This is the first of two installments of this article. Read the second installment here.
I. Audit Statistics; What Are Your Chances of Being Audited?
The 2016 Internal Revenue Service Data Book (IR-2017-69) contains audit statistics for the fiscal year ending September 30, 2016. Here are the audit statistics for returns filed for calendar year 2015 (“CY 2015”):
A. Audit Rates for Individual Income Tax Returns. Only .7% of individual income tax returns filed in CY 2015 were audited (down from .8% of returns audited in FYE 2015). Of these audited returns, only 23.6% of individual tax audits were conducted by revenue agents and the rest of the audits were correspondence audits.
Not surprisingly, the audit rates for Schedule C returns were higher than for individual returns. Schedule Cs filed in CY 2015 showing receipts of $100,000-$200,000 had a 2.2% audit rate (down from 2.5% in FY 2015). Schedule C returns filed in CY 2015 showing income over $200,000 had a 1.9% audit rate (down from 2.0% in FY 2015).
Total Individual Returns Audited .7%
(1) With Schedule C income:
$100,000 to $200,000 2.2%
Over $200,000 1.9%
(2) Non-business income of:
$200,000 to $1 million 1.0%
(3) Positive income over $1 million 5.8%
B. Audit Rates for Partnerships and S Corporations: For partnerships, the audit rate for returns filed in CY 2015 was .4% (down from .5% in FY 2015). For S corporations, the audit rate for returns filed in CY 2015 was .3% (down from .4% in FY 2015).
C. Audit Rates for C Corporations. C corporation returns filed in CY 2015 had an audit rate of 1.1%. However, for large corporations with assets over $10 million, the audit rate was 9.5%.
Total C Corporation Returns Audited 1.1%
(1) Assets less than $1 million 1.0%
(2) Assets $1 million to $5 million 1.0%
(3) Assets $5 million to $10 million 1.6%
(4) Assets $10 million to $50 million 4.7
D. Offers in Compromise. The IRS received 63,000 offers in compromise but accepted only 27,000 of them.
E. Criminal Case Referrals. The IRS initiated 3,395 criminal investigations for fiscal year 2016 (down from 3,853 for 2015). The IRS referred 2,744 cases for criminal prosecutions (1,023 for legal source crimes, 1,037 for illegal source financial crimes, and 684 for narcotics-related financial crimes) and obtained 2,672 convictions. Of those convictions, 2,156 were actually incarcerated
II. Taxpayers’ Interest in a Pension Plan Was Not an Asset for Purposes of the COD Insolvency Test
The general rule under Section 108 is that a debtor recognizes ordinary income equal to the amount of the debt discharged over the amount of cash and the fair market of any property paid to the creditor. However, there is an important exception where the debtor is bankrupt or insolvent. Under Section 108(a), if the debtor is insolvent, income must be recognized only to the extent the cancelled debt exceeds the amount by which the debtor was insolvent before the discharge. However, Section 108(d)(3) does not identify which assets and which liabilities are included in the determination of a taxpayer’s solvency. In Carlson v. Comr., 116 T.C. 87 (2001), the Tax Court held assets exempt from creditor claims must be counted in the determination of the taxpayer’s solvency for purposes of the insolvency exception of Section 108(a)(1)(B).
In Schieber v. Commissioner, TC Memo 2017-32, Mr. and Mrs. Schieber sought to exclude certain cancelled debt from taxable income based upon the insolvency test of Section 108(d)(3). Mr. Schieber was the beneficiary of a monthly pension plan and took the position the pension plan was not a countable asset for the purpose of the insolvency test.
The Tax Court held Mr. Schieber’s interest in the pension plan was not an asset for purposes of the Section 108 insolvency test because Mr. Schieber’s only right in the pension plan was to receive monthly pension benefits. Under the terms of the pension plan, he had no right to withdraw pension benefits in excess of the monthly pension benefit amount. Also, Mr. Scheiber could not borrow from the plan or use the plan benefits as collateral for loans.
III. Section 183 and Hobby Loss Rules: Expansive Ranching Activity Found to be for Profit and Not a Hobby
Section 183 denies the deduction of losses or expenses incurred in connection with a hobby rather than a trade or business. In Welch v. Commissioner, TC Memo 2017-229, the Tax Court held Mr. Welch engaged in his ranching activities with a for-profit motive and not as a hobby. Although Mr. Welch did not have any type of written business plan, there were other factors indicating the activity was not a hobby. For example, Mr. Welch kept detailed books and records for his activities, maintained a separate bank account for the activities, routinely hired experts to assist with his ranching operations, and often made alterations to his business operations to improve the chances of profitability.
IV. Mortgage Broker Fails to Qualify as Real Estate Professional Under the Passive Activity Loss Rules
A. Background of Real Estate Professional Rules. Although a rental activity is generally treated as a passive activity regardless of whether the taxpayer materially participates in that activity, Section 469(c)(7)(B) provides the rental activities of a real estate professional are not per se passive activities. Instead, they are treated as a trade or business subject to the material participation requirements of Section 469(c)(1).
Under Section 469(c)(7)(B), a taxpayer qualifies as a real estate professional if: (1) more than half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real estate property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
B. Hickam. In Hickam v. Commissioner, TC Summary Opinion 2017-66, a mortgage broker failed to demonstrate that he was a real estate professional under the passive activity loss rules of Section 469. Mr. Hickam was a mortgage broker who brokered and originated mortgage loans for his clients to buy real estate. During the tax years at issue, Mr. Hickam also owned several rental properties that reported net losses. Mr. Hickam took the position he was a real estate professional and that the losses were therefore deductible under Section 469(c)(7)(C).
The Tax Court held, although Mr. Hickam’s mortgage brokerage business involved brokering and originating loans secured by real property, that business did not involve operating real properties. Therefore, hours he spent on his mortgage brokerage business could not be counted toward the 750 hour test. The court implied, however, it may have reached a different result if Mr. Hickam had brokered real estate rather than simply brokering loans between buyers and financial institutions.
The Court did determine Mr. Hickam’s real estate activities with respect to the three rental properties may constitute a real property trade or business. Unfortunately, because Mr. Hickam did not keep contemporaneous records as to the hours he spent on the three rental properties, he was not able to demonstrate he qualified as a real estate professional.
In two other cases the Tax Court was convinced by credible time logs and trial testimony. In Zarrinnegar v. Commissioner, TC Memo 2017-34, the court believed a dentist worked fewer than 1,000 hours in his dental practice but more than 1,000 hours in his real estate businesses. In Windham v. Commissioner, TC Memo 2017-68, the court was convinced a stockbroker devoted more hours to operating her real estate business than to her stockbroker work.
V. Depreciation Deductions: Allocating Real Estate Purchase Price Between Buildings and Land
A. Background on General Allocation Rules. Under Reg. 1.167(a)-5, when a single purchase price is paid to purchase both depreciable property (building) and non-depreciable property (land), the purchase price must be allocated between depreciable property and non-depreciable property based upon their relative fair market values at closing. Generally, the purchase price allocation is made based on local county property tax values if other evidence of true fair market values is not readily available. Smith v. Commissioner, TC Memo 2010-162.
B. Neilsen. In Neilsen v. Commissioner, TC Summary Opinion 2017-31, Mr. and Mrs. Neilsen acquired several different properties from 2003 to 2011. For purposes of calculating depreciation on these rental properties, Mr. and Mrs. Neilsen included the cost of the land in their calculation of depreciable basis. The IRS audited the Neilsen’s 2012 tax return and re-determined the appropriate depreciable basis of each rental property for that year, based on county property tax records existing during the years of purchase. The Neilsens argued the county tax records allocated too much value to the land and a more accurate allocation should be made based on other valuation methods. However, the court ruled too much time had passed since the dates of purchase to use other valuation methodologies.
VI. Failed Donee Acknowledgement Letter Resulted in Disallowance of $65 million Charitable Contribution
In 15 West 17th Street LLC v. Commissioner, 147 TC No. 19, an LLC taxed as a partnership made a charitable contribution to a charitable trust. In December 2007, the LLC executed a historic preservation deed of easement in favor of the Trust for Architectural Easements (the “Trust”). In May 2008, the Trust sent the LLC a letter acknowledging receipt of the easement. However, the Trust’s letter did not specifically state whether the Trust had provided any goods or services to the LLC or whether the Trust had otherwise given the LLC anything of value in exchange for the easement. The LLC obtained an appraisal that determined the value of the charitable contribution easement was almost $65 million. In October 2008, the LLC filed its partnership tax return and included a copy of the Trust’s letter of May 2008, along with Form 8283, Non-Cash Charitable Contribution, executed by the appraiser and a representative of the Trust acknowledging the LLC’s gift to the Trust.
The IRS disallowed the LLC’s charitable contribution deduction because the May 2008 donee acknowledgement letter did not meet the “contemporaneous written acknowledgement” (“CWA”) substantiation requirements of Section 170(f)(8)(A) since the Trust failed to confirm the LLC received nothing in exchange for its charitable contribution. Later, the Trust prepared an amended Form 990 for 2007 and reported its receipt of the charitable donation from the LLC of $65 million including all of the information that would meet the substantiation requirements under Section 170.
The LLC argued in Tax Court that Section 170(f)(8)(D) specifically provides a donee acknowledgement letter does not need to be delivered to the donor if the donee charitable organization files an informational tax return that includes all of the information that would have been included in the donee acknowledgement letter “on such form and in accordance with such regulations as the Secretary may prescribe.” The LLC argued, by amending its Form 990 for 2007, the Trust effectively provided the IRS with the identical information that would have been included on the LLC’s donee acknowledgement letter in May 2008.
The court, however, noted the IRS had not issued any regulations that specify how a charitable organization’s informational return Form 990 eliminates the necessity of the contemporaneous donee acknowledgment letter that must be provided by a charity to its donor. Moreover, Section 170(f)(8)(D) does not require the IRS to issue such regulations, but instead states that the IRS may issue regulations that would alleviate the need for charitable organizations to issue contemporaneous donee acknowledgement letters where the organization’s Form 990 discloses the same information that would have been disclosed on the donee acknowledgment letter. Since Congress elected to use “may prescribe” rather than “shall prescribe” in Section 170(f)(8)(D), the charitable organization’s informational return could not save the charitable deduction.
VII. Charitable Deduction Denied for Failure to Provide Tax Basis Information on Form 8283
In RERI Holdings I, LLC v. Commissioner, 149 TC No. 1, the Tax Court denied an LLC’s charitable contribution deduction of $33 million for property donated to a university where the taxpayer failed to include its cost basis in the donated property on its Form 8283 submitted with its tax return. The LLC purchased property for $3 million in March 2002 and donated a remainder interest in the property to the university in August 2003.
Since the taxpayer failed to include its cost basis on the Form 8283, the court ruled the charitable contribution deduction should be denied because the LLC failed to comply substantially comply with the requirements of Reg. § 1.170A-13(c)(2). In reaching its decision, the court reasoned that had the taxpayer shown its tax basis information on the Form 8283, that would have alerted the IRS of the potential overvaluation of the contributed real property based on the much lower amount paid for the property prior to the charitable contribution.
Keith A. Wood is an attorney with Carruthers & Roth, P.A. in Greensboro