Federal Tax Bulletin - Issue 203 - August 13, 2019

IRS Allows Taxpayers to Revoke or Make Late Bonus Depreciation Elections

The IRS issued guidance allowing a taxpayer to make a late bonus depreciation election, or to revoke a bonus depreciation election, under Code Sec. 168(k)(5), Code Sec. 168(k)(7), or Code Sec. 168(k)(10), for certain property acquired by the taxpayer after September 27, 2017, and placed in service or planted or grafted, as applicable, by the taxpayer during its tax year that includes September 28, 2017. A late election or the revocation of an election under Rev. Proc. 2019-33 is treated as a change in method of accounting for a limited period of time to which Code Sec. 446(e) and Code Sec. 481, and the corresponding regulations, apply. Rev. Proc. 2019-33.

Background

Before being amended by the Tax Cuts and Jobs Act of 2017 (TCJA), Code Sec. 168(k)(1) allowed a 50 percent additional first year depreciation (i.e., bonus depreciation) deduction for qualified property for the tax year in which the qualified property is placed in service by the taxpayer. Qualified property was defined in part as property the original use of which begins with the taxpayer.

The TCJA made several amendments to Code Sec. 168(k). For example, the additional first year depreciation deduction percentage was increased from 50 percent to 100 percent; the property eligible for the additional first year depreciation deduction was expanded to include certain used depreciable property and certain film, television, or live theatrical productions; the placed-in-service date was extended from before January 1, 2020, to before January 1, 2027 (from before January 1, 2021, to before January 1, 2028, for property described in Code Sec. 168(k)(2)(B) or Code Sec. 168(k)(2)(C)); and the date on which a specified plant is planted or grafted by the taxpayer was extended from before January 1, 2020, to before January 1, 2027. The TCJA also added Code Sec. 168(k)(10), which allows a taxpayer to elect to deduct 50-percent, instead of 100-percent, additional first year depreciation for qualified property acquired by the taxpayer after September 27, 2017, and placed in service by the taxpayer or planted or grafted, as applicable, during its tax year that includes September 28, 2017. The amendments to Code Sec. 168(k) made by the TCJA apply to property acquired and placed in service after September 27, 2017. However, property is not treated as acquired after the date on which a written binding contract is entered into for such acquisition. The amendments apply to specified plants planted or grafted after September 27, 2017.

The TCJA repealed Code Sec. 168(k)(4), relating to the election to accelerate alternative minimum tax credits in lieu of the additional first year depreciation deduction, for tax years beginning after December 31, 2017, and Code Sec. 168(k)(3), relating to qualified improvement property, for property placed in service after December 31, 2017.

Code Sec. 168(k)(5) allows a taxpayer to elect to deduct additional first year depreciation for any specified plant, as defined in Code Sec. 168(k)(5)(B), that is planted before January 1, 2027, or grafted before that date to a plant that has already been planted, by the taxpayer in the ordinary course of its farming business as defined in Code Sec. 263A(e)(4). The additional first year depreciation deduction is allowable for the specified plant for the tax year in which that specified plant is planted or grafted, and that specified plant is not treated as qualified property under Code Sec. 168(k) in the year the plant is placed in service. Under Code Sec. 168(k)(5)(C), the Code Sec. 168(k)(5) election may be revoked only with the consent of the IRS. Except for the date, the TCJA did not amend Code Sec. 168(k)(5).

The procedures for making the Code Sec. 168(k)(5) election are provided in Rev. Proc. 2017-33. Rev. Proc. 2017-33 provides that, in general, the Code Sec. 168(k)(5) election must be made by the due date, including extensions, of the tax return for the tax year in which the taxpayer plants or grafts the specified plant to which the election applies, and must be made in the manner prescribed on Form 4562, Depreciation and Amortization, and its instructions. The instructions to the 2016 and 2017 Form 4562 provide that the election is made by attaching a statement to the taxpayer's tax return indicating that the taxpayer is electing to apply Code Sec. 168(k)(5) and identifying the specified plant(s) for which the taxpayer is making the election.

Code Sec. 168(k)(7) allows a taxpayer to elect not to deduct additional first year depreciation for all qualified property that is in the same class of property and placed in service by the taxpayer in the same tax year (Code Sec. 168(k)(7) election). Code Sec. 168(k)(7) provides that once made, the Code Sec. 168(k)(7) election may be revoked only with the consent of the IRS. The TCJA did not amend Code Sec. 168(k)(7).

Rev. Proc. 2017-33 provides that rules similar to the rules in Reg. Sec. 1.168(k)-1(e)(3) apply for purposes of Code Sec. 168(k)(7). Reg. Sec. 1.168(k)-1(e)(3) provides the procedures for making the election not to deduct the additional first year depreciation deduction for all qualified property that is in the same class of property and placed in service by the taxpayer in the same tax year. In accordance with Reg. Sec. 1.168(k)-1(e)(3), the Code Sec. 168(k)(7) election must be made by the due date, including extensions, of the tax return for the tax year in which the taxpayer places in service the qualified property, and must be made in the manner prescribed on Form 4562 and its instructions. The instructions to the 2016 and 2017 Form 4562 provide that the election is made by attaching a statement to the taxpayer's return indicating that the taxpayer is electing not to deduct the additional first year depreciation and the class of property for which the taxpayer is making the election.

Code Sec. 168(k)(10), which was added by the TCJA, allows a taxpayer to elect to deduct 50-percent, instead of 100-percent, additional first year depreciation for qualified property acquired after September 27, 2017, by the taxpayer and placed in service or planted or grafted, as applicable, by the taxpayer during its tax year that includes September 28, 2017.

The IRS issued proposed regulations under Code Sec. 168(k) in REG-104397-18 in August of 2018. In comments to the proposed regulations, practitioners requested relief to make late elections under Code Sec. 168(k)(7) or Code Sec. 168(k)(10) for property placed in service during the taxpayer's tax year that includes September 28, 2017, because some taxpayers had already filed their returns for that tax year before the proposed regulations were issued. Practitioners also noted that a taxpayer with a due date (with extensions) of September 15, 2018, or October 15, 2018, for its return for the tax year that includes September 28, 2017, may not have had sufficient time to analyze the proposed regulations to make a timely election under Code Sec. 168(k)(7) or Code Sec. 168(k)(10).

IRS Provides Relief in Rev. Proc. 2019-33

The IRS agreed with the practitioners' comments to the August 2018 proposed regulations requesting relief. In response, the IRS issued Rev. Proc. 2019-33, which is effective July 31, 2019. Rev. Proc. 2019-33 provides procedures for making late elections, or revoking elections, under Code Sec. 168(k)(5), Code Sec. 168(k)(7), or Code Sec. 168(k)(10) for property acquired by a taxpayer after September 27, 2017, and placed in service or planted or grafted, as applicable, by the taxpayer during its tax year that includes September 28, 2017.

In addition, the IRS explained that, because of the administrative burden of filing amended returns, it is appropriate to treat the making of late elections, or the revocation of elections, under Code Sec. 168(k)(5), Code Sec. 168(k)(7), or Code Sec. 168(k)(10) for property acquired by a taxpayer after September 27, 2017, and placed in service or planted or grafted, as applicable, by the taxpayer during its tax year that includes September 28, 2017, as a change in method of accounting with a Code Sec. 481(a) adjustment for a limited period of time.

The relief provided in Rev. Proc. 2019-33 applies to a taxpayer that:

(1) acquired qualified property after September 27, 2017, and placed the property in service during the taxpayer's tax year beginning in 2016 and ending on or after September 28, 2017 (2016 tax year);

(2) acquired qualified property after September 27, 2017, and placed the property in service during the taxpayer's tax year beginning in 2017 and ending on or after September 28, 2017 (2017 tax year); or

(3) planted or grafted a specified plant after September 27, 2017, and during the taxpayer's 2016 tax year or 2017 tax year.

The making of a late election, or the revocation of an election, under Rev. Proc. 2019-33 is treated as a change in method of accounting for a limited period of time to which Code Sec. 446(e) and Code Sec. 481, and the corresponding regulations, apply. A taxpayer that wants to make a late election, or revoke an election, described in Rev. Proc. 2019-33 must use the automatic change procedures in Rev. Proc. 2015-13 or its successor.

Rev. Proc. 2019-33 modifies Rev. Proc. 2018-31, which provides the list of automatic changes to which the automatic change procedures in Rev. Proc. 2015-13 apply, to provide that the IRS will treat the making of a late election, or the revocation of an election under Code Sec. 168(k)(5), Code Sec. 168(k)(7), and Code Sec. 168(k)(10), as a change in method of accounting with a Code Sec. 481(a) adjustment only for the taxpayer's first, second, or third tax year succeeding the taxpayer's 2016 tax year or 2017 tax year. The eligibility rules in Rev. Proc. 2015-13 do not apply to this change for the taxpayer's 2016 tax year or 2017 tax year.

Rev. Proc. 2018-31 is also modified to provide that a taxpayer making the change of accounting method as a result of a late election, or the revocation of an election, under Rev. Proc. 2019-33 for more than one specified plant under Code Sec. 168(k)(5) or more than one class of property under Code Sec. 168(k)(7) for the same year of change must provide a single Code Sec. 481(a) adjustment for all such changes. In addition, a taxpayer making the change for all qualified property under Code Sec. 168(k)(10) should provide a single net Code Sec. 481(a) adjustment for all assets that are qualified property.

Compliance Tip: A taxpayer making a late election, or revoking an election, under more than one section of Rev. Proc. 2019-33 (for example, a Code Sec. 168(k)(5) election and a Code Sec. 168(k)(10) election) for the same year of change should file a single Form 3115 for all such changes. The single Form 3115 must provide a single net Code Sec. 481(a) adjustment for all such changes. The designated automatic accounting method change number for a change to the method of accounting resulting from a late election or revocation of an election under Code Sec. 168(k)(5), Code Sec. 168(k)(7), and Code Sec. 168(k)(10) is "241."

For a discussion of the bonus depreciation rules, see Parker Tax ¶94,200.

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Developer's Payments for Marketing Materials Were Nondeductible Bidding Costs

The Tax Court held that a real estate developer's payments to his wholly owned corporation for marketing materials he used in pursuit of development projects, which he reported as deductible business expenses, were bidding costs under Reg. Sec. 1.263A-1(e)(3)(ii)(T) that were not deductible for the years at issue because the taxpayer failed to establish when (if ever) the development contracts on which he was bidding would not be awarded to him. The court also held that the taxpayer's sale of a unit in a condominium project he developed resulted in ordinary income, not capital gain, because the taxpayer held the property primarily for sale to customers in the ordinary course of business. Ashkouri v. Comm'r, T.C. Memo. 2019-95.

Background

Hisham Ashkouri pursued real estate development projects under the name Hisham Ashkouri, Architects. For one of those projects, Ashkouri formed a limited liability company called Cold Spring Green (CSG). Ashkouri was also the sole shareholder and officer of ARCADD, Inc., a domestic corporation that provided architectural and design services.

Ashkouri hired ARCADD to assist him in his pursuit of development projects by preparing what he referred to as marketing materials, such as building designs, brochures, and three dimensional drawings. Ultimately, however, Ashkouri did not end up serving as developer of any of the projects he pursued. A potential project in Libya could not go forward because of hostilities in that country. Other projects in Washington State and Utah proved unsuccessful because of a lack of financing. Ashkouri said that, if any of those projects had resulted in a real estate transaction, he would have had 20 percent ownership.

Ashkouri was the sole member of CSG, which developed a condominium project in Newton, Massachusetts. In September of 2011, CSG sold one of the units, Unit B, for $1,250,622. CSG's sole purpose and function was to acquire, hold, develop, operate, and sell the condo complex of which Unit B was a part. CSG funded its development activities with a construction loan from a bank and entered into at least nine contracts with subcontractors (including ARCADD). It relied on a real estate firm to market the condos for sale to customers.

On his Forms 1040 for 2009 through 2011, Ashkouri included a Schedule C for his proprietorship on which he reported deductible expenses for payments to ARCADD for architectural or contract services. Ashkouri also included with his 2011 return a Form 4797, Sales of Business Property, which reported the net gain from CSG's sale of Unit B as capital gain. In a notice of deficiency, the IRS disallowed Ashkouri's Schedule C deductions on the basis that they were required to be capitalized under Code Sec. 263A and recharacterized his proceeds from the sale of Unit B as ordinary income. Ashkouri challenged the notice in the Tax Court.

Code Sec. 263A requires the capitalization of direct and indirect costs of property produced by the taxpayer or acquired by the taxpayer for resale. Under Reg. Sec. 1.263A-2(a)(1)(ii)(A), a taxpayer is not considered to be producing property unless the taxpayer is considered an owner of the property produced. Marketing costs are not required to be capitalized under Reg. Sec. 1.263A-1(e)(3)(iii)(A), but under Reg. Sec. 1.263A-1(e)(3)(ii)(T), bidding costs (i.e., costs incurred in the solicitation of a contract) must deferred until the contract is awarded. If the taxpayer is awarded the contract, the costs become part of the indirect costs allocated to the contract. If not, the bidding costs are deductible when the contract is awarded to another party, the taxpayer is notified in writing that the contract will not be awarded or rebid, or the taxpayer abandons its bid or proposal, whichever occurs first.

Ashkouri contended that his payments to ARCADD could not be capitalized as they were used for marketing and promotion and that he was not required to capitalize any expenses of pursuing any project that did not result in his acquiring an interest in property. The IRS characterized the costs as architect's fees and contended that the Tax Court has specifically held that such fees must be capitalized if Code Sec. 263A applies.

Analysis

The Tax Court held that the payments Ashkouri made to ARCADD were bidding costs rather than marketing costs, but found that Ashkouri failed to establish that any of the bidding costs became deductible during the years at issue. The Tax Court also upheld the IRS's characterization of Ashkouri's proceeds from the sale of Unit B as ordinary income.

The court accepted Ashkouri's argument that he was not required under Code Sec. 263A to capitalize his expenses of pursuing any project that did not result in his acquiring an interest in property. However, the court said that finding did not establish that the expenses were immediately deductible. The court found that under Reg. Sec. 1.263A-1(e)(3)(ii)(T), the payments to ARCADD had to be deferred pending the outcome of the bidding process, and concluded that Ashkouri failed to prove that those initially deferred costs became deductible during any of the years at issue. The court noted that Ashkouri was, for the most part, unsuccessful in his pursuit of the various projects in regard to which he claimed to have paid ARCADD for marketing materials. But the court found that Ashkouri did not establish when (if ever) the development contracts he sought were awarded to others, when he received written notice that no contract would be awarded, or when he abandoned his bid or proposal for each project. The court further explained that, even if it accepted that the expenses at issue were not subject to deferral under Reg. Sec. 1.263A-1(e)(3)(ii)(T), it would still conclude that the deductions were properly disallowed because Ashkouri did not adequately substantiate the underlying expenses.

The court rejected the IRS's argument that architect's fees must always be capitalized if Code Sec. 263A applies, finding that the cases cited by the IRS that involved such fees required capitalization of fees paid for plans for development of property owned by the taxpayer. Those cases, in the court's view, did not establish that fees paid for architectural drawings used in the unsuccessful pursuit of development projects must also be capitalized.

With regard to the gain from the sale of Unit B, the court agreed with the IRS that Ashkouri recognized ordinary income rather capital gain. The court noted that Ashkouri failed to challenge the IRS's position that the property was held primary for sale to customers in the ordinary course of Ashkouri's business and thus the gain from the sale of the property was ordinary income. The court inferred Ashkouri's position to be that the property was used in the trade or business under Code Sec. 1231(b) and that its sale therefore resulted in Code Sec. 1231 gain under Code Sec. 1231(a)(3)(A), but the court found that Ashkouri offered no explanation of why Unit B qualified as property used in the trade or business.

For a discussion of the types of costs that must be capitalized under Code Sec. 263A, see Parker Tax ¶242,425. For a discussion of the treatment of business gains and losses under Code Sec. 1231, see Parker Tax ¶112,101.

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Court Strikes Down IRS Rule That Eliminated Exempt Organization Donor Reporting

A district court granted summary judgment in favor of two states that challenged the issuance of Rev. Proc. 2018-38, which eliminated the requirement in Reg. Sec. 1.6033-2 that tax exempt organizations identify to the government contributors donating $5,000 or more, on the grounds that the IRS failed to follow the required notice and comment procedures under the Administrative Procedure Act. The court found that the notice and comment procedures were required because Rev. Proc. 2018-38 is a legislative rule that upended the longstanding practice of requiring organizations to annually report such donor information. Bullock v. IRS, 2019 PTC 290 (D. Mont. 2019).

Background

Tax exempt organizations are required under Code Sec. 6033(a)(1) to file annual returns reporting the items of gross income, receipts, and disbursements, and such other information as the IRS prescribes by forms or regulations. Code Sec. 6033(a)(3)(B) allows the IRS to relieve most exempt organizations from filing an annual return if the IRS determines that the filing is not necessary to the efficient administration of the internal revenue laws.

Reg. Sec. 1.6033-2(a)(2)(ii)(f) requires most exempt organizations to report on Schedule B of Form 990 the names and addresses of all persons who contributed $5,000 or more during the tax year. Exempt social clubs, fraternal beneficiary societies, and domestic fraternal societies are required under Reg. Sec. 1.6033-2(a)(2)(iii)(d) to report on Schedule B the names of each donor who contributed more than $1,000 during the tax year to be used exclusively for exempt purposes. The IRS issued Reg, Sec. 1.6033-2(a)(2)(ii)(f) in 1970, following a public notice and comment period.

Under Code Sec. 6103 and Code Sec. 6104, states tax agencies are allowed to collect and use federal return information gathered by the IRS. Code Sec. 6103(d) provides for federal and state information sharing of tax returns and return information. This information is required to be open to inspection by, or disclosure to, any state agency that administers tax laws. When it updated Code Sec. 6103 in 1976, Congress noted that the purposes of federal and state information sharing are to ensure that people and organizations follow the tax laws and to relieve state governments from the burden of expending resources to gather information already obtained by the IRS.

The collection of donor information changed when the IRS issued Rev. Proc. 2018-38 in July of 2018. Rev. Proc. 2018-38 eliminated the requirement in Reg. Sec. 1.6033-2 that most exempt organizations report donor information on Schedule B. Exempt organizations still must collect and maintain the donor information and make it available to the IRS only upon specific request, and the IRS can demand donor information if it determines that the information would be relevant.

New Jersey and Montana challenged the issuance of Rev. Proc. 2018-38 in a district court. They filed for summary judgment asking the court to set aside Rev. Proc. 2018-38 and order the IRS to follow the rulemaking procedures required by the Administrative Procedure Act (APA). New Jersey explained that it had received the names and addresses of significant contributors through the Schedule B forms and used that information to identify suspicious patterns of activity, determine whether the entity was soliciting from individuals within New Jersey, and otherwise supplement investigations of tax exempt organizations. New Jersey also requires organizations claiming tax exempt status to submit their Forms 990 and all Schedules, and, as a result, obtains substantial donor information pursuant to that requirement. Montana requires entities claiming tax exempt status to report whether they have received a federal exemption. It claimed that it relies on the IRS's information regarding the IRS's exemption determinations when making its own exemption determinations under state law.

Observation: In challenging the change implemented by Rev. Proc. 2018-38, Governor Steve Bullock of Montana pointed out that the revised rules would make it harder to detect illegal spending in political campaigns, including the detection of foreign money in campaigns.

Analysis

The district court granted the states' motion for summary judgment and held that Rev. Proc. 2018-38 was unlawful. The court said that the IRS must follow the proper notice and comment procedures under the APA if it seeks to adopt a similar rule.

The district court found that the states had standing in the case because Rev. Proc. 2018-38 deprived them of previously available information that they were now incurring expenses to obtain on their own. The court also determined that the states interests were protected by Code Sec. 6103 and Code Sec. 6104 because their interests related to the purposes of the statutory policy of information sharing and the requirement in Reg. Sec. 1.6033-2 that exempt organizations submit substantial contributor information.

The district court next determined that the IRS had to follow the APA notice and comment procedures, which it was required to do because Rev. Proc. 2018-38 is a legislative rule. The court explained that for legislative rules, which create rights, impose obligations, or effect a change in existing law, agencies must give the public notice of the substance of the proposed rule and allow the public a period of time to comment. The court explained that this requirement holds government agencies accountable and ensures that they issue reasoned decisions.

The court said that the IRS's issuance of Rev. Proc. 2018-38 appeared to represent an attempt to evade the time-consuming procedures of the APA. In the court's view, Rev. Proc. 2018-38 explicitly upended the 50-year practice of requiring exempt organizations to annually report donor information and effectively amended the existing rule in Reg. Sec. 1.6033-2. The court rejected the IRS's contention that Rev. Proc. 2018-38 simply specifies the type of information that certain organizations are required to provide, reasoning that while the IRS can lawfully determine what information it requires from exempt organizations under Code Sec. 6033, it cannot escape the procedural demands of the APA. The court also concluded that the states' purposes in gathering substantial donor information, including determining whether an organization has violated the prohibition on private inurement and enforcing limits on political activity, supported the need for the IRS to comply with the notice and comment rules before amending a longstanding regulation implicating the collection and sharing of this information.

For a discussion of the annual reporting requirements of tax exempt organizations, see Parker Tax ¶ 65,510.

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Tax-Exempt Status Denied for Entity Operating as a Conduit to Generate Sales Leads

The Tax Court held that a nonprofit corporation that implemented a corporate sponsorship program designed to allow for-profit businesses to generate sales leads in exchange for charitable contributions was not operated exclusively for an exempt purpose and the IRS was therefore justified in revoking the corporation's tax exemption. The court found that the corporate sponsorship agreement, by design and effect, permitted for-profit businesses to invoke the organization's name as part of a telemarketing pitch intended to generate sales leads and revenues and also allowed for-profit businesses to get around the National Do-Not-Call Registry, which applies to for-profit businesses but not to charities. Giving Hearts, Inc. v. Comm'r, T.C. Memo. 2019-94.

Background

Window Plus, Inc. is a for-profit company that sells replacement windows and other home improvement services. Ronald Carrier was a shareholder and the president of Window Plus. Window Plus promoted its business through telemarketing and other channels, relying heavily on its in-house telemarketing staff to generate sales leads. In 2008, Window Plus employed 16 full-time telemarketers. In the years that followed, however, the company reduced its telemarketing staff to eight employees as a result of the National Do Not Call Registry, a federal program that allows individuals to avoid unsolicited phone calls from commercial telemarketers.

Recognizing that charities were not subject to the restrictions of the do-not-call registry, Carrier came up with a plan to combine for-profit telemarketing sales efforts with charitable giving. In 2009, Carrier formed Giving Hearts, Inc., as a Michigan nonprofit corporation, and the IRS approved its application for federal tax exemption. Giving Hearts established a so-called corporate sponsorship program with the aim of providing telemarketing opportunities for businesses to help generate leads and give back to a charity.

In 2011, the telemarketing staff of Window Plus began to test the Giving Hearts corporate sponsorship program by making telemarketing calls to potential customers. Later that year, the Michigan attorney general notified the IRS that a number of individuals had filed complaints alleging that Giving Hearts was operating as a front for a window sales operation. The IRS notified Giving Hearts in April 2012 that it was opening an examination regarding its exempt status.

In 2012, Giving Hearts and Window Plus executed a corporate sponsorship program under which Window Plus would fundraise on behalf of Giving Hearts by making telemarketing calls to potential customers and soliciting donations for Giving Hearts. The telemarketing script said that for every homeowner who accepted a product demonstration and free estimate from Window Plus, Giving Hearts would receive a donation from Window Plus. In 2011, Window Plus reported that 50 percent of its sales leads and 33 percent of its sales originated from telemarketing calls. In 2012, Window Plus reported that 44 percent of its sales leads and 30 percent of its sales originated from telemarketing calls. In 2013, Natalie Simon, an experienced public relations professional was appointed as the president of Giving Hearts. Simon undertook efforts to expand participation in Giving Hearts' corporate sponsorship program. Several companies declined to participate and others expressed interest only if the IRS examination regarding Giving Hearts' tax-exempt status was favorably resolved.

Giving Hearts filed Forms 990-EZ, Short Form Return of Organization Exempt From Income Tax, for tax years 2010-2016 reporting that it received annual charitable contributions ranging from $1,102 to $8,334. Giving Hearts used a small portion of the contributions to pay annual filing and other fees and donated the rest to charitable organizations. After issuing multiple proposals to revoke Giving Hearts' exempt status, the IRS issued a final adverse determination letter in May of 2016 stating that Giving Hearts was not operated exclusively for exempt purposes under Code Sec. 501(c)(3) and was operated for a substantial private and commercial purpose, rather than exclusively for public purposes. Giving Hearts appealed to the Tax Court.

Analysis

The Tax Court upheld the IRS's decision to revoke Giving Hearts' tax exemption because it found that Giving Hearts failed to operate exclusively for an exempt purpose as required under Code Sec. 501(c)(3). The Tax Court noted that, by collecting donations from Window Plus and transferring the funds to other charitable organizations, Giving Hearts operated at least in part to further charitable purposes.

While the court acknowledged that the Code does not preclude the use of for-profit enterprises, such as Window Plus, to solicit or collect charitable donations, it found that the presence of a single substantial purpose that is not described in Code Sec. 501(c)(3) precludes exemption from tax under Code Sec. 501(a) regardless of the number or the importance of the organization's exempt purposes. In the court's view, the purpose of Giving Hearts' corporate sponsorship program was, first and foremost, to generate sales leads and revenues. The court said that although telemarketing calls were ostensibly made on behalf of Giving Hearts, their real purpose was business promotion. The court noted that a participating business was obligated to make a charitable contribution to Giving Hearts only when a potential customer agreed to an in-home product demonstration.

The court concluded that Giving Hearts was primarily engaged in generating sales leads (and ultimately revenues) to advance a commercial enterprise, with charitable donations arising only as a function of the businesses' success in securing in-home product demonstrations and presenting project estimates to potential customers. Because generating sales leads in support of a for-profit enterprise is not an exempt purpose, nor is it related to such an exempt purpose, the court said it necessarily followed that more than an insubstantial part of Giving Hearts' activities was not in furtherance of an exempt purpose under Reg. Sec. 1.501(c)(3)-1(c)(1).

For a discussion of Code Sec. 501(c)(3) organizations, see Parker Tax ¶60,502.

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Fair Market Valuation Method Does Not Include an Exception for Fraudulent or Criminal Actions Not Known to the Public

A district court held that the personal representative of an estate could not use her diagnosis of financial disability to toll the limitations period for filing a refund claim for the estate. With respect to the overvaluation of stock held by the estate and reported on the estate's tax return, the court noted that the fair market valuation method does not include an exception for fraudulent or criminal actions not known to the public, even if those actions lower or destroy the stock's value. Carter v. U.S., 2019 PTC 298 (N.D. Ala. 2019).

Background

Elizabeth Carter is the personal representative of the Estate of Frances E. P. Roper (the Estate). Ms. Roper died on September 21, 2007. At the time of her death, Ms. Roper owned 567,092 shares of Colonial BancGroup stock, worth a market value of approximately $17,605,000. Ms. Roper bequeathed the majority of her estate, comprised primarily of Colonial BancGroup stock, to her niece, Elizabeth Carter (i.e., the personal representative), and her nephew, Randy Roper. Within six months after Ms. Roper's death, the market value of the stock had decreased to $8,549,000.

On June 19, 2008, the Estate filed a federal estate tax return. The return reported an estate valued at $6,261,530 and tendered payment of the computed tax. On April 26, 2009, the Estate filed an amended return reporting a slightly lower tax of $6,169,892. The Colonial stock represented 46.8 percent of the gross estate. In valuing the Colonial stock, the Estate used the alternative valuation date to calculate the fair market value, a method which relied upon the stock's exchange price six months after Ms. Roper's death. The IRS accepted the amended return and issued a refund.

On September 13, 2013, the Estate filed a refund claim with the IRS, alleging it overpaid its estate tax by $3,731,616, due to a criminal fraud perpetrated against Colonial by one of its customers. The Estate asserted it did not have to rely upon the stock's exchange price for valuation due to the criminal fraud involving the bank. Ms. Carter and Mr. Roper alleged that Colonial Bank and its executives urged them not to sell their shares as their value began to decrease. Instead, they obtained a loan from Colonial Bank to pay the estate tax, for which Colonial Bank required personal guarantees from Ms. Carter and Mr. Roper. They remain liable on these personal guarantees. The IRS denied the Estate's refund request.

The United States prosecuted and obtained convictions against Lee Bentley Farkas for bank, wire and securities fraud, and conspiracy to commit the same, arising from a multibillion dollar scheme to hide the financial difficulties of Taylor, Bean, & Whitaker Mortgage Corp. (TBW) during his tenure as chairman and principal owner of TBW. TBW received short-term, secured funding from Colonial Bank via a master advance account, and it also maintained an investor funding account at Colonial which housed proceeds from loan sales to investors in the secondary market. Between 2002 and 2003, Farkas and his co-conspirators disguised overdrafts of TBW's master advance account by "sweeping" funds from TBW's investor funding account into and out of the master advance account. As a result of this sweeping scheme, Colonial Bank's daily reports did not depict the overdrafts. As the deficit in TBW's account grew to well over $100 million, Farkas and his co-conspirators initiated more sophisticated schemes, including "Plan B."

Under Plan B, TBW sold sham mortgage loans and loan pools to Colonial Bank. Colonial Bank held approximately $250 million in Plan B individual loans on its books by mid-2005, and approximately $500 million by August 2009. As a result, Colonial BancGroup significantly overstated the value of its assets in its quarterly and annual reports to the U.S. Securities and Exchange Commission. A grand jury returned an indictment against Farkas on June 15, 2010, and a jury convicted Farkas on April 19, 2011. On August 14, 2009, the Alabama State Banking Department closed Colonial Bank, and the Federal Deposit Insurance Corporation (FDIC) assumed receivership over the bank. By December 17, 2010, Colonial's stock closed at $0.07 per share and could no longer be publicly traded.

The Estate filed another refund claim on August 26, 2016. A medical opinion of Carter's treating physician, Dr. William Hahn, accompanied the claim, in which he declared that Carter suffered from a medical impairment for over five years. Carter asserted that, from Fall 2008 to the end of 2013, she suffered from moderate to severe mental and emotional maladies which rendered her incapable of managing the Estate's financial affairs. She maintained that, because of this disability, Code Sec. 6511(h)'s equitable tolling provision applied so as to excuse the untimely filing of the refund claim. When the IRS failed to dispose of the claim within the statutorily required time, the Estate filed a refund suit in a district court. The Estate argued that the Colonial stock was worthless on the valuation date, based on non-public information which later became available, and that the late filing of the refund suit should be excused as a result of Carter's financial disability.

The government contended that the Estate's action had to be dismissed for lack of subject matter jurisdiction because, under Code Sec. 6511(a), its refund claim was untimely. According to the government, Carter's financial disability did not excuse the untimeliness of the Estate's refund claim.

Under Code Sec. 6511(a), a claim for credit or refund of an overpayment of tax must be filed by the taxpayer within three years from the time the return was filed or two years from the time the tax was paid, whichever is later. Code Sec. 6511(h) provides that, in the case of an individual, the running of the periods specified in Code Sec. 6511(a) is suspended during any period of such individual's life that such individual is financially disabled.

Analysis

The district court dismissed the case after holding that Carter's alleged financial disability did not extend the filing deadline for the Estate to seek a refund and, even if it did, the valuation of the Colonial stock established no entitlement to a refund.

The court found that Carter clearly violated Code Sec. 6511. When the Estate filed its 2013 and 2016 refund claims, the court said, the limitations period for submitting such a claim had lapsed because the Estate had filed its tax returns in 2008 and 2009. The court also rejected Carter's contention that the deadline to file the refund claim should be tolled due to her financial disability. Unfortunately for Carter, the court said, estates do not constitute "individuals" subject to Code Sec. 6511(h)'s provisions. Estates, while able to conduct their affairs only through personal representatives, exist separately from their personal representatives. Therefore, the court observed, Carter could not invoke her financial disability to toll the time for the Estate's refund claim, and thus, Code Sec. 6511(a) barred the Estate's refund claim because it was not timely filed.

With respect to the stock valuation, the court cited Estate of Wright v. Comm'r, 43 B.T.A. 551 (1941) in noting that the fair market valuation method does not include an exception for fraudulent or criminal actions not known to the public, even if those actions lower or destroy the stock's value. While the court expressed sympathy for Carter's plight in these circumstances, it said it could not invoke its equitable powers to fashion relief against the ravages wreaked by the criminal fraud.

For a discussion of the statute of limitations for filing refund claims and the financial disability exception that allows a suspension of the limitations period, see Parker Tax ¶261,180.

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District Court Invalidates Regulation Defining Educational Organizations

A district court held that Reg. Sec. 1.170A-9(c)(1), which provides that an organization qualifies as an educational organization under Code Sec. 170(b)(1)(A)(ii) only if education is the organization's primary function and its noneducational activities are merely incidental to its educational activities, is invalid since it does more than the law allows because it adds requirements - the primary-function and merely-incidental tests - Congress intended not to include in the statute. Applying Chevron U.S.A., Inc. v. Natural Resources Defense Council, 467 U.S. 837 (1984), the court concluded that by omitting those requirements from Code Sec.170(b)(1)(A)(ii) while including a similar test elsewhere in the same statute, Congress unambiguously chose not to include those tests. Mayo Clinic v. U.S., 2019 PTC 295 (D. Minn. 2019).

Background

Mayo Clinic (Mayo) is a Minnesota nonprofit corporation and a Code Sec. 501(c)(3) organization. Mayo is the parent organization of several hospitals, clinics, and the Mayo Clinic College of Medicine and Science. The College is comprised of five distinct medical schools that offer M.D., Ph.D., and other degrees, as well as residencies, fellowships, and continuing medication.

After conducting an audit, the IRS in 2009 asserted that Mayo owed tax on certain income that it received from partnerships. The IRS concluded Mayo was not entitled to a tax exemption with respect to this partnership income because, in its view, Mayo was not an educational organization under Code Sec. 170(b)(1)(A)(ii). In 2013, the IRS issued a Technical Advice Memorandum confirming its position that Mayo did not qualify as an educational organization. The IRS concluded that Mayo's primary function was not formal instruction. Mayo paid the disputed taxes and, in 2016, filed a lawsuit seeking a refund of $11,501,621.

Tax exempt charitable organizations can exclude from their unrelated business income (UBI) certain types of passive income - such as income from dividends, interest, and real-property rents. This passive-income exclusion is generally what allows a tax-exempt organization to avoid incurring unrelated business income tax on the dividends and interest that it earns on its endowment. But there is an exception to this exclusion: if the passive income is earned using borrowed money, then the amount that is excluded from UBI is reduced. And this exception, too, has an exception: when the passive income comes from debt-financed real property, the income can be excluded from UBI if the organization is a qualified organization under Code Sec. 514(c)(9)(C). Included among the qualified organizations is an organization described in Code Sec. 170(b)(1)(A)(ii).

Code Sec. 170(b)(1)(A)(ii) describes an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of students at the place where its educational activities are regularly carried on (the faculty-curriculum-student-place requirements). In Reg. Sec. 1.170A-9(c)(1), the IRS defined an educational organization as one that meets the faculty-curriculum-student-place requirements, but includes two additional requirements that do not appear explicitly in the statute. Those requirements are the "primary function" requirement and the "merely incidental" test. Under the regulation, an organization cannot qualify as an educational organization unless education is the organization's primary function and its noneducational activities are merely incidental to its educational activities.

The government conceded that Mayo met the faculty-curriculum-student-place requirements in Code Sec. 170(b)(1)(A)(ii). But it argued that Mayo is nonetheless not an educational organization because its primary function is healthcare, not education, and even if that were not so, that Mayo's healthcare activities are not merely incidental to its educational activities. Mayo, on the other hand, described its educational and patient-care activities as essential to each other and inextricable. Mayo also contended that the IRS had exceeded its authority in adding the primary function/merely incidental tests because, under Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), Congress had the chance to add those tests to the statute and unambiguously elected not to.

Analysis

The district court awarded summary judgment to Mayo because it found that the government's position that Mayo was not entitled to the refund it sought was premised entirely on Mayo's alleged inability to satisfy the requirements in Reg. Sec. 1.70A-9(c)(1), and the court concluded that those requirements exceeded the bounds of authority given under Code Sec. 170(b)(1)(A)(ii).

Applying Chevron, the court concluded that the regulation did more than the law allows because it added requirements that Congress intended not to include in the statute. The court explained that Chevron requires courts to (1) ask whether Congress has directly spoken to the precise question at issue and, if not, (2) determine whether the agency's answer is based on a permissible construction of the statute. The precise issue, in the court's view, was whether Code Sec. 170(b)(1)(A)(ii) is silent or ambiguous with respect to the primary function and merely-incidental requirements in the regulation.

The court agreed with Mayo that Congress unambiguously chose not to include a primary function requirement in Code Sec. 170(b)(1)(A)(ii) and the Treasury Department exceeded the bounds of its statutory authority when it issued the primary-function requirement in Reg. Sec. 1.170A-9(c)(1).

The court also concluded that Congress decided not to include the merely-incidental test in Code Sec. 170(b)(1)(A)(ii) because "merely incidental" was another way of saying that an organization's educational activities must be its primary purpose or function. The court said that the regulation identifies only one purpose - educational activities - to which all other activities must be merely incidental. In the court's view, requiring all noneducational activities to be merely incidental to the educational activities means an organization could have no non-incidental or primary purpose other than education to qualify as an educational organization. The court also noted that this conclusion was supported by the plain meanings of the relevant terms as well as IRS revenue rulings.

For a discussion of Code Sec. 501(c)(3) organizations, see Parker Tax ¶60,502.