Greenberger v. U.S., 2015 PTC 205 (D. Ohio 6/19/15).

Background

Robert and Penny Greenberger first heard of Spongetech Delivery Systems, Inc. in 2008 from their friend, Douglas Furth. Furth was a professional financial and investment advisor, and was also one of the biggest individual shareholders in Spongetech, owning over 50 million shares. Furth spent years aggressively promoting Spongetech and, as a result, the Greenbergers purchased Spongetech stock. Robert began extensively trading in the stock and all his stock trades were made on the open market; none of the purchases were directly from Spongetech, its affiliates, or any individuals associated with Spongetech. Furth introduced Robert to Steven Moskowitz, Spongetech's Chief Operating Officer and Chief Financial Officer. Robert and Moskowitz talked on the phone dozens of times from 2008 to 2009, and Moskowitz promoted Spongetech's prospects to Robert.

Spongetech reported large revenue gains in 2007 through 2009. In reality, several of Spongetech's executives, including Moskowitz, were running a "pump-and-dump" scheme. They publicized fictitious sales to nonexistent customers that accounted for the vast majority of Spongetech's reported sales. When the price of Spongetech stock increased in response to these reported sales, Moskowitz and the others illegally profited by selling approximately 2.5 billion unregistered shares through various corporations they controlled, pocketing millions of dollars. Eventually, Spongetech's implausible reported sales raised suspicions. Rumors of fraud circulated in the press and online investor forums. Spongetech failed to timely make required Securities and Exchange Commission filings, raising more red flags.

In July 2010, Spongetech filed for bankruptcy and trading in its stock was permanently banned in November 2010. The following month, Moskowitz and several other Spongetech executives were indicted for criminal securities fraud. By the end of 2010, the SEC had permanently barred trading in Spongetech stock, making the billions of outstanding shares worthless. The Greenbergers were left holding 7.5 million worthless shares, losing approximately $569,000 on the stock. In 2012, the Greenbergers filed an amended 2010 tax return claiming a theft-loss deduction and requesting a refund of $177,000. The IRS disallowed the theft-loss deduction and the Greenbergers filed suit in district court.

Analysis

Code Sec. 165(c)(3) and Reg. Sec. 1.165-8 allow individual taxpayers to deduct from their taxable income losses arising from theft crimes such as "larceny, embezzlement, and robbery."

The disagreement between the Greenbergers and the IRS was not whether the Greenbergers could claim a loss on their Spongetech stock but rather what type of loss a theft loss or a capital loss. The main point of contention was whether Moskowitz or Furth intentionally took the Greenbergers' property because, under Rev. Rul. 2009-9, a taxpayer claiming a theft loss must prove that the loss resulted from a taking of property that was illegal under the law of the jurisdiction in which it occurred and was done with criminal intent. Alternatively, the Greenbergers argued that even if they were not the victims of a "theft," they were still the victims of a "theft offense" and therefore qualified for a theft-loss deduction. Since the transactions occurred in Ohio, the district court looked to the definition of "theft" and "theft offense" under Ohio law to determine whether the Greenbergers were eligible for a theft loss deduction.

The district court held that the Greenbergers were not entitled to a theft loss deduction. Under Ohio law, the court noted, a person is guilty of "theft" if "with purpose to deprive the owner of property . . . [he] knowingly obtain[s] or exert[s] control over the property" in any of five specified ways, including deception. To establish theft by deception, the court said, it must be proven that the accused engaged in a deceptive act to deprive the owner of the possession of property or services, and that the accused's misrepresentation actually caused the victim to transfer property to the accused. According to the court, for the Greenbergers to succeed, they had to show two things: (1) that Moskowitz or the other Spongetech executives acted with the specific intent to take the Greenbergers' property through their fraud; and (2) that as a result, the Greenbergers transferred their property to these wrongdoers. The court noted that, due to the lack of direct connection between a wrongdoer and a victim, a theft-loss deduction is generally not allowed in cases where the value of shares bought on the open market declines due to fraud.

The Greenbergers, the court said, bought their Spongetech shares on the open market, without any knowledge of who was on the other side of the transaction. The court did note that it was very possible that at least some of the shares the Greenbergers bought came from the fraud perpetrators, given that the number of Spongetech shares illegally distributed by the fraudsters (about 2.5 billion) far exceeded the number of legitimately issued and outstanding shares (about 700 million). But this was ultimately immaterial, the court said, as the purchase of these shares was done in the open market on the OTC Bulletin Board, rather than being purchased directly from Spongetech or its executives. Just as importantly, the court found that the Greenbergers did not show that Moskowitz or any other Spongetech executive targeted the Greenbergers with the specific intent to take their money. The court noted that, while Robert talked with Moskowitz dozens of time, he did not allege, nor present any evidence, that Moskowitz ever encouraged him to buy Spongetech stock.

Separately, the court considered the Greenbergers' argument that Furth specifically targeted them and that created sufficient privity to make them the victims of a theft. The court concluded that, even if Furth was an agent of Spongetech, the fact that the Greenbergers purchased their shares on the open market still made the Greenbergers ineligible for the theft-loss deduction.

Finally, the court found that the Spongetech executives committed a "theft offense" through their violations of federal securities law. However, the court said, the term "theft offense" does not itself define a substantive crime it is merely a list of other crimes that are grouped together under Ohio law. The term "theft offenses," the court said, is broadly defined and captures a wide array of property crimes and crimes of dishonesty. Not all "theft offenses" require the accused to have taken the property of the victim; for example, forgery and record tampering are both "theft offenses," but neither requires taking property. As such, the court concluded, these would not fit within the IRS's theft-loss regulations as "theft crimes such as larceny, embezzlement, and robbery" even under a general and broad reading, as there is no "criminal appropriation of another's property to the use of the taker.

Because the Greenbergers were not victims of theft within the meaning of Code Sec. 165(c)(3), the district court held the taxpayers were not able to take theft loss deductions from their worthless securities and thus were not entitled to the refunds they sought.

For a discussion of the deductibility of declines in stock value, see Parker Tax, ¶84,512.

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Taxpayers Can't Use DISC to Disguise Excessive Contributions to Roth IRAs

Commissions from an operating corporation to a DISC, which was indirectly owned by Roth IRAs belonging to the sons of the operating corporation's founder, were properly characterized as contributions to the Roth IRAs which exceeded the annual contribution limits and, thus, were subject to excise tax penalties. Summa Holdings, Inc. v. Comm'r, T.C. Memo. 2015-119.

Background

James Jr. and Sharen Benenson are the parents of Clement and James III. In 2001, James III and Clement each established a Roth IRA (James III Roth IRA and Clement Roth IRA; collectively, Benenson Roth IRAs) and transferred $3,500 to each IRA. In 2002, the Benenson Roth IRAs each purchased 1,500 shares of stock in JC Export. JC Export filed an election to be treated as an Interest Charge DISC. The Benenson Roth IRAs then transferred their shares of JC Export stock to JC Export Holding, Inc. in exchange for JC Holding stock. Thus, JC Export was wholly owned by JC Holding, which was owned 50 percent by the James III Roth IRA and 50 percent by the Clement Roth IRA.

Summa Holdings, Inc. was founded by James, Jr. and is the parent corporation of a consolidated group of manufacturing companies (Summa subsidiaries) that make a wide variety of industrial products. James, Jr. owned approximately 23 percent of the shares outstanding, with most of the remaining shares being owned by the Benenson Trust, the beneficiaries of which were James III and Clement. The Summa subsidiaries and JC Export entered into a series of agreements, pursuant to which the Summa subsidiaries paid JC Export over $2.2 million in 2008. JC Export, in turn, paid the same amount to JC Holding in the form of dividends. Each time JC Holding received a payment from JC Export, it estimated the tax due as a result of the payment, withheld the estimated tax, and immediately transferred as a dividend one-half of the remainder of the payment to each of the Benenson Roth IRAs.

From the organization of JC Export through 2008, JC Export received commissions from the Summa consolidated group that, if treated as contributions to the Benenson Roth IRAs, exceeded the annual contribution limits. For 2008, neither Clement nor James III attached to their tax returns a Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. Additionally, neither their parents nor the Benenson Trust reported any dividend distributions. JC Export filed a 2008 Form 1120-IC-DISC, Interest Charge Domestic International Sales Corporation Return, and on Schedule K, Shareholder's Statement of IC-DISC Distributions, reported almost $2.2 as a taxable distribution. JC Holding filed a Form 1120 in which it reported the same amount as dividend income. On its 2008 tax return, Summa claimed a deduction of approximately $2.1 million for DISC commissions.

The IRS issued deficiency notices to the taxpayers in 2012, contending that the transactions at issue shifted value to the Benenson Roth IRAs far in excess of the annual contribution limits. According to the IRS, simply labeling the payments as DISC commissions did not immunize the payments from the application of substance over form principles. The payments made by Summa and its subsidiaries to JC Export during 2008, the IRS said, were not DISC commission payments but dividends to Summa's shareholders followed by contributions to the Roth IRAs.

As a result, the IRS concluded that (1) James, Jr. received over $2.2 million in dividends from Summa; (2) Summa's shareholders contributed over $1.1 million to each of the Benenson Roth IRAs and, since the contributions exceeded the annual contribution limits for Roth IRAs, James III and Clement were each liable for an excise tax deficiency; and (3) Summa was liable for penalties under either Code Sec. 6662A or Code Sec. 6662.

Analysis

Code Sec. 4973 imposes for each taxable year an excise tax of 6 percent for excess Roth IRA contributions, computed on the lesser of (1) the amount of the excess contribution, or (2) the value of the account as of the end of the taxable year. The tax applies each year until the excess contributions are eliminated from the taxpayer's Roth IRA. An excess contribution is defined in part as a contribution to a Roth IRA that exceeds the amount allowable as a contribution. Dividends paid on stock held by a Roth IRA are considered earnings of the Roth IRA itself, rather than contributions by the owner of the Roth IRA, and do not count towards the contribution limits.

In Notice 2004-8, the IRS identified tax-avoidance type transactions in which a preexisting business enters into transactions with a corporation owned by the taxpayer's Roth IRA and in which the transactions have the effect of shifting value into the Roth IRA. The IRS said it would challenge such transactions using a number of theories, including substance over form.

The taxpayers, citing several cases including Hellweg v. Comm'r, T.C. Memo. 2011-58, argued that reclassification of the transactions using substance over form principles was improper because it would result in disregarding the DISC transactions. Hellweg involved a situation where a DISC was indirectly owed by Roth IRAs, which were owned by individuals who held ownership interests in an operating company that paid commissions to the DISC. In Hellweg, the Tax Court stated that, in the absence of fraud or an illegal purpose behind the transaction at issue, the IRS could not challenge the substance of the transaction for income tax purposes because to do so would require the DISC to be disregarded. The taxpayers also argued that since Congress could have prohibited transactions involving DISCs owned by IRAs but chose not to do so, Congress was comfortable with IRAs holding DISC stock.

The Tax Court agreed with the IRS and held that the payments to JC Export were not DISC commissions, but rather dividends to Summa's shareholders followed by contributions to the Benenson Roth IRAs. The Tax Court distinguished the holding in Hellweg, noting that in the instant case, the IRS was not arguing that the DISC should be disregarded but rather was arguing that a transaction involving a DISC should be recharacterized to prevent an abusive transaction.

The Tax Court rejected the taxpayers' argument that Congress could have prohibited transactions involving DISCs but didn't, saying the argument logically erroneous. Congress' choice to prevent one particular abusive transaction involving DISCs and IRAs, the court observed, did not indicate that Congress approved of all other abusive transactions involving DISCs and IRAs.

For a discussion of Roth IRA transactions that the IRS considers abusive, see Parker Tax ¶135,160.

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IRS Issues Proposed Regulations for Section 529A ABLE Programs

The IRS has issued proposed regulations under Code Sec. 529A that provide guidance regarding programs under the Achieving a Better Life Experience (ABLE) Act of 2014. Code Sec. 529A provides rules under which states may establish and maintain a new type of tax-favored savings program through which contributions may be made to the account of an eligible disabled individual to meet qualified disability expenses. REG-102837-15 (6/22/15).

Background

The Achieving a Better Life Experience (ABLE) Act of 2014, enacted on December 19, 2014 as part of The Tax Increase Prevention Act of 2014, added Code Sec. 529A, providing a new type of tax-advantaged savings plan for disabled individuals. Dubbed "ABLE" plans, the new Code Sec. 529A plans are modeled after Code Sec. 529 Qualified Tuition Plans. Read more...

Tax Court Rejects Diabetic Taxpayer's Attempt to Avoid Penalty on Early Retirement Distribution

The Tax Court held that a diabetic taxpayer could not claim a disability exemption to avoid the 10 percent early distribution penalty on amounts distributed from his retirement account. Despite suffering a debilitating coma just weeks after the distribution, the court found the taxpayer could not prove he was disabled within the meaning of the exemption at the time of the distribution. Trainito v. Comm'r, T.C. Summary 2015-37.

Background

Beginning in 1997, Charles Trainito was employed by the City of Boston Department of Environmental Health (DEH). His duties with DEH involved lifting heavy manhole covers and placing rat bait as a means of decreasing the city's rat population. In addition to his work with DEH, Trainito worked part time as a chef at an Italian restaurant in Boston.

Trainito was diagnosed with type 2 diabetes in 2005. As a result of his diabetes, he sometimes experienced symptoms such as blurry vision and neuropathy. Trainito resigned from DEH on October 23, 2010, attributing his resignation to problems stemming from diabetes. He continued to work as a part-time chef after his resignation.

On April 22, 2011, Trainito received an early distribution from his qualified retirement savings account with the City of Boston Retirement Board.

A few weeks later, he began experiencing nausea, vomiting, and diarrhea. Family members, alarmed at being unable to reach Trainito on June 12, contacted Emergency Medical Services, who discovered him unconscious at his home and determined that he had lapsed into a diabetic coma. He was hospitalized until the end of July, and the coma resulted in muscle atrophy and the reduced use of an arm and a leg.

On his tax return for 2011, Trainito attached a Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, claiming the distribution was exempt from the 10 percent penalty tax on early distributions. The IRS rejected taxpayer's claimed exemption and imposed the penalty.

Analysis

Code Sec. 72(t)(1) imposes a 10 percent additional tax on a taxpayer who receives an early distribution from a qualified retirement plan, unless such taxpayer qualifies for an exemption. Code Sec. 72(t)(2)(A)(iii) provides an exemption for distributions which are attributable to the taxpayer's being disabled within the meaning of Code Sec. 72(m)(7).

Code Sec. 72(m)(7) provides that a taxpayer is considered disabled if he or she is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. The "substantial gainful activity" referred to is the activity customarily engaged in by the taxpayer before the onset of the disability.

The Tax Court noted that because Code Sec. 72(t)(2)(A)(iii) requires that the distribution be attributable to the taxpayer's disability, the relevant date to consider was April 22, 2011.

The court stated that the disability must be present at the time the distribution is made to avoid the 10 percent early withdrawal penalty, noting a taxpayer cannot avoid the penalty just by suffering a disability at any point during the tax year. The court concluded the fact that Trainito suffered a diabetic coma in June did not indicate whether he was disabled on the date of the distribution and was not relevant to that determination.

With regard to whether he was disabled on the distribution date, Trainito testified that, following his diagnosis with diabetes in 2005, he saw a primary care doctor twice a month until his resignation from his job with DEH in 2010. However, despite receiving frequent treatment for diabetes, he did not produce any medical records relating to his condition on April 22, and his primary care doctor did not testify on his behalf. Trainito also claimed that he suffered from clinical depression at the time of the distribution, but failed to produce medical records to support the claim.

The court determined that while Trainito undoubtedly suffered from diabetes when he received the retirement distribution, he had not provided sufficient evidence to show that either his diabetes or alleged depression caused him to be disabled within the meaning of Code Sec. 72(m)(7) at the time of the early distribution from his retirement plan.

For a discussion on early distributions from retirement accounts, see Parker Tax ¶134,555.

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Section 752 Regs Don't Determine If Debt Is Recourse or Nonrecourse When Characterizing Income on Foreclosure

The regulations under Code Sec. 752 do not determine if a debt is recourse or nonrecourse to a partnership for purposes of determining whether, upon foreclosure of property purchased by the partnership, the partnership has cancellation of debt income under Code Sec. 61(a)(12) or gains from dealings in property under Code Sec. 61(a)(3). CCA 201525010.

Background

A limited liability company (LLC), taxable as a partnership, was organized to purchase real property and then construct, market, and sell homes built on that property. LLC has three members: two individuals and an S corporation. LLC's operating agreement provides that LLC is a special purpose entity (SPE) (1) organized solely for the purpose of owning the property, (2) that will not engage in any business unrelated to the ownership of the property, and (3) that will not have any assets other than those related to the property.

One of LLC's lenders cancelled outstanding notes created in connection with loans made by that lender to LLC in order to develop the real property. The notes were secured by (1) the property; (2) a general assignment of LLC's rights, title, and interest in and to the property; (3) a general assignment of members' rights, title, and interest in and to the property; (4) pledges of the membership interests in LLC by the members; and (5) unlimited, unconditional, and irrevocable guarantees by each LLC member.

LLC reported the income from the discharge of indebtedness on its Schedule K as cancellation of debt (COD) income, which was allocated to LLC members on their respective Schedules K-1. The LLC members were insolvent. To the extent of their reported insolvencies, the LLC members in the aggregate excluded amounts from gross income under Code Sec. 108(a)(1)(B), and eliminated net operating loss amounts pursuant to the tax attributes reduction rules of Code Sec. 108(b). As a result, the LLC members will receive a permanent tax benefit of a portion of excluded COD, which was passed through to them from LLC.

Upon auditing LLC, an IRS agent raised the issue of whether this COD income should be reclassified as an amount realized from a sale or other disposition of property under Code Sec. 61(a)(3). The agent reasoned that, pursuant to Reg. Sec. 1.1001-2(a)(1) and (4)(i), if debt that is discharged in connection with the sale or other disposition of property is nonrecourse to the borrower, the full amount of the discharged debt is included in the amount realized, and thus the transaction results in gain or loss. One result of this reclassification at the partnership level is that LLC's members will be unable to exclude part of the income under Code Sec. 108 at the partner level.

LLC countered that the regulations under Code Sec. 752 determine whether a loan to a partnership is recourse or nonrecourse for Code Sec. 1001 purposes. According to LLC, the notes are recourse loans because its members are personally liable for repayment under the guaranty agreements. LLC argued that its members' guarantees are payment obligations under Reg. Sec. 1.752-2(b)(3)(i) that represent an economic risk of loss to its members, and, as a result, the notes meet the definition of "recourse" loans under Reg. Secs. 1.752-1(a)(1) and 1.752-2.

Analysis

The IRS Office of Chief Counsel (IRS) advised that the regulations under Code Sec. 752 do not determine if a debt is recourse or nonrecourse to a partnership for purposes of determining whether, upon foreclosure of the property, the partnership has cancellation of debt income under Code Sec. 61(a)(12) or gains from dealings in property under Code Sec. 61(a)(3).

The IRS noted that the regulations under Code Sec. 752 are limited to determining the partners' basis in the partnership. The definition of a recourse liability found in Reg. Sec. 1.752-1(a)(1), the IRS stated, is limited to issues under Code Sec. 752, rather than a definition intended to extend to issues under Code Secs. 61 and 1001.

In the instant case, the IRS said, the operating documents and the loan documents, as well as the LLC's status as an SPE, expressly limited LLC's assets to those related to developing the property, a single project. According to the IRS, any and all assets (including future leases, rents and fixtures) held by LLC necessarily relate to the property, and thus secure the notes. Since LLC was not authorized to acquire other assets, the IRS noted, the operating documents and loan documents stop short of imposing full, unconditional, personal liability on LLC for repayment of the notes. The IRS concluded that the lenders, therefore, had no further recourse against LLC once the property and the assets related to the property were exhausted when the lender foreclosed on the property.

For a discussion of the characterization of partnership liabilities as recourse or nonrecourse, see Parker Tax, ¶25,115, and ¶25,125, respectively.

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Taxpayer's Return Did Not Offer the Necessary "Clue" to Limit Statute to Three Years

The six-year statute of limitations period under Code Sec. 6501(e)(1)(A) applied to the taxpayer's 2003 tax return because he did not adequately disclose on that return a distribution from his employee stock ownership plan. Heckman v. Comm'r, 2015 PTC 191 (8th Cir. 2015).

Background

Thomas Heckman owned KC Investment Management, Inc. (KCIMI), an S corporation, until 2001. In January 2001, KCIMI established an employee stock ownership plan (ESOP), and the ESOP acquired 100 percent of KCIMI's stock, which was its only asset. Heckman participated in the ESOP beginning in 2001, along with one other participant. In December 2002, KCIMI liquidated and transferred all of its assets and liabilities to the ESOP. In February 2003, Prairie Capital, LLC, and SMR Holdings, LLC, were formed. Each received a 50 percent undivided interest in each of the ESOP's assets.

In 2003, the ESOP distributed the Prairie Capital interest to its participants' traditional individual retirement accounts (IRAs). Heckman received a distribution of almost $138,000 from the ESOP that year. Heckman did not include this ESOP distribution on his 2003 tax return, nor did he explicitly reference either the ESOP distribution to his IRA or his IRA's membership interest in Prairie Capital on his 2003 return or in any statement attached thereto. For tax year 2003, Prairie Capital filed a Form SS-4, Application for an Employer Identification Number, and a Form 1065. The forms identified Heckman and Heckman's IRA account, respectively, as members of Prairie Capital.

The IRS learned of the plan distribution through oral and written statements that Heckman provided during an unrelated audit in April 2007. In July 2010, more than three years but fewer than six years after Heckman filed his 2003 return, the IRS issued Heckman a notice of deficiency for 2003 based on the fact that the ESOP was not eligible for favorable tax treatment under Code Sec. 401(a), and that the distribution constituted taxable income to Heckman in 2003. Heckman disagreed with the assessment, arguing that under Code Sec. 6501(a), the IRS was required to assess the deficiency within three years after the relevant tax return was filed and thus the assessment was untimely. The IRS countered that, under Code Sec. 6501(e)(1)(A), the limitations period for Heckman was extended to six years because he had omitted from gross income an amount in excess of 25 percent of the gross income stated on the return.

Heckman took his case to the Tax Court, arguing that the notice of deficiency was untimely under the three-year statute of limitations in Code Sec. 6501(a). The Tax Court sided with the IRS and held that the six-year limitations period applied and the deficiency notice was therefore timely. Heckman appealed to the Eighth Circuit.

Analysis

Before the Eighth Circuit, Heckman argued that Code Sec. 6501(e)(1)(A)'s six-year limitations period did not apply because the IRS gained actual knowledge of the ESOP distribution during the unrelated audit in 2007, which was within three years of the date when he filed his 2003 tax return. His argument was premised on language in Colony, Inc. v. Comm'r, 357 U.S. 28 (1958), which construed former Code Sec. 275(c) of the Internal Revenue Code of 1939, a provision which was superseded by Code Sec. 6501(e)(1)(A). In Colony, the Supreme Court noted that, in enacting former Code Sec. 275(c), Congress intended to give the IRS additional time to investigate tax returns in cases where, because of a taxpayer's omission to report some taxable item, the IRS was at a special disadvantage in detecting errors. According to Heckman, the IRS was not at a special disadvantage in detecting Heckman's error within the ordinary three-year limitations period because the IRS obtained actual knowledge of the distribution before the three-year period expired; thus, the longer limitations period did not apply.

Alternatively, Heckman argued that his distribution from the plan was disclosed in Prairie Capital's 2003 tax filings and that was sufficient to limit the statute to three years. In doing so, he relied on the Eighth Circuit's holding in Benderoff v. U.S., 398 F.2d 132 (1968), a case in which the taxpayers disclosed their status as shareholders in a corporation and reported their respective shares of undistributed corporate income on their individual tax returns, but failed to include a corporate distribution that they received. In that case, the Eighth Circuit reasoned that the corporate information return should be considered along with the individual returns in analyzing the statute of limitations because the purpose of the corporate information return was to allow the IRS to verify the accuracy of the shareholders' individual returns, and because the individual returns made adequate reference to the corporate information return.

Heckman also argued that Rev. Rul. 55-415 applied to his situation. In that ruling, the IRS held that any partner's share of the gross income reported in a partnership information return should be considered as having been reported by the taxpayer, as such information return is a return by or on behalf of each partner.

The Eighth Circuit affirmed the Tax Court's holding and held that the six-year statute applied. In response to Heckman's first argument, the court stated that Colony construed a different statute that was superseded by Code Sec. 6501(e)(1)(A). Like the 1939 statute, the court observed, the successor statute provides for an extended statute of limitations when a taxpayer omits an amount from gross income that exceeds 25 percent of the reported gross income. But unlike the 1939 statute, Code Sec. 6501(e)(1)(A) spells out precisely what amounts should be taken into account in determining the amount omitted from gross income. Specifically, the court said, Code Sec. 6501(e)(1)(A)(ii) provides that an amount is excluded in determining the amount omitted from gross income only if the amount is disclosed in the return, or in a statement attached to the return. There is no provision, the court noted, that says an amount is excluded if the IRS is not "at a special disadvantage" in detecting the error, or if the IRS learns of the amount within the ordinary three-year limitations period. According to the court, the Code provides only two statutes of limitations: three years or six years after the return is filed, not three years after the acquisition of actual knowledge.

With respect to Heckman's reliance on Benderoff, the court contrasted the facts in Heckman's situation with the situation in Benderoff, noting that Heckman's return contained no reference to Prairie Capital or to the distribution; thus, the holding in Benderoff did not apply.

Finally, with respect to the argument that the holding in Rev. Rul. 55-415 applied, the court said that ruling interpreted the 1939 Code and did not address whether income disclosed in a partnership return is disclosed "in the return" or "in a statement attached to the return" for purposes of the later-enacted Code Sec. 6501(e)(1)(A)(ii), where "the return" refers to the return filed by the individual taxpayer. In any event, the court noted, no return filed by Prairie Capital for the 2003 tax year disclosed the distribution from the ESOP to Heckman's individual retirement account.

The Eighth Circuit affirmed the Tax Court, finding it correctly concluded that the distribution that Heckman received from his employee stock ownership plan was an "amount omitted from gross income" that triggered the extended six-year statute of limitations under Code Sec. 6501(e)(1)(A).

For a discussion of the rules relating to the appropriate statute of limitations time periods, see Parker Tax ¶ 260,130.

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Tax Court Fails to Properly Apply "Stern Test", Must Consider Economic Substance in Analyzing Stock Sale

The Ninth Circuit held that by focusing on whether shareholders were transferees before addressing the substance of a series of transactions, the tax court applied the wrong legal standard to characterize a stock sale. The case was sent back to the tax court to consider the economic substance of the transactions in order to correctly apply the Stern Test. Slone v Comm'r, 2015 PTC 187 (9th Cir. 2015).

Background

James Slone began his career in the radio industry in 1955 and, by 2000, owned Slone Broadcasting, a C corporation. In 2000, Slone Broadcasting entered into an asset sale agreement with Citadel Broadcasting. As a result of the asset sale, Slone Broadcasting realized a capital gain of $38.6 million, and incurred federal and state tax liabilities of $15.3 million. The corporation made its first income tax payment of $3.1 million for the 2002 tax year.

Before the closing of the asset sale, a representative of Fortrend International, LLC sent an unsolicited letter to Slone Broadcasting's lawyer, offering to buy the corporation's stock. The lawyer knew that Fortrend had a strategy to reduce the income taxes due as a result of the asset sale, but when he asked how the tax savings would be achieved, he was told the information was proprietary but that the transaction would not be deemed a listed transaction. The reputations of Fortrend and its various advisers were good, and the taxpayer's lawyer and accountant had no reason to suspect any impropriety.

As a result of negotiations between Slone Broadcasting and Fortrend, Berlinetta, Inc., an affiliate of Fortrend, purchased the stock of Slone Broadcasting for $35.7 million and assumed all of Slone Broadcasting's taxes owed as of the closing date. Following the closing, cash distributions were made in the amounts of $30,819,544 and $2,550,456 to the former Slone Broadcasting shareholders.

Shortly after the stock sale, Slone Broadcasting merged with Berlinetta to create Arizona Media Holdings, Inc. (Arizona Media). In 2001, a shareholder contributed Treasury bills with a basis of $38.1 million to the new company, and a month later Arizona Media sold the bills for $108,731. On its 2002 tax return, Arizona Media reported a $37.9 million gain from the asset sale and an offsetting loss of $38 million from the Treasury bill sale. Arizona Media claimed it had no income tax liability, and requested a refund for the $3.1 million tax payment made by Slone Broadcasting, which the IRS granted.

The IRS began investigating Arizona Media in March 2005. The IRS assessed a deficiency for taxes due on Slone Broadcasting's sale of assets to Citadel in the amount of $13.5 million in 2008, along with a penalty of $2.7 million and interest of $7.3 million. In 2009, after Arizona Media's failure to file an annual report, the state administratively dissolved the company. Unable to collect the tax deficiency from Arizona Media, the IRS sent notices of liability to the taxpayers as former shareholders of Slone Broadcasting and as transferees of Arizona Media.

Before the Tax Court, the taxpayers argued that the sale of stock was separate from the prior sale of assets, that there was no ulterior motive in the way the liquidation had been structured and, therefore, the form of the stock sale transaction to Berlinetta should be respected. The court found that Slone Broadcasting's sale of assets to Citadel was independent from the sale of stock to Berlinetta, and that there was no evidence the taxpayers conducted the liquidation process as a tax-avoidance scheme. The court also found that the taxpayers neither knew, nor should have known, that Fortrend and Berlinetta were involved in an illegitimate tax evasion scheme. Based on these findings, the court rejected the IRS's theory that the taxpayers were liable as transferees for the unpaid liabilities and respected the form of the stock sale.

Analysis

Code Sec. 6901 authorizes the IRS to proceed against the transferees of delinquent taxpayers to collect unpaid tax debts. In order to do so, the IRS must apply the two-prongs of the "Stern test" to (1) establish that the target for collection is a transferee of the delinquent taxpayer within the meaning of Code Sec. 6901, and (2) show that the transferee is liable for the transferor's debts under state law (Comm'r v. Stern, 357 U.S. 39 (1958)). The term "transferee" is defined broadly to include any donee, heir, legatee, devisee, or distributee (Code Sec. 6901(h)).

In determining whether to disregard the form of a transaction, courts will look to the subjective aspect of whether the taxpayer intended to do anything other than acquire tax benefits, and the objective aspect of whether the transaction had any economic substance other than creation of tax benefits. Reddam v. Comm'r, 755 F.3d 1051 (9th Cir. 2014).

The Ninth Circuit stated it could not resolve whether the taxpayers were liable for the unpaid taxes because the Tax Court failed to apply the correct legal standard for characterizing the stock sale transaction for the purpose of transferee liability. The circuit court found the tax court did not address either the subjective intent of the taxpayers or the objective economic realities of the transaction, because it failed to address whether taxpayers had a legitimate business purpose for selling the stock, or whether the transaction had economic substance other than shielding the former Slone Broadcasting shareholders from tax liability.

The Ninth Circuit noted the tax court focused its factual inquiry and analysis on factors relevant to the second prong of the Stern test: assessing whether the taxpayers were substantively liable for the transferor's unpaid taxes as a matter of state law. The tax court's findings that taxpayers had not orchestrated the asset sale and the stock sale as a single scheme for tax evasion purposes, that Fortrend and its third-party service provider were legitimate players in the debt collection industry, that taxpayers had no reason to believe that Fortrend was using illegitimate tax evasion methods and had no duty to inquire further, all related to whether the taxpayers had actual or constructive knowledge of the entire tax evasion scheme that rendered their dealings with Fortrend fraudulent under state law.

The Ninth Circuit stated that the tax court did not use these factual findings to analyze the shareholders' liability under the applicable state law, but instead concluded from those findings that, under the first prong of the Stern test, the form of the stock sale should be respected for the shareholders' transferee status. The Ninth Circuit determined that was a reversible error.

The Ninth Circuit held that the tax court applied the wrong legal standard to the question of transferee liability because it failed to make findings relating to whether the IRS could properly disregard the form of the transaction in order to impose tax liability on the taxpayers as transferees. The Ninth Circuit remanded the case, instructing the tax court to make the findings necessary to correctly apply the Stern test.

For a discussion of transferee liability, see Parker Tax ¶262,530.