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Effective date of tangible property regs. delayed  
February 2013

The IRS delayed the mandatory effective date of temporary regulations it issued in December 2011 governing whether tangible property expenses can be deducted or have to be capitalized (T.D. 9564). The temporary regulations originally were to apply to tax years beginning on or after Jan. 1, 2012. In response to numerous comments from taxpayers, in December 2012 the IRS amended the temporary regulations to make them apply to tax years beginning on or after Jan. 1, 2014, instead, but will allow taxpayers to apply the temporary regulations for tax years beginning on or after Jan. 1, 2012, and before the applicability date of final regulations. This makes the use of the temporary regulations optional until 2014. The IRS expects to finalize the regulations in 2013. In Notice 2012-73, the IRS said the final regulations also are expected to apply to tax years beginning on or after Jan. 1, 2014, although taxpayers may choose to apply them to tax years beginning on or after Jan. 1, 2012.

The IRS, recognizing that many taxpayers are expending resources to comply with the temporary regulations, also announced in Notice 2012-73 that when the final regulations are published, the following rules will be revised to simplify them:

The IRS did not specify how these rules would be simplified, but it did note that it would take into consideration comments requesting relief for small businesses.

Taxpayers who choose to apply the rules in the temporary regulations for tax years beginning on or after Jan. 1, 2012, can use the procedures in Rev. Procs. 2012-19 and 2012-20 to obtain automatic consent to change their accounting method. For taxpayers who choose to apply the provisions of the final regulations to tax years beginning on or after Jan. 1, 2012, the IRS says it will publish new automatic consent procedures when the final regulations are issued.

Telecommunication tower leases not subject to self-rental passive income rule  
By Janet A. Meade, CPA, Ph.D.
February 2013

The Tax Court determined that a taxpayer’s rental income from the lease of land and telecommunication towers to his wholly owned S corporation was not subject to the “self-rental rule” of Regs. Sec. 1.469-2(f)(6). Accordingly, the court held, the IRS’s recharacterization of the income as nonpassive was inappropriate. The court, however, agreed with the IRS on the character of rental income from land without towers, holding that the 30% test of Temp. Regs. Sec. 1.469-2T(f)(3) required it to be treated as nonpassive-activity income.

In 2004 and 2005, the years at issue, Francis Dirico leased land and telecommunications towers to his wholly owned S corporation. In exchange, he received a percentage of the S corporation’s revenues from its leasing of tower access to its customers. While the majority of the leases were of land and towers, three were of land only. Dirico sustained net losses on four of the leases of land and towers. On his tax returns he reported each of the individual leases as separate passive activities. Income from the profitable leases therefore offset losses from the unprofitable leases. He also reported the entire amount of his distributive share of income from the S corporation as ordinary business income, which was its character on the Schedule K-1 issued to him.

Sec. 469 defines a passive activity as either an activity involving the conduct of a trade or business in which the taxpayer does not materially participate or a rental activity. It further limits deductions of losses from passive activities to the extent of passive income. Under the self-rental rule of Regs. Sec. 1.469-2(f)(6), rental income received for the use of property in a trade or business activity in which the taxpayer materially participates is treated as nonpassive-activity income. This rule equalizes the tax treatment of taxpayers who place property used in their business in a separate entity with those who retain the property in the same entity as the business operations. It also prevents them from artificially creating passive income to offset losses from other passive activities. The rule, however, does not cover losses from a self-rental activity; those are still passive losses deductible only to the extent of passive income.

The IRS asserted that the income from the land and tower leases to the S corporation was from property used in a trade or business in which Dirico materially participated. Thus, it applied the self-rental rule to recharacterize the income from the profitable leases as nonpassive-activity income, but not the losses. It then argued that the income from the land-only leases was nonpassive because that characterization is required under Temp. Regs. Sec. 1.469-2T(f)(3) when less than 30% of the unadjusted basis of leased property is subject to depreciation. The overall effect of the IRS’s adjustments was to disallow the losses from the unprofitable leases, while taxing the income from the profitable leases.

The Tax Court determined that the applicability of the self-rental rule depended on whether the S corporation used the leased land and towers in a trade or business activity. According to the court, the leasing of tower access to third-party customers was clearly a rental (not a trade or business) activity, and Dirico’s participation in the activity consequently was irrelevant, as the self-rental rule did not apply. The erroneous reporting on Dirico’s Schedule K-1 of the entire amount of the S corporation’s income as ordinary business income did not alter the underlying facts. However, since the land-only leases were not provided in connection with any of the leased towers, the court found that they needed to be grouped separately from the land and tower leases under Regs. Sec. 1.469-4(d)(2). Application of the 30% test was therefore appropriate, and because less than 30% of the unadjusted basis of the land-only leases was depreciable, the income from those leases was characterized as nonpassive-activity income.

Although not discussed in the case, the question of whether income is properly characterized as passive takes on added importance with the new 3.8% Medicare tax on net investment income scheduled to begin in 2013. Tax advisers should consider the implications of this tax when determining the appropriate grouping of separate activities.

 Dirico, 139 T.C. No. 16 (2012)

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

Estate’s settlement payments not deductible  
By Charles J. Reichert, CPA
February 2013

The Tax Court recently held that an estate’s settlement payment to one of its beneficiaries was not deductible since the payment lacked adequate consideration and was consistent with the decedent’s wishes expressed in her will.

When computing its taxable estate, an estate can deduct a claim against it that represents an enforceable personal obligation of the decedent existing on the date of the decedent’s death. In addition, a claim must be founded on a genuine promise or agreement involving full and adequate consideration and cannot be the result of the decedent’s testamentary intent.

In 1997 and 1998, Sylvia Bates executed a will and codicil that would, upon her death, create a trust to be funded by the assets that remained in her estate after all expenses were paid. The trust, to be administered by her granddaughter, Sheri Beersman, would distribute the majority of the trust assets equally to Bates’s three grandchildren and give $100,000 to Reggie Lopez, an unrelated individual with whom Bates had a close relationship. Beginning in 2004, Bates paid Lopez to help her with various tasks after she was diagnosed with Alzheimer’s disease. He was fully paid for his services. In 2005, Bates executed a second will that altered the first will and trust. It named Lopez as executor and trustee and provided that Scott Cable, another of the three grandchildren, would receive all of Bates’s personal property, and that Cable and Lopez would each receive half of the trust interest income.

Bates died on Feb. 18, 2005, and Lopez received $23,113 from a life insurance policy owned by Bates. Both wills were submitted for probate, and after nearly a year of legal wrangling, the heirs reached a settlement in which Lopez would receive $575,000 in full satisfaction of all claims related to the estate. In 2006, a court granted Beersman the authority to administer the estate. On the estate tax return, the estate deducted as administrative expenses $498,113, which consisted of the $575,000 settlement payment to Lopez plus the life insurance proceeds of $23,113, minus the $100,000 bequest to him. The IRS disallowed the deduction in its entirety, and in 2010 the estate petitioned the Tax Court for relief.

The IRS argued that the holding in Estate of Huntington, 100 T.C. 313 (1993), aff’d, 16 F.3d 462 (1st Cir. 1994), applied. The court in Estate of Huntington found settlement payments to beneficiaries were not deductible since they lacked adequate consideration and were consistent with the decedent’s testamentary intent. Bates’s estate argued that the payments in Estate of Huntington were made to family members, and the case at hand was different because Lopez was not a member of the decedent’s family. The court disagreed and held the reasoning in Estate of Huntington applies equally to cases involving nonfamily members. Even though Lopez was not a family member and other beneficiaries did not want him to receive any assets, he was named as a beneficiary in both trusts and had a legitimate interest in the estate, according to the court. Thus $475,000 of the settlement payment was not deductible.

The estate argued the life insurance proceeds of $23,113 were stolen from the estate since Lopez named himself as the beneficiary, and therefore the amount should be deducted as an administrative expense. The court disagreed, holding that the expenses did not satisfy the requirements of Regs. Sec. 20.2053-3(a), which defines administration expenses as those incurred “in the collection of assets, payment of debts, and distribution of property to persons entitled to it.”

  Estate of Bates, T.C. Memo. 2012-314

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

IRS won’t follow Wandry  
February 2013

In Action on Decision 2012-004, the IRS stated it will not acquiesce to the Tax Court’s decision in Wandry, T.C. Memo. 2012-88, in which the court accepted a taxpayer’s use of a defined value formula clause.
In Wandry, decided in March 2012, the taxpayers, Joanne and Albert Wandry, executed assignments and memorandums of gifts to their four children and five grandchildren designed to not exceed their annual and remaining lifetime gift exclusion amounts of $1,099,000 for each taxpayer. Each gift document transferred an unstated number of units of the couple’s member interests in their family limited liability company (LLC) having a fair market value (FMV) equal to $261,000 to each child and $11,000 to each grandchild. The documents further stated that although the number of units was fixed on the date of the gift in 2004, the number was based on the FMV of the gifts as determined after that date, based on “all relevant information.” The donors stated their intent to base the value on an independent third-party appraisal by a qualified appraiser, but that, if the IRS or a court later made a final determination of a different value, the number of gifted units would be adjusted to maintain the dollar values stated in the documents. They obtained an appraisal that determined the value of a 1% member interest in the LLC as of the date of gift.

On their gift tax returns for 2004, the couple reported the dollar amounts of the gifts and, based on the appraisal, further described the gifts as interests of 2.39% and 0.101% in the LLC to each child and grandchild, respectively. The LLC’s financial records for 2004 showed capital account transfers from the donors to the donees that were greater than the dollar amounts in the gift documents.

The IRS redetermined the value of an LLC member interest unit and, applying the gift percentages, increased the values of the gifts. After negotiations, the parties agreed that the percentage interests given each child and grandchild would yield values of $315,800 and $13,346, respectively. However, the taxpayers continued to argue in a petition to the Tax Court that they had not transferred fixed LLC percentage interests. The IRS contended that the gift tax returns, capital accounts, and the gift documents themselves all supported fixed percentages. It also argued the adjustment clause created a “condition subsequent” to completed gifts and thus was void as contrary to public policy, as courts have held in a line of cases from Procter, 142 F.2d 824 (4th Cir. 1944). Such “savings clauses” allow donors or estates to “take property back” in an amount necessary to avoid transfer taxes.

The Tax Court held that despite the gift return’s percentages, there was no evidence the donors intended to give more than the fixed dollar amounts, and that the capital accounts were not controlling. The gift documents did not state a number of LLC units transferred, but the number was nonetheless predefined as a mathematical formula of which the only unknown was the LLC’s FMV, the court said. This, the court noted, was similar to the holding of the Ninth Circuit in Estate of Petter, 653 F.3d 1012 (9th Cir. 2011), aff’g T.C. Memo. 2009-280. In Petter, the additional property transferred under a formula clause was transferred to a charity, and the estate claimed a charitable deduction of the amount (see previous Tax Matters coverage Nov. 2011, page 74). The lack of a charitable component in Wandry did not raise any “severe and immediate” public policy concern, the Tax Court said. The mechanism to determine the allocation between donors and donees did not operate to take property back and was a valid adjustment, not an impermissible savings clause, the court held.

Following the decision in Wandry, the IRS filed an appeal with the Tenth Circuit but in October withdrew it without explanation. In the action on decision, the IRS reiterated its long-held position that “the final determination of value for federal gift tax purposes is an occurrence beyond the taxpayers’ control.” A gift is complete for federal tax purposes when the donor parts with dominion and control and any power to change its disposition, the IRS said, citing Regs. Sec. 25.2511-2(b). The gifts in Wandry were complete on the date of gift as fixed percentage interests, it said. In Petter, any adjustment went to a charity, not to the donor, so the court did not have to consider whether the gift was complete, the IRS said. Thus, in Wandry, the IRS said, the Tax Court erred in considering the gifts as anything other than fixed percentage interests.

For more, see “Formula Clauses: Adjusting Property Transfers to Eliminate Tax” in the February 2013 issue of The Tax Adviser and “New Life for Charitable Lids,” JofA, Sept. 2010, page 50.

Ninth Circuit agrees farming activity is partnership  
By Alice A. Upshaw, CPA, MPA, CMA and Darlene Pulliam, CPA, Ph.D.
February 2013

The Ninth Circuit agreed with the Tax Court that a father-son farming and logging operation was a partnership for federal income tax purposes and that the father’s deduction of the bulk of the activity’s expenses on his individual return was not acceptable.

William and Randal Holdner operated a farming activity, Holdner Farms. Randal, the son, conducted the farm’s day-to-day physical operations, and William, the father, who was also a practicing accountant, was responsible for sales, purchasing, financing, and accounting. Each party reported one-half of the activity’s gross income for tax purposes. However, William Holdner allocated the expenses between himself and his son arbitrarily. Most of the expenses he allocated to himself and deducted on his tax return’s Schedule F, Profit or Loss From Farming, claiming a net loss in each of the years at issue, 2004–2006. Although the Holdners did not file a partnership return for Holdner Farms, upon examination of their individual returns, the IRS determined that Holdner Farms was a partnership in which the Holdners held equal ownership interests and that they must allocate the income and expenses from the partnership accordingly. The IRS also assessed an accuracy-related penalty against William Holdner for the years under examination because of the improper deductions of Holdner Farms’ expenses.

In analyzing the Holdner Farms activity, the Tax Court used the eight-factor test from its opinion in Luna, 42 T.C. 1067 (1964), for determining whether an enterprise is a partnership for federal income tax purposes. The court concluded that seven of the eight Luna factors supported characterizing the activity as a partnership. The court also determined there was not substantial proof that the Holdners did not hold equal interests in the partnership and therefore the income, expenses, and other partnership items should be allocated equally between them. It also sustained the accuracy-related penalty against William Holdner because, as a practicing accountant with many years’ experience, he did not act reasonably in allocating a disproportionate share of Holdner Farms’ expenses to himself.

In a short, unpublished opinion, the Ninth Circuit agreed with the Tax Court that Holdner Farms operated as a partnership for the years at issue.

  Holdner, No. 11-71593 (9th Cir. 10/12/12), aff’g T.C. Memo. 2010-175

By Alice A. Upshaw, CPA, MPA, CMA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Business, both of the College of Business, West Texas A&M University, Canyon, Texas.

Comments sought on COD reporting  
February 2013

In Notice 2012-65, the IRS asked for public comments on whether it should amend existing Regs. Secs. 1.6050P-1(b)(2)(i)(H) and (iv), which require applicable financial entities to issue Forms 1099-C reporting cancellation of debt (COD) income when a 36-month nonpayment testing period has expired.

Under Sec. 6050P and its regulations, COD income of $600 or more must be reported on Form 1099-C, Cancellation of Debt, when any of eight identifiable events occur. Seven of these events are specific instances that actually result in a discharge of debt, such as an agreement between the creditor and debtor. The eighth, the expiration of the nonpayment testing period, does not actually result from a discharge and may be difficult to determine. It may also be confusing to debtors who receive these forms and do not know whether to report the amount in income.

The nonpayment testing period is a 36-month period during which a creditor has not received any payment from the debtor, which creates a presumption that the loan was discharged, thus triggering the Form 1099-C filing requirement. The creditor can rebut this presumption by showing significant, bona fide collection activity or other facts and circumstances that indicate the debt has not been discharged.

The nonpayment testing period was added to the regulations in 1996 in response to creditors’ concerns that the prior facts-and-circumstances test for determining when an identifiable event had occurred was not sufficiently clear to allow them to determine when reporting was required. Commenters requested that reporting be required only after a fixed period during which no collection efforts have been made. The result was the 36-month nonpayment testing period.

However, the IRS has determined that, although creditors must file Form 1099-C at the end of the period, it does not mean the debt has necessarily been canceled. This can then cause confusion about whether the recipient of the form must report the amount on the form as COD income.

The IRS is therefore requesting comments on the following issues:

  • Whether Regs. Secs. 1.6050P-1(b)(2)(i) should be amended to remove the nonpayment testing period as an identifiable event.
  • Whether removing the nonpayment testing period would increase or decrease creditors’ and taxpayers’ burden.
  • If the nonpayment testing period is removed, what rules should be added to address continuing collection activity?
  • If the nonpayment testing period is retained, how can it be modified to make it less confusing?

Comments, which must be received by Feb. 11, 2013, can be sent by mail, email, or hand delivery to the addresses listed in the notice.

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