IRS Response to COVID-19: Installment Agreements, Offers in Compromise, and IRS Collection Actions

By John G. Hodnette

The novel coronavirus known as COVID-19 has changed the world as a global pandemic disrupts the day-to-day business operations of almost every country. The IRS has responded to ease the strain on taxpayers during this difficult time by modifying its procedures for collecting assessed federal tax liabilities.

First, those with existing IRS installment agreements have been granted a temporary pause on all payments from April 1 to July 15. Additionally, the IRS has made it clear it will not treat as a default nonpayment or similar events under any installment agreements during this period for any reason. Interest will continue to accrue on these balances. Although this pause also applies to direct debit agreements, the IRS will not automatically stop direct debit withdrawals from taxpayers’ bank accounts. Therefore, any taxpayer who has a direct debit installment agreement will need to request its bank to halt payments during this period. If the taxpayer has a traditional agreement (i.e., the installment payments are sent in by check or manually paid online every month), the only thing the taxpayer needs to do is stop payment during this period.

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Alimony Modifications: Taxation of Alimony Payments Under the 2017 Tax Act

By John G. Hodnette

Prior to the 2017 Tax Act, Section 71 provided alimony payments entitled the payor to a deduction and required the payee to include them in taxable income.  The 2017 Tax Act repealed Section 71.  For alimony orders executed after December 31, 2018, a payor of alimony receives no deduction, and an alimony recipient is no longer taxable on it.

While this change may seem straightforward, an interesting question arises when an alimony order is executed on or prior to December 31, 2018 but is later modified.  Although Treasury has not yet issued guidance, the 2017 Tax Act provides guidance at Pub. L. 115-97 § 11051(c).  That section states “any divorce or separation agreement (as so defined) executed on or before [December 31, 2018] and modified after such date [shall be bound by the amendments to this section] if the modification expressly provides that the amendments made by this section apply to such modification” (emphasis added).  Thus, one must expressly adopt the new law in the modification of the old alimony for the new law to apply.

By providing that one may essentially contract his or her way into the new law, Congress has passed the responsibility to the taxpayer.  Family law attorneys should be deeply familiar with these aspects of the tax code.

John G. Hodnette, JD, LLM is an attorney with Culp, Elliott, & Carpenter in Charlotte.

NONTAXABILITY OF WORKING CONDITION FRINGE BENEFITS IN LIGHT OF THE SUSPENSION OF MISCELLANEOUS ITEMIZED DEDUCTIONS

By Herman Spence III

On November 7, 2019, John Hodnette posted an article on the Tax Section’s blog regarding employee educational fringe benefits.  As noted in the article, Section 132(a)(3) provides an exclusion from gross income for working condition fringes.  A working condition fringe is any property or service provided to an employee to the extent, if the employee paid for such property or service, the payment would be allowed as a deduction under Section 162 or 167.  The 2017 tax act, however, eliminates individuals’ miscellaneous itemized deductions through 2025, including an employee’s expenses related to his or her job.  That raises the issue of whether working condition fringe benefits remain nontaxable given an employee cannot deduct employment related expenses.

It seems clear Congress did not intend to make working condition fringe benefits taxable.  In other cases in which Congress eliminated a nontaxable benefit, it did so directly, including moving expenses in Section 132(g)(2) and bicycle commuting benefits in Section 132(f).  Also, Section 132 only requires a payment be allowable as a deduction under Section 162 without mentioning Section 67.  Reg. § 1.132-5(a)(1)(vi) states the limitation of Section 67 is disregarded in determining the amount of a working condition fringe.  IRS publications, including Publication 15-B, continue to describe working condition fringe benefits as nontaxable.  Therefore, notwithstanding the suspension of employees’ ability to deduct employee expenses, working condition fringe benefits should continue to be nontaxable.

Herman Spence III is an attorney with Robinson Bradshaw in Charlotte.

FEDERAL INCOME TAX UPDATE

By Keith A. Wood

This is the first of two installments of this article.  The second installment will soon be posted on the Tax Section blog.

I.     Damages for Emotional Distress Not Excludable from Taxable Income Unless Directly Associated with Physical Injury.

A.     Background.
Section 104(a)(2) provides an exclusion from gross income for damages received by a taxpayer for personal injury or physical sickness.  Generally, emotional distress is not physical injury or physical sickness.  Taxpayers, therefore, must report as gross income damages they receive for emotional distress unless they are reimbursements for medical care to treat the emotional distress.  IRC § 104(a).  Damages for emotional distress are excluded from gross income only when the emotional distress is attributable to a physical injury or a physical sickness.

B.     Doyle, TC Memo 2019-8.
Doyle was terminated from his employment after he raised concern with his employer’s president that the company was involved in illegal anti-competition schemes.  After he was terminated, Mr. Doyle began experiencing physical ailments such as nausea, vomiting, headaches, and backaches.  Ultimately, after a confidential settlement with his employer, Mr. Doyle was paid $350,000 “as settlement for unpaid wages” and $200,000 “as settlement for alleged emotional distress and damages”.  The Tax Court held the damages for the emotional distress were not excludable from gross income under Section 104(c)(2).  The underlying wrong committed by Mr. Doyle’s former employer was based on employment or contact matters and had nothing to do with physical injury.

 

II.     Custom Home Builder Not Entitled to Ordinary Loss on Deemed Sale of Lots. Ferguson vs. Commissioner, TC Memo 2019-40.

Mr. Ferguson was a custom home builder operating through an S corporation.  Mr. Ferguson had a dispute with some of his customers regarding a new development project.  In settlement of the lawsuit, Mr. Ferguson’s S corporation transferred lots to the homeowners.  The S corporation claimed an ordinary loss deduction on the deemed sale of three of the lots by the S corporation.  The court disallowed the ordinary losses on the grounds that Mr. Ferguson was unable to prove the lots were not capital assets as defined in Section 1221(a).  The main factor that worked against Mr. Ferguson was he claimed capital gain treatment on six other lots that were transferred to other plaintiffs.

 

III.     Golf Course Operations Were “For Profit” Notwithstanding Long History of Significant Losses. WP Realty LP vs. Commissioner, TC Memo 2019–120.

Corbin Robertson was a 99% limited partner of WP Realty Limited Partnership and the sole owner of Olympia Enterprises, Inc., the general partner of WP Realty.  WP Realty operated a golf course that had years of significant losses totaling millions of dollars.  During the years at issue, Mr. Robertson was CEO and chairman of the board of the directors of two publicly traded companies.  His adjusted gross income for 2011 through 2014 was close to $175 million.  Mr. Robertson also was a very active real estate investor and developer.  The IRS took the position the primary purpose of the golf course was not to earn a profit.  Based on the following factors, the court determined the golf course activities were conducted for-profit:

  1. The partnership kept accurate books and records.
  2. The partnership had a business plan outlining capital improvements to contribute to the golf club’s growth.
  3. The partnership took steps to make the club more marketable.
  4. The golf course was operated in a businesslike manner. Over time the partnership took significant steps to increase its club membership, such as making major capital improvements.
  5. The partnership relied on experts and hired and consulted with experienced professionals in the golf industry.
  6. The partnership hired professionals to manage the golf course. The golf course club hired executive chefs to prepare meals.
  7. Mr. Robertson had been exceedingly successful in many other similar ventures.

The court stated the only factors that weighed against Mr. Robertson were the long history of losses, and anticipated appreciation of club assets were not expected to overcome those losses.  However, considering the other factors, the court concluded the golf course activities were operated with a for-profit motive.  The court noted, however, if the losses continued now that the partnership had initiated a new membership goal and finished major improvements, the partnership “may again find its profit motive before this court.”

 

IV.      Horse Breeding Activity Determined Not For Profit. Donoghue, TC Memo 2019–71.

A married couple incurred significant losses from their horse breeding activity.  The Donoghues owned horses but boarded them at farms and stables owned by others.  Mr. Donoghue was employed full-time, and Mrs. Donoghue was disabled.  From 1985 to 2012, the horse breeding activity incurred over $1 million of expenses but realized only about $34,000 of income.  The activity never turned a profit in any of those 27 years.

The Tax Court agreed with the IRS that the Donoghues did not operate their horse breeding activity for profit during 2010 – 2012.  The court viewed the following factors against Mr. and Mrs. Donoghue:

  1. Manner of conducting business.   The Donoghues did not breed, race or sell any of the horses.
  2. Expertise of advisors.   The Donoghues never hired experts nor sought the advice of experts on how to run a profitable horse breeding activity.
  3. Time and effort devoted to the activity.   Mr. and Mrs. Donoghue did not create any contemporaneous documentary evidence to corroborate the hours they spent on the activity.
  4. Expectation that assets used in the activity may appreciate.    The only assets owned as to the activity were the horses themselves.  and Mrs. Donoghue were unable to provide any evidence the value of the horses would ever exceed the losses of the activity.
  5. History of income and losses.   The activity never earned a profit in any year.
  6. Financial status of the taxpayer.   Mr. and Mrs. Donoghue received more than $100,000 in each of relevant years, but that income was completely wiped out by the losses of the horse farm.
  7. Personal pleasure and recreation. Mrs. Donahue loved her horse operations.  The Donoghues relied on employees to perform the more grueling aspects of the horse breeding business.

The court also upheld assessment of the Section 6662 substantial understatement penalty.  The Donoghues contended they had reasonable cause and acted in good faith because they had a prior audit for 2007 in which the IRS ultimately conceded the hobby loss issue in Tax Court.  However, as stated in Transupport, Inc. v. Commissioner, T.C. Memo 2016-216 at 41:

“Petitioner again argues that the methodology was used consistently over years and was therefore correct.  Petitioner apparently believes that repeating a fallacy over and over again and ignoring contrary evidence will succeed.  It does not.  A well established principle is that what was condoned or agreed to for a previous year may be challenged for a subsequent year.  Auto Club of Mich. v. Commissioner, 353 U.S. 180 [50 AFTR 1967] (1957); Rose v. Commissioner, 55 T.C. 28 (19709).  Thus, the results of a prior audit do not constitute substantial authority.”

 

V.      Bankruptcy Court Refuses to Allow Partnership to Convert to C Corporation Status.

In In Re Schroeder Brothers Farms of Camp Douglas LLP, 123 A.F.T.R. 2d 2019-2080,  the U.S. Bankruptcy Court refused to allow the debtor, an entity taxed as a partnership for tax purposes, to convert to C corporation status by making a check the box election on Form 8832.  The bankruptcy court held that allowing the partnership to convert to a C corporation was not in the best interests of the debtor, the estate, or its creditors.

 

VI.     IRS Rules S Election was Inadvertently Terminated by Operating Agreement Amendment.

In PLR 201930023, the IRS concluded an LLC’s S election was inadvertently terminated after its members adopted an amendment to the distribution provisions in the LLC operating agreement.  The taxpayer was an LLC that elected to be taxed as an S corporation.  Thereafter, the LLC and its members amended the agreement to provide liquidating distributions would be made in accordance with positive capital account balances.  Later, the operating agreement was amended again to provide for distributions on a pro rata basis.

The IRS ruled the S election was terminated by virtue of the first amendment.  However, because all distributions were actually made to the members in proportion to their membership interests, the IRS ruled the termination was inadvertent, and therefore the LLC would continue to be taxed as an S corporation in all periods.

Keith A. Wood is an attorney with Carruthers & Roth, P.A. in Greensboro.

S Corporations: Dealing with Accumulated Earnings and Profits

Please send articles for the Tax Section blog to: Herman Spence at HSpence@robinsonbradshaw.com.

By Kerri L.S. Mast

C corporation income is generally subject to two levels of taxation.  It is taxed at the corporate level when earned and at the shareholder level when distributed.  An S corporation, on the other hand, generally is not taxed at the corporate level; its items of income and deduction flow through to its shareholders when earned.  Subsequent distributions by the S corporation to the shareholders often can be made tax-free.  However, the taxation of distributions is more complicated if the S corporation has C corporation accumulated earnings and profits (E&P).

An S corporation does not generate E&P.  However, it can possess E&P as a result of either converting from C corporation to S corporation or acquiring a C corporation.  E&P generated in a C corporation are subject to two levels of taxation – corporate and shareholder – and retain this character even if subsequently owned by an S corporation.  Accumulated E&P was taxed at the C corporation level and will be taxed again as a dividend to recipient S corporation shareholders when distributed.

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Pro Bono Opportunity

By Helen Herbert

Are you looking for a pro bono opportunity where you can use your tax expertise?  The NCBA Tax Section is looking for tax attorneys to train selected military personnel to be tax return preparers through the Military Volunteer Income Tax Assistance (VITA) Program.

The Military VITA Program is designed to assist US military personnel with preparation of federal and state tax returns and thereby save US military families the cost of tax return preparation and, in many instances, receive tax refunds. Many US military families are unfamiliar with federal and state tax requirements and how to file a complete and accurate tax returns and, accordingly, need help in preparing their personal income tax returns.

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Employee Educational Fringe Benefits Under the 2017 Tax Act

By John G. Hodnette

One of the most appealing benefits of working for a university is an educational assistance program.  Free or discounted college education is extremely valuable given tuition continues to increase at an average of 8% per year.  Whether these benefits are taxed as compensation or excluded from income is vitally important to university employees.

Three code sections are especially important when an employer provides an employee or employee’s family with free or discounted college education.  The first is Section 117, which excludes from gross income qualified scholarships granted to an individual who is a candidate for a college degree.  Section 117(d)(1) additionally provides where an educational institution at the university level grants qualified tuition reduction to an employee for an undergraduate degree, that tuition reduction is not included in gross income.

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The Importance of Purchase Price Allocations in Asset Acquisitions

By John G. Hodnette

The maxim “don’t let the tax tail wag the business dog” is often bandied about in the business world.  Tax attorneys know, however, there are times, such as in Section 1060 allocations in asset acquisitions, when tax issues are an important part of the business negotiation.

Section 1060 applies when a business sells assets constituting its trade or business.  Asset acquisitions can be more attractive to a purchaser than stock acquisitions because of its concerns about hidden liabilities associated with the stock.  Additionally, purchasing assets directly increases the tax basis in the assets to a cost basis consistent with the purchase price.  This step-up in basis translates to larger depreciation deductions for the purchaser, resulting in long-term tax savings.  In contrast, a stock acquisition results only in an increased basis in the stock itself, not in the underlying assets of the company.  Since stock cannot be depreciated, this increased stock basis remains unused, for the most part, unless and until the stock is later sold.  If a purchaser and seller agree to an asset acquisition, how the purchase price is allocated among the purchased assets is important.  That is where Section 1060 comes into play.

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Don’t Get Caught Holding the Bag: Embezzlement Repayments and NOL Limitations

By John G. Hodnette

The net operating loss (“NOL”) rules in Section 172 are complex. A revisit every few years is beneficial, particularly given the 2017 Tax Act modified these rules to disallow NOL carrybacks and allow NOL carryforwards indefinitely, with a new limit of 80% of taxable income.

While the rules seem simple at first glance, how they work with various types of losses is surprising. For example, one who embezzles from an employer is rightfully assessed tax on the income from his or her illegal activities pursuant to the landmark ruling of James v. United States, 366 U.S. 213 (1961). That decision, while answering the question of whether illegally obtained income is taxable, created a new question of how the repayment of embezzled funds is treated for income tax purposes. Although both the IRS and the taxpayers agreed a deduction should be allowed where embezzled funds are repaid, they differed on which Code section provides the deduction. The IRS maintained the deduction is allowed under Section 165(c)(2), which addresses “losses incurred in any transaction entered into for profit, though not connected with a trade or business.”  In contrast, the taxpayers in a number of cases argued the embezzlement itself was a trade or business, the embezzled funds were invested in a trade or business, or the embezzlement from their employer was inextricably linked to their trade or business of being an employee with such employer.

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2017 Tax Act’s $11.2 Million Estate, Gift, and GST Tax Exemption Will Expire In 2025

By John G. Hodnette

The Tax Cuts and Jobs Act of 2017 doubled the unified exemption for the estate, gift, and GST taxes from about $5.6 million to about $11.2 million (adjusted yearly for inflation).  This dramatic change means for years after 2017, a married couple can gift during life or pass by their death up to $22.4 million of assets free of transfer taxes.  While many high net worth clients are aware of the doubled exemption, it is less well known that this doubled exemption is set to expire on December 31, 2025.

This is not the first time Congress has used a sunset schedule for the unified transfer tax exemption amount.  At the end of 2012, taxpayers faced a similar dilemma when it was uncertain whether Congress would act to prevent the automatic reversion of the unified transfer tax exemption from about $5.12 million to $1 million.  In that case, Congress did act to keep the exemption at $5.12 million.  It is unclear, however, if the same will occur in 2025, particularly given the rhetoric about “taxing the ultra-wealthy” from presidential candidates and Democratic Senators such as Bernie Sanders and Elizabeth Warren.  This uncertainty calls for tax planning designed to take maximum advantage of the Tax Act’s increased exemption regardless of what may happen at the end of 2025.

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