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Federal Tax Research Bulletin - The Latest Tax and Accounting Articles


Parker's Federal Tax Bulletin
Issue 181     
October 8, 2018    

 

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 1. In This Issue ... 

 

Tax Briefs

IRS Not Entitled to Priority Status for Couple's Shared Responsibility Payment; IRS Issues 2018-2019 Special Per Diem Rates; Time Is Running Out to Elect Out of 100-Percent Depreciation Deduction for 2017 ...

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IRS Clarifies Deductibility of Business Meal Expenses in Light of TCJA Changes

The IRS issued guidance addressing practitioner questions about the deductibility of business meal expenses in light of the elimination of entertainment expense deduction in the Tax Cuts and Jobs Act of 2017. The guidance, which may be relied on before the issuance of regulations, provides that taxpayers may deduct 50 percent of an otherwise allowable business meal expense if five conditions are met. Notice 2018-76.

Read more ...

Second Circuit Reverses Tax Court: Extensions of Variable Contracts Constituted Taxable Termination and Constructive Sale

The Second Circuit reversed and remanded a Tax Court decision holding that the amendments of a taxpayer's two variable prepaid forward contracts (VPFCs) did not constitute sales or exchanges of property under Code Sec. 1001, were not terminations under Code Sec. 1234A, and were not constructive sales under Code Sec. 1259. Although the Second Circuit agreed with the Tax Court that no sale or exchange occurred, the court found that extending the valuation dates was a fundamental change giving rise to new contracts that could have resulted in taxable income, and found the VPFCs amended resulted in constructive sales of the collateralized shares because the amount of shares to be delivered at settlement was substantially fixed under Code Sec. 1259. Estate of McKelvey v. IRS, 2018 PTC 324 (2d Cir. 2018).

Read more ...

IRS Issues Retroactive Guidance on Employer Credit for Paid Family and Medical Leave

The IRS issued a notice in a question and answer format on the employer credit for paid family and medical leave under Code Sec. 45S, a provision enacted in the Tax Cuts and Jobs Act of 2017. According to the IRS, it plans to publish proposed regulations under the provision but, until then, the guidance supplied in the notice applies to wages paid in tax years beginning after December 31, 2017, and before January 1, 2020. Notice 2018-71.

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S Shareholder's Amended Filings Satisfied Requirement to Identify Inconsistencies with Return

The Ninth Circuit held that the sole shareholder of an S corporation in involuntary bankruptcy, who filed for a refund based on a claimed overstatement of income on the S corporation return filed by the bankruptcy trustee, satisfied the requirement in Code Sec. 6037 to provide a statement identifying the inconsistency between the corporate and the shareholder returns by including a statement that described how his income flowed from the corporation and stating his disagreement with the return filed by the trustee. Rubin v. U.S., 2018 PTC 313 (9th Cir. 2018).

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Owner of Tax Prep Firm Was Not Liable for Penalties on Returns Signed by Employees

A district court held that the sole owner of a tax return preparation business was not liable under Code Sec. 6694(b) for penalties relating to understatements of tax on returns prepared and signed by employees or independent franchisees of the business. The court found that there was no evidence of the owner's involvement with the returns, much less evidence of willful or reckless conduct as required under Code Sec. 6694, and it rejected the government's argument that the employer was liable regardless of the extent of his involvement with the returns or whether he signed them. Lowery v. U.S., 2018 PTC 329 (W.D. N.C. 2018).

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IRS Extends Replacement Period under Sec. 1033 for Certain Livestock Sales

The IRS issued a notice extending the time that farmers and ranchers in 41 states and the District of Columbia have under Code Sec. 1033(e) to replace livestock sold on account of weather-related conditions. The Appendix to the notice lists the U.S. counties that qualify for the extension. Notice 2018-79.

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IRS Abused Its Discretion by Failing to Consider Proposed Offers and Hardship Claim

The Tax Court held that, in a collections due process (CDP) hearing, the IRS abused its discretion by failing to consider a couple's offer in compromise (OIC), installment agreement request, and request for relief due to economic hardship caused by a medical condition. The Tax Court found that the couple's prior negotiations with a collections officer, in the context of which they submitted the same OIC along with financial information supporting their installment agreement and economic hardship claim, was not a previous administrative hearing, so the couple was not barred from resubmitting these items at the CDP hearing. Loveland v. Comm'r, 151 T.C. No. 7 (2018).

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 2. Tax Briefs 

 

Bankruptcy

IRS Not Entitled to Priority Status for Couple's Shared Responsibility Payment: In In re Huenerberg, 2018 PTC 332 (Bankr. E.D. Wisc. 2018), a bankruptcy court held that the IRS was not entitled to priority status for its claim for taxes relating to a couples' shared responsibility payment under Code Sec. 5000A. The court agreed with the debtors that the shared responsibility payment is a penalty, not a tax, and thus the IRS's claim relating to that penalty was not eligible for priority status.

 

Deductions

IRS Issues 2018-2019 Special Per Diem Rates: In Notice 2018-77, the IRS announced the special per diem rates effective October 1, 2018, which taxpayers may use to substantiate the amount of expenses for lodging, meals, and incidental expenses when traveling away from home. The notice also provides the special transportation industry rate, the rate for the incidental expenses only deduction, and the rates and list of high-cost localities for purposes of the high-low substantiation method.

Time Is Running Out to Elect Out of 100-Percent Depreciation Deduction for 2017: In IR-2018-196, the IRS reminds individuals and calendar-year corporations, who placed qualifying property in service during 2017 but choose not to claim the new 100-percent depreciation deduction, that they must file an election with the IRS by October 15, 2018, to opt out of the deduction. Because the deduction is retroactive and applies to qualifying property acquired and placed in service after September 27, 2017, the IRS notes that it may affect many 2017 tax returns.

 

Employee Benefits

IRS Modifies Procedures for Submitting VCPs: In Rev. Proc. 2018-52, the IRS modifies and supersedes Rev. Proc. 2016-51, which sets forth the Employee Plans Compliance Resolution System (EPCRS), a comprehensive system of correction programs administered by the Employee Plans Division (TE/GE) for sponsors of retirement plans that have failed to satisfy certain requirements under Code Secs. 401(a), 403(a), 403(b), 408(k), or Code Sec. 408(p). The revenue procedure (1) sets forth new procedures for using the {{www.pay.gov }}{ website to file Voluntary Correction Program (VCP) submissions and pay user fees; (2) provides that, beginning on April 1, 2019, the IRS will no longer accept paper VCP submissions or process user fees paid with a paper check; and (3) that, during the transition period from January 1, 2019, through March 31, 2019, plan sponsors may file VCP submissions with the IRS either by using {{www.pay.gov }}{ in accordance with applicable provisions of the revenue procedure or by filing paper VCP submissions in accordance with the applicable procedures in Rev. Proc. 2016-51.

 

Employment Taxes

IRS Aims to Have New Form W-4 Ready in 2020: On its website, the IRS announced that it is postponing the issuance of a new version of Form W-4, Employee's Withholding Allowance Certificate, until 2020 and that the 2019 version of the Form W-4 will be similar to the current 2018 version. According to the IRS, it will continue working closely with the payroll and the tax community as it makes additional changes to the Form W-4 for use in 2020 and that the new form will help employees improve withholding accuracy and fully reflect changes included in the Tax Cuts and Jobs Act.

 

Excise Taxes

Court Upholds Excise Tax Deficiency on Founder of Association of Honest Attorneys: In Farr v. Comm'r, 2018 PTC 325 (10th Cir. 2018), the Tenth Circuit affirmed the Tax Court and held that an attorney was liable for an excise tax deficiency for engaging in excess benefit transactions with her Code Sec. 501(c)(3) organization, Association for Honest Attorneys (AHA). The excess benefit transactions occurred when the taxpayer used AHA's checking account to make personal purchases from various grocery, retail, automotive, and home-improvement stores, as well as to make tuition payments for her son and to cover the costs of exhuming her father's remains for DNA analysis.

 

Foreign

IRS to Adjust Timing of Code Section 965 Binding Basis Election: In Notice 2018-78, the IRS announced that it has determined that a requirement under recently issued Code Sec. 965 proposed regulations requiring taxpayers to make a binding basis election before the proposed regulations are finalized would be too onerous for taxpayers and thus the final regulations will provide a transition rule for returns due (determined with regard to any extension) before the date that is 90 days after the date that the final regulations are published and, in such cases, the basis election must be made no later than 90 days after the publication of the final regulations. In addition, the final regulations will provide that if a basis election was made on or before the date the final regulations are published, the basis election may be revoked no later than 90 days after the publication of the final regulations.

FBAR Penalties Did Not Abate Upon Death; Decedent's Son Now Liable: In U.S. v. Est. of Schoenfeld, 2018 PTC 331 (M.D. Fla. 2018), a district court held that the government's claim for foreign bank account report (FBAR) penalties did not abate upon the decedent's death. The court concluded that the government could pursue its claim for FBAR penalties against the decedent's son because the son was a distributee of the decedent's estate.

 

Income

Refunds from Bank Aren't Includible in Taxpayer's Income: In Park v. Comm'r, T.C. Summary 2018-46, the Tax Court held that $12,789 received by a taxpayer from Bank of America (BOA) during 2014 was a reimbursement for erroneously collected payments on the taxpayer's accounts in prior years and thus was not taxable income to the taxpayer. Another $719 received by the taxpayer was interest that accrued on the erroneously collected payments and, thus, was includible in the taxpayer's 2014 income.

 

Innocent Spouse

Husband Who Was Unaware of Wife's Income Qualified for Innocent Spouse Relief: In Merlo v. Comm'r, T.C. Summary 2018-47, the Tax Court held that there was insufficient evidence submitted at trial to establish that a taxpayer had actual knowledge of income received by his wife and not reported on their 2011 joint return, as would be required to disqualify him from innocent spouse relief under Code Sec. 6015(c). The now ex-wife's contentions and testimony that the taxpayer had actual knowledge of that income, the court said, were implausible and without support from, and to some extent contradicted by, the record and, thus, the taxpayer was entitled to innocent spouse relief and was not liable for the tax deficiency on that income.

 

IRS

IRS Can Withhold Info About Commissions Paid to IRS Debt Collectors: In Hodes v. Department of Treasury, 2018 PTC 327 (D. D.C. 2018), a district court held that the Freedom of Information Act (FOIA) did not entitle a taxpayer to certain information about four contracts the IRS awarded to private companies in the outsourcing of debt collection for certain IRS tax liabilities. The court said the IRS was correct in applying a FOIA exemption to the taxpayer's request for the contracts' commission percentage rates.

 

Like-Kind Exchanges

Energy Company Did Not Satisfy Like-Kind Exchange Requirements; Penalties Upheld: In Exelon v. Comm'r, 2018 PTC 338 (7th Cir. 2018), the Seventh Circuit affirmed a Tax Court holding that purported like-kind exchanges involving sale-leaseback strategies by an energy company were not like-kind exchanges but rather were transactions properly characterized as loans since the transactions did not transfer the benefits and burdens of ownership. The Seventh Circuit also affirmed the imposition of $87 million in accuracy-related penalties on the energy company.

 

Procedure

IRS Issues Procedure for Applying for PLRs for Divisive Reorganizations: In Rev. Proc. 2018-53, the IRS provides procedures for taxpayers requesting private letter rulings regarding certain issues pertaining to reorganizations under Code Sec. 368(a)(1)(D) and Code Sec. 355 (i.e., Divisive Reorganizations), including representations, information, and analysis that taxpayers requesting these rulings should submit. Under the procedure, a taxpayer engaging in a Divisive Reorganization may request rulings that no gain or loss will be recognized to Distributing (1) upon Controlled's assumption of liability for an obligation of Distributing under Code Sec. 357(a), and (2) upon Distributing's receipt of Code Sec. 361 consideration and its distribution of the Code Sec. 361 consideration to a creditor in satisfaction of Distributing's debt obligation.

 

Tax Accounting

Accrued Market Discount Is Not Includible in Income under Code Section 451(b): In Notice 2018-80, the IRS announced that it intends to issue proposed regulations providing that accrued market discount is not includible in income under Code Sec. 451(b), which was added to the Code as part of the Tax Cuts and Jobs Act of 2017. Under Code Sec. 451(b), the all events test is considered met with respect to an item of gross income no later than when the taxpayer takes that item of gross income into account as revenue for financial accounting purposes in an applicable financial statement.

 

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 3. In-Depth Articles 

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IRS Clarifies Deductibility of Business Meal Expenses in Light of TCJA Changes

The IRS issued guidance addressing practitioner questions about the deductibility of business meal expenses in light of the elimination of entertainment expense deduction in the Tax Cuts and Jobs Act of 2017. The guidance, which may be relied on before the issuance of regulations, provides that taxpayers may deduct 50 percent of an otherwise allowable business meal expense if five conditions are met. Notice 2018-76.

Last week, the IRS issued some much needed guidance in the area of business meal deductions. After the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), the tax treatment of such deductions was in question because of TCJA's elimination of entertainment expense deductions. Prior to TCJA, taxpayers could deduct 50 percent of qualified business entertainment and meal expenses. As amended by TCJA, Code Sec. 274 generally disallows a deduction for expenses with respect to entertainment, amusement, or recreation, but does not specifically address the deductibility of business meal expenses.

In Notice 2018-76, the IRS provides transitional guidance for the deduction of business meal expenses under Code Sec. 274. The guidance confirms what many practitioners thought but what was not clearly stated: not all business meals are nondeductible entertainment. The IRS plans to issue proposed regulations that will include guidance on the deductibility of business meal expenses. However, until the proposed regulations are effective, taxpayers may rely on the guidance in Notice 2018-76 for the treatment under Code Sec. 274 of expenses for certain business meals.

Background

Code Sec. 162(a) allows a deduction for ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. However, Code Sec. 274(a)(1), as amended by TCJA, generally disallows a deduction for any item with respect to an activity that is of a type generally considered to be entertainment, amusement, or recreation.

Under Code Sec. 274(k), no deduction is allowed for any food or beverage expenses unless (1) such expense is not lavish or extravagant under the circumstances, and (2) the taxpayer (or an employee of the taxpayer) is present at the furnishing of such food or beverages. Code Sec. 274(n)(1) generally provides that the amount allowable as a deduction for any expense for food or beverages cannot exceed 50 percent of the amount of the expense that otherwise would be allowable.

Before TCJA, Code Sec. 274(a)(1)(A) generally prohibited a deduction with respect to an activity of a type considered to be entertainment, amusement, or recreation (i.e., entertainment expenses). However, pre-TCJA Code Sec. 274(a)(1)(A) provided exceptions to that prohibition if the taxpayer established that: (1) the item was directly related to the active conduct of the taxpayer's trade or business (the "directly related" exception), or (2) in the case of an item directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), that the item was associated with the active conduct of the taxpayer's trade or business (the "business discussion" exception).

Pre-TCJA Code Sec. 274(n)(1) generally limited the deduction of food and beverage (i.e., meal) expenses and entertainment expenses to 50 percent of the amount that otherwise would have been allowable. Thus, under prior law, taxpayers could deduct 50 percent of meal expenses and could deduct 50 percent of entertainment expenses that met the directly-related or business-discussion exceptions.

TCJA repealed the directly-related and business-discussion exceptions to the general prohibition on deducting entertainment expenses in pre-TCJA 274(a)(1)(A). Thus, entertainment expenses are no longer deductible. TCJA also amended the 50 percent limitation in pre-TCJA 274(n)(1) to remove the reference to entertainment expenses. Otherwise allowable meal expenses remain deductible, subject to the 50 percent limitation in Code Sec. 274(n)(1).

Reg. Sec. 1.274-2(b)(1)(i) provides that the term "entertainment" means any activity which is of a type generally considered to constitute entertainment, amusement, or recreation, such as entertaining at night clubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation, and similar trips, including such activity relating solely to the taxpayer or the taxpayer's family. The term "entertainment" may include an activity, the cost of which is claimed as a business expense by the taxpayer, which satisfies the personal, living, or family needs of any individual, such as providing food and beverages, a hotel suite, or an automobile to a business customer or the customer's family. The term "entertainment" does not include activities which, although satisfying personal, living, or family needs of an individual, are clearly not regarded as constituting entertainment, such as (i) supper money provided by an employer to an employee working overtime, (ii) a hotel room maintained by an employer for lodging of employees while in business travel status, or (iii) an automobile used in the active conduct of trade or business even though also used for routine personal purposes such as commuting to and from work. On the other hand, the providing of a hotel room or an automobile by an employer to an employee who is on vacation does constitute entertainment of the employee.

Reg. Sec. 1.274-2(b)(1)(ii) provides that an objective test must be used to determine whether an activity is of a type generally considered to constitute entertainment. Thus, if an activity is generally considered to be entertainment, it will constitute entertainment for purposes of Code Sec. 274(a) and Reg. Sec. 1.274-2 regardless of whether the expenditure for the activity can also be described otherwise, and even though the expenditure relates to the taxpayer alone. This objective test precludes arguments that "entertainment" means only entertainment of others or that an expenditure for entertainment should be characterized as an expenditure for advertising or public relations. However, in applying this test the taxpayer's trade or business is considered. Thus, although attending a theatrical performance would generally be considered entertainment, it is not considered entertainment for a professional theater critic attending in a professional capacity. Similarly, if a manufacturer of dresses conducts a fashion show to introduce its products to a group of store buyers, the show generally is not considered entertainment. In contrast, if an appliance distributor conducts a fashion show for its retailers, the fashion show generally would be considered entertainment.

Code Sec. 274(e) enumerates the following nine specific exceptions to Code Sec. 274(a):

(1) food and beverages for employees;

(2) expenses treated as compensation;

(3) reimbursed expenses;

(4) recreational, etc., expenses for employees;

(5) employees, stockholder, etc., business meetings;

(6) meetings of business leagues, etc.

(7) items available to public;

(8) entertainment sold to customers; and

(9) expenses includible in income of persons who are not employees.

Expenses that are within one of the exceptions in Code Sec. 274(e), which may include certain meal expenses, are not disallowed under Code Sec. 274(a). However, those expenses may be subject to the 50 percent limit on deductibility under Code Sec. 274(n).

Observation: The IRS said it intends to issue separate guidance addressing the treatment under Code Sec. 274(e)(1) and Code Sec. 274(n) of expenses for food and beverages furnished primarily to employees on the employer's business premises.

Interim Guidance

In Notice 2018-76, the IRS notes that TCJA did not change the definition of entertainment under Code Sec. 274(a)(1) and, therefore, the regulations under Code Sec. 274(a)(1) that define entertainment continue to apply. The IRS observed that, while TCJA did not address the circumstances in which the provision of food and beverages might constitute entertainment, the legislative history of TCJA clarifies that taxpayers generally may continue to deduct 50 percent of the food and beverage expenses associated with operating their trade or business. According to the IRS, future proposed regulations under Code Sec. 274 will clarify when business meal expenses are nondeductible entertainment expenses and when they are 50 percent deductible expenses. The IRS said that, until the proposed regulations are effective, taxpayers may rely on the interim guidance in Notice 2018-76 for the treatment under Code Sec. 274 of expenses for certain business meals.

In Notice 2018-76, the IRS states that taxpayers may deduct 50 percent of an otherwise allowable business meal expense if the following conditions are met:

(1) the expense is an ordinary and necessary expense under Code Sec. 162(a) paid or incurred during the tax year in carrying on any trade or business;

(2) the expense is not lavish or extravagant under the circumstances;

(3) the taxpayer, or an employee of the taxpayer, is present at the furnishing of the food or beverages;

(4) the food and beverages are provided to a current or potential business customer, client, consultant, or similar business contact; and

(5) in the case of food and beverages provided during or at an entertainment activity, the food and beverages are purchased separately from the entertainment, or the cost of the food and beverages is stated separately from the cost of the entertainment on one or more bills, invoices, or receipts and the entertainment disallowance rule may not be circumvented through inflating the amount charged for food and beverages.

The IRS also provides examples of what does and does not constitute deductible meal expenses. For each of the following examples, the food and beverage expenses are assumed to be ordinary and necessary expenses under Code Sec. 162(a) that are paid or incurred during the tax year in carrying on a trade or business and such expenses are not lavish or extravagant under the circumstances. Additionally, each example assumes that the taxpayer and the business contact are not engaged in a trade or business that has any relation to the entertainment activity.

Example: John invites Bob, a business contact, to a baseball game. John purchases tickets for himself and Bob to attend the game. While at the game, John buys hot dogs and drinks for himself and Bob. The baseball game is considered entertainment under Reg. Sec. 1.274-2(b)(1)(i) and, thus, the cost of the game tickets is an entertainment expense and is not deductible by John. The cost of the hot dogs and drinks, which are purchased separately from the game tickets, is not an entertainment expense and is not subject to the general disallowance rule. Therefore, John may deduct 50 percent of the expenses associated with the hot dogs and drinks purchased at the game.

Example: Carrie invites Doug, a business contact, to a basketball game. Carrie purchases tickets for herself and Doug to attend the game in a suite, where they have access to food and beverages. The cost of the basketball game tickets, as stated on the invoice, includes the food and beverages. The basketball game is considered entertainment and, thus, the cost of the game tickets is an entertainment expense and is not deductible by Carrie. The cost of the food and beverages, which are not purchased separately from the game tickets, is not stated separately on the invoice. Thus, the cost of the food and beverages is also an entertainment expense that is subject to the general disallowance rule. Therefore, Carrie may not deduct any of the expenses associated with the basketball game.

Example: Assume the same facts as the above example, except that the invoice for the basketball game tickets separately states the cost of the food and beverages. As in the above example, the basketball game is entertainment and, thus, the cost of the game tickets, other than the cost of the food and beverages, is an entertainment expense and is not deductible by Carrie. However, the cost of the food and beverages, which is stated separately on the invoice for the game tickets, is not an entertainment expense and is not subject to the general disallowance rule. Therefore, Carrie may deduct 50 percent of the expenses associated with the food and beverages provided at the game.

Observation: Neither the guidance in Notice 2018-76 nor the examples in the notice mention a requirement that there be a business discussion in order for the meal expense to be deductible.

IRS Requests Comments

The IRS is requesting comments for future guidance to further clarify the treatment of business meal expenses and entertainment expenses under Code Sec. 274. In particular, comments are requested concerning the following issues:

  • whether and what further guidance is needed to clarify the treatment of (i) entertainment expenses under Code Sec. 274(a)(1)(A), and (ii) business meal expenses;
  • whether the definition of entertainment in Reg. Sec. 1.274-2(b)(1)(i) should be retained and, if so, whether and how it should be revised;
  • whether the objective test in Reg. Sec. 1.274-2(b)(1)(ii) should be retained and, if so, whether and how it should be revised; and
  • whether and what additional examples should be addressed in guidance.

Comments must be submitted by December 2, 2018, and should be sent by one of the following methods to the applicable address: (1) by mail to: Internal Revenue Service, Attn: CC:PA:LPD:PR (Notice 2018-76), Room 5203, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044; (2) by hand or courier delivery for delivery Monday through Friday between the hours of 8 a.m. and 4 p.m. to: Courier's Desk, Internal Revenue Service, Attn: CC:PA:LPD:PR (Notice 2018-76), 1111 Constitution Avenue, NW, Washington, DC 20224; or (3) electronically to: Notice.Comments@irscounsel.treas.gov, with "Notice 2018-76" in the subject line.

All submissions will be available for public inspection and copying in Room 1621, 1111 Constitution Avenue, NW, Washington, DC, from 9 a.m. to 4 p.m.

For a discussion of the deductibility of business meal and entertainment expenses, see Parker Tax ¶91,115.

[Return to Table of Contents]

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Second Circuit Reverses Tax Court: Extensions of Variable Contracts Constituted Taxable Termination and Constructive Sale

The Second Circuit reversed and remanded a Tax Court decision holding that the amendments of a taxpayer's two variable prepaid forward contracts (VPFCs) did not constitute sales or exchanges of property under Code Sec. 1001, were not terminations under Code Sec. 1234A, and were not constructive sales under Code Sec. 1259. Although the Second Circuit agreed with the Tax Court that no sale or exchange occurred, the court found that extending the valuation dates was a fundamental change giving rise to new contracts that could have resulted in taxable income, and found the VPFCs amended resulted in constructive sales of the collateralized shares because the amount of shares to be delivered at settlement was substantially fixed under Code Sec. 1259. Estate of McKelvey v. IRS, 2018 PTC 324 (2d Cir. 2018).

Background

Andrew McKelvey was the founder and chief executive officer of Monster Worldwide, Inc. (Monster), a company known for its website, monster.com. Monster.com helps inform job seekers of job openings that match their skills and desired geographic location.

In 2007, McKelvey entered into variable prepaid forward contracts (VPFCs) with two investment banks. The investment banks made prepaid cash payments to McKelvey in exchange for his obligation to deliver variable quantities of Monster stock to the banks on specified future settlement dates in 2008. McKelvey treated the VPFCs as open transactions pursuant to Rev. Rul. 2003-7, and did not report any gain or loss for 2007. In Rev. Rul. 2003-7, the IRS ruled that VPFCs that meet certain criteria are open transactions when executed and do not result in the recognition of gain or loss until the future delivery of property. In that ruling, the IRS concluded that a shareholder who entered into a VPFC secured by a pledge of stock neither caused a sale of stock under Code Sec. 1001 nor triggered a constructive sale under Code Sec. 1259.

In 2008, before the original settlement dates, McKelvey paid a total of approximately $11 million to the banks to extend the settlement dates until 2010. These extensions provided that (1) McKelvey would pay additional consideration specifically for the extension of the settlement dates, and (2) the terms of the original VPFCs remained in full force and effect. McKelvey did not report any gain or loss upon the execution of the VPFC extensions and continued the open transaction treatment. McKelvey died in 2008 after the execution of the VPFC extensions.

While agreeing that the original VPFCs were entitled to open transaction treatment under Code Sec. 1001, the IRS determined that the VPFC extensions constituted sales or exchanges of property under Code Sec. 1001, and thus McKelvey should have reported gain from the transactions for 2008. McKelvey's estate contended that no sale or exchange took place and, thus, no gain or loss should be recognized upon the extensions of the VPFCs. The estate took its case to the Tax Court.

The Tax Court agreed with the estate and held that McKelvey's execution of the VPFC extensions did not constitute sales or exchanges of property under Code Sec. 1001, and the open transaction treatment should continue until the transactions are closed by the future delivery of stock. Having determined that the VPFCs were not property on the date of the amended contracts, the Tax Court did not consider whether the amended contracts terminated the obligations of the original VPFCs under Code Sec. 1234A. The Tax Court also held that McKelvey did not engage in constructive sales of stock in 2008 under Code Sec. 1259. The IRS appealed to the Second Circuit.

Analysis

Under Code Sec. 1234A, capital gain or loss arises on the termination of a right with respect to property which is a capital asset in the taxpayer's hands. Code Sec. 1259 provides that when a taxpayer holding appreciated stock enters a forward contract to deliver the same or substantially identical property, a constructive sale occurs and the taxpayer must recognize gain as if that position were sold at its fair market value. Code Sec. 1259(d)(1) defines a forward contract as a contract to deliver a substantially fixed amount of property at a substantially fixed price.

On appeal, the IRS argued that a termination under Code Sec. 1234A occurred with execution of the amended contracts in 2008 because the new valuation dates fundamentally changed the VPFCs from betting on the value of Monster stock in September 2008 to betting on its value in January and February 2010. The IRS also contended that a constructive sale occurred because, on the date the amended contracts were executed, the share price of the stock pledged as collateral was so far below the floor price that McKelvey would almost certainly be required to deliver the maximum number of collateralized shares on the settlement date. As a result, the number of shares to be delivered was substantially fixed under Code Sec. 1259(d)(1), according to the IRS. The IRS's valuation expert applied a probability analysis using the Black-Scholes formula, which is widely used to price stock options, to determine that there was an 85 percent and 87 percent probability, respectively, that the closing price of the shares in the two VPFCs would be below the floor price on the settlement date.

The estate argued that if the extensions resulted in new contracts, there would be no constructive sale because the amended contracts would not constitute forward sales of a substantially fixed amount of property. According to the estate, the amount was not substantially fixed because the possibility of the Monster stock rebounding to above the floor price was not remote and because the contract terms did not fix the amount of shares to be delivered.

The Second Circuit agreed with the Tax Court that the replacement of the VPFCs with amended contracts was not an exchange of property under Code Sec. 1001. However, the Second Circuit found that the VPFC extensions were new contracts resulting in terminations under Code Sec. 1234A that resulted in constructive sales of the collateralized shares.

The Second Circuit agreed with the IRS that extending the stock valuation dates constituted a termination under Code Sec. 1234A because the extensions resulted in new contracts. The court noted that the new valuation dates were 16 and 17 months later than the original dates, respectively. The court also made an analogy to options, where new expiration dates result in new option contracts, and reasoned that the options market regards different expiration dates as constituting different option contracts. The court also inferred from the fact that McKelvey paid approximately $11 million to obtain the new valuation dates that he did not think he was making insignificant changes to the VPFCs.

The Second Circuit also held that the VPFC extensions resulted in constructive sales of the collateralized shares. The court based its conclusion on the IRS expert's probability analysis, which it found to show that the amount of shares to be delivered at settlement was substantially fixed on the dates on which each contract was amended. The court noted that applying probability analysis in this context was neither explicitly authorized nor prohibited by the Code or regulations. Nevertheless, the court accepted its use as a way of taking the economic realities of the transaction into consideration. In the court's view, virtually all stock transactions rest on perceptions of the probabilities of share price movement; such probabilities are an economic reality affecting such transactions, and the court saw no reason why they should not affect the tax consequences. The court also noted that the Black-Scholes formula is widely used to price stock options, so the pertinent economic reality was not only the use of probability analysis in general, but the use of that formula in particular.

The Second Circuit explained that, by repeatedly extending a VPFC, a taxpayer holding a large bloc of appreciated securities can receive a large up-front cash payment without incurring a capital gain. The court observed that the parties can repeat these extensions for the taxpayer's life, knowing that at the taxpayer's death the shares will have a stepped-up basis in the hands of the estate. The up-front payment will have been received without ever incurring capital gains tax that would have been due on a sale of the stock. In the court's view, the Code should not be readily construed to permit such a result.

The court rejected the estate's argument that the amount of shares was not substantially fixed. The court explained that the contract terms keyed the amount of deliverable shares to the closing prices on the settlement date, and noted that McKelvey had the option to settle with shares other than the collateralized shares by delivering property of equal value.

For a discussion of the rules for determining whether a sale of property has occurred for purposes of recognizing gain or loss under Code Sec. 1001, see Parker Tax ¶110,110. For a discussion of gains or losses on the termination of certain contracts under Code Sec. 1234A, see Parker Tax ¶116,130. For a discussion of constructive sales under Code Sec. 1259, see Parker Tax ¶116,140.

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IRS Issues Retroactive Guidance on Employer Credit for Paid Family and Medical Leave

The IRS issued a notice in a question and answer format on the employer credit for paid family and medical leave under Code Sec. 45S, a provision enacted in the Tax Cuts and Jobs Act of 2017. According to the IRS, it plans to publish proposed regulations under the provision but, until then, the guidance supplied in the notice applies to wages paid in tax years beginning after December 31, 2017, and before January 1, 2020. Notice 2018-71.

Background

Code Sec. 45S was enacted by the Tax Cuts and Jobs Act of 2017 (TCJA). It establishes a business credit for employers that provide paid family and medical leave (the credit). The credit is equal to a percentage of wages paid to qualifying employees while they are on family and medical leave. The purposes for which an employee may take family and medical leave under Code Sec. 45S are the same purposes for which an employee may take family and medical leave under the Family and Medical Leave Act of 1993 (FMLA).

To be eligible to claim the credit, an employer must have a written policy that satisfies certain requirements. First, the policy must cover all qualifying employees; that is, all employees who have been employed for a year or more and were paid not more than a specified amount during the preceding year. In general, in determining whether an employee is a qualifying employee in 2018, the employee must not have had compensation from the employer of more than $72,000 in 2017. Second, the policy must provide at least two weeks of annual paid family and medical leave for each full-time qualifying employee and at least a proportionate amount of leave for each part-time qualifying employee. Third, the policy must provide for payment of at least 50 percent of the qualifying employee's wages while the employee is on leave. Fourth, if an employer employs qualifying employees who are not covered by FMLA, the employer's written policy must include language providing "non-interference" protections (see below). Thus, the written policy must incorporate the substantive rules that must be met in order for an employer to be eligible for the credit.

Any leave paid by a state or local government or required by state or local law is not taken into account for any purpose in determining the amount of paid family and medical leave provided by the employer. Thus, any such leave is not taken into account in determining the amount of paid family and medical leave provided by the employer, the rate of payment under the employer's written policy, or the determination of the credit.

For purposes of the credit, an employer is any person for whom an individual performs services as an employee under the usual common law rules applicable in determining the employer-employee relationship. Similarly, wages qualifying for the credit generally have the same meaning as wages subject to the Federal Unemployment Tax Act (FUTA), determined without regard to the $7,000 FUTA wage limitation.

In Notice 2018-71, the IRS provides additional guidance on the credit in question and answer form. This guidance applies to wages paid in tax years beginning after December 31, 2017, and before January 1, 2020.

With respect to businesses that are eligible employers for purposes of the credit, Notice 2018-71 provides that any employer will be an eligible employer under Code Sec. 45S if it has a written policy in place that provides paid family and medical leave, satisfies certain minimum paid leave requirements, and, if applicable, includes the "non-interference" language described below.

Written Policy Requirement

To be eligible for the credit, an eligible employer's written policy must provide paid family and medical leave that meets certain requirements. Generally, the written policy must provide all qualifying employees with at least two weeks of paid family and medical leave (prorated for part-time employees), at a rate of at least 50 percent of the employee's normal wages. In addition, if the employer employs any qualifying employees who are not covered by FMLA, the employer's written policy must include certain "non-interference" language which ensures that the employer will not interfere with, restrain, or deny the exercise of, or the attempt to exercise, any right provided under the policy, and will not discharge, or in any other manner discriminate against, any individual for opposing any practice prohibited by the policy. The following "non-interference" language is an example provided by the IRS of a written provision that would satisfy Code Sec. 45S:

[Employer] will not interfere with, restrain, or deny the exercise of, or the attempt to exercise, any right provided under this policy. [Employer] will not discharge, or in any other manner discriminate against, any individual for opposing any practice prohibited by this policy.

The eligible employer's written policy may be set forth in a single document or in multiple documents. For example, an employer may maintain different documents to cover different classifications of employees or different types of leave, and those documents collectively will constitute the employer's written policy under Code Sec. 45S. An eligible employer's written policy may also be included in the same document that governs the employer's other leave policies. However, if an employer's written policy provides paid leave for FMLA purposes and additional paid leave for other reasons (such as vacation or personal leave), only the leave specifically designated for FMLA purposes is considered to be qualifying family and medical leave.

With the exception of a transition rule for the first tax year of an employer beginning after December 31, 2017, the employer's written policy must be in place before the paid family and medical leave for which the employer claims the credit is taken. The written policy is considered to be in place on the later of the policy's adoption date or the policy's effective date. For example, if an employer adopts a written policy that satisfies all of the requirements of Code Sec. 45S on June 15, 2019, with an effective date of July 1, 2019, and assuming all other requirements for the credit are met, the employer may claim the credit for leave taken on or after July 1, 2019.

For an employer's first tax year beginning after December 31, 2017, a written leave policy or an amendment to a policy (whether it is a new policy for the tax year or an existing policy) will be considered to be in place as of the effective date of the policy (or amendment), rather than a later adoption date, if (i) the policy (or amendment) is adopted on or before December 31, 2018, and (ii) the employer brings its leave practices into compliance with the terms of the retroactive policy (or retroactive amendment) for the entire period covered by the policy (or amendment), including making any retroactive leave payments no later than the last day of the taxable year.

Example: Employer ABC is a calendar year business and Employee X takes two weeks of unpaid family and medical leave beginning January 15, 2018. ABC adopts a written policy that satisfies the requirements of Code Sec. 45S on October 1, 2018, and chooses to make the policy effective retroactive to January 1, 2018. At the time the policy is adopted, ABC pays Employee X (at a rate of payment provided by the policy) for the two weeks of unpaid leave taken in January 2018. Assuming all other requirements for the credit are met, ABC may claim the credit with respect to the family and medical leave paid to Employee X for the leave taken in January 2018.

Compliance Tip: Code Sec. 45S does not impose a notice requirement with respect to the written policy on employers. However, if an employer chooses to provide notice of the written policy to qualifying employees, the policy will not be considered to provide for paid leave to all qualifying employees as required under Code Sec. 45S, unless the availability of paid leave is communicated to employees in a manner reasonably designed to reach each qualifying employee. This may include, for example, email communication, use of internal websites, employee handbooks, or posted displays in employee work areas.

Family and Medical Leave Qualifying for the Credit

An eligible employer may claim the credit only with respect to paid family and medical leave, which is defined as leave for any one or more of the purposes described under FMLA Section 102(a)(1)(A), (B), (C), (D), or (E) or FMLA Section 102(a)(3), whether the leave is provided under the FMLA or by a policy of the employer. If an employer provides paid leave as vacation leave, personal leave, or medical or sick leave (other than leave specifically for one or more of the FMLA purposes), that paid leave is not considered family and medical leave for purposes of the credit. The FMLA purposes for which paid family and medical leave under Code Sec. 45S may be provided are:

(a) the birth of a son or daughter of the employee and in order to care for the son or daughter;

(b) the placement of a son or daughter with the employee for adoption or foster care;

(c) caring for the spouse, or a son, daughter, or parent, of the employee, if the spouse, son, daughter, or parent has a serious health condition;

(d) a serious health condition that makes the employee unable to perform the functions of the employee's position;

(e) any qualifying exigency (as the Secretary of Labor, by regulation, determines) arising out of the fact that the spouse, or a son, daughter, or parent of the employee is a member of the Armed Forces (including the National Guard and Reserves) who is on covered active duty (or has been notified of an impending call or order to covered active duty); or

(f) caring for a covered service member with a serious injury or illness if the employee is the spouse, son, daughter, parent, or next of kin of the service member.

The FMLA purposes are the purposes for which an employee may take leave under the FMLA. The terms used in this Q&A-8 have the same meaning as defined in section 825.102 of the FMLA regulations, 29 CFR Sec. 825.102.

Except for one narrow exception discussed below, paid leave made available to an employee is considered family and medical leave under Code Sec. 45S only if the leave is specifically designated for one or more FMLA purposes, may not be used for any other reason, and is not paid by a state or local government or required by state or local law.

Example: Employer ABC's written policy provides six weeks of annual paid leave for the birth of an employee's child, and to care for that child (an FMLA purpose). The leave may not be used for any other reason. No paid leave is provided by a state or local government or required by state or local law. ABC's policy provides six weeks of family and medical leave under Code Sec. 45S.

Example: Employer ABC's written policy provides three weeks of annual paid leave that is specifically designated for any FMLA purpose and may not be used for any other reason. No paid leave is provided by a state or local government or required by state or local law. ABC's policy provides three weeks of family and medical leave under Code Sec. 45S.

Example: Employer ABC's written policy provides three weeks of annual paid leave for any of the following reasons: FMLA purposes, minor illness, vacation, or specified personal reasons. No paid leave is provided by a state or local government or required by state or local law. In this case, ABC's policy does not provide family and medical leave under Code Sec. 45S because the leave is not specifically designated for one or more FMLA purposes and can be used for reasons other than FMLA purposes. This is true even if an employee uses the leave for an FMLA purpose.

In the limited circumstance where an employer's written policy provides paid leave that otherwise would be specifically designated for an FMLA purpose (for example, to care for a spouse, child, or parent who has a serious medical condition), except for the fact that the leave is available to care for additional individuals not specified in the FMLA (for example, a grandchild, or grandparent who has a serious medical condition), the fact that the leave could also be used to care for additional individuals for whom care under the FMLA purpose is not required does not prevent the leave from being considered specifically designated for an FMLA purpose. However, the employer may not claim the credit for any leave taken to care for an individual other than a qualifying employee's spouse, parent, or child.

Minimum Paid Leave Requirements

For an employer to be eligible to claim the credit, an employer's written policy must meet the following minimum requirements with respect to paid family and medical leave:

(1) the policy must provide at least two weeks of annual paid family and medical leave to all qualifying employees who are not part-time employees, and at least a proportionate amount of paid family and medical leave to qualifying employees who are part-time employees,

(2) the policy must require a rate of payment that is not less than 50 percent of the wages normally paid to the qualifying employee for services performed for the employer, and

(3) if the employer employs one or more qualifying employees who are not covered by title I of the FMLA, the employer's written policy also must include the "non-interference" language previously described.

Any leave that is paid by a state or local government or required by a state or local law is not taken into account for any purpose in determining the amount of paid family and medical leave provided by the employer.

A qualifying employee for this purpose is an employee (as defined in Section 3(e) of the Fair Labor Standards Act of 1938, as amended (FLSA)) who has been employed by the employer for one year or more, and whose compensation for the preceding year does not exceed an amount equal to 60 percent of the amount applicable for that year under Code Sec. 414(q)(1)(B)(i). For 2017, the applicable amount of compensation is $120,000. Accordingly, to be a qualifying employee in 2018, an employee must have earned no more than $72,000 (60 percent of $120,000) in compensation in 2017 (or if applicable, in the employer's fiscal year beginning in 2017).

For a discussion of the employer credit for paid family and medical leave, see Parker Tax ¶105,401.

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S Shareholder's Amended Filings Satisfied Requirement to Identify Inconsistencies with Return

The Ninth Circuit held that the sole shareholder of an S corporation in involuntary bankruptcy, who filed for a refund based on a claimed overstatement of income on the S corporation return filed by the bankruptcy trustee, satisfied the requirement in Code Sec. 6037 to provide a statement identifying the inconsistency between the corporate and the shareholder returns by including a statement that described how his income flowed from the corporation and stating his disagreement with the return filed by the trustee. Rubin v. U.S., 2018 PTC 313 (9th Cir. 2018).

Background

Thomas Rubin was the sole shareholder of Focus Media, Inc. (Focus), an S corporation. In 2000, Focus experienced serious financial difficulties when some of its largest customers became concerned about its possible misuse of funds and sued to prevent additional disbursements. Focus was eventually enjoined from collecting its unpaid receivables. Later in 2000, creditors put Focus into involuntary bankruptcy. A bankruptcy trustee was appointed and advised the bankruptcy court that Focus's receivables were worthless.

The bankruptcy trustee filed Focus's 2000 S corporation tax return. According to Rubin, the trustee incorrectly accounted for over $66 million of cancellation of indebtedness (COD) income and $23 million of bad debt expenses that Focus was entitled to write off. Rubin filed his personal tax return and paid his taxes based on the income reported in the Focus return filed by the trustee for 2000. Rubin later filed an amended return for 2000, however, and for the two preceding years.

With his amended returns, Rubin included a statement describing how his income flowed from Focus and stating his disagreement with the return filed for Focus by the trustee. He attached a pro forma amended Form 1120S, U.S. Income Tax Return for an S Corporation, which reflected the different treatment of Focus's COD income and bad debt expenses. He also attached a pro forma Schedule K-1 showing the income he contended should have been reported to him based on the revised numbers in his pro forma return for Focus. Rubin claimed refunds for 1998 and 1999 based on carrying losses back to those years, again based on the revised figures in the pro forma 2000 Focus return. Rubin claimed refunds of approximately $2.5 million for 1998, $595,000 for 1999, and $6.9 million for 2000.

The IRS disallowed all of Rubin's amended return refund claims. In doing so, the IRS did not indicate that the rejection was based on any failure by Rubin to identify inconsistencies between his returns and Focus's, nor did the IRS suggest any uncertainty or confusion about what Rubin was claiming or what his filings reported. All of the reasons provided by the IRS were based on the merits of Rubin's claims.

In 2016, Rubin sued for the refunds in a district court. The district court granted the government's motion to dismiss Rubin's claims, concluding that Rubin had not filed with his amended returns a statement identifying the inconsistency with Focus's return. Rubin appealed to the Ninth Circuit.

Analysis

Code Sec. 6037(c) generally provides that an S corporation shareholder must report income and loss consistently with what the S corporation reported on its return. However, under Code Sec. 6037(c)(2)(A), if a shareholder's treatment of an item is inconsistent with the S corporation's return, the consistency requirement does not apply provided the shareholder files a statement identifying the inconsistency.

Observation: Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request, is used by S corporation shareholders to report items differently from the way the S corporation reported them. Rubin did not file a Form 8082, but the district court did not rest its decision on that basis, and the government abandoned that argument on appeal.

The IRS argued that Rubin's amended filings did not constitute a statement identifying the inconsistency. According to the IRS, Rubin's filings identified only how his amended returns differed from his original returns, not how his amended returns differed from Focus's returns. The Ninth Circuit interpreted the IRS's position to be that Rubin should have included figures reported on the Focus return with the pro forma returns included the amended filings. The IRS further argued that requiring it to compare the filed Focus return with Rubin's pro forma return would be unduly burdensome because Rubin's filings spanned over 20 pages. The IRS contended that as a policy matter, finding in Rubin's favor would encourage S corporation shareholders not to disclose inconsistencies between their returns and the corporate returns. The IRS argued that the filing of administrative claims would be rendered an exercise in futility, because the IRS would have to defend against refund actions in court based on arguments it was directed to disregard at the administrative level.

The Ninth Circuit held that Rubin's filing satisfied the statement requirement in Code Sec. 6037(c)(2)(A) because it found that in practical terms, the amended filings succeeded in identifying the inconsistencies with the previously filed returns sufficiently for the IRS to understand them and reject them on the merits. Although Rubin did not file a Form 8082, the court based its reasoning primarily on the fact that Rubin's filings in practice complied with the Form 8082 requirements. The court explained that Form 8082 asks the taxpayer to list the relevant amount either from the Schedule K-1 or the taxpayer's return, the amount the taxpayer is reporting, and the difference between the two. In the court's view, Rubin provided this information, and nothing in Form 8082 required the taxpayer to report figures taken directly from the corporation's return as the IRS suggested.

The Ninth Circuit disagreed with the IRS's assertion that requiring it to compare the filed Focus return with Rubin's pro forma return would be unduly burdensome. According to the court, the fact that Rubin's Focus filing was 22 pages did not impose a burden that the IRS could not reasonably accomplish, particularly given the size of the claimed refund. The court explained that in fact, the IRS would be expected to review returns and that is actually what it did. In the court's view, a two page pro forma Schedule K-1 accompanied by a two page statement explaining the inconsistencies did not impose an oppressive task on the IRS, even under Code Sec. 6037 standards.

The Ninth Circuit rejected the IRS's policy argument because it found that Rubin did not argue he was exempt from the requirement to identify the relevant inconsistencies. The court was likewise not convinced that its ruling would render administrative claims futile. The court found that the IRS was not directed to disregard any arguments at the administrative level; to the contrary, it considered Rubin's returns on the merits, and was able to do so because the return included a statement that sufficiently identified the relevant inconsistencies.

For a discussion of the S corporation return consistency requirement, see Parker Tax ¶36,525.

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Owner of Tax Prep Firm Was Not Liable for Penalties on Returns Signed by Employees

A district court held that the sole owner of a tax return preparation business was not liable under Code Sec. 6694(b) for penalties relating to understatements of tax on returns prepared and signed by employees or independent franchisees of the business. The court found that there was no evidence of the owner's involvement with the returns, much less evidence of willful or reckless conduct as required under Code Sec. 6694, and it rejected the government's argument that the employer was liable regardless of the extent of his involvement with the returns or whether he signed them. Lowery v. U.S., 2018 PTC 329 (W.D. N.C. 2018).

Background

Marshall Lowery was the sole member of Computer Plus, LLC, d/b/a "Rapid Tax." Computer Plus employed individuals including Lowery to provide paid tax preparation services to its clients. In 2014, the IRS sought to impose $170,000 in tax preparer penalties against Lowery arising out of 34 tax returns prepared for 2009 and 2010.

Lowery appealed the penalties. IRS Appeals Officer Maria Frazier concluded that there was insufficient evidence to support a penalty for nine of the now 25 returns at issue, and recommended reducing the penalty from $170,000 to $100,000. Lowery sent a request under the Freedom of Information Act for every document in the IRS's files relating to the proposed penalties, but the IRS provided no documents in response.

Before the final penalties were assessed, Lowery's appeal was reassigned to IRS Appeals Officer Sandra Mical. Mical recommended an assertion of $77,500 in penalties: a full penalty of $5,000 each for six returns prepared by Lowery, and a 50 percent penalty for 19 returns prepared by independent franchisees or employees of Computer Plus. In recommending the reduced penalties, Mical noted that there were "hazards to both parties" as to whether Lowery would be determined to be the tax return preparer. She also noted a significant lack of evidence with respect to five of the returns.

In 2016, the IRS sent a notice and demand to Lowery for penalties assessed under Code Sec. 6694(b) arising out of all 25 of the returns. Lowery paid 15 percent of each penalty and filed Forms 6118, Claim for Refund of Tax Return Preparer and Promoter Penalties. After six months of inaction on the IRS's part, Lowery sued for a refund in a district court.

Analysis

Under Code Sec. 6694(b), a tax return preparer is liable for a penalty if a return understates a tax liability and the understatement is willful or the preparer recklessly or intentionally disregards the rules or regulations. Reg. Sec. 1.6694-1(b)(2) provides that, in general, the preparer who signs the return is primarily responsible for all of the positions on the return. However, a nonsigning return preparer who prepares all or a substantial part of a return, and who has overall supervisory responsibility for the position giving rise to the understatement, is generally considered the return preparer who is primarily responsible for purposes of the penalty. Under Reg. Sec. 1.6694-3(a)(2), a firm that employs a return preparer is liable only if an officer of the firm participated in or knew about the wrongful act.

In the district court, Lowery and the IRS filed cross motions for summary judgment. Lowery argued that he was not a nonsigning preparer because the IRS had done nothing to determine whether the signing preparers were or were not primarily responsible for the positions on the returns. Lowery also contended that even if he did play a role in preparing the returns not signed by him, there was no evidence he disregarded any information provided by the taxpayer or intentionally or recklessly disregarded any rule or regulation. According to Lowery, if he was the return preparer, then it was only his conduct that would give rise to the imposition of penalties, which he asserted was consistent Reg. Sec. 1.6694-3(a)(2) and which, he said, imposes liability on a firm only when it can be shown that the firm was complicit in the wrongful act. Lowery cited legislative history to support his contention that Code Sec. 6694 was not intended to impose mere vicarious liability on the employer of a return preparer. Lowery then went on to assert that he was not the employer of any of the signing return preparers; Computer Plus was, and there was no evidence he had a supervisory role or any involvement with the returns signed by other preparers. With respect to the six returns Lowery signed, Lowery argued that there was no evidence he disregarded information or acted willfully or with reckless disregard.

The government argued that whether Lowery was a signing or nonsigning preparer was irrelevant because there was no dispute that he prepared and signed six returns and that he employed individuals who prepared and signed the remaining 19. According to the government, Lowery was a return preparer as an employer because he was the sole member of Computer Plus, which employed the preparers who signed the returns. Reg. Sec. 1.6694-3(a)(2) was inapplicable, according to the government, because it refers to a firm, but the IRS never asserted firm liability.

The district court denied the government's motion and granted summary judgment for Lowery with respect to the 19 returns signed by other preparers, but denied his motion with respect to the six returns he signed. For the six returns prepared by Lowery, the court found that whether his conduct was willful or reckless were questions of fact that should be decided by a jury.

However, the district court found that even if Lowery was considered a return preparer of the 19 returns in question, there was no evidence that he took a position on any of them. In the court's view, there was no evidence of Lowery's involvement with the returns not signed by him, much less evidence of willful or reckless conduct as required under Code Sec. 6694. The court was not persuaded that Lowery could be held liable under Code Sec. 6694(b) for returns he was not involved with and that were signed by other return preparers.

The district court disagreed with the government's assertion that Lowery could be held liable for all of the returns as the employer of the preparers. The court distinguished the district court cases cited by the government, noting that in each case where an employer was found liable, the employer was also the signer of the returns. The court found that Lowery did not sign any of the 19 returns and saw no reason to rebut the presumption that the actual signers of the returns were responsible, especially where there was no evidence that Lowery prepared a substantial portion, or any portion, of the returns. The court concluded that the government had failed to meet its burden of showing willful conduct and that Lowery had adequately shown the absence of reckless or intentional disregard.

For a discussion of the penalty for willful or reckless understatement of a liability by a tax return preparer under Code Sec. 6694(b), see Parker Tax ¶276.315.

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IRS Extends Replacement Period under Sec. 1033 for Certain Livestock Sales

The IRS issued a notice extending the time that farmers and ranchers in 41 states and the District of Columbia have under Code Sec. 1033(e) to replace livestock sold on account of weather-related conditions. The Appendix to the notice lists the U.S. counties that qualify for the extension. Notice 2018-79.

Code Sec. 1033(a) generally provides for nonrecognition of gain when property is involuntarily converted and replaced with property that is similar or related in service or use. A sale or exchange of livestock (other than poultry) held by a taxpayer for draft, breeding, or dairy purposes in excess of the number that would be sold following the taxpayer's usual business practices is treated as an involuntary conversion if the livestock is sold or exchanged solely on account of drought, flood, or other weather-related conditions.

Generally, gain from an involuntary conversion is recognized only to the extent the amount realized on the conversion exceeds the cost of replacement property purchased during the replacement period. If a sale or exchange of livestock is treated as an involuntary conversion and is solely on account of drought, flood, or other weather-related conditions that result in the area being designated as eligible for assistance by the federal government, Code Sec. 1033(e)(2)(A) provides that the replacement period ends four years after the close of the first tax year in which any part of the gain from the conversion is realized. The IRS has the authority to extend this replacement period on a regional basis for such additional time as it deems appropriate if the weather-related conditions that resulted in the area being designated as eligible for assistance by the federal government continue for more than three years.

Notice 2006-82 provides for extensions of the replacement period. If a sale or exchange of livestock is treated as an involuntary conversion on account of drought, the taxpayer's replacement period is extended until the end of the taxpayer's first tax year ending after the first drought-free year for the applicable region. For this purpose, the first drought-free year for the applicable region is the first 12-month period that:

(1) ends August 31;

(2) ends in or after the last year of the taxpayer's four-year replacement period determined under Code Sec. 1033(e)(2)(A); and

(3) does not include any weekly period for which exceptional, extreme, or severe drought is reported for any location in the applicable region.

The applicable region is defined as the county that experienced the drought conditions on account of which the livestock was sold or exchanged and all counties that are contiguous to that county. A taxpayer may determine whether exceptional, extreme, or severe drought is reported for any location in the applicable region by reference to U.S. Drought Monitor maps that are produced on a weekly basis by the National Drought Mitigation Center. In addition, Notice 2006-82 provides that the IRS will publish in September of each year a list of counties, districts, cities, or parishes for which exceptional, extreme, or severe drought was reported during the preceding 12 months. Taxpayers may use this list instead of U.S. Drought Monitor maps (which are archived at droughtmonitor.unl.edu/Maps/MapArchive.aspx) to determine whether exceptional, extreme, or severe drought has been reported for any location in the applicable region.

In the Appendix of Notice 2018-79, the IRS lists the counties for which exceptional, extreme, or severe drought was reported during the 12-month period ending August 31, 2018. Under Notice 2006-82, the 12-month period ending on August 31, 2011, is not a drought-free year for an applicable region that includes any county on this list. Accordingly, for a taxpayer who qualified for a four-year replacement period for livestock sold or exchanged on account of drought and whose replacement period is scheduled to expire at the end of 2018 (or, in the case of a fiscal year taxpayer, at the end of the tax year that includes August 31, 2018), the replacement period is extended under Code Sec. 1033(e)(2) and Notice 2006-82 if the applicable region includes any county on this list. This extension will continue until the end of the taxpayer's first tax year ending after a drought-free year for the applicable region.

For a discussion of the postponement of gain recognition on livestock sales or exchanges resulting from weather-related events, see Parker Tax ¶161,570.

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IRS Abused Its Discretion by Failing to Consider Proposed Offers and Hardship Claim

The Tax Court held that, in a collections due process (CDP) hearing, the IRS abused its discretion by failing to consider a couple's offer in compromise (OIC), installment agreement request, and request for relief due to economic hardship caused by a medical condition. The Tax Court found that the couple's prior negotiations with a collections officer, in the context of which they submitted the same OIC along with financial information supporting their installment agreement and economic hardship claim, was not a previous administrative hearing, so the couple was not barred from resubmitting these items at the CDP hearing. Loveland v. Comm'r, 151 T.C. No. 7 (2018).

Background

James Loveland is a retired boilermaker, and his wife, Tina, is a retired teacher. Over the last decade, the Lovelands experienced financial and health problems. They lost their home to foreclosure in the wake of the recession and housing crisis. Mr. Loveland became disabled due to a heart condition, and Mrs. Loveland survived breast cancer. During this time, the Lovelands stopped paying their taxes, resulting in outstanding tax liabilities for 2011-2014 totaling over $60,000.

In 2015, after the IRS issued a notice of intent to levy on property owned by the Lovelands, the Lovelands entered negotiations with a collections officer. The Lovelands made an offer in compromise (OIC) by submitting a Form 433-A (OIC), Collection Information Statement for Wage Earners and Self-Employed Individuals. They attached a range of financial information including bank statements, pension and income documentation, and information about expenses and assets. The Lovelands asserted that their health problems and the foreclosure constituted special circumstances that limited their ability to pay.

The collections officer rejected the OIC, finding that the Lovelands could pay the full amount and that the special circumstances they raised did not warrant a decision to accept the offer. The Lovelands initially appealed but decided to instead continue negotiating with the collections officer after learning that a proposed installment agreement would not be considered if an appeal were pending. As part of the negotiations over the installment agreement, the Lovelands agreed to pay $800 each month, and made at least two payments.

In October of 2016, the Lovelands applied for a loan secured by a second mortgage on other property they owned. They planned to use the money to make an $11,500 payment to the IRS to bring their liability below $50,000 in order to qualify for streamlined processing of their installment agreement. On the same day in October 2016 that they filed their loan application, the IRS filed a notice of federal tax lien (NFTL) on the property. With the lien having been filed, the Lovelands were unable to secure the loan, and settlement negotiations came to a halt.

The Lovelands then requested a collections due process (CDP) hearing with the IRS Appeals office. They asked that the lien be released because it disrupted their mortgage refinancing and caused economic hardship. An Appeals officer sent the Lovelands a letter scheduling a hearing in March 2017 and informing them that, for a collection alternative to be considered, they would need to submit a completed Form 433-A along with supporting documents. In response, Mr. Loveland sent a letter asking the Appeals officer to review the Lovelands' previously submitted Form 433-A. He attached the completed form, the earlier letter requesting an appeal of the previous rejection of their OIC, and a Form 433-D, Installment Agreement, for $800 per month. The letter explained Mr. Loveland's health problems, stated that paying any amount at that time would result in economic hardship, and specifically asked what would be classified as exceptional circumstances.

The Appeals officer declined to review the OIC and the proposed installment agreement, concluding that the OIC was not properly appealed and that the Lovelands had not submitted the necessary financial information for the proposed installment agreement. Mr. Loveland explained that he did not appeal the rejected OIC because he hoped to work out an installment agreement. He noted that the Lovelands had been working to obtain a loan and that the NFTL halted their loan application.

Although the Appeals officer did not review the Lovelands' offer, she did calculate a monthly payment that would allow the Lovelands to fully pay the liability in 84 months. She determined, based on what the Lovelands owed, that they qualified for an 84 month installment agreement of $853 per month. There was no evidence that the Appeals officer considered any of the financial information the Lovelands had provided.

In April 2017, the Lovelands received a notice of determination stating that they had requested withdrawal of the lien and an installment agreement, and that the Appeals officer did not consider their proposed installment agreement because they did not provide any financial information. Neither the notice nor the case history notes discussed Mr. Loveland's medical condition or the effect of his disability on the Lovelands' ability to pay the taxes owed. The Lovelands petitioned the Tax Court for redetermination of the decision to sustain the lien.

Analysis

In a CDP hearing, a taxpayer may raise any issue relevant to an unpaid tax, NFTL, or proposed levy, including challenges to the appropriateness of the collection action and offers of collection alternatives. However, under Code Sec. 6330(c)(4)(A)(i) and Reg. Sec. 301.6320-1(e)(1), a taxpayer may not raise an issue that was raised and considered in any previous administrative or judicial proceeding.

Responding to the IRS's motion for summary judgment, the Lovelands argued that they submitted the requested financial information when they filed the Form 433-A (OIC) and substantiating documents. They asserted that the lien caused economic hardship and attached copies of their rejected loan application. They also cited regulations that detail compromises to promote effective tax administration related to taxpayers with medical conditions or disabilities that limit their ability to pay.

The Tax Court was faced with the unique issue of deciding whether negotiations with a collections officer constitute a previous administrative proceeding under Code Sec. 6330(c)(4)(A)(i) and Reg. Sec. 301.6320-1(e)(1).

The Tax Court sided with the Lovelands and held that the IRS Appeals officer's failure to consider the Lovelands' proposed OIC, installment agreement, and claim of economic hardship constituted an abuse of discretion. The court found that, although the Lovelands had a prior opportunity for a CDP hearing, they never availed themselves of it, but decided instead to continue negotiating with the collections officer. According to the Tax Court, whether a previously rejected collection alternative can be raised at a CDP hearing does not hinge on whether the taxpayer had a prior opportunity to challenge the rejection; it hinges on whether the rejected collection alternative was actually considered at a previous administrative or judicial proceeding. In other words, it is not a question of whether there was a prior opportunity, but whether there was a prior proceeding.

With respect to the installment agreement, the Tax Court noted its holding in a previous case that an Appeals officer validly rejected a collection alternative after the taxpayer failed to provide the financial information necessary to evaluate the merits of the proposal. In another case, there was no abuse of discretion where an Appeals officer declined to consider a collection alternative when the IRS had requested but not received updated financial information. The Tax Court distinguished those decisions by noting that in this case, the IRS never even considered the Lovelands' financial submissions, the age of the information they provided, or whether any significant changes had occurred. While the IRS's stated reason for the rejection of the Lovelands' installment proposal was that they failed to provide financial information, the court found that they did provide such information and the IRS abused its discretion in failing to consider it.

Finally, the court found that the IRS's failure to consider the Lovelands' claim of economic hardship if they were required to pay their tax liability in full was also an abuse of discretion. The court explained that, in a CDP hearing, the IRS is required to consider all issues raised by the taxpayer. The court found that although the Lovelands' economic hardship claim was noted in the administrative record and the notice of determination, the IRS never evaluated the claim. Because the Lovelands explicitly raised the issue of economic hardship, the IRS abused its discretion in failing to consider it, the court concluded.

For a discussion of CDP hearings, see Parker Tax ¶260,540. For a discussion of offers in compromise, see Parker Tax ¶263,165.

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