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Copyright 2016–2017 AICPA • Unauthorized Copying Prohibited 1

QUARTERLY FEDERAL TAX

UPDATE—THIRD QUARTER 2016

TITLE

Quarterly Federal Tax Update—Third Quarter 2016

FIELD OF STUDY

Taxation

COURSE DESCRIPTION

This course provides various tax update items and other federal tax highlights.

OBJECTIVE

Understand key recent developments that will affect many tax practitioners and their clients.

TARGET PARTICIPANTS

CPAs in industry and public practice

2 Copyright 2016–2017 AICPA • Unauthorized Copying Prohibited

Quarterly Federal Tax Update—Third Quarter 2016

HIGHLIGHTS FOR VARIOUS TYPES OF TAXPAYERS

Final Regulations Modify 83(b) Election Filing 2017 Inflation Adjustments, Tax Brackets, and Rates PATH Act Cost Recovery Changes Guidance Issued Curacao and Saint Lucia Considered North America for Convention Expense Deduction Draft 2017 941 Forms Issued Computation of Interest When There Is a Foreign Tax Redetermination Tax Court Underlines Taxpayer’s Burden of Proof Regarding Basis Right to Retain Deposit Not Capital Gain Initiation of Development Results in Ordinary Income IRS Provides Framework for Crowdfunding Analysis

HIGHLIGHTS FOR INDIVIDUAL TAXPAYERS

Conditional Opt-Out Arrangements Addressed in Premium Tax Credit Regs IRS Acquiesces to Per-Taxpayer Mortgage Interest Deduction Limits IRS Without Authority to Regroup for PAL Purposes Charitable Deductions Denied for Lack of Substantiation Imperfect Appraisal of Charitable Contribution OK IRS Wrong in Characterizing Deductions as Miscellaneous Confusing Records Lead to Denial of Business Deductions Estate Can Deduct Ponzi Scheme Losses Incurred by LLC

HIGHLIGHTS FOR BUSINESS TAXPAYERS

Change To (or From) Net Asset Value Method Now Automatic No 481 Adjustment for Nonqualified Deferred Comp When Changing Overall Method Additional Guidance on Employer Mandate Inherently Permanent Structures Generate Domestic Production Gross Receipts IRS Explains Treatment of Deferred Revenue Obligations Marginal Production Rates Updated Audit Adjustment Deemed an Accounting Method Change


Key Tax Developments Affecting Various Types of Taxpayers

REGULATIONS ISSUED AND PROPOSED

Final Regulations Modify 83(b) Election Filing If property is transferred in connection with the performance of services, the person performing such services may elect to include in gross income under Section 83(b) the excess (if any) of the fair market value of the property at the time of transfer over the amount (if any) paid for such property, as compensation for services. The fact that the transferee has paid full value for the property transferred, realizing no bargain element in the transaction, does not preclude the use of the election as provided for in this section.

If this election is made, the substantial vesting rules of Section 83(a) and the regulations thereunder do not apply with respect to such property, and except as otherwise provided in Section 83(d)(2) and the regulations thereunder (relating to the cancellation of a nonlapse restriction), any subsequent appreciation in the value of the property is not taxable as compensation to the person who performed the services. Thus, property with respect to which this election is made shall be includible in gross income as of the time of transfer, even though such property is substantially nonvested at the time of transfer, and no compensation will be includible in gross income when such property becomes substantially vested. In computing the gain or loss from the subsequent sale or exchange of such property, its basis shall be the amount paid for the property increased by the amount included in gross income under Section 83(b).

Under the final regulations at Reg. Section 1.83-2, the election is made by filing one copy of a written statement with the IRS office with which the person who performed the services files his return. The person who performed the services shall also submit a copy to the person for whom the services are performed. In addition, if the person who performs the services and the transferee of such property are not the same person, the person who performs the services shall submit a copy of such statement to the transferee of the property. The election statement no longer has to be filed with the taxpayer’s return.

IRS RULINGS AND GUIDANCE

2017 Inflation Adjustments, Tax Brackets, and Rates On October 25, 2016, the IRS announced the tax year 2017 annual inflation adjustments for more than 50 tax provisions, including the tax rate schedules.

The standard deduction for married filing jointly rises to $12,700 for tax year 2017, up $100 from the prior year. For single taxpayers and married individuals filing separately, the standard deduction rises to $6,350 in 2017, up from $6,300 in 2016, and for heads of households, the standard deduction will be $9,350 for tax year 2017, up from $9,300 for tax year 2016.


The personal exemption for tax year 2017 remains as it was for 2016—$4,050. However, the exemption is subject to a phase-out that begins with adjusted gross incomes of $261,500 ($313,800 for married couples filing jointly). It phases out completely at $384,000 ($436,300 for married couples filing jointly.)

For tax year 2017, the 39.6 percent tax rate affects single taxpayers whose income exceeds $418,400 ($470,700 for married taxpayers filing jointly), up from $415,050 and $466,950, respectively. The other marginal rates—10, 15, 25, 28, 33, and 35 percent—and the related income tax thresholds for tax year 2017 are described in the revenue procedure.

The limitation for itemized deductions to be claimed on tax year 2017 returns of individuals begins with incomes of $287,650 or more ($313,800 for married couples filing jointly).

The alternative minimum tax exemption amount for tax year 2017 is $54,300 and begins to phase out at $120,700 ($84,500, for married couples filing jointly for whom the exemption begins to phase out at $160,900). The 2016 exemption amount was $53,900 ($83,800 for married couples filing jointly). For tax year 2017, the 28 percent tax rate applies to taxpayers with taxable incomes above $187,800 ($93,900 for married individuals filing separately).

The tax year 2017 maximum earned income credit amount is $6,318 for taxpayers filing jointly who have three or more qualifying children, up from a total of $6,269 for tax year 2016. The revenue procedure has a table providing maximum credit amounts for other categories, income thresholds and phase-outs.

For tax year 2017, the monthly limitation for the qualified transportation fringe benefit is $255, as is the monthly limitation for qualified parking.

For calendar year 2017, the dollar amount used to determine the penalty for not maintaining minimum essential health coverage is $695.

For tax year 2017, participants who have self-only coverage in a medical savings account, the plan must have an annual deductible that is not less than $2,250 but not more than $3,350; these amounts remain unchanged from 2016. For self-only coverage, the maximum out of pocket expense amount is $4,500, up $50 from 2016. For tax year 2017 participants with family coverage, the floor for the annual deductible is $4,500, up from $4,450 in 2016. However, the deductible cannot be more than $6,750, up $50 from the limit for tax year 2016. For family coverage, the out of pocket expense limit is $8,250 for tax year 2017, an increase of $100 from tax year 2016.

For tax year 2017, the adjusted gross income amount used by joint filers to determine the reduction in the lifetime learning credit is $112,000, up from $111,000 for tax year 2016.

For tax year 2017, the foreign earned income exclusion is $102,100, up from $101,300 for tax year 2016.

Estates of decedents who die during 2017 have a basic exclusion amount of $5,490,000, up from a total of $5,450,000 for estates of decedents who died in 2016.

The 2017 tax brackets are as follows:


PATH Act Cost Recovery Changes Guidance Issued In Rev. Proc. 2016-48 the IRS provides guidance for issues related to the enactment of certain provisions of the Protecting Americans From Tax Hikes Act of 2015 (PATH Act). Section 124(c)(1) of the PATH Act amended Section 179(f) of the Internal Revenue Code (IRC) by extending the application of Section 179(f) from any taxable year beginning after 2009 and before 2015 to any taxable year beginning after 2009 and before 2016. Section 143(a)(1) of the PATH Act amended Section 168(k)(2) of the IRC by extending the placed-in-service date for property to qualify for the 50-percent additional first year depreciation deduction. Section 143(a)(3) of the PATH Act amended Section 168(k)(4) of the IRC by allowing corporations to elect not to claim the 50-percent additional first-year depreciation deduction for certain property placed in service generally after December 31, 2014 and before January 1, 2016, and instead to increase their alternative minimum tax (AMT) credit limitation under Section 53(c) of the IRC.

Curacao and Saint Lucia Considered North America for Convention Expense Deduction IRC Sec. 274(h) limits deductions for expenses incurred in connection with a convention, seminar, or similar meeting (collectively, a convention) held outside the North American area. Section 274(h)(3)(A) defines the term North American area as the United States, its possessions, the Trust Territory of the Pacific Islands, Canada, and Mexico. Under Section 7701(a)(9), the United States consists of the 50 states and the District of Columbia. The IRS treats the following as the possessions of the United States for this purpose: American Samoa, Baker Island, the Commonwealth of Puerto Rico, the Commonwealth of the Northern Mariana Islands, Guam, Howland Island, Jarvis Island, Johnston Island, Kingman Reef, the Midway Islands, Palmyra Atoll, the United States Virgin Islands, Wake Island, and other United States islands, cays, and reefs not part of the 50 states or the District of Columbia. The jurisdictions that formerly constituted the Trust Territory of the Pacific Islands—the Republic of the Marshall Islands, the Federated States of Micronesia, and the Republic of Palau—are now covered by the compacts with the United States.

In Rev. Rul. 2016-16, the IRS added Curacao and Saint Lucia to the list of geographical areas that are considered part of the North American area for purposes of the limitation on deductions for convention expenses. The IRS also provided limited transitional relief for conventions held in Sint Maarten and the Caribbean part of the Netherlands during the period (or with respect to which a taxpayer demonstrates that a nonrefundable contractual obligation existed during the period) from Oct. 10, 2010, through June 27, 2016.


New Noncommercial Flight Valuation Amounts Issues For purposes of the taxation of fringe benefits under IRC Sec. 61, Section 1.61-21(g) of the Income Tax Regulations provides a rule for valuing noncommercial flights on employer-provided aircraft. Section 1.61-21(g)(5) provides an aircraft valuation formula to determine the value of such flights. The value of a flight is determined under the base aircraft valuation formula (also known as the Standard Industry Fare Level formula or SIFL) by multiplying the SIFL cents-per-mile rates applicable for the period during which the flight was taken by the appropriate aircraft multiple provided in Section 1.61-21(g)(7) and then adding the applicable terminal charge. The SIFL cents-per-mile rates in the formula and the terminal charge are calculated by the Department of Transportation and are reviewed semi-annually.

In Rev. Rul. 2016-24 the IRS Announced the rates for flights taken from July 1, 2016 through December 31, 2016. The terminal charge for such flights is $37.68. The SIFL mileage rate depends on the total miles flown. For up to 500 miles, the amount is $0.2061 per mile; for 501-1500 miles it is $0.1572 per mile; and for over 1500 miles the SIFL rate is $0.1511 per mile.

Short-Week Benefit Payments Are Wages In CCA 201634023, chief counsel responded to a taxpayer who asked whether short-week benefits paid to workers who work less than 36 hours in a week or who could not work due to weather are excluded from wages for purposes of FICA tax as supplemental unemployment benefits. Under state law, an applicant for state unemployment compensation benefits must be “unemployed, able, available for, and actively seeking suitable full-time work.” Recipients of short-week benefits do not qualify for state unemployment compensation. Thus, these short-week benefits are not “linked to the receipt of state unemployment compensation” as required by Revenue Ruling 90-72. Chief counsel agreed with the taxpayer’s conclusion that these short-week payments are not excluded from wages for purposes of FICA tax because they do not satisfy the narrow exception set forth in Rev. Rul. 90-72. That conclusion is also consistent with PLRs 200322012 and 9734035, which stated automatic short week benefits are wages for FICA and FUTA purposes, unless the benefits are made to individuals who otherwise qualify for excludable regular benefits (that is, if the automatic short week benefits immediately precede or follow a week in which an employee receives regular benefits).

Draft 2017 941 Forms Issued The IRS has issued a draft version of 2017 Form 941, Employer’s Quarterly Tax Return, that reflects the provision in the 2015 PATH Act that allows a qualified small business to elect to claim a portion of their research credit as a tax credit against their employer FICA tax liability. This change is also reflected on the recently posted draft version of 2016 Form 6765, Credit for Increasing Research Activities.

Computation of Interest When There Is a Foreign Tax Redetermination In Program Manager Technical Advice 2016-003, the IRS has concluded that when a taxpayer is subject to an adjustment to a foreign tax credit which results in an increase in U.S. tax liability, interest should be computed based on the interest that would have been assessed and collected under the underpayment rules for that period, taking into account all items for the tax year. Interest should not be computed solely on the amount of the underpayment resulting from the redetermination of the foreign tax credit.


CASES OF NOTE

Tax Court Underlines Taxpayer’s Burden of Proof Regarding Basis Power v. Commissioner, TC Memo 2016-157 The Tax Court upheld the IRS’s determination that commercial real estate broker and S corp. owner had zero basis in corp. and received significant taxable distributions. The court noted that the taxpayer failed to prove that he had any higher basis because he offered only self-serving Forms 1120S that did not themselves contain sufficient information to establish basis. Moreover, it was unclear how taxpayer could calculate his basis using those forms when considering that corporate income and expenses were improperly divided between the taxpayer’s own Schedules C and corporation’s forms. Furthermore, the taxpayer stipulated that he was compensated through distributions rather than wages or salary and used the corporation’s account to pay substantial personal expenses.

Right to Retain Deposit Not Capital Gain Cri-Leslie, LLC, v. Commissioner, 147 TC No. 8 (2016) The Tax Court denied capital gain treatment under IRC Sec. 1234A for an LLC’s right to retain forfeited deposits from canceled sale of real property used in its hotel and restaurant business. The parties stipulated that the property in question was IRC Sec. 1231(b)(1) property, not IRC Sec. 1221(a) capital asset. IRC Sec. 1234A, expressly referring to property that was “capital asset in hands of taxpayer,” applied by its plain language only to capital assets as defined under IRC Sec. 1221(a). Thus, the taxpayer’s argument that Congress intended IRC Sec. 1234A to also extend to payments from terminations relating to IRC Sec. 1231 property was unavailing. In effect, the taxpayer was seeking to expand statute’s scope in a manner that would contravene its plain meaning and purpose.

Initiation of Development Results in Ordinary Income Boree v. Commissioner, 118 AFTR 2d ¶ 2016-5207 (11th Cir.) The Court of Appeals for the Eleventh Circuit, affirming the Tax Court, has held that a taxpayer who purchased 1,892 acres of land, took various steps to develop it for sale in the form of 10-acre lots, sold several of those lots, but then sold the bulk of the land to another developer after the local municipality enacted land use provisions that made his initial plans economically untenable, had ordinary income and not capital gains from the sale to the other developer.

IRS Provides Framework for Crowdfunding Analysis IRC Sec. 61(a) provides the general rule that, except as otherwise provided by law, gross income includes all income from whatever source derived. Gross income includes all accessions to wealth, whether realized in the form of cash, property or other economic benefit. However, some benefits that a taxpayer receives are excludable from income, either because they do not meet the definition of gross income or because the law provides a specific exclusion for certain benefits that Congress chooses not to tax.

In general, money received without an offsetting liability (such as a repayment obligation), that is neither a capital contribution to an entity in exchange for a capital interest in the entity nor a gift, is includible in income. The facts and circumstances of a particular situation must be considered to determine whether the money received in that situation is income.


What that means is that crowdfunding revenues generally are includible in income if they are not 1) loans that must be repaid, 2) capital contributed to an entity in exchange for an equity interest in the entity, or 3) gifts made out of detached generosity and without any quid pro quo. However, a voluntary transfer without a quid pro quo is not necessarily a gift for federal income tax purposes. In addition, crowdfunding revenues must generally be included in income to the extent they are received for services rendered or are gains from the sale of property.

Section 1.451-2 of the Income Tax Regulations sets forth the constructive receipt doctrine and provides that income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. The regulation further provides that income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. However, a self-imposed restriction on the availability of income does not legally defer recognition of that income.

Thus, the income tax consequences to a taxpayer of a crowdfunding effort depend on all the facts and circumstances surrounding that effort.


Key Tax Developments Affecting Individual Taxpayers

REGULATIONS ISSUED AND PROPOSED

Conditional Opt-Out Arrangements Addressed in Premium Tax Credit Regulations The IRS has issued proposed regulations (Prop. Reg. Secs. 1.36B-1, 1.36B-2, 1.36B-3, and 1.36B-5) relating to the premium tax credit and the individual shared responsibility provision (the individual mandate). The proposed regulations would modify rules relating to, among other things, taxpayers’ eligibility for the credit and the treatment of opt-out payments for purposes of determining whether employer-sponsored coverage is affordable.

The proposed regulations provide that amounts made available under conditional opt-out arrangements are disregarded in determining the required contribution if the arrangement satisfies certain conditions (an eligible opt-out arrangement), but otherwise the amounts are taken into account. The proposed regulations define an eligible opt-out arrangement as an arrangement under which the employee’s right to receive the opt-out payment is conditioned on (1) the employee declining to enroll in the employer-sponsored coverage and (2) the employee providing reasonable evidence that the employee and all other individuals for whom the employee reasonably expects to claim a personal exemption deduction for the taxable year or years that begin, or end in, or with the employer’s plan year to which the opt-out arrangement applies (employee’s expected tax family) have or will have minimum essential coverage (other than coverage in the individual market, whether or not obtained through the marketplace) during the period of coverage to which the opt-out arrangement applies. For example, if an employee’s expected tax family consists of the employee, the employee’s spouse, and two children, the employee would meet this requirement by providing reasonable evidence that the employee, the employee’s spouse, and the two children, will have coverage under the group health plan of the spouse’s employer for the period to which the opt-out arrangement applies.


IRS Acquiesces to Per-Taxpayer Mortgage Interest Deduction Limits In AOD 2016-02, the IRS announced its acquiescence with a decision of the Court of Appeals for the Ninth Circuit that the limitations ($1 million of acquisition indebtedness and $100,000 of home equity indebtedness) are applied on a per-individual basis, and not a per-residence basis. Under this interpretation, unmarried co-owners are collectively limited to a deduction for interest paid on a maximum of $2.2 million, rather than $1.1 million, of acquisition and home equity indebtedness.

The case, Voss v. Commissioner, 796 F.3d 1051 (9th Cir. 2015), reversed the earlier Tax Court decision favorable to the IRS in Sophy v. Commissioner, 138 T.C. 204 (2012). Mr. Voss and Mr. Sophy, unmarried co-owners of two residences, each filed an individual tax return claiming a deduction for qualified residence interest paid on acquisition indebtedness and home equity indebtedness in excess of $1.1 million (for a combined amount in excess of $2.2 million). The IRS disallowed portions of each


taxpayer’s deduction for qualified residence interest on the grounds that Section 163(h)(2) and (3) limit the aggregate amount of indebtedness to $1 million and $100,000, respectively, on any qualified residence, allocated among all taxpayers entitled to an interest expense deduction for that qualified residence.

The Tax Court agreed with the IRS, finding that the language of the statute limits the total amount of indebtedness with respect to acquisition indebtedness and home equity indebtedness that may be claimed in relation to the qualified residence, rather than in relation to an individual taxpayer. The taxpayers appealed to the United States Court of Appeals for the Ninth Circuit.

The Ninth Circuit reversed the Tax Court decision, agreeing with the taxpayers that the statutory limitations apply to unmarried co-owners of a qualified residence on a per-taxpayer basis. The court based its conclusion largely on its interpretation of the language of the statute that expressly provides that married individuals filing separate returns are entitled to deduct interest on up to $500,000 of acquisition indebtedness and $50,000 of home equity indebtedness. By providing lower debt limits for married couples, and not for unmarried co-owners, Congress singled out married couples for specific treatment, implying that an unmarried co-owner filing a separate return is entitled to deduct interest on up to $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness.

IRS Without Authority to Regroup for PAL Purposes In PLR 201634022 the IRS concluded that it lacked the authority to regroup, for purposes of the passive activity loss (PAL) rules, a doctor’s interests in two medical practices at which he was an employee, and his indirect interest in an outpatient surgery center. The doctor’s treatment of his interests as separate activities was not inappropriate in light of the overall facts of the case, including his lack of control over the operations of the surgery center.

CASES OF NOTE

Charitable Deductions Denied for Lack of Substantiation Embroidery Express, LLC v. Commissioner, TC Memo 2016-136 Business owner-operators were denied charitable contribution deductions for various items, including for cash donation to Mexican children’s home that was not organized as U.S. charity, as well as for number of other cash donations above $250 to U.S. charities, including to a children’s research foundation, to another individual or entity, and in form of travel expenses for an overseas mission trip, because those donations were not properly substantiated with contemporaneous written acknowledgment. Deductions for office equipment and furniture donations to a faith organization, in respect to which receipt didn’t properly provide description “in detail reasonably sufficient under circumstances,” and for donations made by one of taxpayers’ corporations, were also denied above amounts the IRS allowed. A deduction for a donated car was limited to $5,000 due to taxpayers’ failure to submit qualified appraisal. But, cash donations under $250 to a research foundation were fully deductible.

Imperfect Appraisal of Charitable Contribution OK Cave Buttes, LLC v. Commissioner, 147 TC No. 10 (2016) The Tax Court held that, although several elements of an appraisal of real property contributed to a state agency were not in strict conformity with the relevant regulations, the appraisal met the requirements of a qualified appraisal. It also agreed with the property valuation determined by the taxpayer’s expert.


Although only one of two appraisers attached his resume to the appraisal and signed Form 8283, that was sufficient to satisfy the regulations, especially when considering that both appraisers signed the report itself and the IRS never questioned the 2d appraiser’s qualification until the post-trial briefing. Also, the appraisal’s description of property by address and characteristics, including that it was a hillside lot with mountain and city views, was sufficient to constitute strict compliance with the regulation’s describe-in-detail requirement; and “for filing with IRS” statement was enough to substantially if not strictly comply with prepared-for-income-tax-purposes requirement. The appraiser properly assumed there was legal access, either by express or implied easement, to property such that development was financially feasible; properly accounted for same in his valuation, albeit with downward adjustment to reflect cost of obtaining that access; properly determined that comparable sales should have been adjusted upward to reflect views from property; and properly determined that property should have been valued as separate lots to reflect metes-and-bounds split, rather than as single parcel.

IRS Wrong in Characterizing Deductions as Miscellaneous George v. Commissioner, TC Memo 2016-156 The IRS’s determination that the car salesman was entitled only to miscellaneous itemized deduction for legal fees he incurred in connection with the discrimination complaint he filed against a former employer was rejected; rather, he was entitled to above-the-line deduction under IRC Sec. 62(a)(20) when considering that underlying complaint specifically alleged employment discrimination on account of national origin and that settlement specifically stated it applied to claims for compensation relating to that employment relationship.

Confusing Records Lead to Denial of Business Deductions Walker v. Commissioner, TC Memo 2016-159 Taxpayer who owned and operated ambulance transport business and single-member LLC was denied deductions for ambulance-related expenses above amounts IRS allowed (although taxpayer credibly testified that expenses included gas reimbursement to ambulance drivers and ambulance maintenance costs, and although she also credibly testified that she kept business records, but lost them when storage unit was seized), her testimony was confusing, undetailed, and otherwise insufficient to show that expenses weren’t already included in contract labor expenses which IRS allowed.

Estate Can Deduct Ponzi Scheme Losses Incurred by LLC Estate of James Heller v. Commissioner, 147 TC No. 11 (2016) The Tax Court, in a case of first impression, upheld an estate’s theft loss deduction under for losses incurred by a limited liability company in which it held a 99 percent interest. The LLC’s sole asset was an account that, during the settlement of the case, became worthless as a result of Bernie Madoff’s Ponzi scheme.

James Heller, a resident of New York, New York, died on January 31, 2008. At that time, he owned a 99 percent interest in James Heller Family, LLC (JHF). James Heller’s daughter, Barbara H. Freitag, and his son, Steven P. Heller, each held a 0.5 percent interest in JHF. Harry H. Falk managed JHF, the only asset of which was an account (JHF Madoff account) with Bernard L. Madoff Investment Securities, LLC (Madoff Securities). On or around March 5, 2008, Ms. Freitag, Mr. Falk, and Steven P. Heller were appointed coexecutors of the Estate of James Heller (estate). Between March 4 and November 28, 2008, Mr. Falk withdrew $11,500,000 from the JHF Madoff account and distributed it according to JHF’s ownership interests. The estate’s share, $11,385,000, was used to pay its taxes and administrative expenses.


On December 11, 2008, Bernard Madoff, the chairman of Madoff Securities, was arrested, and the Securities and Exchange Commission issued a press release to alert the public that it had charged him with securities fraud relating to a multibillion-dollar Ponzi scheme. In perpetuating the scheme, Mr. Madoff and his associates fabricated monthly and quarterly statements (that is, financial records that purportedly showed the value of accounts, trading activity, gains, and other financial information) and sent them to Madoff Securities’ clients. The Securities Investor Protection Corporation (SIPC), on December 15, 2008, filed an application for a protective decree with the U.S. District Court for the Southern District of New York, in which it, pursuant to the Securities Investor Protection Act of 1970, sought liquidation of Madoff Securities. On that day, the court approved the application and appointed a trustee for Madoff Securities. Mr. Madoff, on March 12, 2009, admitted that he had perpetrated a Ponzi scheme through Madoff Securities and pleaded guilty to various federal crimes, including securities fraud, investment adviser fraud, money laundering, and perjury. As a result of the Ponzi scheme, JHF’s interest in the JHF Madoff account and the estate’s interest in JHF became worthless.


Key Tax Developments Affecting Business Taxpayers


Change To (or From) Net Asset Value Method Now Automatic In Rev. Proc. 2016-39 and in conjunction with issuance of final regulations that address amendments to SEC rules concerning changes to money market fund (MMF) shares, the IRS has issued procedures to include change to or from the net asset value (NAV) method for gain or loss on MMF shares under automatic change procedures.

Under the revenue ruling, a change to or from the NAV method is made on a cut-off basis. Accordingly, a Section 481(a) adjustment is neither permitted nor required. A taxpayer making a change to or from the NAV method for shares in an MMF applies the new method only to the computation of gain or loss on the shares beginning with the year of change. Under Regs. Section 1.446-7(b)(7)(ii), a taxpayer changing to the NAV method takes a starting basis in those shares for the year of change equal to the aggregate adjusted basis of the taxpayer’s shares in the MMF at the end of the immediately preceding taxable year. A taxpayer changing from the NAV method to a realization method for shares in an MMF must adjust the basis in the shares beginning on the first day of the year of change to account for gain or loss previously recognized under the NAV method. Accordingly, the taxpayer generally takes a basis in each MMF share at the beginning of the year of change equal to the fair market value of that share used in computing the ending value of the shares in that MMF for the final computation period of the taxable year prior to the year of change.

No 481 Adjustment for Nonqualified Deferred Comp When Changing Overall Method Assume a taxpayer provides services to a business that is a tax indifferent party (generally, foreign corporations with no effectively connected U.S. income and partnerships with only foreign or tax-exempt partners). The taxpayer has elected each year (including years before 2009) to defer a portion of its annual compensation for those services under a nonqualified deferred compensation plan of the business for periods including years prior to 2009. The taxpayer and service provider is a cash method, calendar year taxpayer. Assume that the deferral of compensation was not subject to a substantial risk of forfeiture, complied with the requirements of Code Section 409A, and was not otherwise includible in the taxpayer’s income. Now the taxpayer wants to change from the cash method to the accrual method of accounting.

The question addressed by Chief Counsel in Legal Advice Issued by Associate Chief Counsel 2016-003 is whether the taxpayer may take the Section 481(a) adjustment into account over a four-year adjustment period when a portion of the adjustment relates to deferred compensation attributable to services performed before January 1, 2009.

Chief Counsel concluded that, to the extent the Section 481(a) adjustment relates to vested deferred compensation that is attributable to services performed before January 1, 2009, under a plan of a nonqualified entity, the service provider may not take the adjustment into account later than the service provider’s last taxable year beginning before 2018.


Additional Guidance on Employer Mandate In Information Letter 2016-0030 the IRS has addressed whether an employer that has developed a new policy restricting part-time and seasonal employees from working more than 29 hours in any week could face potential “employer mandate” or “shares responsibility” liability if an employee in this category works more than 29 hours of service in a week.

Inherently Permanent Structures Generate Domestic Production Gross Receipts In PLR 201638022, the IRS has concluded that a taxpayer’s renovation, construction, and erection projects qualified as construction of real property and that gross receipts from these projects qualified as domestic production gross receipts eligible for the domestic production activities deduction under IRC Sec. 199. In so holding, IRS concluded that certain units used in the construction projects constitute inherently permanent structures.

IRS Provides Spin-Off Safe Harbor Section 355(a)(1) provides that, if certain requirements are met, a corporation may distribute stock and securities of a controlled corporation to its shareholders and security holders without recognition of gain or loss by the shareholders or security holders. Section 355(a)(1)(A) provides that, for a distribution to qualify for nonrecognition treatment, the distributing corporation must distribute stock or securities of a corporation (the controlled corporation) it controls immediately before the distribution. For this purpose, control is defined by cross-reference to Section 368(c) as ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of each other class of stock of the corporation.

Revenue Procedure 2016-40 provides fact patterns (safe harbors) in which the IRS will not assert that a distributing corporation (D) lacks control of another corporation (C), within the meaning of IRC Sec. 355(a)(1)(A), even though D and C engage in a pre-distribution acquisition of control. This revenue procedure applies to transactions in which

1. D owns C stock not constituting control of C;

2. C issues shares of one or more classes of stock to D and/or to other shareholders of C (the issuance), as a result of which D owns C stock possessing at least 80 percent of the total combined voting power of all classes of C stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of C;

3. D distributes its C stock in a transaction that otherwise qualifies under Section 355 (the distribution); and

4. C subsequently engages in a transaction that, actually or in effect, substantially restores (a) C’s shareholders to the relative interests, direct or indirect, they would have held in C (or a successor to C) had the issuance not occurred; and/or (b) the relative voting rights and value of the C classes of stock that were present prior to the issuance (an unwind).

The IRS will not assert that a transaction described in section 3 of this revenue procedure lacks substance, and that therefore D lacked control of C immediately before the distribution if the transaction is also described in one of the following two safe harbors:

1. No action is taken (including the adoption of any plan or policy), at any time prior to 24 months after the distribution, by C’s board of directors, C’s management, or any of C’s controlling shareholders that would (if implemented) actually or effectively result in an unwind; or


2. C engages in a transaction with one or more persons (for example, a merger of C with another corporation) that results in an unwind, regardless of whether the transaction takes place more or less than 24 months after the distribution, provided that there is no agreement, understanding, arrangement, or substantial negotiations or discussions concerning the transaction or a similar transaction at any time during the 24-month period ending on the date of the distribution; and in more than 20 percent of the interest in the other party, in vote or value, is owned by the same persons that own more than 20 percent of the stock of C.

IRS Explains Treatment of Deferred Revenue Obligations Section 382(a) generally limits the use of pre-change NOLs of a loss corporation to offset income generated after an ownership change. A loss corporation is defined by Section 382(k)(1) as a corporation entitled to use an NOL carryover or having an NOL for the taxable year in which an ownership change occurs. Per Section 382(g)(1), an ownership change occurs when the percentage of stock owned by one or more five-percent shareholders increases by more than 50 percentage points over the lowest percentage of stock of the loss corporation owned by such shareholder(s) at any time during a three-year testing period. Per Section 382(k)(6)(C) determinations of the percentage of stock held by any person are made on the basis of value.

Section 382(b)(1) provides that, for any post-change year, the Section 382 limitation is the amount equal to the value of the old loss corporation multiplied by the long-term Federal tax-exempt rate. In this case, Taxpayer determined Lossco’s value to be zero and therefore Lossco’s annual Section 382 limitation is zero. However, if a corporation has a NUBIG at the time of an ownership change, its Section 382 limitation is increased by its recognized built-in gain (RBIG) each year in the five-year recognition period beginning immediately after the ownership change. Section 382(h)(1)(A). If instead a corporation has a net unrealized built-in loss (NUBIL) at the time of the ownership change, its recognized built-in loss (RBIL) each year in the five-year recognition period beginning immediately after the ownership change is subject to the Section 382 limitation.

Section 382(h)(3)(A) provides that a corporation’s NUBIG/NUBIL equals the difference between the fair market value (FMV) of all of its assets and the aggregate adjusted basis of its assets on the change date. Section 382(h)(3)(B) provides that if the NUBIG or NUBIL does not exceed the lesser of $10 million or 15 percent of the FMV of the loss corporation’s assets (excluding cash and cash items) immediately before the ownership change, then the NUBIG or NUBIL, as applicable, is deemed to be zero.

Section 382(h)(6)(C) provides that NUBIG is properly adjusted for items of income or items of deduction which would be treated as RBIG or RBIL if properly taken into account (or allowable as a deduction) in the recognition period. Section 382(h)(6)(A) provides that “any item of income which is properly taken into account during the recognition period but which is attributable to periods before the change date shall be treated as a RBIG for the taxable year in which it is properly taken into account” (emphasis added). Section 382(h)(6)(B) provides that “any amount which is allowable as a deduction during the recognition period (determined without regard to any carryover) but which is attributable to periods before the change date shall be treated as a RBIL for the taxable year for which it is allowable as a deduction” (emphasis added).

Prepaid income is an item of income that generally arises in the ordinary course of business when a customer makes a prepayment to a vendor under a contract to provide goods or services at some future time. Examples of prepaid income include, but are not limited to, income received prior to the change date that is deferred under IRC Section 455.


In Chief Counsel Advice 201629007, the IRS determined that a loss corporation’s deferred revenue obligations are not includible in its net unrealized built-in gain (NUBIG) calculations for purposes of determining its limitation on pre-change losses following an ownership change. The corporation’s position with respect to the obligations, which entailed treating them as assumed for one purpose but “potential” for another, was rejected by IRS as inconsistent.

Marginal Production Rates Updated In Notice 2016-45, the IRS announced that applicable percentage under IRC Sec. 613A to be used in determining percentage depletion for marginal properties for 2016 calendar year is 15 percent.

CASES OF NOTE

Audit Adjustment Deemed an Accounting Method Change Nebeker v. Commissioner, T.C. Memo 2016-155 The Tax Court has concluded that a sole proprietor’s method of deferring deductions employed by a sole proprietor using the cash of accounting was an accounting method. Therefore, the IRS’s adjustment in a notice of deficiency to that item constituted a change in his accounting method triggering the application of IRC Sec. 481.

Once a taxpayer has adopted an accounting method, it generally must continue to use that method until IRS requires a change or the taxpayer receives permission from IRS to change it. A change in accounting methods includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item (such as the time for the inclusion of an income item or the taking of a deduction) used in the overall plan.

IRC Section 481(a) provides that, in computing the taxpayer’s taxable income for any tax year, if such computation is under an accounting method different from that used for the preceding tax year, then an adjustment is made to prevent amounts from being duplicated or omitted as a result of the change. The adjustment may include amounts attributable to tax years for which assessment is barred by the statute of limitations.

In this case, the taxpayer’s CPA noticed that the sole proprietor had very little income, or possibly, even a loss for 2004 and questioned why the taxpayer stayed in a business that was losing money. The taxpayer explained that the business was paying independent contractor expenses for which it was not receiving the income until much later. As a result of discussions with the CPA, the taxpayer began deferring deductions for the independent contractor expenses for outside services until it received the income associated with those expenses. The IRS maintained that this was not consistent with the cash method of accounting and made adjustments accordingly. The Tax Court agreed that this was an accounting method change and that the Section 481 adjustment provisions applied.


KNOWLEDGE CHECK

1. Which statement is not correct regarding the final regulations on Section 83(b) filings?

a. One copy of the election is filed with the IRS office where the taxpayer files his or her personal return.

b. A copy of the election must be submitted to the employer where the services were provided. c. The election statement must be filed with the taxpayer’s return to be valid. d. Property with respect to which this election is made is includable in gross income.

2. Which statement is correct surrounding Section 382?

a. An ownership change occurs when there is a greater than 80 percent ownership change in the 5 percent shareholders at any time during a three-year testing period.

b. The Section 382 limitation is calculated using the value of the loss corporation times the short-term federal tax-exempt rate.

c. If the net unrealized built in loss (NUBIL) does not exceed the lesser of $20 million or 10 percent of the FMV of the loss corporation’s assets (excluding cash and cash items) immediately before ownership change, then the NUBIL is deemed to be zero.

d. In CCA 201629007, the IRS determined that a loss corporation’s deferred revenue obligations are not includible in its net unrealized built in gain (NUBIG) calculations for purposes of determining its limitation on pre-change losses following an ownership change.

3. Which statement is not correct regarding participants who have self-only coverage in a Medical Savings Account for 2017?

a. The plan must have an annual deductible that is not less than $2,500 but not more than $3,750.

b. For self-only coverage, the maximum out of pocket expense is $5,000. c. For family coverage, the out of pocket expense limit is $8,250. d. Participants with family coverage have to have a deductible that cannot exceed $6,700.

TAX3 GS-0416-0A

QUARTERLY FEDERAL TAX UPDATE – THIRD QUARTER 2016

Solutions

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SOLUTIONS

QUARTERLY FEDERAL TAX UPDATE – THIRD QUARTER 2016

Solutions to Knowledge Check Questions

1. a. Incorrect. The election is made by filing one copy of a written statement with the IRS office with

which the person who performed the services files his or her return. b. Incorrect. The person who performed the services shall also submit a copy to the person for

whom the services are performed. c. Correct. The final regulations state that the election statement no longer has to be filed with the

taxpayer’s return. d. Incorrect. Property with respect to which this election is made shall be includible in gross

income as of the time of transfer, even though such property is substantially nonvested at the time of transfer, and no compensation will be includible in gross income when such property becomes substantially vested.

2. a. Incorrect. An ownership change occurs when there is a greater than 50 percent ownership

change in the five percent shareholders at any time during a three-year testing period. b. Incorrect. The Section 382 limitation is calculated using the value of the loss corporation

multiplied by the long-term federal tax exempt rate. c. Incorrect. If the NUBIL does not exceed the lesser of $10 million or 15 percent of the FMV of

the loss corporation’s assets (excluding cash and cash items) immediately prior to the ownership change, then the NUBIL is deemed to be zero.

d. Correct. Deferred revenue obligations are not to be included in the NUBIG calculations for purposes of determining pre-change losses following an ownership shift.

3. a. Incorrect. The plan must have an annual deductible that is not less than $2,250 but not more

than $3,350. b. Incorrect. For self-only coverage, the maximum out of pocket expense is $4,500. c. Correct. The out of pocket expense limit for family coverage is $8,250. d. Incorrect. Participants with family coverage have to have a deductible that is not more than

$6,750.

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