This is the first of two installments of this article. The second installment will appear soon on the Tax Section’s blog.
I. Audit Statistics; What Are Your Chances of Being Audited?
In early 2016, the IRS published its 2015 Internal Revenue Service Data Book (IR-2016-52), which contains audit statistics for the fiscal year ending September 30, 2015. Here are the audit statistics for returns filed in calendar year 2014 (“CY 2014”):
A. Audit Rates for Individual Income Tax Returns. Only 0.8% of individual income tax returns filed in CY 2014 were audited (down from 0.9% of returns audited in FYE 2014). Of these audited returns, only 27.4% were conducted by revenue agents, and the rest were correspondence audits.
Not surprisingly, the audit rates for Schedule C returns were higher than for individual returns. Schedule Cs filed in CY 2014, showing receipts of $100,000-$200,000, had a 2.5% audit rate (up from 2.4% in FY 2014). Schedule C returns filed in CY 2014, showing income over $200,000, had a 2.0% audit rate (down from 2.1% in FY 2014).
Total Individual Returns Audited
(1) With Schedule C Income:
$100,000 to $200,000
(2) Non-Business Income of
$200,000 to $1 Million
(3) Income Over $1 Million
B. Audit Rates for Partnerships and S Corporations. For partnerships, the audit rate for returns filed in CY 2014 was 0.5% (up from 0.43% in FY 2014). For S Corporation returns, the audit rate for returns filed in CY 2014 was 0.4% (down from 0.42% in FY 2014).
C. Audit Rates for C Corporations. C Corporation returns filed in CY 2014 had an audit rate of 1.3%. However, for large corporations with assets over $10 million, the audit rate was 11.1%.
Total C Corporation Returns Audited
(1) Assets less than $1 Million
(2) Assets $1,000,000 to $5 Million
(3) Assets $5 Million to $10 Million
(4) Assets $10 Million to $50 Million
D. Offers in Compromise. The IRS received 67,000 offers in compromise but accepted only 27,000 of them.
E. Criminal Case Referrals. The IRS initiated 3,853 criminal investigations in fiscal year 2015 (down from 4,297 in FY 2014). The IRS referred 3,289 cases for criminal prosecutions (1,372 for legal source crimes, 1,020 for illegal source financial crimes, and 897 for narcotics–related financial crimes) and obtained 2,879 convictions. Of those convictions, 2,498 were actually incarcerated.
II. Cancellation of Debt Income: Inventory Held by a Dealer Does Not Constitute Real Property Used in a Trade or Business for Purposes of the QRPBI Rules.
A. Background. Under Section 108(c)(3)(A), a taxpayer may elect to exclude, from cancellation of debt income, any relief of debt that constitutes qualified real property business indebtedness (“QRPBI”). Section 108(c)(3) defines QRPBI as debt secured by real property used in the taxpayer’s trade or business that is incurred to acquire or improve that real property.
B. Revenue Ruling 2016-15. In this revenue ruling, the IRS ruled real property that a taxpayer develops and holds for lease in its leasing business constitutes real property used in a trade or business for purposes of Section 108(c)(3)(A). The IRS also ruled, however, the QRPBI exclusion does not extend to real property that a taxpayer holds primarily for sale to customers in the ordinary course of its business.
III. IRS Discusses Section 108 Limits on Qualified Real Property Business Debt Discharge Exclusion.
A. Background. Section 108(a)(1)(D) provides gross income does not include discharged debt that is qualified real property business indebtedness (“QRPBI”). IRS 108(c)(3) defines QRPBI as debt secured by real property used in the taxpayer’s trade or business that is incurred to acquire or improve that real property and as to which the taxpayer files an election to have these provisions apply. However, the amount of the QRPBI debt discharge that can be excluded from gross income is limited to the excess of (i) the outstanding principal balance of the QRPBI over (ii) the fair market value of the property reduced by the amount of other QRPBI secured by that property. See Section 108(c)(2)(A).
B. CCA 201623009. Chief Counsel Advice 201623009 states the only property taken into account for this purpose is property with indebtedness that qualifies as QRPBI, and the only debt taken into account is debt that qualifies as QRPBI with respect to that same property. The CCA provides the following example:
Taxpayer owns two items of real property used in its trade or business, Property A and Property B. Taxpayer had Debt C and Debt D, both of which were secured by Property A and Property B. The proceeds from Debt C were used to improve Property A, and were not used for Property B. The proceeds from Debt D were used to construct or to improve Property B, and were not used for Property A. Debt C was reduced, reflecting a debt discharge amount of $X. In calculating the maximum exclusion available under §108(c)(2)(A), the taxpayer reduced the fair market value of Property A by Debt D, but without also adding the value of Property B to the value of Property A.
The IRS stated Taxpayer should neither add the value of Property B, nor subtract the outstanding amount of Debt D, in computing the Section 108(c)(2)(A) limitation on the amount of excludable debt discharge income resulting from the discharge of Debt C. According to the CCA, the maximum amount of debt discharge that can be forgiven tax-free is the excess of the outstanding principal amount of that indebtedness before the discharge over the net fair market value of the qualifying real property. “Net fair market value” means the fair market value of the qualifying real property, reduced by the outstanding principal amount of any qualifying real property business indebtedness (other than the discharged indebtedness) that is secured by such property immediately before the discharge.
IV. Personal Guaranty of Loan to a Corporation Owned by an IRA Results in Deemed IRA Distribution.
In Thiessen v Commissioner, 146 TC No. 7 (March 29, 2016), Mr. and Mrs. Thiessen rolled over their retirement funds into a newly formed IRA. The IRA then acquired stock of a C corporation that purchased assets of an existing business. The C corporation delivered a promissory note to the seller as part of the acquisition price, and the Thiessens personally guaranteed the loan.
The Tax Court agreed with the IRS that Mr. and Mrs. Thiessen had received a taxable distribution from their IRA by virtue of the loan guaranty. Pursuant to Section 4975(c)(1)(B), loan guarantees are prohibited transactions that cause the IRA to lose its status as an IRA. Thus, all of the assets of the IRA were deemed distributed to Mr. and Mrs. Thiessen in a taxable distribution.
The court also disagreed with Mr. and Mrs. Thiessen’s argument that the guarantees were given in connection with the acquisition of a security as permitted by Section 4975(d)(23), since the Thiessens’ IRA acquired the seller’s assets through its C corporation. The court concluded the guarantee was given in connection with an asset acquisition rather than the acquisition of the C corporation stock.
V. Stock Issued in a Demutualization Has a Tax Basis of Zero.
In Reuden v. U.S., 117 AFTR 2d 2016-313, the Ninth Circuit Court of Appeals affirmed the earlier decision of the District Court holding that stock received pursuant to a mutual insurance company demutualization has a zero tax basis to the stockholder. In Fisher v. U.S., 105 AFTR 2d 2010-357, the Federal Circuit previously held a taxpayer has a cost basis in stock received in connection with a demutualization. Thus, there is a split among the circuit courts as to this issue.
VI. Forfeited Deposits from a Terminated Contract to Sell Real Property Generates Ordinary Income.
A. Background. Under Section 1234A, gains are entitled to capital gain tax treatment if they are attributable to the cancellation, lapse, expiration or other termination of rights or obligations as to property that would have been a capital asset in the hands of the taxpayer. Section 1221(a)(2) states capital assets do not include property used in a taxpayer’s trade or business that is subject to depreciation or real property used in a taxpayer’s trade or business. Instead, Section 1231 provides if property is used in a taxpayer’s trade or business and is held for more than one year, any gain is treated as a long-term capital gain.
B. CRI–Leslie, LLC, 147 TC No. 8. CRI-Leslie, LLC was engaged in hotel and restaurant businesses. It entered into a contract to sell a Tampa, Florida hotel to RPS, LLC. However, after placing a number of purchase price deposits with CRI-Leslie, RPS failed to close on the purchase of the Tampa hotel property, and the purchase agreement terminated. As a result, CRI-Leslie was entitled to retain forfeited deposits of almost $10 million. CRI-Leslie reported the forfeited deposits as long-term capital gain.
The Tax Court held although any gain on the sale of the Tampa hotel would have been taxed as a long-term capital gain (since the property was Section 1231 property held by CRI-Leslie in its hotel and restaurant business), the hotel nevertheless was not a capital asset as defined in Section 1221(a). Therefore, the amounts received as forfeited deposits were not eligible for favorable capital gains tax treatment under Section 1234A because it provides capital gains tax treatment only for amounts received as a result of the cancellation of a contract involving the sale of a capital asset.
VII. Foreclosure Sale Generates Large Capital Loss for Real Estate Developer.
In Evans v. Commissioner, TC Memo 2016-7, Mr. Evans was employed by Athens Group, a real estate development firm. Outside of his full-time job, Mr. Evans also purchased residential real estate properties that he would develop for sale or rent to tenants. From 2003 to 2007, Mr. Evans purchased several properties in California he intended to either tear down and develop for sale or hold for rental to tenants. One of the tear-down properties was located in Newport Beach. Another tear-down property was located in Corona del Mar. Over the course of several years, Mr. Evans developed the Corona del Mar property into a two condominium building, which he later sold.
The Newport Beach property included a shack and a garage. Mr. Evans’ intention was to tear down the shack and the garage and build a two-unit house. In 2008, Mr. Evans lost the Newport Beach property in a foreclosure sale. He reported a Section 165 ordinary loss of over $1 million as a result of the foreclosure. The court agreed with the IRS that the loss should be treated as a capital loss, rather than an ordinary loss, based on the following factors:
The nature of the acquisition of the property. When Mr. Evans acquired the Newport Beach property, he intended to sell that property; but, if he was unable to obtain an adequate sales price, he would continue to hold the property. This factor, however, did not mean that Mr. Evans was in the business of property development.
Frequency and Continuity of Property Sales Over an Extended Period. Evans’ property sales were sporadic and not frequent or continuous.
The Nature and Extent of the Taxpayer’s Business. The court found even though Mr. Evans engaged in several different real estate activities, his personal real estate development activities were isolated. Thus, the court concluded that Mr. Evans’ real estate development activities did not constitute a trade or business.
The Activity of the Seller about the Property. Although Mr. Evans held the Newport Beach property for ultimate sale, this factor was not determinative of whether Mr. Evans was in the business of selling property.
The Extent and Substantiality of Transactions. Evans could only point to a few acquisitions of property over several years. He could not prove his other activities generated net income or gain during that period. Because the Newport Beach property generated a loss in the foreclosure, the Court surmised Mr. Evans’ primary source of income was from his full time job at Athens Group, and any income he earned from developing properties was insubstantial.
Based on the foregoing, the court concluded Mr. Evans personal real estate activities did not constitute a trade or business for the purposes of Section 1221(a)(1), and therefore the Newport Beach property was a capital asset.
VIII. Husband and Wife Were Deemed Dealers Rather than Investors in Real Property.
In Boree v. Commissioner, TC Memo 2014-85, aff’d, 118 AFTR 2d 2016-5207, the issue was whether Mr. and Mrs. Boree could treat gain on their sale of real property to a developer as capital gain rather than ordinary income.
A. Facts. In 2002, Mr. Boree and Daniel Dukes formed Glen Forest, LLC and purchased almost 2,000 acres of land in Florida for approximately $3.2 million. The purchase price was funded with almost $1.9 million in loans from a bank and $250,000 they had borrowed from their parents. Immediately after the purchase of the 2,000 acres, the LLC sold approximately 280 acres to eight purchasers. In 2003, Glen Forest sold approximately 15 lots of the Glen Forest property and began building an unpaved road on the property. Glen Forest, LLC then began planning a residential development community on the property that would consist of over 100 lots. Glen Forest, LLC applied for, and received exemptions for, subdivision requirements that allowed it to sell lots without completing the interior roads or submitting plats to the local governing board. In 2003, Glen Forest executed a declaration of covenants and created a homeowners association to enforce the declaration and to maintain the common area. The declaration referred to Glen Forest as the developer. During 2004, Glen Forest sold approximately six lots of the Glen Forest property. During 2005, Glen Forest sold approximately 17 lots. In March 2005, Mr. and Mrs. Boree purchased Mr. Duke’s interest in the LLC and became the sole owners of Glen Forest. In May 2005, Glen Forest submitted a proposal that the Glen Forest property be rezoned as a planned unit development (PUD). In September 2006, Glen Forest withdrew its PUD application and instead requested non-PUD zoning changes.
In February 2007, Glen Forest sold over 1,000 acres of the Glen Forest property to Adrian Development for $9.6 Million. On their 2005, 2006 and 2007 tax returns, Mr. and Mrs. Boree reported their principal business was being land investors. However, for 2005 and 2006, Mr. and Mrs. Boree reported income from Glen Forest lot sales as ordinary income, and they deducted (rather than capitalized) expenses relating to the Glen Forest property. On their 2007 tax return, Mr. and Mrs. Boree indicated Mr. Boree’s occupation was a real estate professional and reported a long-term capital gain of almost $8.6 million from the Adrian transaction. The IRS challenged the Boree’s characterization of the 2007 sale of their remaining Glen Forest property as long-term capital gain and contended that the Borees should recognize ordinary income.
B. Tax Court Decision. The Tax Court noted that prior to the large sale in 2007, Mr. and Mrs. Boree subdivided the Glen Forest property, built a road, and spent significant time and money on zoning activities in pursuing their continuing development activities. In addition, between 2002 and 2006, Mr. and Mrs. Boree sold approximately 60 lots which consisted of almost 600 acres of the Glen Forest property. The sales of these lots, up until 2007, reflected their intent to develop the Glen Forest property and sell subdivided lots to customers. After Mr. and Mrs. Boree purchased the interest of Mr. Duke, the Borees continued to engage in significant sales and development activities with respect to the Glen Forest property. They reported their gain from sales of lots in 2005 as ordinary income and deducted (rather than capitalized) expenses related to their real estate activities. Also, they did not segregate the property sold to Adrian Development from the rest of the Glen Forest property. Accordingly, the court held the sale of the remaining acreage in 2007 generated ordinary income and not capital gains. The court also upheld the assessment of the substantial understatement penalty under Section 6662(a).
C. Court of Appeals Decision. The Court of Appeals for the 11th Circuit affirmed the Tax Court’s decision that the taxpayers’ sale of a large tract of land should be taxed as ordinary income and not as capital gain. The Borees argued their purpose in holding the Glen Forest property changed from development to investment as a result of certain land use restrictions placed on the property in 2005 and 2006 that made further development so expensive as to be practically impossible. The court held, however, the critical inquiry is the taxpayer’s primary holding purpose before the decision to sell is made. Here, before deciding to sell the Glen Forest tract in one transaction, and during the years leading up to the sale, the Borees had intended to develop the property.
The court did not accept the Borees’ argument that their gain resulted only from market appreciation. In the Tax Court proceeding, the Borees argued their $8 million profit in 2007 was due to the property’s appreciating over a substantial period and was not attributable to any improvements made by the Borees. The court stated, however, an increase in property value being attributable more to market appreciation than to improvements made to the property does not automatically entitle the taxpayer to capital gains treatment. See Suburban Realty Co., 615 F 2d at 186. Because the Borees’ sale arose from their engaging in their development business, they were not entitled to capital gains tax treatment simply because the property had appreciated in value. However, the Court of Appeals ruled the Tax Court erred in imposing an accuracy related penalty, finding the Borees qualified for the reasonable cause and good-faith exception to Section 6664.
IX. Negligence Penalties Upheld Where Bonuses Paid by A C Corporation (Law Firm) to Its Shareholder-Employees Were Disguised Dividends.
In Brinks, Gilson & Lione, v. Commissioner, TC Memo 2016-20, the Brinks law firm (the “Firm”) employed about 150 attorneys, 65 of which were shareholders. The Firm also employed non-attorney staff of around 270 employees. The Firm was a C corporation for tax purposes. Each year, the shareholder-attorneys’ proportionate ownership of stock was set to equal their proportionate share of projected compensation for the next year. Each year the firm’s board set compensation to be paid to the shareholder-attorneys for the next year and then determine adjustments to share ownership percentages necessary to reflect changes in proportionate compensation. During the years at issue, the board set compensation and share ownership percentages in late November or early December of the year preceding the compensation year. The board determined each attorney’s expected compensation and share ownership percentage using a number of criteria, including hours billed, collections, business generated, and other non-monetary contributions. The shareholder-employees were paid a draw throughout the next year, with final bonuses coming through a bonus pool in the following year. During each of the years at issue, the corporation had significant invested capital.
On audit, the IRS disallowed various deductions, including year-end bonuses paid to each shareholder/attorney. The IRS and the Firm reached a settlement under which the Firm paid an additional $1 million of tax for each of the two tax years at issue. The only remaining issue was whether the Firm was liable for the accuracy related penalty under Section 6662. In determining whether the Firm should be subject to accuracy-related penalties, the court considered both the Pediatric Surgical Associates (TC Memo 2001-81) and Mulcahy vs. Commissioner, 680 F.3d 867 (7th Cir. 2012). Based on those cases, the court determined that allowing a deduction of compensation to zero out corporate income would leave investors with no return on their investment. Applying such hypothetical independent investor test and considering the significant amount of capital held by the Firm, the court upheld the accuracy related penalty.
In determining the Section 6662 accuracy-related penalty applied, the court noted the Firm had significant capital on its balance sheet, even without evaluating whether the Firm also held significant off balance sheet intangible assets (such as goodwill and going concern value), which further indicated the shareholders failed the independent investor test. The court concluded the Firm’s practice of paying year-end bonuses to eliminate its book income failed the independent investor test.
X. Tax Court Concludes Compensation Is Reasonable Using the Hypothetical Investor Test.
In H. W. Johnson, Inc. v. Commissioner, TC Memo 2016-95, Mr. and Mrs. Johnson formed their concrete contracting business, H. W. Johnson, Inc. (“HWJ”) in 1974. Bruce and Donald, the sons of Mr. and Mrs. Johnson, took over the operations of HWJ in 1993. Over time, Mr. and Mrs. Johnson made gifts of stock of HWJ to their sons. Due to the leadership of Bruce and Donald, revenues of HWJ increased dramatically over the years. During 2003 and 2004, HWJ paid bonuses of $4 million and $7 million to Bruce and Donald. These bonuses were based on a formula bonus plan that had been adopted in the early 1990s. In late 2002, Bruce and Donald became concerned that consolidation of the concrete supply industry could threaten their ongoing access to concrete. Bruce and Donald suggested to their mother that they form a concrete supply company. However, Mrs. Johnson thought investing in a concrete supply company was too risky. Bruce and Donald decided to form their own concrete supply company, DBJ Enterprises, LLC. For 2004, HWJ paid a $500,000 bonus to DBJ for DBJ’s agreement to provide a guaranteed supply of concrete at market prices.
During an audit of 2003 and 2004, the IRS disallowed the $500,000 guaranty supply bonus, as well as the compensation paid to Bruce and Donald, taking the position those amounts were excessive compensation. Since this case would be heard by the 9th Circuit Court of Appeals, the Tax Court applied the Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983), five-factor test, including the hypothetical investor test. During the Tax Court proceeding, the IRS effectively conceded four of the five Elliotts factors were either taxpayer-favorable or neutral. However, the IRS took the position the company failed the hypothetical investor test. The Tax Court noted that since no one factor is determinative of the reasonable compensation test, the court had to review all five factors under the Elliotts test, even though the IRS had conceded that at least four of the factors were either neutral or in favor of the company. Ultimately, the court ruled in favor of HWJ based on the following analysis of the five factors:
Role in the Company. Because Bruce and Donald were clearly integral to the company’s success, this factor was clearly in favor of HWJ.
External Comparison. As is the case with most closely-held businesses, there were no similar companies with published compensation that could be compared to HWJ. This factor was neutral.
Character and Condition of the Company. During the years at issue, HWJ experienced significant revenue, profit margin and asset growth. This factor was clearly in favor of HWJ.
Internal Consistency. The annual bonuses were based on a formula that had been in place for a number of years. This factor favored HWJ.
Conflict of Interest. The conflict of interest test is analogous to the independent investor test. The experts for HWJ and the IRS agreed HWJ had pre-tax returns on equity of 10.2% and 9% for 2003 and 2004. However, the IRS and HWJ disagreed on what an expected return on equity should have been for HWJ for those years. The IRS contended an expected return of equity for a company like HWJ should range from 13.8% to 18.3%. Using a different data service, the expert for HWJ concluded a more accurate projected industry pre-tax return on equity is from 10.5% to 10.9%, which admittedly was higher than the actual pre-tax rate of return of HWJ in those years. The IRS, therefore, contended because HWJ’s return on equity fell below the industry average for 2003 and 2004, the court should determine all of the compensation paid to Donald and Bruce was unreasonable for those years. The court, however, held the required actual return on equity, for purposes of the independent investor test, does not have to exceed the industry average for companies that had been especially successful. Instead, other courts have generally ruled a return on equity of at least ten percent tends to indicate the independent investor test is met. See, e.g. Thousand Oaks Residential Care Home 1, Inc. v. Commissioner, T.C. Memo 2013-10; Multi-Pak Corp. v. Commissioner, T.C. Memo 2010-139. The court determined HWJ’s return on equity was close enough to this benchmark to pass the independent investor test.
XI. Taxpayer Whipsawed By Renting Property To His S Corporation That Operated A Hobby
In Estate of Stuller, 117 AFTR 2d 2016-379, the Court of Appeals for the 7th Circuit affirmed the decision of the Tax Court that activities conducted by the taxpayer’s S Corporation were a hobby and not a for-profit business. Mr. and Mrs. Stuller owned several restaurant franchises and began breeding horses through their S corporation, LSA, Inc. They also owned a horse farm in their individual names that they rented to LSA.
The Court of Appeals affirmed the decision of the District Court that the Stullers did not prove they operated their horse breeding activity with a for-profit motive. The court held their lack of profit objective was demonstrated by numerous factors, including that the taxpayers did not adequately track expenses or change operating methods or otherwise operate the activity in a business-like manner. Although the taxpayers had significant business experience in running their franchise restaurants, they had no expertise in horse breeding activities. Given the activity had losses for over fifteen years and the taxpayers derived significant pleasure from the activity, the court found there was no for-profit intent as to the horse operations. Thus, the court upheld the disallowance of pass-through losses from LSA.
Things then got worse for the Stullers. Previously, LSA had paid rent to the Stullers. The Stullers argued since the IRS disallowed their pass-through losses associated with LSA, the IRS should likewise be estopped from claiming the rent payments from LSA constituted taxable income to the Stullers. However, the Court of Appeals held the S corporation was a separate legal entity from the Stullers, and the Stullers actually received rent payments from their S corporation. Even though the S corporation’s rent payments were held nondeductible, the Stullers were nevertheless required to include the rental income in their taxable income.
Keith A. Wood is an attorney with Carruthers & Roth, P.A. in Greensboro.