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Second Circuit strikes down part of Defense of Marriage Act  
By Charles J. Reichert, CPA
January 2013

The Second Circuit recently affirmed a New York federal district court decision that allowed the surviving spouse of a same-sex couple to take an unlimited marital deduction when computing the deceased spouse’s estate tax liability. The Second Circuit agreed with the lower court that Section 3 of the Defense of Marriage Act (DOMA), P.L. 104-199, is unconstitutional.

Sec. 2056(a) allows an estate to deduct the value of any property passing from the decedent to a surviving spouse. The law of the state of domicile usually determines whether two persons were married at the time of death when completing an estate tax return. Section 3 of DOMA defines “marriage” and “spouse” for all federal legal purposes and states that marriage can only be “a legal union between one man and one woman,” and a spouse can only be “a person of the opposite sex who is a husband or a wife.” In a previous case, last May, the First Circuit, in Massachusetts v. United States Dep’t of Health and Human Servs., No. 10-2204 (1st Cir. 5/31/12), aff’g Gill v. Office of Personnel Management, 699 F. Supp. 2d 374 (D. Mass. 2010), also held that DOMA violates the Equal Protection Clause of the Constitution because it denies same-sex married couples the same federal benefits, such as filing a joint federal income tax return, afforded most married couples.

For 30 years, Edith Windsor and Thea Spyer were in a committed relationship living in New York City. In 1993, when the option became available in the state of New York, Windsor and Spyer registered as domestic partners, and in 2007 they were married in Canada. Spyer died in 2009, leaving all her assets to Windsor. When Windsor, as executor of Spyer’s estate, filed the estate tax return, she did not claim a marital deduction, resulting in an estate tax liability of $363,053. In 2010, she filed a suit in the U.S. District Court for the Southern District of New York requesting a refund of all of the estate taxes paid, arguing that as the legally married spouse of the decedent, she should have been eligible to claim the marital deduction and that Section 3 of DOMA is unconstitutional. That court agreed with Windsor, and the Bipartisan Legal Advisory Group of the U.S. House of Representatives appealed the decision to the Second Circuit after the Justice Department refused to defend DOMA.

The Second Circuit applied the intermediate scrutiny standard of review to DOMA, a standard that would require DOMA to advance an important government interest by means that are substantially related to that interest for it to be constitutional. The court held that the classification of same-sex spouses in Section 3 of DOMA was not substantially related to an important government interest and, thus, found the provision unconstitutional. Although the Second Circuit in this case and the First Circuit in Massachusetts found Section 3 of DOMA to be unconstitutional, the First Circuit did not apply intermediate scrutiny review. 

  Windsor, No. 12-2335 (2d Cir. 10/18/12), aff’g 833 F. Supp. 2d 394 (S.D.N.Y. 2012)

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

Conservation easements are deductible despite reimbursement provision  
By Janet A. Meade, CPA, Ph.D.
January 2013

The Tax Court upheld charitable donations of conservation easements in a bargain sale, despite a requirement that, in the event of a later disposal of the property and extinguishment of the easements, the donee organization use the proceeds to reimburse the government agencies that funded the purchase. The court determined that the reimbursement provision did not violate the perpetuity requirement of Regs. Sec. 1.170A-14(g) because the donee organization was entitled to an amount at least equal to its proportionate share of the proceeds from any disposition of the properties.

Irby Ranches LLC operated a family-owned cattle ranch in Colorado. In 2003 and 2004, Irby Ranches conveyed conservation easements encumbering two parcels of land to Colorado Open Lands (COL), a qualified charitable organization, in bargain sale transactions. The purchase portion of the transactions was funded with grants from three government agencies. The appraiser hired by COL and the Irbys determined that the easements were worth 60% of one tract’s unencumbered value and 63% of the other’s. Under the terms of the conveyance, COL was entitled to that share of any proceeds should the properties ever be disposed. A reimbursement provision, however, obligated COL to remit most of the proceeds from a disposition to the government agencies as repayment for their funding, leaving COL with 25% of the proceeds.

The IRS disallowed the charitable contribution deduction, arguing that because of the reimbursement provision, the conservation purpose of the easements was not protected in perpetuity. It further contended that the appraisal report was not qualified because it did not state that it had been prepared for income tax purposes. Last, it asserted that Irby Ranches had not obtained contemporaneous written acknowledgment from COL of the contribution, as required by statute.

Generally, a charitable contribution deduction is not permitted for a contribution of less than a donor’s entire interest in property. Sec. 170(f)(3)(B)(iii) provides an exception for a qualified conservation contribution, which must be a qualified real property interest given to a qualified donee organization exclusively for conservation purposes. Regs. Sec. 1.170A-14(g) further requires that the donee organization’s interest must be protected in perpetuity from use inconsistent with the conservation purposes of the donation. In the event future conditions make it impractical to continue the use of the property for conservation purposes, the donee organization must be entitled to a portion of the proceeds from a subsequent disposition at least equal to the proportionate value of the perpetual conservation restriction.

Additional requirements for a deductible charitable contribution in Regs. Sec. 1.170A-13(c) state that certain property valued at $5,000 or more must be appraised by a qualified appraiser whose report must include, among other things, a description of the property, the appraisal dates, the valuation method, the basis for valuation, and a statement that the appraisal was prepared for income tax purposes. A contribution of $250 or more must also be substantiated by a contemporaneous written acknowledgment from the donee organization.

The Tax Court sided with Irby Ranches on all three issues. According to the court, the funding obtained by COL from the government agencies established the validity of the easements’ conservation purpose. Each of the agencies served a conservation purpose consistent with that of COL, and the terms of the grants and reimbursement provision were not negotiable. Further, any extinguishment of the easements and disposition of the properties would result in the proceeds going to COL and, in turn, the government agencies, not Irby Ranches. As such, the reimbursement provision, rather than defeating the conservation purpose of the easements, enhanced the ability of the agencies to conserve and protect more land, since any reimbursed funds would be used for that purpose. The court consequently found that the reimbursement provision was consistent with the requirements of Regs. Sec. 1.170A-14(g).

The court also determined that a discussion in the appraisal report of the purpose of the transaction—to value the donation of conservative easements pursuant to Sec. 170(h)—satisfied the requirement that the report contain a statement that the appraisal was prepared for income tax purposes. Last, the court concluded that a variety of documents, deeds, agreements, and tax forms, taken in their totality, satisfied the requirement of a contemporaneous written acknowledgment.
  Irby, 139 T.C. No. 14 (2012)

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

Subsidiaries’ advance agreements are equity instruments  
By Laura Jean Kreissl, Ph.D. and Darlene Pulliam, CPA, Ph.D.
January 2013

The Tax Court ruled that PepsiCo’s Netherlands subsidiary’s “advance agreements” (AAs) with certain other PepsiCo subsidiaries, newly formed as part of an effort to retain its tax position, were properly characterized as equity for U.S. tax purposes.

Prior to 1996, PepsiCo had a corporate structure that allowed separate Netherlands Antilles subsidiaries to treat interest paid on promissory notes (the pre-’96 notes) to them from PepsiCo and two other subsidiaries as subject to de minimis taxation in the Netherlands Antilles and exempt from U.S. withholding tax. The subsidiaries’ earnings and profits were reduced by foreign partnerships’ deficits in developing the Pepsi brand in new parts of the world, which in turn reduced the amount of interest PepsiCo was required to include under subpart F. In 1996 the subsidiaries transferred ownership of the foreign partnerships to Netherlands holding companies (later merged into a single one) to preserve the tax attributes prior to a Dutch tax treaty amendment that would have made interest on the pre-’96 notes subject to U.S. withholding tax as of Sept. 28, 1996.

Following the formation of these new entities under Netherlands law, PepsiCo issued  them new notes under the AAs, which the new entities had entered into with PepsiCo and its Puerto Rican subsidiary, in exchange for the pre-’96 notes. The AAs were intended to be classified as debt in the Netherlands and as equity in the United States. From a U.S. tax perspective, PepsiCo anticipated that payments to the U.S. entity pursuant to the AAs would be treated as distributions on equity. PepsiCo received a ruling from the Dutch Revenue Service supporting its intended treatment of the AAs.

The draft for the new notes specified that the principal amount was payable in 2011 but that the new, merged Netherlands company had an unrestricted option to extend the payment until 2021. The draft also stated that any “obligation” to pay the principal amount or “preferred return” would be subordinated to all indebtedness of the new company. The finalized AAs provided for payments of principal amounts after initial terms of 40 years, with unrestricted renewal options for 10 years and a separate option of delaying payment of principal for an additional five years. A preferred return that accrued unconditionally pursuant to the agreements would be capitalized into “capitalized base preferred return” and “capitalized premium preferred return” amounts, payment of which was limited by certain “aggregate net cash flow” restrictions. The obligation to repay these amounts was also subordinate to “all the indebtedness … without limitation.”

The IRS assessed deficiencies of approximately $196 million to PepsiCo and $167 million to PepsiCo Puerto Rico for tax years 1998 through 2002. The IRS argued that the substance of the transactions, revealed primarily through the negotiations with the Dutch Revenue Service, was a creditor-debtor arrangement, not the tax-free distributions with respect to stock that PepsiCo purported.

The Tax Court disagreed, citing factors used in resolving prior debt vs. equity inquiries (see Dixie Dairies Corp., 74 T.C. 476 (1980)). Among the reasons supporting equity over debt characterization were:

  • Repayment was not certain, given the “magnitude of the loans and the financially precarious nature of the foreign investments,” and that the foreign entities did not have an unqualified obligation to pay a fixed sum by a fixed maturity date.
  • No legitimate safeguards were afforded to the holders of the AAs to enforce payments.
  • The AAs unequivocally subordinated to its other debts and rights of all creditors any obligation of the new Netherlands company to pay principal or accrued preferred returns.
  • The taxpayers clearly designed the long and possibly perpetual terms of the AAs with the expectation that they would be characterized as equity for U.S. federal income tax purposes.
  • The new Netherlands company’s debt-to-equity ratios of 14.1 to 1 in 1996 and 26.2 to 1 in 1997 indicated that it would have been highly unlikely to get a loan as large as that under the AAs.

Companies need to carefully consider judicial constraints when issuing debt instruments with equity characteristics. Despite the outcome in this case, the IRS is usually successful when those constraints are ignored.

  PepsiCo Puerto Rico, Inc., T.C. Memo. 2012-269

By Laura Jean Kreissl, Ph.D., assistant professor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.

TIGTA: IRS pays millions in unnecessary interest on NOL carrybacks  
January 2013

The Treasury Inspector General for Tax Administration (TIGTA) found that IRS delays in processing net operating loss (NOL) carrybacks result in the IRS’s paying millions of dollars in interest unnecessarily.

According to TIGTA, the IRS pays the excess interest because it does not always process taxpayers’ amended prior returns with NOLs within the 45-day limit imposed by Sec. 6611. TIGTA’s audit of a sample of 2010 individual returns showed that 19% of NOL carryback tax abatements were not processed within 45 days.

Based on these data, TIGTA estimates that the IRS could pay $334 million in avoidable interest payments over the next five years if it does not start processing all NOL cases within the time limit. However, the IRS counters that 2010 had an unusually high number of NOL carrybacks because of a longer carryback period temporarily allowed by the American Recovery and Reinvestment Act, P.L. 111-5, a measure that is not likely to be repeated in future years. TIGTA insists it tailored its estimate to take into account the unusual volume of 2010 NOL carrybacks.

Reasons the carrybacks were not processed within 45 days included multiple reassignments of cases within the IRS, improper priority codes assigned in the IRS’s Correspondence Imaging System (CIS) (which is used to control and assign NOL cases to IRS employees), and failure to issue manual refunds when required, TIGTA said.

IRS procedures require that a manual refund be issued in any case where the NOL carryback is more than $1 million or whenever the 45-day deadline is imminent or has expired. However, 13% of the returns TIGTA sampled met the criteria for a manual refund, but no manual refund was issued. In response to the audit, IRS managers alerted employees to the importance of issuing manual refunds.

TIGTA also found that the IRS does not monitor the amount of interest paid in NOL carryback cases or its compliance with the 90-day period for processing Forms 1045, Application for Tentative Refund.
TIGTA recommended that the commissioner of the IRS Wage and Investment Division:

  • Analyze CIS case reassignments to identify trends and determine the reason for the reassignments and their effect on timely case completion;
  • Modify the CIS to enable a priority code to be revised or added after a case is created;
  • Reevaluate the dollar ranges for the NOL carryback priority codes to verify that they accomplish their intended purpose;
  • Create a process to monitor and track interest paid on carryback cases; and
  • Create a process to monitor adherence to the 90-day statutory period for processing Forms 1045.

IRS management agreed with all the recommendations and plans to take corrective action.
  TIGTA Rep’t No. 2012-40-111

Whistleblower’s claim not entitled to Tax Court review  
January 2013

In a case of first impression, the Tax Court held that it could not order the IRS to reopen an individual’s whistleblower claim under Sec. 7623(b), and the court dismissed his petition.
Sec. 7623(b) authorizes an award to a whistleblower if the IRS proceeds with any administrative or judicial action based on information an individual brings to the IRS’s attention. Under Sec. 7623(b)(4), the Tax Court has jurisdiction to review any award determination the IRS makes. However, the Tax Court has no jurisdiction in cases in which the IRS has not initiated an administrative or judicial action and collected proceeds.
Raymond Cohen submitted a whistleblower claim involving alleged tax law violations by a public corporation. The IRS Whistleblower Office in Ogden, Utah, evaluated his claim and notified him he was not entitled to an award because no proceeds were collected. Cohen then requested the claim be reconsidered, to which the Whistleblower Office replied that the claim was denied because it was based on publicly available information. In his suit, Cohen claimed that he was entitled to a legal and factual explanation of the claim’s denial.
The Tax Court, however, held that the IRS is not obligated under Sec. 7623 to explain its reasons for denying a claim and denied Cohen’s other arguments. The court explained that the IRS’s action was not arbitrary and capricious and therefore did not violate the Administrative Procedure Act because the Whistleblower Office was entitled to deny the claim on the grounds that it cited. Cohen was not entitled to equitable relief because the Tax Court is not a court of equity and Sec. 7623 does not provide for equitable relief.

The Tax Court noted that Sec. 7623(b)(4) authorizes it to review “any award determination,” but that relief was unavailable because the IRS never instituted an action or collected any proceeds. It sympathized with Cohen’s frustration that the IRS did not pursue his claim but reiterated that Congress had not given the court any power to review that failure.

  Cohen, 139 T.C. No. 12 (2012)

Line items  
January 2013

FATCA Deadlines Delayed

The IRS delayed several key deadlines under the Foreign Account Tax Compliance Act (FATCA), some of which otherwise would have taken effect as early as the beginning of 2013 (Announcement 2012-42). The IRS said it had received feedback that complying with the original deadlines and other requirements in proposed regulations (REG-121647-10) was impractical for some taxpayers.

Under the announcement, an obligation will be considered a “preexisting obligation” that is not subject to FATCA withholding if it is maintained or executed by the withholding agent as of Jan. 1, 2014 (instead of 2013). The new date also applies to participating FFIs (foreign financial institutions that enter into withholding agreements with the IRS) and deemed-compliant FFIs (foreign financial institutions that do not have to enter into IRS agreements).

The announcement also amends the transition rules for completing due diligence on existing obligations. Under the new rule, a withholding agent will not be required to withhold on payments made to a prima facie FFI (payees that have indications of being FFIs) for a preexisting obligation prior to July 1, 2014, unless the withholding agent has documentation establishing that the payee is a nonparticipating FFI. A similar rule delays the date participating FFIs must determine the status of a prima facie FFI.

The date by which a withholding agent will be required to document payees that are entities other than prima facie FFIs is delayed to Dec. 31, 2015. A participating FFI will be required to perform the requisite identification procedures and obtain the appropriate documentation to determine whether an entity other than a prima facie FFI is itself a participating FFI by the later of Dec. 31, 2015, or the date that is two years after the effective date of its FFI agreement.

The announcement also delays dates for identifying and documenting preexisting high-value accounts, identifying “recalcitrant” account holders, and filing certain information reports. It also delays withholding by a participating FFI from proceeds of a sale or other disposition producing U.S.-source income to dispositions occurring after Dec. 31, 2016, two years later than previously.

Tax Court Stands Firm on Whitehouse

On remand from the Fifth Circuit of its earlier decision, the Tax Court again held that redevelopers of a New Orleans historic landmark overvalued their qualified conservation contribution of a façade easement on two adjoining buildings, subjecting the partnership to a tax deficiency and an accuracy-related penalty for a gross valuation misstatement.

The case, Whitehouse Hotel Limited Partnership, 139 T.C. No. 13 (2012), involves the Maison Blanche and Kress buildings near New Orleans’s French Quarter. The partnership executed an agreement to redevelop the buildings into a hotel. It also conveyed an easement to the nonprofit Preservation Alliance of New Orleans providing that it would maintain the exteriors’ condition and historic character. Whitehouse subsequently developed the buildings into a Ritz-Carlton Hotel.

Whitehouse claimed on its 1997 federal income tax return a charitable contribution deduction for $7.44 million, the amount an appraiser said reflected the property’s reduction in value caused by the easement. The IRS determined that the allowable deduction should have been $1.15 million.

In earlier proceedings (131 T.C. 112 (2008); see Tax Matters coverage, “IRS, Historic Hotel Face Off Over Façade,” April 2009, page 67), the Tax Court rejected aspects of both sides’ analyses and calculated its own value for a deduction of nearly $1.8 million.

On appeal, the Fifth Circuit vacated the Tax Court’s decision, saying the court had not duly considered the buildings’ highest and best use as a luxury hotel under their likely combination into a single functional unit, which would tend to keep them under single ownership. It also said the Tax Court should further consider the effect on the fair market value of the easement’s prohibition against blocking views of the Maison Blanche building’s façade, thus depriving Whitehouse of an opportunity to build additional stories on top of the Kress building. 

On remand, the Tax Court said the property’s value on its valuation date should have been determined under its second-best use, as a nonluxury hotel. It also reiterated its earlier preference for local, versus national, comparable values. Regarding Whitehouse’s impaired ability to expand atop the Kress building, the Tax Court concluded, as it had earlier, that the evidence did not clearly establish that such a restriction existed, or, if it did, that the condition was enforceable in perpetuity as required by Regs. Sec. 1.170A-14(g)(1). Nonetheless, as instructed by the appellate court, the Tax Court reassessed the easement’s valuation assuming an enforceable restriction. However, using a comparable-sales approach, the court arrived at a figure only slightly higher than its earlier one. It also sustained the application of the accuracy-related penalty.

Dozens Indicted on Stolen Identity Charges

Federal officials in Miami announced indictments on Oct. 11 of 40 people in 20 cases for stolen identity tax refund fraud.

The indictments included one scheme in which three defendants were charged with filing more than 5,000 returns using Social Security numbers of deceased taxpayers to claim fraudulent refunds totaling approximately $14 million, of which more than $6 million allegedly was received and deposited in the defendants’ bank accounts.

Many of the other indictments involved information stolen from living taxpayers, including one in which two employees of a health care provider allegedly stole patients’ personal information and sold it. In another, a husband and wife allegedly operated two tax preparation companies from which they filed false returns for unknowing taxpayers and deposited the fraudulent refunds in the other defendants’ accounts. One defendant was charged with obtaining more than 26,000 stolen Social Security numbers and providing them to co-conspirators to use in filing fraudulent tax returns.

A recent TIGTA report determined that Florida led the nation in stolen identity tax refund fraud, which nationwide went undetected by the IRS more often than not (see previous Tax Matters coverage, “TIGTA Recommends Identity Theft Safeguards,” Oct. 2012, page 65).

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