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Dow SLIPs in court  
By Charles J. Reichert, CPA
May 2013

The U.S. District Court for the Middle District of Louisiana disallowed deductions generated by two Special Limited Investment Partnerships (SLIPs) transactions because the transactions lacked economic substance and did not have a nontax business purpose. In addition, the court found that the two partnerships at the heart of the transactions were sham partnerships because they lacked a true business purpose. The court also ruled that some of the purported partners were not true equity partners because they received guaranteed returns similar to those of a creditor.

Transactions that lack economic reality may be disregarded for tax purposes under the economic substance doctrine (as applied in the Fifth Circuit, which Louisiana is in, under the test from Klamath Strategic Investment Fund, 568 F.3d 537 (5th Cir. 2009)) if the taxpayer fails to establish that the transaction had a reasonable possibility of profit and was entered into for a legitimate nontax business purpose. A partnership will also be disregarded for tax purposes if its partners do not intend “to join together for the purpose of carrying on the business and sharing in the profits and losses or both” (Culbertson, 337 U.S. 733 (1949)). Despite engaging in a transaction with economic substance, a partnership will be disregarded for tax purposes if there is no legitimate business reason for the entity to operate as a partnership.

In 1993, two subsidiaries of Dow Chemical joined with five foreign banks to form Chemtech I, a SLIPs entity. SLIPs was a complex marketed tax shelter involving circular cash flows and the allocation of taxable income to a tax-exempt foreign investor and tax deductions to a U.S. taxpayer. In 1993, Dow Chemical contributed low- or zero-basis patents to Chemtech I, which leased them back to Dow. From 1993 to 1997, Dow made royalty payments to Chemtech I approximating $526 million. During those years, Chemtech I loaned Dow about $543 million and made annual interest-like payments of $13.9 million to the foreign banks. Dow deducted the $526 million royalty payments on its 1993–97 tax returns, while Chemtech I allocated about $383 million and $143 million of its reported taxable income to the foreign banks and Dow, respectively.

At the end of 1997, Chemtech I was terminated due to new Treasury regulations effective at the beginning of 1998, prompting Dow to create Chemtech II, another SLIPs entity. The new transaction also involved the transfer of an appreciated asset (a chemical plant) by Dow to the partnership, circular cash flows, and rental deductions to Dow. A Sec. 754 election at Chemtech II’s inception allowed it to increase the basis of the chemical plant, and virtually all of the resulting depreciation deductions flowed back to Dow on its 1999 to 2003 tax returns. Also, from 1999 to 2003, some of Chemtech II’s income flowed back to Dow, while a foreign bank involved in the partnership received an interest-like payment.

The IRS issued a final partnership administrative adjustment to Chemtech I in 2006 and Chemtech II in 2007. The tax matters partner of each partnership petitioned the district court for a readjustment, and the cases were consolidated for tax years 1993 to 2003.

The court held that the Chemtech transactions were sham transactions that lacked economic substance, since the circular flow of money did not change Dow’s financial position. According to the court, the Chemtech transactions had no business purpose other than tax avoidance, despite Dow’s argument that the purpose was to increase its credit rating and maintain its debt-to-capital ratio by providing off-balance-sheet financing. The court held that there were cheaper and less complex ways of achieving that goal and that a prudent business owner would not have used the SLIPs without their inherent tax benefits.

The court also held that Dow’s SLIPs transactions created sham partnerships since “Dow and the foreign banks did not ‘in good faith and acting with a business purpose’ join together in the present conduct of an enterprise” (slip op. at 55–56, quoting Culbertson, 337 U.S. at 742). According to the court, there was no intent to raise additional revenue from the transferred patents, the cash flows were circular, and one of the partners received a specified guaranteed return. Also, the court held that the foreign banks were not actual partners, since their interests resembled debt rather than equity due to their guaranteed return.

The court also upheld the IRS’s assessment of a 20% penalty on the underpayments of tax from both transactions because the underpayments were due to negligence and a substantial understatement of income tax. However, it rejected the IRS’s claim that a 40% penalty for an underpayment due to a gross valuation misstatement should apply to the Chemtech II transaction.

Chemtech Royalty Associates, L.P., Nos. 05-944-BAJ-DLD, 06-258-BAJ-DLD, and 07-405-BAJ-DLD (M.D. La. 2/26/13)

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

Long-awaited final regs. issued on noncompensatory partnership options  
May 2013

The IRS issued regulations (T.D. 9612) finalizing proposed regulations (REG-103580-02), which were issued in January 2003, on the treatment of certain call options, warrants, convertible debt, and convertible equity that are not issued in connection with the performance of services, i.e., noncompensatory partnership options.

The final regulations apply to noncompensatory options that are issued on or after Feb. 5, the day they were published in the Federal Register.

The final rules, which explain the income tax consequences of issuing, transferring, and exercising noncompensatory partnership options, apply only if the call option, warrant, or conversion right grants the holder the right to acquire an interest in the issuer (or cash measured by the interest’s value). The exercise of a noncompensatory option generally will not cause either the issuing partnership or the option holder to recognize gain or loss.

In addition, the final rules amend the Sec. 704(b) regulations governing the maintenance of the partners’ capital accounts and the determination of the partners’ distributive shares of partnership items. Finally, the final regulations contain a rule providing that the holder of a call option, warrant, convertible debt, or convertible equity issued by a partnership (or an entity eligible to elect to be treated as a partnership under Regs. Sec. 301.7701-3(a) that would become a partnership if the option holder were treated as a partner) is treated as a partner under certain circumstances, which are called measurement events (preamble to T.D. 9612).

In a related development, the IRS issued proposed rules (REG-106918-08) added to the final regulations discussed above. Under the final regulations, the holder of a noncompensatory option is recharacterized as a partner under certain circumstances. The final rules contain a number of measurement events for determining when this recharacterization occurs, and the proposed rules add three measurement events involving certain transfers of interests in the issuing partnership and lookthrough entities.

The proposed rules also change the Sec. 1234(b) regulations, clarifying that for purposes of this section, a security includes a partnership interest (preamble to REG-106918-08). The proposed rules apply the same day the final regulations took effect, Feb. 5.

LLC’s use of deferral method for advance payments upheld  
By Beth Howard, CPA, Ph.D.
May 2013

The Tax Court found that an IRS Criminal Investigations Division agent and his wife, a school manager, could use the deferral method to report certain advance payments relating to their private school LLC-partnership. Further, the court upheld the treatment of payments that the couple made to the LLC-partnership as capital contributions and determined that the IRS failed to prove that the taxpayers lacked basis to deduct passthrough losses from the LLC-partnership. The Tax Court did, however, redetermine the LLC-partnership’s business expenses, disallowing some items due to lack of business purpose or lack of substantiation.

Aimee and Ryan Cvancara formed Desert Academy, a private early-elementary school, in 2003. For federal income tax purposes, the couple elected to treat the school as a partnership. The partnership’s initial Form 1065, U.S. Return of Partnership Income, did not indicate whether it was using the cash method or the accrual method to determine income, but it did indicate on its partnership returns for years 2004 through 2006 that the accrual method was used. Desert Academy deferred recognition of advance payments received during these years. During 2005 and 2006, two of the couple’s children attended Desert Academy. The couple made substantial payments to Desert Academy over the years and did not charge tuition for their children during 2005 and 2006. The Cvancaras reported losses from Desert Academy on their individual income tax return for 2003 through 2007. In 2009, the IRS determined deficiencies in the couple’s income tax related to tax years 2005 and 2006.

Advance payments. Regs. Sec. 1.446-1(c)(ii)(A) states that, generally, under the accrual method, income should be included in the tax year in which the right to the income is fixed and the amount of the income can be determined with reasonable accuracy. However, the IRS has recognized that it is sometimes appropriate to defer advance payments for services on a limited basis, and Rev. Proc. 2004-34 allows accrual-method taxpayers to use the deferral method to account for certain advance payments. Under the deferral method, a taxpayer must include the advance payment in gross income in the year received, to the extent that it is recognized in revenues in the taxpayer’s financial statements. The remaining amount of the advance payment must be included in income in the following tax year.

The IRS asserted that Desert Academy’s income should be determined using the cash method because the school’s records were incomplete and because the school used the cash method to account for its expenses. Further, the IRS contended that Desert Academy was ineligible to use the deferral method as described in Rev. Proc. 2004-34 because the advance payments were subject to a condition subsequent and, thus, were considered earned in the year of receipt.

The Tax Court determined that Desert Academy elected to use the accrual method of accounting and to use the deferral method for advance payments it received. The court pointed out that the IRS’s argument that the deferral method was inappropriate because the advance payments were subject to a condition subsequent was based on a misreading of Rev. Proc. 2004-34. According to the court, the revenue procedure does not make the existence of a condition subsequent controlling. Rather, it states that determining whether an amount is earned in a subsequent year must be done “without regard to whether the taxpayer may be required to refund the advance payment upon the occurrence of a condition subsequent.” Because Desert Academy was entitled to retain the advance payments only if it provided the services that it agreed to provide, it earned the advance payments in the year that the services were provided without regard to any condition subsequent. Thus, the court determined that Desert Academy properly applied the deferral method for the advance payments it received.

Partners’ payments to Desert Academy and basis in Desert Academy. Sec. 721(a) states that, generally, no gain or loss should be recognized by a partnership or its partners when a contribution of property is made to the partnership in exchange for a partnership interest. The partner’s basis in the partnership interest under Sec. 722 is the amount of money contributed plus the adjusted basis of other property contributed and is increased by the amount of gain recognized by the partner. According to Secs. 702(a) and 704(d), partners can generally deduct their share of the partnership’s losses to the extent that the partner has basis in the partnership.

The IRS contended that payments made by the couple to Desert Academy during 2005 and 2006 should be treated as tuition for two of the couple’s children rather than as capital contributions to the school. The IRS noted several cases in which the court had disallowed charitable contribution deductions, deeming the payments instead to be tuition payments because they were made in anticipation of receiving a substantial benefit in return. In addition, the IRS claimed that the taxpayers lacked basis in Desert Academy to be able to deduct its losses for 2005 and 2006.

The Tax Court ruled that the Sec. 170 provisions related to charitable contributions do not apply to this case. Further, the court reasoned that the couple’s payments to Desert Academy were capital contributions in substance rather than tuition payments. The couple did not make these payments anticipating receiving a benefit from the school, but instead made the payments because the school needed additional capital contributions to remain in operation.

With regard to basis, the court found that the IRS had the burden of proof because it had did not make a determination of the couple’s basis in Desert Academy in the notice of deficiency. The court further determined that the IRS had not proved that the taxpayers had insufficient basis to deduct Desert Academy’s losses in 2005 and 2006.

Redetermination of cost of goods sold. Sec. 162(a) allows a taxpayer to deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business. However, Sec. 6001 provides that a taxpayer must generally maintain adequate records to substantiate the deductions or credits claimed.

The Tax Court redetermined Desert Academy’s cost of goods sold, disallowing some of the claimed expenses. The court determined that the taxpayer kept inadequate records to substantiate some of the expenses and that some of the expenses had no apparent business purpose. However, the court did allow 50% of the cost of certain items that lacked itemized receipts to be deducted, after reasoning that a significant percentage of the expenses were deductible business expenses.

Cvancara, T.C. Memo. 2013-20

By Beth Howard, CPA, Ph.D., assistant professor of accounting, Tennessee Technological University, Cookeville, Tenn.

Most whistleblower awards still under pre-2006 law  
May 2013

In its latest annual report to Congress on the whistleblower program Feb. 13, the IRS said it received hundreds of submissions during the 2012 fiscal year (FY) that appeared to meet the higher underpayment threshold for enhanced awards, enacted in 2006. Nearly all of the awards paid during the fiscal year for such claims, however, were still under the previous law. The IRS is required to report to Congress each year on the program’s results and legislative and administrative recommendations for improving it.

Under Sec. 7623(b), which was amended in 2006, the IRS is required to pay awards of specified percentages of collected proceeds if a whistleblower provides information that contributes substantially to the collection of tax, penalties, interest, and other amounts when the amounts in dispute are more than $2 million. The law also established an IRS Whistleblower Office to administer those awards. Before the law was amended, the whistleblower awards were determined at the IRS’s discretion.

In the report, the IRS noted that, in FY 2012, it received 332 submissions involving 671 taxpayers that appeared to meet the $2 million threshold. It paid 128 claims in FY 2012, 12 of which were more than $2 million. Of those 12, however, most were under the pre-2006 law because, as the IRS explained, proceeds cannot be distributed to whistleblowers until the taxpayers involved have exhausted all of their administrative and judicial remedies, which can take many years to complete.

Among the issues the IRS noted need addressing are:

  • The process of pursuing a whistleblower claim does not provide adequate protection from disclosure of the taxpayer’s confidential return information for the taxpayer whose taxes are at issue in the case.
  • Unlike other whistleblower statutes, Sec. 7623 does not protect whistleblowers against retaliation.
  • Statutory limitations on the definition of “collected proceeds” prohibit the IRS from paying amounts collected in criminal tax proceedings and amounts collected as penalties for failure to file forms including Bank Secrecy Act and Foreign Bank Account Reports (Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts, commonly called “FBAR”).
  • Clarification is needed of what is meant to constitute the “amount in dispute” to determine whether it exceeds $2 million and how to determine whether an individual’s “gross income” exceeds $200,000.
  • In some criminal cases, grand jury secrecy laws prevent the IRS from knowing the extent of a whistleblower’s contribution to a particular case.


TIGTA: Noncash charitable contribution claims still often erroneous  
May 2013

The Treasury Inspector General for Tax Administration (TIGTA) estimated that more than 273,000 taxpayers claimed $3.8 billion in potentially erroneous noncash charitable contribution deductions in tax year 2010. The audit report’s findings (Rep’t No. 2013-40-009) echoed TIGTA’s previous examinations of noncompliance in 2007 and 2009.

In the latest review, released in December, TIGTA analyzed statistical samples of returns of 507 individuals claiming large amounts of noncash charitable contribution deductions. In 303 of them, or nearly 60%, taxpayers did not comply with the reporting requirements. These noncompliant returns represented more than $200 million in unsubstantiated claimed contributions. Issues contributing to noncompliance included a lack of proper attached forms; incorrectly completed Forms 8283, Noncash Charitable Contributions, or those with incorrectly reported items; and unclear descriptions of donated property.

The error rate was 74% for contributions of $5,000 to $500,000, but because of the smaller amounts involved, these errors yielded a total of $2.7 million in unsubstantiated contributions. Most of the total $201.6 million in unsubstantiated contributions were from contributions of more than $500,000. TIGTA then extrapolated from the samples to estimate the potential extent and revenue cost of unsubstantiated noncash charitable contributions for all taxpayers for 2010.

In its March 2007 audit report on the issue, the IRS agreed to TIGTA’s recommendation that it flag for examination returns claiming noncash charitable contributions of more than $500 that lacked a Form 8283. However, in the 2012 report, TIGTA found that 18% of the errors it found in returns claiming noncash charitable contributions of more than $5,000 involved missing documents, and none of those returns had been examined by the IRS. TIGTA recommended, and the IRS agreed, that the IRS should expand its processes to identify all returns claiming noncash charitable contributions of more than $500 that lack an attached Form 8283 (as required by Sec. 170(f)(11)(B) and Prop. Regs. Sec. 1.170A-16(c)) and those of more than $500,000 lacking an attached qualified appraisal (as required by Sec. 170(f)(11)(D) and Prop. Regs. Sec. 1.170A-16(e)). The IRS also agreed to revise Form 8283 and its instructions to require taxpayers to include the contribution date in addition to the donee acknowledgment of receipt for donations of noncash property of more than $5,000; to clarify that for purposes of the reporting threshold, taxpayers must group similar items and aggregate their value; and to require taxpayers claiming contributions of securities to include the number of shares donated.

The TIGTA report also found problems with claimed donations of motor vehicles. In about 42% of tax returns with a Form 1098-C, Contributions of Motor Vehicles, Boats, and Airplanes, the IRS did not have on file a copy of the form from the donee, or the value of the donation claimed did not match the IRS’s records. TIGTA recommended matching copies of Form 1098-C submitted with taxpayers’ returns with its records and that the IRS develop a process to identify donees that fail to file the form. The IRS disagreed with the former recommendation, noting that the copy of Form 1098-C is a supporting document only and said it will monitor the effectiveness of its outreach program to advise donee organizations of the filing requirement.

Line items  
May 2013

Co-op Lessee Has Property Interest in Collapsed Wall

The Second Circuit determined that a lessee of a cooperative housing corporation held a property interest in the co-op’s common outdoor areas sufficient to allow her to claim a casualty loss deduction stemming from a collapsed retaining wall.

Thus, the Second Circuit vacated and remanded the Tax Court’s decision in Alphonso, 136 T.C. 247 (2011), vacated and rev’d, No. 11-2364-ag (2d Cir. 2/6/13). For coverage of the Tax Court proceedings, see “Tax Matters: Co-ops and Casualties,” June 2011, page 66.

The 70-foot-tall wall at the co-op, Castle Village in New York City, collapsed in 2005. Christina Alphonso was one of approximately 200 Castle Village tenant-shareholders who claimed a casualty loss deduction (in her case, $23,188) on their income tax returns for payment of their assessments by the co-op to rebuild the wall and repair related damage.

While noting that a leasehold interest could entitle its holder to a casualty loss deduction (citing Towers, 24 T.C. 199 (1955)), the Tax Court held that Alphonso’s lease agreement allowed her only to use the grounds and other common areas including the wall. Therefore, the court held, she held no ownership interest in them.

The Second Circuit noted, however, that the “house rules” allowing use of the grounds were incorporated by reference into Alphonso’s lease agreement. The court held this made her right to use the grounds part of a leasehold interest for which a casualty loss might be claimed.

On remand, the Tax Court will consider whether the wall’s collapse was a casualty within the meaning of Sec. 165(c)(3). For more, see “Tax Practice Corner: When Is a Casualty ‘Sudden, Unexpected, or Unusual’?”.

2013 Automobile Depreciation Limits Released

The IRS issued the 2013 inflation adjustments to the depreciation limitations and lease inclusion amounts for certain automobiles under Sec. 280F (Rev. Proc. 2013-21).

For passenger automobiles (other than trucks or vans) placed in service during calendar year 2013 to which 50% first-year bonus depreciation applies, the depreciation limit under Sec. 280F(d)(7) is $11,160 for the first tax year. Trucks and vans to which bonus depreciation applies have a slightly higher limit: $11,360 for the first tax year.

For passenger automobiles (other than trucks or vans) placed in service during calendar year 2013 to which bonus depreciation does not apply, the depreciation limit under Sec. 280F(d)(7) is $3,160 for the first tax year. For trucks and vans to which bonus depreciation does not apply, the limit is $3,360 for the first tax year.

Bonus depreciation does not affect the limits after the first year. For passenger automobiles, the limits are $5,100 for the second tax year; $3,050 for the third tax year; and $1,875 for each successive tax year. For trucks and vans, the limits are $5,400 for the second tax year; $3,250 for the third tax year; and $1,975 for each successive tax year.

Sec. 280F(c) limits deductions for the cost of leasing automobiles, expressed as an income inclusion amount according to a formula and tables prescribed under Regs. Sec. 1.280F-7. The revenue procedure provides an updated table of the amounts to be included in income by lessees of passenger automobiles and another for trucks and vans, in both cases with lease terms that begin in calendar year 2013.

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