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
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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
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©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.
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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.
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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-
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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
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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