Supreme Court Adopts IRS Position on Jurisdiction and Application of Partnership Penalties

Gary Woods and his partner, Billy Joe McCombs, generated substantial tax losses using the COBRA tax shelter. The COBRA shelter used offsetting options to inflate the basis of property distributed by a partnership, which is then contributed and sold to another partnership or pass through entity, resulting in a large tax loss without a corresponding economic loss. Messrs. Woods & McCombs reaped ordinary income losses of $13 million and capital losses of $32 million when they used the COBRA structure to purchase and sell $3.2 million of options.

After the IRS disallowed their losses, Woods filed a refund claim (which was denied) and pursued that claim with a complaint filed in the U.S. District Court. After Woods prevailed on certain issues in the 5th Circuit, the government petitioned the U.S. Supreme Court for certiorari. The case selected by the high court to resolve a split in the circuits. The Fifth, Federal and D.C. Circuits had all found for the taxpayers. Other circuits had adopted the government’s position.

The Supreme Court addressed two questions in an opinion authored by Justice Scalia. The Court first considered whether the district court has jurisdiction under TEFRA (Tax Equity and Fiscal Responsibility Act of 1982) to determine valuation-related penalties at the partnership level. This is important because partnerships are not taxed as entities for Federal income tax purposes. The income and losses determined at the partnership level pass-through to each partner where they are taxed on the partner’s individual or corporate tax return.

One purpose of TEFRA was to allow determinations at the partnership level and prevent the need for multiple proceedings to determine the tax liabilities of items common to all partners in the partnership. The jurisdictional question has been widely litigated and this decision will affect many millions of dollars of pending tax penalties.

The second, related, question was whether the 40% gross valuation overstatement penalty under I.R.C. Sec. 6662 applied when a partnership was found to not have economic substance. A partnership lacking in economic substance ceases to exist for tax purposes.

The Court ruled for the government on both questions. On the first question, the Court held that there was jurisdiction to consider the penalty question at the partnership level. The court essentially adopted the position suggested at oral argument by Deputy Solicitor General Malcolm Stewart that “any question that will necessarily have the same answer for all partners should be presumptively be resolved at the partnership level.” Justice Scalia opined that “deferring consideration of those arguments until partner-level proceedings would replicate the precise evil that TEFRA sets out to remedy: duplicative proceedings, potentially leading to inconsistent results, on a question that applies equally to all of the partners.”

Relying on the “plain language” of the penalty the Court also held that the 40% substantial or gross valuation penalty applied to the overstated basis of the partners. “[O]nce the partnerships were deemed not to exist for tax purposes, no partner could legitimately claim a basis in the partnership greater than zero.” The Court adopted the observation of Fifth Circuit Judge Prado that “the basis understatement and the transaction’s lack of economic substance are inextricably intertwined” and therefore the penalties were “attributable to” the overstatement of basis that occurred once the partnership ceased to be recognized for tax purposes.

In an final note of interest to tax practitioners, Justice Scalia rejected the taxpayer’s reliance on the “Blue Book” – a publication of the Joint Committee of Taxation often published after the enactment of tax legislation explaining the legislative history of the statute – and clearly stated that this publication is not a relevant source of Congressional intent.

Read the entire opinion here:
U.S. v Woods, 517 U.S. __, No. 12-562 (Dec. 3. 2013).

IRS Resumes Field Exams & Collections

irs-sealThe Internal Revenue Service is back and has released guidance on the resumption of field audits and collection activities. Here are some highlights:

  • If you received an audit report requesting a response in 10 days but were unable to respond because of the shutdown you may still respond.  However, your auditor also should re-establish contact before taking additional actions in your case.
  • If you received a 30 day letter, you should continue to adhere to the deadline.  You may contact your auditor to discuss your options.
  • Failure to pay and failure to file penalties are statutory and are charged from the due date of the return until the date of payment.  These penalties will not be abated during the period of the shutdown.

Please visit IRS.gov for more information or read the FAQs here:

FAQs: Resumption of Field Exam Activities

FAQs: Resumption of Field Collections Activities

Tax Court Reminder: Hours Alone Do Not Turn a Hobby into a Business

430_horse0One of my best friends emailed me yesterday. He’s up for partner at one of the largest law firms in the world. He has dedicated many hours to the practice of law since our days together as law clerks at the Tax Court.

However, the key to partnership in the modern practice of law requires more than substantial legal skill – it takes a business plan. He has been asked to write one and I have no doubt that it will be thorough, detailed and realistic. That is, it will be the product of the same skills that have made him a great lawyer already. When he is invited into the partnership of his firm, which I am confident that he will be, I know that he will be expected to execute on that business plan, and I know that he will. After all, the objective of a law firm is to provide excellent legal services and make a profit while doing it.

Yesterday, the Tax Court issued a fairly lengthy Summary Opinion reminding us that the same standard applies to every business. A Summary Opinion is not a legal precedent and cannot be cited for authority, but Craig v. Commissioner amply shows that lengthy hours and dedicated labor alone are not enough to turn an activity into a business. The opinion is instructive for those who might be unsure about the right standard. There must be a plan to make money – and some profits along the way won’t hurt either.

Ms. Craig worked 25-40 hours per week as a real estate agent. She worked 25-30 more hours per week attending to her several horses – an activity for which she claimed losses for the tax years in question. She also worked part time preparing tax returns for H&R Block. The IRS denied Ms. Craig’s losses from the horse breeding activity and she challenged the Commissioner’s determinations by filing a pro se petition in Tax Court.

The Tax Court accepted the fact that Ms. Craig dedicated many hours a week to cleaning stalls, feeding, grooming, training, and otherwise caring for her horses. It did not, however, accept the fact that Ms. Craig engaged in any of those efforts with “an actual and honest objective of making a profit.”

Notable was Ms. Craig’s business plan for the horse-breeding activity. It was prepared in early 2011, months after the IRS began its examination of Ms. Craig’s tax returns, and listed a total of 10 items (all of which are reproduced in the Court’s opinion). From the time the business plan was written until the date of trial in November 2012, Ms. Craig had accomplished only one item on the business plan (she finished training one horse for handling).

Neither the concise and late-breaking business plan nor the lackadaisical approach to execution helped Ms. Craig’s case. It also didn’t help that she also didn’t maintain a separate bank account for the alleged horse breeding business, instead preferring to run expenses through her personal checking account, and reported gross receipts from the business in only one of seven years ($950 of revenue, not even profit). All of these factors contributed to the Court’s conclusion that Ms. Craig’s horse activities were a hobby and not a business. The Court also sustained a 20% accuracy-related penalty against Ms. Craig. A timely-written and well-executed business plan might not have changed the outcome of Ms. Craig’s case, but it certainly wouldn’t have hurt.

Read the entire opinion here:
Craig v. Commissioner, T.C. Summary Opinion 2013-58

Supreme Court Allows Foreign Tax Credits for U.K. Windfall Tax

us-supreme-courtThe U.S. Supreme Court has resolved a split in the circuits on the U.S. tax treatment of U.K. windfall tax payments made by U.S. utilities. In a unanimous opinion authored by Justice Thomas, the Court held that the windfall tax qualified as a “creditable tax” for U.S. foreign tax credit purposes. The result is that the appellant here, PPL, and Entergy, who had the companion case, will be able to take a credit against their U.S. income taxes for the amounts paid to the United Kingdom.

The central issue was whether the U.K. tax was a tax on income, the general standard for creditable foreign taxes. The ultimate decision was a bit more nuanced and scholars surely will continue to debate the issue including the algebra (don’t see that often in the tax world) and the potential distinction between the regulatory phrase “in the U.S. sense” and Justice Thomas’ phrase “if enacted in the U.S.”

Practitioners, being the practical folks that they are, will look to expand the decision for the benefit of other clients that may have paid taxes similar to the windfall tax but not received the benefit of foreign tax credits against their U.S. income.

This is what happens when the Supreme Court issues a tax opinion. There will be more to come, as the estate tax case that may decide the fate of DOMA has been heard and likely will be decided this year and another tax case (on overpayment penalties) is being briefed for the Supremes right now. Expect a decision in the latter case, U.S. v. Woods, sometime in 2014.

Read the PPL opinion here:
PPL Corp. v. Commissioner, Docket No. 12-43 (U.S.S.C. May 20, 2013)

4th Circuit: District Court Abused Discretion by Allowing Evidence of CPA’s Personal Tax Situation in Tax Shelter Promoter Case

The Fourth Circuit Court of Appeals vacated portions of a jury’s findings, including imposition of a $2.6 million penalty, because the District Court allowed the introduction of evidence of the defendant CPA’s personal tax situation (he didn’t file returns) during the penalty phase of the trial.

The Fourth Circuit held that the District Court abused its discretion by permitting the evidence into the record over the defendant’s objection. The Court of Appeals further held that the personal tax information was not relevant to the tax shelter promotion penalty in question and the effect of allowing it into evidence was highly prejudicial. The lower court’s error was not harmless.

The appellate court concluded that the evidence “bears all the indicia of garden-variety “bad acts” evidence with no other purpose than to emotionally inflame the jury against the defendant.”

Read the opinion here:
Nagy v. U.S., No. 10-2072 (4th Cir. Mar. 29, 2013)

U.S. Supreme Court to Hear Tax Penalty Case

us-supreme-courtThe Supreme Court has granted the government’s petition for certiorari in United States v. Woods, No. 12-562. The high court will decide whether the IRC §6662 overstatement penalty applies to underpayments of tax that are “attributable to an overstatement of basis” when the basis has been disallowed because the transactions that established the basis lacked economic substance.

The Court also asked the parties to brief an additional issue related to the procedural history of the case. Specifically, the Court is interested in whether the district court had jurisdiction under IRC §6226 to consider the substantial valuation misstatement penalty. This question, which arises under the procedural guidelines that govern large partnerships in TEFRA, has been raised in many cases over the course of the last decade. The heart of the matter is what issues are appropriate for resolution in a partner-level proceeding and which should be resolved at the partnership level.

Read the court’s order here:
12-562 U.S. v. Woods

Conservation Easement Deduction Denied as Quid Pro Quo for Subdivision Approval

The Tax Court denied the taxpayers’ deduction for the donation of a conservation easement where the taxpayer granted the easement pursuant to negotiations with a local zoning authority for approval of a subdivision exemption.

The deductibility of conservation easement donations is drawn from the general rule allowing the deduction of charitable contributions under IRC §170. Charitable contributions must be freely given, i.e., a gift, to qualify for the deduction. If the contribution is made in exchange for a specific benefit, i.e., a quid pro quo, then it does not qualify for the deduction.

The Tax Court found that the taxpayer’s donation of the easement was not a gift because it was “part of a quid pro quo exchange for Boulder County’s approving his subdivision exemption request.” The court also approved the application of the 20% substantial understatement penalty under IRC §6662(b)(2) against the taxpayer. The court denied the taxpayer’s reasonable cause argument to avoid the penalty, specifically noting the lack of testimony from the CPA who prepared the returns and invoking the “Wichita Terminal rule” to find for the government. The Wichita Terminal rule is drawn from a 67 year-old Tax Court case and generally provides that when a litigant fails to produce the testimony of a person that might be expected to testify, that failure gives rise to a presumption that the testimony would be unfavorable to the litigant’s case.

While the taxpayer lost on the 20% penalty, the court did reject the government’s argument for the 40% gross valuation penalty under IRC §6662(h)(2). In support of its position the commissioner alleged that the appraisal:

(1) was made more than 60 days before the grant of the second conservation easement; (2) does not describe the property; (3) does not contain the expected date of contribution; (4) does not contain the terms of the second conservation easement; (5) does not include the appraised fair market value of the second conservation easement on the expected date of contribution; and (6) does not provide the method of valuation Mr. Roberts used in that the report does not adequately identify the highest and best use of the property.

The taxpayer urged that the penalty did not apply under the exception provided in IRC §6664(c)(2) because the taxpayer obtained a “qualified appraisal” from a “qualified appraiser” and made a good faith investigation of the value of the property before making the donation. The court sided with the taxpayer and rejected the government’s arguments. The court voiced its particular concern with the government’s claim that the appraisal was not qualified because did not provide a method of valuation. The court noted that the appraisal specifically identified the well-established “before and after” valuation method and repeated, though without citation, the same concerns expressed by the Second Circuit Court of Appeals in Scheidleman v. Commissioner, that is, that the government’s claim really was directed at the reliability of the report and not its validity or “qualification”.

Read the entire opinion here:
Pollard v. Commissioner, T.C. Memo 2013-38

Tax Court: No Penalties for Son of Boss Participants

In a memorandum opinion related to a division opinion we reported earlier this year, the Tax Court has found that underpayment and accuracy-related penalties asserted against investors in a “Son of Boss” tax shelter, did not apply to the participant taxpayers because they established reasonable cause under IRC § 6664(c)(1). However, the Court did sustain the government’s determination, which apparently was uncontested by the taxpayers, that they had underreported tax because of their involvement with the Son of Boss transactions.

The opinion offers a thorough discussion of the taxpayers’ conduct and the applicable standards for reasonable cause. The language and findings may provide useful guidance for taxpayers, and their counsel, seeking to avoid penalties by establishing reliance upon their advisors.

Read the entire opinion here:
Rawls v. Commissioner, T.C. Memo. 2012-340

Food Lion Loses Forced Combination Fight and Gains Penalties in North Carolina Court of Appeals

Delhaize v. Lay has been a closely followed case on the North Carolina “forced combination” question. Interest waned a bit when the North Carolina Court of Appeals decided against Wal-Mart on the same issue in Wal-Mart v. Hinton, 197 NC App, 30, 676 S.E.2d 634 (NC App. 2009). In Wal-Mart, the court found that the Department of Revenue could force combined reporting to reflect the “true earnings” of the enterprise regardless of whether or not it made a finding of “non-arm’s length pricing” between the company’s related entities. The big box retailer petitioned the North Carolina Supreme Court for review but was denied a hearing.Now comes Delhaize, the parent company of the grocery chain, Food Lion, who had the unfortunate luck to have to follow in Wal-Mart’s wake.

It all started in 1998, when Delhaize, with the assistance of Coopers & Lybrand (now PwC), entered into a state tax planning strategy designed to exploit states that employ the separate reporting method of calculating state income tax. The strategy involved isolating trademarks, trade names, and other assets in a new legal entity in a single state. The new entity would then charge the parent entity royalties and fees for the intellectual property and services housed in the new entity, usually at a pre-determined arm’s length rate. The parent entity would deduct these business expenses even though the fees collected by the new entity later would be returned to the parent company as inter-company dividends. On a consolidated tax return the fee expense and the inter-company dividend would be eliminated against one another having no real effect on reportable income. However, in a separate reporting state only the expense items hit the tax return. The result was a reduction in taxable income in the separate reporting state for the expense of payments that never left the corporate family.

Most separate reporting states had statutory provisions in place to prevent this kind of manipulation by forcing the two related entities to file a combined tax return thus bringing the dividend income back into the picture and triggering the tax neutral inter-company elimination. The arm’s length standard was often employed to justify a forced combination. If the inter-company transactions were not arm’s length, and supported by credible documentation to that effect, then the state could force the combination of the returns. This is exactly what happened under audit for Delhaize. Delhaize maintained that the transactions were arm’s length and therefore the state could not force the combination.

As we mentioned before, it was Wal-Mart who tripped up Delhaize. Wal-Mart made the arm’s length argument and lost at both the North Carolina Business Court and the Court of Appeals. When the North Carolina Supreme Court denied review of their case, the cards had been dealt. Delhaize also lost at the North Carolina Business Court on the substantive tax issues. However, they were vindicated on penalties. The Business Court found that the penalties were an unfair violation of 14th Amendment due process, a violation of the power of taxation under the North Carolina constitution, and that the state had abused its discretion in applying the penalty.

Feeling their oats after the Business Court’s strong language dismissing the penalties, Delhaize decided to try a similar approach to reverse the substantive tax issue at the Court of Appeals. Delhaize argued on appeal that North Carolina had violated their 5th Amendment Due Process rights when it changed the “guidelines” for applying its forced combination authority and adopted a “new approach” without properly notifying taxpayers. The Court of Appeals roundly rejected the argument. The other three arguments put forth by Delhaize were all rejected as governed by the binding authority of the Wal-Mart decision.

By putting the substantive tax arguments into play with the appeal, Delhaize also gave the state an opportunity to challenge the Business Court’s determination on the penalties. The state did exactly that and the Court of Appeals agreed with them. It rejected the lower court’s decision on the penalties and reversed the order to refund $1.8 million in penalties to Delhaize.

Read the entire opinion here:
Delhaize v. Lay, No. 11-868-1 (NC App. Aug. 21, 2012)

1st Circuit Vacates Tax Court on Historical Facade Conservation Easement

In a case that has been followed closely by many interested parties, the First Circuit Court of Appeals ruled in favor of the taxpayers and the validity of their charitable contribution of an historical façade conservation easement in Kaufman v. Shulman. The 1st Circuit vacated the Tax Court’s legal ruling on partial summary judgment and remanded the matter for further findings on the questions of penalties and valuation.

The taxpayers in Kaufman owned an approximately 150 year-old row house in the historic district of South End in Boston. The home reflected mid-nineteenth century architecture and included a unique Venetian-Gothic style façade. In 2003, the taxpayers executed a “Preservation Restriction Agreement” donating an easement over the property to a qualified charitable organization for the purpose of protecting and preserving the historical features of the home. On the advice of the donee, the taxpayers obtained an appraisal of the contribution from an experienced appraiser who valued the easement at $220,800. The taxpayers took deductions on their 2003 and 2004 tax returns for the value of the donated easement, subject to the limits of IRC Sec. 170(b)(1)(E).

The property was subject to a mortgage when the taxpayers made the donation. The taxpayers obtained an agreement from the lender subordinating certain of the mortgage-holder’s rights in the property to the donee in accordance with the regulations governing the charitable donation of conservation easements. The agreement included several restrictive clauses, one of which became the focus of the Tax Court’s determination and the 1st Circuit’s ruling. That clause read as follows:

The Mortgagee/Lender and its assignees shall have a prior claim to all insurance proceeds as a result of any casualty, hazard or accident occurring to or about the Property and all proceeds of condemnation, and shall be entitled to same in preference to Grantee until the Mortgage is paid off and discharged, notwithstanding that the Mortgage is subordinate in priority to the [Preservation Restriction] Agreement.

Following an examination of their 2003 and 2004 returns, the IRS issued a notice of deficiency to the Kaufmans disallowing the deductions for the charitable contribution of the easement. The IRS maintained that the donation did not meet the regulatory requirements of Section 170(h). The taxpayers petitioned the U.S. Tax Court.

The Tax Court, in a division opinion by Judge Halpern, ruled for the IRS on a motion for partial summary judgment. Kaufman v. Commissioner, 134 T.C. 182 (2010). The Tax Court held that the conservation easement as executed failed to satisfy the requirement of Treas. Reg. Sec. 1.170A-14(g)(6). The Tax Court’s position on summary judgment, as summarized by the First Circuit, was that

although the Kaufmans in the Preservation Restriction Agreement governing 19 Rutland Square granted the Trust an entitlement to a proportionate share of post-extinguishment proceeds, thus seemingly complying with the regulation, the lender agreement executed by Washington Mutual undercut this commitment–and so defeated the deduction–by stipulating that “[t]he Mortgagee/Lender and its assignees shall have a prior claim to all insurance proceeds . . . and all proceeds of condemnation, and shall be entitled to same in preference to Grantee until the Mortgage is paid off and discharged.”

Even though the Tax Court decided for the government “entirely” on the basis of Treas. Reg. Sec. 1.170A-14(g)(6), the Court of Appeals also addressed paragraphs (g)(1) (perpetuity), (g)(2) (remote events), and g(3) (subordination) of the regulation in its opinion. The First Circuit observed that the IRS’s arguments in support of the Tax Court’s decision under g(6) would “appear to doom practically all donations of easements, which is surely contrary to the purpose of Congress.” The appellate court continued that it “cannot find reasonable an impromptu reading [of a regulation] that is not compelled and would defeat the purpose of the statute, as we think is the case here.” So on the big issue in the case, whether the mortgage subordination clause that granted the lender a prior claim to insurance and condemnation proceeds defeated the deduction, the First Circuit vacated the Tax Court’s legal conclusion.

The First Circuit made clear that it did not rest its decision on either the application of paragraphs (g)(3), addressing the defeasance of the deduction by remote future events, or (g)(2) which the taxpayers argued would have upheld the subordination agreement regardless of the extinguishment provision. This caveat seems to preserve the Tax Court’s recent opinion in Mitchell v. Commissioner from the scope of this ruling.

The appellate panel also addressed the “in perpetuity” requirement of Treas. Reg. Sec. 1.170A-14(g)(1) and the language in the agreement stating that “nothing herein contained shall be construed to limit the [Trust's] right to give its consent (e.g., to changes in the façade) or to abandon some or all of its rights hereunder.” The First Circuit noted its agreement with the D.C. Circuit who decided the same issue in Commissioner v. Simmons, 646 F.3d 6 (D.C. Cir. 2011) and added that the question was not whether the paragraph was a reasonable interpretation of the underlying statute, Sec. 170(h)(5), but whether the IRS’s interpretation of the regulation was reasonable. The court concluded that the regulation did not support the IRS’s stringent view.

Read the entire opinion here:
Kaufman v. Shulman, Docket No. 11-2017P-01A (1st Cir., July 19, 2012)