Federal Income Tax Update
By I. Sections 453 and 1042 Deferral Provisions Can Apply in the Same ESOP Transaction; Berman vs. Commissioner, 163 TC No. 1 (2024).
In 2002, Mr. and Mrs. Berman sold their closely held C corporation stock to an ESOP for promissory notes. They did not receive any sale proceeds in 2002. They purchased qualified replacement property (“QRP”) in an amount equal to or exceeding the gain on the sale of stock to the ESOP. However, some of the QRP purchases did not occur until after the 12-month QRP replacement period. The Bermans elected pursuant to Section 1042 to defer recognition of the entire gain on the ESOP sale. They reported no taxable income from the stock sale to the ESOP.
In 2003, each of Mr. and Mrs. Berman received approximately $450,000 under the ESOP promissory notes. The Bermans used their QRP as collateral for a 90% loan, allowing the lender to keep the remaining 10% as a loan fee. The Bermans later conceded the cash-out loan they collateralized with their QRP was a disguised sale of the QRP. The IRS took the position the cash-out loan caused the Section 1042 deferred gain to be fully recognized in 2003 under the recapture rule of Section 1042(e). The Bermans took the position their 2003 gain should be limited to the $450,000 payments under the installment notes.
The Tax Court agreed with the Bermans. The court stated Sections 453 and 1042(a) are not mutually exclusive. Section 1042 acts to defer gain that otherwise would be recognized under the installment method. By not reporting any of the gain in 2002, the Bermans did not elect out of Section 453, thus allowing the deferral of gain until future note payments were received.
II. Taxpayer Not Allowed to Opt Back in to Installment Method; Barney vs. Commissioner, 2024 US Tax Court Lexis 2627.
In Barney vs. Commissioner, the IRS denied Mr. Barney’s request to revoke his previous election to opt out of the installment method. In 2012, Mr. Barney sold his business for two promissory notes totaling over $400 million. Mr. Barney’s tax advisor recommended he opt out of the installment method. His tax advisor stated he could change his election out of the installment method by filing an amended return at any time prior to the expiration of the statute of limitations for his returns on which the gain was reported. Therefore, Mr. Barney reported the entire gain from the sale on his 2012 tax return thereby evidencing his election to opt out of installment treatment. Later, and within the statute of limitations, Mr. Barney filed amended returns seeking a tax refund for 2012 through 2015. The IRS refused to allow Mr. Barney to elect back into the installment method. The Tax Court held the IRS did not abuse its discretion in refusing to allow Mr. Barney to revoke his election out of the installment method.
Under Section 453(d)(3), the IRS may consent to the revocation of an election to opt out of the installment method only when (1) there was some contemporaneous evidence (i.e., before the time the original tax return was filed) that the taxpayer intended to report on the installment method; (2) the taxpayer’s return preparer misunderstood the taxpayer’s intention or made an error in preparing the return; and (3) as soon as the taxpayer or his advisors discovered the error, the taxpayer promptly filed a request with the IRS seeking to revoke the opt-out election. The regulations further provide the revocation will not be permitted when one of the purposes is the avoidance of federal income tax. Temp. Reg. § 15A.453-1(d)(4).
Citing Krause vs. Commissioner, TC Memo 2000-343, the court stated revocation does not permit a taxpayer the benefit of hindsight. It was clear Mr. Barney made the purposeful decision to elect out of the installment method due to his tax advisor’s statements that capital gains tax rates were scheduled to increase in future years.
III. Attorney’s Fees against the IRS Allowed because the Taxpayer’s Settlement Offer of $1 was a Qualified Offer; Mann Construction, Inc. vs. US, 2024 US Dist. Lexis 199302.
In 2019, the IRS penalized Mann Construction Company for failing to disclose employment benefit plan information on its tax returns in violation of Notice 2007-83. After attempting to settle the dispute, Mann Construction paid the penalties and sued the IRS to recover the penalties. In January 2023, the court awarded a refund to the company of all the paid penalties. The company then sought recovery of its attorney’s fees in pursuing its penalty refund claim.
Section 7430 provides a court may award attorney’s fees and costs in favor of taxpayers who substantially prevailed on their litigation controversy if the IRS position was not substantially justified. In addition, even if the IRS position was substantially justified, a court may award attorney’s fees to the taxpayer when (1) the taxpayer made a qualified offer to settle the case, and (2) the judgment in the proceeding is equal to or less than the taxpayer’s liability had the IRS accepted the offer.
In Mann, the IRS position was substantially justified, but the IRS ultimately recovered $0 in penalties. The question, therefore, was whether Mann Construction’s offer of $1 was a qualified offer under Section 7430. The court ruled Mann’s offer was a qualified offer because $1 was more than the $0 ultimately awarded to the IRS. The court stated the definition of a qualified offer does not include any requirement of a minimum amount or even a good-faith reasonable amount.
IV. Section 183 Deductions are Below-the-Line Miscellaneous Itemized Deductions; Gregory v. Comm’r 69 F.4th 762 (11th Cir. 2023).
Mr. and Mrs. Gregory reported substantial revenues and expenses from their yacht charter activities for 2014 and 2015. After the Gregorys conceded they lacked a for-profit motive for their yacht activities, the IRS moved their Schedule C revenues to the other income line on their return and characterized their yacht expenses as miscellaneous itemized deductions subject to the 2% AGI floor. Because the Gregorys reported income of $20 million and $80 million for 2014 and 2015, the recharacterization of expenses from above-the-line to below-the-line resulted in a $300,000 tax assessment against the Gregorys.
The Ninth Circuit upheld the Tax Court’s decision in favor of the IRS. The courts agreed Section 183(b)(2) merely sets forth the amount of allowable hobby deductions, which is capped at the hobby’s gross income. Section 183(b), however, does not specify where those deductions belong on a taxpayer’s return: above the line (reducing gross income) or below the line as miscellaneous itemized deductions (reducing adjusted gross income). For that determination, the court focused on Sections 62, 63 and 67.
Section 62 specifies the trade or business expense deductions that reduce the taxpayer’s gross income and therefore belong above the line. Those deductions include trade or business expenses under Section 62(a)(1), losses from the sale or exchange of property under Section 62(a)(3), and certain attorney’s fees under Section 62(a)(21). The list of above-the-line deductions in Section 62(a) is exhaustive. Section 62 does not mention Section 183 or hobby expenses.
Section 63(d) defines itemized deductions as all deductions except (1) the above-the-line deductions listed in Section 62 and (2) “any deduction referred to in any paragraph of” Section 63(b). Section 63(b) lists four deductions: the standard deduction, the personal exemption deduction under Section 151, the qualified business income deduction under Section 199A, and the charitable contribution deduction under Section 170(p). Since Section 183 is not listed in Section 63(b), the Section 183 deduction must be an itemized deduction.
Section 67(a), which imposes the 2% floor on miscellaneous itemized deductions, defines miscellaneous itemized deductions as all itemized deductions other than 12 specific deductions, none of which are hobby expenses. Thus, Section 183 expenses are miscellaneous itemized deductions and deductible only to the extent the aggregate of such deductions exceeds 2% of adjusted gross income.
V. IRS Allows S Corporation Status to Continue after Trust Fails to Meet the QSST Income Distribution Requirement; PLR 202405003.
A shareholder transferred S corporation stock to two trusts that qualified as electing small business trusts (ESBTs). Later, the trustees and beneficiaries elected to convert the trusts from ESBTs to qualified subchapter S trusts (QSSTs). Under the terms of the trusts, distributions of income or principal could be made only to the income beneficiary during the beneficiary’s lifetime. However, the trusts did not mandate all trust income be distributed to the income beneficiary each year. Although the trust terms did not mandate all income be distributed each year, the trusts qualified as QSSTs if they actually distributed all income to the income beneficiary each year.
After the new QSST elections were made, the trustees failed to distribute all trust income as required by Section 1361(d)(3)(B) for QSSTs that otherwise do not require annual distributions of all trust income. The IRS concluded, pursuant to Section 1362(f), the S election termination was inadvertent and allowed the corporation to continue its S corporation status.
Keith Wood is an attorney with Carruthers & Roth, P.A. in Greensboro, North Carolina.