Background. A dividend is a distribution of property from a corporation to its shareholders out of the corporation’s earnings and profits. (IRC Section 316(a)) The amount of the distribution equals the fair market value of the distributed property on the distribution date. (IRC Sections 301(b)(1) and (3)) For dividends received before 2011, qualified dividend income is taxed at the same rates as long-term capital gain. (IRC Section 1(h)(11)) After 2010, unless Congress changes the rules, dividend income will be taxed as ordinary income. The amount of a distribution that exceeds earnings and profits, and is therefore not a dividend, is taxable capital gain to the recipient. (IRC Section 301(c)(3)) Under long-established case law, dividends may be formally declared or they may be constructive. A constructive dividend arises when a corporation confers a benefit on a shareholder by distributing available earnings and profits without expectation of repayment.

A corporation that distributes appreciated property to a shareholder recognizes gain as if the property were sold to the shareholder at its fair market value. (IRC Section 311(b)(1)) Gain is recognized to the extent that the property’s fair market value exceeds the corporation’s adjusted basis in the property.

Taxpayers are liable for an accuracy-related penalty for any portion of an underpayment of income tax attributable to negligence or disregard of rules and regulations, unless they establish that there was reasonable cause for the underpayment and that they acted in good faith. (IRC Section 6662(a), IRC Section 6662(b)(1), IRC Section 6664(c)(1)) Under IRC Section 6662(b), an accuracy related applies for a substantial understatement of income tax, i.e., the amount of the understatement exceeds the greater of 10% of the tax required to be shown on the return, or $10,000.

Facts. Mr and Mrs. Cezar were the sole shareholders of RVJ Cezar Corporation, which built “spec” houses that it sold to the public. They paid $500 for their stock. Mr. Cezar, a general contractor, was the sole employee of the corporation. In 2001, Cezar Corp paid $150,000 for a lot, financing part of the purchase price with a mortgage, and spent $502,000 building an amenity-rich home approximately twice the size of its usual spec homes. Cezar Corp was listed as the sole owner of the spec home on the blueprints, permit, and notice of completion. Some of the construction materials were paid with a credit card issued in both Mr. Cezar’s name and Cezar Corp, and the Cezars were unable to document most of the labor costs of building the home.

The home was finished in 2004 and was offered for sale, but there were no takers. That year, Cezar Corp transferred the lot and improvements to the Cezars by quitclaim deed; they assumed the outstanding mortgage of $57,227. At the time of the transfer the lot and improvements had a total fair market value of $920,000. The transfer of ownership report filed with the Assessor’s Office did not indicate that the property interest transferred to the Cezars was a partial interest. The Cezars did not report the receipt of the lot or the improvements on their return for 2004, nor did the corporation report the distribution of the lot and the improvements on its return for 2004.

On audit, IRS determined that the distribution of the lot and the improvements was a constructive dividend from the corporation. It determined that the Cezars received a qualified dividend up to the amount of the corporation’s earnings and profits, and treated the balance of the distribution, less their $500 initial capital contribution, as long-term capital gain. IRS also determined that both the Cezars and their corporation were liable for the accuracy related penalty.

Tax Court sides with IRS. The Cezars conceded that they received the lot as a constructive dividend from the corporation. However, they argued that the improvements were not a constructive dividend because they owned the improvements by having paid for the construction materials and having done all the work to construct the improvements. The Tax Court agreed with IRS’s assessment that improvements are built on land that one owns or else there would be an agreement identifying the rights and responsibilities of the parties. The Cezars failed to show that there was an agreement between them and the corporation that would have allowed them to construct a home on the corporation’s property. Their ownership argument also was directly contradicted by Mr. Cezar’s statements during the audit that the lot and the improvements were both corporate assets. Moreover, there was no credible evidence to support the Cezars’ claim that they owned the improvements by paying the construction costs and personally completing the labor. The only records the Cezars produced to establish that they paid the construction costs were insufficient. Furthermore, the corporation was the sole owner of the lot as well as the improvements from the start of construction until the distribution to the Cezars. The corporation received property tax bills for both the lot and the improvements and did not protest that it had been billed for improvements that it did not own. The Tax Court also find it compelling that the corporation, which was in the business of building and selling homes, offered the lot and the improvements for sale without obtaining any transfer of interest from the Cezars. No prospective buyer would buy only the improvements and not the lot or vice versa. The Tax Court also noted that no other spec home that the corporation sold before or since was owned by the Cezars individually. Rather, all the homes and lots were owned and offered for sale by the corporation.

As a result, the Tax Court found that the Cezars did not establish that they owned the improvements, and sustained IRS’s determination that the Cezars must include the distribution of the lot and the improvements in gross income as a constructive dividend from the corporation. The Tax Court also found that treatment of the home as a constructive dividend to the Cezars caused the corporation to recognize taxable income to the extent that the fair market value of the lot and improvement exceeded its adjusted basis.

The Tax Court also hit the Cezars with an accuracy related penalty for the underpayment of income tax attributable to negligence or disregard of rules and regulations. It also hit Cezar Corp with an accuracy related penalty for substantial understatement of its income tax.

With proper planning, this tax and the penalties could have been avoided.  The tax attorneys at McLaughlin & Quinn, LLC regularly provide planning for taxpayers in situations such as the one faced by the Cezars.  For more information, contact F. Moore McLaughlin, IV, Esq., CPA by e-mail at MMcLaughlin@McLaughlinQuinn.com or by phone at 401-421-5115 ext. 212.

Stay tuned for word about more and even larger tax increases.  The tax attorneys at McLaughlin & Quinn, LLC will be working even harder to help you preserve your hard-earned dollars.  Call founding partner, F. Moore McLaughlin, IV, CPA, Esq. for more information at 401-421-5115 ext. 212 or reach him by e-mail at MMcLaughlin@McLaughlinQuinn.com.

Massachusetts

On June 30, 2010, Governor Deval Patrick signed the 2011 budget act (H4800), which includes credit transparency provisions, extends the historic rehabilitation tax credit, and provides administrative provisions to facilitate collection. The bill takes effect July 1, 2010, unless otherwise stated.

Credit transparency. Effective January 1, 2011, the head of the administrative agency of each tax credit program must submit, on or before May 15 each year, a report to the Commissioner on each tax credit program authorized for the previous calendar year. Tax credits required to be disclosed include the historic preservation tax credit, dairy farm tax credit, USFDA user fees credit, film tax credit, life sciences investment tax credit, low-income housing tax credit, medical device tax credit, refundable research credit, credit under the economic development incentive program, and any transferable or refundable credits under the corporate and personal income tax laws established after January 1, 2011. The report will contain: (1) the identity of each taxpayer receiving an authorized tax credit and from which tax credit program the credit was received; (2) the amount of the authorized tax credit awarded and issued for each taxpayer and each project, if applicable; and (3) the date that the authorized tax credit was awarded and issued for each taxpayer and each project. The report will be a public record. The report will cover only credits awarded or claimed after January 1, 2011. For purposes of the report, the taxpayer is the initial recipient of an authorized tax credit.

Historic rehabilitation tax credit. The historic rehabilitation tax credit is extended for a 12-year period up to December 31, 2017. Under current law the Commissioner, in consultation with the Massachusetts Historical Commission, is authorize to annually grant a historic rehabilitation tax credit in an amount not to exceed $50 million per year to qualified taxpayers for the 6-year period beginning January 1, 2006, and ending December 31, 2011.

Determination of partner’s distributive share. The budget act also includes a provision clarifying how a partner’s distributive share of an item of income, loss, deduction or credit from a partnership is determined. It provides that a partner’s distributive share is determined in accordance with the partner’s interest in the partnership, determined by taking into account all facts and circumstances, such as, if the allocation to a partner under the agreement of income, gain, loss, deduction or credit had no substantial economic effect or the partnership agreement does not provide as to the partnership’s distributive share of income, gain, loss, deduction or credit. It also provides that the determination of a partner’s distributive share must take into account rules and principles developed under the Internal Revenue Code and any regulations promulgated thereunder, and adjusted as required or appropriate to properly reflect income and other tax items for Massachusetts tax purposes.

Pass-through entity provision. The budget act includes provisions involving unified audit procedures for pass-through entities. It requires members or indirect owners of a pass-through entity to report items of income, expense or credit derived from the pass-through entity in a manner consistent with reporting of the pass-through entity, except to the extent that a taxpayer, member or indirect owner makes a declaration of inconsistency with its original return. The Commissioner is mandated to establish by regulation unified audit procedures.

Penalty provisions. The budget act amends the additional tax liability provision in cases when the federal government determines a difference from the amount previously reported in the taxable income of a person or the federal credit to which such person may be entitled or in cases when the tax due any other state, U.S. territory or the Dominion of Canada or any of its provinces, on account of any item of Massachusetts gross income of a Massachusetts resident, is finally determined by that jurisdiction to be less than the tax previously reported, and such tax was the basis for a credit claimed by the Massachusetts resident. It provides that failure to report such difference under both circumstances is subject to a penalty of 10% of the additional tax found due. Prior law provided that the penalty is $100 or 10% of the additional tax found due, whichever sum is smaller. A new provision provides that a person who fails to pay to the Commissioner any cigarette excise required to be paid will be personally and individually liable. “Person” includes, but not limited to, an officer or employee of a corporation or a member or employee of a partnership or limited liability company who, as such officer, employee or member, is under a duty to pay over the cigarette excise tax.

Installment and deferred payment sales. The budget act also provides a new provision requiring interest to be paid on some deferred tax liabilities generated from the use of installment sales applicable for tax years beginning on or after January 1, 2010 with respect to installment obligations as of the close of the tax year.

Sales tax provision. The budget act repeals the sales tax provision making it unlawful for any vendor to advertise or hold out or state to the public or any customer that the vendor will assume or absorb the tax or that it will not be added to the selling price of the property or services sold or, if added, it will be refunded.

For more information on these new provisions, contact tax attorney and CPA Moore McLaughlin at MMcLaughlin@McLaughlinQuinn.com or by phone at 401-421-5115 ext. 212.

Background on cost of goods. In a manufacturing, merchandising, or mining business, gross income means total sales less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. (Reg. § 1.61-3(a)) The amount that a taxpayer claims as cost of goods sold is not subject to the limitations on deductions found in Code Sec. 162 (ordinary and necessary trade or business expense) and Code Sec. 274 (substantiation requirements). Rather, it is treated as a subtraction from gross sales to arrive at a qualifying business’ gross income. (Metra Chem Corp. (1987), 88 TC 654) As a general rule, where the production, purchase, or sale of merchandise of any kind (inventory) is an income-producing factor, inventory on hand at the beginning and end of the year is taken into account in computing the taxable income for the year. If a taxpayer must use an inventory, a taxpayer ordinarily is required to use the accrual method. (Reg. § 1.446-1 , Reg. § 1.471-1) Real property is not generally merchandise for purposes of inventory accounting. (W.C. & A.N. Miller Dev. Co. (1983), 81 TC 619)

Background on business loss deduction. Under Code Sec. 165(a), a taxpayer may deduct a loss sustained during the tax year and not compensated for by insurance or otherwise. To be allowable under Code Sec. 165(a) , the loss must be evidenced by a closed and completed transaction, fixed by identifiable events, and actually sustained during the tax year. If a taxpayer has a claim for reimbursement on which there’s a reasonable prospect of recovery, that “reimbursable” loss can’t be deducted until it’s reasonably certain the reimbursement will or will not be made. This may be ascertained by, among other things, settlement, adjudication or abandonment of the claim. (Code Sec. 165(a), Reg. § 1.165-1(d))

Facts. D.L. White Construction, Inc. (White Construction), is a C corporation that uses the cash method of accounting and a fiscal year ending on September 30. It’s in the business of residential real estate construction. During its 2002 tax year, it bought four parcels of adjoining land in northern Idaho (the Blossom Mountain property), totaling approximately 80 acres, for $290,000 ($90,000 of which was financed through a promissory note). It planned to build four homes on the Blossom Mountain property and sell the homes at a profit. However, to reach the Blossom Mountain property, White Construction used an access road that crossed an adjoining property owned by Mr. and Mrs. Akers. On January 10, 2002, the Akerses filed suit against White Construction in the Idaho district court for negligence and trespass and to quiet title.

White Construction filed its Form 1120, U.S. Corporation Income Tax Return, for the 2002 tax year. It included the $220,000 it spent on the Blossom Mountain property in its cost of goods sold. Although the Akerses’ lawsuit was still ongoing when it filed its Form 1120, White Construction claimed the $220,000 amount because it didn’t have legal access to the Blossom Mountain property and contended that the property was worthless.

The Blossom Mountain litigation was protracted. On January 3, 2003, the Idaho district court found that White Construction did not have a complete easement over the Akerses’ property, had trespassed, was negligent, and had engaged in malicious conduct. On April 1, 2004, the district court reheard the case, again finding against White Construction. This decision was appealed, and the Idaho Supreme Court remanded the case to the district court. On October 6, 2006, the district court again found against White Construction. This decision was appealed, and the case was once again remanded to the district court. On January 22, 2009, the Idaho Supreme Court withdrew its latest decision to remand, and, affirming the district court in part and vacating its judgment in part, once more remanded the case for further proceedings.

After the Idaho district court issued its April 1, 2004 decision, White Construction’s title company’s insurer issued White Construction a $200,000 check.

On audit of the 2002 tax year, IRS reduced White Construction’s cost of goods by $220,000. White Construction sought relief in court, where it acknowledged that its deduction for cost of goods sold might have been incorrect, but argued that it nevertheless should be able to deduct the $220,000 amount as a Code Sec. 165 business loss.

Decision on cost of goods argument. The Tax Court concluded that even if the Blossom Mountain property were properly classified as inventory, White Construction would not be entitled to include the cost of the property in its cost of goods sold.

After first noting the oddness of the fact that White Construction apparently used an inventory in its business even though it claimed to be a cash basis taxpayer, the Court assumed for the sake of argument that merchandise was an income-producing factor in its business and that it was required to use an inventory. That being the case, the Court concluded that White Construction failed to prove that the Blossom Mountain property was merchandise properly includable in calculating its cost of goods sold. White Construction also failed to prove that the Blossom Mountain property, even if properly classified as merchandise includable in inventory, should not have been included in closing inventory for purposes of calculating its cost of goods sold. White Construction continued to own the property on September 30, 2002, and failed to show that it was worthless as of that date.

Decision on business deduction argument. The Court found that White Construction failed to prove any of the elements for a deduction under Code Sec. 165. Its claimed loss for the Blossom Mountain property was not evidenced by a closed and completed transaction, fixed by identifiable events. As of the close of White Construction’s 2002 tax year, the Idaho district court had not issued its first opinion in the lawsuit-a lawsuit that the Court noted was still unresolved. Further, White Construction failed to show that the claimed loss was actually sustained during its 2002 tax year or in any other year. While contending that the Blossom Mountain property was worthless because there was not any access to the property, White Construction continued to own the property. There was no credible evidence that White Construction could not acquire access to the property in some other way or that the property had become worthless as of September 30, 2002. In addition, even if it did establish that it sustained a $220,000 loss with respect to the Blossom Mountain property during the tax year 2002, it still could not deduct the loss because it had a reasonable prospect of recovery as of the end of the year since it had a claim under its title insurance policy. Indeed, White Construction actually received reimbursement of $200,000 for its loss.

For more information about this case or tax planning for real estate developers, contact Moore McLaughlin, Esq. at MMcLaughlin@McLaughlinQuinn.com or by phone at 401-421-5115 ext. 212.

Tax rates. The tax rates have been revised, providing three taxable income brackets for married individuals filing jointly, qualifying widows, head of households, unmarried individuals, married individuals filing separately and bankruptcy estates, effective for tax years beginning after December 31, 2010: $0-$55,000, 3.75%; $55,000-$125,000, 4.75%; and over $125,000, 5.99%. Previously, there were five brackets with rates ranging from 3.75% to 9.9%, and the income brackets differed depending on the filing status. In addition, the revised tax rates provide three taxable income brackets for an estate or trust: $0-$2,230, 3.75%; $2,230-$7,022, 4.75%; and over $7,022, 5.99%. Previously, the rates for an estate or trust were based on five taxable income brackets: $0-2,150, 3.75%; $2,150-$5,000, 7%; $5,000-7,650, 7.75%; $7,650-10,450, 9%; and over $10,450, 9.9%.

Deductions. The legislation eliminates the option to itemize deductions and increases the amounts of the standard deduction based on the filing status as follows: single, $7,500; married filing jointly, $15,000; married filing separately, $7,500; and head of household, $11,250. Previously, the amounts of the standard deductions based on the filing status were as follows: single, $5,700; married filing jointly, $9,550; married filing separately, $4,750; and head of household, $8,400. In addition, the standard deduction is phased out for taxpayers whose adjusted gross income exceed $175,000 such that the standard deduction is reduced by 20 percentage points for each $5,000 by which the taxpayer’s adjusted gross income for the taxable year exceeds $175,000.

Personal exemption. For purposes of computing the personal exemption, the legislation reduces the exemption amount from $3,650 to $3,500. In addition, the personal exemption is phased out for taxpayers whose adjusted gross incomes exceed $175,000 such that the personal exemption is reduced by 20 percentage points for each $5,000 by which the taxpayer’s adjusted gross income for the taxable year exceeds $175,000.

Credits. The legislation limits the types of credits that may be taken against personal income tax to the following: earned income credit; property relief credit; lead paint credit; credit for income taxes of other states; historic structures tax credit; motion picture productions tax credit; child and dependent care credit; tax credits for scholarships to scholarship organizations; and credit for tax withheld. For purposes of the property tax relief credit against personal income tax, the calculation of “income” does not include any deductions for rental losses, business losses, capital losses, exclusion for foreign income, and any losses received from pass-through entities.

Alternative flat tax. The alternative flat tax option is eliminated for tax years 2011 and thereafter.

For more information about these changes, contact Moore McLaughlin, Esq. at 401-421-5115 ext 212 or by e-mail at MMcLaughlin@McLaughlinQuinn.com.

Background. Code §704(c) requires partnerships to allocate income, gain, loss, and deductions for property contributed by a partner so as to take into account variations between the property’s adjusted tax basis and its fair market value at the time of contribution. The allocations must be made using a reasonable method that’s consistent with Code §704 ‘s purpose. Reg. §1.704-3 provides three allocation methods: the traditional method, the traditional method with curative allocations, and the remedial method.

Under the anti-abuse rule of Reg. §1.704-3(a)(10) (as in effect before amendment by T.D. 9485, 06/08/2010), an allocation method (or combination of methods) is not reasonable if the contribution of property (or event that results in reverse Code Sec. 704(c) allocations) and the corresponding allocation of tax items for the property are made with a view to shifting the tax consequences of built-in gain or loss among the partners in a manner that substantially reduces the present value (PV) of the partners’ aggregate tax liability.

Under the anti-abuse rule of Reg. §1.701-2(b), if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the PV of the partners’ federal tax liability in a manner inconsistent with the intent of subchapter K, IRS may recast the transaction as appropriate to achieve tax results that are consistent with the intent of subchapter K. Thus, IRS may disregard: (a) purported partnerships, in whole or part, so that partnership assets are treated as owned by the partner; (b) one or more contributions; or (c) one or more purported partners.

In 2003, the Staff of the Joint Committee on Taxation issued “The Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations,” (JCS-3-03, February 2003) (Enron Report). Although the Enron Report noted that the anti-abuse rule of Reg. §1.704-3(a)(10) (as in effect before amendment by T.D. 9485, 06/08/2010 ), was an effective tool, it recommended strengthening the reg for partnership allocations for property contributed to a partnership, especially for partners that are members of the same consolidated group, to ensure that the allocation rules are not used to obtain unwarranted tax benefits.

The final regs address the recommendation in the Enron Report by clarifying certain aspects of the anti-abuse rule.

Final regulations. The regulations amend the anti-abuse rule of Reg. § 1.704-3(a)(10) to provide that the tax effect of an allocation method (or combination of methods) on both direct and indirect partners is considered. (Reg. § 1.704-3(a)(10)(i)) An indirect partner is any direct or indirect owner of a partnership, S corporation, or controlled foreign corporation (CFC, as defined in Code §957(a) or Code §953(c)), or direct or indirect beneficiary of a trust or estate, that is a partner in the partnership, and any consolidated group of which the partner in the partnership is a member (under Reg. §1.1502-1(h)). However, a CFC owner is treated as an indirect partner only for allocation of items that: (1) enter into the computation of a U.S. shareholder’s inclusion under Code §951(a) for the CFC; (2) enter into any person’s income attributable to a U.S. shareholder’s inclusion under Code §951(a) for the CFC; or (3) would enter into these computation if the items were allocated to the CFC. (Reg. §1.704-3(a)(10)(ii))

The final regs also provide that the principles of Code §704(c), together with the allocation methods in Reg. §1.704-3(b) (the traditional method, the traditional method with curative allocations, and the remedial method) only apply to contributions of property to the partnership. Further, in determining if a purported contribution of property to a partnership should be recast to avoid results that are inconsistent with subchapter K, one factor that might be relevant is the use of the remedial method in which allocations of remedial items of income, gain, loss or deduction are made to one partner and allocations of offsetting remedial items are made to a related partner. (Reg. §1.704-3(a)(1))

For more information on these Final Regulations or other partnership tax matters, contact Moore McLaughlin, Esq. at 401-421-5115 ext 212 or by e-mail at MMcLaughlin@McLaughlinQuinn.com.

Background. In Peterson v. Commissioner of Revenue (Mass. Sup. Jud. Ct., 2004) 806 NE2d 784 (Peterson I), the Massachusetts Supreme Judicial Court held that §32 of L. 2002, c. 186 (2002 act), which set a higher capital gains tax rate effective May 1, 2002, violated the uniformity requirement of Art. 44 of the Amendments to the Massachusetts Constitution because it applied different tax rates to capital gains obtained within the same tax year. In response to Peterson I, the Massachusetts Legislature enacted L. 2004, c. 149 (2004 act) establishing the effective date of the new capital gains tax rate to January 1, 2002 and directing that the Commissioner not adjust the tax liability for capital gains realized between January 1, 2002 and April 30, 2003 for any taxpayer who already paid capital gains taxes at the prior rates. In Peterson v. Commissioner of Revenue (Mass. Sup. Jud. Ct., 2005) 825 NE2d 1029 (Peterson II), the Massachusetts Supreme Judicial Court struck out §413 of the 2004 act as unconstitutional but severable from the section setting January 1 2002 as the effective date of the higher capital gains rate. The legislature again responded by enacting L. 2005, c. 163 (abatement act), which changed the effective date of the new tax rate from January 1, 2002 to January 1, 2003 and addressed the remedy for those taxpayers who had paid long-term capital gains taxes at the higher rate in 2002. It provided that any taxpayers who overpaid capital gains taxes may apply for an abatement pursuant to the administrative procedures generally set for tax abatements and the Commissioner is to abate such overpayments in four equal installments without interest. This provided the exclusive basis for relief stemming from overpayment of the capital gains taxes in 2002.

Action for declaratory relief. In 2002, the taxpayer sold his business and paid capital gains taxes that he would not have been required to pay prior to the 2002 act, which provided that long-term capital gains realized on or after May 1, 2002 were taxed as ordinary income at 5.3%, a rate higher than gains realized before that date. Following the enactment of the abatement act, the taxpayer applied for abatement and received four installments of the refund without interest. On March 18, 2008, the taxpayer filed an action for declaratory relief asserting that the legislature’s determination that no interest was to be paid on the refund of the unconstitutional capital gains taxes is unconstitutional and that he has not been fully compensated for his payment of the wrongful taxes. The taxpayer alleges that his action for declaratory relief is proper because pursuit of administrative remedies would have been futile since neither the Commissioner nor the Board has the authority to declare a statute unconstitutional. His action for declaratory relief was dismissed and he appealed.

Failure to exhaust administrative remedies. The Massachusetts Supreme Judicial Court held that the Superior Court properly dismissed the taxpayer’s declaratory action for failure to exhaust administrative remedies which are deemed exclusive by the abatement act. Even if the Board could not have declared the abatement act facially unconstitutional, it could have declared the statute unconstitutional or illegal as applied to the taxpayer, and could have awarded him interest. Accordingly, the administrative remedies provided by the abatement act were not seriously inadequate. Unless the administrative remedy is seriously inadequate it should not be displaced by an action for a declaration. The Massachusetts Supreme Judicial Court further held that the judge did not abuse her discretion, noting that she concluded that the issues were not sufficiently recurrent or of sufficient public importance to merit declaratory relief in the light of the adequate administrative remedies proscribed and made exclusive by the legislature.

For more information on this or other recent Massachusetts cases, contact tax attorney Moore McLaughlin at 401-421-5115 ext 212 or by e-mail at MMcLaughlin@McLaughlinQuinn.com.

Rhode Island Flooding

The IRS has announced on its website that victims of the recent severe storms and flooding in counties in Massachusetts and Rhode Island are designated as federal disaster areas qualifying for individual assistance have more time to make tax payments and file returns. Certain other time-sensitive acts also are postponed. The following is a summary of the relief that is available.

Who gets relief.  Only taxpayers considered to be affected taxpayers are eligible for the postponement of time to file returns, pay taxes and perform other time-sensitive acts. Affected taxpayers are those listed in Treas. Reg. § 301.7508A-1(d)(1) and thus include:

• any individual whose principal residence, and any business entity whose principal place of business, is located in the counties designated as disaster areas;
• any individual who is a relief worker assisting in a covered disaster area, regardless of whether he is affiliated with recognized government or philanthropic organizations;
• any individual whose principal residence, and any business entity whose principal place of business, is not located in a covered disaster area, but whose records necessary to meet a filing or payment deadline are maintained in a covered disaster area;
• any estate or trust that has tax records necessary to meet a filing or payment deadline in a covered disaster area; and
• any spouse of an affected taxpayer, solely with regard to a joint return of the husband and wife.

What may be postponed. Under Internal Revenue Code §7508A, the IRS gives affected taxpayers until the extended date (specified by county, below) to file most tax returns (including individual, estate, trust, partnership, C corporation, and S corporation income tax returns; estate, gift, and generation-skipping transfer tax returns; and employment and certain excise tax returns), or to make tax payments, including estimated tax payments, that have either an original or extended due date falling on or after the onset date of the disaster (specified by county, below), and on or before the extended date.

The IRS also gives affected taxpayers until the extended date to perform other time-sensitive actions described in Treas. Reg. §301.7508A-1(c)(1) and Rev. Proc. 2007-56, 2007-34 IRB 388, that are due to be performed on or after the onset date of the disaster, and on or before the extended date.  This relief also includes the filing of Form 5500 series returns, in the way described in Rev. Proc. 2007-56, Sec. 8.  Additionally, the relief described in Rev. Proc. 2007-56, Sec. 17, relating to like-kind exchanges of property, also applies to certain taxpayers who are not otherwise affected taxpayers and may include acts required to be performed before or after the period above.

The postponement of time to file and pay does not apply to information returns in the W-2, 1098, 1099 or 5498 series, or to Forms 1042-S or 8027.  Penalties for failure to timely file information returns can be waived under existing procedures for reasonable cause. Likewise, the postponement does not apply to employment and excise tax deposits.  The IRS, however, will abate penalties for failure to make timely employment and excise deposits, due on or after the onset date of the disaster, and on or before the deposit delayed date (specified by county, below), provided the taxpayer made these deposits by the deposit delayed date.

Affected areas and dates for storms, floods and other disasters as published on the IRS’s website:

Massachusetts:  The following are federal disaster areas qualifying for individual assistance on account of severe storms and flooding beginning on March 12, 2010: Bristol, Essex, Middlesex, Norfolk, Plymouth, Suffolk and Worcester counties.  For these Massachusetts counties, the onset date of the disaster was March 12, 2010, the extended date is May 11, 2010, and the deposit delayed date was March 29, 2010. [Note:  In response to the IRS' tax deadline extension, the Massachusetts Department of Revenue has announced that the new filing deadline for state tax returns will be midnight May 11, 2010 for residents of the counties that were federally-declared disaster areas. (Release, Massachusetts Department of Revenue, 03/31/2010 ; Massachusetts Severe Storm and Flooding Victims Have Until May 11 to File Their Tax Returns, 03/31/2010).]

Rhode Island: The following are federal disaster areas qualifying for individual assistance on account of severe storms and flooding beginning on March 12, 2010: Kent, Newport, Providence and Washington counties. For these Rhode Island counties, the onset date of the disaster was Mar. 12, 2010, the extended date is May 11, 2010, and the deposit delayed date was Mar. 29, 2010.

For more information, please contact your CPA or our office.

The IRS received many comments on this issue and has been promising action on it for a long time.  As far back as 2007, when the real estate market started heading south in many areas, the IRS wrote Rep. Barney Frank (D-MA) to say that IRS was considering whether it was appropriate for it to extend relief where QIs went bankrupt.  In substantially similar letters written to a number of Washington legislators in mid-2009, the IRS again said it was considering relief measures.

Background.  In general, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is held either for productive use in a trade or business or for investment. (Code Sec. 1031 )  Under Code Sec. 1031(a)(3), for a deferred exchange to be treated as tax-free, a taxpayer must identify the replacement property within 45 days of the transfer of the relinquished property and must acquire the replacement property by the earlier of 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or the due date (determined with regard to extensions) of the taxpayer’s federal income tax return for the year in which the transfer of the relinquished property occurs.  Absent relief, if the statutory timing requirements are met, a taxpayer would have to treat the relinquished property as having been disposed of in a taxable sale or exchange.

The regulations allow a taxpayer to use a QI to facilitate a like-kind exchange. (Reg. §1.1031(k)-1(g)(4))  When a taxpayer uses a QI, generally he will transfer the relinquished property to the QI, who sells the property to a buyer.  The QI then takes the proceeds of the sale of the relinquished property, buys the replacement property, and transfers the replacement property to the taxpayer. If the taxpayer receives the replacement property within the period in Code Sec. 1031(a)(3) and meets the other Code Sec. 1031 requirements, he is treated as having engaged in a like-kind exchange of property with the QI and he will not recognize gain on the exchange.

Victims of the recession and the troubled real estate markets. In Rev Proc 2010-14, IRS says it is aware of situations in which taxpayers initiated like-kind exchanges by transferring relinquished property to a QI but were unable to complete the exchanges within the statutory time period solely due to the failure of the QI to acquire and transfer replacement property to the taxpayer (a “QI default”). In many of these cases, the QI enters bankruptcy or receivership, thus preventing the taxpayer from obtaining immediate access to the relinquished property’s sale proceeds.

The IRS says it’s generally of the view that in such situations, a taxpayer should not have to recognize gain from the failed exchange until the tax year in which he receives a payment attributable to the relinquished property.

Who is entitled to relief. A taxpayer is entitled to relief under Rev Proc 2010-14 if he:

(1) Transferred relinquished property to a QI in accordance with Reg. §1.1031(k)-1(g)(4).

(2) Properly identified replacement property within the identification period (unless the QI default occurs during that period).

(3) Did not complete the like-kind exchange solely because of a QI default involving a QI that becomes subject to a bankruptcy proceeding or a receivership proceeding under federal or state law.

(4) Did not, without regard to any actual or constructive receipt by the QI, have actual or constructive receipt of the proceeds from the disposition of the relinquished property or any property of the QI before the QI entered bankruptcy or receivership. For purposes of this condition, relief of a liability under the exchange agreement before the QI default, either through the assumption or satisfaction of the liability in connection with the transfer of the relinquished property or through the transfer of the relinquished property subject to the liability, is disregarded.

Relief provisions. Rev Proc 2010-14, Sec. 4, provides that a taxpayer meeting the above conditions recognizes gain on the disposition of the relinquished property only as required under the safe harbor gross profit ratio method, and only as he receives payments attributable to that property.

Under the safe harbor gross profit ratio method, the portion of any payment attributable to the relinquished property that is recognized as gain is found by multiplying the payment by a fraction, having the taxpayer’s gross profit as the numerator, and having the taxpayer’s contract price as the denominator. For this purpose:

• A payment attributable to the relinquished property means a payment of proceeds, damages, or other amounts attributable to the disposition of the relinquished property (other than selling expenses), whether paid by the QI, the bankruptcy or receivership estate of the QI, the QI’s insurer or bonding company, or any other person. Unless it exceeds adjusted basis, satisfied indebtedness is not a payment attributable to the relinquished property.
• Gross profit means the selling price of the relinquished property, minus the taxpayer’s adjusted basis in it (increased by any selling expenses not paid by the QI using proceeds from the sale of the relinquished property).
• The selling price of the relinquished property is generally the amount realized on its sale, without reduction for selling expenses. But if a court order, confirmed bankruptcy plan, or written notice from the trustee or receiver specifies, by the end of the first tax year in which the taxpayer receives a payment attributable to the relinquished property, an amount to be received by the taxpayer in full satisfaction of his claim, the selling price of the relinquished property is the sum of the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) received or to be received and the amount of any satisfied indebtedness not in excess of the adjusted basis of the relinquished property.
• The contract price is the selling price of the relinquished property minus the amount of any satisfied indebtedness not in excess of the property’s adjusted basis. Satisfied indebtedness means any mortgage or encumbrance on the relinquished property that was assumed or taken subject to by the buyer or satisfied in connection with the transfer of the relinquished property.

Rev Proc 2010-14, Sec. 4, has detailed rules covering situations involving satisfied indebtedness exceeding adjusted basis, recapture income, and imputed interest.

A Code Sec. 165 loss deduction may be claimed for the amount, if any, by which the adjusted basis of the relinquished property exceeds the sum of (1) the payments attributable to that property (including satisfied indebtedness in excess of basis), plus (2) the amount of any satisfied indebtedness not in excess of basis. Those claiming a loss deduction may also claim a Code Sec. 165 loss deduction for the amount of any gain recognized in accordance with Rev Proc 2010-14, Sec. 4, in a prior tax year.

Illustration: Mr. Able, a calendar year taxpayer owned investment property (Property 1) with a fair market value of $1.5 million and an adjusted basis of $500,000.  He entered into an agreement with QI to facilitate a deferred like-kind exchange. On May 6, Year 1, Able transferred Property 1 to QI and QI transferred the property to a third party in exchange for $1.5 million. Able intended that the QI use the money held by it to acquire Able’s replacement property. On June 1, Year 1, Able identified Property 2 as replacement property. On June 15, Year 1, QI notified Able that it filed for bankruptcy protection and could not acquire replacement property. As a result, Able failed to acquire Property 2 or any other replacement property within the exchange period. As of December Year 1, QI’s bankruptcy proceedings are on-going and Able has received none of the $1.5 million proceeds from QI or any other source.

On July 1, Year 2, QI exits from bankruptcy and the bankruptcy court approves the trustee’s final report, which shows that Able will be paid $1.3 million in full satisfaction of QI’s obligation under the exchange agreement. Able receives the $1.3 million on August 4, Year 2 and does not receive any other payment attributable to the relinquished property.

Under Rev Proc 2010-14, Able is not required to recognize gain in Year 1 because he did not receive any payments attributable to the relinquished property in that year. He recognizes gain in Year 2, as follows:

… His selling price is $1.3 million, i.e., the payments attributable to the relinquished property (the amount specified by the trustee before the end of the first tax year in which he receives a payment attributable to the relinquished property).

… His contract price also is $1.3 million because there is no satisfied or assumed indebtedness.

… His gross profit is $800,000 (the selling price of $1.3 million less his $500,000 adjusted basis).

… His gross profit ratio is 80/130 (gross profit over the contract price).

… Able’s recognized gain in Year 2 is $800,000 (the $1.3 million payment attributable to the relinquished property multiplied by the gross profit ratio (80/130)).

Even though the payment attributable to the relinquished property ($1.3 million) is less than the $1.5 million that the QI received, Able is not entitled to a Code Sec. 165 loss deduction because the payment attributable to the relinquished property exceeds his adjusted basis in the relinquished property ($500,000). (Rev Proc 2010-14, Sec. 4.10, Ex. 1)

Rev Proc 2010-14 carries four other detailed examples illustrating nuances of the new safe-harbor relief.

Effective date of relief. Rev Proc 2020-14 is effective for taxpayers whose like-kind exchanges fail due to a QI default occurring on or after January 1, 2009.  A taxpayer who is within the scope of Rev Proc 2020-14 may, subject to the Code Sec. 6511 limitations on credit or refund, file an original or amended return to report a deferred like-kind exchange that failed due to a QI default in a tax year ending before January 1, 2009, in accordance with Rev Proc 2010-14.

Supreme Court of the United States of America

The Supreme Court has declined to review a Ninth Circuit holding that a taxpayer could not avoid the Code §1031 like-kind-exchange related-party rule by using a qualified intermediary (QI). Teruya Brothers, Ltd. & Subsidiaries , (CA 9 2/11/2009) 104 AFTR 2d ¶ 2009-5345 , cert denied 2/22/2010.

Background. If statutory identification and replacement period requirements are met, gain or loss is not recognized currently on the exchange of property held for productive use in a trade or business or for investment for property of like kind that will be held for productive use in a trade or business or for investment. (Code §1031) QIs may be used to structure like-kind exchanges. However, under Code §1031(f), gain or loss on an exchange between related persons (under Code §267(b) or Code §707(b)(1)) must generally be recognized if either the property transferred or the property received is disposed of within two years after the exchange. Nonrecognition treatment under the like-kind exchange rules does not apply to any exchange that is part of a transaction or series of transactions structured to avoid the purposes of the related party exchange rule. (Code §1031(f)(4)) However, under Code §1031(f)(2)(C), a disposition will not trigger the related party bar if it is established to IRS’s satisfaction that neither the original transaction nor the later disposition had as one of its principal purposes the avoidance of federal tax.

Facts. Teruya Brothers Ltd. (Teruya) owned 62.5% of the common shares of Times Super Market Ltd (Times), so the two entities were related.  In 1995, in one series of planned transactions, Teruya transferred Real Property 1 to TGE, a QI, which then sold it to an unrelated third party. TGE used the sale proceeds, as well as additional funds from Teruya, to buy like-kind Replacement Property 2 for Teruya from Times, and then transferred Replacement Property 2 to Teruya. In another series of planned transactions, Teruya transferred Real Property 3 to TGE, which sold it to an unrelated party. TGE used the sale proceeds from Real Property 3, plus some cash from Teruya, to buy like kind Replacement Properties 4 and 5 from Times.

Teruya realized a $1.3 million gain on Property 1 and a $10.7 million gain on Property 3. Times realized and recognized a $1.3 million gain on Property 2 and a $2.2 million gain on Property 5, but these gains were offset by a large net operating loss. Times realized a $6.4 million loss on Property 4, but did not recognize it because of the Code §267 related-party restriction on loss recognition.

Teruya treated its transactions as tax-deferred like-kind exchanges under Code §1031, but IRS said the transactions ran afoul of the Code §1031(f)(4) related-party rule and hit Teruya with a $4 million deficiency.

Tax Court. In 2005, the Tax Court held that the transactions were economically equivalent to direct exchanges of properties between Teruya and Times (with boot from Teruya to Times), followed by the sales of the properties by Times to unrelated third parties. The interposition of a QI couldn’t obscure the end result.

Observation: In 2009, the Tax Court applied its Teruya reasoning and decision to rule against another taxpayer on the QI- Code §1031(f) issue (see Ocmulgee Fields, Inc., (2009) 132 TC No. 6).

Ninth Circuit. In 2009, the Ninth Circuit concluded that the Tax Court did not err in determining that the transactions were structured to avoid the purposes of Code §1031(f)(4). It rejected Teruya’s contention that the economic consequences of the transactions to Times were irrelevant, and that Teruya’s continued investment in real property was dispositive. Code §1031(f)(1)(C)(i) disallows nonrecognition treatment if a related party disposes of exchanged property within two years, regardless of whether the taxpayer does as well. Thus, examining the taxpayer and related party’s economic position in the aggregate is often the only way to tell if Code §1031(f) applies.

The legislative history indicating Congress’s desire to bar like-kind exchange treatment where related parties have, in effect, cashed out of the investment, confirmed that a taxpayer and a related party should be treated as an economic unit to see if Code §1031(f) applies. The Ninth Circuit pointed out that the changing economic positions of Teruya and Times readily showed that the related parties used the exchanges to cash out of an investment in low-basis real property. Before the exchanges, Teruya owned Property 1 and Property 3, and Times owned Properties 2, 4, and 5. After the exchanges, Properties 1 and 3 had been sold, Teruya owned Properties 2, 4, and 5, and Times had the cash from the sale of Properties 1 and 3 (along with boot from Teruya). All in all, Teruya and Times decreased their investment in real property by approximately $13.4 million, and increased their cash position by the same amount. By allowing Teruya and Times to cash out of a significant investment in real property under the guise of a nontaxable like-kind exchange, the Ninth Circuit concluded that the transactions were undoubtedly structured to contravene Congress’s desire that nonrecognition treatment only apply to transactions where a taxpayer can be viewed as merely continuing his investment.

The Ninth Circuit said Teruya could have exchanged its properties directly with Times, followed by Times’s selling Property 1 and Property 3 to the third-party purchasers, but this would not have had a tax-free result, since direct exchanges between related parties are ineligible for nonrecognition treatment when the exchanged property is sold within two years. Instead, Teruya employed TGE; the latter’s involvement as a QI served no purpose besides rendering simple, but tax disadvantageous, transactions more complex in order to avoid Code §1031(f)’s restrictions.

The Ninth Circuit also affirmed the Tax Court’s conclusion that Code Sec. 1031(f)(4) applied because improper avoidance of federal income tax was one of the principal purposes of the transactions.

Late in 2009, Teruya appealed the Ninth Circuit’s decision to the Supreme Court. However, on February 22, 2010, the Supreme Court declined to review the decision.

For more information on 1031 exchanges, or to ask specific questions regarding the related party rule of §1031, please contact Alexandra L. Hart, CES® at All States 1031 Exchange Facilitator, LLC by e-mail at AHart@AllStates1031.com or McLaughlin & Quinn, LLC Managing Partner and Owner of All States 1031 Exchange Facilitator, LLC Moore McLaughlin, Esq., CPA, CES® by e-mail at FMM@AllStates1031.com or either of them by phone toll-free at 877-395-1031.