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The Tax Court has concluded that a taxpayer who sold his primary residence and excluded gain, then reacquired it after the buyers defaulted, had to recognize long-term capital gain on the reacquisition, including amounts previously excluded.
In 2006, Marvin Debough sold his personal residence, which he had owned for 40 years. Under the terms of the sales contract, the buyers were to make installment payments until July 2009, at which time the remaining balance would become due and payable.
In 2006, 2007 and 2008, Debough received payments from the buyers. After excluding $500,000 of the gain from the sale of a principal residence and making an installment sale calculation, Debough reported $56,920 of taxable gain during 2006-2008. During those years, he received $505,000 of principal payments from the buyers.
Subsequently, the buyers failed to comply with the terms of the contract, and Debough ultimately reacquired the property in 2009. After some debate, both Debough and the IRS agreed on the basis of the property sold that he had gain to recognize as a result of reacquiring the property. They disagreed as to the amount.
Debough thought that most of the gain should be excluded as gain from the sale of a principal residence. The IRS determined that his gain was $448,080 – the $505,000 cash Debough had received during 2006-2008, less the $56,920 gain he reported during those years.
Internal Revenue Code Section 1038 governs reacquisitions of real property and provides the rules regarding a reacquisition of a principal residence for which gain had been excluded. If the reacquired property is resold within one year of the reacquisition, the resale is treated as part of the original sale. The IRS said that the exclusion was not available to Debough because he did not sell the property within one year after he had reacquired it.
The Tax Court agreed with the IRS. In addition to agreeing with the IRS’s technical reasoning, the court found that there was “nothing unfair” in taxing the income since Debough was actually in a better position than he was before the sale, having both ownership of the property and $505,000 in cash (Marvin E, Debough v. Commissioner, 142 TC No. 17, May 19, 2014).
©2014 CPAmerica International
The IRS in Notice 2014-37 is allowing certain 401(k) and 403(m) retirement plans, including 403(b) plans, to make midyear amendments to reflect the U.S. Supreme Court’s Windsor decision.
The Supreme Court struck down Section 3 of the Defense of Marriage Act in U.S. v. Windsor, et al. (Sup Ct 2013) as an unconstitutional deprivation of equal protection. Section 3 had defined marriage for purposes of administering federal law as the “legal union between one man and one woman as husband and wife.” As a result, same-sex spouses were not recognized for purposes of qualified retirement plans.
Following the court’s decision, the IRS issued Revenue Ruling 2013-17 stating that same-sex couples who were legally married in jurisdictions that recognize their marriage will be treated as married for federal tax purposes, regardless of whether their state of residence recognizes same-sex marriage.
In Notice 2014-19, the IRS provided guidance on the effect of the Windsor decision on qualified retirement plans and plan amendments. To be considered a qualified plan, a cash or deferred arrangement (CODA), such as a 401(k) plan, must meet certain nondiscrimination tests. A CODA that meets safe-harbor provisions described in regulations generally must have those provisions in place before the beginning of the plan year and be maintained throughout a full 12-month plan year.
The IRS has now said that a plan will not fail to satisfy the requirements to be a Code Section 401(k) or 401(m) safe-harbor plan merely because the plan sponsor adopts a midyear amendment pursuant to Notice 2014-19, Q&A 8. ■
©2014 CPAmerica International
With the school year coming to a close, your son or daughter may be starting a summer job. Now may be a good opportunity to teach them a thing or two about taxes.
Several factors affect a student’s tax position, including the amount of anticipated annual earnings, status as a dependent and type of employment.
Their employers will ask your working children to fill out a Form W-4, which is used for computing income tax withholdings. The information provided on this form will affect the amount of taxes your children will owe next April or the size of their refunds. If a child will not earn enough to create an income tax liability, claiming exempt status on the Form W-4 may even eliminate the necessity of filing a tax return for 2014.
To qualify for exempt status, your student must have had no income tax liability in 2013 and also expect no income tax liability for 2014. However, exempt status does not apply to Medicare or Social Security taxes, which are still withheld and reduce your student’s take-home pay accordingly.
A student returning to the same place of employment as last summer may be required to complete a new Form W-4. Although W-4s usually remain valid until an employee wishes to change any information, if an employee claims exempt status from federal withholding, a new W-4 must be completed for the employer each calendar year.
Full-time students under the age of 24 are eligible to be claimed as dependents on their parents’ income tax return. For this purpose, children who attend school full-time during any part of five calendar months during 2014 are considered full-time students for the entire year. So, they may be full-time students even if 2014 is their graduation year.
Students may not need to file individual returns if they meet certain income thresholds. For 2014, a dependent child will not be required to file an individual income tax return if the child meets all of the following requirements:
➤ Is employed
➤ Earns less than $5,850
➤ Has less than $1,000 of unearned income, such as interest, dividends or capital gains
➤ Has gross income – earned plus unearned income – of no more than $6,200
However, if the student does not claim exempt status on Form W-4 and any amount of federal income tax is withheld from the student’s earnings, it will be necessary to file a return for 2014 just to claim the refund.
It is also important to understand the employment classification for the work the student is being hired to perform. Form W-4 filings pertain only to an individual hired as an employee.
Students hired as independent contractors are considered self-employed. This situation often occurs within service industries providing odd jobs, such as mowing lawns or babysitting. At the end of the year, instead of a W-2, self-employed individuals usually receive a Form 1099-MISC, which will not include any taxes withheld from earnings since withholding is not required of self-employed individuals.
Regardless of whether your student receives Form 1099-MISC, anyone earning a profit over $400 from a self-employed summer job is required to file an income tax return and pay the self-employment tax of 15.3 percent, in addition to any income taxes. To determine the amount of profits from self-employment, deduct any qualified expenses incurred that are directly related to the jobs performed from the gross income earned during the year.
Several unique rules frequently apply to students’ summer positions. For example, it is important to remember that all tips received, such as through a wait staff position, are taxable, and any tips received in excess of $20 per month must be reported to the employer. This reporting requirement ensures that the proper amount of tax is withheld not only from hourly earnings but also from tip income.
If a student is in a U.S. armed forces training program, such as ROTC, active duty pay while in training is fully taxable. However, certain allowances provided for food and lodging are not.
While students’ tax positions can vary based on specific circumstances, understanding the tax implications of summer jobs can help your students plan their 2014 tax situation and provide them with valuable tax knowledge that they can carry forward into their future careers.
©2014 CPAmerica International
Appalled by what it called the IRS’s unfair argument, the Court of Appeals for the Eighth Circuit has reversed a Tax Court decision that a taxpayer did not make a timely rollover to his IRA from which he previously had made IRA withdrawals at different times.
The Tax Court had held that the rollover, which was in the same amount as one of the withdrawals, was not timely because it was not made within 60 days of that withdrawal. However, the Eighth Circuit found that the rollover occurred within 60 days of a withdrawal in a larger amount and thus
qualified as a valid partial rollover.
During 2007, Harry Haury made four withdrawals from his IRA:
➤ Feb. 15 – $120,000
➤ April 9 – $168,000
➤ May 14 – $100,000
➤ July 6 – $46,933
On April 30, 2007, Haury deposited $120,000 into his IRA. The IRS matched the $120,000 contribution with the $120,000 distribution and concluded more than 60 days had elapsed, precluding rollover treatment. The Tax Court agreed with the IRS.
On appeal, Haury argued that the $120,000 contribution occurred within 60 days of the April 9 distribution and rollover treatment should be allowed. The appellate court agreed with Haury (Haury v. Commissioner, CA-8, wMay 12, 2014).
During the appeal, the IRS acknowledged that the 60-day limit was satisfied. However, the IRS argued that the partial rollover defense was forfeited because Haury had failed to argue it to the Tax Court. The appellate court rejected this contention.
Then the IRS tried to argue that Haury failed to prove that he had not already exercised his one-rollover-per-year opportunity within the 12 months preceding this transaction.
The appellate court characterized this argument as silly and factually without merit since the IRS agreed that it had access to the transactions in Haury’s IRA account during the year leading up to April 30, 2007. There were no prior rollovers in the records.
Important Reminder: The IRS has historically applied the one-rollover-per-year rule separately to each IRA. However, starting with distributions made after 2014, it intends to apply the rule on a more restrictive aggregate basis.
©2014 CPAmerica International
A recent Tax Court decision serves to re-emphasize that, when the owner of a hobby-like activity meets the requisite profit motive in one year, the courts may not necessarily apply that profit motivation to other years. Each year will be tested on its own.
Merrill Roberts is a former nightclub owner who became a horse breeder. Despite his rudimentary recordkeeping system and history of large losses, his profit objective was shown by the following facts:
➤ He liquidated his old, unsuitable facility and moved his activity to new property on which he built a premier training facility.
➤ He hired an assistant trainer.
➤ His accounting methods allowed him to make informed business decisions.
➤ He consulted with bloodstock agents and respected trainers on various business aspects.
Further, Roberts was asked by peers to run for leadership roles in professional horse racing organizations and lobbied for horse racing interests. He spent substantial time on business and was successful in his prior business ventures.
However, the court found that Roberts did not engage in the activity with the required profit motive during the earliest two years involved in the case. The court determined that his primary motivation in those years was as an investor in real estate.
The court said that Roberts’ participation in horse-related activities during those two years was equally divided between the social aspects and the business aspects of horse racing (Merrill C. Roberts v. Commissioner, TC Memo 2014-74, April 29, 2014).
Roberts avoided accuracy-related penalties during the earlier years by demonstrating reasonable cause/good faith for his tax positions. ■
©2014 CPAmerica International
The IRS has introduced a new one-year pilot program providing administrative relief to plan administrators and plan sponsors of certain retirement plans that must file with the IRS – but not the Department of Labor.
The one-year pilot program, established by Revenue Procedure 2014-32, provides relief to plan administrators who fail to timely file Form 5500-EZ. The relief is available to the plan administrator or plan sponsor of certain one-participant plans and certain foreign plans. No penalty will be assessed for late filing.
The applicant’s submission must include a complete Form 5500 Series Annual Return/Report, including all required schedules and attachments, for each plan year for which the applicant is seeking penalty relief. All returns must be sent to the IRS and cannot be filed through the Department of Labor (DOL) EFAST2 filing system. The relief is effective on June 2, 2014, and will remain in effect until June 2, 2015.
In addition, the IRS recently issued Notice 2014-35 to provide relief for late filers that satisfy certain requirements as well as the Delinquent Filer Voluntary Compliance (DFVC) Program administered by the DOL Employee Benefits Security Administration.
The IRS will not impose penalties for late filing of Form 5500, Form 5500-SF and Form 8955-SSA if the filer:
➤ Is eligible for, and satisfies the requirements of, the DFVC Program with respect to a delinquent Form 5500 series return; and
➤ Separately files with the IRS, within the prescribed time, a Form 8955-SSA with any information required to be filed for the year to which the DFVC filing relates.
Any Form 8955-SSA required to be filed with the IRS must be filed on paper by the later of 30 calendar days after the filer completes the DFVC filing or Dec. 1, 2014.
Parents and grandparents often lend money to their children or grandchildren to help with major expenditures like education, a wedding or the purchase of a new home.
Similarly, closely held businesses may lend money to shareholder-employees. And business owners sometimes lend money to the business to assist with expansion plans.
All of these transactions are examples of related-party loans.
Not surprisingly, the IRS requires that loans be structured in a business-like manner with terms that reflect current market conditions. If the loan terms are deemed too favorable, the IRS has the ability to recharacterize the loan – perhaps as a gift, additional compensation, or a corporate dividend or distribution – with all the tax implications that a recharacterization implies.
For no-interest or below-market interest loans, the IRS also has the right to reflect the current “market” interest rate for tax purposes by requiring that the lender take into income more interest than was actually received under the terms of the loan. The interest for tax purposes is calculated based on the Applicable Federal Rate (AFR).
The IRS publishes AFRs each month. They represent the minimum acceptable interest rates for most loans. If the interest rate on your loan at its inception is equal to or exceeds the relevant AFR, the IRS cannot challenge the appropriateness of the rate during the term of the loan.
AFRs include annual, semiannual, quarterly and monthly rates for short-term loans (terms of three years or less), mid-term loans (terms over three years but not exceeding nine years) and long-term loans (terms longer than nine years).
The recently published AFRs for May 2014 are as follows:
AFR Interest Compounding Period
Annual Semiannual Quarterly Monthly
Short-term 0.33% 0.33% 0.33% 0.33%
Mid-term 1.93% 1.92% 1.92% 1.91%
Long-term 3.27% 3.24% 3.23% 3.22%
To ensure that the IRS recognizes your transaction as a loan for tax purposes and does not recharacterize it as something else – a gift, additional compensation, or a corporate dividend or distribution, for example – you should have a written loan document or promissory note with an interest rate at least equal to the applicable AFR.
The borrower should sign and date the document, which should describe the terms of the loan, including loan amount, interest rate, payment schedule and any other terms. If your borrower is providing collateral, include a detailed description.
If the IRS determines that the interest rate for your loan is below the prescribed minimum established by the AFR, the loan is subject to the below-market loan rules. These rules generally require the lender and the borrower to recognize interest income and interest expense for federal tax purposes based on the relevant AFR rather than the loan’s actual interest rate.
For a demand loan, without a fixed loan term and end date, the Applicable Federal Rate used to calculate interest for tax purposes varies each month, based on fluctuations in the AFR. For a term loan, with a documented loan term and end date, the interest calculation is based on the relevant AFR as of the loan’s start date.
There is an exception to the below-market loan rules for a loan with a total amount outstanding between lender and borrower that does not exceed $10,000, if the loan is not for tax avoidance purposes.
If you create a new term loan now, when the AFR is near its all-time low, you can lock in a very favorable interest rate.
The tax rules governing below-market and related-party loans are complex with a number of exceptions. To understand all of the tax implications, consult your taxadviser before you enter into or renegotiate any loan.
©2014 CPAmerica International
A recent case demonstrates the difficulties involved in securing a tax deduction from transactions between related parties.
In 1990, Robert Alpert established two irrevocable trusts to fund his two sons’ educations. In 1996, he established a third trust for the benefit of his sons.
Between 1990 and 1996, Alpert transferred $1.1 million to the trusts. In January 1996, the trustee of each of the trusts signed a promissory note to Alpert. No funds were actually transferred in connection with the promissory notes.
Rather, the amounts stated as owed approximated the net funds Alpert had previously advanced to each trust. Subsequently, Alpert continued to transfer moneys to the trusts, but no additional promissory notes were executed.
In 2006, Alpert reported a $1.9 million nonbusiness bad debt deduction on account of worthless debts owed him by the 1990 trusts.
The IRS argued that Alpert was not entitled to the bad debt deduction because he did not establish that:
➜ The transfers to the trusts were bona fide debts;
➜ He was the debt holder in 2006; and
➜ The debts became worthless in 2006.
In concluding that the transfers were not bona fide debts, the court noted that:
➜ The beneficiaries of the trusts were Alpert’s sons.
➜ There was no written agreement with respect to the majority of the transfers.
➜ There was no evident plan of repayment.
The court then said that, even if the transfers represented bona fide indebtedness, Alpert failed to establish that he was the creditor in 2006. Finally, the court found that Alpert failed to show that the debts became wholly worthless in 2006, particularly since the trusts were not insolvent.
Alpert was the founder of Aviation Sales Co. (AVS), a publicly traded company. He also had trading authority over his mother’s brokerage accounts.
Acting without his mother’s knowledge, Alpert purchased AVS shares for her at a cost of $2 million. The share price of AVS declined precipitously, and when Mrs. Alpert learned of the purchases, she threatened to sue.
Alpert orally promised his mother that he would cover any losses she incurred if she sold the AVS shares at a loss. In exchange, she agreed that he would share in half of any profits if the shares were sold at a gain. Those promises were later memorialized in a letter.
In 2006, Alpert reported a loss, which he identified as “Indemnification Payment to G. Alpert.” Alpert contended that he was entitled to a loss for his indemnification payments because:
➜ His trade or business involved acquiring majority ownership positions in distressed companies, improving their operations and profitability, and taking them public;
➜ In so doing, he sought out and enlisted other investors for the purpose of acquiring these companies; and
➜ The indemnification agreement with his mother was part of that business process.
In rejecting Alpert’s argument, the court said that the indemnification agreement and the losses stemming from it were not incurred in his business activities. The court said that it was clear from the letter agreement between Alpert and his mother that he was trying to protect himself from liability for mismanagement of his mother’s assets, not from his business activities. (Robert Alpert v. Commissioner, TC Memo 2014-70, April 17, 2014) .
©2014 CPAmerica International
The Tax Court recently concluded that, when the taxpayers in the case asserted that they had reasonable cause and acted in good faith as a defense to penalties assessed by the IRS, they forfeited their privilege protecting attorney-client
communications.
In this case (Ad Investment 2000 Fund, LLC, et.al. v. Commissioner, 142 TC No. 13, April 16, 2014), the IRS asserted that the taxpayers engaged in transactions designed to create artificial tax losses. The IRS also assessed penalties attributable to:
➜ A substantial understatement of income tax;
➜ A gross valuation misstatement; and/or
➜ Negligence or disregard of rules and regulations.
Anticipating the taxpayers’ argument that the penalties should not apply because they acted with reasonable cause and in good faith, the IRS asked the court to compel production of six tax opinion letters the taxpayers had obtained from their law firm.
The taxpayers objected to the disclosure on the grounds that the letters were privileged attorney-client communications. The IRS argued that the taxpayers waived any privilege under the common-law doctrine of implied waiver by relying on affirmative defenses to the penalties that turn on the taxpayers’ beliefs or state of mind. The taxpayers contended that they had developed their reasonable belief by analyzing the pertinent facts and authorities and not by any reliance on advice from their attorneys.
The court concluded that, by putting the taxpayers’ legal knowledge and understanding into contention to establish good-faith and state-of-mind defenses, the taxpayers forfeited the privilege protecting attorney-client communications relevant to the content and formation of their legal knowledge, understanding and beliefs.
The court reasoned that the taxpayers must show that they analyzed the pertinent facts and legal authorities and, in reliance upon that analysis, reasonably concluded in good faith that there was a greater than 50 percent likelihood that the tax treatment would be upheld if challenged. This put into contention their knowledge of the pertinent legal authorities, their understanding of those legal authorities and their application of the legal authorities to the facts.
The court noted that the taxpayers received the opinions well before their tax returns were due and they did not claim that they ignored the opinions. If the opinions formed the basis for the taxpayers’ beliefs, the court concluded that it is only fair to allow the IRS to review those opinions.
©2014 CPAmerica International
The IRS has released a draft of a shorter, less burdensome version of the regular Form 1023 – Form 1023-EZ – for organizations that plan to apply for tax-exempt status. It is not currently available for use.
When finalized, the two-page Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, may be used if an organization meets specific criteria. Organizations that would normally file Form 1023 will be able to file Form 1023-EZ if they meet all of the following requirements:
Some organizations may be considered tax-exempt under Section 501(c)(3) even if they do not file Form 1023 or 1023-EZ. These include churches, synagogues, temples and mosques, integrated auxiliaries of churches and conventions or associations of churches, and any organization that has gross receipts in each tax year of normally not more than $5,000. However, the IRS cautions that, even though these organizations are not required to file Form 1023 or 1023-EZ to be tax-exempt, they may be liable for annual filing requirements.
If an organization files Form 1023-EZ within 27 months after the end of the month in which it was legally formed, and the IRS approves the application, the legal date of formation will be the effective date of its exempt status. If it did not file Form 1023-EZ within 27 months of formation, the effective date of its exempt status will be the postmark date when it filed Form 1023-EZ.
If an organization did not file Form 1023-EZ within 27 months of formation, and it believes it qualifies for an earlier effective date than the postmark date, it must file Form 8940 after it receives exemption to request the earlier date. Alternatively, it could complete Form 1023 in its entirety instead of completing Form 1023-EZ.
©2014 CPAmerica International
