Please join me on June 29, 2017 in Portland, Oregon, for what will be a dynamic presentation on the new partnership audit rules by Jerald August. Jerry is a Partner in the preeminent New York City-based boutique tax firm Kostelanetz & Fink, LLP. He has served as a chair of NYU's Institute on Federal Taxation for a number of years and specializes in federal and state income taxation, including taxation of pass-thru entities and tax controversy. Jerry is not only one of the brightest tax lawyers you will ever meet, he is an outstanding speaker. We are very fortunate to have him present at the Portland Tax Forum on this important topic. We all need to learn about the new partnership audit rules – they come into play on January 1, 2018.
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.”
Congress 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.
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.
On February 2, 2015, President Obama published his 2016 budget proposal. It proclaims that “[a] simpler, fairer, and more efficient tax system is critical to achieving many of the President’s fiscal and economic goals.” While some tax practitioners may debate the claim that the tax provisions embedded in the President’s budget proposal make the tax system simpler, it is a certainty that a significant number of tax practitioners will question the fairness of these provisions.
As in the past, the President’s budget proposes that “wealthy millionaires” pay no less than 30% of their income in federal income taxes. To facilitate accomplishing that goal, President Obama suggests these taxpayers be prevented from making charitable contributions to reduce their tax liability. He states: “…this proposal will act as a backstop to prevent high-income households from using tax preferences to reduce their total tax bills to less than what many middle class families pay.”
This provision of the budget proposal will definitely not receive broad support from the charitable organization community. Taking away the tax deduction resulting from charitable contributions certainly does not motivate taxpayers to transfer their wealth to charities.
Whether a charitable contribution deduction is a tax preference item is open to debate. A charitable contribution certainly does not seem to be “a tax preference” item. All taxpayers generally benefit in the same manner by this deduction. Shouldn’t taxpayers receive a tax deduction for wealth transfers to charities? Don’t we want to incentivize taxpayers to fund charitable needs through contributions? Eliminating this deduction for certain taxpayers may generate billions of dollars of tax revenues, but it will definitely impair charitable organizations from obtaining much needed funding. For this reason alone, hopefully lawmakers will resist removing the charitable contribution deduction from the tax code.
Contributions To College Athletic Programs
College sports fans—whether you are wealthy or not—buried in the President’s budget proposal is a provision that eliminates the deductibility of the charitable contribution you are required to make as a pre-requisite to purchasing tickets for college sporting events. Most colleges will not be pleased with this proposal! While President Obama has talked about this type of tax reform in the past, this is the first time we have seen it in one of his budget proposals. The provision, if enacted into law, is estimated to generate over $2.546 billion in tax revenues during the period of 2016-2025. Like the elimination of the charitable deduction for “wealthy” taxpayers, this provision will result in charities being the biggest losers.
Stay tuned! Time will tell whether lawmakers will adopt these proposals.
The Extender’s Bill impacts Subchapter S in at least two respects. It amends IRC Section 1374(d)(7) and IRC Section 1367(a)(2). Both of these amendments are temporary. Unless extended, they only live until the end of this year. Yes, they only apply to tax years beginning in 2014.
I. IRC Section 1374(d)(7).
In the last five (5) years, we have seen at least three temporary amendments to the built in gains tax recognition period.
- The first amendment is found in Section 1251 of the American Recovery and Reinvestment Tax Act of 2009. This provision shortened the ten (10) year recognition period for tax years 2009 and 2010 to seven (7) years.
- The second amendment is found in Section 2014 of the Small Business Jobs Act of 2010. This provision extended the built in gains tax relief to 2011 and further shortened the recognition period to five (5) years. For tax year 2012, it appeared we would be back to the old ten (10) year recognition period.
- With the passage of the Taxpayer Relief Act of 2012, however, a third amendment to Code Section 1374 was given life. As a result, the five (5) year recognition period was extended to the end of last year.
Unfortunately, it looked like we were back to the ten (10) year built in gains tax recognition period. Lawmakers saved the day one more time, at least temporarily, when both the Senate and the House passed the 2014 Tax Increase Prevention Act on December 16, 2014. President Obama signed the bill into law on December 19, 2014. So, for your clients that dispose of built in gains assets this year, they are subject to a five (5) year built in gains tax recognition rule. For dispositions of built in gains tax property next year, unless Congress acts for a fifth time, we are subject to the old ten (10) year recognition period rule.
II. IRC Section 1367(a)(2).
Section 1367(a)(2) was added to the Code in 2006. It was set to sunset at the end of 2011. Section 325 of the 2012 Taxpayer Relief Act, effective January 1, 2013, however, extended the life of Code Section 1367(a)(2) to the end of 2013. It appeared IRC Section 1367(a)(2) was no longer in existence for 2014. The 2014 Tax Increase Prevention Act gave this provision one more year of life.
So, at least for 2014, shareholders of a S Corporation get to reduce their stock basis by the adjusted basis of property contributed by the S Corporation to a charity, even though the full fair market value of the property passes through to the shareholder as a charitable contribution deduction on their IRS Form K-1.
If any of your S Corporation clients made charitable contributions this year, they may be able to take advantage of this law. Unless extended again, Section 1367(a)(2) will no longer be law on January 1, 2015.
Year end is almost here. For your S Corporation clients, it is worth looking to determine if either of these provisions, amended by the 2014 Tax Increase Prevention Act, apply. Time is running out!
While it is highly unlikely Santa’s little helpers will deliver to taxpayers a tax reform package by the end of 2014 that is acceptable to the Senate, the House of Representatives and the President, House Ways and Means Committee Chairman, Dave Camp, made one last attempt to move the ball forward. On December 11, 2014, shortly before Chairman Camp’s expected retirement, he formally introduced a bill in the House to adopt into law the Tax Reform Act of 2014 which he authored and circulated in proposed form to lawmakers back in February. Affixed with the label “Fixing Our Broken Tax Code So That It Works For American Families and Job Creators,” the proposal is now formally before Congress.
Our lawmakers uniformly agree that we need tax reform in this country. In fact, more than thirty (30) separate congressional hearings dedicated to tax reform have been held in recent times. There exist at least eleven (11) bipartisan working groups which are exploring tax reform. So, we appear to be headed in the right direction. The billion dollar question continues to be, will we get sufficient consensus among our lawmakers so the tax reform will become a reality?
At about the same time as Chairman Camp introduced his tax reform bill in the House, Senate Finance Committee republican staff released a report, “Comprehensive Tax Reform for 2015 and Beyond.” The report exams the history of tax development and the economic issues associated therewith. Senator Orrin Hatch, who is slated to become the Chair of the Senate Finance Committee in 2015, hopes the report will get the issues on the table and act as an invitation to both parties to roll up their shirt sleeves and work together on these tough and ever important issues.
These developments may be an indication that the impetus for tax reform is picking up steam. Hopefully, the momentum will carry into 2015 and will be strong enough to get the ball across the goal line.
Despite these developments, however, I fear tax reform is still far away from becoming a reality. Chairman Camp’s proposal spans almost 1000 pages and impacts some highly sensitive tax issues important to special interest groups. While his proposed legislation cuts both ways (i.e., has provisions that each party could support), the question continues to be whether adequate consensus can be achieved in Washington to pass comprehensive tax reform legislation. Time will tell.
IRC § 6656(a) provides, in the case of any failure to timely deposit employment taxes, unless the failure is due to “reasonable cause and not due to willful neglect,” a penalty shall be imposed. The penalty is a percentage of the amount of underpayment.
- 2% for failures of five (5) days or less;
- 5% for failures of more than five (5) days, but less than 15 days;
- 10% for failures of more than 15 days; and
- 15% for failures beyond the earlier of: (i) 10 days after receipt of the first delinquency notice under IRC § 6303; or (ii) the day on which notice and demand is made under IRC §§ 6861, 6862 or 6331(a)(last sentence)(jeopardy assessment).
In addition to the “reasonable cause” exception contained in IRC § 6656(a), there are two other means by which taxpayers may avoid the imposition of the penalty.
1. Secretary has authority under IRC § 6656(c) to waive the penalty if:
- The failure is inadvertent;
- The return was timely filed;
- The failure was the taxpayer’s first deposit obligation or the first deposit obligation after it was require to change the frequency of deposits; and
- The taxpayer meets the requirements of IRC § 7430(c)(4)(A)(ii) [submits a request within 30 days and comes within certain net worth parameters].
2. The Secretary has authority under IRC § 6656(d) to waive the penalty if:
- The taxpayer is a first time depositor; and
- The amount required to be deposited was inadvertently sent to the Secretary instead of the appropriate government depository.
As the exceptions are limited in application, most taxpayers seeking abatement of the penalty are required to pursue the “reasonable cause” exception.
On April 4, 2014, the Chief Counsel’s Office issued Chief Counsel Advice 201414017 (CCA). The CCA offers guidance on this topic. Unfortunately, the guidance reflects the Service’s position that the “reasonable cause” exception under IRC § 6656(a) is narrow.
In the CCA, the taxpayer was subjected to a IRC § 6656(a) penalty when it failed to timely deposit employment taxes as the result of some of its employees exercising nonqualified stock options. The taxpayer claimed “reasonable cause” existed because its failure to timely deposit employment taxes was the error of its third-party payroll service. The taxpayer bolstered its position with two important facts.
- Its deposits had always been timely filed in the past; and
- The taxpayer immediately remedied the failure upon learning of it and
instituted procedures to avoid future repetition of the failure.
The Service commended the taxpayer for its historic compliance and its prompt remedial efforts. It concluded, however, that “[t]hese actions may amount to the exercise of ordinary business care that the reasonable cause defense requires and to the absence of willful neglect. The reasonable cause defense, however, also requires the taxpayer to demonstrate that despite its exercise of ordinary business care and prudence, it was ‘rendered unable to meet its responsibilities.’” The General Counsel’s Office ultimately concluded the taxpayer was liable for the penalty. It stated that the taxpayer’s reliance on its third-party payroll service provider is insufficient to obtain a penalty waiver as the reliance did not render it unable to otherwise meet its responsibilities.
Next, the General Counsel’s Office looked at whether the taxpayer could raise the first-time depositor defense under IRC § 6656(c) on examination rather than be required to wait until an assessment has been issued. It concluded, on the basis of administrative efficiency, the defense may be raised by the taxpayer on audit and the examiner should grant the request when appropriate.
The moral to the story is two-fold. First, the “reasonable cause” exception may be difficult to obtain. Whether it exists requires a facts and circumstances analysis. The burden of proof is on the taxpayer.
Reliance on third parties alone is generally insufficient. Likewise, failures due to mistake, ignorance of the laws or forgetfulness will not carry the day. Also, a taxpayer’s financial problems alone will generally not constitute “reasonable cause.”
The “reasonable cause” exception is narrow. Failures resulting from matters totally outside the taxpayer’s control appear to be required in order to obtain this penalty waiver. Examples of qualifying “reasonable cause” likely include situations where an otherwise compliant taxpayer, with adequate payroll procedures in place, encounters a natural disaster (e.g., fire, flood, storm), rendering it unable to process payroll and make the required deposits in a timely manner. Other examples of “reasonable cause” may include: (i) the death or serious illness of the taxpayer or the taxpayer’s immediate family; (ii) inability of the taxpayer to obtain necessary records due to no fault of the taxpayer; or (iii) embezzlement by the bookkeeper when and only when the taxpayer has reasonable protections in place.*
Second, taxpayers should raise the first time depositor defense, if applicable, on audit. The examiner should be able to accept the defense if the taxpayer qualifies. As confirmed by General Counsel’s Office, taxpayers are not required to wait for an actual assessment before raising this defense.
The courts presented with the “reasonable cause” exception to the imposition of a penalty under IRC § 6656(a) have taken varying positions—some more taxpayer friendly than others. The Service, however, is clearly taking a narrow view of the exception, leading to less taxpayer friendly results. Caution is advised.
*Reliance on a bookkeeper who embezzled funds from the taxpayer was not reasonable cause because the taxpayer did not have adequate checks and balances in place to prevent the embezzlement. Leprino Foods Co. v. U.S., 85 AFTR 2d 2000-1729 (D. Colo. 2000). Financial difficulties when adequate funds existed, but the taxpayer decided to use the funds for other things, trumped a reasonable cause defense. Van Camp & Bennion, P.S. v. U.S., 251 F.3d 862 (9th Cir. 2001). Failure of the bookkeeper delegated the responsibility of making deposits does not constitute reasonable cause when the bookkeeper was supervised by the owners of taxpayer and the outside CPA. Janet Nesse v. IRS, 93AFTR 2d 2004-1022 (DC MD 2004).
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.
Upcoming Speaking Engagements
- "Subchapter S After the Tax Cuts and Jobs Act – the Good, the Bad and the Ugly," New York University 77th Institute on Federal TaxationNew York, NY, 10.25.18
- "Developments in the World of IRC Section 1031 Exchanges, including the Impact of the Tax Cuts and Jobs Act," IRS Tax Practitioners ForumPortland, OR, 10.31.18
- "Navigating the Built In Gains Tax for C to S Conversions After the Tax Cuts and Jobs Act," 2018 Oregon Society of Certified Public Accountants (OSCPA) Northwest Federal Tax ConferencePortland, OR, 11.5.18
- "The Tax Cuts and Jobs Act – What It May Mean to Your Clients," Estate Planning Council of Portland Mini-SeminarPortland, OR, 11.7.18
- "What a Family Law Practitioner Needs to Know About the Tax Cuts and Jobs Act," Clackamas County Bar Association Fall ConferenceOregon City, OR, 11.8.18
- "Subchapter S After the Tax Cuts and Jobs Act – the Good, the Bad and the Ugly," New York University 77th Institute on Federal TaxationSan Diego, CA, 11.15.18