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Federal Income Tax Update

byEdward Schnee

General

Income

LTR 201203013◦ settlement payments income unless return of capital Return of deposits Non-taxable Interest paid on deposits taxable Additional amount determined by facts

LTR 201232024◦ assignment of income doctrine does not apply to transfer of

judgment until all appeals are exhausted

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Leach Carlebach 139 T.C. No.1◦ To claim a person as dependent, person must be a citizen or resident ◦ Court upheld regulations

Allen L. Davis v. Comm T.C. Memo 2011-286◦ Taxpayer exercised a cashless option related to his performance of services◦ Taxpayer required to report income of $36,962,000 in year of exercise.◦ S corporation could deduct the $36,962,000 as reasonable compensation.

Rev. Proc. 2012-29 ◦ Procedure discusses rules related to taxation of income under section 83◦ Contains examples of Sec 83(b) elections

Dominick DeNaples v. Comm 674 F.3d 172 (CA-3) Taxpayer received interests on installment

payment to settle a condemnation of property by a state. Interest can be excluded under section 103.

Law mandated interest not excludible.

ILM 201115020◦ Airline furnish food to crew during flight. ◦ Crew can exclude this from income under section 119◦ Since this does not qualify under section 132, corporate deduction limited to 50%

LTR 201220004◦ S Corporation files for bankruptcy ◦ Sizeable amount of debt cancelled◦ Debt cancelled results in COD◦ Debt issue costs deductible and not part of COD

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Ramona Mitchell 138 T.C. No.16◦ Taxpayer denied conservation easementdeduction ◦ Failed to have mortgage subordinated Future subordination does not change outcome Remoteness test is not relevant

Gorden Kaufman v. Comm CA-1◦ Tax court denied conservation easement deduction based on two issues:1.Mortgage holder entitled to insurance proceeds before charity2.Charity can give up contribution in the future

◦ Court disagrees with Tax Court because the conclusions are based on unreasonable interpretations of the regulations by IRS1. Mortgage coming first does not deny charity a share of proceeds on disposition of easement 2. Right for charity to give up easement not a violation of perpetuity requirement.

ILM 201151021◦ Taxpayer understated interest expense in years 1 and 2◦ Years 1 and 2 closed◦ Taxpayer can increase NOL carryforward from years 1 and 2 for extra interest expense, even though years closed.◦ Must reduce carryforward by any income in years after 1 and 2 even if those years closed.`

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ILM 201226021◦ Alternative minimum NOL carryover deduction limited to 90% of AMTI. Reduced AMTI by charitable contribution

◦ Charitable contribution limited to 10% of tax income Reduce taxable income by ATNOL carryover

◦ IRS suggests using simultaneous equations to calculate correct amount.

Caltex Oil Venture 138 T.C. No.2◦ Actual question- can taxpayer deduct IDC costs before drilling complete◦ General question-how should the 3 1/2 month rule be applied ◦ Accrual method taxpayer can deduct expenses when incurred◦ Liability incurred when economic performance related to the liability has occurred. services to taxpayer Property to taxpayer Use of property by taxpayer

Reg sec. 1.461-4(d)(ii)◦ Economic performance occurs when liability paid if

services reasonably expected to be performed within 3 ½ month after date of payment IRS required all services to be performed Taxpayer argues for deduction based on portion of services to be performed

◦ Court concluded regulations ambiguous Adopted IRS interpretation Payment requires cash not notes

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Rev Rul 2012-1◦ Under the accrual method a liability is incurred 1. all events have occurred that establish the liability. 2. the amount of the liability can be determined with

reasonable accuracy. 3. economic performance has occurred

◦ Liability established at earlier of The required performance or other event Payment is due

◦ Economic performance for goods and services occurs when services performed or goods provided Services differ from warranty and service contracts

because provided by person other than the person providing goods

◦ Reg. Sec 1.461-5(b) recurring item exception Economic performance by earlier date of return filed or 9 ½ months after year end and Either amount immaterial or results in better matching◦ a. if material for accounting material for tax◦ b. if immaterial for accounting may still be material for

tax◦ c. to use matching rule facts must have overriding facts

or circumstance that indicates better matching then accounting rules

FAA 20121602 F◦ Liability established at earlier of 1. economic performance or other event 2. liability due

◦ Pharmaceutical company sold product and was required to pay wholesaler a discount amount Wholesaler required to submit reimbursement form

◦ Under US v. General Dynamics, liability not fixed until form filed in this case form managerial and thereafter not

required, Rev. Rul. 98-39◦ Since liability fixed can deduct expense if meet

recurring item exception◦ similar conclusion reached in TAM 201223015

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Mass. Mutual Life Ins. Co. 2012-1 USTC ¶50,189◦ The 1984 adoption of the all-events test did not

change first 2 requirements Cases and rulings on these requirement still have

precedential value◦ Liability is fixed even if exact recipient unknown Bonus amount set but actual employee share

determined after year end. Rev. Rul 2011-29◦ Reg. sec. 1.461-5(b)(5)(ii) Safe Harbor for

matching rule 1.Rebates and refunds (g)(3) 2.Awards, prizes and jackpots (g)(4) 3.Insurance, warranty, service contracts(g)(5) 4. Taxes (g)(6)

CCA 201202021◦ Taxpayer filed a return with interests expense deduction limited by 163 (j)◦ Taxpayer decided that limitation does not apply◦ Under section 446, an accounting method change is the overall method or a change in any material item◦ Material item change is a change in time for inclusion of income or deducting expenditure.◦ Since section 163(j) carryover does not guarantee full deduction, elimination of limitation could affect total expense. Result not an accounting method change.

Goodrich Corp. 2012-1 USTC ¶50,159◦ Taxpayer contested back taxes and interest◦ Transferred funds to a trust◦ Notified IRS of trust◦ Sec. 461 (f) 1.Taxpayer contests liability 2.Transfer of money or property to settle liability 3.Liabiltty exists after transfer 4.If not contested, amount deductible

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◦ Reg sec 1.461-2(c)(i) transfer to settle liability Transfer property to trust based on written agreement with trust and person asserting liability Taxpayers argued that transfer to trust and notice to IRS meet these conditions◦ Court divided on whether that meets requirements or need IRS approval of trust

IRS won current case◦ Government interpretation of its own regulations upheld◦ Amount of liability must be agreed by both parties.

James Maguire TC Memo 2012-160◦ Taxpayer had a passive loss from real estate ◦ Taxpayer had negative AGI from S corporation loss◦ Taxpayer can deduct $25,000 of real estate passive losses. ◦ Reduced by AGI over 100,000 if active participant.◦ Active- not regular, continuous, and substantial need to participate in significant management decisions

◦ Can deduct $25,000 since AGI negative

ILM 201216033◦ Taxpayer can file a supplement to a refund claim but not a new claim after date for filing claims.◦ Supplement treated as new claim if it requires new investigation of information not disclosed by original claim or IRS took final action on original claim.

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Intersport Fashions West, Inc.109 AFTR.2d 2012-927◦ Taxpayer filed amended return to reallocate expense between corporations. The allocation was honored by IRS in a newer initial return◦ Section 482 allows IRS to reallocate items between related parties to correctly report taxable income◦ Reg. Sec 1.482-1(a)(3) allows taxpayer to allocate items between related parties without regard to contracts on timely filed return

◦ Court rejected taxpayer’s amended returns◦ Court stated regulations unambiguous they must be applied The fact that original return contains an errordoes not allow taxpayer to file a late amended return The substantial compliance doctrine applied narrowly

Ocean Pines Assoc. CA-4◦ Taxpayer is a tax-exempt 501(c)(4) association. It

provided a separate parking lot and beach facility. IRS imposed UBIT on the income from this separate activity◦ UBIT applies if 1. there is a trade or business 2.regularly carried on, and 3. not substantially related to tax-exempt purpose

◦ Social welfare covers people of community. If limit access to members, unrelated to exempt function.◦ Fact that activity does not compete with profit

operations is immaterial.

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LTR 201216007◦ Taxpayer engaged in a Sec 1031 exchange with

unrelated party using a QI . Since the replacement property was less than exchanged property, taxpayer acquired additional replacement property from related party. Taxpayer than exchanged property from related party for other property in a section 1031 exchange◦ IRS ruled that sec 1031(f) does not apply since

property disposed in a non-taxable exchange.

LTR 201222012◦ The receipt of boot less than 5% of gain in a related

party section 1031 exchange will not trigger section 1031(f)

Peco Foods, Inc TC Memo 2012-18◦ Taxpayer acquired poultry plants and signedcontracts that allocated the purchase price. Afterwards, it had asset segregation study done and filed an amended return using allocation in study.◦ Sec 1060 is binding on both parties. IRS can challenge if allocation unreasonable The Danielson rule also applies since the question is the transaction not the taxation of the agreed transaction. The residual method of section 338 doesn’t override section 1060. Applies to purchase price not allocated in agreement.

LTR 201203003◦ Power purchase agreement held a capital asset ◦ IRS concluded it was not an amortizable section 197 asset.

Dominion Resources CAFC◦ Sec 263A(a)(1) must capitalize both direct and indirect costs◦ Sec 263A(f) indirect costs include interest Direct allocation of related debt Indirect allocation of avoidable debt◦ Basis of temporary inactive assets included by

regulation rejected by court

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Joseph Veriha 139 T.C. No.3◦ Taxpayer owns a trucking business. He owns an entity that rents trucks to the trucking business◦ Rental actually generates passive income except for renting an item to business in which you materially participate◦ Truck rental non-passive Must reclass each truck separately sinceregulation refers to item of property

Belmont Investment LLC CA-5◦ Sec 6662 40% valuation penalty does not apply if deduction or credit completely eliminated.

Arthur Dalton, Jr. CA-5◦ Courts can receive IRS decisions following CDP hearing◦ Review of decisions on facts and law based on reasonableness not de novo.

Luther H. Allcorn139 T.C. No.4◦ IRS can abate interest charge if

a. delay caused by IRSb. occurs after IRS contacts taxpayerc. no significant aspect in delay attributable to taxpayer

◦ Court review based on arbitrary or capricious standard.

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Individual

• First time homebuyer credit• Sec 36(a) defines a first time homebuyer as an individual

• In Jack Trugman,138 T.C. No.22 Court ruled that an S Corporation does not qualify as an individual

• In Feliz Rospond,T.C. Summ 2012-47 Court ruled That an LLC did not qualify as an individual• Court noted in prior cases corporation not automatically excluded from definition of individual

LTR 201149005◦ A trust uses property to terminate a private annuity◦ Trust recognizes gain or loss on transfer which is treated as an annuity payment◦ Trust recognizes gain or loss on the disposition of property equal to value minus basis

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Yulia Feder，T.C. Memo 2012-10◦ Taxpayer wrote insurance company to cancel life insurance policy.◦ Insurance company did not receive letter. Used auto policy loan to pay premiums◦ When loan equaled CSV policy cancelled, company sent 1099-R to taxpayer.◦ Court ruled that cancellation deemed distribution of CSV. Deemed distribution used to pay loan. ◦ Taxpayer has income equal to CSV-premiums paid

Robert Jay Brooks, T.C. Memo 2012-23◦ Employer loaned taxpayer $500.000 as part of

employment contract. Agreed to waive repayment of loan and interest if he worked 5 years.◦ Taxpayer reported forgiven loan as income in year 5 Tax Court states that loan might be conditional

compensation, taxable in year received.◦ Tax payer argues forgiven interest not income Court concludes forgiveness taxable.

◦ Taxpayer did not prove loan used to produce income generating a section 212 deduction.◦ Taxpayer did not show interest deductible against

investment income◦ since interest not deductible-forgiveness income

James F. Alderson CA-9◦ Taxpayer received $ 27,100,000 as relator’s share of settlement.◦ Claimed amount is capital gain.◦ Capital asset narrowly construed◦ Information not capital asset since he could not prevent others from obtaining or using it◦ Relator’s share not capital asset because he did not invest in item to obtain return. Amount received did not reflected increase in value.

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Daniel Rood T.C. Memo 2012-122◦ Divorce decree required husband to pay wife $300,000 in alimony at a rate of $5,000/mo for 60 months.◦ Alimony must terminate at death◦ Court looks at:

1.Unambigious termination provision in decree.2.Unambigious termination requirement in state law

3. Divorce decree to see if payment terminate at death

Kevin Larievy TC. Memo 2012-247◦ Taxpayer and spouse separated and orally agreed to amount of alimony payments◦ Filed for divorce in 2008 and Court entered judgment on Dec. 2008◦ Alimony payments must be based on written agreement only payment after Dec 2008 deductible.

Shannon Fernandez, 138 T.C. No.20◦ Taxpayer’s husband received disability retirement benefits. Divorce decree allocate part of benefits to taxpayer◦ Sec 104(a) applies to injured person◦ Rules under sections 402 and 414 do not apply since do not refer to section 104 ◦ Amount received taxable

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TD 9573 Sec 104(a)(2)◦ Exclusion under sec 104(a)(2) limited to physical injury or physical sickness. It does not include emotional distress even if that results in some physical sickness◦ Damages for emotional distress attributable to a physical injury or sickness excluded◦ Damage for emotional distress excluded up to amount of medical care◦ In M. Blackwood, TC Memo 2012-190 Court indicated that symptoms of depression may be severe enough to qualify as physical injury or sickness.

PMTA 2012-001◦ Sec 108(f)(4) excludes from income student loan

cancellation of healthcare provider. 2010 act expanded rules to include state program

◦ A state program that reimbursed tuition is not a student loan program and is taxable

Reg 137589-07◦ New proposed regulations expand the situations in

which local lodging is not taxable to employee.◦ Regs retain the rule that temporary lodging while

employee searches for new residence or to allow employee to work overtime taxable compensation.

Residential Interest Expense

1.Faina Bronstein 138 T.C. No.21a. Section 163(h)(3) limits qualified acquisition debt

to $ 1 million, $500,000 for filing separately.b. Fact that only one spouse claims deduction on

separate returns does not allow more than $500,000 of debt qualify

2.Charles Sophy 138 T.C. No.8 a. Unmarried taxpayers purchased a residence.b. Qualified acquisition debt limited to $ 1 million per

home not $1 million per taxpayer.

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Charitable contribution

Two current cases discuss the charitablecontribution of a home to a fire departmentto be burnt as a training exercise.1. Theodore Rolfs CA-7

a. Contribution with conditions must adjust value for conditions.

b. Fire department demanded $1,000 to defray costs. Could argue paid for demolition.

c. Can not use before and after valuationsd. No deduction-value of gift less than value of

benefit received.

2. Upon Patel 138 T.C. No. 23a. IRS argued no deduction since contribution of

partial interest.b. Court ruled under state law, house and land

single propertyc. No deduction. Did not meet rules for partial

interest contribution

Contribution of conservation easement

Huda Scheidelman CA-21. Before and after valuation method acceptable

a. No market-place sales available2. In part IRS accepted loss of value equal to 10-

15% of value of residential 10-12% commercial property

a. Therefore, 11.3% reduction reasonable3. Cash contribution to trust to accept easement

deductablea. Court ruled no quid pro quob. tax deduction disregarded

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IRA

1. Young Kim CA-7a. Taxpayer retired at age 55b. Withdrew funds before age 59 1/2c. Withdrawal subject to 10% penalty

1. Exception for retired employee does not apply since funds rolled over to IRA

2. Charles Beech TC. Summ Op 2012-74a. Taxpayer received distributions from inherited IRA b. Rolled funds into new IRAc. Court ruled distribution taxable

1.Rollover does not apply to inherited IRA.2.Substaintial compliance argument rejected.3. Direct transfer to new IRA would have been non-taxable.

Amir H. Jafarpour TC. Memo 2012-165◦ Taxpayer purchased GO Zone property in Alabama◦ Court ruled a. not entitled to special depreciation rules since not

active business.b. loss restricted by sec 469.

1.taxpayer not real estate professionala. accepted election to treat all real estate as one

property◦ Raymond Vandegrift, T.C. Memo 2012-14 Post event estimates of hours not accept under sec 469. Since real estate one business net gain from sales with

losses

Philip Driscoll CA-11◦ The exclusion under Sec 107(2) for a minister is

limited to one home◦ When using the code definition, determine that

Congress intended its use◦ Sec 7701 statement that singular includes plural

has limited applicability.

Jeffery Carter T.C. Summ Op 2012-33◦ Early distribution from retirement plan subject to

10% penalty even if result of storm qualified under federal disaster unless specifically listed in section 1400Q◦ Burden of proof applies to fact questions not law

questions

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Eugene Koprowski,138 T.C. Memo No.5◦ Res Judicata prevents relitigating a question covers

issues that could have been raised◦ Collateral Estoppel prevents relitigating an issue

previously decided in a new litigation Doesn’t appear to prevent issues not previously raised May not apply to small tax cases

◦ Sec 6012(g)(2) denies Res Judicata for innocent spouse cases if a) Issues not previously raisedb) Taxpayer did not materially participate

Joseph DeCrescenzo T.C. Memo 2012-51◦ NOL carryforward can not reduce net earnings from

self employment

Corporate Tax

Prop.Reg 141075-09◦ New rules to prevent deferral of income beyond intend of Congress◦ Limits substantial risk of forfeiture to items related to services or purpose of transfer ◦ If risk of forfeiture related to purpose of transfer consider likelihood event will occur and likelihood forfeiture will be enforced.◦ New examples illustrate effect of sec 16(b) of SEC rules

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TD 9583 Sec 267◦ For purpose of sec 267, controlled group based on 50% not 80%◦ Sec 267 (f) loss between controlled group members deferred not disallowed Loss recognized when property leaves group

◦ New rule- recognized loss to extent gain recognized by acquirer.◦ Apply Reg. Sec 1.1502-13 to reclass deferred loss as non-deductible, non-capitalizable.

DKD Enterprises CA_8◦ Tax Court ruled that DKD was engaged in a hobby when it took over the shareholders “cattery” large losses and minimum revenue does not prove “hobby” Hobby-venture lacked genuine profit motive. Taxpayer lacked subjective intention to make a profit

◦ Total expenditure treated as constructive dividend

Mulcahy, Pavritsch, Salvador & Co, CA-7◦ Excess compensation of owners of a professorial services company Original owners had separate firms that received consulting fees

◦ Independent investor test- adjust for extraneous factors◦ Consider intangible assets of PSC Client lists, etc

“That an accounting firm should so screw up it taxes is the more remarkable feature of this case”

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Ray Feldman T.C. Memo 2011-297◦ Taxpayer decided to sell corporate business.◦ Did not want asset sale followed by liquidation◦ Sold assets. Then sold stock to group who use tax-avoidance technique to eliminate asset sale gain.◦ Court ignored stock sale Treat transaction as corporate liquidation Required former shareholders to pay corporate tax under transferee liability rules

Partnership

TIFD-III-E CA-2◦ Tax shelter partnership-Castle Harbour◦ Court considered 704(e)(1) even though not family partnership◦ Concluded that Culbertson could cause different outcome from sec 704(e)(1) Totality-of-the-circumstance test

Rev. Proc 2012-17◦ Electronic K-1◦ Partner approval◦ May have to provide paper K-1

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Historic Boardwalk Hall, LLC CA-3◦ Tax Court decision reversed◦ Taxpayer ruled not a partner Potential upside and downside limited

Rev. Rul 2012-14◦ Discharge of non-recourse debt◦ Calculation of insolvency◦ Apply Rev. Rul 92-53 That cancelled N/R debt as liability to determine insolvency

GLAM 2012-001◦ Can not calculate separate basis for different interest in

disregarded entity◦ If sell part of ownership-follow Rev. Rul 99-5

Peter McLauchlan T.C. Memo 2011-289◦ Partner can deduct partnership expenses he paid if

agreement requires partners to pay and not be reimbursed.

S Corporation

Santa Clara Valley Housing Group, Inc. DC◦ Court reversed prior decision◦ The safe harbor rules under second class of stock

apply without regard to the location within the code section Option issued with exercise price at least 90% of FMV

not second class of stock

PLR 201207002◦ S Corporation had both voting and non-voting stock

outstanding◦ Redeemed income of non-voting stock◦ Transaction treated as dividend under sec 302 Cash non-taxable since less than AAA

◦ Redemption does not cause second class of stock

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Taproot Administrative Services CA-9◦ Court validated Rev. Rul 92-73 that IRAs are not eligible shareholders.

James Maguire T.C. Memo 2012-160◦ Taxpayer owned 2 S Corps ( Auto and CNAC)◦ Taxpayer’s share of Auto’s loss greater than basis◦ Tax plan CNAC had receivable from Auto Distributed receivable to taxpayer Taxpayer donated receivable to Auto

◦ Court ruled that contribution increased stock basis

Proposed Reg 134042-07 Loans to S Corp◦ Must be real debt under general rules Guarantees do not count Incorporated pocket book loans limited acceptance. Shareholder’s note not a contribution.

◦ Distribution of loan owned to Corp by S Corp treated as shareholders loan if bona fide indebtedness to shareholders.

David Watson CA-8◦ In determining reasonable compensation, reasonableness and not intent rules.