Tax Law Roundup

current law developments in U.S. taxation

Swap of Rental Building for Personal Residence Tax-Free When Original Intent was to Rent Residence

By Steven R. Schneider on Posted in Real Estate

The Tax Court recently held that a couple who purchased a house as investment property was entitled to Section 1031 non-recognition treatment, despite deciding to use the house as their principal residence eight months after they purchased it.  In Reesink v. Commissioner, a husband and wife sold their share of an apartment building and purchased a house with the sale proceeds.  The taxpayers intended to hold the house as investment property at the time of the exchange (as is required for Section 1031 non-recognition treatment), but they decided to use the house as their personal residence eight months later, thus causing the IRS to question their investment intent.

The Tax Court held in favor of the taxpayers based on their treatment of the house as investment property at the time of the exchange.  The couple placed fliers throughout town where the house was located, showed the house to potential renters, and only decided to use the house as their personal residence almost eight months after the purchase.  Given how the taxpayers treated the house, the Tax Court held that their sale of the apartment building and subsequent purchase of the house qualifies as a Section 1031 like-kind exchange.

The IRS relied on Goolsby v. Commissioner for its position that making the purported replacement property a personal residence causes the taxpayer to lack the requisite investment motive.  The court noted that Goolsby was distinguishable because in that case, the taxpayers made their purchase of the replacement property contingent on the sale of their former personal residence, and their only rental efforts consisted of taking out a single advertisement in the local newspaper.  Moreover, they moved into the replacement property within two months of purchasing it.  The taxpayers in Reesink showed much more effort to rent out the property and only made the property a personal residence after eight months of failure to rent the property.

Supreme Court Rules Against IRS in Statute of Limitation Case

By Steven R. Schneider on Posted in General, Litigation/Controversy, Procedure, Statute of Limitations

In a much-anticipated decision, the U.S. Supreme Court voted 5-4 against the IRS and held that the three-year and not six-year statute of limitations applied to a so-called Son of BOSS tax shelter in U.S. vs. Home Concrete & Supply LLC.   This is the culmination of a series of split appeals court decisions on the issue.  The government argued that the §6501(e) six-year statute of limitations, generally applicable to when gross income is understated by over 25%, also applied to the transactions that inflated tax basis and resulted in large losses.  In reaching its conclusion, the Supreme Court applied its own precedent from 1958 (Colony Inc. v. Commissioner) and found that the operative language of the current code provision and the code provision at issue in the Colony case were identical.  The Court also refused to give Chevron deference to the Treasury regulations that interpreted the statutory provision in the IRS’s favor.  The Court held that the Colony decision had “already interpreted the statute, and there is no longer any different construction that is consistent with Colony and available for adoption by the agency.”

IRS Allows Five Year Depreciation for Wind-Facility Power Purchase Agreement

By Steven R. Schneider on Posted in Deductions, Energy, Green

In PLR 201214007, the IRS treated facility-specific power purchase agreements (PPAs) as part of their related energy production facilities, and that such PPAs are therefore eligible for favorable five-year depreciation.  In the PLR, the taxpayer acquired both a wind facility and the related PPA and the question was whether the favorable five-year depreciation life for wind equipment also applied to the value attributable to the PPAs.  The PPAs in the ruling were directly tied to the output of a specific wind energy facility such that energy from other facilities could not fulfill the terms of the PPAs.  As a result, the IRS ruled that the facility-specific PPAs should not be treated as assets separate from the wind energy facilities to which they relate, and that the PPAs should therefore be included in the tax basis of the wind energy facility for depreciation purposes.

PLR 201214007 did not address the more interesting question of whether the costs related to creating the PPA is also treated as part of the alternative energy property eligible for the 30% Section 48 credit or the “Section 1603″ grant.  It would be consistent with this PLR to allow such credit, but previous Treasury guidance, at least as it relates to the Section 1603 grant, generally did not treat such PPA costs as eligible for the 30% grant.

Proposed Regulations Address RIC and REIT Built-in Gains Tax

By Steven R. Schneider on Posted in Corporate, REITs

New taxpayer-favorable regulations clarify the application of the section 337(d) and section 1374 built-in gain rules for transfers of property to RICs and REITs.  The new regulations clarify the prior 2003 regulations.  Under the prior regulations, when C corporations transfer appreciated property to a RIC or a REIT, section 1374 rules track any carryover built-in gain for 10 years.  For example, if a C corporation elects REIT treatment or contributes appreciated property to an existing REIT in a tax-free transaction, absent a gain recognition election, the REIT has a 10-year window where the built-in gain is subject to corporate tax if the assets are sold.

The regulations address comments from the American Bar Association and the National Association of REITs.  The primary change in the proposed regulations is to make clear that a RIC or REIT is not subject to the section 1374 built-in gain rules to the extent that a C corporation transfers property with a built-in gain to a RIC or REIT and the C corporation’s gain is not recognized by reason of either section 1031 or 1033 (relating to like-kind exchanges or involuntary conversions).  For example, if a REIT enters into a tax-deferred like-kind exchange with a C corporation, there is not a new built-in gains tax period on the like-kind asset received by the REIT.

The regulations make other clarifying changes including adding a special exemption to the indirect partnership rule for C corporation partners that are tax-exempt entities.  This exemption applies only to the extent that the tax-exempt would not have been taxable on the gain had it made a gain recognition election at the time the property was transferred (e.g., the gain would not have been subject to the unrelated business income tax).  The proposed regulations are effective when finalized, but taxpayers are allowed to rely on the regulations back to the effective date of the original 2003 regulations.

Court Recaptures Partner Deductions under At-Risk Rules – Subscription Note Disregarded

By Steven R. Schneider on Posted in Partnership/LLC

The Tax Court has held that an individual partner was subject to at-risk recapture with regard to prior partnership losses when the taxpayer’s obligations under a partnership subscription note were subsequently disregarded.  In Zeluck v. Commissioner, T.C. Memo 2012-98, the taxpayer invested in an oil and gas partnership by contributing cash and giving the partnership a subscription note.  The partnership subsequently pledged the taxpayer’s subscription note as collateral for its payment obligations under a drilling contract.

In the year of his investment, the taxpayer included the cash and the value of the note in his amount at-risk in the partnership, and he took tax deductions based on this amount.  Initially, the taxpayer made his scheduled payments on the note, but after a year, he stopped making his payments and made no plans to pay the note.  The partnership never took any action against him, and when the partnership terminated without having paid the drilling company in full, the drilling company who held the taxpayer’s note as collateral also failed to enforce payment of the note.

Although the Court regarded the note as originally a true obligation of the partner, the Court found the note terminated once the parties failed to respect the terms of the note.  Therefore, while the value of the note was properly included in the taxpayer’s amount at-risk in the partnership when the note was genuine, the taxpayer’s amount at-risk was reduced below zero by the value of the note when it ceased to be genuine.  As a result, Code Section 465(e) required the taxpayer to recapture his prior deductions based on the note.  The Court also applied a 20% accuracy penalty.

Rep. Cantor Introduces One-Year Small Business Tax Cut

By Steven R. Schneider on Posted in Legislative

House Majority Leader Eric Cantor (R-VA) recently introduced the Small Business Tax Cut Act of 2012 (the “SBTCA”), which proposes a one-year tax deduction for qualified small businesses.  Under the SBTCA, a small business with fewer than 500 employees would be allowed to deduct 20 percent of its taxable income or domestic business income, whichever is less.  The deduction would apply regardless of the form of business organization.

The deduction is limited to 50 percent of the greater of (1) W-2 wages paid by the taxpayer to non-owner employees, or (2) the sum of W-2 wages paid by the taxpayer to (a) employees who are non-owner family members of direct owners and (b) employees who are 10-percent-or-less direct owners.  In some cases, income allocations to partners could be treated as W-2 wages.  The 50% W-2 wage limitation is similar to the limitation under the domestic manufacturing deduction, with which the SBTCA deduction would be coordinated.  The Joint Committee on Taxation also published JCX-30-12 to explain the SBTCA.

Cantor’s press release provides the following illustration of how the SBTCA would operate:   Assume that a small business under current law would pay a 35% federal tax on $100 of income, resulting in a $35 tax bill.  Under the House proposal, this small business would be able to deduct 20% of its income from tax (20% of $100 = $20), subject to the 50% W-2 wage limitation.  The small business would then pay the same 35% tax on the remaining $80, resulting in a $28 tax bill. Under the SBTCA, the small business would save $7 in federal taxes.

The SBTCA has been referred to the House Committee on Ways and Means.  If enacted in its current form, the SBTCA would apply for a taxpayer’s first taxable year beginning after December 31, 2011.

IRS Issues Guidance on Capitalization vs. Repair Expense Including Automatic Accounting Method Changes

By Steven R. Schneider on Posted in Compliance, Deductions

The IRS released two revenue procedures that describe how taxpayers can obtain automatic consent to change their accounting methods to comply with the recent temporary tangible property capitalization vs. repair regulations.  Revenue Procedure 2012-19 details repair and maintenance, materials and supplies, and related method changes resulting from the temporary regulations.  Revenue Procedure 2012-20 addresses depreciation, disposition, and related method changes resulting from the temporary regulations.  The two revenue procedures add a total of 19 new automatic changes to Revenue Procedure 2011-14, the existing automatic method change revenue procedure.  In addition, the IRS issued a memorandum to its field exam  offices addressing taxpayers who adopted a method of accounting relating to the conversion of capitalized assets to a repair expense.

            Most of the automatic method changes under the temporary regulations, and particularly those in the repair area, are made with a Code Section 481(a) adjustment.  Taxpayers may use the statistical sampling procedures outlined in Revenue Procedure 2011-42 for the adjustment.  Taxpayers record their method changes by filing IRS Form 3115 with their tax returns.

The new revenue procedures also give taxpayers a two-year window to comply with the method change rules.  The otherwise-applicable scope limitations would have required some taxpayers, including taxpayers under exam, to get explicit IRS consent before a method change could be made.

Is It the End or Just the Beginning: Planning with the Final Partnership Debt-for-Equity Regulations

By Steven R. Schneider on Posted in Partnership/LLC, Workouts

 For years taxpayers had argued that a “partnership debt-for-equity” exception to cancellation of debt (COD) income lurked in the far corners of the tax rules. That argument was abruptly taken off the table on October 22, 2004 when Congress added partnerships to the scope of § 108(e)(8), confirming that partnerships have COD income when using partnership equity to pay off debt at a discount. Now, seven years later, the IRS finalized § 108(e)(8) regulations (the “Final Regulations”) and officially passed the baton to taxpayers. Taxpayers now must figure out how to structure transactions in light of the Final Regulations to minimize the significant risks for phantom income, deferred lender losses, and negative tax-character conversions.  Thus, for taxpayers and their advisors, this is just the beginning of a trip down the new road of debt-for-equity planning.

The purposes of this article are to explain the Final Regulations and to suggest potential tax structuring alternatives in light of the new rules.  The Final Regulations are taxpayer-favorable in that they provide procedures for valuing partnership equity at liquidation value for COD calculation purposes and they clarify that a partnership itself will not recognize taxable gain to the extent it uses its equity to pay ordinary income items, such as accrued interest. However, the Final Regulations generally deny lenders an immediate tax loss on any discount of their debt, favor accelerated lender income by assuming the value of the equity received first pays for accrued but unpaid interest, and include potential foot-faults that may prevent taxpayers from receiving the benefit of the liquidation valuation rule.  In the end, the Final Regulations are a welcome addition to the law on the topic, but now it’s up to taxpayers to turn the few unwanted lemons into lemonade.

 

Levin Reintroduces Carried Interest Legislation

By Steven R. Schneider on Posted in Legislative, Partnership/LLC

Rep. Levin (D-MI) today introduced the Carried Interest Fairness Act of 2012.  According to the Democrat press release, the legislation “would fix the loophole that enables private equity managers to pay reduced income tax rates.”  The bill is proposed to apply to income from partnerships from taxable years ending after the date of enactment or partnership distributions/transfers occurring after the date of enactment.  This version looks similar to prior versions, although numerous changes appear when compared to the 2011 American Jobs Act version or the 2010 Senate version.

According to the technical explanation, the provision generally treats as ordinary income the net capital gain with respect to an investment services partnership interest except to the extent the gain is attributable to the partner’s qualified capital interest.  The capital gain re-characterized under the provision is taxed at ordinary income rates and is subject to self-employment tax.

Featured in the New York Times – The Advantages and Risks of Gingrich’s Tax Strategy

By Steven R. Schneider on Posted in General, Partnership/LLC, Passthrough Entity

Steven R. Schneider, a tax lawyer, said that not all companies were suited for the S corporation, a tax structure used by Newt Gingrich.

 

 

 

Steven Schneider was recently featured in an article in the New York Times regarding New Gingrich’s tax planning strategy.

“Steven R. Schneider, a partner at Goulston & Storrs, a law firm, said real estate companies were particularly ill-suited for S corporations, which limit the amount of depreciation on properties to the equity in them. . . . Using the same example of a real estate partnership, Mr. Schneider said that a limited liability company would be easier to break up than an S corporation. “Say we own three properties together and you want one of those properties back,” he said. “In an S corporation, when you distribute that property out, it accelerates the taxable gain. In an L.L.C., you carry that gain with you.”