BUSINESS DEVELOPMENTS NOVEMBER 10, 2010 -...

The Tax CurriculumSM

Nichols Patrick CPE, Inc.

BUSINESS DEVELOPMENTS

NOVEMBER 10, 2010

Section: ERISA Participant's Spouse's Reliance on Representation of Plan Fiduciary

Cannot Give Rise to Claim Under ERISA for Breach of Fiduciary Duty ..................... 1

Section: ERISA Where Insurer Had No Discretion Under the Plan, Burden of Proof Not

Shifted to Insurer For Dispute Over Termination of Disability Benefits ...................... 2

Section: ERISA Employees Were Aware of Fiduciary Breach Six Years Before Filing

Suit, Thus Their Suit Was Time Barred ...................................................................... 3

Section: ERISA Denial of Disability Benefit Under Plan an Abuse of Discretion,

Attorneys Fees Awarded ............................................................................................ 4

Section: ERISA 29 USC §1001 Plan Administrator Violated Fiduciary Duty to Participant

by Not Disclosing Customer Service Line Responses Could Not Be Relied Upon .... 5

Section: ERISA 29 USC §1102(b)(3) Eighth Circuit Rules that Summary Plan

Description That Is More Restrictive than Plan Document Terms Cannot Be

Considered ................................................................................................................ 6

Section: Accountants Liability Accountant Who Failed to Disclose Proper Amount of Tax

on 7004 Found Liable to Clients for Treble Damages and Attorney Fees .................. 7

Section: FIN48 IRS Releases Final Form 1120 Schedule UTP and Modifies Some

Requirements ............................................................................................................ 8

Section: Legislation COBRA Subsidy Program Modified, Granting Relief to Employees

Who Terminate Employment Following a Reduction in Hours Event ....................... 11

Section: GAO GAO Reports Most S Corporation Returns Contain Errors, Recommends

Corrective Actions .................................................................................................... 12

Section: FIN48 FASB Gives Go Ahead to Private Company Reporting Under FIN48 ... 13

Section: 11 Land Surveying Properly Defined as Engineering in Regulations for Purpose

of Personal Service Corporation Rules .................................................................... 13

Section: 38 Employers Who Retain "Payroll Tax Holiday" Workers To Receive $1,000

Retention Credit in Following Year ........................................................................... 14

Section: 41 Expenses of Molds Sold to Customers Found to Be Properly Includable in

Computing Research Credit ..................................................................................... 15



Section: 45R IRS Issues Explanations and Guidance for Small Employer Health

Insurance Credit....................................................................................................... 15

Section: 45R IRS Releases List of Average Premiums for Small Group Market for 2010

................................................................................................................................. 18

Section: 48 Covering Incorporated into Exterior Windows of High Rise Building Qualifies

for Energy Credit ...................................................................................................... 21

Section: 61 IRS Publishes Terminal Charge and SIFL Mileage Rates for July-December

2010 ......................................................................................................................... 21

Section: 61 IRS Sets Annual Limits On Value of Vehicles for Cents Per Mile Valuation

Rule ......................................................................................................................... 22

Section: 62 IRS Finds a Tool Reimbursement Plan They Like ...................................... 22

Section: 105 Spouse Was Participant in "Shared Enterprise" Rather than Employee,

Medical Reimbursement Deduction Denied ............................................................. 23

Section: 106 Guidance Issued Regarding Removal of Over-the-Counter Drugs Obtained

Without a Prescription from Eligible Expenses for HSAs, MSAs, HRAs and medical

FSAs ........................................................................................................................ 24

Section: 106 Current Employer's Payment of Employee's Premiums for COBRA

Coverage from Prior Employer Generally Excludable From Income. ....................... 25

Section: 108 Treatment of §108(i) Debt Issues for S Corporations and Partnership

Issued by IRS .......................................................................................................... 25

Section: 108 C Corporation Treatment of §108(i) Acceleration Rule Addressed in

Temporary and Final Regulations ............................................................................ 27

Section: 108 Debt Secured by Single Member LLC Holding Only Real Estate Can

Qualify for Qualified Real Property Business Indebtedness ..................................... 29

Section: 108 IRS Finalizes S Corporation Reduction of Attributes Regulations When

Debt Discharge Excluded from Income Under §108 ................................................ 30

Section: 108 Deferral of Cancellation of Indebtedness Rules Explained ....................... 31

Section: 125 Medical FSA Full Reimbursement Available During Employment Period

Even if Employee Discharged Before Year End ...................................................... 32

Section: 132 Taxpayer Allowed to Exclude Value of Clothing and Accessories Provided

to Employee as De Minimus Fringe-But the Facts of the Case Matter ..................... 33



Section: 132 IRS Delays Effective Date of Debit Card and Smartcard Revenue

Procedure Used for Transportation Benefit .............................................................. 34

Section: 162 Payments to Investors to Not Redeem Shares Were Deductible Until Clear

Agreements Were Reasonably Expected to Be Renewed at Termination ............... 34

Section: 162 Owner's Compensation Found Reasonable in Profitable Year, But

Unreasonably High in Loss Year.............................................................................. 35

Section: 162 Taxpayer Not Allowed to Treat Reserve Arrangement With One Subsidiary

of AIG as Part of Insurance Policy with Other Subsidiary and Claim Full Current

Deduction ................................................................................................................. 37

Section: 162 No Deduction Allowed for Payments to Purported 419 Plan Far in Excess

of Annual Benefit Promised Under the Plan ............................................................. 38

Section: 162 Payments to Purported Management Corporation Disallowed ................. 39

Section: 165 Utility Should be Allowed Casualty Loss Deduction Currently Even Though

State Granted Rate Increase to Allow Recovery of Loss ......................................... 40

Section: 165 Lots That Could Not Be Accessed Not Properly Treated as Worthless Due

to Reasonable Prospect of Recovery ....................................................................... 40

Section: 167 SILO Transaction Lacked Any Economic Substance Apart from Tax

Benefits .................................................................................................................... 41

Section: 168 Street Lights Properly Classified by Electric Utility as Seven Year Property

................................................................................................................................. 42

Section: 168 Coordinate Issue Paper Holds That Proper Recovery Period for Open Air

Parking Structures is 39.5 Years, Not 15 Years ....................................................... 43

Section: 172 IRS Adds to Guidance for ARRA and WHBAA Net Operating Loss

Elections .................................................................................................................. 43

Section: 172 Options for Five Year Net Operating Losses for Consolidated Groups

Explained ................................................................................................................. 45

Section: 172 Dentists Repayments of Amounts Received from Insurance Fraud

Committed by Spouse Gave Rise to Business Expenses and Net Operating Loss . 45

Section: 172 Revised Elective 5 Year Net Operating Loss Added By Congress ........... 46

Section: 179 Truck Lease Not Equivalent to Sale, No Section 179 Deduction Allowed 47



Section: 179 $250,000 §179 Amount Extended Through End of 2010 ......................... 48

Section: 197 Designation of Vineyard as an American Viticultural Area Can Give Rise to

a §197 Intangible ..................................................................................................... 48

Section: 197 Taxpayer's Income from Sale of Customer Relationships That Could Be

Shown to Be Self-Created Not Subject to §1245 Recapture .................................... 49

Section: 197 15 Year Amortization of Agreement Not to Compete Required for

Acquisition of Any Sized Interest in a Trade or Business ......................................... 50

Section: 199 Production of Genetically Modified Material Qualifies for §199 Treatment,

But Only Minor Amount of Licensing Arrangement Would ....................................... 51

Section: 263 IRS Defines Safe Harbor Accounting Methods for Inventory for Auto

Dealers .................................................................................................................... 52

Section: 263 Manufacturer Required to Capitalize Incentive Payments Paid to

Customers Only for Contracts with Minimum Purchase Clause ............................... 53

Section: 263A Packaging Material Costs Must Be Capitalized, But Taxpayer Only Has

to Adjust Prospectively Due to Prior Letter Ruling ................................................... 54

Section: 263A Tax Court Ruling Requiring Capitalization of Royalty Payments Triggered

on Sale under §263A Reversed by Second Circuit .................................................. 54

Section: 274 IRS Adds "Public Safety Officer Vehicle" to List of Qualified Nonpersonal

Use Vehicles ............................................................................................................ 55

Section: 274 IRS Announces Auto Mileage Rates for 2010 .......................................... 56

Section: 274 IRS Updates Per Diem Rates for New Fiscal Year ................................... 56

Section: 280F IRS Announcing Depreciation and Lease Inclusion Amounts on Vehicles

for 2010 .................................................................................................................... 56

Section: 304 IRS Finalizes Rules Allowed It to Ignore Corporations Formed to Avoid

Application of §304 .................................................................................................. 57

Section: 316 Auto Titled in Shareholder Name Treated as Corporate Asset, and Date of

Check Determined by Date on Check Not Date Deposited by Shareholder ............ 58

Section: 351 Taxpayers Did Not Transfer Farming Activity to New Corporation, Income

Taxable to Shareholders Directly ............................................................................. 59



Section: 368 Revised Regulations Provide for Issuance of Deemed Share of Stock in D

Reorganization Where No Stock is Issued ............................................................... 59

Section: 401 IRS Announces Pension Plan Limitations for 2011 .................................. 60

Section: 401 Sixth Circuit Reverses Previous Position, Now Holds Equitable Estoppel

Can Apply to ERISA Pension Cases ........................................................................ 61

Section: 401 Department of Labor Relents, Allows Third Service Providers to Complete

and Electronically File Electronic 5500s for Clients.................................................. 62

Section: 401 Plan Administrator's Revised Interpretation of Plan Terms Still Must be

Granted Deference by Court Even if Initial Interpretation Found to Be Unreasonable

................................................................................................................................. 63

Section: 401 Adopters of Pre-Approved Defined Benefit Plans Will Have Until April 30,

2012 to Adopt Restated Version of Plans ................................................................ 64

Section: 401 IRS Releases Question and Answer Guidance on Implementing Provisions

of the 2008 HEART Act ............................................................................................ 64

Section: 402 Value of Life Insurance Policy Distributed from Qualified Plan Is Not

Reduced by Surrender Charges .............................................................................. 65

Section: 404 Eighth Circuit Again Denies Deduction to Corporation for Amounts Paid to

ESOP to Redeem Stock .......................................................................................... 66

Section: 409A IRS Analyzes Requests for Distributions to Determine If They Were

Unforeseeable Emergencies .................................................................................... 67

Section: 409A Relief Granted for Certain Documentation Issues Related to Nonqualified

Deferred Compensation Plans ................................................................................. 67

Section: 411 Modifications to Welfare Plan Held to Be Constructive Amendment to

Pension Plan that Violated Anti-Cutback Rule ......................................................... 69

Section: 415 IRS Announces 2010 Qualified Plan Inflation Adjusted Limits .................. 70

Section: 419 §419A(f)(6) Plan Revised to Eliminate Attempt at Qualification as 10 or

More Employer Plan Ruled No Longer Similar to Listed Transaction ...................... 70

Section: 446 IRS Announces Release of New Form 3115 That Will Generally Be

Required to Be Used for Requests After May 30, 2010. .......................................... 71

Section: 446 Change in Timing of Reporting Advance Payments on Applicable Financial

Statements is an Accounting Method Change for §446 ........................................... 72



Section: 451 Taxpayer Who Received Check in 2006 Could Not Show Substantial

Restrictions Existed and Had To Include in 2006 Income Though Not Cashed Until

2007 ......................................................................................................................... 72

Section: 451 Taxpayer Can Use Deferral Method of Revenue Procedure 2004-34 for

Prepaid Royalties Received in Lawsuit Settlement .................................................. 73

Section: 453 Taxpayer Granted Permission by IRS to Accelerate Recovery of Basis

Under Contingent Sales Price Installment Agreement ............................................. 74

Section: 460 Extended Maintenance Period on Road Paving Job Not Eligible for

Percentage of Completion Treatment for Tax Purposes .......................................... 75

Section: 461 Amounts Due Under Bonus Plan That Required Employees Remain

Employed Until Date of Payment Could Not Be Accrued Despite Requirement That

Amounts Not Paid to Employees Be Paid to Charity................................................ 76

Section: 465 At Risk Amount for Leasing Activity Did Not Include Amount Due on

Promissory Note for RV Not Owned by LLC or Used in LLC's Leasing Activity ....... 76

Section: 469 Participation by Trustee of Trust, and Not of Beneficiaries, Is Measured to

Determine Material Participation by Trust ................................................................ 77

Section: 472 Method of Properly Identifying Items for Creation of LIFO Pools for a

Vineyard Detailed ..................................................................................................... 78

Section: 481 Taxpayer Not Allowed to Submit Request to Change Accounting Method in

Current Year When IRS on Exam Disputed Whether Taxpayer Had File for

Permission in Prior Year .......................................................................................... 78

Section: 481 IRS Updates List of Automatic Accounting Method Changes ................... 79

Section: 481 Auto Dealers Losing a Franchise May Elect to Terminate LIFO and Spread

Adjustment Over Four Years ................................................................................... 79

Section: 482 IRS Chastised for Poorly Supported Position on Value of Intangibles

Transferred and Use of Temporary Regulations Issued 10 Years After the

Transaction .............................................................................................................. 80

Section: 501 Virtual Congregation Not Sufficient For Religious Organization to Qualify

as a Church Under the IRC ...................................................................................... 81

Section: 501 Bluetooth Certification Group Did Not Qualify as Tax Exempt Business

League ..................................................................................................................... 82



Section: 501 Foundation to Provide Single Donor's Sperm Free of Charge to Selected

Applicants Properly Denied Tax Exempt Status ...................................................... 83

Section: 512 Operation of Beach House and Parking Lot Were Unrelated-Business

Income for Homeowners Association ....................................................................... 84

Section: 512 Computer Software Intellectual Property Developed for Internal Use by

Church Was Not Unrelated Business Income When Sold ....................................... 85

Section: 512 VEBA Cannot Avoid Limit on Exempt Function Income By Claiming

Investment Income Used to Pay Benefits ................................................................ 85

Section: 565 IRS Allows Corporation to Make Late Consent Dividend Election for PHC

When Finally Advised of the Option Two Years Later .............................................. 86

Section: 704 §704(c) Anti-Abuse Rules Added by IRS to Regulations .......................... 87

Section: 705 Taxpayer's Initial Victory on Option Loss Generating Partnership Reversed

by Tenth Circuit ........................................................................................................ 88

Section: 705 Basis Calculation is a Cumulative and Not Year by Year Calculation When

Applying "Not Below Zero" Limit Found in §705(b) .................................................. 89

Section: 707 Transfer of Subsidiary to Partnership Was a Disguised Sale ................... 89

Section: 707 Investors Were Actually Partners, and There Was Not a Disguised Sale of

State Tax Credits ..................................................................................................... 90

Section: 707 Transfer of Assets to Partnership Followed by Pledge of Interest to

Receive Nonrecourse Loan and Related Put Held to Be Disguised Sale ................ 91

Section: 752 Son-of-BOSS Transaction Found to Lack Economic Substance, so Issue

of Retroactive Application of Reg. §1.752-6 Not Relevant. ...................................... 92

Section: 851 Discharge of Indebtedness Income From Requiring Debt by Regulated

Investment Company Held to Be Qualifying Income ................................................ 93

Section: 864 Worldwide Allocation of Interest Delayed Yet Again ................................. 93

Section: 881 Guarantee Fees Paid to Foreign Parent Corporation Held Not to Be U.S.

Source Income ......................................................................................................... 94

Section: 1001 Transfers of Building on Owned Land Were Sales, Those on Leased

Land Were Not ......................................................................................................... 94



Section: 1031 Exchange Had Principal Purpose of Tax Avoidance, Deferral of Gain Not

Allowed .................................................................................................................... 95

Section: 1031 Pollution Control Credits Treated As Like Kind Property ........................ 96

Section: 1031 Leasing Company Could Not Avoid Recognizing Gain on Exchange Via

Qualified Intermediary to Acquire Equipment from Related Dealer .......................... 97

Section: 1221 Taxpayer's Ignorance of Need to Specifically Identify Hedging

Transactions Not "Inadverent Error" Allowing Treatment as Ordinary Losses ......... 98

Section: 1361 Stockholder Agreement Providing for Distributions to Pay Tax in

Accordance With Interest for Year Tax Arises Does Not Create Second Class of

Stock ........................................................................................................................ 98

Section: 1361 Merger of Parent into QSUB Was an F Reorganization, S Election Not

Terminated ............................................................................................................... 99

Section: 1361 Roth IRA Account is Not an Eligible S Corporation Shareholder .......... 100

Section: 1362 Corporation Removal of Guarantee of Return of Principal to Single

Shareholder Was Treated by IRS as Reason to Treat Termination as Inadvertant 100

Section: 1362 IRS Allows Late Election When Individuals Who Signed S Election Only

Believed They Were Shareholders ........................................................................ 101

Section: 1362 IRS Rules That Termination of S Election Due to Excess Passive Income

Was Inadvertent ..................................................................................................... 101

Section: 1362 S Corporation Shareholder Agreement Served to Preserve S Status

Despite Attempt to Transfer Shares to Ineligible Shareholder ............................... 102

Section: 1362 Trust That Erroneously Elected QSST Rather than ESBT Status Allowed

to Correct Error and Corporation Remained an S Corporation .............................. 103

Section: 1363 Section 291 Does Not Apply to Limit Deduction for Interest Paid on Debt

to Acquire Qualified Tax Exempt Securities for QSUB With S Status More than 3

Years ..................................................................................................................... 103

Section: 1363 LIFO Recapture Tax Does Not Apply to Proprietorship Electing S Status

Immediately Following §351 Incorporation ............................................................. 104

Section: 1366 Taxpayer's Inability to Show Basis, Combined with Fact that Debt

Guarantee Doesn't Create Basis, Means No S Corporation Loss Deduction......... 105



Section: 1367 Contribution of Capital Not Treated As Either Tax Exempt Income for S

Corporation Debt Basis Or Loss Under §165 ......................................................... 106

Section: 1374 Linked Prepaid Variable Forward Contract and Share Lending Agreement

Triggered Immediate Gain Recognition in Built In Gain Measurement Period ....... 107

Section: 1374 Price Paid Nine Months After S Election Was a Factor, But Did Not By

Itself, Establish Value at S Election Date for Built In Gain Tax .............................. 108

Section: 1402 IRS Protective Assertion of FICA Tax Due From S Corporation Did Not

Prohibit IRS From Later Arguments Payments Were Personal Self-Employment

Income ................................................................................................................... 109

Section: 3101 IRS Not Limited to Assessing Payroll Taxes Only Against Designated as

Compensation in Corporate Minutes for S Corporation ......................................... 110

Section: 3102 Owner of Company Held Liable for Payroll Taxes on Individuals He

Claimed Were Independent Contractors ................................................................ 110

Section: 3111 Qualified Employees Must Sign New Form W-11 or a Similar Affidavit For

Employer to Claim HIRE Act FICA Relief ............................................................... 111

Section: 3111 Employers Hiring Certain Individuals Not Responsible for Employer

Social Security for That Employee Through End of 2010 ...................................... 112

Section: 3121 Service Providers Working at Spa Held Not To Be Employees ............ 113

Section: 3121 IRS No Longer to Contest Claims for Refunds of FICA Taxes Paid to

Medical Residents Prior to April 1, 2005 ................................................................ 114

Section: 3121 Disagreeing with Federal Circuit Court of Appeals, Michigan District Court

Holds that Severance Payments Not Subject to FICA ........................................... 114

Section: 3121(b)(20) Performance of Repair Services for Boat Owner Did Not Render

Crew Member an Employee .................................................................................. 115

Section: 3302 Taxpayer Who Relied On Payroll Service Unable to Show State

Unemployment Taxes Actually Paid, Therefore Loses FUTA Credit...................... 116

Section: 3401 Public Officials Paid a Salary Are Employees Regardless of Status Under

Traditional Common Law Employee Test .............................................................. 117

Section: 4965 Final Regulations for Tax Exempt Entities That Participate in Prohibited

Tax Shelter Transactions Issued, 7/2/10 ................................................................ 117



Section: 4975 Disclosures of Fees Required by Service Providers to Qualified Plans,

Including Accountants and Auditors ....................................................................... 118

Section: 4980B COBRA Subsidy Period Extended and Expanded ............................. 120

Section: 6001 IRS Begins Accepting (and Potentially Demanding) Taxpayer Records in

Electronic Format ................................................................................................... 121

Section: 6011 IRS Updates List of "Transactions of Interest" and "Listed Transactions"

............................................................................................................................... 122

Section: 6031 IRS Adds New Inquiries and New Schedule B-1 to 2009 Form 1065 ... 122

Section: 6039 IRS Publishes Final Regulations on Reporting ISOs and ESPP Options

with First Reports Required for Calendar Year 2010 ............................................. 123

Section: 6050N Website that Keeps Percent of Charge Established by Artist When

Selling Music Must Report Net Paid to Artist on Form 1099 .................................. 123

Section: 6051 IRS Will Not Penalize Employers For Failing to Report Cost of Employer

Paid Health Care on 2011 Forms W-2 ................................................................... 124

Section: 6053 IRS Extends Attributed Tip Income Program Through December 31, 2011

............................................................................................................................... 125

Section: 6109 IRS Adds Requirement to List Name and Identifying Number of

Responsible Party When Applying for EIN ............................................................. 125

Section: 6205 Procedures for Correcting Employment Tax Errors In Various Situations

Explained by IRS ................................................................................................... 126

Section: 6226 Tax Court Had Jurisdiction to Determine Partnership a Sham, But Not to

Determine Affect on Individual Partners' Basis ...................................................... 127

Section: 6229 Fees Paid Related to Son of BOSS Partnership Transaction Transaction

Billed to S Corporation Nevertheless Is An Affected Item ...................................... 127

Section: 6231 Items Affecting Nonpartners Not Affected Items Nor Properly Handled Via

TEFRA Procedures ................................................................................................ 128

Section: 6231 Designation of a Tax Matters Partners on a 1065 By Partnership

Otherwise Exempt from Unified TEFRA Procedures Does Not Serve As Election to

Have Procedures Apply ......................................................................................... 128

Section: 6231 IRS Required to Issue Notice of Deficiency if No Partnership Item is

Changed, but Error Was Harmless ........................................................................ 129



Section: 6302 Paper Federal Tax Deposit Coupons To Be Eliminated Effective in 2011,

Businesses Must Deposit Virtually All Federal Taxes Electronically ...................... 130

Section: 6330 Appeals Officer's Admitted Lack of Understanding of Transcript Relied

Upon to Verify Tax Assessment Found Sufficient to Overturn CDP Hearing Holding

Against Taxpayer ................................................................................................... 130

Section: 6331 California Stop Notice To Be Treated as Superior to Federal Tax Lien 131

Section: 6331 Failure to Immediately Honor Levy Makes Medical Clinic Liable for

Amounts Not Paid Over ......................................................................................... 132

Section: 6501 Gross Receipts Not Reduced By Returns or Allowances for Purposes of

25% Test for Six Year Statute ................................................................................ 132

Section: 6501 Credits Carried Back After Release of Credit from Net Operating Loss

Carryback to Later Year Do Open Year to Assessment ......................................... 133

Section: 6501 IRS, After Losing in Court, Revises Regulations to Redefine an

Overstatement of Basis as Creating an Understatement of Income Under

§6501(e)(1)(A) ....................................................................................................... 134

Section: 6601 Taxpayer Cannot Elect to "Redesignate" Application of Overpayment

After Return is Filed ............................................................................................... 135

Section: 6621 Consolidated Group Not Eligible for Interest Netting With Overpayments

from Subsidiaries Acquired After Year of Underpayment ....................................... 135

Section: 6652 Exempt Organization Late Filing Penalty Is To Be Either Completely

Abated Due to Reasonable Cause or Applies in Full ............................................. 136

Section: 6656 Taxpayer Reasonably Relied on Erroneous Advice from CPA Regarding

Payroll Issues, Penalties Waived ........................................................................... 137

Section: 6662 Taxpayer Could Not Reasonably Rely on Advice from Two Accountants

When Taxpayers Provided Neither With All Relevant Facts .................................. 137

Section: 6662 Corporation's Reliance on Opinion Letter From CPA Firm Involved In

Structuring Transaction Not Reasonable, Penalties Applied .................................. 139

Section: 6662 Executor Reasonably Relied Upon Preparer, Was Unaware Preparer Had

Been Disbarred by OPR ........................................................................................ 140

Section: 6662A Penalties Apply to Reportable Transaction, Did Not Violate Due Process

............................................................................................................................... 141



Section: 6665 Large Corporate Estimated Taxes Due in July, August and September of

Three Years Accelerated ....................................................................................... 142

Section: 6672 Owner Who Lacked Signature Authority Over Checking Account Held

Liable for Responsible Person Penalty .................................................................. 142

Section: 6698 & 6699 Penalties Increased Dramatically for Late Filed Partnership or S

Corporation Returns ............................................................................................... 143

Section: 6901 Buyer of Corporate Assets Found Not Liable for Tax of Seller Under

Transferee Liability Theory .................................................................................... 143

Section: 7206 Taxpayer Who Admitted He and Preparer Had "Agreed to Cover Each

Other's Backs" Properly Convicted of Filing False Returns and Conspiracy .......... 145

Section: 7422 Characterization of Transaction as Sham a Partnership Item, Statute of

Limitations Defense Not Available to the Individual Partners in Refund Action ...... 146

Section: 7422 IRS Settlement Did Not Amount to Concession on Sham Transaction

Doctrine or That Sham Transaction Issue Not a Partnership Item ......................... 147

Section: 7430 Attorneys Fees Awarded for Initial IRS Postion, But Not for Second

Position Taken Following Rejection of First ........................................................... 148

Section: 7602 DC Circuit Rules Disclosures to Auditors Did Not Remove Work Product

Privilege ................................................................................................................. 149

Section: 7602 Supreme Court Declines to Review Holding that Tax Accrual Workpapers

Not Protected by Work Product Privilege ............................................................... 150

Section: 7701 Late Request For Automatic Relief Under Rev. Proc. 2009-41 Should

Result in Change Effective Exactly 3 Years and 75 Days Prior to Date of Request

............................................................................................................................... 151

Section: 7701 IRS Liberalizes Relief for Late Entity Elections Under Check the Box

Rules ...................................................................................................................... 152

Section: 7805 Failure to Properly Answer Question About Controlled Entities Allowed

IRS to Retroactively Revoke Plan's Determination Letter ...................................... 152

Section: 9100 Taxpayer That Accidentally Neglected to Scan Required 3115 to Submit

with Efiled Return Granted Reprieve ...................................................................... 153

Section: 9100 IRS Grants Taxpayer Permission to File Copy of 3115 with National

Office After Due Date ............................................................................................. 154



Section: 9815 Preventive Care Must Be Provided Without Cost Sharing in Group Health

Plans ...................................................................................................................... 155

Section: 9815 Temporary Regulations Give Requirements for Preexisting Conditions,

Benefit Limits and Rescissions Following Patient Protection and Affordable Care Act

............................................................................................................................... 156

Section: 9815 Temporary Regulations Outline Requirements for Grandfathered Health

Care Plans and Policies ......................................................................................... 159

Section: 9815 Temporary Regulations Outline Requirements for Meeting Age 26 Test

for Group Health Plans that Offer Dependent Coverage ........................................ 163


1 Nichols Patrick CPE, Inc.

SECTION: ERISA

PARTICIPANT'S SPOUSE'S RELIANCE ON REPRESENTATION OF PLAN

FIDUCIARY CANNOT GIVE RISE TO CLAIM UNDER ERISA FOR BREACH

OF FIDUCIARY DUTY

Citation: Shook v. Avaya, Inc, CA3 No. 09-4043, 11/2/10`

The Third Circuit Court of Appeals ruled that there could not be an action for breach of

fiduciary duty under ERISA when a participant claimed he had been damaged by a

misrepresentation that caused he and his wife to decide that she should retire from her

job. The case in question involved an employer that had been subject to an acquisition.

The key question became how many years of service the participant would have credit

for under the plan, and to what extent his service to the predecessor employer would

count under the successor employer's plan.

Based on answers the participant had received to inquiries regarding his start date for

various benefits the participant had computed his expected retirement benefit. The

benefit he computed presumed that he would be able to obtain a full retirement benefits

even if he were to be, as it turns out he was, laid off in a force reduction in the near

future. Based on that expected benefit, it was decided that his wife could go ahead and

retire from her job with a different employer. Unfortunately, the actual benefit he

qualified for when he was laid off was substantially less than what he had computed.

Even worse, his wife had retired before he had been laid off.

The Court held that the actions of a non-participant, that is the wife in this case, could

not be the source of a claim for breach of fiduciary duty due to detrimental reliance on a

fiduciary's representation. Rather, the Court held that it was required to show action on

the part of the participant that led to the damages.

The Court noted that the wife's decision to retire had no impact on the participant's

benefits, nor did it have any effect on benefits potentially payable to her as a beneficiary

of her spouse under the plan. The Court found that this was not a reasonably

foreseeable consequence to the fiduciary.



SECTION: ERISA

WHERE INSURER HAD NO DISCRETION UNDER THE PLAN, BURDEN OF

PROOF NOT SHIFTED TO INSURER FOR DISPUTE OVER TERMINATION

OF DISABILITY BENEFITS

Citation: Muniz v. Amec Construction Management, No. 09-55689, 10/27/10

The Ninth Circuit Court of Appeals sustained a District Court ruling holding an individual

did not qualify for disability benefits under the terms of an employer plan, and that the

plan was justified in terminating the individuals disability benefits.

The individual in question was diagnosed with HIV in 1989, and stopped working in

1991. He began receiving disability benefits under the plan in 1992. In 2005 his claim

came up for periodic review.

After examining medical records submitted by the employee, the insurer determined

that he could perform sedentary employment which rendered him no longer disabled

under the terms of the plan. Eventually the employee filed an appeal with the United

States District Court. The court reviewed the insurer's decision using a de novo

standard of review after finding the plan did not grant discretion to the insurer in this

area.

An expert appointed by the court to perform this review determined that the employee

was no longer disabled under the terms of the plan and the court sustained the denial of

benefits.

The employee argued that because he had presented his own physicians statements

regarding proof of disability, the burden of proof should have shifted to the insurer to

clearly show he was no longer disabled.

The Ninth Circuit declined to follow this result. The Court noted that the employee was

citing cases on the burden of proof under situations where the administrator had

discretion and the test was for an abuse of discretion. In this case, the administrator did

not have discretion and the prior burden decisions did not apply to the District Court's de

novo review.

The Court also found that while the fact the employee had previously been paid

disability benefits may be relevant to the question of whether he remained disabled, that

fact itself did not shift the burden of proof to the plan.



The key factor in this case was the lack of discretion on the part of the plan

administrator. Where the plan administrator has discretion under the plan, the Courts

have expressed concern that a conflict may exist where the funds to pay the benefit will

come from the organization which is exercising the discretion. However, in this case the

plan did not grant discretion and the District Court conducted its own independent de

novo review of the determination of disability. Thus it appears the Ninth Circuit panel

concluded that the risk inherent when there is discretion did not exist here, and

therefore no special burden rested upon the plan administrator.

SECTION: ERISA

EMPLOYEES WERE AWARE OF FIDUCIARY BREACH SIX YEARS

BEFORE FILING SUIT, THUS THEIR SUIT WAS TIME BARRED

Citation: Brown, et al v. Owens Corning Investment Review Committee, et al,

CA6 No. 09-3692, 9/27/10

Better late than never did not apply to participants in a plan who were alleging the plan’s

fiduciaries should have acted to remove from the plan an investment option in employer

securities for an employer who ended up filing bankruptcy, causing the value of the

stock of the employer to plunge dramatically. The company filed bankruptcy after facing

numerous lawsuits related to asbestos in an industrial insulating product the company

had produced prior to 1972.

Prior to 2000 all employer matching contributions and ½ of the employer’s discretionary

profit sharing contribution was required to be invested in employer stock. The

requirement was dropped via a plan amendment in the year the employer eventually

filed bankruptcy.

The participants did not initiate their suit until six years after the bankruptcy. ERISA

generally limits suits for breach of fiduciary duty to the earlier of six years following the

alleged breach or three years after the participant becomes aware of the alleged

breach. In the view of the Sixth Circuit, which heard this case, such knowledge does

not require that the participant be aware that the matter could qualify as breach under

ERISA, only that the participants be aware of the breach. The court noted that other

circuits do require that the participants be aware of the potential ERISA action,

specifically citing the Third Circuit’s 1992 decision in Int’l Union v. Murata Erie N. Am.,

Inc. The Sixth Circuit indicated that it clearly disagrees with that view.



The Sixth Circuit ruled that the participants were aware of key facts at the date of the

bankruptcy filing—that the investment had dropped dramatically in value and that

fiduciaries for the plan existed in the area of investment selection. The panel rejected

the claim that they were only aware that the plan could have been amended and not

that fiduciaries existed that could have selected plan investments. The Court indicated

that the receipt of the amendment in 2000 that changed the requirements to invest in

the company stock fund made clear that someone had the authority to select the

investments, knowledge sufficient to trigger the beginning of the statute of limitations.

In a concurring opinion, Judge Helene White took some issue with the majority’s finding

that the making available a summary plan description electronically should be held

against a participant who failed to read the document. Judge White complained that

ERISA imposes a high standard on employers to insure employees actually receive the

SPD, and that the sponsor’s action of simply posting the SPD online did not, in her view,

meet the standard expected for the employer to be able to rely on the disclosures in that

SPD even if an employee did not actually read it.

She concluded that, in this case, this finding did not ultimately change the view that the

participants (including one who failed to read the document) had waited too long, but

the discussion does raise some questions about what is adequate disclosure for such

documents.

SECTION: ERISA

DENIAL OF DISABILITY BENEFIT UNDER PLAN AN ABUSE OF

DISCRETION, ATTORNEYS FEES AWARDED

Citation: Rote v. Titan Tire, CA8 Nos. 09-2510/2890, 7/28/10

While ERISA plan administrators' discretion in interpreting a plan are generally given

deference by the courts, there is a limit—and in this case the administrator was found to

have abused that discretion. The case came at the end of what was a long strike for the

union that the participant was a member in. The participant had surgery to replace the

joints in both of her thumbs. While recovering from the surgery in April 1998, the strike

began—a strike that did not end until October 2001.

When the strike ended, she asked to return to work and was evaluated by a physician

that the administrator selected to determine if she could return to work. The physician

determined there were substantial restrictions on her abilities, and the company

informed her that no jobs existed at the plant that were compatible with the required

restrictions.



The employer maintained a long term disability plan that covered participants who were

permanently and totally disabled so as to be unable to perform the work of any

classification at the plant. The employee, after much difficulty in obtaining the

paperwork, filed for the long term benefits. The physician who performed her surgery

noted that her restrictions had not changed and in his opinion. However, the employer

summarily dismissed her claim, saying only she was not disabled under the plan.

The employee filed suit, and the District Court found the decision purely conclusory and

lacked the explanation of a denial required under ERISA, and remanded the case for

further consideration. On remand, additional evidence was submitted on the question of

whether her disabilities were permanent. The sponsor focused on a technical reading

that since her attorney initially only asked if these restrictions would continue

indefinitely, that wasn't permanent under the plan. She asked for a review, and her

doctor clarified that when he said indefinitely, he meant that he intended the restrictions

to be permanent.

The District Court and the Eighth Circuit found that the sponsor had abused its

discretion in denying the benefits, finding the case ―wasn't a close matter‖ and ordered

the benefits to be paid. As well, the sponsor was ordered to pay the participant's

attorney fees for both cases and the administrative claim.

SECTION: ERISA 29 USC §1001

PLAN ADMINISTRATOR VIOLATED FIDUCIARY DUTY TO PARTICIPANT

BY NOT DISCLOSING CUSTOMER SERVICE LINE RESPONSES COULD

NOT BE RELIED UPON

Citation: Kenseth v. Dean Health Plan, Inc., CA7 No. 08-3219, 6/30/10

Under ERISA the Seventh Circuit ruled a plan administrator had a fiduciary duty to warn

participants in the health plan it administered that calls to its customer service

department, which participants were directed in documents given to the participants to

call if they had questions about covered procedures, could not be relied upon and the

existence of a second method to obtain a binding ruling had to be disclosed to those

individuals.



In the case in question a participant who had undergone gastric surgery years earlier

(prior to working for the plan sponsor) to treat morbid obesity developed problems

related to the surgery. The plan Certificate provided that it would not pay for any

surgical treatment for morbid obesity, and on another page of the document it provided

wording that the plan would deny treatment for procedures related to noncovered items.

However the plan had paid for one prior procedure to treat her complications, and when

she faced a more extensive surgery she called the customer service line and was told

the procedure would be covered. But once her surgery was completed, the plan ruled

that the procedure was not covered under the plan and refuse to pay.

The Seventh Circuit ruled that due to the fact that the document was not clear to an

average reader, and it directed the reader to call the customer service line to resolve

issues of coverage the plan violated its fiduciary duty to the participant by failing to

disclose the limits of the customer service representative and the existence of another

means that would be binding. However, the Court found that because the participant

was suing as an individual, and not on behalf of participants as a whole, she could only

seek an equitable remedy—and it wasn't clear if any such remedy would do her any

good. The case was remanded to District Court to determine if, in fact, there was any

equitable remedy being requested, or whether there was no remedy available.

SECTION: ERISA 29 USC §1102(B)(3)

EIGHTH CIRCUIT RULES THAT SUMMARY PLAN DESCRIPTION THAT IS

MORE RESTRICTIVE THAN PLAN DOCUMENT TERMS CANNOT BE

CONSIDERED

Citation: Ringwald v. Prudential, CA8, No. 09-1933, 6/21/10

The Eighth Circuit Court of Appeals, clarifying a previously holding that the District Court

had attempted to rely upon in its decision, held that a Summary Plan Description would

not be considered where it provided for discretion to the plan administrator not granted

in the plan document. The Circuit held that while it had previously ruled an SPD

provision in conflict with the plan that was in the participant's favor would generally

control, that would not be true of SPD provisions that conflicted and granted more

favorable positions for the administrator.



In this case the participant had been denied disability benefits under an ERISA plan that

limited benefits to 24 months if the disability was due to mental illness. In this case,

there was both a physical ailment (HIV) along with depression, and the plan

administrator (who was also the insurer under the plan) found that the participant was

not disabled based solely on his HIV condition. The District Court, relying on a

provisions in the SPD, but not in the plan document, that granted full discretion to the

administrator refused to review the determination from scratch, and rather only

conducted an abuse-of-discretion analysis, after which it dismissed the participant's

claim.

The Eighth Circuit sent the case back to the District Court to be reviewed de novo. The

Court held that the plan must have provisions to allow the plan itself to be amended,

and no provision allowed for such an amendment to be made informally via the SPD.

As well, the plan contained language that specifically disclaimed the power of the

summary plan description to amend the plan. Thus, the Eighth Circuit panel ruled, the

District Court should not have granted the level of deference that it did to the plan

administrator's decision and sent the case down for a new decision under the standard

it outlined.

SECTION: ACCOUNTANTS LIABILITY

ACCOUNTANT WHO FAILED TO DISCLOSE PROPER AMOUNT OF TAX

ON 7004 FOUND LIABLE TO CLIENTS FOR TREBLE DAMAGES AND

ATTORNEY FEES

Citation: Haddad Motor Group v. Karp, Ackerman, CA1 Nos. 06-2206, 09-

1479, 4/20/10

An accounting firm found that even though it was found not liable for the major claim of

damages against it, its actions were enough to trigger an award of treble damages

under Massachusetts law and, as well, a complete award of attorney fees and costs

incurred by the plaintiffs—amounts that were far in excess of the actual damages found.

The CPA firm in question acquired a client in December of 1997 that was already a

party to a ―margin-against-the-box‖ transaction that gave the corporation access to the

funds represented by appreciated stock it held, but delayed the payment of tax on that

transaction until the position was closed out. The corporation continued with the

accountant, and in December of 1998 met to discuss whether to close out the ―margin-

against-the-box‖ transaction (which incurred fees each year it was kept open) and

whether the corporation should make an S election.



On February 11, 1999 the corporation closed out the transaction, triggering the gain.

On March 15, 1999 the corporation filed an S election retroactive to the beginning of the

year—and causing the February transaction to be subject to built-in gains tax. In

December of 1999 the accounting firm informed the corporation it was subject to the

built in gains tax, and suggested the corporation file an extension at March 15 due to

the ongoing audit of the corporation’s 1997 return.

An extension was prepared, but no amount was shown as being due with the extension.

When the return was filed on the extended due date, the tax due, plus penalties for

underpayment of estimated taxes, late payment of taxes and interest were imposed.

The client sued the CPA firm asking for damages from the BIG tax and the penalties

and interest. The trial court found no damages from the BIG tax itself, but did find that

the penalties and interest were related to the CPA firm’s failure to advise the client to

make payment earlier.

More troubling, the court found that the firm acted willfully, rather than merely

negligently, based on the fact that the Form 7004 the firm prepared showed a very small

tax liability when the firm at that point knew a substantial liability for the built in gain tax

on this transaction was due. The willful action triggered an automatic trebling of the

$12,345 of damages to $37,035. But that wasn’t the worst of it—the finding also

triggered an award of attorney’s fees and costs in the case that amounted to over

$250,000, which included costs incurred on the portion of the claim for which the

plaintiffs did not prevail (in fact, that appears to have made up the vast majority of such

costs).

On appeal the First Circuit Court of Appeals sustained the result. The Court found it

plausible that the accounting firm had failed to discuss the payments due largely to

avoid having to admit the large amount of tax due that they had failed to warn the client

about, and found very damaging the preparation of the Form 7004 that failed to include

taxes the firm knew were due.

SECTION: FIN48

IRS RELEASES FINAL FORM 1120 SCHEDULE UTP AND MODIFIES SOME

REQUIREMENTS

Citation: Announcement 2010-75 and 2010-76, 9/25/10

The IRS has issued the final Form 1120 Schedule UTP for tax year 2010. In issuing

the final version of the form, the IRS also made modifications from the original proposal

that affects which entities will be required to file the return and the types of items that

will be reported.



Corporations that file Forms 1120, 1120-F, 1120-L or 1120-PC and issue or are

included in audited financial statements that have total assets exceeding $100 million

must file the schedule for their 2010 tax year. The total asset threshold will be reduced

over five years to include a larger number of corporations. The threshold for filing will

drop to entities with total assets of more than $50 million for 2012 tax years, and down

to total assets of $10 million for tax years beginning in 2014. The IRS indicated that it

will consider whether to extend these requirements to other taxpayers, such as

passthrough entities and tax exempt organizations, for 2011 and later years.

The final schedule dropped the requirement that taxpayers report the maximum tax

adjustment for each tax position listed on the schedule. Rather, taxpayers will required

to rank the positions in order based on the United States federal income tax reserve,

including interest and penalties, recorded for each position on the return. The taxpayer

must also specifically identify those tax positions for which the reserve exceeds 10% of

the aggregate amount of reserves.

The final version of the schedule no longer includes the requirement that a taxpayer

must disclose the rationale and nature of the uncertainty, replacing that with a

requirement that the taxpayer include a concise description of the tax position, including

a description of the relevant facts affecting the tax treatment of the position and

information that reasonably can be expected to apprise the Service of the identity of the

tax position and the nature of the issue.

The IRS has also eliminated the requirement that taxpayers report

tax positions for which no reserve was created due to a widely-understood

administrative practice, but indicated they would ―continue to explore‖ ways to

determine the impact of such positions on overall tax compliance.

The IRS clarified the instructions to indicate that the schedule looks for reporting of tax

positions consistent with the reserve decisions made by the entity for purposes of the

audited financial statements. As well, the unit of account for purposes of the form

should be applied consistent with the treatment in FIN 48. If a corporation uses IFRS or

another comprehensive basis of accounting other than GAAP for financial reporting

must identify a unit of account based on FIN 48 or any other level of detail that is

consistently applied if that identification is ―reasonably expected to apprise the Service

of the identity and nature of the issue underlying a tax

position taken in the tax return.‖



A number of other clarifications were made to the instructions based on the comments

received. The instructions were clarified to make clear that Schedule UTP requires the

reporting of U.S. income tax positions, but not foreign or state tax positions. As well, a

UTP must be filed once 1) a reserve for a tax position is recorded and 2) a tax position

is taken on the return, regardless of the order of those two events. As well, a

corporation reports only its own tax positions and not those of a related party.

Taxpayers also will not be required to report on tax positions taken in years before 2010

even if a reserve is recorded in audited statements issued for 2010 or later years. The

form is not required to be attached to returns for short tax years ended in 2010. As well,

worldwide assets is used to determine if a corporation meets the filing requirements.

The instructions define an audited financial statement as ―one on which an independent

auditor

expresses an opinion‖ and specifically excludes audited or compiled statements. The

definition of a reserve was clarified to indicate that it includes a reserve for United

States federal income taxes, interest and penalties, and that differences that are

temporary must still be reported on Schedule UTP.

If a corporation's information is included in multiple financial statements, the existence

of a reserve in any of those audited financial statements that relates to a position of the

taxpayer triggers the requirement to file the Schedule UTP.

The IRS did not adopt suggestions that taxpayers not be required to report positions for

which no reserve was recorded because the taxpayer expects to litigate the position,

litigation for which the taxpayer expects to prevail. No guidance is provided on how to

determine such ―expected to litigate‖ positions except to indicate that it ―expects that a

corporation would continue to document its

decision in the same way as it substantiates any decision not to record a reserve in its

financial statements.‖

The IRS also provided that disclosure of a position for other than a reportable

transaction on Schedule UTP will be considered a disclosed position for the purposes of

the penalty under §6662(i) for undisclosed positions lacking economic substance. As

well, complete and adequate disclosure of a position on the Schedule UTP will be

treated as if the corporation had filed a Form 8275 or 8275-R for the position in

question. For the moment such disclosure will not satisfy the requirement to file Form

8886 for listed and reportable transactions, but the IRS is studying whether it may be

possible to eliminate this filing as well for disclosed positions.



Along with the announcement for the final Schedule UTP, the IRS released

Announcement 2010-76 that modified the IRS's ―policy of restraint‖ of seeking

documents in certain situations. The revised procedure provides that generally the IRS

will not seek to assert that disclosure to the outside auditor of items authorized subject

to privilege amounts to a waiver of the privilege unless the taxpayer has engaged in

other activities that would waive the privilege or it relates to a listed transaction for which

a request is made under IRM 4.10.20.3.

As well taxpayers may redact from any tax reconciliation workpapers related the

preparation of Schedule UTP requested by the IRS during exam that are ―(a) working

drafts, revisions, or comments concerning the concise description of tax positions

reported on Schedule UTP; 3 (b) the amount of any reserve related to a tax position

reported on Schedule UTP; and (c) computations determining the ranking of tax

positions to be reported on Schedule UTP or the designation of a tax position as a

Major Tax Position.‖ The revisions in the notice are to be incorporated in IRM 4.10.20.

SECTION: LEGISLATION

COBRA SUBSIDY PROGRAM MODIFIED, GRANTING RELIEF TO

EMPLOYEES WHO TERMINATE EMPLOYMENT FOLLOWING A

REDUCTION IN HOURS EVENT

Citation: Temporary Extension Act of 2009, 3/3/10

The Temporary Extension Act of 2010 extended the COBRA subsidy qualification

period for one month, from its scheduled February 28, 2010 termination date to March

31, 2010. But in addition it contains a couple of additional provisions that modified the

COBRA subsidy program.

The bill retroactively modified the program to allow individuals whose initial COBRA

event was a reduction of hours to qualify for the subsidy if they later were involuntarily

terminated. Such a person is eligible to elect COBRA coverage at the date of

involuntary termination even if the person had declined coverage at the initial loss of

coverage due to a reduction of hours.

The bill also grants protection to employers who reasonably determine that an

employee was involuntarily terminated. In such a case the employee will be deemed to

be involuntarily terminated for purposes of qualifying for the COBRA subsidy. Without

that protection, it was possible the employer might find upon an IRS examination that

the IRS might decide the termination did not qualify as involuntary and seek to recover

the Form 941 credit.



These provisions are effective as if they had been originally in the American Recovery

and Reinvestment Act of 2009. For employees that were involuntarily terminated

following a reduction of hours prior to the passage of this bill, a special 60 day election

period is created from the date of enactment of the bill, March 3, 2010.

After the expiration of this provision, Congress yet again extended the program towards

what became a May 31 ending date in the Continuing Extension Act of 2010. When

May 31 comes and goes, we’ll see if Congress yet again gives us a short term

extension of the COBRA subsidy.

SECTION: GAO

GAO REPORTS MOST S CORPORATION RETURNS CONTAIN ERRORS,

RECOMMENDS CORRECTIVE ACTIONS

Citation: Tax Gap: Actions Needed to Address Noncompliance with S

Corporation Rules, GAO-10-195, 12/15/09

In a report to the Senate Finance Committee, the GAO discussed the results of the

IRS’s National Research Project on S Corporations. The GAO found that, per the NRP,

68 percent of S corporation returns filed for tax years 2003 and 2004 had at least one

item misreported that affected net income, resulting in a net underreporting of income of

$85 billion. The GAO also found that returns prepared by paid preparers actually had a

higher error rate of 71 percent.

The GAO also noted significant problems for taxpayers in the computation of basis in

their S corporation shares, resulting in taxpayers claiming losses beyond those allowed

under the law. The GAO suggests that S Corporations be required to prepare a

computation of basis to be given to each shareholder.

The largest median adjustment was for shareholder compensation, amounting to

$20,127. The GAO noted that the largest adjustments in total for compensation took

place on S corporations with a single shareholder, decreasing as the number of

shareholders increased—and for S corporations with 4 or more shareholder there was

actually a negative adjustment.

The GAO also recommended the IRS take action to improve preparer compliance in this

area. The recommendations include licensing of paid preparers, including consideration

of special licensing for S corporation preparers and increased penalties imposed on

paid preparers.



SECTION: FIN48

FASB GIVES GO AHEAD TO PRIVATE COMPANY REPORTING UNDER

FIN48

Citation: ASU 2009-06, Income Taxes, 9/2/09

After a couple of delays, the Financial Accounting Standards Board gave the go ahead

for the implementation of the measurement and disclosure requirements of FIN48 to

private companies (or ―nonissuers‖ in the current parlance) and passthrough entities,

effective for annual statements with an ending date after December 31, 2009. The

FASB did make some modifications found in Accounting Standards Update 2009-06 in

the final requirements.

The ASU did remove some disclosure requirements for nonpublic entities. Such entities

will not be required to disclose a tabular reconciliation of uncertain return positions, nor

would they prepare a summary of exposures that would change the effective tax rates.

However the other measurement and disclosure requirements of FIN48 will apply to

such entities.

Firms should be readying procedures to handle FIN48 compliance for clients that

require GAAP compliant statements. Firms should also consider the potential impact on

their independence of any assistance tax practitioners render to the client’s accounting

staff in assembling the information necessary to comply with FIN48, specifically

considering issues related to nonattest work covered by Ethics Interpretation 101-3.

SECTION: 11

LAND SURVEYING PROPERLY DEFINED AS ENGINEERING IN

REGULATIONS FOR PURPOSE OF PERSONAL SERVICE CORPORATION

RULES

Citation: Kraatz & Craig Surveying, Inc. v. Commissioner, 134 TC No. 9,

4/13/10

The Tax Court had, in the case of Rainbow Tax Serv. vs. Commissioner, 128 TC

42, had ruled that the definition of accounting for purposes of determining if a C

corporation is a personal service corporation, the field was not limited to those licensed

as accountants under state law. Rather, the court held that we had to test that field

based on its normal meaning.



Now the Tax Court turns to another of the defined fields for personal service

corporations, engineering. In the current case, the taxpayer argued that land surveying

should not be treated as engineering because state law did not treat land surveying as

engineering, required separate licensing, and the firm had no licensed engineers on its

staff. However, the Tax Court held that the IRS had included surveying in the definition

of engineering in Temporary Reg. §1.448-T(e)(4)(i), and that the definition conformed to

both the legislative record of what Congress saw as engineering and general dictionary

definitions of engineering.

The Tax Court specifically held yet again that state licensing laws do not

determine whether an activity falls into one of the affected categories, noting that due to

lack of consistency among the laws making use of those laws would end up with

taxpayers performing identical services being taxed differently.

Thus, the land surveying firm was subject to the flat 35 percent tax rate on its

taxable income.

SECTION: 38

EMPLOYERS WHO RETAIN "PAYROLL TAX HOLIDAY" WORKERS TO

RECEIVE $1,000 RETENTION CREDIT IN FOLLOWING YEAR

Citation: Section 102, Hiring Incentives to Restore Employment Act, 3/18/10

As a companion to the payroll tax exemption provision of the HIRE Act, the law at Act

Section 102 grants an addition to the general business credit in the following year

(which will generally be 2011) of the lesser of $1,000 per qualified individual who first

meets the following criteria during the tax year in question or 6.2% of the wages paid

during the 52 week measuring period.

The employee must be employed by the taxpayer on any date during the tax year in

question, must be so employed for a period of not less than 52 consecutive weeks and

whose wages for the last 26 weeks of the period equaled at least 80 percent of the

wages paid to the employee for the first 26 weeks of that period. The 52 week period

mentioned above is the ―measuring period‖ for purposes of determining the credit.

Amounts paid to domestic workers and workers eligible for the foreign earned income

exclusion do not qualify as wages for purposes of this credit.

The credit is implemented as a part of the general business credit of §38, but this part of

the credit cannot be carried back to any taxable year beginning before the date of

enactment of HIRE (March 18, 2010).



SECTION: 41

EXPENSES OF MOLDS SOLD TO CUSTOMERS FOUND TO BE PROPERLY

INCLUDABLE IN COMPUTING RESEARCH CREDIT

Citation: TG Missouri Corporation v. Commissioner, 133 TC No. 13, 11/12/09

The Tax Court held that molds a taxpayer commissioned to be made by a third party

and were later sold to their customers were not ―assets subject to depreciation‖ and

qualified as supplies for purposes of computing the research credit under §41. The

taxpayer manufactured custom molds for customers in the auto industry, outsourcing

much of the work to outside entities. When a mold was complete, the mold would either

be sold to the customer or held by the taxpayer as equipment and depreciated.

In either case the taxpayer used the molds to manufacture parts. If a customer bought

the mold, the charge per unit was lower than if the customer did not do that. However, if

the customer bought the mold it took on the risks of ownership, while otherwise the

taxpayer had those risks. The IRS argued that because molds that weren’t purchased

were depreciated by the taxpayer, the property were ―assets subject to depreciation‖

and their cost did not count currently in computing the research credit.

The Tax Court held that because the sold molds were properly not depreciated by the

taxpayer, they were not such property and the expense did count currently in computing

the research credit.

SECTION: 45R

IRS ISSUES EXPLANATIONS AND GUIDANCE FOR SMALL EMPLOYER

HEALTH INSURANCE CREDIT

Citation: Notice 2010-44, 5/17/10

The IRS has provided additional guidance and a general explanation of the application

of the new tax credit for health insurance expenses of small employers. In the notice,

the IRS outlines employer eligible for the credit, the calculation of the credit, and how

the credit is claimed on the return, along with its interaction with estimated taxes and the

alternative minimum tax. The notice goes on to provide transition rules for 2010 that the

IRS had originally committed to provide in the explanation of the credit that was posted

to the IRS website.

The IRS outlines the following steps that are necessary to determine if an employer is

eligible to claim the credit:

Determine the employees who are taken into account for purposes of the credit.

Determine the number of hours of service performed by those employees.



Calculate the number of the employer’s FTEs.

Determine the average annual wages paid per FTE.

Determine the premiums paid by the employer that are taken into account for purposes

of the credit.

Employees taken into account do not include sole proprietors, partners in a partnership,

more than 2% shareholders of an S corporation and more than 5% owners of any other

business (which would include a C corporation). As well, family members or

dependents of those individuals are not taken into account. Seasonal workers are

excluded from the computation of full time equivalents (FTEs) unless the seasonal

worker works for the employer more than 120 days during the taxable year, but the

premiums paid for them may still be counted in computing the credit.

Hours of service include each hour for which an employee is paid, or entitled to

payment, for duties performed for the employer during the year and each hour for which

the employer is paid, or entitled to payment, for time in which no duties are performed

due to vacation, holiday, illness, incapacity, jury duty, military duty or leave of absence.

However, no more than 160 hours is counted under the ―no service‖ category for any

single continuous period for which service is not performed.

The IRS offers three methods that an employer may use to compute the hours of

service. The hours can be based on 1) the record of actual hours that meet the above

criteria, 2) a ―days-worked equivalency method‖ counting 8 hours of service for each

day for which an employee would be credited for one hour under the first criteria or 3) a

―weeks-worked‖ equivalency method counting 40 hours for each week for which an

employee would be credited with one or more hours.

The number of FTEs is computed by dividing the hours computed in step 2 by 2,080,

with result rounded down to the next lowest whole number if the calculation does not

result in a whole number. Average wages are computed by taking the total wages paid

to employees who are counted in the FTE calculation and dividing them by the number

of FTEs. This number is rounded down to next lower multiple of $1,000 if it does not

result in an even multiple of 1,000.

The amount of premiums paid are those paid under a qualifying arrangement for the

employee’s health care by the employer. If the employee pays a share of the

premiums, the employee’s payment is not counted. Payments made by employee

deferrals under a §125 cafeteria plan are not deemed paid by the employer for

purposes of the credit. Prior to 2014, the coverage can include a broad range of health

insurance options, but does not include specific types of coverage listed in §9832(c)(1).



The premiums paid for all coverage for an employee are limited to no more than the

amount that would have been paid under the average premium for the small group

market in the State (or area within the State) in which the employer offers overage.

That average rate will be published by the IRS for each year to which it applies, with the

2010 amounts found in Revenue Ruling 2010-21.

The notice then goes on to describe how to calculate the actual credit, laying out a three

step process:

1. Calculate the maximum amount of the credit;

2. Reduce the maximum credit in step 1 in accordance with the phaseout rule, if

necessary; and

3. For employers receiving a State credit or subsidy for health insurance,

determine the employer’s actual premium payment .

From 2010 to 2013 the maximum credit is 35% of eligible premium payments for a

taxable entity, and 25% of such premiums for a tax-exempt entity. For tax exempt

entities the credit is capped at the total amount of income tax withheld from employees

pay plus the employer and employee portion of Medicare taxes (but not social security

taxes).

The reductions for FTEs in excess of 10 and average wages in excess of $25,000 apply

separately, and thus the notice points out that an employer with less than 25 employees

and average wages of less than $50,000 may nevertheless find it qualifies for no credit.

In each case, the reduction is based on a ratio of the excess over the beginning of the

phase out level, which results in a percentage to reduce the credit by. If the total of

those percentages exceed 100%, no credit will be allowed.

The IRS gives the following example in its notice:

Example 12 – Calculating the credit phase-out if the number of FTEs exceeds 10

or average annual wages exceed $25,000. (i) For the 2010 taxable year, a

taxable eligible small employer has 12 FTEs and average annual wages of

$30,000. The employer pays $96,000 in health insurance premiums for its

employees (which does not exceed the average premium for the small group

market in the employer's State) and otherwise meets the requirements for the

credit.

(ii) The credit is calculated as follows:

(1) Initial amount of credit determined before any reduction: (35% x $96,000) =

$33,600

(2) Credit reduction for FTEs in excess of 10: ($33,600 x 2/15) = $4,480



(3) Credit reduction for average annual wages in excess of $25,000: ($33,600 x

$5,000/$25,000) = $6,720

(4) Total credit reduction: ($4,480 + $6,720) = $11,200 (5) Total 2010 tax credit

equals $22,400 ($33,600 – $11,200).

The notice also describes the special limitations that apply if a state government pays a

subsidy or grants a tax credit to employers who offer coverage. Such amounts are

treated as payments made by the employer for the purpose of the credit, but in no case

may the credit allowed exceed the net amount of premiums actually paid by the

employer after removing the subsidy or offsetting the payments by the state credit.

The credit is claimed on the employer’s income tax return as a general business credit

(the IRS indicated it will announce later how nonprofits will be able to claim the credit).

Generally the credit can be carried back one year and forward 20. However, since the

law provides the credit cannot be carried back to a year prior to enactment, 2010 credits

will not be able to be carried back.

For 2010 only a special transition rule granting relief from the uniform percentage rule

will apply. In 2010, so long as the employer pays at least 50% of the premium for

employee-only coverage for all employees covered it will be deemed to satisfy the

uniformity requirement for 2010.

SECTION: 45R

IRS RELEASES LIST OF AVERAGE PREMIUMS FOR SMALL GROUP

MARKET FOR 2010

Citation: Revenue Ruling 2010-13, 5/3/10

The IRS in Revenue Ruling 2010-13 has released a table of the computed average

premiums for the small group markets in the various states. That amount serves as a

cap on the amount of insurance premiums that can qualify for the small employer credit

under §45R as added by the Patient Protection and Affordable Care Act.

The table for the 2010 tax year is as follows:

State

Employee-

Only

Coverage

Family

Coverage

Alaska $6,204 $13,723

Alabama 4,441 11,275

http://www.irs.gov/pub/irs-drop/rr-10-13.pdf



Arkansas 4,329 9,677

Arizona 4,495 10,239

California 4,628 10,957

Colorado 4,972 11,437

Connecticut 5,419 13,484

District of Columbia 5,355 12,823

Delaware 5,602 12,513

Florida 5,161 12,453

Georgia 4,612 10,598

Hawaii 4,228 10,508

Iowa 4,652 10,503

Idaho 4,215 9,365

Illinois 5,198 12,309

Indiana 4,775 11,222

Kansas 4,603 11,462

Kentucky 4,287 10,434

Louisiana 4,829 11,074

Massachusetts 5,700 14,138

Maryland 4,837 11,939

Maine 5,215 11,887

Michigan 5,098 12,364

Minnesota 4,704 11,938

Missouri 4,663 10,681

Mississippi 4,533 10,501

Montana 4,772 10,212



North Carolina 4,920 11,583

North Dakota 4,469 10,506

Nebraska 4,715 11,169

New Hampshire 5,519 13,624

New Jersey 5,607 13,521

New Mexico 4,754 11,404

Nevada 4,553 10,297

New York 5,442 12,867

Ohio 4,667 11,293

Oklahoma 4,838 11,002

Oregon 4,681 10,890

Pennsylvania 5,039 12,471

Rhode Island 5,887 13,786

South Carolina 4,899 11,780

South Dakota 4,497 11,483

Tennessee 4,611 10,369

Texas 5,140 11,972

Utah 4,238 10,935

Virginia 4,890 11,338

Vermont 5,244 11,748

Washington 4,543 10,725

Wisconsin 5,222 12,819

West Virginia 4,986 11,611

Wyoming 5,266 12,163



The notice provides that additional amounts may be released for areas within a state

that have higher averages later, but in no case will the amounts be less than the amount

noted in the above table.

The amounts will enable taxpayers to begin to determine how much, if any credit, they

can expect to qualify for on their 2010 income tax return.

SECTION: 48

COVERING INCORPORATED INTO EXTERIOR WINDOWS OF HIGH RISE

BUILDING QUALIFIES FOR ENERGY CREDIT

Citation: PLR 201043023, 10/29/10

The IRS ruled that a specialized photovoltaic curtain wall that serves to cover the

window area of a high-rise building qualifies as energy property for purposes of the

Section 48 30% energy credit. In this design, some or all of the glass panes covering

the window area of a high-rise building are substituted with photovoltaic panes. When

these panes are connected to each other, they generate electricity.

Normally structural components of a building are excluded from the definition of Section

38 property. However, the IRS had ruled in Revenue Ruling 79-183 that a structural

component of a building that is engineered to be in essence part of the machinery or

equipment with which it functions qualifies as section 38 property.

The IRS ruled in this case that the photovoltaic curtain was the type of property

described in that ruling, and as such would qualify for the energy credit under Section

48.

SECTION: 61

IRS PUBLISHES TERMINAL CHARGE AND SIFL MILEAGE RATES FOR

JULY-DECEMBER 2010


The IRS has published the terminal charge and SIFL mileage rates applicable for the

taxation of fringe benefits related to valuing noncommercial air flights provided to certain

employees.

For the period from July 1, 2010 to December 31, 2010 the terminal charge will be

$41.00. The SIFL mileage rate for up to 500 miles is $0.2243 per mile, from 501-1000

miles is $.1710 per mile and for over 1500 miles is $.1644 per mile.



SECTION: 61

IRS SETS ANNUAL LIMITS ON VALUE OF VEHICLES FOR CENTS PER

MILE VALUATION RULE

Citation: Revenue Procedure 2010-10, 1/15/2010

The IRS set the limits for 2010 for the value of vehicles for which the cents per mile

valuation rule found at Reg. §1.61-21(e) can be used, which for 2009 is set at 50¢ a

mile. For a vehicle placed in service in 2010 the maximum value for a passenger

automobile is set at $15,300, the maximum value for a truck or van is set at $16,000. If

20 or more vehicles are being valued, then the amounts rise to $20,300 for an auto and

$21,000 for a truck or van.

SECTION: 62

IRS FINDS A TOOL REIMBURSEMENT PLAN THEY LIKE

Citation: LTR 200930029, 7/24/09

In 2005 the IRS released Revenue Ruling 2005-52 where the IRS attempted to warn

taxpayers about various plans being marketed to employers as ―tool reimbursement‖

plans that would reduce their payroll taxes and the taxes of their employees. The IRS

reminded taxpayers that in order for expense reimbursements to be excludable from

income, a plan had to meet the requirements imposed by IRC §62(c) and Reg. §1.62-2.

The plan in Revenue Ruling 2005-52 allowed employees to be given credit for tools they

already owned, applied average expense amounts to employees, and did not require an

accounting of expenses paid or the return of any excess reimbursement. In that case

the IRS held the entire amount of any reimbursements had to be treated as wages

subject to tax withholding and all payroll taxes.

The plan described in this letter ruling deals with all of these objections, and illustrates

the nature of a reimbursement plan that will meet the IRS’s standards. The plan only

reimbursed costs actually incurred while employed by the employer. The

reimbursement is only made if the tools are used exclusively in the employer’s

business, are maintained at the employer’s place of business, are needed to perform

the employee’s job assignments, are purchased from an approved vendor and are

considered necessary for the industry in question.

To be reimbursed, an employee must submit a claim form certifying that all information

is complete and that the plan will be complied with. The employee’s manager has to

approve the application, and documented proof of purchase must be submitted. An

employee must remain as an employee for six months after any reimbursement or will

be required to repay the reimbursement to the employer.



SECTION: 105

SPOUSE WAS PARTICIPANT IN "SHARED ENTERPRISE" RATHER THAN

EMPLOYEE, MEDICAL REIMBURSEMENT DEDUCTION DENIED

Citation: Shellito v. Commissioner, TC Memo 2010-41, 3/3/10

Sharlyn Shellito had for many years worked with her husband on the family farm, a farm

that reported under his name on Schedule F. Checks to pay expenses for the farm

were written from a joint checking account. In 2001, based on the advice of their

banker, the Shellitos consulted with a CPA who suggested that Milo should treat

Sharlyn as an employee, enabling him to offer her a medical reimbursement plan under

which the couple’s medical expenses could be paid and deducted. The couple took the

CPA’s advice, though the pay to Mrs. Shellito aside from the medical reimbursement

plan was only $100 a month.

The couple claimed reimbursed medical expenses of $15,593 in 2001 and $20,897 in

2002, which consisted of payments for expenses for the entire family. The IRS agreed

that if Mrs. Shellito were truly an employee these expenses would be deductible—but

they argued that, in fact, nothing had changed to suddenly make Mrs. Shellito an

employee in 2001.

The Tax Court agreed with the IRS. The court noted that the nature of the work that

Mrs. Shellito performed on the farm did not change when her status changed. The

Court did not agree that they had merely formalized a pre-existing employment

arrangement, finding that the payment of compensation for services rendered is a key

component of an employment arrangement. Rather Mrs. Shellito continued to

participate in what was a ―shared enterprise‖ with her husband.

The Court found some other problems—the payments of the reimbursements from a

joint account meant that, effectively, ½ of the payments Mrs. Shellito received came

from her. The court noted that Mr. Shellito was equally responsible for all medical

expenses incurred under state law. As well, while the fact the transaction was tax

motivated did not automatically render the payment nondeductible, it does give rise to a

heightened level of scrutiny about the underlying validity of the employment

arrangement.



SECTION: 106

GUIDANCE ISSUED REGARDING REMOVAL OF OVER-THE-COUNTER

DRUGS OBTAINED WITHOUT A PRESCRIPTION FROM ELIGIBLE

EXPENSES FOR HSAS, MSAS, HRAS AND MEDICAL FSAS

Citation: IRS Notice 2010-59, 9/3/10

The IRS has provided transition rules to deal with the removal of over the counter drugs

for which no prescription has been obtained as of January 1, 2011 as expenses eligible

to be reimbursed by an HSA, MSA, HRA or medical FSA. The change to the

reimbursement provisions as part of the Patient Protection and Affordable Care Act

passed by Congress early in 2010.

The notice contains a reminder of the scope of the definition and its requirements, as

well as pointing out that items that are not medicines or drugs, including medical

equipment (such as crutches), supplies (such as bandages) and diagnostic devices

(such as blood sugar test kits) may still be reimbursed under these programs so long as

the items otherwise meet the requirements to be treated as medical expenses.

The notice provides a limited grace period for health FSA and HRA debit cards to be

converted to no longer allow their use for payment of over the counter drugs. Such use

will not be challenged for expenses incurred prior to January 15, 2011 to give time for

the issuers to implement the necessary changes rather than requiring those limits to

become active as the clock strikes midnight and we enter 2011.

The notice also provides relief to cafeteria plans regarding the necessary amendments

to implement this new restriction. Generally cafeteria plans cannot adopt amendments

that have retroactive effect, but if the amendment is adopted no later than June 30,

2011, the amendment can apply retroactively for expenses incurred after the effective

dates of these new provisions.

The IRS also issued Revenue Ruling 2010-23 that obsoletes the guidance in Revenue

Ruling 2003-102 regarding the reimbursement of over-the-counter drugs from employer

health plans.



SECTION: 106

CURRENT EMPLOYER'S PAYMENT OF EMPLOYEE'S PREMIUMS FOR

COBRA COVERAGE FROM PRIOR EMPLOYER GENERALLY

EXCLUDABLE FROM INCOME.

Citation: Chief Counsel Email 201024047, 6/18/10

In emailed advice, a member of the Chief Counsel's office determined that the

reimbursement by a current employer of COBRA premiums under a prior employer's

plan could generally be excluded from the employee's income under §106 as payments

under a medical plan of the new employer.

While the email did not directly reference it, such a finding would seem to be governed

by looking at Revenue Ruling 61-146 for the appropriate guidelines an employer would

need to follow to make such a reimbursement fall into the ―generally excludable‖

category mentioned.

SECTION: 108

TREATMENT OF §108(I) DEBT ISSUES FOR S CORPORATIONS AND

PARTNERSHIP ISSUED BY IRS

Citation: TD 9498, 8/11/10

The IRS issued temporary and proposed regulations outlining the application of the

§108(i) cancellation of debt income deferral provisions as they apply to partnerships and

S corporations.

Unlike C corporations where the rules apply to all debt, for a partnership or S

corporation the rule only applies to what is referred to as an ―applicable debt

instrument.‖ An ―applicable debt instrument‖ generally is a debt instrument issued by

the partnership or S corporation in connection with the conduct of a trade or business.

While the regulations hold that this determination is based on all facts and

circumstances, five safe harbor tests are provided where the debt will be treated as

issued in connection with the conduct of a trade or business. Meeting any of the five

tests will cause the debt to be treated as an ―applicable debt instrument.‖

1. At the date of issuance of the debt instrument, the gross fair value of the trade or

business assets of the entity represented at least 80% of the gross fair value of the

entity's total assets;

2. For the taxable year of issuance, the trade or business expenditures of the entity

represented at least 80% of the entity's total expenditures for the year in question;



3. For the year of issuance at least 95% of the proceeds of debt instruments are

traceable to trade or business assets under the interest tracing rules of §1.163-8T;

4. At least 95% of the proceeds from the debt instrument were used by the entity to

acquire one or more trades or businesses within 6 months of the date the debt was

issued; or

5. The entity issued the debt instrument to a seller of the trade or business to acquire

the trade or business. [Reg. §1.108(i)-2T(d)(1)]

While COD income must be allocated in accordance with the standard §704 rules for a

partnership, after the amount has been allocated among the partners, the partnership

can designate what portion of each partner's COD income is subject to the election and

which portion is not. [Reg. §1.108-2T(b)(1)] For an S corporation, the COD income is

shared prorata among the shareholders that are shareholders immediately before the

reacquisition of the debt. [Reg. §1.108-2T(c)(1)]

Basis generally is not adjusted for either a partner nor an S corporation shareholder on

the deferred COD income until the income is taken into income by either the partner or

shareholder. However, for purposes of §752 special rules apply, and for purposes of

capital account maintenance deferred items are treated as if no §108(i) election had

been made.

There are rules in the regulation to prevent the election under §108(i) from triggering

recapture of losses under §465(e). The decrease in amount at risk is not taken into

account until such time as the amount is recognized in income by the partner or

shareholder.

Acceleration events are addressed in the regulations. These are events that trigger the

early recognition of the COD income. There are separate triggers that can apply to the

entity as a whole, or those that apply to individual partners or shareholders.

The following events at the entity level would trigger an acceleration event for all direct

and indirect interest holders: 1) liquidation of the entity, 2) sale, exchange, transfers or

gifts of substantially all of the entity's assets, 3) cessation of business by the entity or 4)

filing a petition in a bankruptcy or similar case. As well, for an S corporation the

termination of the S election is an acceleration event under the regulations.

Substantially all of the entity's assets is defined to mean assets representing at least

90% of the fair value of the entity's net assets and at least 70% of the fair value of the

entity's gross assets. Special rules are provided for partnership transfers subject to

§721 where subsequent transactions result in dispositions.



At the individual partner level, the following items will be treated as acceleration events:

1) death or liquidation of the partner, 2) sale, exchange, transfer or gift of all or a portion

of the partners' interest, 3) redemption of the partner's interest or 4) abandonment of the

partner's interest. Events 1, 2 or 4 in the context of an S corporation will cause an S

corporation shareholder to have an acceleration event.

If only a portion of an interest is sold, exchanged, transfers or gifted, only a

proportionate amount of the COD deferral is triggered.

Certain events are not treated as acceleration events. Transfers under §721 (tax free

contributions to a partnership) are generally excluded, as are like kind exchanges under

§1031 though for the latter the receipt of boot will be considered in determining what

proportion of assets were sold. Technical terminations of a partnership under §708(b)

are also not treated as acceleration events.

The regulations apply to applicable debt instruments reacquired in taxable years ending

after December 31, 2008.

SECTION: 108

C CORPORATION TREATMENT OF §108(I) ACCELERATION RULE

ADDRESSED IN TEMPORARY AND FINAL REGULATIONS

Citation: TD 9497, 8/11/10

The IRS issued temporary and proposed regulations that impact C corporations that

have deferred recognition of cancellation of indebtedness income under §108(i). These

regulations deal largely with the provisions of the acceleration of inclusion of the

deferred gain under the provisions of §108(i)(5)(D). Generally that section provided that

gain would be accelerated on certain events which include ―the death of the taxpayer,

the liquidation or sale of substantially all the assets of the taxpayer (including in a title

11 or similar case), the cessation of business by the taxpayer, or similar

circumstances...‖ per the statute.

The IRS held that while technically appearing to be a triggering event, it would be

contrary to the stated goal of §108(i) for the acceleration provisions to apply to

transactions where §381(a) applies to allow the acquiring corporation to succeed to the

tax attributes of the acquired corporation, specifically in the liquidation of a subsidiary

under §332 or a transfer in an A, C, D, F or G reorganizations where §361 applies.

Thus the regulations hold that such transactions will not be triggering events to

accelerate the recognition of income.



Rather under the temporary and proposed regulations a C corporation will trigger

acceleration if certain events that threaten ultimate collection of the tax take place.

Those events are 1) a change in the entity's tax status, 2) the cessation of existence of

the corporation in a transaction to which §381(a) does not apply or 3) engages in a

transaction that reduces the net value of the corporation to such an extent that the

ultimate collection of the tax is threatened. The regulations provide a net value

acceleration rule test that, if violated, will trigger the recognition in the third

circumstance.

Generally the net value acceleration rule is triggered generally if a corporation enters

into an ―impairment transaction‖ and the corporation at that points fails a mechanical net

value test. An impairment transaction is any transaction that impairs the corporation's

ability to pay the amount of the Federal income tax liability on the deferred COD

income. Specifically such transactions would include distributions (including §381(a)

transactions), redemptions, below market sales, donations and incurrence of additional

indebtedness without a corresponding increase in asset value. Excluded from the

treatment are value for value exchanges, including ones to which §351 (tax free

incorporation) or §721 (tax free contributions to partnerships) apply.

If an impairment transaction takes place, the net value acceleration rule is triggered if

the gross value of the corporation's assets is less than 110% of the sum of the the

corporation's total liabilities and the tax on the net amount of the tax that would be due

on the deferred items under §108(i). The tax due is computed by using the tax that

would due at the highest applicable rate for the taxable year on the outstanding deferral,

even if the corporation's actual tax rate is not that rate.

If the acceleration provision is triggered, then the entire remaining deferral is subject to

tax at the time of the impairment transaction. However a corporation can escape this

treatment if if value value is restored to the corporation by the due date of the corporate

return, including extensions. The corporation must restore the lesser of the value of

amounts that were removed in one or more impairment transactions (net of any

amounts previously restored under this option) or the amount of the shortfall under

110% rule.

Special rules are provided that allow a member of a consolidated group to, at any time,

trigger all of its remaining deferred COD income.

The regulations also provide that earnings and profits are not increased for the deferred

amount of income until such time as the item is brought into income for the corporation.



Generally the rules apply to acceleration events occurring on on or after August 11,

2010. Given that the rules appear to be more generous than the literal reading of the

law would allow, the regulations allow a corporation to elect to treat acceleration events

occurring before August 11, 2010 under these rules and, if necessary, to restore value

by the fifteenth day of ninth month following August 11, 2010.

SECTION: 108

DEBT SECURED BY SINGLE MEMBER LLC HOLDING ONLY REAL

ESTATE CAN QUALIFY FOR QUALIFIED REAL PROPERTY BUSINESS

INDEBTEDNESS

Citation: PLR 200953005, 12/31/09

The taxpayers had a loan that was secured by their interest in a single member LLC, an

LLC formed solely to hold a piece of real estate and which is treated for tax purposes as

a disregarded entity. The taxpayers are negotiating to refinance that indebtedness.

The real estate securing that debt has declined in value and the taxpayers believe that

some of the debt will end up being cancelled as part of the refinancing operation. They

sought a ruling from the IRS that even though the debt is secured by the LLC interest

rather than directly by the real estate, the reduction in indebtedness would still be able

to qualify as qualified real property business indebtedness under §108(c)(3)(A).

The IRS ruled that the existence of the LLC as a disregarded entity means that the

property is treated as being owned directly by the taxpayer. The ruling notes that it

would ―incongruent‖ to pay attention to the LLCs for purposes of determining whether

the debt is secured by real property when that LLC is otherwise disregarded for federal

tax purposes. The IRS therefore held that merely having the property titled in the name

of the LLC, and then having the interests pledged against the debt, did not remove the

ability for such a debt to qualify for treatment as qualified real property business

indebtedness under §108(c)(3)(A).

Therefore, if the debt otherwise meets the requirements, the debt cancellation could be

excluded from income and the basis of the property reduced. Since, for environmental

liability concerns, a number of property acquisitions have been structured in this form

(many times at the behest of the lender), this ruling gives comfort that this technicality

will not remove such real estate related debt from the potential relief provisions of

§108(c)(3)(A).



SECTION: 108

IRS FINALIZES S CORPORATION REDUCTION OF ATTRIBUTES

REGULATIONS WHEN DEBT DISCHARGE EXCLUDED FROM INCOME

UNDER §108

Citation: TD 9127, Reg. §1.108-7(d), 10/30/09

The IRS has finalized the revisions of the regulations found at §1.108-7(d) dealing with

how an ―NOL‖ is to be reduced when income from debt discharge is excluded in the S

corporation context under IRC §108. The tests under IRC §108(a) for exclusion from

discharge of debt from income are tested at the S corporation level, pursuant to IRC

§108(d)(7). However, if debt discharge is excluded from income various tax attributes

are reduced, one of the first being any net operating loss of the taxpayer. S

corporations obviously don’t have such an item, so IRC §108(d)(7)(B) provides that

losses disallowed under IRC §1366(d)(1) at the shareholder level are treated as the

NOL for these purposes.

The regulations outline how this net operating loss is to be handled by the S

corporation. The overall disallowed losses of all shareholders are treated as the

―deemed NOL‖ and the S corporation reduces those losses. The reduction is allocated

among the shareholders under the methods contained in these regulations and then

reported back to the shareholders. Reduction is prorated based on the various types of

losses or deduction that each shareholder has.

Shareholders are required to report their disallowed losses to the corporation to enable

this calculation. However, if a shareholder either fails to provide this information after

reasonable attempts are made to obtain it by the corporation, or the corporation

determines that the information provided to it is in error, the corporation can make its

own calculation of a shareholder’s disallowed loss and use that. The regulations

contain comprehensive examples of how to calculate the amount of disallowed loss and

allocate it among the shareholders.



SECTION: 108

DEFERRAL OF CANCELLATION OF INDEBTEDNESS RULES EXPLAINED


In Revenue Procedure 2009-37 the IRS gave guidance on the application of §108(i),

added by American Recovery and Reinvestment Act of 2009, which provided for a

deferral of recognition on gain from cancellation of indebtedness in certain situations.

The new Revenue Procedure is the exclusive method for making an election to defer

recognition of gain, and also provides details on the information required to be provided

by a taxpayer electing the benefit of this provision.

Section 108(i) applies to debt instruments issued by a C corporation, or by any other

person in connection with the conduct of a trade or business. The deferral option is

available for a reacquisition of the debt (including indirect reacquisitions as defined by

Reg. §1.108-2(c)), which is defined as any of the following:

Acquisition of debt instrument for cash or other property

Exchange of the debt for another debt (including via a modification of the original

debt)

Exchange of the debt for corporate stock or a partnership interest

Contribution of the debt instrument to capital or

Complete forgiveness of the debt by the holder of the debt

The debt must be reacquired after December 31, 2008, and before January 1, 2011 to

be eligible to make the election (or, put more simply, in 2009 or 2010).

Recognition of the gain is made ratably over a five year period beginning, effectively, in

2014 (regardless of whether the reacquisition took place in 2009 or 2010).

If the election is made, the taxpayer cannot make use of the exclusions for this debt that

might otherwise be available for insolvency, bankruptcy, qualified farm and/or qualified

real property indebtedness found in Section 108. However, the procedure provides that

a taxpayer may make a partial election of this section covering only the portion of the

debt not otherwise excludable under those provisions of §108.



The Revenue Procedure also allows for taxpayers to file protective §108(i) elections that

would apply if it is determined that a transaction did not qualify for an exclusion under

Section 108. However, there is a downside to the protective election―should the IRS

determine, after the statute has closed on the year in which the forgiveness took place,

that the transaction did not qualify for the original §108 exclusion claimed, the taxpayer

will be required to recognize the income in the later years―that is, the election is

treated as effectively made in the closed year. Without the election, the IRS would have

only been allowed to assess tax for the year of discharge, and the statute would have

rendered the IRS unable to go after that tax.

The Procedure provides detailed rules for the election, as well as information to be

provided to passthrough interest holders as this election is made at the entity level for

both partnerships and corporations.

With the broad definition of ―reacquisition‖ which includes loan modifications and early

payoffs for cash, this provision may apply to many taxpayers that otherwise fail to

qualify for Section 108 relief on the restructuring (or even full forgiveness) of debts

related to business activities or in C corporations. At a minimum, consideration must be

given to discussing pros and cons of a protective election under this procedure for any

taxpayer that is claiming other Section 108 relief.

SECTION: 125

MEDICAL FSA FULL REIMBURSEMENT AVAILABLE DURING

EMPLOYMENT PERIOD EVEN IF EMPLOYEE DISCHARGED BEFORE

YEAR END


Sometimes we just need a short, succinct document that has IRS authorship to assure

a client that what we are telling them about the tax law truly is the answer, despite the

fact that they don’t like the answer. If you’ve ever had to deal with a client who couldn’t

believe that an employee who had elected to defer for the entire year to a medical FSA

could file a claim for the entire amount to be deferred in the first month of the year, then

leave in the second month and not owe back the difference, Chief Counsel email

201012060 is the document you need.

That email provides a one paragraph description of the rule, and makes clear that the

employer cannot limit payment of medical expenses only to amount already deferred,

and cannot recover any amounts paid in excess of the amounts deferred should an

employee leave employment before the end of the year.



SECTION: 132

TAXPAYER ALLOWED TO EXCLUDE VALUE OF CLOTHING AND

ACCESSORIES PROVIDED TO EMPLOYEE AS DE MINIMUS FRINGE-BUT

THE FACTS OF THE CASE MATTER

Citation: PLR 201005014, 2/5/10

The IRS ruled on the question of whether, for a large governmental subdivision, the

value of clothing and accessories provided to its employees could qualify as a de

minimus fringe benefit under §132(a)(4) and thus excluded from the employee’s

income.

To qualify as a de minimus fringe, the item must be of low value, it is not received too

frequently and it would be administratively impractical for the taxpayer to account for the

items in question. In the case at hand, the IRS found the individual items were of low

value. The departmental policies limited the availability of the items to the employee to

at most once or twice per year, allowing the IRS to find that the benefit was not provided

so frequently as to preclude it being low value overall.

Finally, the IRS found that due to the way that the items were acquired and distributed,

it would be administratively impractical for the taxpayer to determine the fair value of

items received by its employees.

The IRS noted that a factor in this determination was the taxpayer’s relatively large size

and large number of employees, and also noted that the taxpayer had not intentionally

designed its procedures to render the accounting impractical. These comments make

clear that this ruling does not stand either for the proposition that all employers may

provide clothing to employees tax free, nor that a taxpayer may attempt to design its

procedures and procurement process to make accounting impractical. Rather the ruling

illustrates the very case dependent nature of a determination if a fringe benefit is truly

de minimus.



SECTION: 132

IRS DELAYS EFFECTIVE DATE OF DEBIT CARD AND SMARTCARD

REVENUE PROCEDURE USED FOR TRANSPORTATION BENEFIT


The IRS has once again delayed the effective date of Revenue Ruling 2006-57 which

outlined requirements for the use of smartcards and debit cards for providing a qualified

transportation fringe benefit. The ruling listed requirements that had to be met that

limited the use of such cards to acquiring only a transportation benefit. If that

requirement was not met, such cards could only be used if it was part of an accountable

plan that would require employees to document qualified use.

The rules were first scheduled to go into effect on January 1, 2008. However, it has

been delayed twice before as the due date for compliance approached. Again the IRS

has delayed the effective date because transit systems have indicated they have not

been able to modify their systems to meet these requirements. The new effective date,

barring yet another IRS delay, is for benefits provided on or after January 1, 2011.

However, employers and employees may continue to rely on the ruling for transactions

prior to the effective date.

SECTION: 162

PAYMENTS TO INVESTORS TO NOT REDEEM SHARES WERE

DEDUCTIBLE UNTIL CLEAR AGREEMENTS WERE REASONABLY

EXPECTED TO BE RENEWED AT TERMINATION

Citation: Media Space, Inc. v. Commissioner, 135 TC No. 21, 10/18/10

Payments made by a corporation to investors to not exercise their right to force the

corporation to redeem their shares were held to be deductible in part by the Tax Court.

In the case in question the corporation was obligated to redeem certain shares at

specified dates at the shareholder’s request, something it lacked the liquidity to do as

the dates approached. To prevent the shareholders from exercising those rights, the

corporation offered to make a payment to the shareholders in exchange for their

agreement not to exercise those rights for one year.

At the end of that year the company’s position had improved, but it did not have the

funds right away to redeem the shares. As such, it negotiated an 8 month extension of

the agreement and paid an additional sum. When that 8 month term expired the

company determined that it not only did not have the liquidity to make the payment, but

was unlikely to have such ability in the foreseeable future. At point additional

agreements were entered into.



The Tax Court agreed with the IRS that the corporation’s initial treatment of the

payments as interest deductible under §163 was incorrect, holding that no liability

existed until a redemption was actually requested—something the payments prevented

from happening. But the Tax Court for a time agreed with the taxpayer’s alternative

view that the payments were deductible as ordinary trade or business expenses under

§162(a).

The Tax Court found evidence was submitted that making such payments to delay a

redemption was normal operating practice in the industry, making it an ordinary and

necessary expense. The Court did not agree with the IRS’s view that the payments

represented a payment in connection with the reacquisition of its stock blocked by

§162(k) since, again, no such redemption occurred. The Court also rejected the IRS’s

alternative view that the payment was related to a reorganization under §368, with a

deduction blocked by §361(c)(1).

The Court found that while Reg. §1.263(a)-4(d)(2)(i) would generally require the

payments to be capitalized, the special 12 month exception found at Reg. §1.263(a)-

4(f)(1) allowed a deduction for the payment for the first period as well as the first 8

month extension. In both cases, the corporation had an expectation of being able to

redeem the shares at the end of that period.

However the Court found no such reasonable expectation existed after that date, with

Reg. § 1.263(a)-4(f)(5)(i) requiring the expected duration of a right include the amount of

any expected renewal period. By the time the second extension was made, experience

suggested clearly that it was not reasonable to assume that another extension would

not be the result at the end of the latest period, requiring that the payments be

capitalized.

SECTION: 162

OWNER'S COMPENSATION FOUND REASONABLE IN PROFITABLE

YEAR, BUT UNREASONABLY HIGH IN LOSS YEAR

Citation: Multi-Pak Corporation v. Commissioner, TC Memo 2010-139,

6/22/10

The Tax Court decided that the sole shareholder of a corporation had been paid a

reasonable salary in the profitable year under question, but that his salary for the

following year when performance suffered was unreasonably high and reduced that

salary to a level that produced a 10% return on equity.



The case involved a company involved in a packaging business. The owner of the

company had taken over the company from his father in 1972 when the company was

near bankruptcy and over the years had made the company very successful. A major

customer had increasing demands for packaging, and the sole shareholder was

involved in the design and renovation of a new warehouse facility in the first half of the

first year under consideration. In that year hit its all time high in revenue and paid the

owner a total salary and bonus of $2,020,000. Net income after the payment of that

compensation was $140,700.

The following year sales were not as good, but the shareholder received $2,058,000 in

salary and bonus. For that year the company sustained a net loss of $474,000 after

deducting the compensation to the owner.

The owner was paid a low base salary and monthly bonuses based on the company's

results for the month. Bonuses were paid to the owner and his sons based on sales

and the owner's judgment regarding results of operations and relative contributions of

each.

The Tax Court rejected the testimony of both experts that testified on the

reasonableness of compensation. The Court found that the taxpayer's expert failed to

come to a conclusion about the reasonability of the rate of return to a theoretical

independent investor, a key factor in the view of the Ninth Circuit to whom an appeal of

this case would be taken. The IRS's expert did make a conclusion on the rate of return,

but the Court found this expert had not used reasonably comparable entities to compare

the results to, and had failed to adjust for those differences.

Ultimately the Court found an investor would have been satisfied with return in the

profitable year, allowing the owner additional compensation due to the increase in sales

and the fact that he was clearly responsible for the company's overall financial stability.

But the Court found an investor would not have been satisified with a higher level of

compensation in the following year when sales dropped and the payment of the

compensation produced a return on equity in the negative of over 15%. Rather, the

Court reasoned, an independent investor would have demanded reduced

compensation.

The Court determined that the investor would be satisified with a 10% return, and

reduced the salary deduction to $1,284,104 for the second year. The Court also found

that even though the resulting deficiency for that year was high enough to trigger the

substantial understatement penalty of §6662, the taxpayer had reasonably relied on the

advice of its outside accountant as to the reasonability of compensation paid. The

corporation regularly consulted with the accounting firm on this matter, and the firm

advised the company on the reasonability of the salary paid.



SECTION: 162

TAXPAYER NOT ALLOWED TO TREAT RESERVE ARRANGEMENT WITH

ONE SUBSIDIARY OF AIG AS PART OF INSURANCE POLICY WITH

OTHER SUBSIDIARY AND CLAIM FULL CURRENT DEDUCTION

Citation: FW Services, Inc. v. Commissioner, TC Memo 2010-128, 6/14/10

A corporation purchased two insurance policies from a subsidiary of AIG. The policies

would pay all valid employee liability claims up to $1 million for each accident or disease

suffered by an employee of the corporation. The policies provided, however, that the

corporation would reimburse the insurance carrier up to $500,000 for each incident—

that is, there was a per incident $500,000 deductible, presumably lowering the cost of

the policy.

However, the carrier required that the corporation to provide financial responsibility

assurance for the deductibles prior to entering into the contract. The corporation did so

by contracting with another insurance subsidiary of AIG. The corporation would pay into

a reserve fund held by this carrier, with the reserve fund being used to pay the

deductibles as the liabilities arose.

The corporation claimed a deduction for both the premiums paid on the original two

policies and the entire amount of the reserves deposited with the second subsidiary,

claiming the entire arrangement should be treated as one policy. The IRS disagreed,

holding that the amounts paid to the reserve funds should only be deductible as

amounts were paid out of it, holding this was a distinct and separate transaction from

that entered into with the other subsidiaries.

The Tax Court agreed with the IRS. It did not agree with the taxpayer that the mere fact

it procured its financial assurance from a subsidiary of AIG allowed it to treat the entire

transaction as with a single insurance carrier, and the Court noted that the reserve

arrangement did not ―morph into insurance‖ merely because there was an insurance

policy in the mix.



SECTION: 162

NO DEDUCTION ALLOWED FOR PAYMENTS TO PURPORTED 419 PLAN

FAR IN EXCESS OF ANNUAL BENEFIT PROMISED UNDER THE PLAN

Citation: Curcio, et al v. Commissioner, TC Memo 2010-115, 5/27/10

Taxpayers who were attempting to use a welfare benefit plan to obtain life insurance

found the Tax Court wasn’t terribly concerned about how Section 419 applied to the

plans. Rather the Tax Court found similar to its holdings in the cases of Neonatology

Associates P.A. v. Commissioner (115 TC 43) and V.R. DeAngelis M.D.PC. v.

Commissioner, TC Memo 2007-360 that the large amounts paid to the plans in the

years in question were not deductible as ordinary and necessary business expenses

under §162.

The Court noted that while the plans purported to offer the owners only an annual pre-

retirement death benefit, the amounts actually contributed to the plans were grossly in

excess of the amounts needed to provide such a term insurance benefit each year. In

reality, the Court noted that each individual owner, along with the owner’s personal life

insurance representative, selected the policies to be used. The plan itself was not

involved in the selection of the policies. The Court found that the only reasonable

explanation for this process was that the owners believed these were truly their

personal policies and not an asset of the trust used to fund benefits.

The Court also noted that while the plan was continually amended to attempt to deal

with changes in the case law and regulations, in practice when the owners wanted to

withdraw the policies it was done at very favorable values. While eventually the plans

were amended to ―require‖ that the policies be purchased from the plan at the computed

fair value, what actually happened was that a ―prepaid interest‖ amount equal to 10% of

the prior year’s net surrender value was charged, with the entire balance supposedly

payable via a note secured by a collateral assignment of the policy. However, the policy

would then be distributed to the owner who could (and in one case did) borrow out

virtually all of the value.

The Court found these debts weren’t real, noting that none of the owners seemed to

remember the details of these loans, which seemed unusual for what were supposedly

large outstanding loans for each of the covered individuals.



The Court also found that the taxpayers had not reasonably relied on the advice of a

professional in taking the tax positions. While various of the individuals had consulted

with the outside accountant that prepared their return, in each case the accountants had

no expertise in the area of benefit plans, and relied entirely on an opinion letter provided

by the promoter of the structure. The individuals also claimed to rely on their insurance

agents, but the Court found there was no evidence these individuals had any tax

expertise. Finally, the Court noted that the materials the taxpayers signed with the

promoter clearly stated that they could not rely on the plan promoter for any tax effect

that may arise from the transaction.

SECTION: 162

PAYMENTS TO PURPORTED MANAGEMENT CORPORATION

DISALLOWED

Citation: Vlock v. Commissioner, TC Memo 2010-3, 1/5/10

Francis Vlock was an insurance representative who decided that he wanted to reduce

his taxes. So to accomplish this feat, he and his wife, Jeanne Vlock, formed a

corporation with the assistance of their attorney/tax preparer that she was to perform

services in on behalf of the Francis’ insurance business. The corporation was paid

management fees of over $100,000 per year for each of the three years under

examination.

The corporation paid no salary to Jeanne during those years, but did pay virtually all of

the couple’s personal expenses out of the corporation. Ms. Vlock testified that the

arrangement was primarily meant to avoid paying her cash wages, since she would

have to pay on such wage income.

The IRS examined both the Vlock’s and the corporation. While the IRS issued a ―no

change‖ letter to the corporation, the IRS disallowed all deductions personally. The

Vlock’s contended that by issuing the no change letter to the corporation the IRS had

conceded that the payments were legitimate business expenses, treating them as

business income to the corporation.

The Tax Court rejected that contention, holding that the no change letter for the

corporation did not mean the IRS had conceded the payments to the corporation were

proper—just that the IRS did not choose to change the corporation’s returns. The Tax

Court further held that the there was little evidence, aside from self-serving testimony

and documents, that the corporation had any true existence or that Ms. Vlock was

actually performing her services via the corporation. Thus, the Court held, there was no

deduction allowable for these expenses to Mr. Vlock as business expenses under §162.



SECTION: 165

UTILITY SHOULD BE ALLOWED CASUALTY LOSS DEDUCTION

CURRENTLY EVEN THOUGH STATE GRANTED RATE INCREASE TO

ALLOW RECOVERY OF LOSS

Citation: Chief Counsel Advice 201036001, 9/10/10

The IRS ruled that a utility that was granted a rate increase to compensate it for a

casualty loss it incurred was not precluded from deducting the casualty loss. The IRS

ruled that although the intent of the rate increase was to reimburse the utility for the

loss, the payment was not truly in the nature of insurance. Citing Revenue Ruling 87-

117 the IRS noted that the utility’s customers, and not the state, would be the source of

the funds. The customers were not attempting to make the utility whole, but rather were

simply paying their utility bill

While noting the payments do have some of the characteristics of insurance in terms of

reimbursing for costs, the Chief Counsel’s office noted that in general utility rates are set

to provide for a return above the costs of the utility. If such ―reimbursements‖ were

treated as nondeductible, a utility would essentially not have any deductions. The ruling

noted that utilities are not taxed in that fashion, as all businesses hope to recover an

amount in excess of their costs incurred, and the mere fact that rates are set by the

state agency should not change the treatment.

SECTION: 165

LOTS THAT COULD NOT BE ACCESSED NOT PROPERLY TREATED AS

WORTHLESS DUE TO REASONABLE PROSPECT OF RECOVERY

Citation: D. L. White Construction, Inc. v. Commissioner, TC Memo 2010-

141, 6/28/10

D.L. White Construction, Inc. acquired a lot of land on which it planned to build four

homes, to be sold for a profit as part of its business activities. However, it turned out

that in order to get to those lots, an individual would need to make use of an access

road across property owned by another individual. That individual sued for negligence

and trespass and to quiet title, prevailing in trial court in early January 2003.

The taxpayer appealed the case in question, as well as filing a claim with title insurer.

The taxpayer succeeded on appeal in having the case remanded to the trial court, who

held again for the other party. A second appeal resulted in another remand, and

another finding for the original owner. In 2004 the title insurer paid $200,000 that was

placed to secure a bond for yet another appeal of the case.



On the taxpayer's 2002 return the company claimed a deduction for the $200,000,

initially as a cost of sale but at trial changed its position to claim it was a loss under

§165 for worthless property. The Tax Court disallowed the loss in 2002, noting that a

loss under §165 for worthlessness would only be allowed if there was no reasonable

prospect for recovery. Given that the original case was not even decided at December

31, 2002, the taxpayer continued with multiple appeals and eventually received a

settlement from the title company, the Tax Court found that clearly the evidence

suggested a reasonable chance of recovery—and, in fact, such recovery (at least from

the insurer) had take place.

SECTION: 167

SILO TRANSACTION LACKED ANY ECONOMIC SUBSTANCE APART

FROM TAX BENEFITS

Citation: Wells Fargo & Company v. United States, United States Court of

Federal Claims, Docket No. 06-628T, 2010 TNT 6-15, 1/8/10

Wells Fargo was turned down by the Court of Federal Claims in its request for a refund

of $115 million related to tax benefits it argued it should receive from a set of Sale In

Lease Out (SILO) transactions the corporation participated in. In the transactions in

question, Wells Fargo on paper purchased (under a tax though not property law

definition) assets from various tax-exempt entities (such as public transit agencies) and

then leased them back to the original owner.

While Wells Fargo borrowed most of the funds to make the purchase, the seller

immediately deposited those funds in an entity affiliated with the lender. These funds

and their earnings were used to make lease payments that happened to exactly be

equal to the debt payments required—and the fund would end up being completely

exhausted just as the last lease payment was made. As well, Well Fargo paid an

additional sum to the tax-exempt entity as its equity funds. The tax exempt retained ¼

of these funds (which was the tax-exempt’s incentive for participating), and then

invested the rest in investments that would earn over the term of the lease just enough,

when added to the original principal placed in the account, exactly the funds needed to

execute the buyback provision by the tax-exempt entity. In the view advanced by Wells

Fargo and its advisers, this would allow Wells Fargo to claim the tax benefits associated

with ownership of such assets.

The tax-exempt entity remained the legal owner of the assets, and was responsible for

all expenses related to the asset during the term of the lease.



The court found that the transaction lacked economic substance, and disallowed all

deductions and benefits that Wells attempted to claim. Aside from the tax benefits, the

court found no prospect of the corporation profiting from these transactions. The Court

found that Wells Fargo’s only reason for entering these transactions was to gain the

claimed tax benefits—something the Court was not willing to grant the corporation.

The Court also showed extreme displeasure with the accounting and legal advisers who

helped structure these transactions, noting ―a cadre of company executives, in concert

with teams of well known legal and accounting firms and other consultants, regularly

constructed and participated in these tax schemes for Wells Fargo, apparently blind to

professional standards of care‖ finally noting it ―has little sympathy for those who have

lost out as a result of this decision.‖

SECTION: 168

STREET LIGHTS PROPERLY CLASSIFIED BY ELECTRIC UTILITY AS

SEVEN YEAR PROPERTY

Citation: PPL Corporation v. Commissioner, 135 TC No. 8, 7/28/10

The IRS lost its argument that an electric utility could not depreciate street lights over a

seven year period under MACRS. The IRS argued such street lights were properly

categorized under asset class 49.14, Electric Utility Transmission and Distribution Plant

(with a recovery period of 20 years) or, if not then, then asset class 00.3 land

improvements (with a recover period of 15 years).

The taxpayer contended, and the Tax Court agreed, that these street light are property

without a class life, and therefore cost recovery takes place over seven years.

The Tax Court noted that while the lights were a relatively minor part of the utility's

business, for depreciation purposes the actual use of the item is what counts. Street

lights are not used to deliver electricity, but rather to provide a service of providing light.

The court distinguished various classification methods under other regulatory regimes

that it argued allowed lumping the lights with the transmission lines, holding that they

were not relevant for, and did not address, the matters of concern for tax depreciation.

The Court also rejected the IRS's claim that such lights were land improvements. First,

the Court noted that the majority of the lights were simply affixed to poles or

foundations, and could be easily moved. The taxpayer stored such lights for future use.

The court also found that since such lights often have to moved during their useful life,

they are not intended to be permanent.



One cautionary point on the case is that the Tax Court's ruling also covered the subset

of the street lights that are set in concrete, but it held those were not land improvements

primarily due to technical rules that, due to the IRS raising the issue late in the case,

made proving that treatment the burden of the IRS, a burden the court found the IRS did

not carry. Thus if a taxpayer has such lights that are set directly in the ground (as

opposed to being attached to a foundation), this case doesn't give any real assurance

that the IRS would not be able to force the taxpayer to treat the property as land

improvements.

SECTION: 168

COORDINATE ISSUE PAPER HOLDS THAT PROPER RECOVERY PERIOD

FOR OPEN AIR PARKING STRUCTURES IS 39.5 YEARS, NOT 15 YEARS

Citation: LMSB Coordinated Issue Paper, LMS-04-0709-029, 7/31/09

In a Coordinated Issue Paper, the Large and Medium Sized Business division of the

IRS states that the proper recovery period for an open air parking structure is 39.5 years

as a building and not 15 years as a land improvement. The IRS rejected the contention

that such structures do not meet the definition of a building for tax purposes. The IRS

notes that although the structure is partially open, it does have partial walls on each

level and has a floor that serves as the roof for the floor below.

The paper also suggests that the IRS take a hard line against taxpayers who have

taken this position. The paper indicates that, in the IRS’s view, there has been no cited

support for the taxpayer’s position that the structure is not a building and is instead a

land improvement. Because of this, the paper suggests examiners should consider

imposing a 20% negligence penalty under IRC §6662 on the deficiencies of taxpayers

who have taken this position.

SECTION: 172

IRS ADDS TO GUIDANCE FOR ARRA AND WHBAA NET OPERATING

LOSS ELECTIONS


IRS issued additional guidance in the form of questions and answers relating to net

operating loss elections under the American Recovery and Reinvestment Act of 2009

(ARRA) and the Worker, Homeowner and Business Assistance Act of 2009 (WHBAA).

The guidance was issued to address certain issues that have arisen as taxpayers have

filed returns related to the net operating loss elections under §172(b)(1)(H) for each of

the two acts.



The ruling notes that a taxpayer cannot revoke an ARRA net operating loss made for

2008 in order to elect a WHBAA net operating loss for that year. Fiscal year taxpayers

that could elect to make an ARRA carryback for the year beginning in either 2007 or

2008 can only make a single additional net operating loss election—that is, they can't

make an ARRA NOL election for the year beginning in 2007, and then use WHBAA

elections for both 2008 and 2009. Below are discussed some of the more interesting

items in the notice.

The notice explains the options a taxpayer has who was only able to carry a portion of

its net operating loss back under ARRA when a portion arose from a source other than

an ESB, generally allowing a taxpayer to elect the WHBAA provision for the non-ESB

portion of the loss. However a taxpayer that makes that election to apply both

provisions to the ARRA year cannot make another WHBAA election for the following

year—the taxpayer burned both possible elections in one year under that fact pattern.

The guidance also explains how to handle the 50% of income limitation on the WHBAA

portion of the loss when a taxpayer makes both an ARRA and WHBAA election for the

same year.

As NOLs under both ARRA and WHBAA are subject to a special rule where the use of

the alternative tax net operating loss deduction is not subject to the 90% limitation, the

IRS has ruled that a taxpayer who used a three year NOL carryback for a Ponzi loss to

the 3rd preceding tax year can now elect a WHBAA three year carryback for that year to

eliminate the 90% limitation on the ATNOL.

However, if a taxpayer only has two prior taxable years the taxpayer cannot elect to

make a WHBAA carryback to take advantage of the ATNOL 90% rule—an entity must

have a 3rd, 4th or 5th preceding taxable year to make a WHBAA election. However,

there is not a problem if there are losses for years 3, 4 and 5—the election will still be

valid even though the first year a loss will actually produce a tax refund is year 2.

The guidance also discusses the interaction of the WHBAA 5 year 50% of income rule

and prior net operating losses, noting that the 50% test is applied after all prior net

operating losses not resulting from a §172(b)(1)(H) election for the same year have

been applied. The impact of the 50% limit on the computation of losses available for

carryforward is also discussed, noting that portion of the NOL deemed absorbed is 50%

of the modified taxable income after the adjustments required by §172(b)(2).

The due date for the carryback is also addressed. The use of a Form 1045 or 1139 is

addressed, noting that the taxpayer had until 6 months after the unextended due date

for the tax return for the final tax year beginning in 2009 to file a Form 1045 or 1139 for

any year for which an election is made. However if the taxpayer decides to use a two

year carryback, the standard dates apply for when the 1045 or 1139 must be filed.



A taxpayer also cannot revoke a prior election to waive the carryback period unless the

taxpayer also makes a timely election to apply WHBAA to the year in question to carry

the loss back.

The IRS also gives notice that it will not give permission to taxpayers to revoke an

election to not claim additional depreciation under §168(k)(4) if the taxpayer is using

hindsight to increase the NOL available for carryback for the prior year,

If a corporation makes the WHBAA and merges into another corporation in a later

taxable year, the acquiring corporation is not prohibited from make a WHBAA election in

the later year if it had not made one previously.

SECTION: 172

OPTIONS FOR FIVE YEAR NET OPERATING LOSSES FOR

CONSOLIDATED GROUPS EXPLAINED

Citation: Temporary Reg. §1.1502-21T, TD 9490, 6/23/10

Consolidated groups have special problems that arise with net operating losses due to

the fact that the makeup of the group may have changed during the applicable period

for a carryback. Those problems are more likely to occur the further back a loss is

carried, and the optional five year carryback period under §172(b)(1)(H) increases the

number of such issues. To deal with these unique issues, the IRS has released

temporary regulations to deal with such issues for consolidated groups.

The regulations provide for options to waive all or part of the pre-acquisition or pre-

acquisition Extended carryback period for a subsidiary. Consolidated groups with

changes in their make-up during the carryback period will wish to consult these

regulations for the options available to the group.

SECTION: 172

DENTISTS REPAYMENTS OF AMOUNTS RECEIVED FROM INSURANCE

FRAUD COMMITTED BY SPOUSE GAVE RISE TO BUSINESS EXPENSES

AND NET OPERATING LOSS

Citation: Caveretta v. Commissioner, TC Memo 2010-4, 1/5/10

Dr. Peter Caveretta was a dentist who had his spouse handle billing on his behalf—and

she, without Dr. Caveretta’s knowledge, began submitting bills to an insurance carrier

for procedures the doctor had not performed. Karen Caveretta’s fraud was uncovered

and she was convicted of health-care fraud. Dr. and Mrs. Caveretta agreed, in a memo

attached to Karen’s sentencing document, to pay the civil claim of the insurance

company for the overpayments.



Dr. Caveretta deducted the payments on his Schedule C, creating a net operating loss

which was carried back. The IRS agreed the amounts were deductible, but claimed that

since they represented restitution they were only deductible under §165(c)(2) as losses

incurred in a transaction entered into for a profit rather than trade or business expenses

deductible under §162. Such deductions would not give rise to a net operating loss.

The Tax Court, while agreeing that the amounts were paid as restitution, did not agree

that automatically made them something other than ordinary and necessary business

expenses under §162. Dr. Caveretta was not aware of his spouse’s fraud, and he

repaid the amounts in order to enable himself to be able to retain his business. While

Karen Caveretta, the Court agreed, would not be allowed to claim the expense as a

business expense, her husband could independently do so since it related to his

business—and the right of either spouse to claim the deduction meant the deduction

would be allowed on a joint return.

SECTION: 172

REVISED ELECTIVE 5 YEAR NET OPERATING LOSS ADDED BY

CONGRESS

Citation: Worker, Homeowner, and Business Assistance Act of 2009, Sec. 13,

11/6/09 and Revenue Procedure 2009-52, 11/20/09

Congress has given us a revised version of the five year optional net operating loss that

we first saw in the American Recovery and Reinvestment Act of 2009 back in February.

Unlike the ARRA 2009 version, the new version is no longer limited only to eligible small

businesses. Rather now every business is allowed to elect to carry back a single net

operating loss from a taxable year ending after December 31, 2007 and before January

1, 2010 back 3, 4 or 5 years from the year of the loss. The new version also limits

carrybacks to the fifth year to 50% of the taxpayer’s income for that year, though all

other years can be entirely offset. The election must be made by the extended due date

of the taxpayer’s final return ending before January 1, 2010.

A special rule will allow entities that were eligible small businesses that file loss

carrybacks under the ARRA 2009 rules to still be able to elect to carryback a second

year, while non-ESB entities will have to choose which year to carryback if the entity

has multiple loss years ending within the two year period.



On November 30, 2009 the IRS issued Revenue Procedure 2009-52 to give guidance

on how entities should file these elections and claims. The ruling covers situations

where a taxpayer had not previously elected a carryback, had previously claimed an

ARRA 2009 net operating loss or had elected to carry forward an NOL from a year that

is now available for a five year carryback. As with the ARRA 2009 procedures, the IRS

will allow a taxpayer to make the election on a statement filed with the ―applicable

return‖ or an amended version of the same, or on the forms carrying back the loss

(Forms 1045, 1138, amended 1041, 1040X or 1120S).

SECTION: 179

TRUCK LEASE NOT EQUIVALENT TO SALE, NO SECTION 179

DEDUCTION ALLOWED

Citation: Boyce v. Commissioner, TC Summary Opinion 2010-100, 7/26/10

A taxpayer wanted to claim an immediate Section 179 deduction for the acquisition of a

Ford truck. He had entered into a lease contract for the truck, a lease with fixed

monthly payments of $607.06 over 48 months. The taxpayers were permitted to drive

the truck only 11,294 miles per year, after which the taxpayers would owe an excess

mileage charge of 18 cents per mile. At the end of the lease the taxpayers had the right

to purchase the truck for $17,612, and if they did not exercise that option a $395

termination fee was due.

The Tax Court noted that a lease contract might be structured such that it would be

treated for tax purposes as a purchase, if the lessor's obligations appear similar to a

secured seller's obligations. The Court noted for such to be true 1) the term of the lease

must be for the entire useful life of the equipment, 2) the lease must be an open-end

lease, 3) title automatically passes to the lessee either at the end of the lease or when

the sum of rental payments equal the cost of the equipment, 4) the lessee has the right

to purchase the equipment at a nominal or below-market price or 5) the lessor has an

option to compel the lessee to purchase the equipment.

The Court found none of these elements present in this case. The Court noted that

although an excess mileage fee was due, it was lower than the implicit depreciation per

mile in the contract factored into the monthly payments. Thus the form of the lease had

to be respected, and the asset did not qualify for an expensing treatment under §179.



SECTION: 179

$250,000 §179 AMOUNT EXTENDED THROUGH END OF 2010

Citation: Secton 201, Hiring Incentives to Restore Employment Act, 3/18/10

In the HIRE Act, at Act Section 201, Congress voted yet again to extend the enhanced

Section 179 expensing amount that had been in place since the beginning of 2008. The

$250,000 limited on expensing of assets under §179 has been extended to include

assets acquired in taxable years beginning before 2011. Similarly, the amount of asset

purchases at which the limit begins to be phased out continues to remain at $800,000

for the same period.

The enhanced amount of Section 179 has been in place since January 1, 2008, enacted

for one year periods each time. While it is now scheduled to revert to the previous

inflation adjusted figures for years beginning in 2011 it seems possible Congress might

again grant this provision a reprieve, as in recent years Congress has enacted a

number of ―temporary‖ increases in this provision but have not allowed the amount to

actually drop back to lower levels when the enhanced expensing allowance has been

scheduled to expire.

SECTION: 197

DESIGNATION OF VINEYARD AS AN AMERICAN VITICULTURAL AREA

CAN GIVE RISE TO A §197 INTANGIBLE

Citation: Chief Counsel Memorandum 201040004, 10/8/10

The taxpayer in the matter in question purchased a vineyard in two ―American

viticultural areas‖ as designated by the Alcohol and Tobacco Tax and Trade Bureau of

the United States Treasury. The taxpayer argued that it should be able to allocate a

portion of the purchase price of the land to the right to use the ―AVA‖ designation and

treat it as a Section 197 intangible which may be amortized. The Chief Counsel’s office

was consulted on whether such a treatment was appropriate.

The memorandum looks at the details of how an area is designated as an AVA and the

right to use that designation for wines that come from the regions in question. The

memorandum concludes that the right to use the AVA designation is not a right that

attaches to a particular piece of land and therefore not an interest in land under

§197(e)(2), but rather a right granted by a governmental unit governed by §197.



However the memorandum cautions that valuing this right could prove to be a problem,

since it will be difficult in many cases to find comparable land that does not have the

right to the designation that would be necessary to determine the incremental value of

that right. As well, the memo notes that the taxpayer would need to show a clear

premium, such as a marketable and recognizable tradename to a taxpayer’s vineyard,

to be able to recognize the intangible asset.

SECTION: 197

TAXPAYER'S INCOME FROM SALE OF CUSTOMER RELATIONSHIPS

THAT COULD BE SHOWN TO BE SELF-CREATED NOT SUBJECT TO

§1245 RECAPTURE

Citation: PLR 201016053, 4/23/10

A taxpayer had acquired customer contracts through various acquisitions over the

years. These customer relationships were treated as §197 intangible assets and

amortized over 15 years. The taxpayer had also expended significant resources to

build the customer base outside of the acquisitions. Now the taxpayer looked to sell the

overall customer relationship asset and a simple question arose—could the taxpayer

treat separately the portion of the sale of the customer relationships that represented

those remaining from the acquisition from that which it could show was self-developed?

The answer to that question is important, since §197 intangibles are subject to §1245

recapture on sale. A fully self-created relationship, which will have no basis, will not

trigger a §1245 recapture event on sale. The IRS ruled that since the taxpayer had

detailed documentation to support the allocation of the value of the customer

relationship between the acquired and self-developed ones, it could split the sale

between the two items, and proceeds related to the self-developed relationships would

not trigger §1245 recapture.

Note that a key factor here would be the existence of proper documentation to support

the valuation between the two classes of intangible assets, as well as a realistic method

of valuing each type of asset.



SECTION: 197

15 YEAR AMORTIZATION OF AGREEMENT NOT TO COMPETE REQUIRED

FOR ACQUISITION OF ANY SIZED INTEREST IN A TRADE OR BUSINESS

Citation: Recovery Group v. Commissioner, TC Memo 2010-76, 4/15/10

Figuring out exactly what Congress meant in a statute is sometimes difficult. The case

of Recovery Group involved an attempt to decipher exactly what a particular phrase in

§197 meant, coming down to exactly which phrase the word ―thereof‖ referred to. In this

case the corporation had written off over a one year term an agreement not to compete

it entered into with a 23% shareholder of the corporation who signed a single year

agreement not to compete.

The provision in question is §197(d)(1)(E) which applies to covenants not to compete

―entered into in connection with an acquisition (directly or indirectly) of an interest in a

trade or business or substantial portion thereof‖. The taxpayer’s accounting firm

determined that this phrase meant that only covenants entered into as part of the

acquisition of 100% ownership of a business or of a substantial portion of such

ownership are required to be amortized over 15 years under §197. In this viewpoint, the

―thereof‖ modifies the word ―interest‖ in that provision.

The IRS contended that, in reality, the phrase is more properly parsed to mean any

interest in a complete trade or business, or the acquisition of a substantial portion of the

assets making up that trade or business. In the IRS’s view, the word ―thereof‖ modifies

―trade or business.‖

The Tax Court agreed with the IRS. The Court analyzed the legislative record and

concluded that Congress was concerned both with the acquisition of ownership

interests and assets of a business, thus reading the provision as the IRS did

accomplished both goals. In the Court’s view, reading it as the taxpayer suggested

would eliminate the applicability of the provision to the acquisition of assets, which is

contrary to Congress’s goal in enacting the provision.

The Court also analyzed the applicability of the penalty under §6662(a) for a substantial

underpayment of tax in this case. First it noted that the amount of the understatement

was mechanically sufficient to require application of the penalty, so the burden fell on

the taxpayer to who they met the requirements for a waiver of the penalty. The Court

rejected the view that there existed substantial authority for the position, criticizing the

accountant’s reliance on a footnote in the Frontier Chevrolet case, a case that dealt

primarily with whether §197 could be triggered by acquiring an interest in a business the

taxpayer already held an ownership interest in.



The Court also held that the position was not adequately disclosed on the return.

Merely listing the amount of the expense claimed was not sufficient to alert the IRS to

the nature of the transaction or the items that might reasonably be in dispute.

However, the Court did hold that the taxpayers had reasonably relied on its tax

professionals, and thus escaped the penalties. The taxpayer had provided all

information necessary to the professionals to make a determination on the tax

treatment, and the matter is one that it is not reasonable to have expected an average

businessperson to understand. Thus the penalty did not apply.

SECTION: 199

PRODUCTION OF GENETICALLY MODIFIED MATERIAL QUALIFIES FOR

§199 TREATMENT, BUT ONLY MINOR AMOUNT OF LICENSING

ARRANGEMENT WOULD

Citation: CCA 201014050, 4/9/10

The §199 domestic production activity deduction meets the practical facts of genetic

engineering in a Chief Counsel Advice the IRS issued. The IRS looked at the

differences that occur depending on how a genetically modified product is handled in

treatment under §199. The IRS considered three scenarios involving a genetic

modification made to a product that could be sold by the taxpayer in three different

ways.

The taxpayer modified the genetics of product Y by inserting genetic material X into it.

In the first case, the taxpayer itself produces and sells the modified product, making use

of X to do so, and sells the product under its own name. In case two, the taxpayer

transfers a small noncommercial amount of the product to another party, who then uses

that to reproduce Y into commercial quantities. The product is then sold, again under

the taxpayer’s name, but the taxpayer receives a licensing fee. In the third case the

only difference is that the product is not sold under the taxpayer’s name, but the

taxpayer again receives the licensing fee. The noncommercial quantity is transferred

because the only practical way to product the product is to start with a small supply of

the product, and then use that to create new product.

The IRS ruled that while all the proceeds in case one are domestic product gross

receipts. However, in the last two cases only the minor amount of revenue related to

the transfer of the noncommercial quantity of the product qualify as domestic product

gross receipts. All remaining revenue is deemed by the IRS to be nonqualifying

licensing revenue.



SECTION: 263

IRS DEFINES SAFE HARBOR ACCOUNTING METHODS FOR INVENTORY

FOR AUTO DEALERS


The IRS issued a revenue procedure that allows certain motor vehicle dealerships to

use either or both up safe harbor method of accounting to treat certain sales facilities as

retail sales facilities for purposes of Section 263A and be treated as resellers without

production activities for purposes of the same section.

The first method is the retail sales facility safe harbor method. Under this method, a

dealership they treat this entire sales facility as a retail sales facility under regulation

section 1.263A-3(c)(5)(ii)(B). The dealer will not be required to capitalize handling and

storage costs incurred at its retail sales facility.

The second method is the reseller without production activities safe harbor method.

Under this method activities that a dealership or a contractor perform on dealership-

owned vehicles and customer-owned vehicles are handling activities, but the cost of

these handling activities, other than the cost of vehicle parts, are not required to be

capitalized to the extent in curve at the motor vehicle dealership's sales facility. The

dealership must capitalize the cost of vehicle parts used on dealership-owned vehicles

as an acquisition cost of its vehicles. A motor vehicle dealership using the reseller

without production activities safe harbor method may use the simplified resale methods

under Regulation 1.263A-3(c)(1) for its vehicles and other eligible property.

A dealership that wants to change its method of accounting to either or both of the safe

harbor methods described in the Revenue Procedure must use the automatic change of

accounting method provisions of Revenue Procedure 2008-52 , as further modified by

this revenue procedure, if it falls within the scope of Revenue Procedure 2008-52.

Otherwise, the dealership must request an accounting method change under Revenue

Procedure 97-27.



SECTION: 263

MANUFACTURER REQUIRED TO CAPITALIZE INCENTIVE PAYMENTS

PAID TO CUSTOMERS ONLY FOR CONTRACTS WITH MINIMUM

PURCHASE CLAUSE

Citation: PLR 20132025, 8/13/10

The taxpayer was a manufacturer that entered into three types of contractual stand-by

supply agreements with customers, and makes certain incentive payments to customers

to enter into these contracts. The issue the Chief Counsel's office was asked to rule

upon in its PLR was whether, under the terms of the various contracts, the incentive

payments had to be capitalized under IRC §263(a) or whether the payments could be

immediately expensed.

In the first type of agreement, the contracts do not contain a minimum purchase

requirement and do not require the customer to retain the manufacturer as the supplier

for products not specifically designated in the supply agreement. The Chief Counsel's

office found that, in this case, the payment was not a an amount paid to acquire an

intangible under Reg. §1.263(a)-4(b)(1) as the supply agreements were not acquired by

the taxpayer. The payments were also not payments made to facilitate the acquisition

of or creation of an intangible under Reg. §1.263(a)-4(b)(1)(v), as the payments are not

made until the execution of the agreement. The Chief Counsel's office also found that

the payment was not an amount paid to create an intangible under Reg. §1.263(a)-

4(b)(1)(ii). While these payments due generally seem to be paid to create the

agreement, the fact that no minimum purchase requirement existed under the

agreement meant that the contract was not one of the types of contracts enumerated in

this regulation. Therefore, the IRS concluded, the payments did not have to be

capitalized.

The IRS came to the same conclusion for a second group of contracts that differed from

the first category by a requirement that the customer must use the manufacturer as its

supplier for products not specifically designated in the supply agreement, should such

products arise. Similarly, a provision that could require the customer to reimburse the

manufacturer for certain costs incurred for investment in manufacturing technologies

should the agreement be terminated early did not serve to change the IRS's view that

the payments could be expensed.

However the IRS ruled that such payments did have to be capitalized for a third

category of contracts that contained a minimum purchase requirement, the agreements

are supply agreements described in Reg. §1.263(a)-4(d)(6) and thus are required to be

capitalized as payment for an amount to create an intangible under Reg. §1.263(a)-

4(b)(1)(ii).



SECTION: 263A

PACKAGING MATERIAL COSTS MUST BE CAPITALIZED, BUT TAXPAYER

ONLY HAS TO ADJUST PROSPECTIVELY DUE TO PRIOR LETTER

RULING

Citation: TAM 201030025, 7/30/10

The taxpayer in this case was under examination. Previously the taxpayer had received

IRS approval for a change in accounting method to treat the amounts they paid for

certain packaging material as part of ―pick and pack‖ activities and thus excluded from

being capitalized under §263A.

Under examination the IRS agent felt that this was not the proper treatment, and

technical advice was sought. The TAM indicated that, in fact, the amounts are not truly

related to pick and pack materials, since the materials were not used solely after

customers placed orders in advance for product, but were used on any other products

the entity made. As such, they were not truly used in ―pick and pack‖ activities and

could not be excluded from capitalization.

However, the taxpayer would only have to apply this method prospectively because the

taxpayer qualified for relief under §7805(b). The IRS found that 1) the law had not

changed since the letter ruling was issued, 2) the taxpayer relied in good faith on the

letter ruling and 3) revocation or modification would be detrimental to the taxpayer. As

well, the taxpayer had not misstated or omitted facts in the original request and the facts

at the time of the ruling were not materially different than the facts that existed now.

SECTION: 263A

TAX COURT RULING REQUIRING CAPITALIZATION OF ROYALTY

PAYMENTS TRIGGERED ON SALE UNDER §263A REVERSED BY

SECOND CIRCUIT

Citation: Robinson Knife v. Commissioner, CA2, No. 09-1496-ag, 3/23/10

Many accountants may have found very troubling the Tax Court’s 2009 ruling in the

Robinson Knife case (TC Memo 2009-9). In that case, the Tax Court ruled that royalty

payments that were triggered only upon the actual sale of goods nevertheless had to be

capitalized under §263A when the taxpayer had elected the simplified production

method under Regulation § 1.263A-2(b).



The Tax Court determined that even though such costs were clearly directly related to

the sale, the simplified method treated all such royalties as indirect costs, meaning they

could not be immediately expensed but rather a portion had to be capitalized in the year

end inventory—even though it is clear that the actual sale of a particular item no longer

in inventory is what triggered the expense. To the Tax Court the problem was Robinson

Knife’s election of the simplified production method which, in its viewed, required the

mechanical inclusion of these costs as indirect costs regardless of the fact that only an

actual sale triggered the expense.

The Second Circuit appears to have also been troubled by the Tax Court’s ruling, and

reversed the Tax Court’s decision. The Second Circuit held that the Tax Court

erroneously concentrated on whether the licensing agreements benefitted the

production process, not whether the royalty payments did. The Court held that the latter

did not do so in this fact pattern, and were clearly sales and marketing expenses eligible

for immediate deduction.

The Court held that royalties that ―(1) are calculated as a percentage of sales revenue

from inventory and (2) are incurred only upon the sale of that inventory‖ are immediately

deductible as they are not properly allocable to property produced.

SECTION: 274

IRS ADDS "PUBLIC SAFETY OFFICER VEHICLE" TO LIST OF QUALIFIED

NONPERSONAL USE VEHICLES

Citation: Final Regulation §1.274-5, TD 9483, 5/19/10

The IRS added clearly marked public safety officer vehicles to the list of qualified

nonpersonal use vehicles that are treated as 100% used for business purposes under

§274 when provided by an employer to a public safety officer. Previously clearly

marked police and fire vehicles met this qualification.

A public safety officer is defined by reference to Section 1204(9)(A) of the Omnibus

Crime Control and Safe Streets Act of 1968, which generally applies to an individual

who serves in an official capacity in a public agency as a law enforcement officer,

firefighter, chaplain, or as a member of a rescue squad or ambulance crew.

This revision is effective for uses occurring after May 19, 2010.



SECTION: 274

IRS ANNOUNCES AUTO MILEAGE RATES FOR 2010


For 2010, the IRS has announced the following mileage rates for mileage beginning

January 1, 2010, reflecting decreases from the 2011 levels:

50 cents per mile for business miles driven

16.5 cents per mile for medical or moving

14 cents per mile for charitable

The use of the auto mileage rate is available in some cases as an alternative to the use

of actual expenses. The method cannot be used for more than four vehicles. It also

cannot be used for any vehicle where the taxpayer previously claimed §179 treatment in

a prior year, or where the Modified Accelerated Cost Recovery System was used in a

prior year.

SECTION: 274

IRS UPDATES PER DIEM RATES FOR NEW FISCAL YEAR


The IRS released update per diem rates for the federal government’s fiscal year

beginning October 1, 2009. The rates provide for travel within the 48 states. Full per

diem rates under the new schedule range from $163 to $258 per day, while meal and

incidental rates range from $39 to $64. The special worker transportation rate for meals

and incidental expenses is $59.

SECTION: 280F

IRS ANNOUNCING DEPRECIATION AND LEASE INCLUSION AMOUNTS

ON VEHICLES FOR 2010


The IRS released the limits on depreciation for vehicles subject to the limitations of

§280F(d)(7)(B)(i) for items placed in service in 2010. The limits are as follows:



The procedure also contains updated tables to be used for the lease inclusion amount

under Reg. §1.280F for lease terms beginning in calendar year 2010.

SECTION: 304

IRS FINALIZES RULES ALLOWED IT TO IGNORE CORPORATIONS

FORMED TO AVOID APPLICATION OF §304

Citation: TD 9477, 12/29/09

Final regulation §1.304-4 modified what had been a discretionary look through rule in

Reg. §1.304-4T when the formation of a corporation avoided the application of §304 to

a transaction. Generally, IRC §304 generally applies to transactions that attempt to

effect what would otherwise be treated as a redemption (or attempted redemption) into

a transfer of assets for the stock of the corporation. In such transactions, a portion of

the property received is treated as a dividend to the extent of the earnings and profits of

the two corporations.



Temporary Regulation §1.304-4T had been issued to address transactions where a new

corporation or corporations were formed to avoid the application of this section. The IRS

gives an example where Corporation A owns two foreign corporations that it labels F1

and F2. The basis and fair market value of F1 is $100,000, it has at least $100,000

worth of cash but has no earnings and profits. The basis and fair market value of F2 is

$100,000 and it has more than that amount of earnings and profits. Corporation A

forms a new foreign corporation F3 and contributes F2’s stock to that corporation in

exchange for F3 stock. Corporation A then transfers F3 stock to F1 in exchange for

$100,000 of cash. Since neither F1 nor F3 has earnings and profits, Corporation A

reported the transaction as a return of basis.

The temporary regulations allowed the IRS to unwind this transaction at the District

Director’s discretion, treating it as an acquisition by F2 (and getting access to F2’s

earnings and profits). The final regulations removes the discretionary standard and

instead has the rule apply if a principal purpose for creating, organizing, or funding the

acquiring or issuing corporation was to avoid the application of §304. The new

regulations are effective on December 29, 2009

SECTION: 316

AUTO TITLED IN SHAREHOLDER NAME TREATED AS CORPORATE

ASSET, AND DATE OF CHECK DETERMINED BY DATE ON CHECK NOT

DATE DEPOSITED BY SHAREHOLDER

Citation: Rosser v. Commissioner, TC Memo 2010-6, 1/6/10

In general the taxpayers in Rosser v. Commissioner and Rosser Enterprises, Inc. v.

Commissioner, TC Memo 2010-6 failed to gain deductions for which they had not

provided supported, and were charged with a number of constructive dividends. But the

IRS failed on two issues that may be of interest to practitioners.

The IRS failed in its claim that payments the corporation made on a loan for the

purchase of a Ford van were constructive dividends. The van was titled in the name of

the individual, and the loan was also in the individual shareholder’s name.

Nevertheless, the Tax Court found that the actual use of the van was for the business of

the corporation. The Court held that the loan was in the shareholder’s name for

financing purposes, and the shareholder held the van as a nominee for the corporation.



The IRS also attempted to assess the shareholder a constructive dividend for 2004 on a

check that was dated December 31, 2003 for $20,200, but which was deposited in the

shareholder’s bank account on January 6, 2004. The IRS claimed that the deposit six

days into 2004 indicated that the taxpayer had backdated the checks and therefore it

was available for assessment in 2004. However, the Court did not agree—it held that

the date on the checks, in the absence of any evidence that the checks had been

backdated, controlled in this case.

SECTION: 351

TAXPAYERS DID NOT TRANSFER FARMING ACTIVITY TO NEW

CORPORATION, INCOME TAXABLE TO SHAREHOLDERS DIRECTLY

Citation: Slota v. Commissioner, TC Summary Opinion 2010-152, 10/12/10

Taxpayers at times aren’t the best at following all the formalities when establishing a

corporation or transferring their business to the corporation. In this case the taxpayer’s

inability to show that the underlying assets were transferred to the corporation resulted

in the court finding that the deposit of proceeds from the taxpayer’s crop in the

corporate checking account was an impermissible assignment of income to the

corporation.

The taxpayer owned and operated a farm as a sole proprietor. In 2005 he organized a

corporation under Iowa law. However they executed no documents transferring title of

any assets, including the farm land or crops, to the corporation, transferring only

$10,000 of cash from their checking account. However when the money came in from

the USDA for $61,416 or $195,938 for the crops, the amounts were deposited in the

corporation and reported there.

The Court found that merely depositing the cash wasn’t enough to treat the income as

corporate income—rather, the amounts were truly taxable to the individuals.

SECTION: 368

REVISED REGULATIONS PROVIDE FOR ISSUANCE OF DEEMED SHARE

OF STOCK IN D REORGANIZATION WHERE NO STOCK IS ISSUED

Citation: TD 9475, 12/17/09

The IRS released regulations dealing with the case of an acquisitive Type-D

reorganization where no stock is actually issued. The regulations, effective for

transactions occurring on or after December 17, 2009 provide for the deemed issuance

of a share of stock from the transferree to the transferor, followed by a distribution of

that stock to the shareholders of the transferor.



The regulations apply if the same person owns, directly or indirectly, all of the stock of

both corporations in equal proportions and there is only a de minimus variation in

shareholder identity or proportionality of ownership in the two corporations. The

shareholder is allowed to designate which share he/she already holds in the transferor

will receive the carryover basis.

The IRS has modified Reg. §§1.358-2(a)(2)(iii), 1.368-2(l) and 1.1502-13(f)(7).

SECTION: 401

IRS ANNOUNCES PENSION PLAN LIMITATIONS FOR 2011

Citation: IRS News Release IR–2010–108, 10/28/10

The IRS announced cost-of-living adjustments that will be in place for pension plans

and other plan related items for tax year 2011. Most of the items are not changed for

2011 or have very small adjustments.

Elective deferrals for employees in 401(k), 403(b), and 457(b) plans remain at $16,500.

Catch-up contribution limits for those age 50 and over also remain unchanged at

$5,500.

The phase-outs for IRA contribution deductions for those covered by employer-

sponsored retirement plan are unchanged from 2010. The limits for single individuals

and those filing head of household remain between $56,000 and $66,000. For married

couples, the income phase-out range is from $90,000 to $110,000 up slightly from the

range of $89,000 to $109,000 in 2010. If the IRA contribution is for the spouse who is

not an active participant in the plan, but the other spouse is an active participant, the

deduction phases out between $169,000 and $179,000. In 2010 the reduction was

phased out between $167,000 and $177,000.

The phase-out range for Roth IRAs also increased slightly from 2010. For a married

couple filing jointly the ability to make a Roth IRA contribution is phased out between

$167,000 and $177,000. For those filing either single status or head of household, the

phase-out range will be between $107,000 and $122,000 for 2011. As always, for

married individuals filing separate returns, the phase-out range remains between $0 and

$10,000.

The Section 415 limitations for both defined benefit and defined contribution plans

remain unchanged for 2011. For defined benefit plans the limit on the annual benefit

remains at $195,000. For defined contribution plans the maximum amount of allocation

allowed to a single participant in the plan remains at $49,000.



Annual compensation limits remain unchanged at $245,000. As well, the dollar limitation

for the definition of the key employee in a top-heavy plan remains unchanged at

$160,000. The dollar amount for definition of a highly compensated employee under

Section 414(q)(1)(B) remains at $110,000.

Compensation to be considered for participation in a simplified employee pension plan

(SEP) remains at $550 for 2011. The limits on deferrals to SIMPLE retirement accounts

remains at $11,500.

SECTION: 401

SIXTH CIRCUIT REVERSES PREVIOUS POSITION, NOW HOLDS

EQUITABLE ESTOPPEL CAN APPLY TO ERISA PENSION CASES

Citation: Bloemker v. Laborer's Local 265 Pension Fund, CA6, No. 09 -3536,

5/19/10

The Sixth Circuit modified its holding that equitable estoppel could not apply in a

pension benefit claim under ERISA, holding that if a plaintiff meets the standard

requirements for a general claim of equitable estoppel and, as well, shows ―(1) a written

representation; (2) plan provisions which, although unambiguous, did not allow for

individual calculation of benefits; and (3) extraordinary circumstances in which the

balance of equities strongly favors the application of estoppel‖ that it could apply to a

pension benefit claim.

In the case in question a plan participant had taken early retirement based on a

calculation he received in writing from the third party administrator of the plan that

detailed the amount he would receive per month for life. Over a year later he received a

letter from the plan indicating that due to an audit the administrator had recently

conducted his benefit may have been improperly computed, followed later by another

later informing him of a reduction in monthly benefits of $509.78. The letter informed

him his benefits would be reduced from that point forward, and that he needed repay

the $11,215.16 amount he had been overpaid.

The Court held that while the new figure may be the appropriate amount under the

explicit terms of the plan, in this case the participant should be allowed to show that the

computation of his actuarial benefit was not something he reasonably would have been

able to compute on his own, and thus had reasonably relied upon the erroneous

monthly benefit computation to his detriment.



The Sixth Circuit notes that the Second, Third, Fifth and Ninth circuits had previously

held that an estoppel claim were applicable to ERISA cases, but imposed an

―extraordinary circumstances requirement‖—and the Sixth Circuit elected to follow the

holdings of those courts. In a footnote the opinion notes that the Fourth Circuit holds

that waiver and estoppel are ―prohibited concepts‖ in ERISA cases, and that other

circuits have not yet applied estoppel to published pension cases.

SECTION: 401

DEPARTMENT OF LABOR RELENTS, ALLOWS THIRD SERVICE

PROVIDERS TO COMPLETE AND ELECTRONICALLY FILE ELECTRONIC

5500S FOR CLIENTS

Citation: Department of Labor Employee Benefit Security Administration FAQ

on EFAST2, 5/13/10

The Department of Labor announced a new e-signature option that allows services

providers to complete and file annual reports for their clients. Previously electronically

filed Forms 5500, which were made mandatory except for 5500EZ filings after January

1, 2010, had to be electronically signed by the plan administrator, who obtained his own

electronic credentials.

Under the new option, the service provider must obtain specific written authorization

from the plan administrator to submit the plan’s electronic filing. The administrator also

must sign a paper version of the completed filing, and a PDF copy of the manually

signed Form 5500 or 5500-SF must be submitted as an attachment to the electronic

filing submitted to EFAST.

The service provider is required to notify the plan administrator of any inquiries received

from EFAST, the Department of Labor, the Internal Revenue Service or the PBGC on

the filing. The administrator also must be informed that the image of the administrator’s

manual signature will be included in the report that will be available for public disclosure.

The new program was made available on the DOL’s IFILE application on May 13.

Software vendors will need to update their software to allow the use of this option.



SECTION: 401

PLAN ADMINISTRATOR'S REVISED INTERPRETATION OF PLAN TERMS

STILL MUST BE GRANTED DEFERENCE BY COURT EVEN IF INITIAL

INTERPRETATION FOUND TO BE UNREASONABLE

Citation: Conkright v. Frommert, US Supreme Court, No 08-810, 4/21/10

The Supreme Court, in a 5-3 decision, reversed the Second Circuit’s holding that if a

Court finds that a plan administrator had abused its discretion in interpreting a plan

document, the Court is not required to grant deference to the plan administrator’s

revised interpretation of the plan document. The Supreme Court majority reversed what

it saw as a ―one-strike-and-you’re-out‖ view, rather indicating that the trial court should

determine if the proposed revised interpretation is a reasonable interpretation of the

plan rather than deciding if it is, in the view of the court, the ―best‖ interpretation of the

plan.

The case involved Xerox’s defined benefit plan that, when it was amended,

inadvertently omitted language that described how benefits would calculated in the

following circumstances. The issue arose where an employee separated from service,

received a lump sum payout from the plan of their vested accrued benefit and then were

later rehired by Xerox. When that employee eventually retired, their benefit would be

computed based on their total service with Xerox, but then reduced to account for the

fact that a portion of the benefit had already been paid out.

The original plan provided there would be a ―phantom account‖ calculation where the

amount paid to the employee would be treated as if it had remained in the plan’s

investment pool, and the amount that would have been available was used to reduce

the benefit received. When amended, the plan omitted the phantom account language,

only stating the employee’s benefit would be reduced by what they had previously been

paid, but was silent on how that offset would take place. The plan administrator

determined the phantom account method should continue to be used, but that treatment

was ruled to be an unreasonable interpretation of the plan as written, as employees

were not on notice that a phantom account calculation would serve to reduce their

benefit by more than the actual amount received.

The trial court invited both the plan and the plaintiffs to propose a proper interpretation

based on the ruling. When the court was reviewing the submitted options, the court

decided that since the plan had already been found to have unreasonably interpreted

the plan initially, the plan’s new proposed interpretation was not required to be granted

deference by the court. The court did not rule on whether the plan’s proposal was a

reasonable interpretation, but rather fashioned its own interpretation that was to applied

in this case.



The Supreme Court majority ruled that the mere fact the plan administrator’s initial

interpretation was found to be unreasonable did not allow the court to set aside the

second proposal without determining that it also was an unreasonable interpretation of

the plan document. The Supreme Court returned the case to the trial court with

instructions to review the administrator’s proposal under the deferential standard of

review, and to decide if the administrator’s proposal was a reasonable interpretation of

the plan consistent with the issues the court raised on the first interpretation.

SECTION: 401

ADOPTERS OF PRE-APPROVED DEFINED BENEFIT PLANS WILL HAVE

UNTIL APRIL 30, 2012 TO ADOPT RESTATED VERSION OF PLANS

Citation: Announcement 2010-20, 3/29/30

The IRS expects to issue opinion and advisory letters for master and prototype and

volume submitter defined benefit plans that were restated for EGTRRA 2001 and other

changes listed in Notice 2007-3 by March 31, 2010 or shortly thereafter. This action will

start the clock running for employers that have adopted a defined benefit plan using one

of these preapproved plan documents to adopt the restated version that will now have

IRS approval.

Such employers will have until April 30, 2012 to adopt the revised plan in order to be

treated as having adopted the plan during the employer’s six-year remedial amendment

cycle. Failure to adopt the revised plan would mean an employer’s plan would no

longer meet the qualification requirements under §401(a), which can prove to be a very

expensive mistake to correct, especially if the issue is not uncovered until an IRS or

Department of Labor examination of the plan.

As well, the IRS announced it would allow employers adopting these restated plans to

apply for an individual determination letter with respect to these plans beginning May 1,

2010.

SECTION: 401

IRS RELEASES QUESTION AND ANSWER GUIDANCE ON IMPLEMENTING

PROVISIONS OF THE 2008 HEART ACT


The IRS released guidance in question and answer form on the implementation of

provisions of the Heroes Earnings Assistance and Relief Act of 2008 (HEART Act). The

Act provided certain benefits that were either required to be or allowed to be offered to

individuals who left a civilian job for military service that is entitled to be reemployed

under the Uniformed Services Employment and Reemployment Act of 1994.



Guidance is given on HEART Act Sections 104 (relating to survivor and disability

payments with respect to qualified military service), 105 (relating to survivor and

disability payments with respect to qualified military service), 107 (relating to

distributions from retirement plans to individuals called to active duty), 109 (relating to

contributions of military death gratuities to Roth IRAs and Coverdell education savings

accounts) and 111 (relating to differential wage payments to employees who are active

duty members of the uniformed services).

SECTION: 402

VALUE OF LIFE INSURANCE POLICY DISTRIBUTED FROM QUALIFIED

PLAN IS NOT REDUCED BY SURRENDER CHARGES

Citation: Matthies v. Commissioner, 134 TC No. 6, 2/22/2010

The Matthies had entered a transaction suggested by advisers to take funds out of an

IRA, move them into a profit sharing plan for an organization they controlled, use those

funds to purchase life insurance inside the plan and then purchase the policy from the

profit sharing plan. At the time of the transfer from the plan, the policy had a cash

surrender value of $1,368,327.33 subject to a surrender charge that reduced the net

cash surrender value to $305,866.74.

The taxpayers transferred $315,023 to the plan in exchange for the policy, basing it on

Hartford’s computation of the interpolated terminal reserve as of that date, and

transferred ownership to a family irrevocable trust. One day later the trust exchanged

the policy for another one with the Hartford, getting full credit for all premiums paid on

the prior policy.

The IRS contended the true value of the policy at the date of transfer under §402 should

be the cash value without reduction for the surrender charges. The Tax Court,

analyzing the relevant language and cross-references between sections 72 and 402,

found that the proper valuation was the cash value without reduction by the surrender

charges. The Court found that this result occurred even under the regulations for §402

as they existed prior to amendment in 2005.



SECTION: 404

EIGHTH CIRCUIT AGAIN DENIES DEDUCTION TO CORPORATION FOR

AMOUNTS PAID TO ESOP TO REDEEM STOCK

Citation: Nestlé Purina Petcare Co. v. Commissioner, CA8 No. 09-1381,

2/9/10

Ralston Purina (whose name was changed to Nestlé Purina Petcare Co.) attempted a

different approach than the approach that failed to work for General Mills, Inc in front of

the Eighth Circuit on the question of whether the corporation could get a deduction for

amounts paid to its ESOP to redeem shares of departing participants. As the Eighth

Circuit had denied a similar claim in the case of General Mills, Inc. when that sponsor

attempted to claim that §162(k)(1) was overruled by §404(k) to allow a deduction for

such payments.

Going in front of the Eighth Circuit, Ralston tried a tact that General Mills had not taken.

Ralston claimed that the amount was a ―deduction for dividends paid‖ under §561. IRC

§162(k)(2)(A)(iii) permits a deduction for dividends paid under §561.

Ralston agrees that §561 does not itself authorize a deduction, but defines a deduction

that are authorized in other sections (such as for registered investment companies and

REITS). The IRS took the position that only those items specifically authorized in

Treasury Regulation §1.561-1(a) are proper applications of §561, while Ralston took the

position that the regulation was issued before §404(k) came into the law and is clearly

outdated.

The Eighth Circuit disagreed. It notes that §162(k)(2)(A)(iii) permits a dividends paid

deduction ―within the meaning of §561‖ not ―within the meaning of §404(k)‖—and

§404(k) itself does not provide a dividends paid deduction under §561. Thus the Eighth

Circuit affirmed the original ruling of the Tax Court denying a deduction.

The Supreme Court in November of 2010 declined to hear the corporation’s appeal of

the Eighth Circuit’s decision in this case.



SECTION: 409A

IRS ANALYZES REQUESTS FOR DISTRIBUTIONS TO DETERMINE IF

THEY WERE UNFORESEEABLE EMERGENCIES


The IRS has issued guidance on what constitutes an unforeseeable emergency for

purposes of distributions from 457 and 409A plans. In both cases distributions are

allowed for events meeting the test, but are not allowed for other events. The ruling

posits three separate fact patterns to which the IRS applies to the appropriate standard.

In the first case the taxpayer asks for a distribution for an unforeseeable emergency for

the cost of repairing his residence after significant water damage occurred from a water

leak discovered in the basement of his principal residence. In the second case, the

taxpayer asked for a distribution to pay for the expenses of a funeral for his non-

dependent son who died unexpectedly. The IRS ruled that in both cases, the taxpayer

met the requirements for an emergency distribution, even though these events are not

specifically spelled out in the regulations or model amendment.

In the third case, the taxpayer asked for a distribution to pay accumulated credit card

debt. The IRS ruled that this event did not qualify, as it did not meet the requirements

for being an unforeseeable event, nor was it an emergency circumstance that arose as

a result of the events beyond the taxpayer’s control.

SECTION: 409A

RELIEF GRANTED FOR CERTAIN DOCUMENTATION ISSUES RELATED

TO NONQUALIFIED DEFERRED COMPENSATION PLANS


The IRS in Notice 2008-113 issued relief provisions related to operational issues related

to nonqualified deferred compensation plans under §409A. However, that guidance did

not deal with problems with the plan document, and the IRS asked for comments

regarding potential guidance with regards to document failures. In Notice 2010-6 the

IRS released its guidance for relief from document failures for plans covered by §409A.



In order to take advantage of this program, a taxpayer must take commercially

reasonable steps to identify other nonqualified plans that have a similar document

failure and correct all such failures consistent with the notice. As well, relief is not

available if either the service provider or service recipient is under examination, for

intentional failures or listed transactions. If the relief provision requires inclusion of

income by the service provider, the service provider must actually include the amount in

income, pay all taxes due, including the 20% additional tax (though not the premium

interest tax) and the service recipient must comply with the information reporting

requirements.

The notice provides for relief related to the following general categories of

documentation problems:

Ambiguous Plan Terms That Could be Interpreted to Violate §409A

Impermissible Definitions of Otherwise Permissible Payment Events

Impermissible Payment Periods Following a Permissible Payment Event

Certain Impermissible Payment Events and Payment Schedules

Failure to Include Six-Month Delay for Certain Employees

Provisions Providing for Impermissible Initial and Subsequent Deferral Elections

The notice provides that if a plan otherwise would have qualified for this relief and the

problem is corrected before December 31, 2010, the correction will be treated as if it

occurred on January 1, 2009. As well, prior to December 31, 2011, a service provider

will be treated as under examination for purposes of this relief only for a provision that

has been identified specifically as an issue in the examination.



SECTION: 411

MODIFICATIONS TO WELFARE PLAN HELD TO BE CONSTRUCTIVE

AMENDMENT TO PENSION PLAN THAT VIOLATED ANTI-CUTBACK RULE

Citation: Battoni v. IBEW Local Union No. 102, CA3 No. 08-3743, 2/5/10

The Court of Appeals for the Third Circuit held that a change in a welfare plan

amounted to, in effect, an unlawful cutback of participants’ benefits in a pension plan in

violation of the anti-cutback provisions of ERISA and IRC §411(d)(6). The matter in

question involved the merger of two locals of the International Brotherhood of Electrical

Workers (IBEW) and their plans. Prior to the merger, IBEW Local 675’s pension plan

permitted beneficiaries to choose between a lump sum retirement benefit or periodic

payments, while Local 102’s plan (which was to be the surviving plan) did not provide

for such a benefit. The combined pension plan provided that members of Local 675

retained the right to take a lump sum payment, but only for benefits accrued prior to the

merger.

The plans also combined their welfare plans which provided healthcare benefits. To

receive the benefits the retiree had to meet certain conditions. Shortly after the merger

the combined welfare plan was amended to add the requirement that to receive health

care benefits an individual must not choose a lump sum benefit under the combined

pension plan, a condition that did exist prior to the amendment. Certain members of

Local 675 filed suit claiming that the modification of the welfare plan amounted to an

impermissible cut-back of their pension benefit, even though the pension plan itself was

not amended, but rather the union amended the welfare plan which is not subject to the

anti-cutback rule.

The Court of Appeals, sustaining the District Court, held that the amendment was

effectively a part of the pension plan to the extent it pertained to the pension benefits.

The Court held that because the amendment imposed a condition on the receipt of a

lump sum benefit under the pension plan, it served to decrease an accrued benefit,

citing the Supreme Court’s 2004 holding in Central Laborers’ Pension Fund v. Heinz

that the imposition of a new condition on a benefit necessarily makes it less valuable.

The change in the welfare plan was held to constructively be an amendment of the

pension plan that decreased an existing benefit in violation of the Anti-Cutback rule.



SECTION: 415

IRS ANNOUNCES 2010 QUALIFIED PLAN INFLATION ADJUSTED LIMITS


The IRS announced the inflation adjusted limitations imposed on qualified plans for

2010. Generally the limits are either unchanged or had extremely modest increases.

Type 2010 Amounts 2009 Amounts

Maximum annual benefit-DB Plan (§415) $ 195,000 $ 195,000

Contribution limit DC Plan (§415) 49,000 49,000

Annual Compensation Limit (§404(l)) 245,000 245,000

Catch up Contributions to Employer Plan 5,500 5,500

Elective Deferrals (§402(g)) 16,500 16,500

Highly Compensated Employee (§414(q)) 110,000 110,000

Key Employee Compensation (§416(i)) 160,000 160,000

SIMPLE Deferral Limitation (§408(p)) 11,500 11,500

SEP Compensation Limit (§408(k)) 550 550

Roth IRA Maximum Contribution Phaseout Begins:

Married filing joint 167,000 166,000

Other except married filing separate 105,000 105,000

SECTION: 419

§419A(F)(6) PLAN REVISED TO ELIMINATE ATTEMPT AT

QUALIFICATION AS 10 OR MORE EMPLOYER PLAN RULED NO LONGER

SIMILAR TO LISTED TRANSACTION

Citation: PLR 201027007, 7/9/10

The IRS granted a ruling that a set of Employee benefits that were amended by the

sponsor to change what they had previously claimed were 10 or more employer plans

exempt from the §§419 and 419A deduction limits to clearly no longer qualify as 10 or

more employer plans were no longer to be treated as listed transactions substantially

similar to the transaction described in Notice 95-34.



The IRS notes that the ruling identified arrangements that claimed to meet the 10 or

more employer exemptions, but also contained descriptions of other factual elements

found in such arrangements. For purposes of this ruling, the IRS assumed that some of

those other factual elements described in Notice 95-34 may still be present in the new

plans.

However, even with that caveat, the IRS ruled that the plans no longer were sufficiently

similar to the transaction described in Notice 95-34 to be treated as a listed transaction.

However the ruling includes the caveat that it does not address whether there may be

disclosure requirements for particular employers that adopt the plan, or list maintenance

requirements for advisers to the plans.

While this gives us some guidance on what exactly the National Office views as ―similar‖

for these purposes, we must remember the rather nasty penalties and statute of

limitation issues that apply to reportable transactions for which a report is not made. As

such, caution will still need to be taken for clients who enter into arrangements where

the promoters have not taken the step of asking for an IRS ruling on their particular

structure, especially when the same promoter was previously pushing a supposed ―10

or more employer‖ solution that also gave assurance that an employer's own experience

would be respected.

SECTION: 446

IRS ANNOUNCES RELEASE OF NEW FORM 3115 THAT WILL

GENERALLY BE REQUIRED TO BE USED FOR REQUESTS AFTER MAY

30, 2010.

Citation: Announcement 2010-32, 4/22/10

The IRS has issued a new Form 3115, Application for Change in Accounting Method.

The new form, which bears December 2009 revision date, is required to be used for

applications for changes in method filed after May 30, 2010 except for cases where the

use of the older Form 3115, with a revision date of December 2003 is specifically

required in guidance published in the Internal Revenue Bulletin.

If the taxpayer properly used the December 2003 version of Form 3115 to file with the

national office prior to the May 30, 2010 effective date, it may file the required copy of

the Form 3115 with its return using either the December 2003 or December 2010

revision of Form 3115.



SECTION: 446

CHANGE IN TIMING OF REPORTING ADVANCE PAYMENTS ON

APPLICABLE FINANCIAL STATEMENTS IS AN ACCOUNTING METHOD

CHANGE FOR §446

Citation: CCA 201011009, 3/19/10

In a Chief Counsel Advice, the IRS concluded that if a taxpayer which had been

deferring the reporting of advance payments under Revenue Procedure 2004-34

changed its method of accounting for payments for financial statement purposes, that

was a change in its method of accounting under §446, and that consent must be

obtained from the IRS for such a change of method.

The taxpayer in this case was arguing that since the change in its book method of

accounting modified the ―applicable financial statement‖ for purposes of Revenue

Procedure 2004-34, this should not constitute a change of accounting method for tax

purposes, effectively arguing that it’s ―method‖ for tax purposes was linked to its method

used on its financial statements.

The IRS disagreed, noting this method changed the timing of reporting income vs. the

timing for similar transactions in prior years, a key component of ―accounting methods‖

for purposes of Section 446. The IRS concluded that permission must be obtained to

change the accounting method, and that the §481(a) provisions would be applied to

deal with the cumulative change in reported income rather than a cut-off method.

SECTION: 451

TAXPAYER WHO RECEIVED CHECK IN 2006 COULD NOT SHOW

SUBSTANTIAL RESTRICTIONS EXISTED AND HAD TO INCLUDE IN 2006

INCOME THOUGH NOT CASHED UNTIL 2007

Citation: Morgan v. Commissioner, TC Summary Opinion 2010-29

David Morgan admitted he received a check for $16,987 from MPC, run by his long time

friend, prior to the end of 2006. But he noted he did not cash the check in 2006 and he

also claimed he had agreed not to cash the check immediately.

The Tax Court first noted that the mere fact he did not cash the check in 2006 did not

mean he did not have income—it noted the court has long followed the ―cash-

equivalent-upon-receipt‖ rule that is found in the 1952 case of Kahler v. Commissioner.

However, if the check is subject to substantial restriction it would not necessarily be

income when received—and the court noted that in the case of Fischer v.

Commissioner, 14 TC 792, an oral agreement with the vendor not to cash the check can

count as such.



However David failed to produce any proof aside from his own testimony that such an

agreement actually existed. He failed to have his friend testify that such an agreement

actually existed or that the check would not have been honored if presented for

payment in 2006. As well, the Court noted that David also failed to report this amount

on his 2007 return as income.

Note that if the payer is also on the cash basis of accounting, this agreement would cut

both ways—the payer, since it had not truly paid for the item in the year in question,

would not have a valid deduction. That factor might explain why David may have found

his friend not so willing to testify to the existence of such an agreement.

SECTION: 451

TAXPAYER CAN USE DEFERRAL METHOD OF REVENUE PROCEDURE

2004-34 FOR PREPAID ROYALTIES RECEIVED IN LAWSUIT SETTLEMENT

Citation: CCA 201008035, 2/26/10

Lawsuits alleging infringement of intellectual property are a fairly routine occurrence in

the technology industry, and a recent Chief Counsel Advice took a look at the tax

consequences of the final resolution of one such case. The taxpayer received an award

for prior infringing use, as well as an agreement for the payment of royalties for future

use.

In the year following the resolution, the prevailing party received a lump sum cash

payment that represented partial consideration for licensed products sold prior to and

during the year of resolution, prepaid royalties for sales products over the license

agreement and a fully paid up license for licensed products. The taxpayer recognized

the entire amount of royalties for prior year as income for financial statement and tax

purposes. The remaining payments were treated as deferred revenue for financial

statement purposes to be reported over the term of the agreement.

While full inclusion in the year of receipt is a permissible method of accounting under

Rev. Proc. 84-31, the CCA rules the amount may be deferred under Revenue

Procedure 2004-34 so that a portion would be recognized in the following year. The

type of payment is one that is covered since the amount is received is both for services

and intellectual property.



SECTION: 453

TAXPAYER GRANTED PERMISSION BY IRS TO ACCELERATE

RECOVERY OF BASIS UNDER CONTINGENT SALES PRICE

INSTALLMENT AGREEMENT

Citation: PLR 201002006, 1/15/10

The IRS granted a taxpayer’s to recover his basis more quickly than the default method

provided in Reg. §15a.453A-1(c)(3)(i) due to an economic downturn that it was unlikely

it would receive any of the contingent payment that would have been due in the final

year of its installment sale. The taxpayer was an LLC taxed as a partnership that

operated as an investment adviser and financial consultant. The LLC sold its business

on a five year payment schedule that had contingent payment amounts for three

periods. Those final payments were based on an earn out based on future results of

the buyer.

The general rule under Reg. §15a.453A-1(c)(3)(i) is that when the amount of the

payment is unknown, but the period for contingent payments is fixed, the basis is

applied equally to each taxable year involved. Due to the loss of 50% of the customers

since the sale and the decline in the market value of the assets due to declines in the

security market, the taxpayer argued that it was extremely unlikely that it would receive

any payment for that final year, and asked under Reg. §15a.453-1(c)(7)(ii) that it be

allowed to recover all remaining basis in year 4. As required under that regulation, the

request was made prior to the due date of the taxpayer’s return including extensions.

The taxpayer must demonstrate that application of the normal ratable recovery rules

would inappropriately defer recovery of basis. While the taxpayer normally cannot rely

on projections of future events to demonstrate this fact, in special cases the regulations

allow for accepting one based on an event that has already occurred. The IRS ruled

that the severe decline in the market and the loss of customers by the buyer justified

reliance on the projected results, and found it reasonable to assume that the taxpayer

would receive no earn out payment in the final year. Thus the taxpayer was granted

permission to recover all remaining basis in the next to last year of the agreement.



SECTION: 460

EXTENDED MAINTENANCE PERIOD ON ROAD PAVING JOB NOT

ELIGIBLE FOR PERCENTAGE OF COMPLETION TREATMENT FOR TAX

PURPOSES

Citation: Koch Industries v. United States, CA10 No. 08-3347, 4/29/10

The issue of whether a taxpayer that entered into contract with the state of New Mexico

to build a highway and then insure that highway met minimum standards for years in the

future could use the percentage of completion method for the entire term was the

question before the Tenth Circuit Court of Appeals.

Koch Industries had developed a high quality road paving system that was more

expensive to build, but which had significantly lower maintenance cost over an extended

period. However it turns out that it took 12 years, based on the company's calculations,

for the state to see that benefit. So to sell their paving system to the state of New

Mexico for a contract to pave a state highway, the firm agreed to a guarantee that the

road would meet certain minimum standards defined in the contract for 14 years.

The contract specified amounts of the price that were for the initial paving, and a

separate amount for the long term maintenance. The contract provided that the

contractor was under no obligation to perform any maintenance to earn the

maintenance fee unless the road failed to meet the defined standards. It was, however,

almost certain the contractor would end up having to perform some services over the

term of the maintenance portion of the contract.

The firm used the percentage of completion method for the contract, and counted the

warranty work and costs expected to be incurred during the maintenance period as part

of its percentage of completion calculation. The IRS argued that, under the regulations,

this was warranty work that was not allowed to be counted under the percentage of

completion method. The District Court held for the taxpayer.

However, the Court of Appeals reversed the District Court's decision, holding that the

work was warranty work which could not, under the regulations, be included as part of

the paving contract since under the regulations warranty work can never be treated as a

cost incident to or necessary for the construction of the property.

The maintenance portion itself was not properly treated as a separate job for

construction since, the court noted, the contract explicitly held that there was nothing

the company was required to construct--and the mere fact it was likely that work would

be performed was not enough to make this a long term construction contract.



SECTION: 461

AMOUNTS DUE UNDER BONUS PLAN THAT REQUIRED EMPLOYEES

REMAIN EMPLOYED UNTIL DATE OF PAYMENT COULD NOT BE

ACCRUED DESPITE REQUIREMENT THAT AMOUNTS NOT PAID TO

EMPLOYEES BE PAID TO CHARITY

Citation: ILM 200949040, 12/4/09

An employer had an nonexecutive bonus plan that provided bonuses accrued for the

prior year would be paid within 2 ½ months of the year end to the employee. However,

the employee had to still be an employee of the employer at the time the bonus was

paid. However, the company had determined that if forfeitures back to it from

employees that left caused less than 90% of the bonus to be paid, an amount

necessary to get to the 90% level would be paid to charity.

The corporation argued that since somebody would receive at least 90% of the bonus, it

had a right to deduct that amount in the year accrued rather than the year paid, and was

asking for IRS permission to change its method of accounting to reflect that treatment.

The entity argued that such a deduction would be allowed either under §404 (for

accrued payments of compensation) or §170 (for authorized charitable contributions).

In a legal memorandum the IRS concluded that such a treatment was not permissible.

It found that it was not permissible to combine the tests under §404 and §170—and the

plan satisfied neither if tested separately. All events had not occurred to fix the liability

for payments for services to employees as of the end of year due to the requirement

that they stay employed, and all the requirements for a charity contribution had not been

met since no contribution would be made unless more than 10% of the bonus went

unpaid.

SECTION: 465

AT RISK AMOUNT FOR LEASING ACTIVITY DID NOT INCLUDE AMOUNT

DUE ON PROMISSORY NOTE FOR RV NOT OWNED BY LLC OR USED IN

LLC'S LEASING ACTIVITY

Citation: Estate of Roberts v. Commissioner, TC Memo 2010-156, 7/21/10

To determine whether the (by the time of trial) deceased Keith Roberts was eligible to

use the $425,000 he advanced for the purchase of an RV that cost over $1,300,000 as

an additional amount at risk for his equipment leasing activity, the Tax Court needed to

decide if, in fact, the single member LLC that was the leasing activity actually owed

money to Mr. Roberts. That, in turn, would depend on whether the LLC (CTI Leasing,

LLC) actually was the owner of this RV.



When Mr. Roberts purchased the RV, he lent CTI Leasing, LLC $425,000, received a

promissory note in that amount and on the following day received a cashier's check for

$425,000, which was used towards the purchase of the RV. On the title Mr. Roberts

listed the owner as ―Keith Roberts, DBA CTI Leasing‖ a name that was a) technically

different from the LLC's name and b) for which no trade name application had been

made with the state, a requirement in Indiana if an LLC were to operate under a name

other than its own. Mr. Roberts listed the EIN for the corporation which normally leased

equipment from CTI Leasing, LLC on the title for the RV.

While the Tax Court briefly considered the issues of whether the name on the title

meant the vehicle was CTI Leasing's or whether the EIN made any difference, ultimately

the Court found that the taxpayer produced no evidence that the RV was actually used

in CTI Leasing, LLC's business, since the taxpayer could not show the vehicle was

actually leased to the corporation. As well, during the examination representatives of

the LLC never reported that it owned the LLC, nor was the $425,000 note shown as due

to Mr. Roberts. So, in the end, the Tax Court concluded that Mr. Roberts could not

increase his amount at risk in the activity conducted by CTI Leasing, LLC by the

$425,000 note.

SECTION: 469

PARTICIPATION BY TRUSTEE OF TRUST, AND NOT OF BENEFICIARIES,

IS MEASURED TO DETERMINE MATERIAL PARTICIPATION BY TRUST

Citation: PLR 201029014, 7/23/10

The IRS, in a private letter ruling, held that the proper way to determine if a trust is

treated as materially participating in a business activity is by looking to the actions of the

fiduciary of the trust. The IRS noted that regulatory guidance has not been issued to

deal with participation by trusts, so it looked to interpret §469(h)(1)'s language in the

context of trust. To do so the IRS turned to the Senate Committee Reports related to

that provision. That report explained that a trust or estate would be treated as materially

participating if the executor or trustee was so participating in the activity.

The ruling likened the activities of beneficiaries of a trust to those of employees of a

taxpayer, noting that an individual employer is not given ―credit‖ for material participation

purposes to actions of employees. Rather, the designated trustee is the person

appointed to act on behalf of, and in the interests of, the beneficiaries.



SECTION: 472

METHOD OF PROPERLY IDENTIFYING ITEMS FOR CREATION OF LIFO

POOLS FOR A VINEYARD DETAILED

Citation: CCA 201043029, 10/29/10

The IRS's Chief Council's office issued a memorandum that described in some detail

the methods that should be used by a winery using the Dollar-Value LIFO method of

inventory. The analysis notes the importance of properly defining an item to be used to

build the LIFO indices, noting the importance of defining items in such a way that they

properly reflect the inflation inherent in the cost of the goods.

The notice gives a list of criteria that should be used for bulk wine items and a different

list to be used for classifying bottled wine and cased goods. It also discusses the issues

regarding grapes that are grown on the estate versus grapes used in the process that

are required from other parties, noting that it may be of importance whether the latter

are acquired solely when there is a shortfall in the vineyard's own production.

While not of general application, since most of us do not do the taxes for vineyards, the

notice does give a good discussion of the types of criteria used to determine the

definition of items for building the LIFO pools.

SECTION: 481

TAXPAYER NOT ALLOWED TO SUBMIT REQUEST TO CHANGE

ACCOUNTING METHOD IN CURRENT YEAR WHEN IRS ON EXAM

DISPUTED WHETHER TAXPAYER HAD FILE FOR PERMISSION IN PRIOR

YEAR

Citation: Chief Counsel Email Advice 201033038, 8/20/10

In emailed advice, the Chief Counsel's office refused to allow an automatic change of

accounting method request to go for a taxpayer to be processed under the following fact

pattern.

The taxpayer and the IRS were in a current dispute regarding the taxpayer's proper

method of accounting for an item. On exam the IRS contended that the taxpayer had

not requested consent under the automatic change procedures to change its method of

accounting for certain obligations. The taxpayer began using that method in the year in

question and had continued to use that method for four years.



The taxpayer is now requesting that the IRS grant permission to change its method to

continue to use its current method. The Chief Counsel's office determined that the IRS

could not grant this request. Because the old method, at this time, is not the method the

taxpayer is actually using this is not a change request.

The IRS position on exam is not final at the point the request is being made. As such,

the method does not yet qualify as a Service-imposed method. Thus, at this point, the

request is improper since no change is being requested. Revenue Procedure 97-27

only applies to a taxpayer requesting a change.

SECTION: 481

IRS UPDATES LIST OF AUTOMATIC ACCOUNTING METHOD CHANGES


The IRS issued a revision to its procedures on accounting method changes, modifying

the automatic procedure guidance in Rev. Proc. 2008-52 and clarifying the guidance on

nonautomatic changes found in Rev. Proc. 2007-67. This new procedure needs to be

read in conjunction with the above two procedures in order to obtain the latest

procedures for method changes.

The new procedure created additional automatic changes, including ones for materials

and supplies, repair and maintenance costs and tenant construction allowances. The

procedure clarifies the definition of ―under examination‖ for purposes of requested

method changes and clarifies when multiple Form 3115s are required for multiple

change requests.

SECTION: 481

AUTO DEALERS LOSING A FRANCHISE MAY ELECT TO TERMINATE

LIFO AND SPREAD ADJUSTMENT OVER FOUR YEARS

Citation: ILM 200935024, 8/17/09

A number of car dealerships lost their franchises in the past year during the

bankruptcies of General Motors and Chrysler as those car manufacturers sought to

reduce the number of dealerships selling their vehicles. In this memorandum, the IRS

concluded that such dealers who were using the LIFO method of accounting may

reduce the pain somewhat of being forced to push out the old LIFO layers as their

inventory is liquidated by electing to change their accounting method for such inventory.

The memorandum interprets the automatic change rules in Rev. Proc. 2008-52.



The memorandum concludes that a dealer is not forced to recognize the entire

adjustment in the year of change so long as it continues in a trade or business, even if

the loss of the franchise eliminated all new car franchises that it held. The §481(a)

adjustment would be spread over four years. The memorandum also contains guidance

regarding how a taxpayer that had a single pool for multiple franchises who lost a single

franchise could accomplish a spread of the adjustment on just that pool by making two

method changes—that is, breaking apart the pool into separate pools for each franchise

under Rev. Proc. 97-27 by filing a Form 3115 before the end of its tax year and then

change from the LIFO method for the pool that contains the vehicles from the lost

franchise.

SECTION: 482

IRS CHASTISED FOR POORLY SUPPORTED POSITION ON VALUE OF

INTANGIBLES TRANSFERRED AND USE OF TEMPORARY REGULATIONS

ISSUED 10 YEARS AFTER THE TRANSACTION

Citation: Veritas v. Commissioner, 133 TC No. 14, 12/10/09

The Tax Court was none too happy with the IRS’s experts and its position in the case of

Veritas Software v. Commissioner, 133 TC No. 14. The technical matter at issue was

whether the taxpayer had properly valued existing intangibles under a cost sharing

arrangement in which certain intangibles were transferred to an offshore subsidiary

under §482.

During the examination the IRS made use of an expert to come up with its own value for

the intangibles, deciding the proper value was $2.5 billion. The IRS based its

assessment on that value. The taxpayer raised numerous objections to that experts

report when it filed with the Tax Court. At this point the IRS, rather than dealing with the

objections to that expert’s report, brought in a new expert and now claimed the true

value of $1.675 billion.

However, this expert made a number of errors of his own. He insisted upon using an

income method to value the intangibles, but at trial made numerous concessions about

errors in his methodology.

As well, he and the IRS attorneys made numerous references to the temporary

regulations §§1.482-1T through 1.482-9T, regulations issued in January of 2009,

regulations issued more than a decade after the transactions. As the Tax Court

quipped, ―Taxpayers are merely required to be compliant, not prescient,‖ and applied

the regulations actually in force at the time of the transaction to decide the case. The

IRS position, both in the initial assessment and at trial, was found to be arbitrary,

capricious, and unreasonable.



The Court found that generally the taxpayer’s use of the comparable uncontrolled

transaction method was more appropriate, though the Court did make some

adjustments to the taxpayer’s calculation.

Even if you never get near the specific issue of transfers of intangibles, the case is

interesting for looking at the limits of the IRS’s presumption of correctness (and how the

IRS may lose that presumption at trial) and the importance of tracking what the status of

regulations were at the time a transaction took place.

SECTION: 501

VIRTUAL CONGREGATION NOT SUFFICIENT FOR RELIGIOUS

ORGANIZATION TO QUALIFY AS A CHURCH UNDER THE IRC

Citation: Foundation of Human Understanding v. United States, CA FC 2009-

5129, 8/16/10

The Court of Appeals for the Federal Circuit sustained the Court of Federal Claims'

ruling that a religious organization that did not hold meetings of its followers, failing the

associational test, was properly not treated as a church, but rather as a religious

organization under §501(c)(3).

The organization in this case had originally been found by the Tax Court to be a church

in a Tax Court ruling in the 1980s. At that time the organization both owned two

buildings where it regularly conducted religious services, though it devoted substantial

resources to disseminating its messages to a wider audience through broadcast and

print media.

During the 1990s the organization sold its buildings in which the regular meetings of

believers had been held, and added the dissemination of its message via the Internet as

well as the print and broadcast methods it had previously used. The IRS, in a church-

tax inquiry, found that the organization no longer qualified as a church, but rather was a

§501(c)(3) religious organization.

The organization claimed first that a religious organization should be treated as a

church as long as there was a ―body of followers‖ but the Court rejected that view,

noting that every religious organization would meet that requirement, but that in the IRC

the Congress intended there to be a difference between a religious organization and a

church, with the latter being a subset of the former.

The organization pointed out it did hold 21 seminars during the three period under

examination. The Court agreed with the IRS that these infrequent meetings did not

establish that the organization conducted regular meetings or had an established

congregation.



The Court also rejected the Foundation's argument that, via its electronic ministry, its

members gathered regularly to worship as a ―virtual congregation‖ finding that the mere

fact individuals may have received the message at the same time did not mean they

had associated with each other, a requirement under the judicial association test for

being classified as a church.

SECTION: 501

BLUETOOTH CERTIFICATION GROUP DID NOT QUALIFY AS TAX

EXEMPT BUSINESS LEAGUE

Citation: Bluetooth SIG, Inc. v. United States, CA9 No. 08-35312, 7/8/10

The Ninth Circuit Court of Appeals sustained a U.S. District Court decision that

Bluetooth SIG, Inc. did not qualify for exemption from taxation under §501(c)(6) as a

business league. The group is the organization effectively placed in charge of certifying

Bluetooth equipment produced for the wireless telephone and computer industries and

licensing the underlying patents and trademarks. The IRS denied the application for

exemption, holding that the organization's ―primary purpose was to promote a single

brand of inter-connection technology‖ as opposed to improving business conditions in

general for the industry and that it had a substantial activity that consisted of providing

particular services to individual persons.

The Bluetooth SIG cited Revenue Ruling 70-187 in favor of its position. That ruling held

that a nonprofit organization formed by manufacturers for testing and certification of the

product to establish acceptable standards within the industry as a whole qualified for

exemption. However, the Court found that there were important differences, including

that the Bluetooth SIG had created the ―industry‖ they were arguing they were serving

and the organization did not merely certify standards but also barred those not meeting

its standards from selling the product at all. The Court found Revenue Ruling 58-294,

where the IRS held that an organization that operated for the purposes of ―promoting

uniform business, advertising and fair trade practices in connection with the

manufacture and sale of a certain patented product‖ was more on point with the

operations of Bluetooth SIG.

The Court also held it was important that the organization effectively only benefitted

members, while a tax exempt business league would generally bring some benefits

even to nonmembers in the industry. In this case only members of the Bluetooth SIG

are able to manufacture Bluetooth devices, and the activities of the SIG would seem to

work directly against any competing wireless technology.

Finally, the Court found that the group provided significant services to particular

members, specifically selling licenses needed to manufacture each product.



SECTION: 501

FOUNDATION TO PROVIDE SINGLE DONOR'S SPERM FREE OF CHARGE

TO SELECTED APPLICANTS PROPERLY DENIED TAX EXEMPT STATUS

Citation: Free Fertility Foundation v. Commissioner, 135 TC No. 2, 7/7/10

The Tax Court ended up having to decide one of the more unusual cases of the year in

the case of Free Fertility Foundation. The Foundation was established by William

Naylor to provide his sperm, free of charge, to women looking to become pregnant via

artificial insemination or in vitro fertilization. Mr. Naylor was protesting the IRS denial of

his application for the Foundation to be treated as a private operating foundation under

§501(c)(3).

Mr. Naylor argued that the organization promoted health for the community and was

operated exclusively for exempt purposes. He had entered into a contract with a sperm

bank in Spokane, Washington to store and distribute his sperm to recipients that would

be selected by the Foundation. Mr. Naylor and his father were the Foundation's only

board members and trustees.

Mr Naylor is a software engineer who holds more than 10 patents on various inventions.

He argued that the Foundation would make more of a positive difference to the world

than all of the inventions and discoveries he could create. The apparent goal to create

a bunch of William Naylors who would, it appears, be similarly gifted and able to pursue

the work that Naylor himself undertook.

The Foundation maintained a website and invites potentially qualified women to apply to

the Foundation to obtain the sperm free of charge. The Naylors created a questionnaire

that the women had to fill in giving their background. Preference was to be given to

women ―with better education‖ and no record of divorce, domestic violence or ―difficult

fertility histories‖ and come from families with ―a track record of contributing to their

communities. The women should be in ―a traditional marriage situation,‖ be under age

37, with preference given to women who are ethnic minorities and are from locations

other than those where the Foundation had already accepted recipients. The scores,

based on an algorithm, were adjusted to account for the number of vials of sperm that

were available, but the Naylors reserved the right to ―adjust‖ a score if they felt the

algorithm had not properly ranked the women.

The Tax Court agreed with the IRS that this operation did not qualify for tax-exempt

status as a private operating foundation under §501(c)(3). The Court found that the

number of individuals benefitted would be too limited to benefit the general health of the

community. As well, the criteria had little or nothing to do with promoting health, but

rather were geared more towards William Naylor's own personal goals.



SECTION: 512

OPERATION OF BEACH HOUSE AND PARKING LOT WERE UNRELATED-

BUSINESS INCOME FOR HOMEOWNERS ASSOCIATION

Citation: Ocean Pines Association, Inc. v. Commissioner, 135 TC No. 13,

8/30/10

A homeowners' association was found to have unrelated-business income subject to tax

from the operating of a parking lot and beach club. The parking lot and beach club were

located approximately eight miles from the area where the homes were located. The

association claimed the income from the parking lot was not unrelated-business income

under the exception for rents from real property. The association claimed the income

from the beach club was substantially related to the promotion of community welfare,

and thus not unrelated-business income—a claim the association claimed also applied

to the parking lot even if it failed the rent test.

The Tax Court found that the activities did not promote the general welfare of the

community, as full use of the facilities was open only to members of the association.

The members of the association could not be counted as constituting the entire

―community‖ for purposes of finding a promotion of the general welfare of the

community.

The Tax Court also found, after consulting Congressional reports from the enactment of

the tax on unrelated-business income that the operation of a parking lot was specifically

held out as an example of the type of rental that would not qualify for the rental of real

estate exception, noting similar language in Reg. §1.512(b)-1(c)(5). The services

provided by the association at the lots (hiring parking guards to open the lots and check

for proper parking decals) are primarily for the convenience of the occupant and other

than those of a type normally rendered in connection with the rental of rooms or space

for occupancy only.



SECTION: 512

COMPUTER SOFTWARE INTELLECTUAL PROPERTY DEVELOPED FOR

INTERNAL USE BY CHURCH WAS NOT UNRELATED BUSINESS INCOME

WHEN SOLD

Citation: PLR 201024069, 6/18/10

A church had developed software that it used to manage its own website. The software

attracted the attention both of other churches and for profit organizations that wanted to

use that software for their own sites, and approached the church about licensing the

intellectual property for this use. The church, which had undertaken the project solely

for its own use, decided to sell all intellectual property rights to the property to an

organization. The sales agreement provided that the church, while retaining a perpetual

license to the software, was prohibited from engaging in further development of the

software except as a user, and also generally from competing with the buyer.

The church asked the IRS if this amount was unrelated business income under §512,

subject to the unrelated business income tax of §511. The IRS ruled that the sale was

trade or business income, but because the church did not regularly develop software or

other intellectual property for sale, it was not income of the type discussed under §512,

and thus no unrelated business income tax was due on these amounts under §511.

The ruling noted that the church, like virtually any other church, does regularly develop

intellectual property as a by-product of its exempt functions (sermons, teaching

materials, and music), but that intellectual property is not developed for sale and the

software which was sold was not initially developed for sale, and the church was not

undertaking any other software development programs.

SECTION: 512

VEBA CANNOT AVOID LIMIT ON EXEMPT FUNCTION INCOME BY

CLAIMING INVESTMENT INCOME USED TO PAY BENEFITS

Citation: CNG Transmission Management VEBA v. Commissioner, CA FC,

No. 2009-5025, 12/14/09

A VEBA was found to have taxable income on its investment income, even though it

asserted that the amount, being less than the amount it paid out in benefits, should be

exempt from taxation since the amounts were spent on benefits. The VEBA that such

income, having been offset by the payment of benefits, could have caused its year-end

account balance to exceed the limits found in §512(a)(3)(E)(i).



The Court of Appeals for the Federal Circuit sustained the ruling of the Court of Federal

Claims, holding that the plain language of the statute simply looks to the account

balance at the end of the year and the extent to which investment income caused that

balance to exceed the statutory limits at year end. The Court stated that the VEBA

could not escape tax via a ―bookkeeping entry‖ that claimed to apply the investment

income to member benefits.

While rejecting a comparison to the facts in Sherwin-Williams Co. Employee Health

Plan Trust v. Commissioner that the VEBA argued existed, the Federal Circuit

nevertheless commented that it agreed with the Court of Federal Claims that the Sixth

Circuit had erred in its analysis of the law in deciding that case where the Sixth Circuit

found that §512(a)(3)(B) imposed a limit on a VEBA’s ―accumulated funds‖ rather than

its set-aside funds.

SECTION: 565

IRS ALLOWS CORPORATION TO MAKE LATE CONSENT DIVIDEND

ELECTION FOR PHC WHEN FINALLY ADVISED OF THE OPTION TWO

YEARS LATER

Citation: PLR 201035002, 9/3/10

While, in general, ignorance of the law is not an excuse, in some cases it may get

sympathy from the IRS Chief Counsel's office to allow for a late election. In the case in

question the Company's president was a CPA, but apparently one not well versed in

corporate taxation. He was the son-in-law of the couple that owned the corporation,

and apparently was relied upon for tax decisions. One of his decisions was not to make

a Subchapter S election when the corporation was formed. The CPA felt there was no

need to do this, as the return would be simple as the only income of the corporation was

interest income.

Of course, having only investment generated interest income meant that the corporation

was subject to the personal holding company tax, something the CPA discovered when

he prepared the return with unspecified tax preparation software. Being unaware of the

option to have the couple take a consent dividend under §565, the CPA simply had the

corporation pay the personal holding company tax. He then elected S status for the

second year of the corporation's existence.

In late October of the third year, the President met with outside tax advisors to plan for

year 3. The outside advisors informed him of the existence of the option to have taken

a consent dividend back in the first year.



While not stated in the ruling request, it seems likely a problem the advisors noticed was

that the corporation would have accumulated earnings and profits from that first year,

thus triggering the application of the §1374 excess passive income tax and, more

ominously, the potential loss of the S status under §1362(d)(3) after the third successive

year of excess passive income. The imposition of that tax can be avoided if the

accumulated earnings and profits are distributed to the shareholders, but if that was

done in this case the taxpayers would now be paying tax on a dividend on top of the

PHC tax paid for Year 1. An election under §565 would have avoided that double tax

issue.

The IRS granted the corporation's request to make a late election for the shareholders

to take a consent dividend for year one, finding that the taxpayers had acted reasonably

and with good faith and granting the election would not prejudice the interests of the

government.

SECTION: 704

§704(C) ANTI-ABUSE RULES ADDED BY IRS TO REGULATIONS

Citation: Final Regulations §1.704-3, TD 9485, 6/8/10

The IRS has added anti-abuse provisions to the regulations under §704(c). Generally

§704(c) governs allocations related to the difference between the basis of property and

that property's fair value upon contribution to the partnership. Reg. §1.704-3 provides

for three methods to be used to handle such matters, but the IRS has become

concerned about the possibilities for what they see as abuses of these rules.

Revisions to Reg. §1.704-3, effective for tax years beginning after June 9, 2010, provide

first that the methods found in Reg. §1.704-3 apply only to contributions of property

―otherwise respected,‖ specifically noting that under Reg. §1.701-2 a contribution

transaction may be recast to, in the view of the IRS, avoid tax results inconsistent with

the intent of Subchapter K.

Second, a specific §704(c) anti-abuse rule is added at Reg. §1.704-3(a)(10) to provide

that a method selected, even if one of those outlined earlier in §704(c) regulations, will

be deemed to be not reasonable if the contribution of property and allocation of tax

items are made with a view to shifting the tax consequences of built-in gain or loss

among the partners in a manner that substantially reduces the present value of the

partners' aggregate tax liabilities, considering both direct and indirect partners.



SECTION: 705

TAXPAYER'S INITIAL VICTORY ON OPTION LOSS GENERATING

PARTNERSHIP REVERSED BY TENTH CIRCUIT

Citation: Sala v. United States, CA10 No. 08-1333, 7/23/10

One of the few taxpayer victories in the various marketed tax shelters that used

offsetting options to generate a tax loss due to the position that contingent liabilities

would not be counted as liabilities for a contribution to a partnership was the Sala case.

The operative word now is was—on appeal, the Tenth Circuit reversed the District

Court's holding in the Sala case, finding that the transaction in question lacked

economic substance.

The Court of Appeals first found the District Court erred by looking an entire five year

investment program rather than concentrating on the single part of the transaction that

created a large loss that the taxpayer conceded was created intentionally as part of the

transaction.

The Court of Appeals also faulted the District Court for finding that the partnership

transaction that took place in the year in question had a profit potential if held for a year,

noting that that profit potential was minimal compared to the tax benefit that would be

created, and that the loss could only be created if the partnership were liquidated prior

to the end of the year. Thus, the panel held, even if the transaction showed evidence

that holding it to maturity would generate the largest possible gain, the need to generate

the tax loss would require the partnership to be immediately liquidated.

For that reason, the Court held, the claimed loss had to be disregarded because the

transaction lacked any true economic substance—the transaction existed solely to

generate a $24 million loss on demand.



SECTION: 705

BASIS CALCULATION IS A CUMULATIVE AND NOT YEAR BY YEAR

CALCULATION WHEN APPLYING "NOT BELOW ZERO" LIMIT FOUND IN

§705(B)

Citation: Leblanc v. United States, Court of Federal Claims, 1:05-cv-00743,

12/4/09

What does IRC §705(b) mean when it says, in computing partnership basis, that the

amount will not go below zero? The taxpayer in this case claimed that it means that a

taxpayer’s basis gets reset to zero at that point, and any losses passed out in excess of

that amount will never apply in computing basis. That was important because, in the

taxpayer’s case, the partnership later passed out amounts of income prior to the

taxpayer’s eventual abandonment of their interest, and they claimed a loss based on a

calculation that added in that later income while ignoring a large first year loss that was

in excess of their basis at the time.

The IRS disagreed, arguing that basis is a cumulative calculation as envisioned by

§705, and the §705(b) stopping basis at zero only served as a temporary ―hold‖ at that

point until the cumulative calculation brought the basis above zero. If the IRS’s position

was correct, the taxpayer’s basis in the activity would have been zero at the date of

abandonment, and thus there would be no loss to deduct.

The Court of Claims agreed with the IRS’s view, noting that if the taxpayers were

correct, wildly different results would be obtained had that loss year been the final rather

than first year of the partnership.

SECTION: 707

TRANSFER OF SUBSIDIARY TO PARTNERSHIP WAS A DISGUISED SALE

Citation: Canal Corporation v. Commissioner, 135 TC No. 9, 8/5/10

The Tax Court ruled that an attempt by a corporation to defer taxation of gain on the

sale of its subsidiary by contributing it to a partnership ran afoul of the disguised sale

rules of §707(b). In this case the corporation wished to exit a particular industry that

was conducted by a subsidiary. However, the corporation wished to avoid a direct sale

of the subsidiary since its tax basis in the subsidiary was low.



The corporation consulted with an investment bank and the CPA firm which served as

its independent auditor. The bank and CPA firm determined that the tax on a

disposition would be deferred for up to 30 years if the subsidiary contributed its assets

to an LLC along with the acquiring entity contributing its own similar, but much smaller,

operation in the same entity. The LLC would borrow funds from a third party,

guaranteed by the acquiring entity, that would be distributed to the subsidiary. In the

end the old owner would end up with a 5% interest in the partnership even though it had

contributed the vast majority of the assets. So far, that looked like a textbook disguised

sale.

However, the accounting firm suggested that the sale treatment would be avoided if the

subsidiary indemnified the acquiring company in a limited fashion on the debt. The

acquiring company itself did not require or seek the indemnity, rather it was undertaken

to be able to allocate the debt entirely to the subsidiary under the debt allocation rules of

§752, and escape the default treatment under the disguised sale rules.

The IRS objected that the indemnification was effectively a sham and should be

disregarded under the anti-abuse provisions of Reg. §1.752-2(j)(1). Specifically, the

indemnity, in addition to not being required by the buyer, did not require the subsidiary

to maintain any minimal amount of capital, was placed in the subsidiary specifically to

limit the maximum liability to the parent and the transaction was reported as a sale for

accounting purposes. The Tax Court agreed with the IRS position, treating the

transaction as a disguised sale to be reporting in the year of formation of the LLC.

SECTION: 707

INVESTORS WERE ACTUALLY PARTNERS, AND THERE WAS NOT A

DISGUISED SALE OF STATE TAX CREDITS

Citation: Virginia Historic Tax Credit Fund v. Commissioner, TC Memo 2009 -

295, 12/22/09

Partnerships were set up in Virginia to engage in the rehabilitation of historic buildings,

supported by a state tax credit. The state law provided that the credits could be (and

were expected to be) allocated specially to various partners of the partnership. These

limited partners, while deemed to own a small portion of the project and to be allocated

a small portion of the income or loss, were told not to realistically expect any significant

amount of income or loss to be allocated to them. As well, the partners agreed that the

general partner could buy their interests for fair market value once the partnership had

fulfilled its purpose.



The IRS argued on the one hand that the limited partners were not truly partners or, in

the alternative, that their contribution of capital was a disguised sale of the state tax

credits under §707.

The Tax Court ruled first that the entities were partnerships. The Court found that the

taxpayers had come together for a business purpose. The Court noted that while a tax

benefit may have been the prime economic force driving the investment, that tax benefit

was a state law tax benefit, not a federal one—and a state law benefit clearly intended

to be used in this fashion by the state in question to encourage the preservation and

restoration of historic buildings.

The Court also found that the substance of the arrangement was a true contribution of

capital and receipt of credit as a partner, and not a disguised sale of tax credits. The

Court found that the transfer was not simultaneous and there was entrepreneurial risk—

that is, there was a possibility the partnership would be unable to pool sufficient credits,

as well as other risks faced by the limited partners.

SECTION: 707

TRANSFER OF ASSETS TO PARTNERSHIP FOLLOWED BY PLEDGE OF

INTEREST TO RECEIVE NONRECOURSE LOAN AND RELATED PUT HELD

TO BE DISGUISED SALE

Citation: United States v. G-I Holdings Inc., DC NJ, 2009 TNT 240-17,

12/14/09

The disguised sale rule of §707(a)(2)(B) was applied in a case where a taxpayer

contributed assets from a division of its business worth $480 million dollars to a trust,

and then shortly thereafter the interests were transferred to a trust that received a $460

million nonrecourse loan against those interests, of which $450 million was transferred

to the taxpayer. A put agreement required the partnership to purchase the partnership

interests of the taxpayer at the taxpayer’s capital account at the time the put was

exercised.

The taxpayer contended that these transactions were truly separate, and that they could

not be collapsed under §707(a)(2)(B). However, the U.S. District Court of New Jersey

disagreed. When it analyzed the entirety of the transaction it found that the transaction

has been structured in an attempt to avoid tax on the sale of the division by creating the

partnership, but then effectively disposing of that interest indirectly through the

nonrecourse loan borrowing procedure.



The Court found that the taxpayer had no reasonable expectation of a profit on the

underlying transaction in excess of the costs it had incurred, that its potential losses had

been capped in the transaction and that the capital contribution and loan were a

―package deal‖ that had to be looked at as whole. Thus the Court concluded that the

$450 million part of the package was a disguised sale.

However the victory proved a hollow one for the IRS. The Court found that the IRS had

not assessed the tax due within the three year statute of limitations period and the

transaction did not cause an omission of income from the return in excess of 25% that

was necessary to trigger the six year statute of limitations under §6501(e). So while the

taxpayer should have paid tax on the transaction, the IRS waited too long to raise the

issue.

SECTION: 752

SON-OF-BOSS TRANSACTION FOUND TO LACK ECONOMIC

SUBSTANCE, SO ISSUE OF RETROACTIVE APPLICATION OF REG.

§1.752-6 NOT RELEVANT.

Citation: Palm Canyon X Investments v. Commissioner, TC Memo 2009-288,

12/15/09

The Tax Court dodged the question of whether Reg. §1.752-6 can be applied

retroactively to unwind a Son-of-BOSS style transaction, instead ruling that the

underlying transaction lacked economic substance. The court applied both the

subjective and objective prong of the economic substance test. It found that the

transaction failed the subjective prong, as the nontax reasons offered for executing the

transaction were not credible. Among the reasons the court ruled that way included a

finding that there was no real need for the taxpayers to hedge foreign currency in the

foreseeable future (one of the purported reasons for entering into the transaction), no

investigation into the foreign currency aspects of the transaction, a lack of rational

economic behavior in pricing the contracts, the adding of a partner solely to be able to

remove that partner to trigger the basis shift in liquidation of the partnership, and that

the transaction was specifically developed as a tax shelter.

The transaction also failed the objective test, which requires showing the transaction

had a reasonable prospect of earning a profit. The court found that the prospects of the

transaction hitting the ―sweet spot‖ where it would turn profitable were small (estimated

at 1.3% by an individual involved). And, in any event, the fees paid were greater than

any potential profit the transaction might produce.



The Court also found that since it held the case was appealable to the Court of Appeals

for the District of Columbia, that the transaction was subject to a penalty under §6662

for a valuation misstatement. While the Fifth and Ninth Circuits had held that the

valuation negligence penalty could not apply when a transaction was disregarded for

economic substance, the Tax Court disagrees with that holding. While both parties

originally stated the case was appealable to the Ninth Circuit, the IRS later disagreed

and the Tax Court agreed with the IRS’s new view. The Court also denied relief from

any other penalties under §6662.

SECTION: 851

DISCHARGE OF INDEBTEDNESS INCOME FROM REQUIRING DEBT BY

REGULATED INVESTMENT COMPANY HELD TO BE QUALIFYING INCOME

Citation: PLR 201006015, 2/12/10

A regulated investment company (RIC) had borrowed funds in order to make various

qualified investments. Now those debts are trading at a substantial discount to their par

value, and the fund believes it makes economic sense for its investors to reacquire this

debt at the lower price. But doing so would generate substantial discharge of

indebtedness income and if that income is not considered qualifying income under

§851(b)(2) the company would not longer be an RIC—a result the entity wished to

avoid.

The IRS ruled that to the extent the original proceeds of the debt instruments could be

traced to purchase of qualified income securities within the meaning of Reg. §1.163-8T,

the discharge of indebtedness income would be qualifying income under §851(b)(2) as

other income derived with respect to the fund’s business of investing in securities.

SECTION: 864

WORLDWIDE ALLOCATION OF INTEREST DELAYED YET AGAIN


HIRE Act Section 551 delays, yet again, the effective date for the worldwide allocation

of interest. The election, last delayed in the American Recovery and Reinvestment Act

of 2009, now will be available for the first taxable year beginning after December 31,

2020 rather than December 31, 2017.



SECTION: 881

GUARANTEE FEES PAID TO FOREIGN PARENT CORPORATION HELD

NOT TO BE U.S. SOURCE INCOME

Citation: Container Corporation v. Commissioner, 134 TC No. 5, 2/17/10

Container Corporation was charged a fee by its parent, a Mexico based corporation, to

guarantee its debt. The IRS argued that such a payment represented a fixed or

determinable annual or periodic income received from sources within the United States

and sought to impose a 30% tax under §881(a). The IRS argued that the fees should be

treated like interest, which would cause the income to be sourced in the country of

residence of the obligor.

The Tax Court, however, disagreed with the IRS’s view on this matter, finding the

payments for the guarantee did not represent United States source income, but rather

should be treated as sourced in Mexico. Since there was no loan from the parent to the

subsidiary, the Court found that the payments were not interest. The Court also

disagreed with Container Corporation’s claim that the amount was payment directly for

a service.

However the Court found that in this case it must apply the rules by analogy, and it

found the income analogous to a payment for services Thus under Reg. §1.861-4

would be sourced to the country of residence of the ―service‖ provider—in this case, the

country of the parent, Mexico.

SECTION: 1001

TRANSFERS OF BUILDING ON OWNED LAND WERE SALES, THOSE ON

LEASED LAND WERE NOT

Citation: TAM 201027045, 7/9/10

In technical advice, the IRS Chief Counsel's office determined that the issue of whether

a taxpayer owned the land on which it constructed buildings would determine whether

or not its transfers of buildings would be treated as sales. The taxpayer in the case was

a retailer who had two methods of building stores and paying for the construction under

consideration. In most cases the retailer acquired land, built a building on the land and

then sold the property to a third party to lease it back under an initial 22 year term with

the right to extend the lease for two separate ten year periods at substantial rents.

However, in other cases the retailer would build on land already owned by the third

party. The building would then be transferred to the landlord at the end of construction,

and the landlord would obligated to pay a ―Tenant Improvement Allowance‖ and a lease

similar to the one described above would be entered into.



The Chief Counsel's office, disagreeing with the position advocated by the examining

agents, held that the transactions where the taxpayer owned the land were sale

transactions. The TAM distinguished this case from Rev Ruling 72-543 (which involved

a 99 year lease), holding that Examination had erroneously determined the useful life

didn't extend beyond the lease term noting that a) if the tenant did not exercise the

option to renew the lease the building would be available to the landlord and b) the land,

which was also transferred, does not have a finite useful life. The nature of the gain

would be ordinary and not capital, as it held that in this case the properties were

effectively stock in trade of the seller, as this system of constructing buildings

specifically tailored to the retailer's needs were an integral part of its business

operations.

However the Chief Counsel's office determined that the building constructed on leased

land were not sales transactions, finding against the taxpayer in this position. The TAM

noted that the payments were specifically labeled as a tenant improvement allowance

and thus offset th taxpayer's basis in the building. If there was remaining basis after the

allowance was received, it was required to be depreciated rather than treated as loss on

the sale of the building.

SECTION: 1031

EXCHANGE HAD PRINCIPAL PURPOSE OF TAX AVOIDANCE, DEFERRAL

OF GAIN NOT ALLOWED

Citation: Ocmulgee Fields, Inc. v. Commissioner, CA11 No. 09-13395,

8/13/10

The Eleventh Circuit Court of Appeals affirmed the Tax Court's decision that a like kind

exchange between a corporation and a related partnership fell afoul of §1031(f)(4)'s

denial of deferral treatment for such a related party exchange. Specifically, the

appellate panel found that the Tax Court did not commit clear error in its factual finding

that the transaction had as one of its principal purposes the avoidance of federal income

tax.

In the transaction in question Ocmulgee Fields, a C corporation, had a highly

appreciated piece of property that it was going to sell. Treaty Fields, a partnership

controlled by similar interests, had a higher basis piece of property that Ocmulgee

eventually identified as its replacement property. Thus, when the transactions were

completed, Treaty Fields reported a taxable sale of the high basis property while

Ocmulgee Fields held the property previously held by Treaty Fields, but now with a

lower basis. As Ocmulgee fields would have paid a 34% corporate income tax on any

taxable portion of the gain, the transaction had a secondary advantage of exposing

what gain was taxable to a much lower personal income tax rate on capital gains.



The Court noted that, in addition to the obvious significant tax advantage of the deferral

transaction (had it been upheld), the use of a qualified intermediary was an

unnecessary complexity. The only reason it made sense to use one was because, had

the transaction taken place directly between the two entities, it would have automatically

been disallowed §1031 treatment by §1031(f)(1).

The Court rejected the corporation's theory that the partnership's property was merely a

―fallback position‖ after its search for other suitable property failed, noting that only six

days elapsed between the time a qualified intermediary was engaged and the contract

was entered into with the partnership. The Court also found unpersuasive the

taxpayer's claim of legitimate business reasons for selecting this specific property,

noting that the mere existence of a legitimate business would not, in any event,

establish that a principal purpose of this specific transaction remained tax avoidance.

SECTION: 1031

POLLUTION CONTROL CREDITS TREATED AS LIKE KIND PROPERTY

Citation: PLR 201024036, 6/18/10

The IRS ruled in favor of the taxpayer's request that an exchange of one type of

pollution control credits for another should be treated as a tax free exchange under

§1031. The taxpayer received emission control credits for reducing its output of

nitrogen oxide (NOx) at its plant. Such credit could be used to offset emissions

elsewhere in the area that would exceed allowed levels. A similar program existed for

volatile organic compounds (VOCs).

The taxpayer had an excess of NOx credits, but its plans for construction required

obtaining VOC credits. Under the region's pollution control program, such credits could

be purchased from other entities. The taxpayer proposed to exchange its excess NOx

credits for excess VOC credits held by third parties.

The IRS ruled that both credits were rights granted by the regional government as

licenses or permits. Since both programs sought to control ozone causing pollutants,

the IRS ruled that the differences in the chemicals underlying each credit should be

regarded as differences in grade or quality, not character or nature. As such, the credits

were like kind property for purposes of §1031.



SECTION: 1031

LEASING COMPANY COULD NOT AVOID RECOGNIZING GAIN ON

EXCHANGE VIA QUALIFIED INTERMEDIARY TO ACQUIRE EQUIPMENT

FROM RELATED DEALER

Citation: CCA 201013038, 4/1/10

A taxpayer was an equipment leasing company that had an old piece of equipment with

a basis of $150,000 and a fair market value of $750,000. A related taxpayer was an

equipment dealer, and that dealer obtained a new piece of equipment with a cost of

$760,000 that it would normally hold for retail sale. However, the leasing company

entered into a sales arrangement with a qualified intermediary, who sold the old

equipment for $750,000 and the proceeds of that sale, along with $10,000, was used to

acquire the new equipment from the dealer.

The taxpayer admitted it could have obtained the property directly from the

manufacturer or an unrelated dealer, but contended it had legitimate business reasons

for wanting the sale to go through the dealer. The dealer’s location was close to the

taxpayer, the stability of the supply due to good relations between the dealer and the

manufacturer, as well as allowing the dealer to receive manufacturer incentives for the

sale of this vehicle. The taxpayer contended these valid business reasons should allow

it to use §1031(f)(2)(C)’s exception to the general rule of §1031(f) that would trigger gain

recognition.

The Chief Counsel’s office disagreed. It noted that in order to take advantage of the

§1031(f)(2)(C) exception, the taxpayer needed to show that neither the exchange nor

the disposition had as one of its principal purposes the avoidance of Federal income

taxes. The fact that other valid reasons existed for the structure did not show that one

of the principal reasons for this structure was to avoid recognizing the income on the

sale.



SECTION: 1221

TAXPAYER'S IGNORANCE OF NEED TO SPECIFICALLY IDENTIFY

HEDGING TRANSACTIONS NOT "INADVERENT ERROR" ALLOWING

TREATMENT AS ORDINARY LOSSES


Essentially ruling that ignorance of the law is not a valid excuse, the IRS Chief

Counsel's office in an email ruled that the taxpayer could not treat certain transactions

as hedging transactions, avoiding the automatic 60% long term capital and 40% short

term treatment for gains and losses on the transactions. If they had been identified in

that fashion, any gains or losses would have been ordinary losses. Presumably the

taxpayer had incurred losses.

The taxpayer claimed that even though the contracts had not been identified as hedging

transactions in its books, they had been incurred for that purpose and would have been

so identified had the taxpayers known about the regulatory requirement. The taxpayer's

case was not helped by an answer to a question in an earlier examination that they had

no hedging transactions in response to IRS inquiries.

The Chief Counsel's office found no evidence the taxpayer had identified the

transactions as hedging transactions either in their books or in any other form for any

tax or nontax purpose. It also specifically held that the taxpayer's ignorance of the law

did not rise to an ―inadvertent error‖ under Reg. §1.1221-2(g)(2)(ii).

SECTION: 1361

STOCKHOLDER AGREEMENT PROVIDING FOR DISTRIBUTIONS TO PAY

TAX IN ACCORDANCE WITH INTEREST FOR YEAR TAX ARISES DOES

NOT CREATE SECOND CLASS OF STOCK

Citation: PLR 201017019, 4/30/10

The IRS dealt with a taxpayer’s request to rule on whether the following arrangement

would create a second class of stock, invalidating the corporation’s S election. The

corporation has a provision in its Shareholder Agreement that requires that it make a

distribution based on its taxable income passed out on shareholder’s K-1s in sufficient

amounts to enable shareholders to pay their taxes by December 31 following the year in

which the income arises. The Agreement also provides that if a later adjustment is

made to items reported on the K-1, the agreement allows a discretionary payment to be

made to handle the increased taxes resulting from the adjustment.



The corporation proposes to change the Agreement so that if an adjustment is made

and it makes a discretionary payment, the payment would be made in accordance with

the taxpayer’s interest in the corporation during the taxable year the adjustment applies

to, rather than the interests at the date the distributions are made.

The IRS issued the letter ruling requested, holding that this arrangement would not

create a second class of stock, nor will actual distributions under the arrangement

create a second class of stock.

SECTION: 1361

MERGER OF PARENT INTO QSUB WAS AN F REORGANIZATION, S

ELECTION NOT TERMINATED

Citation: PLR 201007043, 2/19/10

The taxpayers wished to combine the operations of a parent corporation and its

subsidiary. The parent corporation had an S election in place, while the subsidiary had

a valid QSUB election in place. Due to certain legal agreements, the subsidiary could

not be merged upstream into the parent, but rather had to be the surviving entity

following the merger. Adding another wrinkle to the transaction, the parent also owned

another subsidiary that had a valid S election.

The subsidiary would be merged with the parent, with the shareholders of the parents

receiving subsidiary stock in exchange for their old parent stock. The subsidiary would

receive all assets of the parent, including the stock in the other subsidiary.

The IRS ruled that this transaction was properly treated an F reorganization of the

parent under § 368(a)(1)(F), with no gain or loss recognized on the transaction. As well,

the S election remained intact, effectively being transferred to the surviving subsidiary

that had previously been a QSUB. The QSUB election of the other subsidiary also

survived the transaction.



SECTION: 1361

ROTH IRA ACCOUNT IS NOT AN ELIGIBLE S CORPORATION

SHAREHOLDER

Citation: Taproot Administrative Services, Inc. v. Commissioner, 133 TC No.

9, 9/29/09

A Nevada corporation was formed with a single shareholder—a Roth IRA. The

corporation had elected S status, having its income flow through to Roth IRA. The IRS

contended that a Roth IRA was not an eligible S corporation shareholder and took the

position that the corporation instead was now a C corporation. In a split decision the

Tax Court agreed with the IRS.

The majority noted that there was no direct authority on whether a Roth IRA could be a

shareholder. However the court found the situation analogous to the situation for a

regular IRA that was covered in Rev. Ruling 92-73 where the IRS ruled that a regular

IRA was not an eligible S corporation shareholder. The court found that ruling

persuasive. As well, the court felt that there was no evidence the Congress intended for

Roth IRAs to be eligible S corporation shareholders, noting that in 2004 the Congress

passed a provision that allowed IRAs as shareholders in S corporation banks—a

provision that would be unnecessary if, in fact, IRAs had all along been allowed to be S

corporation shareholders.

Once it was determined the Roth IRA was not an eligible shareholder, the S status

issue is quickly resolved. If there is an ineligible shareholder, the corporation ceases to

be an S corporation and instead is taxed as a C corporation.

SECTION: 1362

CORPORATION REMOVAL OF GUARANTEE OF RETURN OF PRINCIPAL

TO SINGLE SHAREHOLDER WAS TREATED BY IRS AS REASON TO

TREAT TERMINATION AS INADVERTANT

Citation: PLR 201042014, 10/22/10

The IRS allowed an S corporation to reinstate its S election after it, in the words of the

IRS, ―may‖ have been terminated by the following transaction. The corporation sold its

shares to an eligible trust, but the purchase agreement had a clause that guaranteed

that the shareholder would receive its initial investment back if there were a sale of the

corporation that resulted in the loss. As the corporation was the entity giving that

guarantee, there was concern that the clause may have created a second class of

stock, something not allowable for an S corporation under §1361(b)(1)(D).



The corporation had never paid out any funds based on that portion of the purchase

agreement, and it had now amended the agreement to remove the clause. The

corporation asked for and received an IRS ruling that the termination (if it had occurred)

was inadvertent and that relief was granted to treat the election as if it were not

terminated, pursuant to §1362(d).

SECTION: 1362

IRS ALLOWS LATE ELECTION WHEN INDIVIDUALS WHO SIGNED S

ELECTION ONLY BELIEVED THEY WERE SHAREHOLDERS

Citation: PLR 201030002, 7/30/10

A corporation looked to make an S election, but there turned out to be some confusion

about who were the shareholders at the date of the election. The plan was for an estate

to sell its shares to one individual. An agreement was drawn up to transfer the estate's

shares to the individual for a set price. The agreement, with a blank check for the

amount of the purchase, were delivered to the individual. However, the attorney

directed the individual not to execute the agreement pending further instruction.

The individual buying shares from the estate and another individual executed a Form

2553. The agreement noted above was dated prior to the date of the Form 2553, but

was not yet executed at the date of the S election. The Form 2553 was signed only by

the two individuals and not by the executor of the estate.

After the date of the Form 2553 the check was delivered and the agreement was

executed transferring the shares. The taxpayers later became concerned the S election

was invalid, as the estate appears to have been a shareholder at the date the election

was executed.

The IRS agreed that the election was not valid, but that it was inadvertant and late

election relief was granted.

SECTION: 1362

IRS RULES THAT TERMINATION OF S ELECTION DUE TO EXCESS

PASSIVE INCOME WAS INADVERTENT

Citation: PLR 201030018, 7/30/10

While §1375(d) allows a waiver of the excess passive income tax if a taxpayer in good

faith believed it did not have earnings and profits and it distributed the earnings and

profits within a reasonable time after it was discovered, that exception does not serve to

undo the termination of S status under §1362(d)(3)(A)(i) if there have been three years

of excess passive income.



However a taxpayer that has such a termination can have that termination waived by

the IRS if the IRS determines the termination was inadvertent pursuant to §1362(f). In

the case at hand, the taxpayer requested the IRS find the termination was inadvertent.

The IRS granted the request, so long as a payment of the tax now was timely made.

SECTION: 1362

S CORPORATION SHAREHOLDER AGREEMENT SERVED TO PRESERVE

S STATUS DESPITE ATTEMPT TO TRANSFER SHARES TO INELIGIBLE

SHAREHOLDER

Citation: PLR 201026006, 7/2/10

A restriction on the transfer of S corporation stock to impermissible shareholders that

was upheld by a state court served to preserve the corporation's S corporation status in

this letter ruling. The Shareholders' Agreement of the Corporation, which was executed

by the founding shareholders of the corporation, stated that a shareholder desiring to

transfer shares of stock to another party had to 1) obtain the consent of the other

shareholders prior to the transfer, 2) the new shareholder must become a party to the

Shareholders' Agreement and 3) any transfer that would result in the termination of the

corporation's S status would not be valid.

Eventually a shareholder attempted to transfer shares to an ineligible shareholder.

Court proceedings followed, and an order was entered that held this transfer was null

and void, and that the original shareholder remained the legal owner of all shares that

he had attempted to transfer to an ineligible shareholder.

The IRS ruled that because the transfer was held to be null and void, the S election was

held not to terminate. However the IRS conditioned the ruling on having all

shareholders file amended returns within 60 days, if necessary, to have the original

owner treated as the owner of all shares.

Because it is a letter ruling where we see only the IRS response, we don't know whether

this was likely to be an issue with the shareholders, though it's easy to imagine a

circumstance where the person whose sale was voided might not be in a very

cooperative mood. However it's easy to imagine cases where that cooperation might

not be easy to come by, or where such cooperation would need to be mandated by the

court action voiding the transfer.



SECTION: 1362

TRUST THAT ERRONEOUSLY ELECTED QSST RATHER THAN ESBT

STATUS ALLOWED TO CORRECT ERROR AND CORPORATION

REMAINED AN S CORPORATION

Citation: PLR 200952037, 12/24/09

The taxpayers requesting a ruling in PLR 200952037 appear to have somehow gotten

confused over the difference between a QSST and an ESBT. The facts indicate that a

trust that qualified as an ESBT but not a QSST was a shareholder of the S corporation

at the time of its election. The trust made a timely election to be treated as a QSST—

which it wasn’t eligible to be. The ―wannabe‖ S corporation also had two wholly owned

subsidiaries for which it filed a QSUB election to be effective upon election.

Due to the trust having made the wrong election, the parent corporation was not eligible

to elect S status and so would revert to a C corporation. As well, the QSUB election

was also an invalid one, since the corporation holding the potential QSUB’s stock was

not an S corporation. The taxpayer was asking that the IRS grant the trust the right

make a late ESBT election and to treat the subsidiaries as QSUBs.

The IRS granted relief, subject to the receipt of an actual election and the filing of

amended tax returns on behalf of the trust that recognize that the trust was an ESBT.

SECTION: 1363

SECTION 291 DOES NOT APPLY TO LIMIT DEDUCTION FOR INTEREST

PAID ON DEBT TO ACQUIRE QUALIFIED TAX EXEMPT SECURITIES FOR

QSUB WITH S STATUS MORE THAN 3 YEARS

Citation: Vainisi v. Commissioner, No. 09-3314, 3/17/10

Reversing the holding of the Tax Court, the Seventh Circuit Court of Appeals held that

§1363(b)(4) explicitly makes the limitations on the deduction of interest to purchase

qualified tax exempt securities inapplicable to a QSUB bank that had been in S status

for more than three years.

The parent S corporation in this case had been an S corporation for six years prior to

the year in question. The IRS argued that regulations issued under the authority found

at IRC §1361(b)(3)(A) allowed it to apply the general financial institution rules to this

QSUB, thus applying Section 291 to limit the deduction of interest. The taxpayers

argued that Section 291 did not apply to them based on the explicit language of the

statute and that they should be able to deduct all of the interest.



The Seventh Circuit panel noted that the explicit language of §1363(b)(4) held that §291

would only apply to an S corporation that had been a C corporation during the prior

three years. The Court rejected the IRS’s view that since this provision had been

enacted prior to when banks could be S corporations or subsidiary it was inapplicable,

and found that neither the plain wording of the statute nor the Treasury’s own

regulations supported the IRS’s interpretation.

The Court commented that if this result is not what is intended, Congress should

change law or, possibly, the Treasury should revise its regulation. On the latter point

the Court noted that the IRS had issued proposed regulations to do just that—but those

regulations had never been made final and many commentators suggested the

regulations if made final would go beyond what the IRS could do via regulation. The

Court specifically reserved judgment on whether the IRS could, in fact, accomplish this

goal by regulation.

SECTION: 1363

LIFO RECAPTURE TAX DOES NOT APPLY TO PROPRIETORSHIP

ELECTING S STATUS IMMEDIATELY FOLLOWING §351 INCORPORATION

Citation: PLR 201010026, 3/12/10

In response to a taxpayer request for a private letter ruling, the IRS reaffirmed that the

LIFO recapture tax of §1363(d) does not apply when a sole proprietorship incorporates

under §351, makes a timely LIFO election for its first year of existence and makes a

valid S election for its first year as a corporation. The IRS notes that the literal language

of §1363(d) requires that the S corporation be a C corporation at some point before the

effective date of its S election.

The IRS also goes on to analyze the rationale behind the LIFO recapture tax, noting

that it serves as a backstop to the built in gains tax of §1374. The IRS reasons that

Congress enacted the LIFO recapture tax as otherwise an S corporation that did not

experience a decrease in inventory during its first ten years would escape the built in

gain on its inventory that existed when it made the S election.



What we need to remember from this ruling is that there is a danger that still lurks for

sole proprietorships that incorporate. If the S election does not take effect that first

year, then the LIFO recapture tax would come into play if the entity elects its S status in

a later year. Certainly the issue of the later imposition of a LIFO recapture tax if the

entity later elects S status should be discussed when a sole proprietor on the LIFO

basis is deciding to convert to a C corporation. As well, this issue also needs to be kept

in mind when we discover an S election that was intended to be made was not made—

failing to go through procedures to obtain relief for a late election may be much more

costly than we might first expect.

SECTION: 1366

TAXPAYER'S INABILITY TO SHOW BASIS, COMBINED WITH FACT THAT

DEBT GUARANTEE DOESN'T CREATE BASIS, MEANS NO S

CORPORATION LOSS DEDUCTION

Citation: Weisberg and Peterson v. Commissioner, TC Memo 2010-55

Robert Weisberg’s K-1 from his law firm’s S corporation for 2003 showed a loss of

$199,141, a loss claimed on his personal return by the accounting firm that prepared his

return. Robert had guaranteed the firm’s line of credit and, in 2004, ended up borrowing

money personally that he then used to pay off the corporation’s credit line.

However, Robert did not present any evidence to show his basis in the S corporation.

The Tax Court noted that a guarantee of debt did not create any basis in the S

corporation, and his actual payment on that guarantee in a later year was not relevant to

his ability to claim a deduction in 2003.

The Court also imposed a negligence penalty on Robert. Although he used an

accounting firm to prepare his return, he presented no evidence on the information he

had provided to that firm, in particular any information about basis in his S corporation.

As such, the Court found he did not qualify for an exception to the penalty for having

reasonably relied on a professional—such reliance requires a showing that the taxpayer

had provided the preparer with all information the taxpayer believed relevant and

actually relied on the advice provided.



SECTION: 1367

CONTRIBUTION OF CAPITAL NOT TREATED AS EITHER TAX EXEMPT

INCOME FOR S CORPORATION DEBT BASIS OR LOSS UNDER §165

Citation: Nathel v. Commissioner, CA2 No. 09-1955-ag, 6/2/10

The taxpayers in this case had loaned money to their S corporation and also

guaranteed debts the corporation had to the bank. Losses had wiped out their stock

basis, and the basis in their debt (which appears to have an open account balance not

evidenced by a note) had been reduced in order to take losses in prior years. The

taxpayers, readying to sell off the operations, contributed capital to the corporation, a

step that was necessary to have the bank remove the shareholders from the guarantee.

The corporation repaid the shareholder loans and redeemed their stock.

The taxpayers initially claimed that the contribution of capital should be treated as tax

exempt income. The taxpayers argued that §118, which excludes such contributions

from income, would only be needed if the item were one of income and, therefore,

under the logic the Supreme Court had originally laid out in the Gitlitz case for

cancellation of indebtedness income excluded under §108, it would add to basis. In

their case this is important because basis is first restored to debt by income. If it wasn't

income, it would create stock basis and the repayment of their debt whose face value

would be less than its basis would create ordinary income.

The IRS argued that was exactly the result and the Tax Court agreed. The taxpayers

appealed to Second Circuit Court of Appeals which sustained the Tax Court. The

Second Circuit held that capital contributions from shareholders had never been an item

of item. §118 was enacted primarily to codify case law regarding contributions to capital

by nonshareholders and did not serve to convert contributions by shareholders into an

item of income.

The taxpayers argued in the alternative that they should be able to treat the contribution

of capital as an ordinary loss under §165, as they argued they made the contribution to

be released from their guarantees. The Tax Court had ruled that such a loss could be

claimed only if the taxpayers could show that was the sole reason for the contribution,

and the Tax Court found there were significant other reasons in the transaction.



The Second Circuit agreed in result, but held that in its view the taxpayers would have

prevailed if they could have shown the primary purpose of their contribution had been to

secure the release. The panel noted that there is a bit of diversity in the holdings of the

various courts in this matter, some holding to the sole purpose test the Tax Court

applied, while others (the Tenth Circuit in the 1964 Condit decision) had appeared to

allow the deduction even when there was no primary purpose. But this panel came

down for the primary purpose test and held that the taxpayers in this case had failed to

show their payment was made for the primary purpose of securing a release from the

guarantees.

SECTION: 1374

LINKED PREPAID VARIABLE FORWARD CONTRACT AND SHARE

LENDING AGREEMENT TRIGGERED IMMEDIATE GAIN RECOGNITION IN

BUILT IN GAIN MEASUREMENT PERIOD

Citation: Anschutz Company v. Commissioner, 135 TC No. 9, 7/22/10

Having acquired the Staples Center in Los Angeles and two professional sports team,

Philip Anschutz needed some cash. His wholly owned S corporation's, which has

elected its status only a year before, held a number of highly appreciated securities in a

subsidiary it owned that had elected QSUB status. A sale of the shares would trigger

the built-in gain tax of §1374 along with individual income taxes at the shareholder level,

so Mr. Anschutz looked to avoid that result.

To accomplish that goal, he entered into a pair of transactions, one where the

corporation entered into a prepaid variable forward contract (PVFC) involving various

appreciated shares he held, and another that required him to lend those same shares to

the investment bank with which he entered into the agreements with under a share-

lending agreement (SLA). The transactions would ultimately finish up after the 10 year

built-in gain period at which time, in the taxpayer's view, any gain or loss would be

recognized.

The agreements limited the QSUB's ability to participate in appreciation of the

underlying shares to no more that 50% of the value when the contract was entered

into—all additional appreciation accrue to the benefit of the investment bank. Similarly,

because the PVFC could be settled by delivering the initial number of shares, the QSUB

had locked in the lowest price it would receive for the shares, that being the initial 75%

value received.



The taxpayer contended that the two transactions had to be evaluated separately citing

the Tax Court's decision in Samueli v. Commissioner, 132 TC 37, while the IRS

contended that rather they were an integrated whole. The Tax Court sided with the IRS,

finding that the taxpayer had misinterpreted the holding in Samueli which involved an

arrangement the taxpayers argued they could have (but did not) enter into. The Court

found that, viewed as a whole, the QSUB transferred all risk of loss and most of the

opportunity for gain when it executed this pair of transactions.

The Court also refused to consider that the QSUB had the right to recall the lent shares

and, in fact, did so twice after the examination commenced. The Court pointed out the

recalls were not done for any valid economic reason, but rather solely to try and

influence the result in the case. The taxpayers, being insulated from loss by the overall

arrangement, could not obtain the protection of §1058 for the lending transactions, as

the loss protection violated the requirements of §1058(b)(3).

However the Court did not agree with the IRS that the QSUB should be taxed on the full

fair value of the shares transferred. The IRS argued that, effectively, the QSUB had

received 75% in cash and the remainder in equity options. The Tax Court rejected that

view, holding that the amount to be received cannot be determined until the contract is

settled, so only payments received by the QSUB would be taxable.

SECTION: 1374

PRICE PAID NINE MONTHS AFTER S ELECTION WAS A FACTOR, BUT

DID NOT BY ITSELF, ESTABLISH VALUE AT S ELECTION DATE FOR

BUILT IN GAIN TAX

Citation: The Ringgold Telephone Company v. Commissioner, TC Memo

2010-103, 5/10/10

Ringold Telephone Company had been a C corporation, but effective January 1, 2000

the corporation elected S status. At the time it held a minority interest in a

telecommunications company, the majority interest of which was held by BellSouth in

various forms. In September of 2000, BellSouth acquired the interest for over

$5,000,000.

The built in gain tax under §1374 applied in this case, but the question became how

much of the gain was subject to that tax. The IRS contended that since the sale took

place a few months after the S election that the sales price was the value at the date of

the S election. The taxpayer argued that the true value at the date of conversion was

less than that amount, not because the entity had suddenly become more valuable in

those few months, but rather because BellSouth had its own reasons for paying a

higher than market price.



The Tax Court found that the September price paid by BellSouth was an indicator of the

value. The court agreed with the IRS that BellSouth did not pay extra to get a

controlling interest, since it already had one and this purchase did not add to its control,

a position the S corporation had argued. However, the court found that the S

corporation’s valuation expert, who had significant experience in valuing

telecommunications organizations, was able to show that BellSouth had a history of

―doing whatever it takes‖ to be sure to complete a deal once it decided it wished to

acquire an interest.

In this case, there existed a right of first refusal for the other minority partners to buy the

interest that Ringold was selling to BellSouth. The Court found that BellSouth likely did

pay more than the market price to some extent to insure the right of first refusal options

would not be exercised. The Court therefore factored in other valuation methods in

arriving at its own value at the date of the S election.

SECTION: 1402

IRS PROTECTIVE ASSERTION OF FICA TAX DUE FROM S

CORPORATION DID NOT PROHIBIT IRS FROM LATER ARGUMENTS

PAYMENTS WERE PERSONAL SELF-EMPLOYMENT INCOME

Citation: Daniel v. Commissioner, TC Summary Opinion 2010-61, 5/13/10

The mere fact that the IRS had assessed the taxpayer’s S Corporation alleging an

underpayment of payroll taxes did not prevent the IRS from taking the alternative

position that the taxpayer owed self-employment taxes on the income.

The taxpayer received real estate commissions from Holland Realty as a real estate

agent. The taxpayer had reported such items not on Schedule C, but rather treated

them as assigned to his S corporation. The S corporation claimed various expenses

and then issued a W-2 for the remaining income.

The IRS examined the taxpayer and issued a notice to the S Corporation finding that

Daniel was an employee and assessing payroll taxes on the entire amount of

commissions paid. The IRS, after a petition in Tax Court was filed, decided that

assessment was in error as the return had treated Daniel as an employee and asked

that the case be dismissed. The Tax Court dismissed that case.

The IRS assessed the taxpayer personally at the same time for self-employment tax

due on the commissions. The taxpayer argued that the IRS had conceded he was an

employee of the S Corporation in the prior case and could not claim an inconsistent

position here.



The Tax Court did not agree. The Court found, first, that the question of whether Daniel

was or was not an employee was never decided in the first case so there was no prior

ruling. The Court also held that the IRS was allowed to take inconsistent position as a

protective measure—in this case, to capture an underpayment regardless of whether

the assignment of income was or was not effective.

SECTION: 3101

IRS NOT LIMITED TO ASSESSING PAYROLL TAXES ONLY AGAINST

DESIGNATED AS COMPENSATION IN CORPORATE MINUTES FOR S

CORPORATION

Citation: David E Watson, P.C. v. United States, US District Court for the

Southern District of Iowa, 5/27/10

A CPA whose S corporation was a partner in an accounting firm with no other activities,

basing his arguments on IRS wins in cases involving attempts by taxpayers at trial to

recharacterize payments as compensation, argued that since his S corporation had only

designated $24,000 of payments to him as compensation, the IRS was barred from

reclassifying additional payments made to him in the form of dividends as wages. In

those cases, taxpayers were blocked by trying to claim payments were truly wages

when, at the time the payments were made, the corporation had shown no intention to

treat these payments as compensation.

However, the Court noted that in those cases it was the corporation trying to argue after

the fact that payments it had labeled as one thing were truly another—and the

corporation was, of course, the party that had full control of what it decided to label them

when they were paid.

The Court cited a number of S corporation cases where the opinions had supported IRS

efforts to recharacterize the payments as wages, noting that S corporations had an

incentive under the tax law to understate wages to avoid payroll taxes. Thus, the Court

held, the mere recitation of salary in the corporate minutes did not serve to fix the

amount that the IRS could argue was compensation.

SECTION: 3102

OWNER OF COMPANY HELD LIABLE FOR PAYROLL TAXES ON

INDIVIDUALS HE CLAIMED WERE INDEPENDENT CONTRACTORS

Citation: United States v. Porter, DC SD Iowa, 7/21/09

The US District Court for the Southern District of Iowa found Raymond Porter liable for

payroll taxes that should have been paid for individuals he had treated as independent

contractors in his livestock products company.



The Court found that Raymond did not qualify for relief under the special rules of

Section 530 of the Tax Reform Act of 1976, a key defense used by entities who in a

position such as Raymond’s. In order to get Section 530 protection, Raymond had to

show that a) he consistently treated all such individuals as nonemployees, b) he filed all

required information returns consistent with his position that the individuals were

independent contractors and c) he had a reasonable basis for treating the individuals as

independent contractors. While Raymond met the first test, the court found he failed the

last two.

The IRS had no record of receiving Raymond’s 1099s for 1996. Despite Raymond

providing copies of the returns he had given to his salesmen and the salesmen

testifying that they had received the 1099s, the court still found Raymond had not

proven he had filed the forms with the IRS.

As well, the Court found Raymond had no reasonable basis for treating these

individuals as employees. He claimed he relied on the advice of his now deceased

accountant-attorney. However he produced no document containing that advice from

this individual. The court decided that given the ―convenience‖ of this explanation

(relying on the advice of someone who could not be called forward to testify on whether

he had given such advice) the court required additional corroboration—and Raymond

presented none.

Clients should be cautioned about the liabilities they face if they treat individuals as

independent contractors who potentially should be employees. That’s doubly true now

that the IRS has announced plans to conduct a National Research Project into the area

of proper reporting of employment related items.

SECTION: 3111

QUALIFIED EMPLOYEES MUST SIGN NEW FORM W-11 OR A SIMILAR

AFFIDAVIT FOR EMPLOYER TO CLAIM HIRE ACT FICA RELIEF

Citation: Draft Form W-11, 3/31/10

The IRS has issued a draft form W-11 that will be completed by employees that qualify

under the HIRE Act for FICA relief for employers. The draft form indicates that an

employee must sign either the Form W-11 or a similar affidavit signed under penalties of

perjury that the employee meets the requirements of the HIRE Act. An employer must

have this signed document in order to be able to claim the FICA relief.



SECTION: 3111

EMPLOYERS HIRING CERTAIN INDIVIDUALS NOT RESPONSIBLE FOR

EMPLOYER SOCIAL SECURITY FOR THAT EMPLOYEE THROUGH END

OF 2010


Section 101 of the HIRE Act granted an exemption for employers from their share of the

FICA tax paid on certain new hires, found at IRC §3111(d). Employers will not be

required to pay the employer portion of social security taxes (but not Medicare taxes) on

the wages of certain employees hired after February 3, 2010 for wages paid after March

18, 2010. The relief applies to wages paid from the date of hire (or March 18, 2010 if

later) until December 31, 2010.

The employee in question must be hired after February 3, 2010 and before January 1,

2011. The employee must certify to the employer that he/she has not been employed

for more than 40 hours during the 60 day period ending on the date the individual

begins employment. The employee cannot be hired to replace another employee of the

employer unless that employee left employment voluntarily. If applicable, the employee

must not be an ineligible employee as defined in §51(i)(1) for the work opportunity

credit—such class includes most related individuals.

A special rule is applied for wages paid during the first quarter of 2010. Since the bill

was enacted less than two weeks before the end of the quarter, the bill recognizes that

employers are not going to have time to modify payroll systems to take this into

account. Thus the employer social security tax technically still applies for the first

quarter, but the employer will be given a credit on the second quarter taxes for the

amount that would have been excluded in the first quarter [IRC §3111(d)(5)].

Wages for which payroll taxes are forgiven under this provision cannot be counted for

purposes of the work opportunity credit. However, an employer can elect to not have the

payroll tax forgiveness provisions apply if the employer prefers to make use of the work

opportunity credit.

A parallel provision is created for railroad retirement taxes imposed under IRC §3221.



SECTION: 3121

SERVICE PROVIDERS WORKING AT SPA HELD NOT TO BE EMPLOYEES

Citation: Cheryl Mayfield Therapy Center v. Commissioner, TC Memo 2010-

239, 10/28/10

In what the court found was a close case, the Tax Court found that massage therapists,

cosmetologists and nail technicians that worked on the premises of a spa were

independent contractors and not employees of the spa. The individuals paid a booth

rent of approximately $80 as a base rent or, if higher, 25% of the service provider's

gross revenues earned.

The Tax Court discussed a number of Revenue Rulings that had dealt with the question

of employment status of individuals in similar industries, including Revenue Ruling 73-

592, Revenue Ruling 57-110, Revenue Ruling 73-591, Revenue Ruling 73-574 and

Revenue Ruling 70-488. The Court noted that the existence of a fixed rental

component generally argued for independent contractor treatment. While the spa was

not consistent, normally the rent charged was based on the $80 minimum or, if higher,

25% of gross receipts.

Also in the spa's favor was the fact that all compensation was on a straight and mission

basis, no business or travel expenses of the service providers was paid for by the spa

and many of the service providers made significant investments to outfit and decorate

their room. These factors meant the service providers both had a risk of loss and an

opportunity to profit by working longer hours.

The spa did not tell the service providers how to provide the services to their clients, the

service providers were all licensed professionals, set their own hours and although they

provided their schedules in advance, the service providers could change the schedules

as they please.

Arguing against the treatment of the service providers as independent contractors were

certain factors the Tax Court pointed out. The services given were integrated directly

into the spa's operation, the services were provided almost exclusively on the spa's

premises, some basic training was provided and the service providers did not generally

offer their services to the public outside of the spa.

Ultimately the Tax Court decided that, although it was a close case, these individuals

were properly treated as independent contractors.



SECTION: 3121

IRS NO LONGER TO CONTEST CLAIMS FOR REFUNDS OF FICA TAXES

PAID TO MEDICAL RESIDENTS PRIOR TO APRIL 1, 2005

Citation: IR-2010-025, 3/2/10

The IRS on March 2, 2010 announced that it would accept the position that payments

made to medical residents prior to April 1, 2005 was not subject to FICA taxes based on

the student exception. Thus the IRS will honor claims for refund that have been made

for FICA taxes paid prior to that date.

On April 1, 2005, the IRS promulgated revised regulations that the IRS now plans to use

to argue that residents are subject to FICA taxes, thus creating the date through which

the IRS will no longer contest a claim for refund. The IRS reading of the case law for

cases that applied under the old regulations has apparently led them to believe that the

―problem‖ for them resulted from defective regulations, and believe the April 1, 2005

changes now support their position.

Of course, this change of heart by the IRS only helps taxpayers who still are able, under

the statute of limitations, to claim a refund for taxes paid at that time—generally

meaning those that had filed claims a while back. The IRS announced they would be

contacting hospitals, universities and medical residents that filed claims for those

periods with more information and procedures. If the taxpayer currently has a suit

pending, the taxpayer should contact the Department of Justice attorney assigned to the

case.

SECTION: 3121

DISAGREEING WITH FEDERAL CIRCUIT COURT OF APPEALS, MICHIGAN

DISTRICT COURT HOLDS THAT SEVERANCE PAYMENTS NOT SUBJECT

TO FICA

Citation: United States v. Quality Stores, 2010-1 U.S.T.C. ¶50,250, 2/23/10

The District Court for the Western District of Michigan weighed in the question of

whether severance payments made under a severance plan are subject to FICA taxes,

disagreeing with the recent conclusion of the Federal Circuit Court of Appeals in CSX

Corp. v. United States, 518 F.3d 1328 (Fed. Cir. 2008). The Michigan court concluded

that the payments are not subject to FICA, being properly treated as supplemental

unemployment compensation benefits (―SUB‖ pay).



The IRS position, stated in Revenue Ruling 90-72, is that such a program only qualifies

for an exemption the pay must be linked to the receipt of state unemployment benefits

and not paid in a lump sum. However, the Michigan District Court, sustaining the prior

holding of the Bankruptcy Court that was appealed to it, found that while IRC had the

authority under §3121(a) to issue regulations treating such a payment as wages, the

IRS had not done so, but rather simply issued the Revenue Ruling.

Given that no regulations had been written, the Court felt the wording of §3402(o) that

said such payments shall be treated as ―if they were wages‖ for purposes of income tax

withholding implied that they were not otherwise wages—and thus not subject to FICA.

Thus the Court held that the Bankruptcy Court had properly decided that Quality Stores

was due a refund of FICA taxes paid on the payments.

From practical standpoint the split in the courts on this issue complicates matters on the

proper treatment. The IRS clearly holds, in Revenue Ruling 90-72, that such payments

are subject to FICA withholding and any taxpayer that fails to withhold and pay over

FICA on such payment will likely face an assessment on examination. The IRS

certainly believes that the District Court erred in this decision (see Chief Counsel Email

201024048). But if the amount is significant enough (in this case it was over $1 million),

it may be worth pursuing litigation for a refund of taxes paid if it appears the venue to

which the taxpayer would pursue the case is favorably disposed to rule in the taxpayer’s

favor.

SECTION: 3121(B)(20)

PERFORMANCE OF REPAIR SERVICES FOR BOAT OWNER DID NOT

RENDER CREW MEMBER AN EMPLOYEE

Citation: Anderson v. Commissioner, TC Memo 2010-1, 1/4/10

IRC §3121(b)(20) contains a special rule that exempts from treatment as an income

from employment the service of a crewmember on a fishing boat that normally has less

than 10 crew members if that crewmembers’ compensation is based solely on the

proceeds of the sale. Instead the amount is treated as self-employment income.

In the case of James Anderson, Mr. Anderson had been compensated during the year

for making a few repairs to the boat on an hourly basis in addition to receiving a share

of the catch. He argued that due to those payments he should be treated as employee,

and his income not subject to self-employment taxes.

The Tax Court disagreed, holding that Mr. Anderson’s limited amount of repair work

constituted a separate trade or business for which he qualified as not an employee

under the common law tests. As such, he was subject to self-employment tax on all of

the income received both from the catch and from his repair work.



SECTION: 3302

TAXPAYER WHO RELIED ON PAYROLL SERVICE UNABLE TO SHOW

STATE UNEMPLOYMENT TAXES ACTUALLY PAID, THEREFORE LOSES

FUTA CREDIT

Citation: 535 Ramona Inc. v. Commissioner, 135 TC No. 17, 9/14/10

If a taxpayer cannot show that payment was made to an appropriate state agency for

state unemployment taxes for a year, the taxpayer is not allowed a credit against FUTA

taxes for state payments under §3302(b). The taxpayer in this case may or may not

have actually made such payments, but the taxpayer's failure to prove the matter one

way or the other was fatal to its defense.

In the case at hand the taxpayer had used a payroll service to handle its payroll in 1996.

On the Form 941 for the year in question the taxpayer claimed the credit for state

unemployment taxes paid, but the identification number it used to report the state

unemployment paid was actually for another entity with the same ownership. When the

IRS went to confirm with the state agency that the state tax had been paid, the state

agency reported that it showed no taxes paid.

The IRS inquired of the taxpayer about this discrepancy, but the taxpayer ignored the

correspondence (not an effective strategy). The IRS assessed over $16,000 of tax,

along with interest and penalties, based on the denial of the credit. Both the IRS and

the taxpayer made additional inquiries of the state agency, which again noted that it

showed no taxes paid and, in fact, the taxpayer did not have an active account with the

agency until three years after the year the IRS was assessing tax for.

At trial the taxpayer claimed its payroll service had paid the tax, basing that claim largely

on the testimony of an accountant who talked about the operation of payroll services in

general, but admitted he had not been involved with the actual payroll service used, nor

did he know their day to day procedures. While showing generally the company had

used the payroll service, the taxpayer never could show that actual deposits of the tax

had been made on its behalf by the service to the state agency.

Nor, inexplicably, did the taxpayer even produce evidence related to the payment of tax

for the other entity to be able to claim that it was (as seems likely) simply credited to the

wrong account. Even more interesting is that it does not appear the taxpayer had

anyone from the payroll service give evidence of what might have happened.



Failing to show the state tax was paid, the taxpayer did not qualify for the credit under

§3302(b). A key factor to note here is that it was held not sufficient merely to show that

the taxpayer had engaged a payroll service. The taxpayer is still responsible for

insuring that the deposits get made and, if questioned, must present such evidence of

payment.

SECTION: 3401

PUBLIC OFFICIALS PAID A SALARY ARE EMPLOYEES REGARDLESS OF

STATUS UNDER TRADITIONAL COMMON LAW EMPLOYEE TEST

Citation: Davis v. Commissioner, TC Summary 2010-89, 7/7/10

While the common-law test for whether an individual is an employee is normally what is

employed by the Tax Court when a taxpayers claims he is not an employee, in some

cases there are statutory provisions that override those common-law tests. One of

those cases involves taxpayers that are public officials pursuant to §3401(c). Only a

public official that is compensated on a fee basis will be treated as other than an

employee.

Thus the Court ruled that the taxpayers in this case could not look to the common-law

tests (which the Court observed anyway would be a difficult test to apply to a public

official), but rather was stuck with employee status. As both husband and wife in this

case were a city councilman and school board member respectively and in each case

were compensated via salary, they could only claim expense deductions as an itemized

deduction subject to the 2% of adjusted gross income limitation. As well, such amounts

were not deductible for alternative minimum tax purposes.

SECTION: 4965

FINAL REGULATIONS FOR TAX EXEMPT ENTITIES THAT PARTICIPATE

IN PROHIBITED TAX SHELTER TRANSACTIONS ISSUED, 7/2/10

Citation: TD 9492, Regs. §1.6033-5, §§54-4965-1 to 9, 7/2/10

The IRS issued final regulations affecting tax exempt entities under §§6033 and 4965

that engage in tax shelter transactions. The rules require reporting by the tax exempt

entity and impose an significant excise tax on entities participating in such transactions.

The proposed regulations were modified somewhat in the final regulations. The final

regulations no longer consider a tax exempt entity that engages in a transaction to

reduce its own tax liability as being a party to a prohibited tax exempt transaction under

the regulations, the entity being subject to the rules applicable to taxable entities in such

cases.



The rules also were modified with regard to required disclosure by taxable entities to tax

exempt entities when the taxpayer becomes aware that it may have a prohibited tax

exempt transaction that would subject the tax exempt entity to taxation. Under the final

regulations, a person who has reason to know the tax exempt entity is engaged in a

prohibited tax exempt transaction must notify the tax exempt entity within 60 days of the

the last to occur of 1) the date the person became a party to the transaction, 2) the date

the person had reason to know the tax exempt entity is a party to the transction or 3) the

date the final regulations were published in the federal register.

SECTION: 4975

DISCLOSURES OF FEES REQUIRED BY SERVICE PROVIDERS TO

QUALIFIED PLANS, INCLUDING ACCOUNTANTS AND AUDITORS

Citation: ERISA Reg. §2550.408b-2, 7/16/10

The Department of Labor issued revised regulations for disclosure of fees paid to

service providers of qualified plans that will require new information to provided by all

individuals, including accountants, that provide services to qualified plans. The

revisions to ERISA Reg. §2550.408b-2 are to be effective beginning on July 11, 2011.

In order to avoid treatment of transactions with the service provider as a prohibited

transaction under IRC §4975 due to unreasonable fees under ERISA §408(b) the plan

must receive from the service provider required disclosures of fees incurred in the

services provided to the plan. While retirement plans generally will have to comply with

these requirements, the regulations exclude from coverage simplified employee

pensions, SIMPLE retirement accounts and individual retirement accounts [Reg.

§2550.408b-2(c)(1)(ii)].

Service providers affected by this rule will include plan fiduciaries, registered investment

advisers, providers of recordkeeping or brokerage services, and those providing

accounting, auditing, actuarial, banking, consulting, custodial, insurance, investment

advisory, legal, investment brokerage, third party administration or valuation services to

the plan [Reg. §2550.408b-2(c)(1)(iii)].

The initial disclosure to the plan fiduciary must include a description of the services to

be provided to the plan, a statement that the provider plans to provide services as a

fiduciary (if applicable), a statement the adviser plans to provide services as a

registered investment adviser (if applicable) and details of compensation. [Reg.

§2550.408b-2(c)(1)(iv)]



The compensation disclosure must specifically address direct compensation (received

directly from the plan), indirect compensation (received from any source other than the

covered plan, the plan sponsor, the service provider, an affiliate or a subcontractor), and

any compensation paid among related parties. [Reg. §2550.408b-2(c)(1)(iv)(C)]. A

description must also be given of any compensation the service provider, an affiliate or

subcontractor expects to receive if the arrangement is terminated, and the calculation of

how any amounts prepaid would be refunded on termination. [Reg. §2550.408b-

2(c)(1)(iv)(C)(4)]

If a service provider provides recordkeeping services for which no explicit compensation

is charged (presumably because of other fees being received), a good faith estimate of

the cost to the plan to provide such recordkeeping services, and a description of the

methodology and assumptions used to compute this figure. [Reg. §2550.408b-

2(c)(1)(iv)(D)]

The provider must also describe the method by which the compensation will be billed or

will be directly deducted from the plan's investments. [Reg. §2550.408b-2(c)(1)(iv)(E)]

Additional specific disclosures will be required for service providers that are fiduciaries

and investment advisers [Reg. §2550-408b-2(c)(1)(iv)(F)] or are providing

recordkeeping and brokerage services [Reg. §2550-408b-2(c)(1)(iv)(G)].

The initial disclosure must be made reasonably in advance of the date the contract or

arrangement is entered into. However if an investment contract, product or entity is

determined not to hold plan assets, but later is determined to hold such assets, the

initial disclosure must be made as soon as practicable, but no later than 30 days after

the time the service provider becomes aware plan assets are being held. If an

investment alternative is added after the time to the recordkeeping program, the

disclosure must be made as soon as practicable, but again absolutely no later than the

date the investment alternative is designated. [Reg. §2550-408b-2(c)(1)(v)(A)]

Any subsequent change to the information contained in the original disclosure must be

made by the service provider as soon as practicable, but no later than 60 days from the

date the service provider is informed of the change. [Reg. §2550-408b-2(c)(1)(v)(B)]

As well, the service provider must comply with any request by the plan for any additional

compensation information required to comply with ERISA, and the information must be

provided within 30 days of the receipt of the request. [Reg. §2550.408b-2(c)(1)(vi)].



If a service provider fails to comply with these requirements, the plan fiduciary can avoid

prohibited transaction treatment if the fiduciary demonstrates he/she did not know the

service provider would fail to provide the necessary information and, upon discovering

the failure, the fiduciary requests in writing that the service provider furnish the

information. If the service provider fails to do so within 90 days, the fiduciary is required

to give specific notice of the failure to the Department of Labor and shall be required to

determine whether it is appropriate to terminate the arrangement. [Reg. §2550.408b-

2(c)(1)(ix)]

As well, the regulations specifically provide that no portion of these rules shall be

construed to supersede any State law requirements for disclosure unless the State law

provision would serve to prevent the application of the regulations. That is, if the State

requires additional disclosure, a service provider won't be allowed to cite ERISA

preemption as a reason not to provide the information. [Reg. §2550.408b-2(c)(1)(x)]

Many of the provisions noted above require certain actions be done ―as soon as

practicable‖ and no later than after a certain time. In such cases, the Department of

Labor generally will not accept compliance on or near the ―no later than‖ date unless it

can be shown why that was the earliest date practicable. Thus those working with plans

should plan procedures to insure compliance well before those ―no later than‖ dates.

The Department of Labor will accept and review comments on this regulation, and

changes may be made before the regulations come into affect. But plans and service

providers should begin considering procedures to insure compliance with the rules.

SECTION: 4980B

COBRA SUBSIDY PERIOD EXTENDED AND EXPANDED

Citation: Department of Defense Appropriations Act of 2010, 12/19/09

In a year end attachment to the Department of Defense Appropriations Act of 2010, the

Congress extended the COBRA premium assistance program. The bill extends until

February 28, 2010 the qualifying date for individuals who are involuntarily terminated

through that date. The cut-off date had been scheduled to be December 31, 2009.

As well, the period of COBRA premium assistance is extended from nine months under

the American Recovery and Reinvestment Act of 2009 original provision up to fifteen

months of qualified coverage. The new law also provides a new transition period that

allows qualified individuals until February 17, 2010 to pay the premiums due during the

coverage period to maintain their COBRA coverage in addition to the standard 30 days

after notice period.



If an individual had previously paid the full premium, he/she is to be provided a refund of

the excess payment. As under the prior law, the subsidy creates a credit that the

employer would use on Form 941 to offset the amount of premium not paid by the

former employee.

An individual that was a qualifying individual as of October 31, 2009 or any time

thereafter, or who has a qualifying termination event relating to COBRA coverage must

receive notification regarding the new subsidy provisions. As well, notice must be

provided to any individual that was covered under COBRA coverage under the old rule

at any time before December 19, 2009 and qualifies now for the additional subsidy due

to the extended time period rules. That notice must include information about the ability

to make retroactive premium payments to maintain COBRA coverage.

SECTION: 6001

IRS BEGINS ACCEPTING (AND POTENTIALLY DEMANDING) TAXPAYER

RECORDS IN ELECTRONIC FORMAT

Citation: IRS Website Headliner Volume 303, 10/15/10

The IRS announced on its website that it will begin accepting taxpayer data in electronic

format. In reality, this is the IRS's announcement on the website of its program to begin

equipping its small business auditors with QuickBooks programs for analyzing taxpayer

data.

The IRS in the posting emphasizes that taxpayers and tax professionals have been

advocating for the IRS to accept records electronically. However, a number of

commentators have raised concerns about the breadth and depth of data found in the

average QuickBooks database.

In the Headliner the IRS notes that it has the authority to ask for such information citing

Section 6001, Regulation 1.6001-1, Revenue Ruling 71-20 and Revenue Procedure 98-

25. The notice indicates, in a note that doesn't sound quite as taxpayer friendly as the

rest of the Headliner, that Revenue Procedure 98-25 does not "prevent or exempt a

taxpayer from providing such electronic records, if such records exist."

Professionals should consider actions and procedures that clients may want to

undertake to deal with the IRS's new interest in the QuickBooks databases. One

obvious option is to provide for annual preparation of an archive version of the database

that contains information only used to prepare that year's income tax return.



As well, entities should consider when providing such information to the IRS about the

potential need to create a user account for the IRS that allows only access to the

information they need, rather than having unfettered administrator access to the

database. Professionals should note that sensitive information is often contained in the

vendor and customer files, as well as the employee files, that would not be of direct

interest to the IRS in dealing with tax compliance.

SECTION: 6011

IRS UPDATES LIST OF "TRANSACTIONS OF INTEREST" AND "LISTED

TRANSACTIONS"

Citation: Notice 2009-55 and Notice 2009-59, 7/15/09

The IRS has updated its list of transactions of interest in Notice 2009-55. Such

transactions are ones that fall short of the IRS’s listed transaction threshold, but for

which disclosure is still required by taxpayers for transactions entered into after

November 1, 2006.

The IRS also updated its list of listed transactions in Notice 2009-59. These

transactions carry more significant consequences for failure to disclose including, for the

moment, the potential of an automatic $100,000 per year affected penalty for failure to

disclose even if no tax deficiency ends up being shown by the IRS. While some relief in

this area is being considered by Congress, it’s unlikely the entire disclosure and penalty

regime will go away once Congress makes its changes.

All tax practitioners should be aware of where to find the most current list of such

transactions, since some of the items detailed apply only to individuals or small closely

held businesses. No matter what type of client you serve, it’s possible for your clients to

run afoul of these rules.

SECTION: 6031

IRS ADDS NEW INQUIRIES AND NEW SCHEDULE B-1 TO 2009 FORM

1065

Citation: 2009 Form 1065, 12/15/09

The Form 1065 for 2009, while not being as radical a change as the one we saw when

going to the 2008 1065 from the 2007 version, still has some new additions that indicate

areas of IRS interest for partnerships. The changes for 2009 include:

Schedule B-1. A new Schedule B-1 has been added which will be required to be filled

out when the partnership checks yes to questions 3a or 3b on Part B, indicating there is

a greater than 50% partner.



§704(c) Issues. The partners’ K-1 now contains an item ―M‖ that asks if a partner

contributed assets that had a built-in gain or loss. If the question is answered yes, a

statement must be attached that describes each property the partner contributed, the

date it was contributed and the amount of the built-in gain or loss.

§108(i) Elections. A new code has been added to the K-1 to report information related

to any election the partnership makes under §108(i), added by the American Recovery

and Reinvestment Act of 2009, to defer recognition of gain on the cancellation of certain

debts that occur after 2008 but before 2011.

SECTION: 6039

IRS PUBLISHES FINAL REGULATIONS ON REPORTING ISOS AND ESPP

OPTIONS WITH FIRST REPORTS REQUIRED FOR CALENDAR YEAR 2010

Citation: TD 9470, 11/17/09

The IRS finalized regulations under §6039 implementing that section’s requirement that

employers file a report for any year in which a share of stock is transferred pursuant to

an incentive stock option or where there is a transfer of legal title of shares received

under employee stock purchase plan under §423(c).

The information will be reported on either Form 3921, Exercise of an Incentive Stock

Option Under Section 422(b) or Form 3922, Transfer of Stock Acquired Through an

Employee Stock Purchase Plan under Section 423(c).

The final regulations exempt employers from filing information returns in 2007, 2008 and

2009. The above forms will therefore first be required for 2010.

SECTION: 6050N

WEBSITE THAT KEEPS PERCENT OF CHARGE ESTABLISHED BY

ARTIST WHEN SELLING MUSIC MUST REPORT NET PAID TO ARTIST ON

FORM 1099

Citation: CCA Email 200952048, 12/24/09

In email advice (CCA Email 200952048), the IRS Chief Counsel’s office ruled that the

following structure would require reporting on Forms 1099 to the artist and has the

potential for backup withholding.



The entity in question accepts music uploaded from an artist for a fee. The artist then

allows others to download the music from the entity’s website for a fee set by the artist.

The entity keeps a percentage of the payment as a fee and then forwards the rest to the

artist in question. The email rules that under §6050N the website must report the

amounts paid to the artist under this arrangement as a royalty.

Given that the IRS document in question is an email, it doesn’t go into much detail

about why these would be royalties to the artist. The conclusion, at first blush, appears

backwards since in most normal royalty arrangement it is the royalty paying entity that

sets the price it charges to customers. But in this case the IRS apparently concluded

that the key issue is that the artist effectively is getting a percentage of the gross for

allowing the sale, even though the artist has full control of the gross price.

The conclusion is of interest not just to musicians—other internet based businesses use

a similar arrangement. For instance, programmers who upload programs for the iPhone

to Apple’s AppStore set the purchase price and Apple keeps a percentage of the sale.

Similarly, online publisher Lulu has a similar arrangement where book authors set a

price for their works and then Lulu charges a printing fee plus keeps a percentage.

SECTION: 6051

IRS WILL NOT PENALIZE EMPLOYERS FOR FAILING TO REPORT COST

OF EMPLOYER PAID HEALTH CARE ON 2011 FORMS W-2


The IRS has announced relief from the requirement for employers to report premiums

paid on behalf of employees as an information line on 2011 Forms W-2. The IRS

indicated that the relief was being granted to give employers time to modify their

information reporting systems to be able to obtain the necessary information for

payment of medical premiums for each employee.

The guidance technically doesn’t repeal the requirement, but merely notes that the IRS

will not impose any penalties on employers that fail to report the amounts paid as

required by §6051(a)(14) paid for employer provided coverage for each employee.

The notice goes on to note that the IRS expects to issue guidance on the reporting

requirements under this provision by the end of 2010.



SECTION: 6053

IRS EXTENDS ATTRIBUTED TIP INCOME PROGRAM THROUGH

DECEMBER 31, 2011


The IRS extended the Attributed Tip Income Program, originally scheduled to end on

December 31, 2009, for two additional years through December 31, 2011. The

program, originally established in Revenue Procedure 2006-30, was established to

simplify recordkeeping for the reporting of tip income. However, the IRS did reserve the

right to terminate the program at any time.

Employers that participate in this program report tip income based on a formula that

uses a percentage of the establishment’s gross receipts, which are then allocated

among the employees.

Employers that wish to make use of this program check a box on Form 8027,

Employer’s Annual Information Return of Tips and Allocated Tips. Employees of that

employer are then able to elect to have their tip income computed under the program

and reported as wages.

SECTION: 6109

IRS ADDS REQUIREMENT TO LIST NAME AND IDENTIFYING NUMBER OF

RESPONSIBLE PARTY WHEN APPLYING FOR EIN

Citation: Form SS-4, 2/2/10

The IRS revised Form SS-4 on February 2, 2010. The new form added lines 7a and b

to the form that request the name and identifying number of the ―responsible party‖ for

the entity applying for the number.

For entities traded on a public exchange, the responsible party is the principal officer of

a corporation, general partner of a partnership, owner of a disregarded entity and the

grantor, owner or trustor of a trust. For other entities, the responsible party is the

person who, per the IRS instructions, ―has a level of control over, or entitlement to, the

funds or assets in the entity that, as a practical matter, enables the individual, directly or

indirectly, to control, manage, or direct the entity and the disposition of its funds and

assets.‖ An indentifying number must be provided unless the only reason for applying

for an EIN is to make an entity classification election under the check the box

regulations and the responsible party is an alien or foreign entity with no effectively

connected income from sources within the United States.



The new form also contains an option on line 14 for eligible employers to elect whether

or not they wish to file Form 944 annually rather than Form 941 quarterly. The filing of

Form 944 is no longer mandatory for qualifying employers so long as they opt out of that

program, and this SS-4 allows a new employer to opt out at the time of application for

an identification number.

SECTION: 6205

PROCEDURES FOR CORRECTING EMPLOYMENT TAX ERRORS IN

VARIOUS SITUATIONS EXPLAINED BY IRS


The IRS has issued new ―X‖ series payroll tax reporting forms for the correction of

payroll reporting errors, implementing changes to the regulations for interest free

corrections found issued July 1, 2008 in TD 9405. Employers were given revised

guidance on the submission of corrections of employment tax errors in the following ten

situations by the IRS, explaining the use of the new Form 941-X:

(1) an underpayment of FICA tax and income tax withholding (ITW) when the error is

not ascertained in the year the wages were paid; (2) an overpayment of ITW when the

error is ascertained in the same year the wages were paid; (3) both an overpayment

and an underpayment of FICA tax for the same tax period; (4) an underpayment of

FICA tax when the employer's filing requirement has changed; (5) an underpayment of

FICA tax and ITW resulting from a failure to file an employment tax return because the

employer failed to treat any workers as employees; (6) an overpayment of FICA tax on

wages paid to a household employee; (7) an overpayment of FICA tax when the error is

ascertained close to the expiration of the period of limitations on credit or refund; (8) an

underpayment of FICA tax and ITW ascertained in the course of an employment tax

examination; (9) an underpayment of FICA tax and ITW ascertained in the course of the

appeals process; (10) an underpayment of FICA tax and ITW resulting from the

misclassification of employees ascertained in the course of the appeals process.

The new ruling renders Revenue Ruling 75-464 obsolete.



SECTION: 6226

TAX COURT HAD JURISDICTION TO DETERMINE PARTNERSHIP A

SHAM, BUT NOT TO DETERMINE AFFECT ON INDIVIDUAL PARTNERS'

BASIS

Citation: Petaluma FX Partners, LLC v. Commissioner, CA DC, Docket No.

08-1356, 2010 TNT 8-9, 1/12/10

The Court of Appeals for the District of Columbia affirmed in part and reversed in part

the Tax Court’s earlier holding in Petaluma FX Partners, LLC v. Commissioner (131 TC

No. 9).

The Court of Appeals agreed that the Tax Court had jurisdiction to determine the entity

was a sham and that the determination was a partnership item within the meaning of

§6226(f). The Court found that the determination clearly related to the proper amount to

reported from the partnership for income tax purposes, and that the most appropriate

level to determine whether the partnership is a sham is at the partnership level.

However, the Court of Appeals held that the Tax Court did not have jurisdiction in this

case to make the determination that the partners had no basis in their interests. The

Court did not rule the Tax Court was in error on the point—just that it had no right to

make that ruling at that point. The opinion notes that ―the fact that a determination

appears obvious or easy does not expand the Court’s jurisdiction beyond what the

statute provides.‖ Similarly, the Tax Court lacked jurisdiction to determine that, due to

this lack of basis, accuracy related penalties applied to the partners.

SECTION: 6229

FEES PAID RELATED TO SON OF BOSS PARTNERSHIP TRANSACTION

TRANSACTION BILLED TO S CORPORATION NEVERTHELESS IS AN

AFFECTED ITEM

Citation: Domulewicz v. Commissioner, TC Memo 2010-177, 8/5/10

If over $1,000,000 of fees related to a partnership transaction are billed to an S

corporation that the same taxpayers controlled, are those fees properly treated as an

affected item? The question was crucial because only if they were was the statute of

limitations still open for the IRS to assess tax related to a disallowance of the expenses.



The Tax Court held that the provisions of §6229 operated in this case to keep the

statute open, as the fees were an affected item. The Tax Court noted that the fees

were related to the Son of BOSS transaction itself, a factor that was not clear from the

original returns in question. As the partnership itself was held to be a sham, the issue of

the deductibility of these fees were an affected item, since the transactions required a

determination at the partner level and the fees' deductibility related to the partnership

transaction.

The taxpayer's claim that because the fees had been billed and paid through their S

corporation rendered them not affected items was rejected by the court.

SECTION: 6231

ITEMS AFFECTING NONPARTNERS NOT AFFECTED ITEMS NOR

PROPERLY HANDLED VIA TEFRA PROCEDURES


Just because an item arises in a TEFRA partnership examination, it does not follow that

TEFRA governs treatment of all taxpayers involved in the transaction. A Chief

Counsel’s office email noted that a recharacterization on a partnership exam of a loan

by a corporation to a partnership was not an affected item to the corporation, as the

corporation was not a partner, and its treatment is not bound by the treatment found on

exam at the partnership level.

Similarly, an issue that arose where Mom may have made a deemed gift to the partners

in a family partnership was also not properly assessed via a TEFRA proceeding as, in

the case in question, Mom was not a partner of the partnership.

SECTION: 6231

DESIGNATION OF A TAX MATTERS PARTNERS ON A 1065 BY

PARTNERSHIP OTHERWISE EXEMPT FROM UNIFIED TEFRA

PROCEDURES DOES NOT SERVE AS ELECTION TO HAVE PROCEDURES

APPLY


The naming of a Tax Matters Partner on the return of a partnership that otherwise is

exempt from the TEFRA partnership examination procedures does not serve as an

election under §6231(a)(1)(B)(ii) to have the unified procedures of §6231 apply, the IRS

Chief Counsel’s office noted in an email. The email pointed out that while the

designation of a Tax Matters Partner is only required for TEFRA partnerships, many

partnerships routinely fill in that portion of the Form 1065—but that does not serve to

make the election to have the unified audit procedures apply.



To make an effective election, the partnership would need to follow the guidance found

in Reg. §301.6231(a)(1)-1(b)(2) which must be signed by all persons who were partners

at any time during the partnership year and shall be filed at the time and place

designated for filing the partnership return.

SECTION: 6231

IRS REQUIRED TO ISSUE NOTICE OF DEFICIENCY IF NO PARTNERSHIP

ITEM IS CHANGED, BUT ERROR WAS HARMLESS

Citation: Bush v. United States, CA FC, No. 2009-5008, 3/31/10

The Federal Circuit reversed part of the holding of the Court of Federal Claims in

deciding that a notice of deficiency was required when a closing agreement in a TEFRA

partnership case stated that no partnership item would be adjusted, but rather each

partner’s amount at risk would be capped at $50,000. The Federal Circuit held that it

was not sufficient that the individual partner’s liability could be fully computed from the

closing agreement with no other information—§6231(a)(6) specifically limits a

computation adjustment, for which no deficiency notice is required, to changes that

reflect the proper treatment of a partnership item.

However, the Federal Circuit ruled that this defect in the end wouldn’t help the

taxpayers in their refund case. The taxpayers had argued that because no notice of

deficiency was issued, they were denied their right to litigate the case in the Tax Court.

However, the Federal Circuit found that because the taxpayers had paid the tax

voluntarily before any collection proceedings were initiated by the IRS, they could not

now get the refund solely on the fact that the IRS hadn’t issued the notice.

Had the IRS actually initiated collection proceedings, the result would be different—but

since no collection proceedings took place, the taxpayers were required to show they

were prejudiced by litigating the case in a refund proceeding rather than in the Tax

Court. Thus, the Federal Circuit held, the failure to issue the deficiency notice was

―harmless error‖ in this matter. The Court makes clear that ―what the taxpayer may not

do is forgo his right to resist collection, voluntarily pay the tax, and then secure a refund

of tax admittedly owed without showing prejudice.‖



SECTION: 6302

PAPER FEDERAL TAX DEPOSIT COUPONS TO BE ELIMINATED

EFFECTIVE IN 2011, BUSINESSES MUST DEPOSIT VIRTUALLY ALL

FEDERAL TAXES ELECTRONICALLY

Citation: Treasury Press Release TG-644, 4/19/10

The Treasury Department announced in News Release TG-644 that beginning in 2011

virtually all tax deposits made by businesses will have to be made electronically rather

than using paper Federal Tax Deposit coupons. The release indicated that the only

exception would be for businesses with quarterly tax liabilities of $2,500 or less who

currently pay with their Form 941.

SECTION: 6330

APPEALS OFFICER'S ADMITTED LACK OF UNDERSTANDING OF

TRANSCRIPT RELIED UPON TO VERIFY TAX ASSESSMENT FOUND

SUFFICIENT TO OVERTURN CDP HEARING HOLDING AGAINST

TAXPAYER

Citation: Byk v. Commissioner, TC Summary Opinion 2010-137, 9/16/10

First things first, the Tax Court stated what many of us know all too well—that IRS

transcripts are cryptic and difficult to interpret. The Court quoted from its earlier Barnes

decision which noted ―Many of the documents in the administrative file and most of the

documents labeled as transcripts of * * * [the taxpayer's] account are full of

abbreviations, alphanumeric codes, dates, and digits that are indecipherable and

unintelligible without additional explanation.‖

In the case before the Tax Court the IRS's own appeals officer apparently didn't really

know what those notes meant either. The taxpayer was asking the Tax Court to grant

relief of the officer's decision to sustain the issuance of a notice of Federal tax lien

related to employment taxes for the second quarter of 2000. In 2007 the IRS send the

taxpayer a notice that the Form 941 in question had not been filed. Despite the

passage of time, the taxpayer's accountant produced a copy of the Form 941 in

question and sent it to the IRS.

The IRS treated that return as an original form filed without payment, and ten months

later issued a Notice of Federal Tax Lien filing. The taxpayer appealed the case and

the IRS action was sustained on appeal. The taxpayer then filed the Tax Court petition.



The Court noted that for a collection due process hearing regarding a self-reported

liability, the appeals officer must verify that: ―1) The IRS timely assessed the liability, (2)

the taxpayer failed to pay the liability, (3) the taxpayer was given a notice and demand

for payment, and (4) the taxpayer was given an NFTL filing.‖ In the Notice of

Determination the appeals officer simply recited, verbatim, what the Internal Revenue

Manual stated was the minimum that must be shown to meet the requirements.

It appeared the appeals officer relied upon the IRS's transcripts and computer records in

coming to the necessary conclusions, but at trial the officer was unable to offer an

explanation for why entries normally found related to the nonfiling of returns were not

found in the transcripts, and the appeals officer was unable to explain other cryptic

codes in the transcript noting that he ―did not understand the letters and numbers that

make up the code in respondent's transcripts‖ and could not explain many of the codes

actually in the transcript.

The Tax Court found these steps clearly inadequate in light of the Form 941 that the

taxpayer's accountant had produced and the taxpayer's assertion that the tax had (long

ago) been paid.

SECTION: 6331

CALIFORNIA STOP NOTICE TO BE TREATED AS SUPERIOR TO

FEDERAL TAX LIEN

Citation: Field Attorney Advice 20102601F, 7/2/10

A city in California had a contract with a contractor who ran into financial problems and

failed to pay both the IRS and the subcontractors on the job. One of the subcontractor

had complied with California requirements to qualify for a remedy of a ―Stop Notice‖

under state law should the subcontractor not be paid by the prime contractor. A Stop

Notice, when served on the owner of the property, requires the owner to withhold

payment due to the prime contractor on the job until the subcontractor is paid.

The subcontractor served two Stop Notices on the city with regard to the subcontractor.

Following the issuance of those notices, the IRS served a Notice of Levy to the city

regarding unpaid taxes of the contractor and the city paid on that lien notice. However,

the Chief Counsel's office, in a Field Attorney Advice, concluded that the IRS should

return the funds to the City.

The question of whether a lien can be effective depends on whether the taxpayer has a

property interest in the property against which the lien is filed, and the question is

decided by the applicable state law. So the question became whether, during the

period when a Stop Order demanded funds be withheld, the contractor had any property

interest in the funds in question, a question that had to be answered by California law.



The advice notes that the IRS's litigating position is that it will not assert the priority of a

federal tax lien against an unperfected claim, such as the ―Stop Notice‖ in this case,

where there are unpaid laborers or materialmen, based on the understanding that the

contractor may not have a property interest in those funds until the Stop Notice issue is

resolved. The advice notes that while California courts have not yet specifically

answered the question of whether the contractor retains a property interest in such

funds, the Counsel's office believes it is likely the California courts would so hold if ever

the question came before them.

SECTION: 6331

FAILURE TO IMMEDIATELY HONOR LEVY MAKES MEDICAL CLINIC

LIABLE FOR AMOUNTS NOT PAID OVER

Citation: United States v. Mission Primary Care, DC SD Mississippi, 7/13/09

A medical clinic continued to make payments to an independent contractor physician

after receiving a notice of levy on the physician. The District Court noted that even

though the statute refers to an employee, case law has allowed the levy statutes to be

applied to independent contractors. As well, if a payer disregards a levy notice and

continues to make payments to the service provider, the payer becomes itself liable for

the amounts not transmitted.

In this case, Mission Primary Care was found to be liable for $43,200 that was paid to

the physician following receipt of the notice of levy, including $2,000 paid out on the day

the levy was received, but actual receipt of the notice of levy.

SECTION: 6501

GROSS RECEIPTS NOT REDUCED BY RETURNS OR ALLOWANCES FOR

PURPOSES OF 25% TEST FOR SIX YEAR STATUTE

Citation: Chief Counsel Memorandum 201023053, 6/11/10

A taxpayer's gross receipts are not reduced by returns and allowances when computing

gross income for purposes of §6501(e)(1)(A)(i)'s 25% threshold for the trigger of a six

year statute of limitations, according to a Chief Counsel Advice. While the advice notes

that in some contexts returns and allowances are offset against revenues to arrive at

gross income, §6501(e)(1)(A)(i) creates its own special definition of gross income.



The advice goes on to outline three specific fact pattern. In the first, a taxpayer sells

100 units of a product with a ticket price of $100 for $80 each. In that case, $80 is the

gross income and not the $100 because $80 was the actual price the product was sold

for, and there was no return or allowance. In the second case, the 100 units were sold

for $100 each, but with an agreement that the taxpayer would pay the customers a

rebate of $20 each. In that case, the rebate is an allowance and thus the $100 is the

gross income. Similarly, if the products are sold for $100 each but 20 customers return

their product for a full refund, the original sales count as gross income and are not

reduced by the products for which refunds were eventually issued.

SECTION: 6501

CREDITS CARRIED BACK AFTER RELEASE OF CREDIT FROM NET

OPERATING LOSS CARRYBACK TO LATER YEAR DO OPEN YEAR TO

ASSESSMENT

Citation: CC Email 201008044, 2/26/10

The taxpayer had a net operating loss in year 5 that was carried back to year 3. The

loss carryback released foreign tax credits from 3 year, which were then carried back to

year 1. Years 3 and 1 were other closed for the assessment of tax. The Chief

Counsel’s office was asked if year 1 was opened for assessment of tax, which could be

used to offset the foreign tax credit being claimed on carryback, or whether that year

remained closed for assessment of additional tax.

The Chief Counsel’s office held that the refund from year 1 was attributable to a net

operating loss carryback and, as such, the year would be open for assessment to offset

the claimed refund under §6501(h).



SECTION: 6501

IRS, AFTER LOSING IN COURT, REVISES REGULATIONS TO REDEFINE

AN OVERSTATEMENT OF BASIS AS CREATING AN UNDERSTATEMENT

OF INCOME UNDER §6501(E)(1)(A)

Citation: TD 9466, Temp. Reg. §301.6501(e)-1T, 9/28/09

Smarting from losses in the case of Bakersfield Energy Partners (568 F.3d 767, CA9)

and Salman Ranch Ltd. (573 F.3d 1362, CA FC), the IRS has issued temporary

regulations holding that an overstatement of basis for assets sold will count in

determining if there has been an understatement of gross income for purposes of

applying the 25% omission of income test under IRC §6501 that triggers a six year

statute of limitations on assessment. In both of the above cases the courts ruled that the

item of gross income to be tested was the sales price reported and not the net gain/loss

reported when looking to trigger the six year statute. Both courts determined that

Congress’s key issue was insuring the IRS was put on notice about the transaction,

which reporting the sale did.

However the IRS is not happy with that decision, being aware that quite often the item is

reported as a single line item on a K-1 from a passthrough entity. The IRS indicates

that under the ―adequate disclosure‖ exception a taxpayer who adequately discloses the

nature and amount of the omissions from gross income will not be subject to the six

year statute.

The IRS is attempting an end run around the contrary decisions by changing the

temporary regulations to clearly state that overstatements of basis amount to an

understatement of income, noting that both courts had commented that the previous

temporary regulations were ambiguous. The IRS position is that these new regulations

apply to all cases where the period of time for assessing tax had not expired by the time

the regulations were issued.



SECTION: 6601

TAXPAYER CANNOT ELECT TO "REDESIGNATE" APPLICATION OF

OVERPAYMENT AFTER RETURN IS FILED

Citation: CCM 201024040, 6/18/10

In a Chief Counsel Memorandum, the IRS considered the issue of whether a taxpayer

could later change its mind and redesignate what had been an overpayment of tax for a

year that was applied to the following year. In the matter in question, the IRS later

examined the year in question and determined there was an underpayment. The

taxpayer, who was in bankruptcy, proposed to ―revise‖ its designation of the original

overpayment as being applied to the following year, preferring to use it to offset the

taxes the IRS now indicated was due for the year that had originally shown the

overpayment.

The Chief Counsel's office determined that once a taxpayer elects to apply an

overpayment shown on the return, the election cannot be undone by the taxpayer. The

IRS relied on the interest and underpayment of estimated income tax provisions

outlined in Revenue Ruling 90-40, which treats the overpayment as being applied to

unpaid installments of estimated taxes arising on or after the date the overpayment

arose.

The memorandum notes that, as far as the author could determine, the issue had not

been directly addressed by a court.

The memorandum also dealt with a second issue, holding that zero interest netting did

not apply to a taxpayer in a Chapter 11 proceeding where the interest due on an

underpayment was governed by the bankruptcy code.

SECTION: 6621

CONSOLIDATED GROUP NOT ELIGIBLE FOR INTEREST NETTING WITH

OVERPAYMENTS FROM SUBSIDIARIES ACQUIRED AFTER YEAR OF

UNDERPAYMENT

Citation: East Energy Corporation v. United States, United States Court of

Federal Claims, No. 1:07-cv-00812, 3/12/10

IRC §6621(d) allows for ―netting‖ for purposes of computing interest due on tax

assessements any overpayments and underpayments by the same taxpayer. In a case

of first impression for this court, the Court of Federal Claims had to decide if a parent

corporation and subsidiaries acquired after the date the tax underpayment by the parent

took place should be considered the ―same taxpayer‖ for these purposes.



The Court of Federal Claims decided that to be the ―same‖ taxpayer, it was crucial that

the taxpayer be ―identical‖ and ―without addition, change or discontinuance,‖ basing its

view on the ―plain meaning‖ of the term. The court consulted Webster's Ninth Collegiate

Dictionary specifically to arrive at the ―plain meaning‖ of the word ―same‖ and noted that,

in fact, the new consolidated group failed to be the ―same‖ taxpayer under that

definition. Thus the overpayments and underpayments could not be netted for

purposes of computing the interest due from the now consolidated group.

SECTION: 6652

EXEMPT ORGANIZATION LATE FILING PENALTY IS TO BE EITHER

COMPLETELY ABATED DUE TO REASONABLE CAUSE OR APPLIES IN

FULL

Citation: Service Employees International Union v. Untied States, Nos. 07-

17256, 08-16105, 3/17/10

The Ninth Circuit, overturning a ruling of a U.S. District Court, held that the penalty

imposed under §6652(c)(1)(A) is an ―all or nothing‖ penalty and that the District Court

did not have authority to reduce the penalty after first determining that reasonable cause

for late filing did not exist.

The Court noted that §6652(c)(1)(A) says there shall be paid a penalty if the report is

filed late by the exempt organization. There is a relief option available at §6652(c)(4) if

the late filing is due to reasonable cause, but the Court notes that this provision

provides that no penalty shall apply if the late filing is due to reasonable cause. Thus,

either the penalty is fully applicable or there no penalty—the Court found no option for a

―middle ground‖ solution in the statutory language.

The Ninth Circuit cites a similar analysis by both the Eleventh Circuit in the Sanford

case (979 F.2d at 1513) and the Second Circuit in the McMahan case (114 F.3d at 368)

when applying similar language to penalties imposed on individuals. The panel

believed that a similar analysis applies in this case to the penalty imposed on exempt

organizations.



SECTION: 6656

TAXPAYER REASONABLY RELIED ON ERRONEOUS ADVICE FROM CPA

REGARDING PAYROLL ISSUES, PENALTIES WAIVED

Citation: Ken Ryan, Inc. v. Commissioner, TC Summary 2010-8, 2/23/10

Ken Ryan, the owner and sole employee of Ken Ryan, Inc., consulted with his CPA

regarding a matter of his payroll. Ken wanted to take a single payroll check each year

as his wages for the year and he asked his CPA if that was acceptable. The CPA

researched the matter and concluded that since nothing seemed to prohibit a single

paycheck that would be fine.

He didn’t change his position when Ken asked if he could have the company make

advances to him during the year, concluding that so long as Ken was truly liable on the

debt there was no problem. Ken followed this advice, taking advances during the year

and then recorded a single paycheck at year end against which the advances were

offset.

However, on examination, the IRS did not agree with the CPA’s conclusions and sought

to penalize Ken for late payroll tax deposits, concluding that those ―advances‖ were the

real payroll for the year—a position that Tax Court noted was correct. But the court

agreed that Ken had reasonably sought out and relied on the advice of his CPA in

deciding when payroll tax deposits were due and, as such, was not liable for the

penalties in this case.

SECTION: 6662

TAXPAYER COULD NOT REASONABLY RELY ON ADVICE FROM TWO

ACCOUNTANTS WHEN TAXPAYERS PROVIDED NEITHER WITH ALL

RELEVANT FACTS

Citation: Estate of Strangeland v. Commissioner, TC Memo 2010-185,

8/16/10

The tax issue in this case related to whether or not the taxpayers' activity was a passive

activity with losses limited under §469 and, the Tax Court concluded, based on the facts

of the case it was clear the activity was properly treated as passive. However, a key

question was whether the taxpayers would be subject to the substantial understatement

penalty under §6662.



The taxpayer's understatement was sufficient to meet the mechanical test for

qualification, and the Tax Court found that their underlying position did not have the

required substantial authority for an undisclosed position, as the cases they claimed to

have relied upon were materially distinguishable, and thus did not constitute substantial

authority.

However a taxpayer can still escape the penalty if the taxpayer can show he/she acted

with reasonable cause and in good faith. In this case the taxpayers had their return

prepared by an accountant with over 20 years of experience and sought and obtained

an opinion letter from a major accounting firm that opined that their activity was not a

passive activity. The taxpayers argued that their reliance on an experienced accountant

and obtaining an opinion letter on the issue of the passive activity treatment showed

they acted with reasonable cause and in good faith due to their reliance on these two

professionals.

The Tax Court did not accept the argument. First, it noted that they attempted to claim

charitable contributions and investment expenses as a business expense rather than as

itemized deductions to avoid the limits on such deductions, a treatment that argued

against a good faith attempt to properly compute their tax—and that would be true even

if a professional had blessed the arrangement, something they did not show.

The taxpayers also did not provide their long time preparer with all the information

necessary to make a proper determination of their income. Their accountant testified

that he believed they spent over 500 hours in the activity, while no evidence supporting

that belief was presented at trial.

The other accountant's letter was criticized for having numerous incorrect assumptions

regarding the level of the taxpayer's actual participation in the activity. So despite the

letter's conclusion that the taxpayers had actively participated, the taxpayers did not

show they had ever provided the correct information to their preparer, rendering any

reliance on the letter unreasonable.

To get the protection of having reasonably relied on the advice of a professional, the

taxpayer must be able to show that he/she provided all necessary information to the

professional so that a proper judgment could be made. This ruling reminds us that even

before the revisions to Circular 230 in 2005 that specifically prohibited a professional

from giving written advice with unreasonable assumptions, a opinion letter issued before

that date that included such assumptions did not provide very much protection to the

taxpayer from penalties.



SECTION: 6662

CORPORATION'S RELIANCE ON OPINION LETTER FROM CPA FIRM

INVOLVED IN STRUCTURING TRANSACTION NOT REASONABLE,

PENALTIES APPLIED

Citation: Canal Corporation v. Commissioner, 135 TC No. 9, 8/5/10

A corporation’s reliance on an opinion letter from its CPA firm regarding a transaction

that the CPA firm member authoring the letter had been involved in designing was not

reasonable. Since the opinion itself used unreasonable assumptions and failed to show

substantial authority existed for the opinion, the taxpayer was held liable for the

substantial understatement penalty for the tax related to the disallowance of the

transaction.

The CPA firm in question was the auditor for the corporation and had been such for

many years. However the transaction in question, which was meant to allow the client

to dispose of a subsidiary, was structured with the help of a member of the firm other

than the company's long time engagement partner, and that member later issued an

opinion letter that indicated the transaction ―should‖ receive a favorable tax treatment,

the highest level of comfort this firm would give for such a letter.

In fact, the firm’s fee for the letter, $800,000, would only be paid if the underlying

transaction closed, and the transaction would not close unless a ―should‖ letter could be

obtained to support the hoped for tax treatment. The taxpayer had agreed to a

significantly lower sales price than it otherwise would have been willing to accept only

because of its belief this transaction would not subject it to a large income tax payment.

The Tax Court first found that the underlying opinion did not rise to the standard

required to show substantial authority existed for the opinion. It found that the opinion

used unreasonable assumptions, and that the drafting member of the firm had created

bright line tests that did not exist under the law by using rulings on matters totally

unrelated to the issues at question. In fact, the court found no authority existed for the

matters being discussed, rather the crucial issues addressed relied solely on what the

court found to be the ―dubious‖ legal reasoning of the author.



The Court indicated that given the lack of any authority on the matter at hand, it seemed

unreasonable to believe a ―should‖ opinion would have been issued by the firm if they

had not been involved in the transaction. The underlying conflict of interest in this

matter, which the taxpayer clearly should have taken into account, rendered the

taxpayer’s reliance on this opinion unreasonable. While a taxpayer can reasonably rely

even on the erroneous opinion of a truly independent competent tax adviser, the same

will not be true where it is clear the adviser had a vested interest in arriving at a

particular conclusion. In this case, regardless of the work the firm did on the opinion, it

would be paid exactly $800,000 if and only if it issued the requested ―should‖ opinion.

SECTION: 6662

EXECUTOR REASONABLY RELIED UPON PREPARER, WAS UNAWARE

PREPARER HAD BEEN DISBARRED BY OPR

Citation: Estate of Robinson v. Commissioner, TC Memo 2010-168, 8/2/10

The fact that the individual the executor had relied upon to prepare the estate return

was now a former enrolled agent who had been disbarred was not held against the

taxpayer when the Tax Court looked to see if reasonable cause existed for purposes of

applying the negligence penalties of §6662. The executor in question was not

sophisticated in tax matters, had sought a referral from a successful businessman to

find a tax preparer to assist him in preparing his own returns, and discovered that the

gentleman in question was an enrolled agent. The taxpayer discovered this meant the

individual had passed an examination on tax related matters administered by the IRS.

After using the preparer for a few years, he noticed that the preparer's business cards

now indicated he provided estate planning services. He inquired if the preparer

provided such services, and the preparer indicated that he had always offered them and

now was ―certified‖ in that area as an expert. The individual retained the preparer to

provide estate planning services for the decedent.

Ultimately it was found that the advice wasn't quite so wonderful after the IRS examined

the estate. In fact, the individual in question had been disbarred by the Office of

Professional Responsibility of the IRS. However the executor was not aware of that fact

and had provided the preparer with complete information. As such, the Tax Court found

the preparer had reasonably relied upon the expertise of the former EA and therefore

the estate was not held subject to the penalties under §6662.



SECTION: 6662A

PENALTIES APPLY TO REPORTABLE TRANSACTION, DID NOT VIOLATE

DUE PROCESS

Citation: McGee Family Clinic, P.A and Prossner v. Commissioner, TC Memo

2010-202, 9/15/10

The Tax Court specifically rejected a taxpayer's claim that the penalties imposed on

underpayments related to listed transactions from a welfare benefit plan substantially

similar to the plan described in Notice 95-34 should not apply to the taxpayers since

such an application would violate due process due to the rule being applied retroactively

and without fair warning.

The tax years in question ended December 31, 2004 (for the individuals) and March 31,

2005 (for the corporation). Congress in October 2004 passed the provisions imposing

the penalties in the case, as well as the obligation to report such transactions. Even

though that date may have been after the taxpayers had entered into the transactions in

question, the Tax Court noted that the penalty applied to the tax treatment claimed on

the tax returns, returns prepared long after the provisions became law. Thus the law

was not being applied retroactively in violation of their due process.

The Tax Court also rejected the taxpayer's claims that because the IRS had not

specifically notified them of the requirement to make this disclosure due to their

investment in the plan the penalty should not apply. The Tax Court noted that such a

requirement would be administratively impossible and, in fact, clearly at odds with the

purpose of the reportable/listed transaction reporting regime. The whole point of these

rules is to require taxpayers to voluntarily disclose their involvement rather than simply

hoping to avoid detection. The penalties are imposed on those that choose to play the

―audit lottery‖ and find that their luck didn't hold out.



SECTION: 6665

LARGE CORPORATE ESTIMATED TAXES DUE IN JULY, AUGUST AND

SEPTEMBER OF THREE YEARS ACCELERATED


HIRE Act 561 gives us yet another use of one of Congress’s favorite techniques for

moving funds between fiscal years. The estimated tax payments due under §6665 from

corporations with assets of $1,000,000 or more, increasing the estimates due in July,

August or September of 2015 to 121.5% of the amount due, and the payment for the

same three months in 2019 will be increased to 106.5% of the amount due. As well, the

already scheduled increase in the payment related to the same three months in 2014

that was scheduled to be set at 100.25% is now raised to 123.25%. As always, in each

case the next estimated tax payment due is decreased by the amount of the previous

increase, thus moving funds from the later fiscal year (which begins October 1) into the

earlier one.

SECTION: 6672

OWNER WHO LACKED SIGNATURE AUTHORITY OVER CHECKING

ACCOUNT HELD LIABLE FOR RESPONSIBLE PERSON PENALTY

Citation: Erwin v. United States, CA4, No. 08-1564, 1/13/10

A one third owner of a restaurant was found to be a responsible person by the Fourth

Circuit Court of Appeals. The Court both that Charles Erwin was a responsible person

and that the Company generated revenues and paid other creditors in preference to the

IRS.

In determining whether Mr. Erwin was a responsible person, the Court applied the

factors outlined in its 1999 decision in Plett v. United States (185 F.3d 216) and found

that most of them favored a finding that Mr. Erwin was a responsible person. The Court

noted that he was an officer actively involved in the business, he exercised substantial

supervisory control over those that did control the payroll and eventually took full

control, on more than one occasion determined who would be paid, he negotiated

payments to other creditors (many of which were debts he had personally guaranteed),

he participated to some extent in the day-to-day management of the entity, and he had

and exercised hiring and filing powers.

While he did not have check writing authority during the periods in question, the Court

found that the level of control shown by the other factors made it clear he had the power

to exercise check writing authority had he chosen to do so.



The Court then turned to the willfulness issue. Mr. Erwin discovered that the firm he

had engaged to handle the accounting issues, including paying of payroll taxes, had

failed to pay taxes. While he and the other partners infused cash, directed the

accountants to pay the payroll taxes and not to fall behind again, he did not monitor the

status of the payroll tax payments to assure the accountants followed his orders, but

rather continued to rely on the accountants to take care of the payroll tax issues. He

was fully aware the entity was experiencing severe financial difficulties.

As well, the entity did not use all current and future unencumbered funds available to

pay the back tax liabilities. The entity generated substantial revenue after Mr. Erwin

became aware of the unpaid taxes, and yet he did not take steps to insure that the cash

first went to pay the trust fund liability.

SECTION: 6698 & 6699

PENALTIES INCREASED DRAMATICALLY FOR LATE FILED

PARTNERSHIP OR S CORPORATION RETURNS

Citation: Worker, Homeowner, and Business Assistance Act of 2009, Sec. 16,

11/6/09

Congress has revisited what has become a recent favorite place to visit to find funds—

raising the penalties imposed on late filed partnership and S corporation returns. The

penalties for late filed returns for taxable years beginning after December 31, 2009 will

be $195 per partner/shareholder per month or portion of a month. The penalty

continues for up to 12 months. This is an increase from the current level of $89 per

month.

SECTION: 6901

BUYER OF CORPORATE ASSETS FOUND NOT LIABLE FOR TAX OF

SELLER UNDER TRANSFEREE LIABILITY THEORY

Citation: LR Development Company LLC v. Commissioner, TC Memo 2010-

203, 9/16/10

In the case at hand the IRS had determined a corporation owed tax, but by the time the

IRS actually got around to attempting collection the corporation had long ago been

dissolved and the tax was considered uncollectible. However the corporation had sold

assets to another party, and now the IRS attempted to collect the tax due from that

party under a transferee liability theory under IRC §6901.



The IRS had three theories it asserted in this case: 1) the new owner was liable under

the assumption agreement with the selling corporation, 2) the new owner was liable

under the Illinois fraudulent transfer statute or 3) the new was liable under what the IRS

labeled the ―trust fund doctrine.‖

The Tax Court found that while the assumption agreement did provide the new owner

would be liable to old owner for any taxes found to be due, the agreement specifically

stated that third parties could not assert such an agreement. As the original corporation

was not filing a claim against the new buyer, as it never paid the tax, there was no

liability under that provision. The Tax Court also rejected the IRS's theory that such a

clause would violate public policy, finding that it was IRS's own problems in assessing

the tax due that was why the tax was not paid by the taxpayer, not due to any incentive

offered to the seller by this agreement.

While finding that, due to the structure of the agreement, the buyer had not transferred

effectively any consideration to the sellers (rather it going through another party in a

complicated transaction), nevertheless the sellers did not ―lack any objective basis‖ to

believe that a secondary transaction that generated a large loss (later disallowed by the

IRS) would not be respected and therefore transferred assets at a time when the seller

expected to trigger a large tax liability.

The Tax Court also rejected the IRS's ―trust fund doctrine‖ that asked the court, as a

matter of equity, to find a liability transferrred when ―(1) a transferee receives assets

from a corporation, (2) the transferee pays the consideration for the assets to someone

other than the transferor corporation, and (3) the transferor corporation is unable to pay

its debts.‖ The Tax Court held that for the equitable relief provisions to be triggered, the

IRS would have to show true fraudulent intent, a showing the Tax Court had already

rejected in handling the earlier arguments.

Ultimately the taxpayer appears to have prevailed primarily because the transferring

corporation could not be shown to have had reason to believe the transaction being

proposed to offset the gain would not be respected for tax purposes.



SECTION: 7206

TAXPAYER WHO ADMITTED HE AND PREPARER HAD "AGREED TO

COVER EACH OTHER'S BACKS" PROPERLY CONVICTED OF FILING

FALSE RETURNS AND CONSPIRACY

Citation: United States v. Kruse, CA7, No. 09-4077, 5/25/10

The taxpayer presented himself as simply a person who relied upon his accountant, and

therefore the government had failed to prove he had willfully filed false income tax

returns, a necessary component of a criminal case. However, the Seventh Circuit Court

of Appeals didn’t see matters that way, sustaining his prior conviction at District Court.

At trial, it was shown the taxpayer gave conflicting explanations on a number of matters

related to the return. He told the IRS agent originally that he had totaled receipts to

come up with one rather large claimed expense deduction, but then later told the

Special Agent that he had no idea where the numbers came from—from which the

Court concluded that it was reasonable to conclude he was changing his story because

he was aware the numbers on the return were false. He also had admitted to the

Special Agent that he was making between $300,000 and $400,000 a year from the

business, even though his tax returns showed far less income. He also took draws

each year far in excess of the reported income. Thus the Court found, it was

reasonable for the District Court to have found that the taxpayer had been aware his

income was understated significantly when he filed the returns.

The Court also found sufficient evidence to sustain his conviction for conspiracy to

defraud the United States. The taxpayer admitted that he and his preparer had ―agreed

to cover each other’s backs‖ making it reasonable for the Court to conclude that the

reason they needed to do so was because they had agreed to proceed in an illegal

fashion with regard to the taxpayer’s returns.



SECTION: 7422

CHARACTERIZATION OF TRANSACTION AS SHAM A PARTNERSHIP

ITEM, STATUTE OF LIMITATIONS DEFENSE NOT AVAILABLE TO THE

INDIVIDUAL PARTNERS IN REFUND ACTION

Citation: Prati v. United States, Deegan v. United States, CA FC, Nos 2008 -

5117, 2008-5129, 5/5/10

Taxpayers are generally barred from challenging the treatment of partnership items

when they are resolved in a proceeding subject to the TEFRA rules for certain

partnerships. So, not surprisingly, the question of what is a partnership item is a matter

of dispute. In this case, the taxpayers were challenging whether they could litigate a

statute of limitations issue, as well as whether they could challenge the finding that a

partnership transaction was a sham.

The taxpayers asserted, based on the Federal Circuit’s prior holding in AD Global Fund,

LLC, that the statute had expired on the IRS’s ability to assess tax against the taxpayers

under §6501. Since the court had held that §6229 ―does not create an independent

statute of limitations,‖ the taxpayers argued that only the standard §6501 statute period

applied to them unless, apparently, the IRS specifically were able to get the taxpayers

to agree to the application of §6229. The Federal Circuit disagreed with the taxpayers’

reading of the Court’s prior decision—the panel explained that §§6229 and 6501

operate in tandem to create a single limitations period, and a taxpayer cannot assert

one in isolation to avoid liability.

The taxpayers also argued that they should be able to challenge the court’s finding that

the transaction was a sham, which for the year in question involved a higher level of

interest on the underpayment under former §6621(c). However, the Court held that the

characterization of a partnership’s transaction is a partnership item.

While we no longer contend with §6621(c) specifically, the newly enacted §6662(b)(6)

20% accuracy-related penalty on underpayments from transactions found to lack

economic substance under new §7701(o) would seem likely to be treated similarly.



SECTION: 7422

IRS SETTLEMENT DID NOT AMOUNT TO CONCESSION ON SHAM

TRANSACTION DOCTRINE OR THAT SHAM TRANSACTION ISSUE NOT A

PARTNERSHIP ITEM

Citation: Schell v. United States, CA FC 2009-5010, 12/22/09

The taxpayers argued that the fact that the IRS had entered into an agreement with the

taxpayers settling the question of the proper deductions from a partnership on their

individual returns amounted to either a) a concession by the IRS that the transactions

were not shams nor b) convert the question of whether the transactions were sham

transactions into something other than a partnership item with regard to the taxpayers.

The IRS examined two partnerships in which the taxpayers had invested, issuing Final

Partnership Administrative Adjustments denying all losses. The partnership contested

the IRS position.

After the FPAA was issued but before the case was decided by the Tax Court, the

taxpayers entered into an agreement with the IRS regarding their claimed deduction

from the partnerships where the IRS and taxpayer agreed to reduce the claimed

deductions by between fifty and fifty-five percent.

The IRS continued against the partnership itself, and ultimately the Tax Court concluded

that the items the IRS questioned lacked economic substance and denied the

deductions in full.

The taxpayers claimed that the IRS’s settlement with them was effectively a concession

that the transactions were not shams. However, the Court of Appeals for the Federal

Circuit did not agree, holding instead that the settlement did not address whether or not

the transactions were shams and the fact that some deduction was allowed simply was

part of the settlement. As well, the Court also ruled that the independent agreement did

not convert the question of whether the transactions were not shams into something

other than a partnership item. Thus, the Court of Appeals for the Federal Circuit ruled,

the Court of Federal Claims properly ruled it had no jurisdiction.



SECTION: 7430

ATTORNEYS FEES AWARDED FOR INITIAL IRS POSTION, BUT NOT FOR

SECOND POSITION TAKEN FOLLOWING REJECTION OF FIRST

Citation: Center for Family Medicine v. United States, CA8 No. 09-2780,

7/30/10

The Eighth Circuit agreed with the District Court that the taxpayer was eligible for an

award of attorney fees for the position the IRS took in its initial motion for summary

judgment in the case that was directly opposite to the binding precedent of the Court of

Appeal where the case would be appealed to. However, both courts also found that the

IRS's second motion, which was also ultimately denied, nevertheless applied the case

specific factual analysis demanded by the precedential case, so that the government

position was substantially justified even if it was not ultimately accepted by the courts.

The case involved FICA taxes imposed on medical residents, and the IRS initially

contended in its first motion for summary judgement that, as a matter of law, such taxes

were due. The Eighth Circuit, in the Apfel case, had rejected that contention, a rejection

the District Court was bound to accept. The IRS position, therefore, was no

substantially justified and the taxpayer, as the prevailing party had a right to attorneys

fees.

However the government then made a second motion for summary judgment, this time

holding to a factual analysis. While the analysis was one that had been rejected by

another District Court in a similar case, the appellate court noted that a District Court is

not bound to following the reasoning of another District Court in the same matter. Thus,

even thought the Court eventually did reject the IRS position, the IRS position was

based on the analysis required by the opinion in the Apfel case.



SECTION: 7602

DC CIRCUIT RULES DISCLOSURES TO AUDITORS DID NOT REMOVE

WORK PRODUCT PRIVILEGE

Citation: United States v. Deloitte, LLP, CADC No. 09-5171, 6/30/10

The Court of Appeals for the District of Columbia added its views to the issues

surrounding auditor's work and its relationship to an assertion of work product privilege

in tax matters, a matter visited earlier in 2010 by the First Circuit in the Textron case. In

the case in question the government sought three documents. The first was a

memorandum prepared by the auditors which documented discussions the firm had with

employees of the taxpayer and the taxpayer's outside legal counsel regarding the

possibility of litigation over a partnership investment. The other two documents were

documents the government conceded were generally subject to work product privilege

(one prepared by the company's employees and the other prepared by outside

counsel), but which the government argued lost their protection upon disclosure to the

outside auditor.

The District Court had ruled against the IRS on all three documents, holding that they

were all protected by work product privilege. The Court of Appeals sustained the

District Court on the two documents not prepared by the auditor, and held that the

District Court need to do an in camera review of the auditor prepared document to

determine if any part of it did not contain protected work product.

The Court quickly dismissed the IRS's arguments on the latter two documents, holding

that work product documents did not lose that protection merely because they were

disclosed to an outside auditor. The Court noted that in the majority of Circuits,

including this one, the test for work product was whether a document was prepared

because of the anticipation of litigation, with only the Fifth Circuit holding to a stricter

test that looked to whether a document was prepared primarily because of anticipated

litigation.

Disclosure to the auditor of the two documents did not remove protection because the

auditor was not possible adversary on the legal issue being analyzed and the firm was

obligated to maintain confidentiality of information under AICPA standards. The Court

did not consider the possibility that such information might influence the disclosures the

auditors would require to issue an unqualified opinion to be of such magnitude to

constitute indirect disclosure to potential adversaries.



The Court also found that the documents prepared by the auditor could be protected

work product to the extend they reflected the thoughts of counsel and other protected

ideas that were communicated to the auditor orally. The mere oral transmission of the

information did not remove work product protection. The Court's only concern with the

District Court's action was that it did not review the document before ruling it non-

discoverable, holding that it was possible the documents contained other information

that was not work product and that those parts would be subject to disclosure—so it

remanded the matter back to District Court to conduct that review.

The Court also commented on the recent Textron case. Officially the decision

distinguished its holding from that in Textron, as the Textron majority claimed their

decision revolved around the detailed factual material in the documents in question and

did not exclude the possibility that other documents prepared during audit might be

protected. However, the Court in passing did imply that Second Circuit, despite its

official holding to the contrary, had used the stricter Fifth Circuit ―because of‖ test as the

dissenting opinion in that case complained.

What this means is that it appears, as a practical matter, that we have a significant split

of opinion in the two Circuits to consider auditor/work product disclosure issues.

Obviously we can expect the issue to continue to arise, and should expect to hear from

other Circuits on this matter.

SECTION: 7602

SUPREME COURT DECLINES TO REVIEW HOLDING THAT TAX ACCRUAL

WORKPAPERS NOT PROTECTED BY WORK PRODUCT PRIVILEGE

Citation: United States v. Textron, Supreme Court denial of certiori, CA1, No.

07-2631, 5/24/10

The U.S. Supreme Court denied certiorari in the case of United States v. Textron, CA1

No. 07-2631, leaving the Court of Appeals reversal of the original U.S. District Court

decision intact.

The District Court had originally ruled that legal analyses prepared for Textron which

were later shared with the company’s outside auditors as part of their consideration of

the tax accrual were protected from disclosure to the IRS under the work product

privilege rule. In general that rule grants less protection than attorney client privilege,

but sets up a significant hurdle for the other party (in this case the IRS) to clear in order

to obtain the materials. The District Court had initially ruled that the materials were

prepared in an environment where it was likely the IRS would challenge the

transactions, so as such the amounts were prepared in anticipation of litigation.



The Court of Appeals reversed, holding with the IRS that the documents were required

to be prepared in order to support the entity’s financial statements, as evidenced by the

disclosure to the outside auditors. As such, the IRS had a right to see those documents

as well.

The Supreme Court denial of cert does not necessarily mean they agree with the

holding—rather, they have simply decided not to decide and to let the ruling stand. But

it certainly suggests the Court did not see the ruling as one that a majority vigorously

disagreed with, so expect the IRS to treat this as an indirect indication of support from

the Supreme Court for their right to obtain such information.

For CPAs in local practices that provide both tax and attest services, even the original

Textron decision did not offer much comfort with regard to protection of the CPA’s tax

analysis from the IRS should the IRS decide to obtain it—unlike a large public company,

most privately held companies do not have a reasonable expectation of every significant

transaction being looked at by the IRS, a key condition for the original District Court

finding. But clearly now a firm that handless both tax advice and reporting on a client’s

financial statements needs to make their client aware that any advice given could be

obtained by the IRS in an examination.

And note that §7525 preparer privilege is of no help here—that section is specifically

limited to providing the same privilege an attorney would have had. But even the

original District Court never ruled that attorney-client privilege existed under these facts,

and that is a specific requirement for §7525 to shield any communications.

SECTION: 7701

LATE REQUEST FOR AUTOMATIC RELIEF UNDER REV. PROC. 2009-41

SHOULD RESULT IN CHANGE EFFECTIVE EXACTLY 3 YEARS AND 75

DAYS PRIOR TO DATE OF REQUEST


In emailed advice the Chief Counsel’s office considered an issue arising under Revenue

Procedure 2009-41, the ruling that liberalized the relief for late entity choice elections

under the check the box regulations, giving automatic relief in some cases. The

question discussed in this letter is what should the IRS Service Center do if a taxpayer

files for such relief, but the request is filed more than 3 years and 75 days after the

requested effective date.

Revenue Procedure 2009-41 requires that the taxpayer must request relief within 3

years and 75 days after the date when the election had originally been intended to be

effective and show reasonable cause for the late filing.



Interestingly enough, the email suggests the proper course is for the IRS to initially

grant the request effect as of the date 3 years and 75 days before the filing date of the

request. That is interesting because, in fact, the taxpayer is not claiming an intent to

have made that arbitrary date as the date for which a change of entity was to be

effective.

The email notes that the Service Center should suggest to the taxpayer that it could

apply for a private letter ruling granting relief back to the originally requested date. Note

that such a ruling would have to go through the formal ruling request procedure

including the payment of the required fee.

SECTION: 7701

IRS LIBERALIZES RELIEF FOR LATE ENTITY ELECTIONS UNDER CHECK

THE BOX RULES


The IRS liberalized the rules for automatic late election relief for entity classification

elections. For an entity that failed to timely file an election to make or change its entity

classification, it can qualify for automatic relief if all returns have filed consistent with the

classification chosen (if any returns have yet been due), the only reason the entity does

not have its intended classification is due to the late filing of Form 8832, the entity has

reasonable cause for the late filing and the request is filed within 3 years and 75 days of

the date the entity intended to have its different classification.

An election under this procedure must be filed on a Form 8832 that includes a

declaration that all requirements of the procedure have been met and, until Form 8832

is modified, must have ―Filed Pursuant to Rev. Proc. 2009-39‖ written at the top of the

Form 8832. The 8832, the declaration and the reasonable cause statement must be

filed with the applicable IRS service center.

SECTION: 7805

FAILURE TO PROPERLY ANSWER QUESTION ABOUT CONTROLLED

ENTITIES ALLOWED IRS TO RETROACTIVELY REVOKE PLAN'S

DETERMINATION LETTER

Citation: Yarish Consulting Inc. v. Commissioner, TC Memo 2010-174, 8/4/10

A taxpayer established a management S corporation which received management fees

from the taxpayer's controlled corporations and a corporation that the taxpayer was

selling to a third party. The S corporation sponsored an ESOP that would become the

principal owner of the S corporation presumably allowing the income of the S

corporation to remain untaxed until the owner took a distribution from the plan.



In its application for a determination that the ESOP was a qualified plan, the taxpayer

indicated that the sponsor was not a member of a affiliated service group or a controlled

group of corporation, something that was not true. The taxpayer continued to answer

similar questions in the same manner on its Form 5500s filed for the plan.

The taxpayer terminated the plan and rolled the value of the ESOP's assets (over $2.4

million) to an IRA. The 5500 the taxpayer filed for the final year failed to note that the

taxpayer had terminated the plan at that time. The IRS eventually examined the plan

and, after discovering that the S corporation was a member of an affiliated service

group and a controlled group, proposed to disqualify the plan retroactively. As well, the

IRS noted that since the S corporation ESOP transaction was a listed transaction, the

plan could not take advantage of the EPCRS program to correct its defects.

The taxpayer argued the IRS could not retroactively revoked its determination letter,

arguing the errors it committed in answering questions were mere ―scrivener's errors‖ in

this case, thus limiting the IRS to only a prospective effect of the revocation of the

original determination.

The Tax Court disagreed, holding that there was no mutual mistake of fact between the

taxpayer and IRS and rather the taxpayer simply failed to disclose a crucial fact on its

initial application, and continued to give that erroneous answer on four straight Forms

5500. Thus, the IRS was not required to limit its action to prospective revocation only,

as the taxpayer failed to qualify for relief under §7805(b).

SECTION: 9100

TAXPAYER THAT ACCIDENTALLY NEGLECTED TO SCAN REQUIRED

3115 TO SUBMIT WITH EFILED RETURN GRANTED REPRIEVE

Citation: PLR 201017026, 4/30/10

An electronic filing glitch gave rise to a request for relief from the IRS. The taxpayer was

attempting to make a change of accounting method for which automatic consent was

available. One of the requirements for an automatic consent is that the taxpayer must

attach the Form 3115 to the tax return and sign that form.

In this case the return was being filed electronically, which required scanning the signed

3115—except it turned out that the accounting firm that prepared the electronically filed

Form 3115 had neglected to scan the Form 3115 and include it with the efiled return,

which meant the taxpayer had not complied with the requirements to obtain automatic

consent to change its accounting method.



The taxpayer asked for and received permission under Reg. §§301.9100-1 and

301.9100-2 to file a new original Form 3115 requesting the change and a duplicate copy

of that form attached to an amended return. Once the taxpayer takes those steps, it will

obtain the permission to change account methods.

The case serves as a reminder that we have to consider slightly different procedures to

insure against oversights with electronically filed returns, since the actual return being

transmitted to the government can’t be scanned as a final review for completeness as a

paper one can be. It also reminds us that the National Office of the IRS is generally

understanding in such cases—but generally only if the taxpayer comes forward

voluntarily to disclose the problem.

SECTION: 9100

IRS GRANTS TAXPAYER PERMISSION TO FILE COPY OF 3115 WITH

NATIONAL OFFICE AFTER DUE DATE

Citation: PLR 201016049, 4/23/10

A taxpayer must have permission to change its method of accounting. In some cases

the IRS has provided for automatic permission to be granted, generally by filing one

copy of Form 3115 with the taxpayer’s return and a second copy with the National

Office of the IRS. If the taxpayer fails to comply with the requirements, permission has

not been granted to change the method—meaning that on examination the IRS could

put the taxpayer back on the old method of accounting.

In the case at hand, it was discovered sometimes after filing the return and Form 3115

that no copy had been filed with the National Office as required. The taxpayer asked

the IRS to give relief under Reg. §301.9100-3 to allow the late filing of the Form 3115

with the National Office. The IRS, applying the standards of Reg. §301.9100-3, granted

permission for the late filing—a not very surprising result.

So why should this ruling be one you are aware of? Because too often when we

discover that some procedure was not properly followed, the first inclination of the client

and, if the CPA was in some way culpable, the CPA is to ignore the problem under the

theory the ―IRS will never notice‖ and out of fear for the consequences of informing the

IRS of the failure.



The large number of waivers granted every week in the published letter rulings of the

IRS makes clear, the IRS tends to be very understanding so long as the matter is

brought to their attention voluntarily by the taxpayer. However, if it is the IRS that

discovers the matter on exam, it’s less likely there will be such a conciliatory tone. And

if, on top of that, the IRS discovers the problem is one that the parties were aware of but

decided not to inform the IRS of, then the likelihood of a favorable outcome drops

dramatically.

SECTION: 9815

PREVENTIVE CARE MUST BE PROVIDED WITHOUT COST SHARING IN

GROUP HEALTH PLANS

Citation: Tempoary Reg. §54.9815.2713T, 7/16/10

Employer group health plans for plan years beginning after September 23, 2010 must

provide for specified preventive care benefits without requiring a cost sharing payment

[Reg. 54.9815-2713T]. Such items and services that must be offered without cost

sharing include a) evidence based items that have in effect a rating of A or B in the

current recommendations of the United States Preventive Services, b) recommended

immunizations for routine use in children, adolescents and adults, c) with respect to

infants, children and adolescents, evidence-informed preventive care and screenings

provided for in comprehensive guidelines supported by the Health Resources and

Services Administration and with d) with respect to women, any additional preventive

care and screenings provided for in comprehensive guidelines issued by the Health

Resources and Services Administration.

The guidelines specifically carve out an exception for breast cancer screenings,

mammography and prevention, effectively striking out the recommendations made

around November 2009 that suggested that routine early mammograms should not be

used, moving back to the 2002 recommendations which provide for a screening

mammogram every one or two years upon reaching age 40 [Reg. §54-9815-2713T(c)].



SECTION: 9815

TEMPORARY REGULATIONS GIVE REQUIREMENTS FOR PREEXISTING

CONDITIONS, BENEFIT LIMITS AND RESCISSIONS FOLLOWING PATIENT

PROTECTION AND AFFORDABLE CARE ACT

Citation: Temporary Regs. §§54.9815-2704T, 54.9815-2711T, 54.9815-2712T

& 54.9815-2719T, TD 9491, 6/25/10

The IRS issued temporary and proposed regulations on June 25 that implement the

preexisting medical conditions, benefits limitations and rescission provisions of the

Patient Protection and Affordable Care Act [TD 9491, Temporary Regs. §§54.9815-

2704T, 54.9815-2711T, 54.9815-2712T, and 54.9815-2719T]. At the same time, the

Departments of Labor and Health and Human Services issued complementary

regulations implementing the same provisions. Except for those provisions regarding

preexisting medical conditions, the regulations apply to plan years (for group plans and

insurance coverage) or policy years (for individual health insurance coverage) beginning

on or after September 23, 2010.

For preexisting medical conditions the regulations apply to plan years or policy years

beginning on or after January 1, 2014 except for individuals under age 19 for whom the

regulations apply for plan or policy years beginning on or after September 23, 2010.

The preexisting medical condition regulations are an expansion of the preexisting

medical conditions rules already in place under HIPAA that previously applied only to

group health plans and group medical insurance coverage, extending the coverage to

individual health insurance coverage. The Patient Protection and Affordable Care Act

§2704 also expands the preexisting condition rules to include a complete exclusion from

a plan or coverage if based upon a preexisting medical condition in addition to

exclusions that were limited to a restriction of benefits related to a specific preexisting

medical condition. The preamble to the regulations notes that it is not a violation to

exclude benefits that may relate to a particular individual's preexisting medical condition

if the exclusion applies to all participants regardless of when the condition arose relative

to the date of coverage.

Grandfathered group health plans must comply with the preexisting medical condition

provisions as revised as they come into effect, but grandfathered individual health

insurance plans are not required to comply with this provision.



The regulations make clear the the prohibition on the limitations on annual or lifetime

benefits do not apply to flexible spending accounts, which are eventually capped at a

$2,500 annual amount by other provisions in the Patient Protection and Affordable Care

Act. Similarly, such rules do not apply to Medical Savings Accounts (MSAs) or Health

Savings Accounts (HSAs).

Health Reimbursement Arrangements (HRAs) which are maintained in addition to other

coverage (such as when an employer agrees to pay some or all of the an annual

deductible incurred by its employees) will be evaluated with the other coverage as a

whole when determining compliance with the limitations on lifetime or annual benefits.

As well, stand alone HRA plans limited to retirees or those covering two or fewer current

employees are exempted by statute under the Patient Protection and Affordable Care

Act from these provisions. The agencies ask for comments specifically on how the rules

should apply to stand-alone plans that do not meet one one of those two exemptions.

The annual/lifetime benefit limitations are phased in over time, even though they begin

to have an impact in September of 2010. The rules will allow for phased in annual

limitations on those benefits designated as ―essential health benefits‖ for plan years

beginning before January 1, 2014. For plan or policy years beginning on or after

September 23, 2010 but before September 30, 2011, the minimum allowed annual limit

will be $750,000; for plan or policy years beginning on or after September 23, 2011 but

before September 30, 2012, the minimum allowed annual limit will be $1.25 million; and

for plan years beginning on or after September 23, 2012 but before January 1, 2014 the

limit will be $2 million. These limit are individual limits, not family limits, under the plans.

The purpose of the phase-in is to restrict the impact of premium increases, and the

regulations provide for HHS to establish a program under which these requirements

could be waived during the phase-in period if compliance with the regulations would

result in a significant increase in premiums or decrease in access to benefits.

Grandfathered individual market plans are exempted from the benefit limitation rules.

As well, annual or lifetime limits can be applied to individual benefits that are not

―essential health benefits‖ under the Patient Protection and Affordable Care Act.

Plans must notify individuals who have reached a lifetime limit under a plan, but remain

eligible under the the plan of insurance of the fact that the lifetime limit no longer

applies, and must be given the opportunity for an enrollment (in the group plan arena) or

reinstatement (in the individual health policy market). For individuals in the individual

health plan market, these rules do not apply if the contract is not renewed or is no

longer in effect, but would apply to a family member who no longer is covered if other

members of the family remain covered under the individual health plan.



The rules explain the broadened restrictions on rescission of coverage, limiting

rescission to cases of fraud or where the individual knowingly misrepresented a material

fact in obtaining the coverage. Previously, coverage could be rescinded if an individual

misrepresented a material fact, even if the person did not do so knowingly. Cancellation

of policies are limited to cases of nonpayment of premiums; fraud or intentional

misrepresentation of a material fact; movement of an individual or employer outside of

the service area of the insurer; withdrawal of a product or issuer from a market; or, for

bona fide association coverage, cessation of association membership.

For individual policy years beginning on or after January 1, 2014, rules will apply to

individual policies on the guaranteed issue of all products, nondiscrimination based on

health status and no preexisting medical condition exclusions, expanding many of the

rules previously applicable to group plans under HIPAA.

If other requirements of Federal or State law include stricter requirements than those

found in Patient Protection and Affordable Care Act for allowing rescissions, those more

restrictive rules will apply.

The regulations clarify that the standards apply regardless of whether the coverage in

question involves a single individual, a family or a group of individuals. As well, the

standards apply to representations made by the individual or group seeking coverage

on behalf of the individual. Thus, if that representative were to make

misrepresentations or engaged in fraud in obtaining the coverage, the rescission would

be allowable of the individual's coverage even though the individual him/herself had

committed no fraud, nor had misrepresented any information to the issuer.

A rescission is defined as a cancellation or discontinuance of coverage that has

retroactive effect. Cancellations or discontinuance of coverage that has only

prospective effect, or a retroactive cancellation or discontinuance of coverage that is

effective only to the extent of the failure to pay a premium is not a rescission.

In cases where a rescission is allowed, 30 days notice must be given to an individual

before coverage can be rescinded in order to give individuals an opportunity to contest

the rescission or find other coverage.



If group plan or issuer has a network of participating providers, it must comply with

standards relating to the choice of a primary care physician or pediatrician. The must

allow the participant to select any participating primary care physician or pediatrician

who is available to accept the individual, and notice must be provided to the participant

of these rights. The plan also cannot require authorization or referral for in-network

obstetrical or gynecological services, for these purposes treating that provider as the

primary care provider. This provider would continue to be subject otherwise to referral

and authorization rules applicable for care that would apply to the primary care provider.

The plan can also require the obstetrical or gynecological care provider to notify the

primary care provider or the plan or issuer of treatment decisions. Model language is

provided for these provisions and, if a plan does not use a network of participating

physicians, these rules would not apply.

For emergency services, the regulations prohibit a plan or policy from requiring

preapproval or limiting such benefits to being provided by participating providers. Cost-

sharing or coinsurance rates may not higher for use of out-of-network providers for

emergency services, but the out-of-network provider is allowed to bill for any remaining

balance due from the patient after the insurer has paid their normal amount. However,

the regulations require that the insurer pay a reasonable amount in such case to limit

the impact of balance billing. Such reasonable amounts will be the highest of three

amounts set forth in the regulations (amounts negotiated with in-network providers to be

paid, using the method the plan uses to determine what to pay out-of-network providers,

but substituting the in-network cost sharing or coinsurance rates, or the amount that

would be paid under Medicare). The emergency services rules do not apply to

grandfathered plans.

SECTION: 9815

TEMPORARY REGULATIONS OUTLINE REQUIREMENTS FOR

GRANDFATHERED HEALTH CARE PLANS AND POLICIES

Citation: Temporary Reg. §54.9815-1251T, TD 9489, 6/14/10

Temporary regulations explaining the definition of and limitations of grandfathered plans

under the Patient Protection and Affordable Care Act were issued by the government in

TD 9489, creating Temporary Reg. §54.9815-1251T. Grandfathered plans do not have

to comply with all of the requirements that will be imposed on health care plans under

the Act. In theory you can keep the existing plan-but there are conditions, and certain

changes still must be made to most plans, at least by the time the Act is fully effective.



If an employer wishes to maintain grandfathered status for its plan, care must be taken

whenever any change in contemplated in the plan. Such changes may remove the

grandfathering exemption for the plan, resulting in the coverage failing to meet the

minimum requirements or being subject to additional requirements that could impact the

cost of the plan.

Realistically, over time it will become more and more difficult to continue to maintain a

grandfathered plan, if for no other reason than the lack of flexibility in changing a benefit

plan. For instance, generally changing from insurance carrier to another will cause a

health plan to lose grandfathered status. But sponsors and

To be a grandfathered plan a plan must:

Have been in place as of March 23, 2010 and provided continuous coverage since then

(even if employees come and go)

Plan must disclose in all plan materials given to participants that it is a grandfathered

plan and provide contact information (model language in temporary regulations)

Maintain records documenting terms of plan as of March 23, 2010

Family members of covered individual can enroll in plan and will be treated as

grandfathered plan

Grandfathered plans must comply with following changes in the law even though they

are granted grandfathered status (as they become applicable):

Prohibition on recissions except in case of fraud or intentional misrepresentation

Elimination of lifetime limits

Coverage of dependent until age 26

Prohibition on preexisting conditions exclusion (group only)

Prohibition on excessive waiting periods

No lifetime or annual limits (annual limits prohibition does not apply to individual

grandfathered plans)

Uniform explanation of coverage documents

Cost reduction provision (PHS §2718)



Additionally, the following provisions are provided regarding changes, modifications,

and other events that take place that will or will not change a plan’s status from

grandfathered.

Adding New Employees to the plan generally is allowed. However:

Anti-abuse rule if principal purpose of merger, retructuring, etc. is to cover new

individuals under grandfathered plan

Anti-abuse rule on transferring employees from one grandfathered plan to another to

get around prohibited changes

The grandfathered plan must continue to comply with all parts of ERISA, PHS Act and

the IRC that were in effect prior to Patient Protection and Affordable Care Act except to

extent changes made by Patient Protection and Affordable Care Act

If the plan was established under a collective bargaining agreement:

Plan will be treated as grandfathered plan, at a minimum, until the end of the current

contract

However, still must comply with all requirements for grandfathered plans

These special rules do not apply to self-insured plans

Grandfather plan can make certain changes. Allowed changes to the plan guidance

includes:

Extent to Which Benefits May Be Reduced

Cannot eliminate all or substantially all benefits to diagnose or treat a particular

condition

Elimination of benefits for any necessary element to diagnose or treat a particular

condition treated as an elimination of benefits

Limits on Increase in Fixed or Cost Sharing Components

Level of coinsurance is the measuring level (20% has to stay at 20%) and any change

in percentage is disallowed

For fixed cost sharing arrangements

Co-payments rule – either medical inflation plus 15% or $5 increased by medical

inflation



Other than co-payments rule – increase can be no more than medical inflation

(measured from March 23, 2010) plus 15 percentage points

Employer Contributions

Contributions based on cost of coverage – cannot decrease contributions towards any

tier of coverage for any similarly situated class of individuals by more than 5% below the

contribution rate on March 23, 2010

Contributions based on a formula – organization decreases its contribution rate towards

any class of similarly situated individuals by more than 5% below the contribution rate

on March 23, 2010

Limit on Benefits

If the plan did not impose a limit on March 23, 2010 – cannot impose a limit now

Plan imposed an overall lifetime limit but no annual limit on March 23, 2010 – cannot

impose an annual limit

Plan imposed an annual limit on March 23, 2010 – cannot decrease that annual limit

Other changes – can change other items, such as premiums, changes to comply with

federal or State requirements, changes to voluntarily comply with provisions of the

Patient Protection and Affordable Care Act or changing third party administrators.

As well, if changes made to coverage due to filing with State insurance department or

amendments adopted prior to March 23, 2010, is still OK

Will consider good faith efforts to comply prior to release of temporary regulations

The government is looking for comments on the following issues for these regulations:

Changes to plan structure that would lose grandfathered status

Magnitude of changes to a provider’s network

Changes to a prescription drug formulary

Any other substantial change to overall benefit design



SECTION: 9815

TEMPORARY REGULATIONS OUTLINE REQUIREMENTS FOR MEETING

AGE 26 TEST FOR GROUP HEALTH PLANS THAT OFFER DEPENDENT

COVERAGE

Citation: Temporary Reg. §54.9815-2714T,TD 9482, 5/10/10

The IRS, Department of Labor and Department of Health and Human Services jointly

issued regulations to implement the requirements under the Patient Protection and

Affordable Care Act that group plans that offer coverage to children of employees must

offer such coverage up to age 26. Plans are not required to offer dependent coverage,

but if the plan does so it now must make the coverage available until age 26.

Because the Patient Protection and Affordable Care Act and IRS interpretations of the

changes in the law, a plan no longer can limit coverage for children to thoe that are

eligible to be claimed as a dependent by the taxpayer, and such provisions in a group

health plan will need to be modified. The temporary regulations also make clear that

since the Patient Protection and Affordable Care Act does not distinguish between

minor children and other children, coverage for minor children also cannot be

conditioned on items that qualify that child as a dependent under the IRC.

Plans also cannot limit coverage only to children of the employee who are not married,

as that limitation in Patient Protection and Affordable Care Act was struck from the law

by the Reconciliation Act. However, in that case the employer is not required to offer

coverage to the child’s spouse, nor must coverage be provided to a child of the child.

The regulations note that due to a quirk in the law, while coverage must be offered until

the child turns 26, the coverage is excludable from the employee’s income only for

years in which the child has not attained age 26 by the end of the year, resulting in

inclusion of income for the period from January 1 to the child’s birthday in the year the

child turns age 26.

Specifically, a health plan cannot use the following factors for defining a dependent

eligible to be covered under the plan: financial dependency on the employee, residing

with the employee, student status, employment, eligibility for other coverage or any

combination of these factors. Terms of the plan or policy cannot vary based on the age

of the child except for children age 26 or older.



Grandfathered plans under Patient Protection and Affordable Care Act will not lose that

status due to modifications made to the program solely to comply with these

regulations. As well, for plan years beginning before January 1, 2014 a grandfathered

plan is allowed to exclude a child who has not attained age 26 if the child is eligible to

enroll a group plan other than the plan of the parent. However, if the only other plan

available to the child is the plan of the other parent, neither parent’s employer plan can

exclude based on eligibility for the other plan.

A key point to remember is that no plan is required to offer any coverage to children of

an employee. However, once a plan does so it has to comply with the age 26 rules for

employees covered by a plan that offers benefits to children of the employee.

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