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November 2012

LB&I Ends Tiered Issues

Effective Aug. 17, 2012, the IRS will no longer use the tiered management process to set examination priorities and address important issues in the Large Business & International (LB&I) Division. Instead, it will examine the former Tier I, II, and III issues and assess risk in the same manner as any other issue in an examination (LB&I-4-0812-010). As part of this process, the IRS withdrew all industry director directives (IDDs) on tiered issues.

In place of the tiered issue process, LB&I is developing a knowledge management system consisting of issue practice groups (IPGs) and international practice networks (IPNs), which will provide IRS examination teams with technical advice. Relevant guidance from the former IDDs will be retained on the IPG and IPN websites. Other guidance will be updated.

Issue tiering, a practice established in 2006, involved separating examination issues into one of three tiers (for a more complete explanation, see “IRS Tiered Issues,” Corporate Taxation Insider, Jan. 28, 2010).

In place of the tiered issue process, the new IPGs and IPNs (currently being piloted by the IRS) are designed to foster knowledge sharing across LB&I and the Office of Chief Counsel. For more, see “New LB&I Knowledge Management Strategies: IPGs and IPNs,” by Robert D. Adams, The Tax Adviser, Oct. 2012, page 668.

Chief Counsel Advises on Identity Theft Returns

In Program Manager Technical Advice (PMTA) 2012-13, the IRS Office of Chief Counsel explained in a memorandum to Small Business/Self-Employed Division attorneys what the IRS can do when a return is filed by an identity thief to generate a fraudulent refund and the IRS has issued a statutory notice of deficiency based on that fraudulent return.

The PMTA explained that a return filed by an identity thief is not a valid return because it is not filed by the true taxpayer or with the true taxpayer’s consent and it lacks a valid signature. The Office of Chief Counsel has taken this position in prior guidance.

Once the IRS issues a statutory notice of deficiency based on the identity thief’s return, the IRS can adjust the victim’s account before the period to petition the Tax Court under Sec. 6213(a) (generally 90 days) expires, including abating any assessments that were based on the bad return, the PMTA stated. The only exception would be if a necessary adjustment required an additional assessment on the victim’s account, but even in that case, the taxpayer could waive the restriction on assessment under Sec. 6213(a) so that the IRS could adjust the account immediately.

The PMTA also stated that if the taxpayer establishes that he or she did not submit the bad return, then the issuance of a notice of deficiency was an administrative error and the IRS should rescind the notice if the taxpayer consents, especially because that will preserve the IRS’s ability to later issue a notice if a deficiency is discovered on the victim’s actual return.

Benistar Plan Taxpayers Lose Appeal

The Second Circuit upheld the Tax Court’s holding in Curcio (Nos. 10-3578, 10-3585, 10-5004, and 10-5072 (2d Cir. 8/9/12), aff’g T.C. Memo. 2010-115) that contributions to a purported welfare-benefit plan known as the Benistar 419 Plan were not deductible.

The four consolidated cases involved business owners who enrolled in Benistar, which offered in its promotional literature “virtually unlimited deductions for the employer.” Other employees of the businesses were not enrolled. The businesses paid amounts into a trust that Benistar used to purchase life insurance policies on the owners, who could select the type of insurance and the premium payment term to fully pay for the death benefits. Businesses also could withdraw from or terminate their participation, upon which the plan would distribute the underlying policy to the insured.

The Tax Court held, as it has in similar cases (see previous Tax Matters coverage, “Tax Court Again Takes Dim View of Benistar Plan,” Jan. 2011, page 56) that the contributions to the plan were not ordinary and necessary expenses as required by Sec. 162(a) but were used by the taxpayers to “funnel pretax business profits into cash-laden insurance policies over which they retained effective control.”

The Second Circuit agreed, noting that Sec. 419(a), which governs deductibility for welfare-benefit plan contributions, requires that they be deductible under another Code provision, and that Rev. Rul. 69-478 states that the proper provision for deductibility of contributions to an employee trust for life insurance is Sec. 162(a) and related regulations.

The appeals court also affirmed accuracy-related penalties on the resulting underpayments.

What is an item of property?  
By Charles J. Reichert, CPA
November 2012

The Tax Court held the IRS properly recharacterized income generated from the rental of semi truck tractors and trailers as nonpassive under the self-rental rule, since each tractor or trailer was considered an item of property under Regs. Sec. 1.469-2(f)(6).

Generally, taxpayers’ passive losses are currently deductible only to the extent of their passive income. Rental activities are generally considered passive; however, any net rental income generated from renting an item of property to a business in which the taxpayer materially participates is considered nonpassive under the self-rental rule of Regs. Sec. 1.469-2(f)(6).

In 2005, Joseph Veriha was the sole owner of, and materially participated in, John Veriha Trucking (JVT), a trucking company in Wisconsin. In addition, Veriha was the sole owner of JRV Leasing LLC (JRV) and owned 99% of the stock of Transportation Resources Inc. (TRI). JRV and TRI generated all of their income in 2005 by leasing semi truck tractor and trailer units to JVT. Each individual tractor unit or trailer unit was rented under a separate lease agreement to JVT. Because of the leases in 2005, TRI produced a net profit, while JRV had a net loss. Veriha and his wife treated the net profit from TRI and the net loss from JRV as passive on their 2005 joint tax return and thus netted the loss against the income. The IRS recharacterized the net profit from TRI as nonpassive income under the self-rental rule and assessed a deficiency of $258,785. The taxpayers petitioned the Tax Court for relief.

The taxpayers argued that the entire group of all tractors and trailers owned by both JRV and TRI should be treated as a single item of property for purposes of the self-rental rule, while the IRS maintained that each individual tractor or trailer was an item of property. Since the term “item of property” is not defined in either the Internal Revenue Code or regulations, the court held the ordinary meaning of “item” should be used, and that it meant “a separate thing that is part of a larger collection.” Therefore, the court concluded that each individual tractor or trailer was a separate item of property for purposes of the self-rental rule and that the net income from TRI was nonpassive. The taxpayer argued that, often in the trucking industry, the phrase “item of property” means an entire fleet; however, the court found this implausible and further stated that it appeared that JVT, TRI, and JRV viewed each tractor or trailer as a separate unit of property, since they were owned by two separate companies and a distinct lease agreement was written for each tractor and each trailer.

While each tractor or trailer leased by TRI was held by the court to be a separate item of property, the IRS did not object to the taxpayer’s netting the profitable leases against the unprofitable leases within TRI or JRV. Thus, the court treated only TRI’s overall net profit as nonpassive, which was more favorable to the taxpayer than treating the income from each lease of the two companies as nonpassive.

Veriha, 139 T.C. No. 3 (2012)

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.

IRS wins again on appeal of rehabilitation credit  
By Janet A. Meade, CPA, Ph.D.
November 2012

In the IRS’s second successful appeal of historic rehabilitation credits for private investors in public projects, the Third Circuit reversed and remanded the Tax Court’s decision in Historic Boardwalk Hall LLC. The IRS victory follows earlier success in Virginia Historic Tax Credit Fund, 639 F.3d 129 (4th Cir. 2011). Prior coverage of the two cases appeared in Tax Matters (April 2011, page 52, and June 2011, page 66, respectively).

The Third Circuit’s decision is likely to affect the syndication of several federal tax credits, including low-income housing credits, new markets credits, and renewable energy credits. Unlike the Fourth Circuit’s earlier decision in Virginia Historic Tax Credit Fund, which the IRS won on appeal and which concerned transitory participation by partners in a state tax credit fund, Boardwalk involved a federal tax credit and a conservatively structured operating partnership. The Third Circuit’s decision suggests that credit structures relying on managing member guaranties, fixed priority returns, and put-and-call exit strategies fail the risk-sharing requirement necessary for a bona fide partnership.

In 1992, the state of New Jersey authorized the New Jersey Sports and Exposition Authority (NJSEA) to rehabilitate and operate East Hall, a government-owned convention center on Atlantic City’s Boardwalk listed as a National Historic Landmark. To generate the funds needed for the project, the NJSEA created Historic Boardwalk Hall (HBH), an LLC treated for tax purposes as a partnership. The NJSEA served as the managing member with a 0.1% ownership interest, and Pitney Bowes invested $17.5 million in return for an investor interest of 99.9%. HBH’s operating agreement allocated 99.9% of the approximately $17.6 million worth of rehabilitation credits from the project to Pitney Bowes, plus a 3% preferred return. The NJSEA, as a tax-exempt authority, received no tax benefit from the credits allocated to it.

The NJSEA and Pitney Bowes also signed a contract containing put and call options. The call option gave the NJSEA the right to purchase Pitney Bowes’ interest, while the put option gave Pitney Bowes the right to demand that the NJSEA purchase its interest. Neither option could be exercised prior to HBH’s holding the property for 60 months, the holding period required by Sec. 47 to avoid recapture of the rehabilitation credits. In separate agreements, the NJSEA guaranteed the projected tax credits to Pitney Bowes and indemnified it against construction risks, environmental hazards, and operating deficits.

The Tax Court (136 T.C. 1 (2011)) sustained the allocation of credits to Pitney Bowes, finding that the partnership served a legitimate business purpose by allowing Pitney Bowes to invest in the renovation. It viewed the 3% return and the rehabilitation credits as a whole, and it pointed out that even though the NJSEA had agreed to indemnify Pitney Bowes for most risks of the project, there was no guaranty that it would be financially able to do so. It concluded that HBH was a valid partnership and that Pitney Bowes was a bona fide partner.

On appeal, the IRS argued that the guaranties of the NJSEA virtually eliminated any downside risk to Pitney Bowes, while the put and call options for repayment of its investment deprived it of any meaningful upside potential. The IRS also asserted, as it had in the Tax Court case, that the partnership was a sham, that HBH did not own the property, and that Pitney Bowes was not a bona fide partner for federal tax purposes.

The Third Circuit, siding with the IRS, found that Pitney Bowes was not a bona fide partner because it did not share sufficiently in the economic risks of the project. The court first considered whether, under the totality-of-the-circumstances test of Culbertson, 337 U.S. 733 (1949), the NJSEA and Pitney Bowes had intended to join together in the conduct of a business enterprise.

It then turned to two decisions of the Second and Fourth Circuits. In TIFD III-E, Inc. (Castle Harbour), 459 F.3d 220 (2d Cir. 2006), the Second Circuit found that a purported partnership interest more closely resembled debt than equity, in that it was largely unaffected by the partnership’s success or failure. In Virginia Historic Tax Credit Fund, the Fourth Circuit applied the disguised-sale rules of Sec. 707(b) to reach a similar conclusion.

The Third Circuit concluded that because Pitney Bowes lacked a meaningful stake in either the success or failure of HBH, it was not a bona fide partner. The court rejected arguments by HBH that the partnership was a legitimate business duly organized under New Jersey law, that Pitney Bowes was a bona fide partner that had made a substantial financial investment in HBH, that NJSEA and Pitney Bowes communicated regularly about the project, and that Pitney Bowes had spent significant time investigating and negotiating the terms of its interest. It found that this evidence related to the form of the overall transaction and did not prove that Pitney Bowes had a meaningful stake in the success or failure of the partnership or disprove that in substance the transaction was a sale of historic rehabilitation tax credits.

Historic Boardwalk Hall, LLC, No. 11-1832 (3d Cir. 8/27/12)

By Janet A. Meade, CPA, Ph.D., University of Houston.

TIGTA: Appeals errors persist  
November 2012

The IRS Office of Appeals continues to make errors in classifying hearings and determining the statute of limitation on collections, the Treasury Inspector General for Tax Administration reported (TIGTA Rep’t No. 2012-10-077).

The audit and report, required annually by statute, indicates that, based on statistical samples studied, the potential number of errors has increased in each of the previous four fiscal years. During that period, the number of new appeal cases under collection due process (CDP) and equivalent hearing (EH) provisions has increased 66%, outstripping Appeals’ case closures each year (see related graphic, “CDP Appeals on the Rise,” below).

Taxpayers that receive a notice of federal tax lien or intent to levy may request a CDP hearing. If the IRS receives the request within 30 calendar days plus five business days of the filing of the lien or 30 days of the notice of intent to levy, it suspends collection action while Appeals provides a CDP hearing. If the taxpayer does not timely request a CDP hearing, the IRS may at its discretion grant an equivalent hearing, which is similar to a CDP hearing except that the IRS is not required to suspend collection action and the taxpayer is not entitled to a judicial review.

Of 70 CDP cases for fiscal year 2011 that TIGTA examined, three were incorrectly classified as EH; of 70 EH appeals, one was misclassified as CDP. Extrapolating to the total number of each type of case, TIGTA estimated that as many as 1,772 CDP cases should have been EH, and 150 EH cases should have been CDP. The combined total, 1,922, compares with an estimated potential 947 misclassified cases from the previous year’s audit.

TIGTA also found that, of the 70 CDP cases studied, Appeals staff had overstated the collection statute expiration date (generally 10 years from the date of assessment) in 13 cases and had understated it in three cases. Extrapolating to all CDP cases for the fiscal year, TIGTA estimated that as many as 9,450 taxpayers may have been affected.

Appeals managers agreed with TIGTA recommendations to provide more training and written guidance to hearing officers and undertake other remedies and to correct the errors found.

TIGTA: IRS unable to detect ITIN fraud; AICPA urges changes  
November 2012

IRS management created an atmosphere that discourages tax examiners from identifying potentially fraudulent applications for individual taxpayer identification numbers (ITINs), the Treasury Inspector General for Tax Administration reported in August (TIGTA Rep’t No. 2012-42-081).

ITINs allow individuals who are not eligible for Social Security numbers to obtain an identification number for tax purposes. TIGTA reported that in 2011, the IRS processed more than 2.9 million ITIN tax returns resulting in tax refunds of $6.8 billion.

TIGTA audited the ITIN program after members of Congress referred complaints from IRS employees regarding the management of the ITIN program. The complaints alleged that IRS management was not concerned about addressing questionable applications and was interested only in the volume of applications that could be processed, regardless of whether they were potentially fraudulent.

TIGTA’s review substantiated many of the allegations in the IRS employees’ complaints. It found procedures for documentation and review of ITIN applications were lax, with a danger of ITIN-related tax fraud going undetected. In particular, TIGTA found that IRS management eliminated successful processes used to identify questionable ITIN application fraud patterns and schemes. The processes and procedures it did use were inadequate to verify each applicant’s identity and foreign status, TIGTA said.

TIGTA recommended that the IRS develop more detailed procedures and deliver adequate training on reviewing documentation supporting ITIN applications to identify questionable documents. It also recommended that the IRS expand the quality review process to include adequate emphasis on whether employees are accurately identifying fraudulent documents and that it revise the criteria for identifying questionable applications.

The IRS agreed with most of the recommendations and has announced plans to implement interim changes based on TIGTA’s findings. One recommendation was that the IRS require only original documents or documents certified by the issuing agency to be provided in support of an ITIN application. The IRS addressed that recommendation in June when it announced it would stop issuing ITINs unless the applicant furnishes original documents or certified copies from the issuing agency with Form W-7, Application for IRS Individual Tax Identification Number (News Release IR-2012-62; see previous Tax Matters coverage, “Original Documents Now Needed for ITINs,” Sept. 2012, page 70). Notarized copies not certified by the issuing agency will not be accepted. The IRS also announced in June that Certifying Acceptance Agents (CAAs) must send the documents to the IRS rather than, as formerly, review them and certify to the IRS that they are authentic, complete, and accurate. For the IRS’s frequently asked questions on the procedures, see

The AICPA urged the IRS to consider the effect of the tighter documentation procedures on ITIN taxpayers and to reconsider its disallowance of notarized copies. The chair of the AICPA Tax Executive Committee, Patricia Thompson, also requested immediate guidance on the changes in an Aug. 28 letter to IRS Commissioner Douglas Shulman.

Thompson noted that the IRS has indicated it may take 60 days or longer to return the documents to applicants, which could cause a hardship, especially with passports, a common form of verification. Certified copies may be difficult or impossible for applicants to obtain. “We have also heard from our members that some prospective ITIN applicants who are currently residing in the United States have been advised by their home country’s consulate that it does not issue certified copies of passports,” Thompson wrote.

Thompson also urged the IRS to continue to allow CAAs to certify identification documents. CAAs can help mitigate tax fraud and are “essential” for applicants who live overseas or in remote locations, she wrote.

The letter also suggested the IRS underestimated the number of applicants affected by the change, pointing out that although the normal filing deadline for individuals for the 2011 tax year had passed, the automatic extended due date of Oct. 15, 2012, had not. Many applicants file on extension because they have filing obligations in multiple jurisdictions and/or need extra time to satisfy the substantial-presence test of Sec. 7701(b), Thompson wrote.

Corporation cannot deduct California business privilege tax in year paid  
November 2012

Banking corporation Wells Fargo, an accrual-basis taxpayer, could not deduct the California business privilege tax it paid in one year (year 1) for the privilege of doing business the next year (year 2), even though California law had since 1972 treated the tax as being incurred in year 1, a federal district court held.

Until 2003, Wells Fargo had deducted the business privilege tax in year 2, but chose to change its treatment to deducting it in year 1 because the obligation to pay those taxes and the amount of those taxes became fixed by the end of year 1 (and Wells Fargo actually paid the tax in year 1 through its estimated tax payments). These facts meant that the “all-events test” by which an accrual-basis taxpayer is able to deduct a liability was met.

The district court found that the all-events test had been met; however, because of a quirk in the federal tax law, Wells Fargo nevertheless could not deduct the tax in year 1. Under Sec. 461(d), which governs the tax year in which a taxpayer can take a deduction for accrued taxes, any change to a state’s tax laws that occurs after Dec. 31, 1960, cannot affect the timing of a deduction. As a result, the court had to determine how California tax law before 1961 would have treated the accrual of the business privilege tax.

Current California law requires a corporation to pay business privilege tax calculated on the basis of its year 1 income for the privilege of conducting business in year 2, even if the taxpayer discontinues operations before the end of year 2. Before 1972, however, the amount of the corporation’s tax liability would be reduced if it discontinued operations in year 2.

Because liability for the California business franchise tax before 1972 was contingent on actually conducting business in California in year 2, the event that would create the liability was not fixed for purposes of the all-events test until year 2, according to the court, and therefore the tax was not deductible until year 2.

Because Sec. 461(d) forbids post-1960 law changes from affecting the timing of the deduction, Wells Fargo therefore had to continue deducting its California business privilege tax in year 2, even though current California law fixes the liability in year 1.

Wells Fargo & Co., No. 09-CV-2764 (D. Minn. 8/10/12)

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