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On November 2, 2015, the Bipartisan Budget Act (“Act”) was signed into law by President Barack Obama. One of the many provisions of the Act significantly impacts: (i) the manner in which entities taxed as partnerships[1] will be audited by the Internal Revenue Service (“IRS”); and (ii) who is required to pay the tax resulting from any corresponding audit adjustments. These new rules generally are effective for tax years beginning after December 31, 2017. As discussed below, because of the nature of these rules, partnerships need to consider taking action now in anticipation of the new rules.

The Current Landscape

Colorado RiverEntities taxed as partnerships generally do not pay income tax. Rather, they compute and report their taxable income and losses on IRS Form 1065. The partnership provides each of its partners with a Schedule K-1, which allows the partners to report to the IRS their share of the partnership’s income or loss on their own tax returns and pay the corresponding tax. Upon audit, pursuant to uniform audit procedures enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), examinations of partnerships are conducted generally under one of the following scenarios:

  • For partnerships with ten (10) or fewer eligible partners,[2] examinations are conducted by a separate audit of the partnership and then an audit of each of the partners;
  • For partnerships with greater than ten (10) partners and/or partnerships with ineligible partners, examinations are conducted under uniform TEFRA audit procedures, whereby the examination, conducted at the partnership level, is binding on the taxpayers who were partners of the partnership during the year under examination; and
  • For partnerships with 100 or more partners, at the election of the partnership, examinations may be conducted under uniform “Electing Large Partnership” audit procedures, whereby the examination, conducted at the partnership level, is binding on the partners of the partnership existing at the conclusion of the audit.

Lawmakers believed a change in TEFRA audit framework was necessary for the efficient administration of Subchapter K of the Code. If a C corporation is audited, the IRS can assess an additional tax owing against a single taxpayer—the very taxpayer under examination—the C corporation. In the partnership space, however, despite the possible application of the uniform audit procedures, the IRS is required to examine the partnership and then assess and collect tax from multiple taxpayers (i.e., the partners of the partnership). In fact, the Government Accountability Office (the “GAO”) reported in 2014 that, for tax year 2012, less than one percent (1%) of partnerships with more than $100 million in assets were audited. Whereas, for the same tax year, more than twenty-seven percent (27%) of similarly-sized corporations were audited. The GAO concluded the vast disparity is directly related to the increased administrative burden placed on the IRS under the existing partnership examination rules.

DiplomaEarlier this week, United States Tax Court Judge Richard T. Morrison ruled, in the case of Emmanuel A. Santos v. Commissioner, T.C. Memo 2016-100 (May 17, 2016), that the government will not pay the cost of a taxpayer obtaining a law degree.

Case Background

This is a pro se case. While the record was not very clear, the taxpayer, Emmanuel A. Santos, claimed he earned a degree in accounting from Indiana University in 1988. Thereafter, he began a career as a tax return preparer. In 1996, he obtained a master’s degree in taxation. Eventually, Mr. Santos expanded his tax return preparer practice to include accounting and financial planning services.

Mr. Santos attended a law school in California, graduating in 2011. He was admitted to the California Bar Association and the United States Tax Court in 2014. In 2015, Mr. Santos and his father started Santos & Santos Law Offices LLP, a law firm offering attorney, tax planning, accounting and financial planning services.

On his 2010 federal income tax return, Mr. Santos deducted, in addition to various expenses, including laundry costs, $20,275 for law school tuition and fees. On audit, many of these deductions were denied.

After likely losing at the IRS Office of Appeals, Mr. Santos headed to the United States Tax Court. The sole issue in dispute was whether the deduction of $20,275 for law school tuition and fees was allowable under Code § 162 as an ordinary and necessary business expense.

When Educational Expenses Are Considered Deductible (and When They Are Nondeductible)

Treas. Reg. § 1.162-5(a) is clear—educational expenses that either: (i) maintain or improve skills required by the taxpayer in his or her current employment; or (ii) are required by the taxpayer’s employer (or applicable law) as a condition to continued employment or rate of compensation, are deductible. On the other hand, certain types of educational expenses are expressly nondeductible, including expenses for education that qualify the taxpayer for a new trade or business. Treas. Reg. § 1.162-5(b)(1) provides examples of these nondeductible educational expenses. One of the examples set forth in the regulations specifically references a taxpayer practicing accounting who pursues a law degree. The costs of attending law school are nondeductible because the course of study qualifies the taxpayer for a new trade or business. The law degree is not required to continue practicing accounting.

Previous Tax Court Holdings

Judge Morrison cited numerous cases where the courts have held, consistent with the Treasury Regulations, a law degree qualifies a taxpayer for a new trade or business, and thus the cost of the degree is a nondeductible educational expense. This is true, even if the degree improves the taxpayer’s accounting and tax skills, and the taxpayer remains practicing accounting (i.e., never practices law). See e.g., Taubman v. Commissioner, 60 T.C. 814 (1973).

Despite the clear language of the Treasury Regulations and the numerous cases supporting the government’s position, Mr. Santos brought his case to the United States Tax Court. He appears to have argued that the holdings in the cases where the court relied upon the Treasury Regulations are incorrect because the regulations are invalid. Mr. Santos’s argument, at first blush, appeared intriguing to me. By gosh, I recently won an Oregon Tax Court case invalidating a long-existing administrative rule (which is akin to Treasury Regulations).

Shortly after Treasury promulgated Treasury Regulation § 1.162-5, the United States Tax Court ruled that it was valid. The Ninth Circuit Court of Appeals affirmed the tax court’s conclusion. See Weiszmann v. Commissioner, 52 T.C. 1106 (1969), aff’d 443 F.2d 29 (9th Cir. 1971).

Giving It the Old College Try 

Mr. Santos argued that the court in Weiszmann employed the wrong standard to examine the validity of the regulation at issue. Unfortunately for him, the tax court quickly dismissed the argument without much discussion. Then, Mr. Santos asserted that Treasury failed to adequately respond to public comments before finalizing the regulations at issue, thus making the regulations invalid. Unfortunately, Mr. Santos did not raise that issue until after the trial had concluded. Consequently, the trial court record contained no evidence upon which the tax court could even evaluate his assertion. While his argument was creative and certainly intriguing, it never gained any traction. If he had offered evidence on the issue at trial, the tax court’s opinion would have been a much more interesting read. Who knows if any evidence exists to support his assertion of invalidity – Mr. Santos lost!

Lesson Learned

The clear take-away from this case is that: educational expenses are generally only deductible if they are incurred to maintain or improve the skills required for current employment or to retain current employment or current compensation. The costs of education required to prepare for a new trade or business are generally nondeductible.

The outcome of these cases is generally dependent upon the facts and circumstances. For example, if Mr. Santos had been a practicing tax lawyer (i.e., had already obtained his J.D. degree, had already passed the bar examination and was practicing as a tax lawyer), the costs of obtaining his LL.M. (taxation) may have been deductible.

Many nuances exist in this area of tax law. Consequently, careful analysis is required.

In general, the Oregon income tax laws are based on the federal income tax laws. In other words, Oregon is generally tied to the Internal Revenue Code for purposes of income taxation. As a consequence, we generally look to the federal definition of taxable income as a precursor for purposes of determining Oregon taxable income.

What does this mean to taxpayers in the trade or business of selling recreational or medical marijuana in Oregon?

Currently, it appears these taxpayers are stuck with the federal tax laws. Consequently, unless the Oregon legislature statutorily disconnects from IRC § 280E, for Oregon income tax purposes, all deductions relating to the trade or business of selling medical or recreational marijuana will be disallowed.

I suspect the result of IRC § 280E and its impact on Oregon income taxation will be that many taxpayers in this industry will go to lengthy efforts to capitalize expenses and add them to the cost of goods sold. Caution is advised. The taxing authorities will likely closely scrutinize this issue.

In addition to income taxes, retail marijuana sales in Oregon are subject to a sales tax. This is a tax that is paid by the customer, and collected and paid over to the taxing authorities by the retailer. Interestingly, the sales tax regime has been strenuously resisted by Oregon taxpayers for decades. The Oregon Legislature, however, passed HB 2041, introducing a state sales tax of 17% (with the possible add-on of up to 3% by local governments) on the retail sales of marijuana. Governor Kate Brown signed the bill into law on October 5, 2015. As a consequence, taking into consideration both income taxes and sales taxes, the marijuana industry and its customers may become a big contributor to the state’s tax revenues. I am not sure I could have ever predicted the current state of affairs.

As a general rule, in accordance with IRC § 162(a), taxpayers are allowed to deduct, for federal income tax purposes, all of the ordinary and necessary expenses they paid or incurred during the taxable year in carrying on a trade or business.  There are, however, numerous exceptions to this general rule.  One exception is found in IRC § 280E.  It provides:

“No deduction or credit shall be allowed for any payment paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any state in which such trade or business is conducted.”

Marijuana-plant-300x200Congress enacted IRC § 280E as part of the Tax Equity and Fiscal Responsibility Act of 1982, in part, to support the government’s campaign to curb illegal drug trafficking.  Even though several states have now legalized medical and/or recreational marijuana, IRC § 280E may come into play.  The sale or distribution of marijuana is still a crime under federal law.  The impact of IRC § 280E is to limit the taxpayer’s business deductions to the cost of goods sold.

On October 22, 2015, the U.S. Tax Court issued its opinion in Canna Care, Inc. v. Commissioner, T.C. Memo 2015-206.  In that case, Judge Haines was presented with a California taxpayer that is in the business of selling medical marijuana, an activity that is legal under California law.

The facts of this case are interesting.  Bryan and Lanette Davies, facing significant financial setbacks and hefty educational costs for their six (6) children, turned to faith for a solution.  After “much prayer,” Mr. Davies concluded that God wanted him to start a medical marijuana business.  Unfortunately, it does not appear that he consulted with God or a qualified tax advisor about the tax implications of this new business before he and his wife embarked upon the activity.

The good news for the Davies is that their business blossomed.  In fact, they employ ten (10) people in the business and have enjoyed financial success.  They timely filed state and federal income tax returns, reported income and paid, what they believed, was the proper amount of taxes.  The bad news for the Davies is the fact that the IRS did not agree with their computation of the tax liability.

The IRS issued a notice of deficiency.  Not able to resolve the matter at IRS appeals, the Davies found themselves in the U.S. Tax Court.  The sole issue in the case was whether the taxpayers’ business deductions were properly disallowed by the Service under IRC § 280E.

To no avail, the Davies presented numerous arguments as to why marijuana should no longer be a controlled schedule I substance.  They also asserted that their new business created employment opportunities for others, cured their family’s financial woes, and allowed them to participate in civic and charitable activities.

Judge Haines quickly dismissed the Davies’ arguments, concluding the sale of marijuana is prohibited under federal law—marijuana is a schedule I controlled substance.  Accordingly, IRC § 280E prevents taxpayers from deducting the expenses incurred in connection with such activity (other than the cost of goods sold).

Faced with a tax assessment exceeding $800,000, the Davies argued that their business does more than sell marijuana.  In fact, it sells books, shirts and other items related to medical marijuana.  Citing other cases, they argued that their expenses should be apportioned among the various activities (i.e., the sale of medical marijuana and the sale of other items), and that they should be able to deduct the expenses related to the sale of the non-marijuana items.

The court explained that, where a taxpayer is involved in more than one distinct trade or business, it may be able to apportion its ordinary, necessary and reasonable expenses among the different trades or businesses.  Unfortunately for the Davies, they could not show that they operated two (2) or more trades or businesses.  In this case, the facts indicated that the sale of shirts, books and other items was merely incidental to the sale of medical marijuana.  There was not more than one (1) trade or business.

PRACTICE ALERT:  Whether more than one (1) trade or business exists is a question of facts and circumstances.  Under CHAMP v. Commissioner, 128 T.C. 182 (2007), if a taxpayer operates more than one (1) distinct trade or business, it may be allowed to apportion its expenses among the trades or businesses.  If only one (1) of the businesses is impacted by IRC § 280E, only the expenses relating thereto should be denied.  The key is establishing that more than one (1) trade or business exists, and reasonably be able to apportion the expenses among those trades or businesses.  Keeping separate books and records, and accounting for business expenses in a separate manner, is likely the best approach.  The more separation and distinction among the businesses the better the chances of showing more than one (1) trade or business exists.  Maintaining separate entities or business names for each activity may be warranted.

The Davies lost the case and are now faced with a hefty tax bill.  Unless IRC § 280E is amended, taxpayers involved in the sale of medical and/or recreational marijuana, despite state legalization, will be presented with the same dilemma faced by the Davies in Canna Care, Inc. v. Commissioner.

iStock_000001776980_LargeBackground

Actual or constructive receipt of the exchange funds during a deferred exchange under IRC Section 1031 totally kills an exchange and any tax deferral opportunity.  Treasury Regulation Section 1031(k)-1(f)(1) tells us that actual or constructive receipt of the exchange proceeds or other property (non-like-kind property) before receiving the like-kind replacement property causes the exchange to be treated as a taxable sale or exchange.  This is the case even if the taxpayer later receives the like-kind replacement property. In accordance with Treasury Regulation 1.1031(k)-1(f)(2), a taxpayer is in constructive receipt of money or property if it is credited to his, her or its account; set apart for the taxpayer’s use; or otherwise made available to the taxpayer.

The treasury regulations specifically tell us that security (such as a third party guarantee, letter of credit or mortgage) put in place to ensure a transferee (including the Qualified Intermediary) actually transfers the replacement property to the taxpayer does not constitute actual or constructive receipt of the exchange funds.

Last, where the exchange funds are held in a “qualified escrow account,” no actual or constructive receipt exists by the mere fact that the escrow holds the funds.  A qualified escrow account exists if two criteria are met:

Requirement #1: The Escrow may not be established so that the holder of the funds is the taxpayer or a “disqualified person.”

Under Treasury Regulation Section 1.1031(k)-1(k), a disqualified person is:

  • Any person or firm that acted as the taxpayer’s employee, attorney, accountant, investment  banker or business broker, or real estate agent within two (2) years prior to the transfer of the relinquished property (or when there are multiple relinquished properties, the time period starts at the transfer of the earliest relinquished property).  For this purpose, some services are ignored such as services routinely provided by title insurance companies, escrow companies, and financial institutions.

  • The attribution rules of IRC Sections 267(b) and 707(b) come into play, but we have to substitute 10% for 50% in applying these rules.  So, for example, related persons include: the taxpayer’s spouse, siblings, ancestors, and lineal descendants; a corporation or a partnership owned more than 10% by the taxpayer or a related person; or a trust in which the taxpayer or a related person is a beneficiary or the fiduciary.

Requirement #2: The terms of the escrow must expressly provide that the taxpayer’s rights to the funds are limited.

The taxpayer cannot be allowed to receive, pledge, borrow against or otherwise obtain the benefits of the funds until after the exchange period expires, until after the 45 day identification period where the taxpayer failed the exchange by not identifying any replacement property, or after the time when the taxpayer has received all of the property identified within the 45 day identification period.

Chief Counsel Advice 201320511

Chief Counsel Advice 201320511 raises a not so obvious issue in the area of constructive receipt of exchange funds.  An issue that likely occurs often.

In the CCA, Chief Counsel was presented with a taxpayer that was in the equipment rental business.  It regularly engaged in Code Section 1031 deferred exchanges to dispose of its rental equipment and to obtain new rental equipment in a tax deferred environment.  Machinery and equipment rental businesses, rental car businesses, trucking companies and airlines likely find themselves in this same predicament.

The taxpayer maintained various lines of credit that it used to assist in funding operations during parts of the year and to acquire new rental equipment.   The lines of credit, as you may suspect, were secured by the equipment.

Under the exchange agreement, the two specific requirements of a qualified escrow were met, but the Qualified Intermediary was required to pay down the lines of credit with the exchange proceeds and then (through the taxpayer) use the same lines of credit to fund the purchase of the replacement property.  Again, one would assume this often occurs in personal property exchanges by taxpayers in related or similar businesses.

The specific issue presented to Chief Counsel was whether the use of the exchange proceeds to pay down the taxpayer’s debt (which may or may not have been directly related to the relinquished property) constituted constructive receipt by the taxpayer of the exchange funds, thereby killing the taxpayer’s opportunity to obtain tax deferral.  The taxpayer was getting the benefit of the exchange funds during the time the deferred exchange was ongoing.

Chief Counsel, citing the boot netting rules, concluded in favor of the taxpayer and held no actual or constructive receipt existed.  The new debt secured by the replacement property equaled or exceeded the debt secured by the relinquished property which was paid off in the exchange.

Put this Chief Counsel Advice in your bag of tricks.  The issue may come up when taxpayers undertake personal or real property exchanges where a line of credit serves as security.

 

Under Code Section 1031(a), the relinquished property must have been held by the taxpayer for productive use in a trade or business, or held for investment.  Likewise, the replacement property, at the time of the exchange, must be intended to be held by the taxpayer for productive use in a trade or business, or for investment.

As you know, it is ok to exchange trade or business property for investment property, and vice versa.  At least two (2) recent tax court cases look at this issue.

Adams v. Commissioner, TC Memo 2013-7 illustrates a common issue in the Code Section 1031 environment -- whether the taxpayer intended to hold the replacement property for use in a trade or business, or for investment purposes.

The facts of the case are fairly straightforward.  The taxpayer exchanged an investment property in San Francisco for a rental home in Eureka that required loads of work.  By mere coincidence, the taxpayer’s son lived in Eureka.  The taxpayer even told the IRS that he acquired the rental home in Eureka because it was large enough to accommodate his son’s large family.  By further coincidence, the son had vast experience renovating homes.

Post-exchange, the son and his family put in about sixty (60) hours per week, working on the renovation of the home.  The son and his family eventually moved into the father’s replacement property.  They did pay rent, but it was below the market.  The Service asserted that the below-market rent equated with the taxpayer using the property as personal use property.  The taxpayer argued that, while the rent payment alone was below market, when you add in the value of the services that the son and his family performed on the property, it equated to market rent.  Also, the taxpayer asserted, if the rental payments and services together did not equate to fair rent, the difference was a gift from him to his son.

The tax court properly focused on the taxpayer’s intent at the time of the exchange.  It concluded that the taxpayer did not intend to charge below market rent.  Rather, he reduced the rent to take into consideration all of the renovation work being performed by the tenant.  Evidence supported the conclusion that the actual rent paid and the renovation work performed by the son and his family on the property together equated to fair rental value.  If this had not been the case, the exchange would have failed.  The son’s use of the property for less than market rent would have likely rendered the taxpayer’s holding of the replacement property as personal use.

Mr. Adams clearly won the battle, but he may have lost the war.  The value of the renovation services should have been reported by the taxpayer as rental income on Schedule E of his income tax return.  Mr. Adams received renovation services in consideration of the son being able to reside in the home at less than fair market rent.  Under Code Section 61, the fair value of the renovation services should be taxable income to Mr. Adams.  Also, the value of the improvements, to the extent they do not constitute repairs, should be added to basis, capitalized and depreciated over 27 ½ years under Code Section 168(c).

Yates v. Commissioner, TC Memo 2013-28 is another recent tax court case dealing with the “held for productive use in a trade or business, or investment” standard.  In that case, the taxpayers, husband and wife, exchanged a rental home for a property which, at least they said, they intended to use as a bed and breakfast.  Unfortunately, the facts were not consistent with that intent.

Rather than apply for permits to use the property as a bed and breakfast, as the purchase agreement expressly stated would be done by the taxpayers, the Yates simply moved into the home a few days post-closing and lived there happily ever after, or at least until they received a notice of audit from the IRS.

The IRS quickly challenged the validity of the exchange on the ground that the replacement property was acquired for personal use.  In other words, the Service asserted that the taxpayers had no intent at the time of the exchange, evidenced by the facts and circumstances, to use the replacement property for trade or business, or investment purposes.

The proper focus is on the taxpayer’s intent at the time of the exchange.  At least two facts show that the taxpayers’ intent at the time of the exchange was to use the replacement property for personal use rather than for use in a trade or business or for investment purposes:

  • #1:  The taxpayers never did anything to obtain permits to use the property as a bed and breakfast.  In fact, no efforts to use the property as a bed and breakfast were evident.  They simply moved into the property shortly after closing.  The taxpayers never advertised the property as a bed and breakfast.  No evidence that the taxpayers ever attempted to rent the property to others existed.  In fact, they never actually rented it to others.
  • #2:  The taxpayers moved into the home a mere four (4) days after closing.  There was no intervening time or intervening facts to change their intent post-exchange.

The Yates lost!  At the time of the exchange, the taxpayer must intend to hold the replacement property post-exchange for either use in a trade or business, or for investment.  The burden of proof is on the taxpayer.  It is that simple.

iStock Beach with coconutIn 2009, the Service introduced its first Offshore Voluntary Disclosure Program (“OVDP”). As a result of this program, more than 50,000 taxpayers have come forward and disclosed offshore financial accounts. In a news release issued by the IRS on January 28, 2015 (IR-2015-09), it reported that the government has collected over $7 billion from this initiative. In addition, as we know from the Zwerner case (reported in my blog on June 16, 2014), the Service has conducted thousands of civil audits relating to offshore financial accounts, resulting in the collection of taxes and penalties in the “tens of millions of dollars.” Last, the IRS has not been shy about pursuing criminal charges against taxpayers who fail to disclose their offshore financial accounts. In fact, the IRS reports that it has collected “billions of dollars in criminal fines and restitutions” since the introduction of the OVDP.

One may wonder whether the government’s offshore compliance enforcement activity will slow down as a result of the recent slashing of the Service’s budget. Reading the statements made by the IRS in the January 28, 2015 news release, the answer appears to be no. In fact, the announcement proclaims:

The IRS remains committed to our priority efforts to stop offshore tax evasion wherever it occurs. Even though the IRS has faced several years of budget reductions, the IRS continues to pursue cases in all parts of the world, regardless of whether the person hiding money overseas chooses a bank with no offices on U.S. soil.

IRS Commissioner John Koskinen recently stated that: “Taxpayers are best served by coming in voluntarily and getting their taxes and filing requirements in order.” Consequently, the Service announced that the OVDP “will be open for an indefinite period until otherwise announced (emphasis added).” While the OVDP may be a good means for taxpayers to get their houses in order, tax practitioners need to fully inform their clients about the program and its impact on their situation before placing them into the program, including:

  1. The reporting rules and the cost of compliance. Even under the OVDP, taxpayers routinely feel they are being overcharged/penalized by the government for doing nothing wrong. Clients need to be fully informed of the rules relating to foreign financial accounts and the costs of noncompliance.
  2. OVDP flaws. The OVDP is not without flaws. Its rules are not perfect. In fact, in many instances, the rules are unclear and/or incomplete, and application is blemished with subjectivity, potentially leading to unexpected results. Caution is advised!
  3. Penalties. If a taxpayer’s disclosure is incomplete or inaccurate, the taxpayer may be faced with hefty civil and/or criminal penalties.
  4. Closure Time. The OVDP, especially given continued IRS budget cuts, can be a lengthy process. From the time a complete submission is filed with the IRS, it can take months to close the matter. This can be unnerving to taxpayers, especially in light of the huge civil and/or criminal penalties that can result from noncompliance.

There are at least four (4) takeaways from IR-2015-09:

  1. The IRS, despite huge budget cuts, intends to remain focused on offshore financial accounts.
  2. The OVDP appears to be here to stay (or at least until the Service announces otherwise).
  3. The OVDP does not generate prompt results. Patience is required.
  4. While the OVDP may be a good mechanism to resolve offshore financial account noncompliance, it is not without flaws. Tax practitioners need to adequately advise clients about the program and the applicable law so that they are fully informed before submitting an OVDP application.

Continuation of the OVDP is generally good news for taxpayers. As stated, however, it is not the most taxpayer friendly voluntary tax compliance program. Consequently, tax practitioners need to: have a good understanding of the OVDP and the applicable law; they need to fully advise clients of their compliance obligations, including the costs and risks of noncompliance; and they need to fully inform clients about the OVDP, including the timing, risks, and liability, before making a submission to the program.

President Obama’s 2016 budget proposal includes provisions which, in the aggregate, increase income tax revenues by approximately $650 billion over 10 years.  At least three of the proposed tax increases will be of concern to a broad spectrum of taxpayers:

1.  President Obama proposes to increase both capital gains and dividend tax rates to 28%.  This rate hike will apply to many taxpayers.  It represents an increase of approximately 40% over the previous rate of 20% that came into play in 2013, and an increase of approximately 87% over the previous rate of 15% that we enjoyed from 2003 to 2013.

2.  President Obama proposes to abolish a taxpayer’s ability to obtain a basis step-up upon receipt of an asset from a bequest.  Also, he proposes that bequests and gifts be treated as realization events, triggering a capital gains tax.  His proposal also provides that decedents would be allowed a $200,000 per couple ($100,000 per individual) exclusion for capital gains.  There would be a separate exclusion of $500,000 per couple ($250,000 per individual) for personal residences.  The President proposes to exclude tangible personal property and family-owned and operated businesses from this tax change.

3.  President Obama proposes to return the estate tax rules to the 2009 laws.  This would result in the unified credit being reduced from the current $5.43 million level (indexed for inflation) to a $3.5 million level (without an inflation index).

These three changes to the income tax code alone would raise $208 billion over 10 years.  Time will tell whether lawmakers will enact this part of the President’s budget proposal.  While these provisions will certainly raise tax revenues, they appear to be counter to the administration’s goal of creating a “simpler, fairer and more efficient tax system.”  If these proposals are pushed forward, the President’s budget proposal will likely face significant turbulence.

Thomas v. Commissioner, TC Memo 2013-60 (February 26, 2013)

The saga of Michael and Julie Thomas started in the early part of this decade.  Michael was the head of real estate acquisition for DBSI in Idaho.  There, he met fellow DBSI employee Don Steeves, who was a CPA with seven (7) years of experience, primarily working in the real estate investment industry.  When Michael started two real estate businesses, TIC Capital ("TIC") and TICC Property Management ("TICC"), he hired Steeves as an independent contractor to serve as CFO of TIC and as the managing partner of TICC.  His compensation was incentive based—he received compensation which was based on the financial success of the two businesses.  In good years, Steeves’ compensation was off the charts.  In addition to acting as CFO for the two businesses, Steeves prepared Michael’s and Julie’s income tax returns.  They relied upon him to oversee all aspects of accounting and tax compliance for both of the businesses and their personal affairs.  They let him take total control of these functions.

TIC acquired real estate and then broke it into tenancy-in-common interests, and sold the interests to passive investors who were generally acquiring property through Section 1031 exchanges.  In most cases, the acquisition and resale of the tenancy-in-common interests occurred simultaneously.  After the properties were sold, TICC would manage the properties for the tenancy-in-common owners for a fee.

While the economy and the real estate markets were hot, both of the companies made significant profits.  As we all know, the booming economy and real estate markets did not last forever.

In September 2007, Steeves resigned from the two businesses, but continued to perform bookkeeping work for both of the businesses, as well as for Michael and Julie, until about March 2008.  He continued to prepare the Thomas’s tax returns until about 2009.

In late 2008, the IRS entered the picture.  It audited the Thomas’s 2006 and 2007 income tax returns.  Guess who appeared on IRS Form 2848 (Power of Attorney and Declaration of Representative) for the Thomas’s?  You guessed correctly – CPA Don Steeves!

The IRS quickly learned the tax returns did not comport to the Thomas’s business records.  Upon learning this, Mr. Thomas demanded CPA Steeves produce accounting records to support the entries he placed on their tax returns.  Apparently, CPA Steeves did not comply with the Service’s request.

Mr. Thomas hired a CPA named Dave Stewart to take over the audit.  Mr. Stewart, who had thirty-four (34) years of experience, quickly learned that CPA Steeves did a very poor job of maintaining the accounting records for Michael and Julie and likely misappropriated funds.  He worked with the auditor and they ultimately agreed to a tax deficiency for both years under review.

Michael and Julie eventually turned the matter over to the Boise Police Department; they alleged CPA Steeves had committed theft, fraud, and misappropriation of their funds.  Also, they sued Don Steeves in a civil suit for more than $1.2 million.

This case focused on the applicability of the Code Section 6662 accuracy-related penalty.

Under Code Section 6662(a), a taxpayer is liable for a 20% penalty on any under-payment of tax attributable to:

  1. negligence; or
  2. disregard of rules or regulations; or
  3. a substantial underpayment of a tax.  For this purpose, a substantial underpayment of tax is an underpayment which is more than the greater of:  10% of the tax required to be shown; or $5,000.

There is a major exception to the application of this penalty.  The penalty does not apply to any portion of an underpayment of tax if it is shown the underpayment was due to reasonable cause and the taxpayer acted in good faith.

In this case, Michael and Julie Thomas alleged they relied upon Don Steeves, an experienced tax advisor.  They turned all accounting and tax matters over to him.  Accordingly, they argued that they acted with reasonable cause and in good faith.  They had no reason to believe that Mr. Steeves was other than competent and honest.

Reliance on the advice of a tax professional may establish reasonable cause and good faith. In accordance with Treasury Regulation Section 1.6664-4(b)(1), if a taxpayer relies upon the professional judgment of a competent tax advisor who has been provided all of the necessary and relevant information, the taxpayer will generally be cleared of an accuracy-related penalty.

To prove “reasonable reliance,” the taxpayer must jump over three hurdles:

Hurdle #1:  The tax advisor must have sufficient experience or expertise to justify reliance;

Hurdle #2:  The taxpayer must have provided the advisor with the necessary and accurate information; and

Hurdle #3:  The taxpayer must have relied in good faith on the tax advisor’s guidance.

Here, Don Steeves was a CPA; he had 7 years of experience in the real estate industry.  Mr. Thomas knew CPA Steeves from his work with DBSI.  According to testimony at trial, Mr. Thomas provided Mr. Steeves with all documents and information he requested, including mortgage and interest records.

So, the court concluded Hurdle #1 and Hurdle #2 were met.  Steeves had sufficient experience and expertise.  Also, the taxpayers provided him with all of the information required to accurately prepare the tax returns.  The ultimate question came down to whether the Thomas’s reliance upon CPA Steeves was in good faith.

In this case, Michael and Julie Thomas gave CPA Steeves their power of attorney at the outset of the audit.  It was not until the IRS uncovered the numerous return problems that Mr. Thomas terminated Mr. Steeves, instituted a civil lawsuit against him, and went to the police so criminal action could be pursued.  Before that, Michael and Julie believed in Don Steeves and they relied upon him.

Judge Gerber of the US Tax Court concluded that Michael and Julie Thomas met their burden and showed they had acted in good faith and with reasonable reliance on the advice of a professional tax advisor.  Consequently, the Code Section 6662 penalty was tossed out.

This is a textbook case for applying the reasonable reliance defense to a Code Section 6662 penalty.  The Tax Court clearly and thoughtfully reviewed the elements of the reliance defense.  So, this decision should serve as a good textbook reference if you come across a case where the defense may be viable.  The take-away is simple:  The accuracy-related penalty does not apply to any portion of an underpayment of tax where the taxpayer acted with reasonable cause and in good faith.   A reasonable cause determination takes into account all of the relevant facts and circumstances.   The taxpayer claiming reliance on a tax professional must prove that:

  1. The tax adviser was a competent professional who had sufficient expertise to justify reliance;
  2. The taxpayer provided necessary and accurate information to the tax adviser; and
  3. The taxpayer actually relied in good faith on the tax adviser’s judgment.

Barnes v. Commissioner, 712 F.3d 581 (D.C. Cir. 2013) aff’g T.C.M. 2012-80 (2012) is illustrative of the point that understanding the basis adjustment rules is vital.

If this case was made into a movie, the name of the movie would tell the entire story – S corporation shareholders are not allowed to just make up the basis adjustment rules!  Also, as I have repeatedly stated, poor records lead to disastrous results.  The DC Circuit affirmed the US Tax Court in April of 2013 to finally put an end to the case.

Marc and Anne Barnes, husband and wife, are entrepreneurs.  They were engaged in several businesses, including restaurants, nightclubs and entertainment promotion.  These businesses were operated through a sole proprietorship and several entities they owned 100% of, including two S corporations and a C corporation.

The tax returns at issue were the 2003 returns.  One of the Barnes’ S corporations was Whitney Restaurants, Inc. which operated a Washington DC restaurant and nightclub called Republic Gardens (Whitney has since sold Republic Gardens).  Upon audit of the Barnes’ 2003 tax return, the Service pulled in the 1120S of Whitney Restaurants.

In addition to some smaller items, the Service disallowed a $123,006 loss stemming from Whitney on the ground the Barnes’ had insufficient basis to take the losses.  In addition, the Service assessed an IRC Section 6662 accuracy related penalty and an IRC Section 6651 late filing penalty.

The Barnes’ contested the assessment, including the penalties, and filed a petition in the US Tax Court.  Prior to the court’s ruling, however, they conceded liability for the late filing penalty.  The return was eight months late.  So, the Court was left to decide whether the assessment of taxes and the accuracy related penalty were appropriate.

The facts are a little convoluted.  In 1995, the Barnes’ had a $22,282 loss from Whitney, suspended due to lack of basis.  On their 1996 joint return, they reported the $22,282 loss even though their 1996 K-1 showed an additional $136,229 loss for the tax year.  In 1997, they contributed $278,000 in capital to Whitney, enabling them to finally take the suspended losses from 1995 and 1996, which totaled $158,511, but in fact they only deducted the current 1997 loss of $52,594 on the 1997 return.  USER ERROR!

To follow the story, we must fast forward to 2003.  The taxpayers awake from the sleep they were in and with the help of a new accountant, they determine they should have deducted the losses on the 1997 return.   Guess what; that year is closed.  Ouch!

Sounds bad; but, the Barnes’ find a way to relieve some of the pain.  They claim, since they did not use the basis for the losses from 1995 and 1996, they can take a deduction for the losses resulting from the current year on the current return – tax year 2003 -- using the unused basis from 1997.  They make three arguments in favor of this position:

First, they argue IRC Section 1367(a)(2)(B) only requires you to reduce basis for losses you actually report on your return.  So, since they did not take the losses on the 1997 return, there should be no reduction in basis.  WRONG!

IRC Section 1367(a)(2)(B) requires an S corporation shareholder to reduce stock basis by any losses that a shareholder should have taken into account under IRC Section 1366(a)(1)(A), even if the shareholder did not actually claim the benefit of the pass-through of the losses on his/her return.

Next, the Barnes’ argued the tax benefit rule allowed them to claim a deduction in 2003 for the loss they should have deducted in 1997.  WRONG AGAIN!

The tax benefit rule generally only applies when taxpayers recover amounts they deducted in a prior year.  When that situation arises, the taxpayer may exclude the recovered income to the extent the prior deduction did not give rise to a tax benefit.  The tax benefit was inapplicable in the Barnes case.

Last, the Barnes argued that their failure to properly deduct the losses in 1997 caused them to compute an incorrect amount of losses that could be used to offset income in 2003.  I do not understand the argument.  It makes no sense.  Guess what, the Tax Court did not understand it either.  The Barnes’ lose the battle!

The Barnes’ do not go down for the count.  Instead, they turn on their CPA and claim they relied upon professional advice.  So, no penalties for accuracy or negligence are appropriate.  Unfortunately, the court concluded they did not provide evidence to show they acted in good faith in relying upon professional advice. In fact, the evidence showed the accounting firm’s advice was limited by the Barnes’ inadequate accounting records and erroneous basis information from prior years in which it did not represent the taxpayers.

The result is simple:  The Barnes’ were stuck with the tax and penalty assessment and a boat load of interest as the case muddled through the IRS and the court system for over nine years.

There are two pearls of wisdom to take away from the case:

  1. You reduce stock basis by the losses allowable under IRC Section 1366 even if you fail to report the losses on your return; and
  2. If a taxpayer does not provide you with adequate records, they will not likely prevail in a dispute over negligence or accuracy related penalties.

CPAs and other tax advisors need to be careful.  You want to resist the temptation to represent or continue to represent clients that do not maintain adequate records.

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Larry Brant
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Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.

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