ISSUE 19 SEPTEMBER 15, 2009 Practical Tax Bulletin INSIDE Tax Highlights Disallowed interest does not reduce earnings and profits ....................................... 5 IRS approves maximum elective deferral (with catch-up) of $34,000 for contributions to 403(b) and 457 plans...... 5 Individuals reminded of COBRA penalty ...... 6 Guidance provided for acceleration of accounting adjustment ................................. 7 Settlement from trade secret appropriation taxable as ordinary income, not capital gain......7 Tax Court rejects IRS’s gift tax treatment of transfers to single-owner LLC ................. 8 IRS provides FAQs on TEFRA procedures ......8 IRS Modifies Change of Accounting Method Guidelines The IRS has made significant revisions to its required procedures for taxpayers to obtain automatic IRS consent to a change in accounting method (Rev. Proc. 2009-39, 2009-38 IRB __). The new revenue procedure adds to the number of methods for which taxpayers may obtain automatic consent and modifies the rules that must be followed for obtaining automatic consent to an accounting method change. Comment: “We have experienced a significant increase in the number of accounting method changes being filed,” Jack Donovan, Ernst & Young’s Director of Tax Accounting Methods and Inventories, told CCH. “Companies are looking at accounting methods as part of their cash tax planning to enhance cash flow.” In a survey of 572 corporate tax officials, Ernst & Young LLP found that 31 percent seek to generate cash tax savings by filing an accounting method change that would reduce the current year’s taxes or recoup past years’ taxes. S corporation’s interests in LLC were not applicable retained interests ........................ 9 Final regulations issued on comparable contributions to HSAs and excise tax return requirements ..................................... 10 Late entity classification election relief broadened, extended ....................................11 Tax Briefs ............................................ 12 Code Sec. Index ............................... 12 Continued on page 2 Preparing For The 2010 Traditional IRA to Roth IRA Conversion Opportunity In 2010, a much-anticipated change in Roth individual retirement account (IRA) conversion rules will take effect. Beginning in 2010, the $100,000 adjusted gross income (AGI) limit that has prevented individuals from converting from a traditional IRA to a Roth IRA will disappear, and all individuals will be able to do so without any income or filing status limits. Practitioners can send or email the following letter to their clients to inform them about the opportunity to convert a traditional IRA to a Roth IRA in 2010 and thereafter. Dear Client: As the end of 2009 approaches, a significant opportunity awaits many individuals. Beginning in 2010, taxpayers will be able to convert their traditional IRA (and funds that have been rolled over from a qualified plan) to a Roth IRA, regardless of their income level or filing status. What’s more, the tax on the taxable income generated from a 2010 conversion may be deferred until 2011 and 2012. This new conversion option presents both tax Continued on page 4 2 SEPTEMBER 15, 2009 CHANGE OF ACCOUNTING METHOD Continued from page 1 Comment: Donovan said that the benefits have widespread applicability across all industries and all size companies. In addition to enhanced cash flow, the time value of money is effectively a permanent benefit for recurring items. Comment: “Cash flow is very important,” Carol Conjura, partner, KPMG LLP’s Washington National Tax practice, told CCH. “For cash flow planning, it’s helpful to defer tax payments appropriately. If you’re not on the optimal accounting method, you’re prepaying taxes,” Conjura explained. “Companies are putting taxes under a microscope and [taking a hard look] at everything,” Conjura said. She has seen “an uptick of changes because of the need for cash flow and because the Service is making it easier [to change methods].” Background Taxpayers must obtain IRS consent to change a method of accounting. The IRS has attempted to streamline this process by permitting taxpayers to obtain automatic consent for over 140 enumerated changes. Taxpayers still must submit an application (Form 3115) and follow extensive procedures for obtaining automatic consent. The latest revenue procedure amplifies and clarifies these procedures. The office of the IRS Chief Counsel has discretion to review these applications and deny changes that do not comply with the procedures in Rev. Proc. 2008-52, 200836 IRB 587 for obtaining automatic consent to a change of accounting method. Repair and maintenance costs. A taxpayer may obtain automatic consent to deduct repair and maintenance costs as ordinary and necessary business expenses rather than capitalizing them. A taxpayer may also change the unit of property it uses to determine the deductibility of repair and maintenance costs to another permissible unit of property. Caution: The automatic consent to change accounting methods is not a determination that the taxpayer is using the appropriate unit of property. Tenant construction allowances. Taxpayers improperly accounting for tenant construction allowances may obtain automatic consent to change their method of accounting to a proper method. The new provision applies both to methods that improperly treat the taxpayer as having a depreciable interest in the property subject to the tenant construction allowances and methods that improperly treat the taxpayer that do not treat the taxpayer as having a depreciable interest in the property. The automatic consent procedure does not apply to any tenant construction allowance that qualifies under Code Sec. 110 (qualified lessee construction allowances for short-term leases). Dispositions of structural components of a building. Taxpayers may obtain automatic consent to change accounting methods to change to a different unit of property for purposes of determining when the taxpayer has disposed of a building. The change in accounting method does not apply to property that is not depreciated under Code Sec. 168, any section 1245 property or depreciable land improvement, any leasehold improvement, any property disposed of in a nonrecognition transaction, any Practical Tax Bulletin Comment: Audit protection is an important benefit for taxpayers who obtain consent to change their accounting method. In PMTA 2009-107, the Associate Chief Counsel (Income Tax & Accounting) notified the Large and Mid-Size Business industry director of a taxpayer’s use of an impermissible method for depreciating rotable spare parts, after the taxpayer had withdrawn its application. New Methods Added The IRS will provide automatic consent for eight methods of accounting added in Rev. Proc. 2009-39, including: Materials and supplies. A taxpayer who wants to change its method of accouting for materials and supplies on hand to account for them as a deferred expense to be taken into account when they are actually consumed may obtain automatic consent for the change. Managing Editor Karen Heslop, JD Coordinating Editor John Buchanan, JD, LLM No claim is made to original government works; however, within this Product or Publication, the following are subject to CCH’s copyright: (1) the gathering, compilation and arrangement of such government materials; (2) the magnetic translation and digital conversion of data, if applicable; (3) the historical, statutory and other notes and references; and (4) the commentary and other materials. Practical Tax Bulletin (USPS 189.020). Published biweekly by CCH, a Wolters Kluwer business, 4025 W. Peterson Ave., Chicago, IL 60646. Periodicals postage paid at Chicago, Illinois, and at additional mailing offices. POSTMASTER: SEND ADDRESS CHANGES TO CCH, 4025 W. PETERSON AVE., CHICAGO, IL 60646. Printed in the U.S.A. ©2009 CCH. All Rights Reserved. PTE references are to the 2009 Practical Tax explanations. ©2009 CCH. All Rights Reserved PRACTICAL TAX BULLETIN • ISSUE 19 property subject to a general asset account election, any building with multiple condominium or cooperative units, or multiple buildings that are treated as a single building under the taxpayer’s present or proposed method of accounting. tions, such as obtaining consent or applying within designated 90-day or 120-day windows. Rev. Proc. 2009-39 expands the times when a taxpayer is under examination to include the following situations: Dispositions of tangible depreciable assets. Taxpayers who want to change to a unit of property for determining when the taxpayer has disposed of section 1245 property or a depreciable land improvement for depreciation purposes may now use the automatic consent procedures. The change in accounting procedures will also affect the determination of gain or loss from such disposition. The change in accounting method does not apply to: any property that is not depreciated under Code Sec. 168, any building, any leasehold improvement, any property disposed of in a nonrecognition transaction, any property subject to a general asset account election, any property subject to a mass asset election, or any property subject to a repair allowance under Reg §1.167(a)-11(d)(2). An IRS representative contacts the taxpayer to schedule any type of examination. Debt issuance costs. Taxpayers that want to change their method of account for capitalized debt issuance costs to comply with Reg. §1.446-5, which provides rules for allocating the costs over the term of the debt. Accrual of real property taxes. Taxpayers may obtain automatic approval to change their method of accruing property taxes to accrue such taxes ratably. The taxes must relate to a definite period of time. Note that taxpayers requesting a change of accounting provision with respect to any of the above-mentioned costs are required to comply with the UNICAP rules for any portion of these costs that is required to be capitalized. A taxpayer that is required to capitalize costs under the UNICAP rules with respect to which it is requesting a change but is not currently capitalizing such costs is required to change its accounting methods to comply with the UNICAP rules. Comment: “Companies will be pleased to see, as anticipated, that the new guidance makes repair and maintenance accounting method change requests automatic, with certain exceptions,” Donovan commented. Comment: Conjura noted that the trend is to add more changes to the automatic consent category and that there is more visibility to these methods. “The IRS has viewed voluntary changes, including automatic changes, as a way to promote voluntary compliance,” she said. Under Examination A taxpayer “under examination” who wants to apply for an automatic change must comply with additional restric- The taxpayer is participating in the Compliance Assurance Process. The taxpayer’s refund or credit is under review by the Joint Committee on Taxation. A foreign corporation has a controlling domestic shareholder under examination. Comment: “Many companies will be surprised by the new provisions significantly limiting the ability to file accounting method changes when they have a refund or credit under review by the Joint Committee on Taxation,” Donovan said. “With limited exception, [the taxpayer] cannot file an accounting method change request, and cannot look to the window periods or director consent as possible avenues to file accounting method change requests unrelated to the matter before Joint Committee.” Revisions Rev. Proc. 2009-39 revises several provisions in Rev. Proc. 2008-52, including provisions concerning: the need for a Code Sec. 481(a) adjustments, when a method is changed, to prevent duplication or omission of amounts; filing requirements for more than one change in method of accounting and for taxpayers under examination, before IRS Appeals, or before a federal court; a change in overall method from cash to accrual basis; and accounting for advance payments, self-insured employee medical benefits, bonuses, and vacation pay. Effective dates Rev. Proc. 2009-39 applies to applications filed under Rev. Proc. 2008-52 on or after August 27, 2009, for a year of change ending on or after December 31, 2008. In the case of Rev. Proc. 97-27 (nonautomatic consent), Rev. Proc. 2009-39 applies to applications filed on or after August 27, 2009, for a year of change ending on or after that date. 3 4 SEPTEMBER 15, 2009 IRA CONVERSIONS Continued from page 1 planning opportunities and challenges for 2009, 2010, and 2011. Before 2010, only individuals with modified adjusted gross incomes (AGI) of $100,000 or less can convert amounts in their traditional IRA to a Roth IRA. Moreover, married taxpayers filing separate returns are also been prohibited from converting their traditional IRA to a Roth IRA as well. However, beginning in 2010, the $100,000 AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated completely. This special treatment gives everyone regardless of his or her income level the opportunity to convert a traditional IRA to a Roth IRA. Additionally, filing status restrictions are also lifted, allowing married taxpayers filing a separate return to convert a traditional IRA to a Roth IRA. It is important to understand that an IRA conversion is treated as a taxable distribution, taxed as ordinary income at your marginal tax rate. This in effect accelerates the taxable income that you would eventually pay on distributions from a traditional IRA once you retire, but does so in exchange for never taxing any future appreciation in the value of your account from what it is today. That is often a significant tax advantage. You should also note that unlike a withdrawal from an IRA, a conversion does not trigger any 10 percent early withdrawal penalty. Although conversion to a Roth IRA does trigger immediate taxable income, Congress provided a special incentive in 2010 to jump-start Roth conversions. In 2010 (and 2010 only), individuals will have the choice of recognizing their conversion income in 2010 or averaging it over 2011 and 2012. The latter option, which must be elected, allows you to pay taxes on the converted amount ratably over two years, instead of recognizing it all as income in one year. You will be taxed at the rates in effect for 2011 and 2012. 2012 because of the anticipated increase in the top marginal tax rates, may want to avoid, for year-end 2009, the traditional year-end-planning techniques of accelerating deductions and deferring income. Alternatively, consider doing the opposite this year to avoid being pushed into the highest brackets by a large IR to Roth IRA conversion. Taxpayers are expected to convert their traditional IRAs to Roth IRAs for a variety of reasons. Roth IRAs have two major advantages over traditional IRAs: Roth IRA distributions are tax-free if they are qualified distributions. To be qualified, they must be made after a five-year holding period has passed and after the accountholder reaches age 59 ½ or on account of death, disability, or the qualified purchase of a first home. Roth IRAs are not subject to the required minimum distribution (RMD) rules that apply to traditional IRAs (as well as individual qualified plans). Therefore, a Roth IRA accountholder who reaches age 70 ½ does not need to begin taking distributions; instead, the funds can continue to grow tax free until they are needed or are passed on to heirs. The tax-free nature of qualified Roth IRA distributions may prevent individuals from being taxed in a higher tax bracket that would otherwise apply if he or she were withdrawing taxable distributions from a traditional IRA. Moreover, these distributions—unlike those from traditional IRAs—do not effect the calculation of tax owed on Social Security payments and do not affect AGI-based deductions. An IRA to Roth IRA conversion should be considered by individuals who: can afford the tax on the converted amounts; anticipate being in a higher tax bracket in the future than they are currently in; and For some taxpayers, their tax rate may rise after 2010 even if their income does not. President Obama has proposed, and Congress is expected to enact, legislation to restore the top two pre-2001 marginal income tax rates after 2010. This means that the top two brackets will be 39.6 percent and 36 percent after 2010. Consequently, if you do not want to take the chance that your income tax rate will be higher in 2011 and 2012 than in 2010, you may want to elect to pay the full tax on the Roth conversion in your 2010 income tax return, at 2010 income tax rates. If you are planning on taking advantage of the Roth IRA conversion opportunity next year, consider some of the following strategies this year: Higher-income individuals who plan to pay the entire conversion tax in 2010 instead of ratably in 2011 and Because of the economic slowdown, many individuals are postponing retirement. Roth IRAs, unlike tradi- have a significant amount of time before reaching retirement to allow assets to grow tax-free and recoup dollars that may have been lost due to the conversion tax. ©2009 CCH. All Rights Reserved PRACTICAL TAX BULLETIN • ISSUE 19 tional IRAs, generally have no age limitation on contributions from earned income or on mandatory payouts. This is an advantage for individuals who are extending their careers beyond traditional retirement age. If you are able to make deductible IRA contributions this year, do so. This can help you reduce your 2009 tax bill and, if you convert to a Roth IRA in 2010, you will not have to pay back the tax savings until 2011 and 2012, if you elect to ratably pay the tax over the two-year period. If you anticipate being below the $100,000 AGI level this year, consider converting to a Roth IRA right away while your traditional IRA account balance is still low because of stock market declines. If your situation is different from what you anticipate before you file your 2009 return, you might consider “recharacterizing” your 2009 Roth conversion back to a traditional IRA and then converting to a Roth IRA in 2010 instead. There are a significant number of tax and financial considerations that come into play when determining whether to convert your traditional IRA to a Roth IRA. If you have any questions about traditional IRA to Roth IRA conversions and the new 2010 planning opportunity, please contact our office. Sincerely, TAX HIGHLIGHTS Code Sec. 312 Disallowed Interest Does Not Reduce Earnings and Profits Interest disallowed under Code Sec. 264(a)(4) reduces earnings and profits for the tax year in which it would have otherwise been allowed as a deduction, the IRS has ruled (Rev. Rul. 2009-25, 2009-38 IRB __). It does not further reduce earnings and profits when the death benefit is received under a life insurance contract. In the fact pattern considered by the IRS, a corporation purchases an individual’s life insurance contract from him and names itself as the beneficiary. It borrows the purchase price at a commercially reasonable interest rate and pays the interest on the loan in Years 1 and 2. Other than the initial purchase price, the interest on the loan is the only amount the corporation incurs with respect to the contract. The individual dies in Year 3, and the corporation receives the death benefit under the contract. The corporation includes in its Year 3 income the amount of the death benefit minus the amount it paid for the contract minus the disallowed interest deductions. Under Code Sec. 264(a)(4), an interest deduction is disallowed for any interest paid or accrued on any indebtedness with respect to life insurance policies owned by the taxpayer covering the life of any individual or any endowment or annuity contracts owned by the taxpayer covering any individual. Instead, the amount paid is recovered by reducing the income received when benefits are paid out under the policy. However, the IRS reasoned, earnings and profits, by contrast, are a measure of a corporation’s economic capacity to pay dividends, which is distinct from taxable income. Because disallowed interest depletes the assets of a corporation at the time the interest would be allowed as a deduction if it were not disallowed under Code Sec. 264(a) (4), earnings and profits should also be reduced in that year. Accordingly, the corporation reduces its earnings and profits in each of Years 1 and 2 by the amount of disallowed interest in each of those years. Items excluded from gross income normally increase earnings and profits. However, since the corporation’s earnings and profits were already reduced by the amount of the disallowed interest for Years 1 and 2, reducing earnings and profits in Year 3 by the amount of the disallowed interest would cause a double reduction of earnings and profits for the disallowed interest and therefore is not permitted. References: Kleinrock §216.3; PTE §26,610 Code Sec. 403 IRS Approves Maximum Elective Deferral (With Catch-Up) of $34,000 for Contributions to 403(b) And 457 Plans The IRS has approved separate limitations of $15,500 for salary reduction contributions to a 403(b) tax-sheltered annuity and to an eligible 457 plan for 2008 (IRS Letter Ruling 200934012). Furthermore, a 15-year employee of an educational institution may contribute an additional $3,000 in special catch-up contributions to the 403(b) plan, without reducing his contribution to the 457 plan. 5 6 SEPTEMBER 15, 2009 TAX HIGHLIGHTS cont’d Comment: Code Sec. 457 formerly reduced the maximum amount deferred under a 457 plan by amounts contributed to a 403(b) plan. This rule no longer applies. The limitation on elective deferrals under Code Sec. 402(g) applies to 403(b) plans but does not include deferrals to a 457(b) plan. Thus, a single employee can defer $15,500 in elective contributions to each plan, plus $3,000 in special catch-up contributions to the 403(b) plan. The taxpayer was the president of a college and had been employed by the college for 24 years. The college maintained a 403(b) plan for all employees and a 457(b) plan for the taxpayer only. The taxpayer intended to defer the maximum amount allowed in 2008 for both plans. Both plans authorized a participant to defer the maximum amount allowed under the Code. The taxpayer previously contributed slightly less than $107,000 in elective deferrals to the college’s 403(b) plan. Code Sec. 402(g) limits the amount of elective deferrals that can be contributed tax-free to certain plans, including 401(k) plans and 403(b) plans. Code Sec. 402(g)(4) provides for a cost-of-living adjustment to the maximum deferral. Under both provisions, the limit for 2008, known as the applicable dollar amount, is $15,500. Code Sec. 402(g)(3) defines “elective deferrals” to include employer contributions under a 403(b) salary reduction agreement. The provision does not include deferrals under a 457 plan. Thus, 403(b) contributions do not have to be aggregated with 457 deferrals, the IRS determined. Code Sec. 457(b) allows an employee to contribute a maximum deferral of the lesser of the applicable dollar amount and the employee’s includible compensation. This applicable dollar amount also is $15,500. The includible compensation is the compensation for the year from the employer, as defined in Code Sec. 415(c)(3). Code Sec. 457(e)(15) provides a cost-of-living adjustment for this amount, which also equals $15,500. Comment: Code Sec. 457(c) used to reduce the maximum deferral by any amount contributed for the employee to another plan, such as a 403(b) plan. This limitation was repealed 2001. Code Sec. 402(g)(7) allows a special catch-up contribution of the least of $3,000 or two other specified Individuals Reminded of COBRA Penalty The IRS has reminded individuals who have qualified and received the 65-percent subsidy for COBRA health insurance, due to involuntary termination from a prior job, that they should notify their former employer if they become eligible for other group health coverage. The reminder appeared as a Headliner on the IRS’s website. The American Recovery and Reinvestment Act of 2009 (P.L. 111-5) provided a subsidy of 65-percent of the COBRA health insurance premium for qualifying employees. If an individual becomes eligible for other group health coverage, they should notify their plan. The notice that the United States Department of Labor sent to the individual advising them of their right to subsidized COBRA continuation payments includes the form individuals should use to notify the plan that they are eligible for other group health plan coverage or Medicare. If an individual continues to receive the subsidy after they are eligible for other group health coverage, such as coverage from a new job or Medicare eligibility, the individual may be subject to the new Code Sec. 6720C penalty of 110 percent of the subsidy provided after they became eligible for the new coverage. Taxpayers who fail to notify their plan that they are no longer eligible for the COBRA subsidy may wish to self-report that they are subject to the penalty by calling the IRS toll-free at 800-829-1040. In addition, taxpayers will need to notify their plan that they are no longer eligible for the COBRA premium subsidy. References: Kleinrock §107.10; PTE §20,743.15 amounts, provided the employee has completed at least 15 years of service with the employer maintaining the 403(b) plan, and provided the employer is a qualified tax-exempt educational organization. The IRS noted that the taxpayer worked 24 years as a full-time employee for the college and assumed it was a qualified educational organization. As a result, the taxpayer would be able to make a $3,000 elective deferral catchup contribution to the 403(b) plan in 2008. References: Kleinrock §130.2; PTE §25,305.20 ©2009 CCH. All Rights Reserved PRACTICAL TAX BULLETIN • ISSUE 19 Code Sec. 481 Guidance Provided for Acceleration of Accounting Adjustment The IRS provided guidance regarding whether an automobile dealer that properly obtained automatic consent to terminate its last-in, first out (LIFO) method of accounting must accelerate the Code Sec. 481(a) adjustment upon the loss of one of its five automobile franchises where the dollar-value pool included only the new vehicles under the lost franchise (CCA 200935024). Three factual situations were discussed. In the first situation a taxpayer obtained a franchise to sell new Pontiac-brand automobiles. The dealership also sold used cars and had a service department that provided maintenance and repairs and sold automotive parts and accessories. The taxpayer treated all of these activities as a single trade or business. The taxpayer also had franchises to sell Ford, Chevrolet, Toyota, and Honda automobiles. It used the dollar-value LIFO method for all inventories and maintained different pools for vehicles sold under each franchise. The taxpayer lost its Pontiac franchise on July 7, 2009, and liquidated its inventories of new Pontiacs by December 31, 2009. The dealer still sells other brands of automobiles. Comment: Although the guidance does not explicitly mention the General Motors (GM) restructuring, the Pontiac brand of automobiles is being phased out as part of this restructuring, and GM is terminating dealer franchises. The taxpayer decided it wanted to cease using the LIFO method and to begin using the specific identification method for new Pontiacs for its tax year ending December 31, 2009. On March 15, 2010, the taxpayer submitted Form 3115, Application for Change in Accounting Method, with its tax return, seeking automatic consent to make this change, as provided in Rev. Proc. 2008-52, 2008-36 IRB 587, and computed its income based on the new method for Pontiac vehicles. The taxpayer determined its Code Sec. 481(a) adjustment (a net positive adjustment) and included one-fourth of that amount on its tax returns. The IRS determined that Rev. Proc. 2008-52 allowed the taxpayer to maintain the four-year period to make the adjustment, and did not require it to accelerate it simply because there was no ending inventory for the year in which the taxpayer changed its method of accounting. In the second situation, the facts are the same, except that the taxpayer never acquired the other franchises, but that it continued to operate the other activities of its trade or business (selling used vehicles, selling parts and accessories, and maintaining and repairing vehicles) after December 31, 2009. The IRS ruled that the taxpayer was still allowed to take the adjustment into account over the four-year period so long as it maintained its trade or business for this time period. Finally, in the third situation the facts are the same as in the first situation, except that the dealer had used a single dollar-value pool accounting method across the inventories of its multiple franchises. The dealer in this situation may not change its method of accounting for only the Pontiacs and not the other brands. However, it may change its pooling method under Rev. Proc. 9727, 1997-1 CB 680, by filing Form 3115, Application for Change in Accounting Method, and change from the LIFO method with respect to the dollar-value pool that included the vehicles from the lost franchise. References: Kleinrock §508.7; PTE §38,610.05 Code Sec. 1221 Settlement From Trade Secret Misappropriation Taxable As Ordinary Income, Not Capital Gain The Tax Court has found that a settlement payment made to an S corporation arising from a trade secret misappropriation lawsuit was taxable as ordinary income, not capital gain (Freda v. Commissioner, Dec. 57,913(M), TC Memo. 2009-191). The settlement payment was for lost profits and other items that are taxed as ordinary income. The taxpayers’ S corporation was in the business of supplying sausage to pizza vendors. It had developed a process for making precooked sausage that had the taste and appearance of home-cooked sausage and obtained a patent on that process, which it treated as a trade secret. The S corporation filed a lawsuit against one of its major customers, alleging trade secret appropriation. During the tax year in question, the S corporation entered into a settlement agreement with respect to that lawsuit. On its Form 1120 return for that year, the S corporation treated the settlement proceeds as capital gain and on Schedule K-1 reported each shareholder’s proportionate share of the company’s net long term capital gain. The shareholders reported their proportionate shares of the capital gain on Schedule D. The IRS issued notices of de- 7 8 SEPTEMBER 15, 2009 TAX HIGHLIGHTS cont’d ficiency to the shareholders determining that the amount paid to the S corporation under the settlement agreement was ordinary income and not long-term capital gain. The Tax Court rejected the argument that the S corporation’s trade secret was a capital asset and that proceeds from the damage inflicted to that asset by the other business should be treated as capital gain. According to the court, this argument disregarded the fundamental principle that the tax treatment of the settlement amount depends on the nature of the claim and the actual basis of recovery. The only claim outstanding at the time of settlement was the misappropriation count, which the S corporation alleged resulted in “lost profits, lost opportunities, operating losses and expenditures.” The settlement payment represented damages for lost profits or other items taxed as ordinary income, and therefore was taxable as ordinary income and not capital gain. The Tax Court also rejected the argument that the settlement payment should be treated as proceeds from the sale of a capital asset (the trade secret) under Code Sec. 1235(a). The court noted that under Code Sec. 1235(a) the sale or transfer of a capital asset must involve the transfer of “all substantial rights” to the trade secret. The court found none had been transferred. The court also was not persuaded that the settlement terminated certain contractual rights that the S corporation had pertaining to its confidentiality agreement with the other business, resulting in Code Sec. 1234(a) gain “from the cancellation, lapse, expiration or other termination of a right or obligation with respect to a capital asset.” The settlement stipulated that the payment was made to compromise and settle claims disputed as to both liability and amount. IRS Provides FAQs on TEFRA Procedures The IRS has released a notice on frequently asked questions regarding unified partnership audit and litigation procedures, better known as TEFRA procedures (CC-2009-027). Topics include: partnership items, with particular attention to outside basis, losses, withholding, and profit motive; notices of partnership proceedings, including the tax matter partner (TMP), notice partners, notice groups, correct addresses and final partnership administrative adjustment (FPAA); Tax Court petitions to challenge an FPAA, including proper parties, participating partners, communications with partners and motions and pleadings; assessments, including penalties, challenges, notice of computational adjustment, affected item notice of deficiency, Munro stipulations and adjustments on a partner’s tax return; limitations, including the relationship between the general limitations period for assessments and the special limitations period for assessments arising from partnership and affected items, consents to extend the assessment period, replacement of the TMP, fraud, omissions from gross income, failure to file returns and unidentified partners; and settlements, including settlements with the IRS and the Department of Justice, effect on indirect partners, TMP authority to bind other partners, consolidated groups, notice of settlement agreement and settlements with participating partners. References: Kleinrock §402.7; PTE §31,101 of the LLC, the Tax Court has held (Pierre v. Commissioner, Dec. 57,910, 133 TC __). Consequently, the transfers would be subject to valuation discounts for lack of marketability and control. The court rejected the IRS’s interpretation of the check-the-box regulations as overly broad and stated that, if accepted, such interpretation would overturn the long-established federal gift tax valuation rules. References: Kleinrock §18.3; PTE §3,801 Code Sec. 2512 Tax Court Rejects IRS’s Gift Tax Treatment Of Transfers To Single-Owner LLC A taxpayer’s transfers from her single-owner limited liability company (LLC) to two trusts should be valued for federal gift tax purposes as transfers of interests in the LLC and not as transfers of a proportionate share of the underlying assets Comment: “The Tax Court could have easily gone the other way,” Charles Rubin, managing partner, Gutter Chaves Josepher Rubin Forman Fleisher P.A., Boca Raton, Fla., told CCH. “The regulations treat such an entity as disregarded for all purposes, and thus the court could have applied ©2009 CCH. All Rights Reserved PRACTICAL TAX BULLETIN • ISSUE 19 it for gift tax purposes. Nonetheless, the focus by the court on state law property concepts is both correct and refreshing.” In 2000, after receiving a $10-million cash gift, the taxpayer organized a single-owner LLC. The taxpayer did not elect to treat the LLC as a corporation for federal tax purposes. The taxpayer also created two trusts for the benefit of family members. The taxpayer transferred $4.25 million in cash and securities to the LLC. Shortly thereafter, the taxpayer transferred her entire interest in the LLC to the trusts. The taxpayer gave a 9.5-percent membership interest in the LLC to each of the trusts to use a portion of her then-available credit amount and her GST exemption. The taxpayer subsequently sold each of the trusts a 40.5-percent membership interest in exchange for a secured promissory note, which each had a face amount of $1,092,133. The taxpayer set this amount using an appraisal that valued a one-percent non-managing interest in the LLC at $26,965. The appraiser determined the value of a one-percent interest by applying a 30percent discount to the value of the LLC’s assets. The IRS’s proposed check-the-box treatment, the court found, would go beyond classifying the LLC for tax purposes. Federal law and not state law would define the property rights and interests transferred by a donor. Comment: Two dissenting judges claimed that the majority ignored the plain language of the check-the-box regulations, which require that a single-member LLC be disregarded for federal tax purposes and not just federal income tax purposes. Another dissent observed that the check-the-box regulations put the choice of entity classification in the hands of the taxpayer. References: Kleinrock §759.3; PTE §34,810.05 Code Sec. 2701 S Corporation’s Interests in LLC Were Not Applicable Retained Interest The IRS has ruled on a proposed series of separate transactions between a calendar-year, accrual-basis S corporation, its wholly owned limited liability company (LLC) treated as a disregarded entity with respect to the S corporation, and one of the S corporation’s related-party shareholders (IRS Letter Ruling 200934013). The taxpayer reported the value of the taxable gift to each trust as $256,168. The IRS determined that the transfers of the 9.5-percent LLC interests to the trusts were gifts of proportionate shares of the LLC’s assets In the first transaction, the shareholder made a capital and not transfers of interests in the LLC. Additionally, contribution to the LLC in exchange for a newly isthe IRS determined that the taxpayer made gifts to the sued, preferred interest in the LLC. The LLC owned trusts of the 40.5-percent interests in the LLC to the exa professionally managed tent that the value of 40.5 diversified portfolio of inpercent of the underlying assets exceeded the value “The court found that state law establishes vestment assets. By makof the promissory notes. property rights and interests, and federal law ing an investment in the LLC, the shareholder was able to invest excess cash in The taxpayer and the IRS defines the treatment of those rights.” the portfolio and receive a disagreed if the LLC could priority return on invested be disqualified for gift tax capital at a rate that remained fixed for a period of time purposes. The court found that state law establishes prop(the “dividend right”). erty rights and interests, and federal law defines the treatment of those rights. In a concurrent, but not interdependent, transaction, the S corporation distributed a portion of its ownership inThe court found that, under state law, the taxpayer did terests in the LLC pro rata to all of its shareholders. The S not have a property interest in the underlying assets of corporation retained a capital interest in the LLC, which the LLC. The LLC was an entity separate and apart entitled the S corporation to receive a disproportionate from its members. Consequently, federal law could share of profits based on it providing future management not create a property right in the underlying assets. services to the LLC. The taxpayer’s gift tax liability would be determined by the value of the transferred interests in the LLC and The ruling determined that the related-party shareholdnot by a hypothetical transfer of the underlying assets er’s dividend right in the preferred stock was an appliof the LLC. 9 10 SEPTEMBER 15, 2009 TAX HIGHLIGHTS cont’d Correction cable retained interest subject to the special valuation rules for gifts under Code Sec. 2701, because it was an equity interest in a controlled entity with respect to which the shareholder had a distribution right. The dividend right was not, however, a qualified payment right because it was not payable at a fixed rate or in a fixed amount. In accordance with Reg. §25.2701-2(c), the shareholder made an election to treat the distribution right as a qualified payment right and, based on that election, the shareholder was treated as holding a qualified payment right. The story Cash for Clunkers Credits Taxable to Dealers”on page 6, in Issue 17 (August 18, 2009), incorrectly stated that a trade-in vehicle must get more than a specified number of miles per gallon (MPG) of gasoline, and the new vehicle must get less than a specified number of MPG. The story should have said that the trade-in must get less than a specified MPG, and the new car must get more than a specified MPG. We regret the error. The shareholder’s acquisition of an interest in the LLC, together with all the shareholders of the S corporation receiving interests in the LLC, caused the LLC to no longer be a disregarded entity. Instead, the LLC converted to being taxed as a partnership in accordance with Rev. Rul. 99-5, 1991-1 CB 434. who are in the same category of employees with highdeductible health plan coverage (HDHP). References: Kleinrock §759.3; PTE §34,810.05 Code Sec. 4980G Final Regulations Issued on Comparable Contributions to HSAs and Excise Tax Return Requirements The IRS has issued final excise tax regulations that provide guidance on employer comparable contributions to Health Savings Accounts (HSAs) under Code Sec. 4980G (T.D. 9457). Regulations are also finalized covering the return requirements for excise tax payments for failure to meet the continuing coverage requirements under Code Sec. 4980B and Code Sec. 4980D, as well as the comparable coverage requirements for Archer MSAs under Code Sec. 4980E and for HSAs. The final regulations define a highly compensated employee as either (1) a 5-percent owner during the tax year or the preceding year or (2) an employee who for the preceding year has compensation from the employer in excess of $110,000 (indexed for inflation for 2009) and, if elected by the employer, was in the group consisting of the top 20 percent of employees when ranked on compensation. Eligible individuals may make or have made on their behalf the maximum annual HSA contribution based on their HDHP coverage during the last month of the tax year. Under the final regulations, an employer can contribute up to this maximum contribution on behalf of all employees who are eligible individuals during the last month of the tax year, including employees who become eligible after January 1 of the calendar year and eligible individuals who are hired after that date (“mid-year eligible individuals”). The final regulations allow an employer to contribute to the HSAs of nonhighly compensated employees in an amount that is larger than the employer’s contribution to the HSAs of the highly compensated employees with comparable coverage during a period. Contributions to highly compensated employees may not exceed employer contributions to the HSAs of nonhighly compensated employees with comparable coverage during a period. A qualified HSA distribution is a direct distribution of an amount from a health flexible spending arrangement (health FSA) or from a health reimbursement arrangement (HRA) to an HSA. Under the final regulations, if an employer offers this type of distribution to any employee covered under any HDHP, the employer must offer qualified HSA distributions to all employees who are eligible individuals covered under any HDHP. Employers who offer qualified HSA distributions only to employees who are eligible individuals covered under the employer’s HDHP are not required to offer qualified HSA distributions to employees who are eligible individuals, but who are not covered under the employer’s HDHP. The comparability rules will still apply with respect to contributions to HSAs for those eligible individuals Under the final regulations, persons liable for excise taxes under Code Sec. 4980B, Code Sec. 4980D, ©2009 CCH. All Rights Reserved PRACTICAL TAX BULLETIN • ISSUE 19 Code Sec. 4980E or Code Sec. 4980G must file Form 8928, Return of Certain Excise Taxes Under Chapter 43 of the Internal Revenue Code. The tax must be paid at the time prescribed for filing the return, without extensions. With respect to the excise tax under Code Sec. 4980B and Code Sec. 4980D for failure to continue coverage, the return is due on or before the due date or filing the person’s federal income tax return for employers and third parties. For multi-employer or specified multiple health plans, the return is due on or before the last day of the seventh month after the end of the plan year. sification or reclassification solely because Form 8832, Entity Classification Election, was not timely filed, and the entity has either: not filed federal tax or information returns for the first year in which the election was intended because the due date for such filing has not yet passed, or timely filed all required federal tax and information returns consistent with its required classification for all of the years the entity intended the requested election to be effective. If an entity is not required to file such returns, each afThe excise tax return for noncomparable contributions fected person must have met the filing requirements. Reunder Code Sec. 4980E or Code Sec. 4980G is due on lief must be requested beor before the 15th day of fore three years and 75 days the fourth month following the calendar year in “Eligible entities will no longer be required from the requested effective which the noncomparable to obtain a private letter ruling under Reg. date and reasonable cause for the failure to timely contribution was made. make the classification elecThe final regulations also §§301.9100-1 and -3.” tion must be shown. provide guidance with respect to the general requirements of excise tax reEligible entities will no longer be required to obtain turns (Reg. §54.6011-2), the time and place for fila private letter ruling under Reg. §§301.9100-1 and ing these excise tax returns (Reg. §54.6071-1 and Reg. -3. Entities that do not satisfy the requirements, §54.6091-1), signing the returns (Reg. §54.6061-1) however, will have to apply for a private letter ruland the time and place for paying the tax shown on the ing and will also have to either make an affirmative returns (Reg. §54.6151-1). representation with respect to the timeliness of all U.S. tax and information returns that they are reReferences: Kleinrock §140.4; PTE §20,515.35 quired to file or explain why they cannot make such a representation. Certain eligible entities may qualify Code Sec. 7701 for alternative relief under Reg. §301.7701-3(c)(3) (v)(C), which treats an entity as having made a classiLate Entity Classification Election fication election to be treated as an association when Relief Broadened, Extended it timely elects to be an S corporation under Code Sec. 1362(a)(1). The IRS has issued a revenue procedure providing relief with respect to a late entity classification election This guidance is generally effective September 28, to both initial classification elections and changes in 2009, and applies to requests pending with the naclassification elections, and has extended the time for tional office or with the IRS service center pursuant filing late entity classification elections (Rev. Proc. to Rev. Proc. 2002-59, 2002-2 CB 615, on September 2009-41, 2009-39 IRB __). This guidance is the ex28, 2009, and to requests thereafter. If an entity has clusive means for eligible entities to obtain relief for a filed a request for a letter ruling seeking relief for a late entity classification. late entity classification, the entity may rely on this guidance, withdraw the request and receive a refund Comment: The new revenue procedure superof its user fee. However, pending letter ruling requests sedes Rev. Proc. 2002-59, 2002-2 CB 615. will be processed unless the entity notifies the national office that it is withdrawing its request. An entity that is eligible for relief under the new procedure is an entity that failed to obtain its requested clasReferences: Kleinrock §202.7; PTE §30,015.05 11 12 SEPTEMBER 15, 2009 TAX BRIEFS S Corporations. Payments made to a state taxing authority on behalf of an S corporation’s shareholders residing in that state did not violate the one-class-of-stock rule (IRS Letter Ruling 200935019). Amounts that related to the shareholders’ personal income taxes were consistent with the amounts that would have been distributed to the shareholders if they had received current distributions under the stated policy in the same manner as shareholders residing in other states. Code Sec. 1388. Employment Taxes. The illness of the president of a corporation was not reasonable cause for the corporation failing to meet its tax obligations, as the vice-president was aware that the president was responsible for filing and paying the corporation’s employment taxes but was unable to perform those duties (Benton Workshop v. United States, DC Ark., 2009-2 ustc ¶50,598). The corporation should have exercised ordinary business care by verifying the schedule on which it was required to file and pay its employer’s taxes. Code Sec. 6651. Withholding. The IRS has announced updated specifications for electronically filing Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding (Rev. Proc. 2009-35). The following changes have also been made for 2009: the formula for determining U.S. Federal Tax Withheld located in Part A, Section 8.09, was modified; a taxpayer’s file size cannot exceed 899,999 records; and amended transactions must reflect an Amended Code Indicator in position 810 of the W and Q Records. Code Sec. 6011. Alcohol Fuels Credit. The IRS has determined that a taxpayer’s ethanol production facility did not have a productive capacity in excess of 60 million gallons during its tax year; therefore, the taxpayer was a small ethanol producer eligible for the credit under Code Sec. 40(a) (3) (CCA 200935022). Although the taxpayer determined after the close of its tax year, but before it filed its return for such year, that its facility could exceed the 60 million gallon capacity, it did not have this knowledge during its tax year; therefore, it was not deemed to have a capacity in excess of the limit for the credit. Code Sec. 40. Oil and Gas Properties. The inflation adjustment factor for calendar year 2009 for use in determining enhanced oil recovery credit is 1.5003 (Notice 2009-73, 2009-38 IRB __). Because the reference price for 2008 ($94.03) exceeds $28 multiplied by the inflation adjustment factor for the 2008 calendar year ($42.01) by at least $6, the credit for qualified costs or incurred in 2009 is completely phased out. Code Sec. 43. Exempt Organizations. User fees will increase for all applications for exemption (Forms 1023, 1024, and 1028) postmarked after January 3, 2010, to: $400 for organizations whose gross receipts are $10,000 or less annually over a four-year period; $850 for organizations whose gross receipts exceed $10,000 annually over a four-year period; and $3,000 for group exemption letters. Code Sec. 7528. Mark-to-Market. The applicable percentage to be used in determining percentage depletion for oil and gas produced from marginal wells for the 2009 calendar year is 15 percent (Notice 2009-74, 200938 IRB __). The reference price for the 2008 calendar year (used in determining the applicable percentage for 2009) is $94.03. Code Sec. 613A. ICE Futures Canada, a regulated exchange of Canada, has been recognized by the IRS as a qualified board or exchange within the meaning of Code Sec. 1256(g) (7)(C) (Rev. Rul. 2009-24, 2009-36 IRB 306). A taxpayer may change to the Code Sec. 1256 mark-to-market accounting method for the first tax year during which the taxpayer holds an ICE Futures Canada contract that was entered into on or after October 1, 2009. Code Sec. 1256. Code Sec. 613A Notice 2009-74 ....................................12 Code Sec. 1221 Freda ........................................................ 7 Code Sec. 1256 Rev. Rul. 2009-24 ................................12 Code Sec. 1388 IRS Letter Ruling 200935019 .............12 Code Sec. 2512 Pierre ....................................................... 8 Code Sec. 2701 IRS Letter Ruling 200934013 .............. 9 Code Sec. 4980G T.D. 9457 ..............................................10 Code Sec. 6011 Rev. Proc. 2009-35 ..............................12 Code Sec. 6651 Benton Workshop .................................12 Code Sec. 7701 Rev. Proc. 2009-41 .............................. 11 Oil Recovery Credit. Code Section Index Code Sec 40 CCA 200935022 ..................................12 Code Sec. 43 Notice 2009-73 ....................................12 Code Sec. 312 Rev. Rul. 2009-25 ................................. 5 Code Sec. 403 IRS Letter Ruling 200934012 .............. 5 Code Sec. 481 CCA 200935024 .................................... 7 ©2009 CCH. All Rights Reserved