Thursday, September 29, 2011

Health care tax credits: Many left wanting

By Catherine Clifford (CNN Money)

NEW YORK (CNNMoney) -- The health reform passed last year included tax credits to help ease the burden of surging health care costs for small businesses. But many small firms are ineligible.

Four million small businesses would qualify for the credit if they provide health insurance to their employees, estimates the White House Council of Economic Advisors. Of those, only 30% -- or about 1.2 million businesses -- would be eligible for the full tax credit, according to research from the Families USA and the Small Business Majority. Only the smallest companies will qualify for the maximum amount.

The tax credit refunds small businesses for a portion of the money they spend on health care premiums. However, the size of the business and the average salary can disqualify a business.

Therefore, a lot of small businesses that are struggling with the growing expense of providing their employees with health insurance don't qualify.

"We feel like we are in a doughnut hole," said Bev Hagadorn, who owns 11 Great Clips salons in the Las Vegas area with her husband, Dick. "We are a small business, but the law -- as we understand it -- doesn't treat us like a small, family-owned business," said Dick.

Dear Mr. President...

Although, they pay for employee benefits, they are ineligible for the tax credit. Their staff is too big, according to the reform law.

Bev and Dick bought their first franchise 12 years ago. They have 110 employees. Almost all of their employees work full-time. The Hagadorns offer health insurance, dental, vision, a retirement plan, and a week of vacation every six months. Managers get three weeks of vacation a year.

Benefits cost the couple about $140,000 a year and that will increase between 5% and 10% yearly.

Recently, they have had to ask employees to contribute a bit more. The Hagadorns used to pay 100% of the health care costs for their managers, but they now pay 90%.

The requirements for the tax credit: Small businesses that pay at least half of their employee's health coverage can get a significant tax refund. In what the White House claims is "broad eligibility," the maximum credit goes to businesses with 10 or fewer full-time employees with annual average wages of $25,000 or less. Companies with the equivalent of 25 full-time employees or more (the hours worked by part-timers count) or employees with annual average salaries of $50,000 or more are out of luck.

From 2010 to 2013, the tax credit is worth up to 35% of the money that a qualifying business spends on its health insurance premiums. In 2014, businesses can get a maximum of 50% of what they spend on premiums for their employees. The credit is available for a maximum of six years: 2010 through 2013 and for any two years after that.

The White House says the tax credit is doing exactly what it is supposed to do. "The tax credits were designed and targeted to the smallest businesses that often have the most difficulty offering insurance to their workers," said an administration official.

But that is of little consolation to those firms that don't qualify. "There are not too many businesses that have 25 or fewer employees -- probably real estate agents, maybe doctor offices -- but if you are a real small business, you are going to employ people," said Dick.

Sam Kumar, the owner of MYCO Medical in Cary, N.C., won't qualify for the health care tax credit, either. He only has 22 employees, but the average salary of his employees is $62,000.

Kumar spends about $60,000 a year providing health care for his employees. He pays 100% of the health care premiums for his employees and a generous suite of benefits. "And despite the fact that we have very healthy employees, our costs went up 27%," he said.

Back in 1993 when Kumar started the company with $5,000 from his 401(k), he wasn't able to pay for benefits. But now he has been able to pick up the cost for the past three years. As his business grows, he must continue to offer benefits to stay competitive.

The tax credit would help him hire.

"Right now, I have plans to hire one more person by the end of the year," said Kumar. "That could potentially be easier and could be larger had I some kind of assistance."

Regulation nightmares

"Waiting for a referee": Indeed. Rising health care costs and uncertainty about the health reform getting fully implemented have been stumbling blocks to many small business owners hiring.

For now, the Hagadorns are sitting on expansion plans. The couple has submitted applications for another six Great Clips locations and paid the down payment on those agreements. But they have yet to sign any leases with landlords.

They are still trying to figure out what the health care reform will mean for them.

"Every other sentence is if-then-but-however-and-maybe," said Dick. "And then they haven't figured this out yet. They haven't decided that yet. It is just noodle soup."

"We are waiting for the referee to decide what the rules are," he said.

Don't Cross IRS On Payroll Taxes

By Robert W. Wood, Forbes

It’s tough to get out of paying payroll taxes. When you withhold tax money from employees but fail to give it to the IRS, they will come after you. Quite rightly, the IRS views it as government money, a trust fund belonging to the IRS.

In a cash-strapped business, keeping the lights on or the warehouse stocked can seem more important. It may be tempting to think you can always pay the IRS later. But these problems have a way of snowballing, so it’s best to keep payroll taxes current at all times. Consider using a payroll service that directly pays the money over to the IRS.

One more good reason to be careful?

Personal Liability. Business owners and other “responsible persons” have personal liability for these taxes and excuses are rarely accepted. In Colosimo v. U.S., the Eighth Circuit Court of Appeals refused to take sympathy on a company owner who claimed he was duped by his bookkeeper.

More recently, in Jenkins v. U.S., the Court of Federal Claims held the majority owner and CEO of a publishing company responsible for payroll taxes. Although he didn’t exercise day-to-day control, he had the authority to do so and he knew payroll taxes were unpaid. You can be liable even if have no knowledge the IRS is not being paid. See What Is The Trust Fund Recovery Penalty?

The IRS can assess a Trust Fund Recovery Assessment—also known as a 100-percent penalty—against every “responsible person.” See Section 6672(a). In determining “willfulness,” courts focus on whether you had knowledge of the non-payment of taxes or showed reckless disregard whether they were being paid. But a person need not actually perform the withholding and payment functions to be considered “responsible.”

If you have signature authority but don’t exercise it, that can be enough to result in liability. Factual nuances matter, so one person may get stuck while another gets off scot-free. The IRS often makes an assessment against every officer, watching them turn on each other.

For example, in Johnson v. U.S., the IRS went after two employees for a casino’s payroll taxes. Brian Toms was the secretary/treasurer responsible for making tax deposits and electronic transfers for payroll taxes. Bonnie Johnson was the CFO but was not a member of the board, nor an officer or shareholder. She was authorized to pay vendors in the morning before Brian arrived, but otherwise paid vendors only when Brian instructed.

Brian was held liable for the taxes but Bonnie was not. She had check-signing authority and even prepared and signed tax returns. However, she did not have control of the payroll, could not authorize tax deposits, and did not have authority to sign contracts. The court found that she did not have the authority to pay the IRS without permission from Brian.

Huge numbers of businesses each year get caught in this no-win situation. See Personal Tax Liability When A Business Goes Under. Disputes are expensive and often do not go well. Be careful out there.

Robert W. Wood practices law with Wood LLP, in San Francisco. The author of more than 30 books, including Taxation of Damage Awards & Settlement Payments (4th Ed. 2009, Tax Institute), he can be reached at This discussion is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.

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Justice Dept. asks high court to look at health care law

By Joan Biskupic, USA TODAY

WASHINGTON – The Obama administration on Wednesday asked the Supreme Court to decide the constitutionality of a requirement that most Americans buy health insurance by 2014, paving the way for a ruling in the middle of the 2012 presidential election campaign.

Separately, 26 states and the National Federation of Independent Business, which have challenged the mandate as exceeding federal power, urged the justices to intervene and strike it down.

The new filings all but guarantee the justices will review the law that is at the heart of President Obama's domestic agenda and that has become a flashpoint in the race for Republican nomination. All the major Republican presidential candidates have vowed to overturn the law.

The justices, who open a new term on Monday, would likely act on the pending appeals this fall and hold oral arguments in early 2012.

Justice Department lawyers have appealed a decision by an Atlanta-based appeals court that said the individual-insurance mandate went beyond Congress' power to regulate interstate commerce. The lawyers say that appeals court decision, which conflicts with two appeals court rulings rejecting challenges to the law, undermines federal efforts to tackle the "crisis in the national health care market." The administration said the appeals court ruling "denies Congress the broad deference it is due … to address the nation's most pressing economic problems."

The requirement that most Americans buy insurance or face a tax penalty is the centerpiece of the health care law passed by Congress and signed by Obama in March 2010. The law was the most significant change in the nation's health care system since the creation of Medicare and Medicaid in 1965 and extends insurance coverage to 32 million Americans.

The administration says people without insurance incur billions of dollars in costs that are passed on to the insured. It contends that creates a substantial burden on interstate commerce that is within Congress' power to address.

The U.S. Court of Appeals for the 11th Circuit disagreed as it declared that forcing people to buy insurance represents an "unbounded assertion of congressional authority."

The 26 states and business group won major portions of their challenge, but the 11th Circuit rejected claims that the law's expansion of Medicaid encroaches on the states and that if the mandate is unconstitutional, the entire law is void. The states and business group have asked the justices to reverse those findings.

Wednesday, September 28, 2011

Is Failing To Issue IRS Forms 1099 Criminal?

By Robert W. Wood, Forbes

Everyone knows something about IRS Form 1099, and if you don’t, you should. It’s that little slip of paper—barely a third of a sheet—but bearing oh-so-critical numbers: your Social Security number and how much you got paid. In that sense, a 1099 is a precursor to a tax bill.

You can look forward to getting a pile of these pesky little forms each January reporting how much each person paid you the previous year. More importantly, the IRS gets a copy of each and every one. For that reason, these Forms are all about computer matching. If you fail to report the income, the IRS will send you a bill. See Care With Forms 1099 Helps Audit-Proof Tax Returns.

If you’re in business, you probably dread these forms since issuing them is a royal pain. There are many different flavors of 1099 and many different dollar thresholds, some as low as $10 (interest). See Forms 1099 For Cost Basis: What, Me Worry? The most common, though, is $600.

If you pay someone for services in the course of your business and the payments total $600 or more during the year, you must issue the form. See Beware Each Form 1099! Since the $600 is cumulative, keep track of little payments too. There are penalties if you don’t. Rarely though, does the little old Form 1099 get mentioned in a criminal case. But where there’s a will, there’s a way.

An athletic complex in New York called Chelsea Piers is the site of adult basketball leagues where referees are paid about $40 per game. That’s not much but adds up, and you can guess where this story is headed. What if it adds up to over $600 per year? The payor must issue a Form 1099, of course.

But according to an indictment filed by the U.S. Attorney, some enterprising guys in striped outfits—referees not prison stripes—used stolen IDs to ensure they got less than $600 per year in their own names. Clever, no? Soon they may be exchanging one striped suit for another.

According to the indictment, the idea was to avoid the Forms 1099 so they could under-report their income and save at tax time. Based on stolen identification information, Chelsea Piers issued checks in many names which the defendants would (fraudulently) endorse, claim prosecutors.

Named in the indictment were: Peter Iulo, a former referee and basketball program supervisor at Chelsea Piers, and James Murray, a Chelsea Piers employee who oversaw the basketball program. Named in a separate criminal Information were two referees, Gerard Fahy, and Robert Spence.

All four were charged with conspiracy to defraud the U.S., to evade taxes, to file false tax returns, and conspiracy to commit identity theft. Several defendants were also charged with tax evasion.

No one wants to be indicted for a tax crime. Most of our tax system is voluntary and based on self-assessment. But sometimes the IRS gets tough and makes an example. My advice? Always color between the lines.

Robert W. Wood practices law with Wood LLP, in San Francisco. The author of more than 30 books, including Taxation of Damage Awards & Settlement Payments (4th Ed. 2009, Tax Institute), he can be reached at This discussion is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.

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IRS Loses a Gift-Tax Battle

By Laura Saunders, Wall Street Journal

Wealthy taxpayers who want to make large gifts to family members recently got good news: A federal appeals court affirmed a popular technique to sidestep gift taxes.

The decision, Estate of Petter v. Commissioner, was published in August by the Ninth Circuit in San Francisco. It joins earlier rulings on related issues by the Eighth and Fifth circuits. All the cases originated in Tax Court, but appeals go to the federal circuit court in which the taxpayer lives.

"These decisions make it easier for senior family members to transfer hard-to-value assets to heirs and charity with reduced gift-tax risk," says John Porter of Baker Botts in Houston, who argued all the cases. These and other victories have made him a rock star in the staid trust-and-estates bar.

The Internal Revenue Service declined to comment on the case.

The techniques affirmed by the Petter case are especially relevant now, says estate attorney Howard Zaritsky of Rapidan, Va. With asset values low and the estate- and gift-tax exemption slated to snap back to $1 million in 2013 from its current $5 million level, many are considering making large gifts.

But there is a hitch: valuations. These are always an issue with large gifts, especially with real estate or a business. What if the IRS challenges an estimate and wants more gift taxes? Many taxpayers are loath to write a check, and some don't have ready cash. Petter offers a solution.

Anne Petter was a Washington state teacher who died in 2008. In 1982 she inherited United Parcel Service stock from an uncle who was among the company's first investors. In May 2001, when the top gift- and estate-tax rate was 55%, she held $22 million of stock.

Estate planners advised Ms. Petter to transfer all the UPS stock to a limited-liability company. Then she both gave and sold units of the LLC to two of her children in 2002.

Why do this? In the eyes of the law, putting stock into an LLC lowers its value when units are given away or sold. That's because no one member of the LLC owns a controlling interest in it, and units can't easily be traded. This strategy also allowed Ms. Petter to retain some control. Being charitable, she also gave units to a local nonprofit with a donor-advised fund.

Ms. Petter claimed that putting the stock in the LLC entitled her to a 51% discount from its market value on the transfers made to her children. The IRS challenged that, and the two parties ultimately settled on a 36% discount.

The crux of the case: Was gift tax due once the discount dropped to 36% from 51%? Because each LLC unit had a smaller discount than Ms. Petter first assumed, it took fewer units to reach the gift-tax exemption, which was $1 million at the time. The revised discount also raised the price of the units her children bought.

As a result, some LLC units transferred by Ms. Petter weren't covered either by the gift-tax exemption or the amount her children paid her. The IRS said she owed gift tax on the transfer of these units. But she had specified that in such a case they would bounce to her IRS-registered charity—with no gift tax due.

The IRS didn't like that one bit, because it meant the penalty for an exaggerated discount was simply a donation to a charity, not a check to Uncle Sam.

"The government said if Ms. Petter prevailed, it had no incentive to audit," says Carlyn McCaffrey, an attorney at McDermott, Will & Emery in New York. The IRS's real fear, says retired tax expert Tom Ochsenschlager, is that without audits, taxpayers could "get away with murder on valuations."

The courts sided with Ms. Petter, giving a lift to taxpayers and charities, if not the IRS.

Some experts hope the decision can be broadened to include a spousal trust or perhaps a grantor-retained annuity trust benefiting heirs instead of a charity.

Others warn that the IRS has the power to change its own regulations to invalidate Ms. Petter's strategy. Mr. Zaritsky's advice: "Taxpayers interested in these transactions should do them soon."

Wednesday, September 21, 2011

Revenue Procedure 2011-44

Revenue Procedure 2011-44 which modifies the procedures for church plans that are filing a request for a determination letter. The revenue procedure provides that plan participants and other interested parties be notified of the letter request.

Revenue Procedure 2011-44 will be in Internal Revenue Bulletin 2011-39 on Sept. 26, 2011.

IRS Notice 2011-79

Notice 2011-79 explains the circumstances under which the 4-year replacement period is extended for livestock sold on account of drought. The Appendix to this notice contains a list of counties that experienced exceptional, extreme, or severe drought conditions during the 12-month period ending August 31, 2011. Taxpayers may use this list to determine if an extension is available.

Notice 2011-79 will be published in Internal Revenue Bulletin 2011-41 on Oct. 11, 2011.

IRS Announcement 2011-64

Announcement 2011-64 provides notice and details regarding a new Internal Revenue Service Voluntary Classification Settlement program that provides partial relief from federal employment taxes for eligible taxpayers that agree to prospectively treat workers as employees.

Announcement 2011-64 will be published in Internal Revenue Bulletin 2011-41, dated Oct. 11, 2011.

IRS Announces New Voluntary Worker Classification Settlement Program; Past Payroll Tax Relief Provided to Employers Who Reclassify Their Workers as Employees

WASHINGTON – The Internal Revenue Service today launched a new program that will enable many employers to resolve past worker classification issues and achieve certainty under the tax law at a low cost by voluntarily reclassifying their workers.

This new program will allow employers the opportunity to get into compliance by making a minimal payment covering past payroll tax obligations rather than waiting for an IRS audit.

This is part of a larger “Fresh Start” initiative at the IRS to help taxpayers and businesses address their tax responsibilities.

“This settlement program provides certainty and relief to employers in an important area,” said IRS Commissioner Doug Shulman. “This is part of a wider effort to help taxpayers and businesses to help give them a fresh start with their tax obligations.”

The new Voluntary Classification Settlement Program (VCSP) is designed to increase tax compliance and reduce burden for employers by providing greater certainty for employers, workers and the government. Under the program, eligible employers can obtain substantial relief from federal payroll taxes they may have owed for the past, if they prospectively treat workers as employees. The VCSP is available to many businesses, tax-exempt organizations and government entities that currently erroneously treat their workers or a class or group of workers as nonemployees or independent contractors, and now want to correctly treat these workers as employees.

To be eligible, an applicant must:

• Consistently have treated the workers in the past as nonemployees,

• Have filed all required Forms 1099 for the workers for the previous three years

• Not currently be under audit by the IRS, the Department of Labor or a state agency concerning the classification of these workers

Interested employers can apply for the program by filing Form 8952, Application for Voluntary Classification Settlement Program, at least 60 days before they want to begin treating the workers as employees.

Employers accepted into the program will pay an amount effectively equaling just over one percent of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years. Participating employers will, for the first three years under the program, be subject to a special six-year statute of limitations, rather than the usual three years that generally applies to payroll taxes.

Full details, including FAQs, are available on the Employment Tax pages of, and in Announcement 2011-64, posted today.

Friday, September 16, 2011

Boehner: Debt panel can start on major tax changes

By DAVID ESPO - AP Special Correspondent

WASHINGTON (AP) — House Speaker John Boehner urged Congress' deficit "supercommittee" on Thursday to lay the groundwork for a broad overhaul of the U.S. tax code, rejecting Democrats' talk of tax increases but leaving open the possibility the government's take could rise as a result.

Tax increases "are not a viable option" for the committee, Boehner declared in a speech to the Washington Economic Club, ruling out many of the proposals that President Barack Obama is expected to forward to the 12-member panel next week, including some that are part of his major jobs proposal.

Boehner made his remarks as White House officials disclosed that Obama intends to travel to Cincinnati next week as he campaigns for public support of his $447 billion proposal to cut into the nation's 9.1 percent unemployment rate. The political symbolism of the site was unmistakable — an overcrowded bridge that links Boehner's Ohio with Senate GOP leader Mitch McConnell's Kentucky, a span the president has cited as an example of the repair work his jobs program would make possible.

"We are going to run this like a campaign in the sense that we have to take it to the American people," Obama said Thursday, describing the White House strategy to donors at a political fundraiser.

"The Republicans in the House, their natural instinct right now is not to engage in the cooperation we'd like to see," he said.

Separately, White House spokesman Jay Carney said Obama will not recommend any budget savings from Social Security when he releases his recommendations to the deficit-cutting committee next week, despite the president signaling support for that idea in summertime debt-reduction talks with Boehner.

Carney declined to say what, if any, recommendations the president might make to find savings from Medicare.

The day's events underscored the extent to which the committee of 12 lawmakers is likely to be guided by the views of the most senior leaders in both political parties as it tries to develop legislation to reduce deficits by $1.2 trillion or more over a decade.

The panel has almost unlimited authority to recommend changes in federal spending and taxes and is working against a deadline of Nov. 23. It held a closed-door meeting during the day, but officials declined to provide details of what was discussed.

In his speech, Boehner was alternately critical of Obama's economic policies and somewhat conciliatory.

"Businesses are not going to hire someone for a $4,000 tax credit if government mandates impose long-term costs on them that significantly exceed the temporary credit," he said, describing a portion of what the president asked Congress to approve in his jobs program.

"Let's be honest with ourselves," he said. "The president's proposals are a poor substitute for the pro-growth policies that are needed to remove barriers to job creation in America."

The centerpiece of Obama's jobs program is a one-year extension of Social Security payroll tax cuts for workers, expanded to include businesses. He is also seeking other tax breaks, as well as an extension of unemployment benefits, aid to states to permit them to hire teachers and first responders, and construction funding for highways and bridges like the one he intends to visit in Ohio next week.

Asked whether the congressional debt panel might include some of Obama's jobs recommendations in its own work, Boehner said, "I think it's too early to determine whether some of it ends up being the work of the ... committee or whether we do it separately."

Any broad compromise that clears the bipartisan committee is almost certain to require Democratic agreement to savings from benefit programs such as Social Security and Medicare, along with Republican acquiescence to additional revenues, although any such tradeoffs are rarely discussed openly until the last possible moment in negotiations.

The committee's charter is to cut deficits, and Boehner said, "That has everything to do with jobs."

Ruling out tax increases, he said the panel has "only one option, spending cuts and entitlement reforms," a reference to government benefit programs such as Social Security, Medicare and Medicaid.

At the same time, he said the committee 'can tackle tax reform and it should." Boehner said it was probably unrealistic to expect the panel to rewrite the tax code by Nov. 23. "But it can certainty lay the groundwork by then for tax reform in the future that will enhance the environment for economic growth."

He said the elements of an eventual overhaul of the tax code would be lower rates for individuals and corporations while closing deductions, credits, and special carve-outs.

"Yes, tax reform should include closing loopholes. Not for the purposes of bringing more money to the government. But because it's the right thing," he said.

Boehner did not rule out that tax changes might result in additional government revenue, and officials in both parties say that in his talks with Obama last summer the two men were discussing the possibility that an overhaul could mean as much as an additional $800 billion for the Treasury over a decade.

At the White House, Carney said, "I would simply note that the speaker of the House made clear that in the negotiations he had with the president, he put, in his words, revenues on the table. Well, we believe revenues have to be on the table if we're going to solve our deficit and debt problems."

Similarly, in the same talks, Obama appeared willing to include a provision to slow the growth in cost-of-living increases in Social Security and to raise the age of eligibility for Medicare from 65 to 67.

Both provisions sparked strong opposition from liberal lawmakers in the president's own party, and it was not clear whether Obama has decided to rule them out of any future talks or was merely was shelving them for the time being.

The collapse last July of the talks between Obama and Boehner led to legislation that cut spending by nearly $1 trillion over a decade, averted a first-ever government default and created the debt committee that is just now beginning its work in earnest.

Associated Press writer Jim Kuhnhenn contributed to this story

12,000 tax cheats come clean under IRS program

By STEPHEN OHLEMACHER - Associated Press

WASHINGTON (AP) — About 12,000 tax cheats have come clean under a program that offered reduced penalties and no jail time to people who voluntarily disclosed assets they were hiding overseas, the Internal Revenue Service announced Thursday.

Those people have so far paid $500 million in back taxes and interest. IRS Commissioner Doug Shulman said he expects the cases to yield substantially more money from penalties that have yet to be paid.

The voluntary disclosure program, which ran from February to last week, is part of a larger effort by the IRS to crack down on tax dodgers who hide assets in overseas accounts. The agency stepped up its efforts in 2009, when Swiss banking giant UBS AG agreed to pay a $780 million fine and turn over details on thousands of accounts suspected of holding undeclared assets from American customers.

Since then, the IRS has opened new enforcement offices overseas, beefed up staffing and expanded cooperation with foreign governments. A similar disclosure program in 2009 has so far netted $2.2 billion in back taxes, penalties and fines, from people with accounts in 140 countries, Shulman said.

Between the two disclosure programs, a total of 30,000 tax cheats have come clean.

"The world has clearly changed," Shulman said. "We have pierced international bank secrecy laws, and we're making a serious dent in offshore tax evasion."

The IRS has long had a policy that certain tax evaders who come forward can usually avoid jail time as long as they agree to pay back taxes, interest and hefty penalties. Drug dealers and money launderers need not apply. But if the money was earned legally, tax evaders can usually avoid criminal prosecution.

Fewer than 100 people apply for the program in a typical year, in part because the penalties can far exceed the value of the hidden account, depending on how long the account holder has evaded U.S. taxes.

The latest disclosure program offered reduced penalties, but it was no free walk. Taxpayers were required to pay up to eight years of back taxes and a penalty of up to 25 percent of the highest annual amount in the overseas account from 2003 through 2010.

The disclosure programs have also provided the IRS with information about banks and advisers who have assisted people with offshore tax evasion. Shulman said the agency will use the information to continue its enforcement efforts.

"Unlike a few years ago, it's very clear now that there's a real price to be paid for people who think they can hide offshore and not pay their taxes," he said.

Thursday, September 15, 2011

IRS Notice 2011-72: Tax Treatment of Employer-Provided Cell Phones

Part III - Administrative, Procedural, and Miscellaneous

Tax Treatment of Employer-Provided Cell Phones

Notice 2011-72


This notice provides guidance on the tax treatment of cellular telephones or other similar telecommunications equipment (hereinafter collectively “cell phones”) that employers provide to their employees primarily for noncompensatory business purposes.


Section 2043 of the Small Business Jobs Act of 2010, Pub.L.No. 111-240, (the Act) removed cell phones from the definition of listed property for taxable years beginning after December 31, 2009. The Act did not otherwise alter the requirement that an employer-provided cell phone is a fringe benefit, the value of which must be included in the employee’s gross income, unless an exclusion applies, or the potential treatment of an employer-provided cell phone as an excludible fringe benefit. Since enactment of the Act, the IRS has received questions about the proper tax treatment of employer-provided cell phones. Accordingly, this notice addresses the treatment of employer-provided cell phones as an excludible fringe benefit.

Gross Income

Section 61 of the Internal Revenue Code (Code) defines gross income as all income, from whatever source derived. Section 61(a)(1) provides that gross income includes compensation for services, including fees, commissions, fringe benefits, and similar items. A fringe benefit provided by an employer to an employee is presumed to be income to the employee unless it is specifically excluded from gross income by another section of the Code. See Income Tax Regulations § 1.61-21(a).

Working Condition Fringe Benefits

Section 132(a)(3) of the Code provides that gross income does not include any fringe benefit which qualifies as a working condition fringe. Section 132(d) provides that “working condition fringe” means any property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction under §§ 162 or 167.

Section 1.132-5(a)(1)(ii) of the Income Tax Regulations (Regulations) provides that if, under section 274 or any other section, certain substantiation requirements must be met in order for a deduction under §§ 162 or 167 to be allowable, then those substantiation requirements apply when determining whether a property or service is excludable as a working condition fringe. See also Regulations § 1.132-5(c)(1).

Section 162(a) of the Code provides that a deduction is allowed for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. However, section 262(a) of the Code provides that, except as otherwise expressly provided, no deduction shall be allowed for personal, living, or family expenses.

In the case of certain listed property, as defined in section 280F(d)(4) of the Code, special heightened substantiation rules apply. Section 274(d)(4) of the Code provides that no deduction shall be allowed with respect to any listed property (as defined in § 280F(d)(4)), unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer’s own statement (A) the amount of such expense or other item, (B) the use of the property, (C) the business purpose of the expense or other item, and (D) the business relationship to the taxpayer of persons using the property.

The Act removed cell phones from the definition of listed property for taxable years beginning after December 31, 2009. Because the Act removed cell phones from the definition of listed property, the heightened substantiation requirements that apply to listed property no longer apply to cell phones for taxable years beginning after December 31, 2009.

De Minimis Fringe Benefits

Section 132(a)(4) of the Code provides that gross income does not include any fringe benefit which qualifies as a de minimis fringe. Section 132(e) defines a de minimis fringe as any property or service the value of which is (after taking into account the frequency with which similar fringes are provided by the employer to the employer’s employees) so small as to make accounting for it unreasonable or administratively impracticable. Except as specifically provided (i.e., occasional meal money or local transportation fare and reimbursements for public transit passes), a cash fringe benefit is not excludable as a de minimis fringe. See Regulations §1.132-6(c).

Guidance Regarding Employer-Provided Cell Phones

Many employers provide their employees with cell phones primarily for noncompensatory business reasons. The value of the business use of an employer-provided cell phone is excludable from an employee’s income as a working condition fringe to the extent that, if the employee paid for the use of the cell phone themselves, such payment would be allowable as a deduction under section 162 for the employee.

An employer will be considered to have provided an employee with a cell phone primarily for noncompensatory business purposes if there are substantial reasons relating to the employer’s business, other than providing compensation to the employee, for providing the employee with a cell phone. For example, the employer’s need to contact the employee at all times for work-related emergencies, the employer’s requirement that the employee be available to speak with clients at times when the employee is away from the office, and the employee’s need to speak with clients located in other time zones at times outside of the employee’s normal work day are possible substantial noncompensatory business reasons. A cell phone provided to promote the morale or good will of an employee, to attract a prospective employee or as a means of furnishing additional compensation to an employee is not provided primarily for noncompensatory business purposes.

This notice provides that, when an employer provides an employee with a cell phone primarily for noncompensatory business reasons, the IRS will treat the employee’s use of the cell phone for reasons related to the employer’s trade or business as a working condition fringe benefit, the value of which is excludable from the employee’s income and, solely for purposes of determining whether the working condition fringe benefit provision in section 132(d) applies, the substantiation requirements that the employee would have to meet in order for a deduction under §162 to be allowable are deemed to be satisfied. In addition, the IRS will treat the value of any personal use of a cell phone provided by the employer primarily for noncompensatory business purposes as excludable from the employee’s income as a de minimis fringe benefit. The rules of this notice apply to any use of an employer-provided cell phone occurring after December 31, 2009. The application of the working condition and de minimis fringe benefit exclusions under this notice apply solely to employer-provided cell phones and should not be interpreted as applying to other fringe benefits.


This notice is effective for all taxable years after December 31, 2009.


The principal author of this notice is Joseph Perera of the Office of Associate Chief Counsel (Tax Exempt & Government Entities). For further information regarding this notice contact Joseph Perera on (202) 622-6040 (not a toll-free call).

Hedge Fund Fair Tax Can Cut Deficit By $18 Billion

By Peter Cohan

President Obama suggested that we help finance the American Jobs Act, in small part, by asking hedge funds to pay what I think is a fair tax. And if they do, the budget deficit will drop by $18 billion.

The proposed tax change would require hedge funds to pay an ordinary income tax rate (35%) instead of the current capital gains rate (15%) on their so-called carried interest. Carried interest is the money that hedge fund managers get paid as a reward for making profits on their fund’s investments.

Hedge funds typically get paid through a combination of management fees and carried interest. For a hedge fund managing $5 billion, the management fees might be $100 million a year (2% of the assets under management). And if the hedge fund returned 10% — adding $500 million to the value of that asset pile, the fund’s investors would get $400 million (80%) and the hedge fund managers’ carried interest would total $100 million (20%).

Currently that $100 million is taxed at 15%. To understand why it should be taxed at 35%, it helps to understand the rationale for setting the capital gains rate below that of ordinary income. As I discussed on CNBC with the Wall Street Journal’s Alan Murray back in 2007, we want to encourage putting capital at risk so we tax the gains from such risk at a lower rate.

The reason that raising that rate for hedge fund managers is fair, in my opinion, is because the money that hedge funds invest is partially that of the hedge fund managers themselves and mostly that of the hedge fund’s investors. The hedge fund manager should not be rewarded with a lower tax rate for putting someone else’s money at risk.

Simply put, carried interest is a blend of at risk and not at risk profits, so it should be taxed in a blended way. To the extent that a general partner is putting his or her own capital at risk in a deal, then the carried interest in that deal should be taxed as a capital gain.

However, to the extent that the general partner is putting the limited partners’ capital at risk, the pro-rata share of the carried interest should be taxed to the general partner at the ordinary income rate.

Simply put, since general partners put very little of their own money at risk, most of the carried interest is really a fee for managing other people’s money and that fee should be taxed at the ordinary income rate. After all, any income that is part of regular trade or business normally is taxed at ordinary tax rates. And for most hedge funds, profiting with other peoples’ money is a regular occurrence.

How well will this argument go over in Washington? If money buys votes, then the answer as of April 2011 is pretty simple — like a lead balloon. That’s because according to the Center for Responsive Politics, hedge funds have shifted the lion’s share of their money from the Democratic Party to the Republicans. Specifically, in 2008 hedge funds gave $12 million to Democrats and $7 million to Republicans but by 2010 the split had shifted to $4.5 million for the Democrats and $13 million for the Republicans.

I’d challenge a hedge fund manager to defend the idea that it’s as risky for them to put a client’s money into a trade as it is to bet their own cash. It doesn’t seem defensible to me though. After all, if the client loses money on a trade, that doesn’t cost the hedge fund manager much beyond the client’s frustration. It’s only when he loses his own money, that he feels the burn in his own bank account.

Being a hedge fund manager is the world’s most lucrative job — in 2010, the nine highest paid made over $1 billion personally. If hedge funds paid a fair tax, their managers would still be the highest paid people in the world.

Even if a few people did drop out of the hedge fund industry because they had to pay a 35% tax rate on their profits, do hedge funds really create so much value for society that those drop-outs would be missed?

Read the full article here:

Tuesday, September 6, 2011

Final Regs. Governing Practice Before the IRS

by Jordan Adams, CPA, and Karen Galvin, CPA, Oak Brook, IL

Procedure & Administration

On May 31, 2011, Treasury issued final regulations governing practice before the IRS to increase taxpayer compliance and to ensure uniform and high ethical standards of conduct for all tax return preparers (T.D. 9527). The final regulations, which became effective August 2, 2011, amend Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, Enrolled Retirement Plan Agents, and Appraisers Before the Internal Revenue Service (31 C.F.R. Part 10). The new rules create a new class of practitioner called a registered tax return preparer. They also revise the professional standards applicable to all practitioners with respect to the standards for tax return preparation under Circular 230, Section 10.34(a), to align these rules with the civil penalty standards under Sec. 6694(a). In addition, the final regulations provide guidance surrounding incompetence and disreputable conduct by tax return preparers.


In June 2009, the IRS initiated a review of tax return preparers with the intent to both increase taxpayer compliance and propose a comprehensive set of recommendations to ensure uniform and high ethical standards of conduct for all tax return preparers. As part of the industry review, the IRS received input through public forums, solicitation of written comments, and meetings with advisory groups. An overwhelming number of commentators supported increased government oversight of tax return preparers, particularly for individuals who are not attorneys, CPAs, or others currently authorized to practice before the IRS. They believed that taxpayers, the IRS, and tax administration would all benefit from the registration of tax return preparers. In addition, the commentators favored minimum education or testing requirements and the establishment of quality and ethics standards for paid tax return preparers. The IRS reported the findings and recommendations of its review in Publication 4832, Return Preparer Review (December 2009), which it released on January 4, 2010. The report recommends increased oversight of the tax return preparer industry through the issuance of regulations.

To implement recommendations made in the report, in September 2010 the IRS issued final regulations under Sec. 6109 that require all individuals who prepare tax returns to register with the IRS and to obtain a preparer tax identification number (PTIN). The tax return preparer must furnish the PTIN when he or she signs a tax return or claim for refund. The PTIN registration mandate is expected to improve the accuracy, completeness, and timeliness of tax returns. The IRS will be able to match preparers with the tax returns and claims for refund that they prepare, which will help the IRS with oversight of tax return preparers and with administration of requirements intended to ensure that tax return preparers are competent, trained, and conform to rules of practice.

To further implement the recommendations made in the report, the IRS issued proposed Circular 230 regulations (REG-138637-07) that were finalized on May 31, 2011. The final regulations create a new class of practitioner and provide standards for all tax return preparers that align with the tax preparer penalty provisions under Sec. 6694.

Registered Tax Return Preparers

Under prior regulations, tax return preparers generally were not subject to the provisions of Circular 230 unless the preparer was a CPA, attorney, or enrolled agent. Prior to the issuance of the final regulations, any individual could prepare tax returns and claims for refund without meeting specific qualifications or competency standards. The final regulations adopt the proposed amendments to Circular 230, Section 10.3(f), and establish the new designation of registered tax return preparer. A registered tax return preparer is any individual so designated under Circular 230, Section 10.4(c)—that is, who is 18 years old or older, has passed an IRS administered competency exam, possesses a current PTIN, and is not currently under suspension or disbarment from practice before the IRS. CPAs, attorneys, and enrolled agents are not registered tax return preparers.

The final regulations provide that practice as a registered tax return preparer is limited to preparing and signing tax returns, claims for refund, and other documents for submission to the IRS (Circular 230, §10.3(f)(2)). The new rules state that the IRS will prescribe the tax returns and claims for refund that a registered tax return preparer may prepare and sign.

Registered tax return preparers may represent taxpayers before revenue agents, customer service representatives, and similar officers and employees of the IRS (including the Taxpayer Advocate Service) during an examination if the preparer signed the tax return or claim for refund for the tax year or period under examination (Circular 230, §10.3(f)(3)). However, registered tax return preparers may not represent taxpayers before appeals officers, revenue officers, counsel, or other similar officers or employees of the IRS or Treasury.

In addition, a registered tax return preparer’s authorization to practice does not include the authority to provide tax advice to a client or another person except as necessary to prepare a tax return, claim for refund, or other document intended to be submitted to the IRS. The preamble to the final regulations provides that Treasury and the IRS have concluded that the federally authorized tax practitioner privilege generally does not apply to communications between a taxpayer and a registered tax return preparer because the advice the preparer provides is ordinarily intended to be reflected on a tax return and is not intended to be confidential or privileged. (The privilege under Sec. 7525 does not extend to documents and communications used in tax return preparation.) The conduct of a registered tax return preparer in connection with the preparation of the return, claim for refund, or other document, as well as any representation of the client during an examination, will be subject to the standards of conduct in Circular 230. Inquiries into possible misconduct and disciplinary proceedings relating to registered tax return preparer misconduct will be conducted under the provisions in Circular 230.

Circular 230, Section 10.5, prescribes the applicable procedures for becoming a registered tax return preparer, which are generally consistent with the procedures currently used for enrolled agents and enrolled retirement plan agents. An individual who wants to become a registered tax return preparer or to renew his or her designation as such must use forms and comply with the procedures established and published by the IRS. As a condition for consideration of an application, the IRS may conduct a federal tax compliance check and a suitability check. The tax compliance check will be limited to an inquiry about whether the individual has filed all required individual or business tax returns and has paid or made proper arrangements with the IRS for payment of any federal tax debts. The suitability check will be limited to an inquiry about whether the individual has engaged in any conduct that would justify suspension or disbarment of a practitioner, including whether the applicant has engaged in disreputable conduct.

In addition to the compliance and suitability checks, a registered tax return preparer must pass a competency examination and possess a valid PTIN. Notice 2011-45, which the IRS released to accompany the final regulations, provides that during the time period before the competency examination is available and the compliance and suitability checks are final, individuals with a provisional PTIN may not represent themselves as registered tax return preparers. Only individuals who have met all the conditions, including passing the examination and the compliance and suitability checks, may represent that they are registered tax return preparers.

To qualify for renewal as a registered tax return preparer in subsequent years, an individual must complete a minimum of 15 hours of continuing education credit, including 2 hours of ethics or professional conduct, 3 hours of federal tax law updates, and 10 hours of federal tax law topics during each registration year (Circular 230, §10.6(e)(3)). A registration year includes each 12-month period the registered tax return preparer is authorized to practice before the IRS. The registered tax return preparer must maintain records related to the completion of the continuing education credit hours for a period of four years following the renewal date.

To qualify for continuing education credit, a course must be designed to enhance professional knowledge in federal taxation or federal tax-related matters and must be consistent with the Code and effective tax administration (Circular 230, §10.6(f)). The maximum continuing education credit allowed for instruction and preparation is four hours annually. No continuing education credit hours are allowed for authoring articles, books, or other publications.

Standards with Respect to Tax Returns

In addition to the rules for registered tax return preparers, the Circular 230 standards under Section 10.34(a), which apply to all practitioners, were updated to be consistent with the tax return preparer civil penalty standards under Sec. 6694. Since the professional standards included in Circular 230 were not aligned with the Sec. 6694 tax return preparer penalty standards, some commentators on the proposed Circular 230 regulations were concerned that a violation of Sec. 6694 would translate to a per se violation of Section 10.34. The final regulations indicate that a practitioner liable for a penalty under Sec. 6694 is not automatically subject to discipline under Circular 230, Section 10.34(a).

The final regulations provide that a practitioner may not willfully, recklessly, or through gross incompetence sign a tax return or claim for refund that the practitioner knows or reasonably should know contains a position that:

* Lacks a reasonable basis;

* Is an unreasonable position as described in Sec. 6694(a)(2) (including the related regulations and other published guidance); or

* Is a willful attempt by the practitioner to understate the liability for tax or a reckless or intentional disregard of rules or regulations as described in Sec. 6694(b)(2) (including the related regulations and other published guidance).

A practitioner may not willfully, recklessly, or through gross incompetence advise a client to take a position on a tax return or claim for refund containing a position as described in the three points above. In addition, the practitioner may not prepare a portion of a tax return or claim for refund containing a position described above.

The final regulations also provide guidance on incompetence and disreputable conduct by tax preparers. Section 10.51 of Circular 230 defines disreputable conduct for which a practitioner may be sanctioned and includes the following scenarios under which such standards are applicable. Sec. 6011(e)(3) requires certain specified tax return preparers to file individual income tax returns electronically. Treasury and the IRS believe that the failure to comply with this requirement is disreputable conduct. Accordingly, Circular 230, Section 10.51(a)(16), as finalized provides that disreputable conduct includes willfully failing to file on magnetic or other electronic media a tax return prepared by the practitioner when the practitioner is required to do so by federal tax laws unless the failure is due to reasonable cause and not willful neglect. Under Section 10.51(a)(17), disreputable conduct includes willfully preparing all or substantially all of, or signing, a tax return or claim for refund when the practitioner does not possess a current or otherwise valid PTIN or other prescribed identifying number. Section 10.51(a)(18) prescribes that willfully representing a taxpayer before an officer or employee of the IRS unless the practitioner is authorized to do so under Circular 230 is disreputable conduct. These standards generally apply to all tax return preparers and come as a result of feedback to ensure ethical conduct by those in the profession.


Over the years, the IRS has implemented several tax return preparer standards with the intent of increasing taxpayer compliance and ensuring uniform and high ethical standards of conduct for all tax return preparers. The new rules regarding registered tax return preparers and the standards on tax return preparation are further attempts by the IRS to enhance these professional standards and will continue to affect the tax profession for years to come.

Transaction Cost Considerations: Rev. Proc. 2011-29 and Other Related Matters

by Matthew J. Mittman, CPA, Oak Brook, IL, and Thomas J. Brecht, CPA, Elkhart, IN

Expenses & Deductions

The treatment of success-based fees that are paid or incurred in connection with the successful closing of business acquisitions or reorganizations described in Regs. Sec. 1.263(a)-5(e)(3) (covered transactions) continues to be the subject of controversy between the IRS and taxpayers. Specifically, numerous disagreements have arisen regarding what documentation is necessary to establish that a portion of the success-based fee is allocable to activities that do not facilitate a business acquisition, which could result in an immediate deduction to the taxpayer.

In an effort to eliminate the controversy over the allocation of success-based fees and corresponding documentation requirements, the IRS issued Rev. Proc. 2011-29, providing taxpayers with a safe-harbor election for allocating 70% of success-based fees paid or incurred in a covered transaction described in Regs. Sec. 1.263(a)-5(e)(3) to activities that do not facilitate the transaction. The remaining 30% of the success-based fees must be capitalized as an amount that facilitates the transaction. The election is available for success-based fees paid or incurred in tax years ending on or after April 8, 2011.

Taxpayers that choose not to make the election must maintain documentation under Regs. Sec. 1.263(a)-5(f) to establish that a portion of the success-based fees are allocable to activities that do not facilitate the transaction. As addressed below, the safe-harbor election under the revenue procedure attempts to eliminate the controversy over the allocation of success-based fees and the documentation requirements for only certain transactions.


Under Sec. 263(a)(1) and Regs. Sec. 1.263(a)-2(a), capitalization is required and no immediate deduction is allowed for any amount paid for property that has a useful life substantially beyond the tax year of the taxpayer. In the case of an acquisition or reorganization of a business entity, acquisition costs that generate significant long-term benefits must be capitalized.

Under Regs. Sec. 1.263(a)-5, a taxpayer must capitalize amounts paid that facilitate transactions, including business acquisitions and reorganizations, described in Regs. Sec. 1.263(a)-5(a). An amount paid or incurred in the process of investigating or otherwise pursuing the transaction is an amount paid to facilitate a transaction described in Regs. Sec. 1.263(a)-5(a), unless the services were performed prior to the date the letter of intent was signed or the material terms of the transaction were agreed to by representatives of the acquirer and the target (this date is referred to as the bright-line date and is described in Regs. Sec. 1.263-5(e)(1)). (See Regs. Sec. 1.263-5(e)(2) for exceptions to Regs. Sec. 1.263-5(e)(1).)

A success-based fee paid or incurred on the closing of a transaction described in Regs. Sec. 1.263(a)-5(a) is presumed to facilitate the transaction under Regs. Sec. 1.263(a)-5(f). To rebut the presumption that a success-based fee paid or incurred is facilitative of a covered transaction, the taxpayer must maintain sufficient documentation in accordance with Regs. Sec. 1.263(a)-5(f). Covered transactions under 1.263(a)-5(e)(3) consist of:

* A taxable acquisition by the taxpayer of assets that constitute a trade or business;

* A taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer or the target in the acquisition) if, immediately after the acquisition, the acquirer and the target are related within the meaning of Sec. 267(b) or 707(b); and

* A reorganization described in Sec. 368(a)(1)(A), (B), or (C) or one described in Sec. 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under Sec. 354 or 356 (whether the taxpayer is the acquirer or the target in the reorganization).

The IRS and Treasury expect that much of the controversy surrounding the treatment of success-based fees and the type and extent of documentation required to establish that a portion of a success-based fee is allocable to activities that do not facilitate a covered transaction can be eliminated by giving taxpayers a simplified method for allocating a success-based fee paid in a covered transaction. Accordingly, Rev. Proc. 2011-29 provides a safe harbor for allocating a success-based fee between activities that facilitate a covered transaction and activities that do not facilitate a covered transaction.

Making the Safe-Harbor Election and Its Impact

Instead of taxpayers having to maintain the documentation required under Regs. Sec. 1.263(a)-5(f) to substantiate the allocation of success-based fees between activities that facilitate and those that do not facilitate a covered transaction described in Regs. Sec. 1.263(a)-5(e)(3), the IRS will not challenge the taxpayer’s allocation of a success-based fee if the taxpayer:

* Treats 70% of the amount of the success-based fee as an amount that does not facilitate the transaction;

* Capitalizes the remaining 30% as an amount that does facilitate the transaction; and

* Attaches a statement to its original federal income tax return for the tax year the success-based fee is paid or incurred, stating that the taxpayer is electing the safe harbor, identifying the transaction, and stating the success-based fee amounts that are deducted and capitalized.

The 70% of the success-based fees that is treated as not facilitative of the transaction is essentially treated the same as nonfacilitative costs incurred prior to the bright-line date would have been had the taxpayer completed an analysis and allocation of the actual time incurred.

An election under Rev. Proc. 2011-29 is irrevocable and applies only with respect to all success-based fees paid or incurred by the taxpayer in the transaction for which the election is made. An election for any acceptable transaction generally does not constitute a change in the taxpayer’s method of accounting for success-based fees. Accordingly, a Sec. 481(a) adjustment is neither permitted nor required.

Immediate Deduction or Start-up Cost

If the purchasing entity (Purchaser) acquires the corporate stock of a target entity (Target) or the assets that constitute the trade or business of Target in a covered transaction under Regs. Secs. 1.263(a)-5(c)(3)(i) and (ii), and Purchaser is currently in the same line of trade or business as Target, the portion of expenses that are not facilitative of the transaction is immediately deductible by Purchaser under Sec. 162 as an ordinary business expense. Accordingly, a safe-harbor election under Rev. Proc. 2011-29 can result in an immediate deduction for 70% of the success-based fees paid by Purchaser. If Purchaser is not in the same trade or business as Target, the costs incurred that are not facilitative of the transaction, including 70% of the success-based fee, are deductible as they are amortized under Sec. 195.

In the acquisition of Target’s stock or assets that constitute the trade or business of Target (asset acquisition) by a non-strategic buyer, such as a private equity group, Purchaser is commonly a newly formed corporate entity (Newco). If Target is an add-on to one of the private equity group’s existing portfolio companies, and Newco acquires the stock or assets of Target and makes the safe-harbor election under the revenue procedure, 70% of the success-based fee paid by Newco is not facilitative of the covered transaction. However, as explained below, the portion of the success-based fee that is not facilitative of the transaction is not immediately deductible by Newco.

In Specialty Restaurants Corp., T.C. Memo. 1992-221, the Tax Court held that a parent corporation could not deduct the start-up expenses of subsidiaries incorporated to open and operate theme restaurants as Sec. 162 business expenses because the restaurants had not been opened and therefore the expenses were not related to trade or business. The amounts paid should have been either capitalized under Sec. 263 or amortized under Sec. 195. Accordingly, 70% of the success-based fee paid by Newco is not immediately deductible under Sec. 162 as an ordinary business expense but instead is a start-up expense subject to Sec. 195.

Bargain Purchase

If Purchaser acquires Target in an asset acquisition, the costs that facilitate the transaction are capitalized and allocated to the basis of the acquired assets under Regs. Sec. 1.263(a)-5(g)(2)(i). As discussed above, an election made by Purchaser under Rev. Proc. 2011-39 to treat 70% of the success-based fee paid as nonfacilitative of the transaction results in an immediate deduction if Purchaser is currently in the same line of trade or business as Target. If Purchaser is not in the same line of trade or business as Target, the nonfacilitative costs are subject to Sec. 195.

In the case of a bargain purchase (an asset acquisition where total purchase consideration—i.e., amounts paid plus liabilities assumed—is less than the fair market value (FMV) of Target’s assets), Purchaser might recognize income immediately after the transaction. For example, if, after allocating total purchase consideration in accordance with Sec. 1060(a) and Regs. Sec. 1.338-8(b), Purchaser’s tax basis in acquired inventory is less than its FMV and Purchaser subsequently sells the inventory, Purchaser has taxable income equal to the difference between the sales price and tax basis of the inventory. When there is a bargain purchase of Target and Purchaser is not in the same line or business as Target, the amount of the success-based fee that is not facilitative of the transaction under the revenue procedure is a start-up cost under Sec. 195. If the amount of nonfacilitative costs exceeds the annual deduction allowed under Sec. 195, Purchaser will obtain a tax benefit for this amount over a period of 15 years. However, if Purchaser does not make the safe-harbor election under the revenue procedure, the entire success-based fee is allocated to the assets acquired as discussed above. Accordingly, Purchaser will realize a tax benefit for the amount of the fee paid in the first tax year subsequent to the transaction, assuming the entire success-based fee is allocated to the acquired inventory and all inventory is sold shortly thereafter.

Legal and Other Fees

Rev. Proc. 2011-29 appears to apply only to success-based fees paid or incurred in a covered transaction. However, Purchaser typically incurs legal, accounting, and consulting fees that are not success based in conjunction with a covered transaction. If Purchaser does not want to capitalize the other costs incurred into either the stock basis of Target or the basis of Target’s assets, Purchaser must analyze the various costs paid or incurred in the transaction to determine which amounts are not facilitative of the transaction and are immediately deductible as Sec. 162 normal business expenses, or subject to Sec. 195.

Success-Based Fees Allocable to Debt Issuance Costs

In business acquisitions by private equity groups, Newco’s purchase of Target’s stock or assets is typically funded by new borrowings and capital equity. Many private equity groups also charge a success-based fee upon the close of the business acquisition, of which a portion is attributable to the time spent in obtaining the financing. Based on Regs. Sec. 1.263(a)-5, the amount of a private equity group’s success-based fee that is allocated to debt issuance costs and amortized under Regs. Sec. 1.446-5 is determined by the percentage of the private equity group’s time spent arranging the financing.

Under Regs. Sec. 1.263(a)-5(c)(1), an amount paid to facilitate a borrowing is not facilitative of another transaction that is described under Regs. Sec. 1.263(a)-5(a). Accordingly, a private equity group that obtains financing to fund the purchase of Target’s stock or assets has two separate transactions identified under Regs. Sec. 1.263(a)-5(a). However, a success-based fee paid to the private equity group is related to the successful closing of both transactions, which are integrally related to the private equity group.

As discussed above, the election under Rev. Proc. 2011-29 is available only to covered transactions. However, a transaction that constitutes a borrowing is not one of the covered transactions listed under Regs. Sec. 1.263(a)-5(e)(3). As such, it appears that the safe-harbor election under the revenue procedure does not apply to the allocation of a success-based fee to debt issuance costs.

There is some uncertainty in this interpretation, though as the revenue procedure also states, “[t]he election applies with respect to all success-based fees paid or incurred by the taxpayer in the transaction for which the election is made” (Rev. Proc. 2011-29, §4.02; emphasis added). It appears that the reference to the transaction within the revenue procedure is to a covered transaction. The plain language seems to indicate that a borrowing that takes place in conjunction with a covered transaction is a separate and distinct transaction. Consequently, it appears that the costs associated with the borrowing are not includible in the revenue procedure election.

If the success-based fee allocated to the financing transaction is not subject to Rev. Proc. 2011-29, presumably it is reasonable for the taxpayer to first allocate the fee between the debt issuance costs and the covered transaction, then make the safe-harbor election under the revenue procedure for the portion of the success-based fee allocated to the covered transaction. Accordingly, the taxpayer could end up with the ability to capture a larger portion of the overall success-based fee paid through amortization or immediate deduction. However, the taxpayer must obtain proper documentation to substantiate the allocation of success-based fees paid to the debt origination and the covered transaction, which defeats the purpose of the revenue procedure. The IRS needs to provide further clarification to confirm this understanding.


It is important to consider that the election under Rev. Proc. 2011-29 is available to success-based fees paid or incurred (including the sell-side costs, which this item does not explicitly address) in a covered transaction. Generally, costs incurred in a transaction that a taxpayer is not required to capitalize under Regs. Sec. 1.263(a) or Sec. 195 are deductible as ordinary and necessary expenses. As a result, it is important to analyze the timeline of the transaction and determine the bright-line date when considering whether to make the election under the revenue procedure. If more than 70% of the activities that generated the success-based fee occurred prior to the bright-line date, the election might not be beneficial. The tax benefit might be larger in specific fact patterns when making the election under the revenue procedure; however, the net present value of the tax benefit might still be larger without making the election due to the timing of the resulting deductions. One must consider both the amount and the timing of the deductions with and without the election. Further clarification is needed from the IRS regarding the application of Rev. Proc. 2011-29 to a success-based fee paid or incurred in a transaction that is composed of both a debt issuance and a covered transaction, as commonly encountered by private equity groups.

Unclaimed Property: The Nontax State Revenue Generator

by Angela R. Gebert, CPA, Fort Wayne, IN (formerly with Crowe Horwath LLP), and Chris Hopkins, CPA, New York, NY


Why should tax professionals care about unclaimed property? After all, unclaimed property is not a tax but a property right. However, unclaimed property looks and acts very much like a tax. In fact, similarities can cause compliance responsibilities and audit notices to drop squarely in the lap of a tax practitioner. To recognize the issues and potential risks, the fundamentals of unclaimed property need to be understood.


Unclaimed property, also known as abandoned property, consists of property held or owing in the ordinary course of business that the owner has not claimed for a certain period of time (the dormancy period). All 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, and Guam, as well as a handful of foreign countries, have enacted unclaimed property laws. Unclaimed property can include uncashed payroll and vendor checks, accounts receivable credit balances, dormant bank and brokerage accounts, life insurance policies, gift certificates and gift cards, customer refunds and rebates, publicly traded securities, benefit plan payments, and the contents of safe deposit boxes. While unclaimed property or escheat laws date back to the Middle Ages, aggressive compliance enforcement by states is a relatively recent phenomenon. When dealing with the state taxes, tax practitioners think in terms of physical presence, nexus, and equitable apportionment. But since unclaimed property is technically not a tax, these concepts generally do not apply.

The Supreme Court established the jurisdictional rules for states claiming property in the 1965 case Texas v. New Jersey, 379 U.S. 674 (1965). The priority rules are:

* The jurisdiction of the owner’s last known address as reflected in the holder’s records is entitled to custody of the unclaimed property; and

* If the owner’s last address is unknown, the jurisdiction in which the holder is domiciled (incorporated) is entitled to claim the unclaimed property.

As discussed below, liberal interpretations of the second rule by some states create the biggest challenge—and potential liability—for many companies. A number of states have also adopted a third-priority or “throwback” rule. Under this rule, if there is no owner address and the holder’s state of domicile does not have unclaimed property laws that apply to the property, the state in which the transaction giving rise to the property occurred may claim the property. The Supreme Court has not sanctioned the third-priority rule.

Current Economic Climate and Trends

Due to the current economic environment and the budgetary problems of many states, unclaimed property is turning into what amounts to a tax—or at least a means to fill depleted state coffers. A number of states now view unclaimed property enforcement as a politically neutral, no-cost revenue generator and participate in multistate audits conducted by contract audit firms.

Some unclaimed property administrators have expanded the definition of what constitutes unclaimed property, leading to new and sometimes creative types of property being subject to state claim. Increased legislative activity has also resulted in the enactment of shorter statutory dormancy periods. While dormancy periods were historically often 7–15 years, dormancy periods of three years or less are becoming the norm. The purported rationale for the shorter dormancy periods is to more quickly reunite property with owners, but the reality is that they accelerate states’ receipt of funds.

While the purpose and intent of the unclaimed property laws in most states is to reunite lost property with owners, cash-strapped states sometimes lose sight of this objective. In 2007, a U.S. appeals court effectively enjoined the state of California from taking unclaimed property due to inadequate efforts by the state to return property to owners (Taylor v. Westly, 488 F.3d 1197 (9th Cir. 2007)). After the state tightened its custodial safekeeping practices, the order was lifted.

In 2009, a U.S. district court ruled in favor of an issuer of traveler’s checks after the Kentucky legislature attempted to shorten the dormancy period for uncashed traveler’s checks from 15 to 7 years (American Express Travel Related Servs. v. Hollenbach, 630 F. Supp. 2d 757 (E.D. Ky. 2009), vacated and remanded, No. 09-5898 (6th Cir. 5/5/11)). The court concluded that the legislative change was “arbitrary and capricious and violate[d] the Due Process Clause of the United States Constitution.” However, the Sixth Circuit disagreed and held that the amendment does not violate the Due Process Clause.

On January 31, 2011, the Third Circuit issued a temporary injunction against New Jersey’s statutory requirement that stored value card issuers obtain and maintain a record of the zip code of stored value card purchasers (American Express Travel Related Servs. v. Sidamon-Eristoff, No. 11-1141 (3d Cir. 1/31/11)). The law, which included a presumption that the place of a card’s sale or issuance was the purchaser’s address if the purchaser’s name and address were not known, was a not-so-subtle attempt by the state to collect unredeemed stored value card balances. Notwithstanding these and other decisions, states continue to increase enforcement efforts to shore up budget gaps. Along with this increased enforcement comes significant audit exposure and financial risk.

Traditional Taxes Versus Unclaimed Property

While traditional state taxes and unclaimed property both serve as revenue generators for states, there are some significant differences that are important to recognize. In addition to tax nexus rules and equitable methodologies for apportionment not applying to unclaimed property, most states have no or limited statutes of limitation. Even companies that have a long history of compliance may be shocked to find that an unclaimed property audit can cover a period of up to 25 years. And although no state provides written rules for estimating a liability when a holder’s records are “incomplete,” there are limited or no rights for holders to administratively challenge assessments that seem unreasonable or egregious. Another significant difference is that contract auditors, not state employees, usually perform unclaimed property audits. States typically compensate contract audit firms on a commission or contingent fee basis, creating an incentive for such firms to propose very large assessments.

A major factor in the discrepancy between money collected by states on audit and money returned to owners is the fact that estimation techniques are often used to determine a holder’s liability. An estimated liability is outright revenue for a state since there is no owner to whom the state can return the property. A company needs to change its approach when considering unclaimed property issues. Unlike traditional taxes, where liability generally relates to the geographies in which the company has a business presence, most risk and exposure for unclaimed property usually lies with the company’s state of legal domicile. Risk and exposure increases if there is a lax history of compliance or there are limited available historical financial records. Liability is typically estimated in such circumstances, and the state of legal domicile is generally entitled to claim the entire estimated amount.

Interestingly, while the Supreme Court has addressed unclaimed property jurisdictional rules several times (Standard Oil Co. v. New Jersey, 341 U.S. 428 (1951); Texas v. New Jersey; Pennsylvania v. New York, 407 U.S. 206 (1972); Delaware v. New York, 507 U.S. 490 (1993)), there have been no federal cases that address the use—or permissibility—of estimates. And the authors are aware of only one state case that has considered the use of estimates in the context of an unclaimed property audit (New Jersey v. Chubb Corp., 570 A.2d 1313 (N.J. Super. Ct. Ch. Div. 1989)). It is worth noting that in Chubb, the New Jersey court concluded that the jurisdictional guidelines established by the Supreme Court in Texas v. New Jersey were relevant only to conflicts among states, and the rules did not apply to disputes between the state and a holder.

Relevance to Tax Practitioners

The relevance of unclaimed property to tax practitioners should now be obvious. Despite the differences, as administered and enforced by a number of states, unclaimed property looks and acts very much like a tax. Unclaimed property compliance is also often an organizational hot potato. It is technically not a tax, and it does not fall squarely into any single corporate function—there are legal aspects of rights to unclaimed property, accounting records to be tracked and analyzed, and annual reports to be filed with states. As a result, frequently no department within an organization claims ownership. If a company has not specifically assigned unclaimed property responsibilities to a functional group, chances are that no formal unclaimed property policies and procedures or reporting processes exist. This leads to heightened risk of audit and potentially significant unfavorable financial implications. Unfortunately, when the audit notice comes, it will usually find its way to the tax practitioner, who will be charged with “fixing the problem.”

What should tax practitioners do? At a minimum, they should educate their company’s CEO, CFO, or general counsel. While they can be reminded that unclaimed property is not a tax, executives should be made aware of the potential risks and financial exposure. Taking further steps, practitioners can determine if there is a history of compliance and if someone in the organization already has responsibility for tracking and reporting unclaimed property. Evaluating the company’s current policies and procedures and its compliance processes will provide a starting point for addressing possible gaps. Next, estimate potential unreported liability. Factors to consider include the company’s history of compliance, the availability and location of owner and historical financial records, states in which the company conducts business, and most important, the unclaimed property laws of the company’s state of legal domicile. If the amount of estimated exposure is significant, the company should consider entering into a voluntary disclosure agreement with one or more states. Most states have formal or informal voluntary disclosure programs under which penalties and interest are usually waived and lookback periods are shortened. Finally, once historical exposure has been addressed, companies need to adopt policies, procedures, and processes for prospective compliance.

Discharge of Indebtedness on Principal Residences and Business Real Property

by John C. Zimmerman, CPA, MST, J.D.


* Discharge of indebtedness income generally must be included in income. However, under Sec. 108(a)(1)(E), qualified principal residence indebtedness that is discharged is excluded from income.

* Qualified principal residence indebtedness is acquisition indebtedness up to $2 million. Principal residence for these purposes has the same meaning as it does for the Sec. 121 exclusion for gain on the sale of a principal residence.

* The tax consequences of a discharge of qualified principal residence indebtedness depends on whether the debt is recourse or nonrecourse.

* Under Sec. 108(a)(1)(D), a taxpayer other than a C corporation may exclude a discharge of qualified real property business indebtedness from income. For purposes of this exclusion, courts have held that the rental of a single property may qualify as a trade or business if the taxpayer is actively involved in the rental of the property.

The meltdown in real estate values in recent years has led to numerous debtor defaults and to creditors’ lowering the carrying values of mortgages. This article discusses the differing tax consequences under Sec. 108(a)(1)(E) of a borrower’s default and/or indebtedness discharge on recourse versus nonrecourse loans on principal residences. It then addresses the unresolved issue of what constitutes business indebtedness for purposes of the Sec. 108(a)(1)(D) exclusion from taxation for discharge of qualified real property business indebtedness. Planning opportunities are presented in each section.

Principal Residence Indebtedness

Sec. 61(a)(12) provides that gross income includes income from the discharge of indebtedness. However, as introduced by the Mortgage Forgiveness Debt Relief Act of 20071 and extended by the Emergency Economic Stabilization Act of 2008,2 Sec. 108(a)(1)(E) excludes from gross income qualified principal residence indebtedness discharged after 2006 and before January 1, 2013. Sec. 108(h)(2) states that qualified principal residence indebtedness is “acquisition indebtedness” as defined in Sec. 163(h)(3)(B), except that the total indebtedness excluded for purposes of Sec. 108 is $2 million, not the $1 million mentioned in Sec. 163(h)(3)

Sec. 163(h)(3)(B)(i) defines acquisition indebtedness as indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence and is secured by the residence. The term also includes refinancing indebtedness as long as the refinanced loan does not exceed the original indebtedness. However, if the refinanced indebtedness in excess of the original acquisition indebtedness is used to substantially improve the principal residence, it will also be considered acquisition indebtedness. The above definition of acquisition indebtedness excludes home equity indebtedness unless the taxpayer uses the equity debt to make improvements to the principal residence. Hence, absent finding some other provision that would exclude discharged home equity indebtedness from income (i.e., title 11 bankruptcy under Sec. 108(a)(1)(A)) or insolvency under Sec. 108(a)(1)(B), such discharge will result in income recognition.

Sec. 108(h)(5) defines a principal residence as having the same meaning as used in Sec. 121. Sec. 121(a) provides that for a residence to qualify as a principal residence, the taxpayer must own and use the residence for two of the five years preceding the sale by the taxpayer. The ownership and use tests need not be concurrent. The exclusion is limited to $250,000 in the case of an individual and $500,000 in the case of a married couple filing jointly. Sec. 121(a)(2)(A) provides that for a married couple, both spouses must meet the use requirement but only one spouse must meet the ownership requirement.

When a creditor reduces a loan balance on the principal residence, Sec. 108(h)(1) provides that the basis of the residence shall be reduced (but not below zero) by the amount of the discharge. However, Sec. 108(h)(3) states that the general rule of nontaxability will not apply if the reason for the discharge is services performed by the debtor for the lender or any other factor not related to the decline of the property’s value or the taxpayer’s financial condition.

Further, under Sec. 108(a)(2)(A) the general exclusion rule on principal residence indebtedness discharge will not apply if the discharge occurs in a title 11 bankruptcy case. Rather, the exclusion under Sec. 108(a)(1)(A) will apply. However, Sec. 108(a)(2)(C) provides that the principal residence exclusion rule will take precedence over the insolvency exclusion rule listed in Sec. 108(a)(1)(B) unless the taxpayer elects otherwise. A taxpayer who uses any of the income exclusion provisions under Sec. 108 must file with the tax return Form 982, Reduction of Tax Attributes due to Discharge of Indebtedness (and Section 1082 Basis Adjustment).

As noted above, the total amount of principal residence indebtedness that qualifies for relief is $2 million. However, there will be no limit on the amount of relief if the debt is a purchase money mortgage as described in Sec. 108(e)(5). This means that the property’s seller is carrying the mortgage. This is not an unusual occurrence for very large mortgages where a third party may not be willing to extend credit. Debtors who have purchase money mortgages simply reduce their basis in the property by the amount of the indebtedness discharge. It should be emphasized that the provisions of Sec. 108(e)(5) apply to all property, not only principal residences. However, the exclusion will not apply in a title 11 case or when the purchaser is insolvent.

Recourse and Nonrecourse Debt

The tax consequences of principal residence acquisition indebtedness discharge can have differing impacts depending upon whether the debt is recourse or nonrecourse. Recourse debt means that the debtor can be held personally liable in the event of default. Thus, if the fair market value (FMV) of the property that secures a loan is not sufficient to cover the outstanding principal of the loan in the event of default, a creditor can attach other property owned by the debtor to cover the loan balance. Nonrecourse debt means that the creditor can seize only the property that secures the loan, even if the FMV of that property is not sufficient to cover the loan balance. For example, principal residences are sold in California on a nonrecourse basis. Hence, homeowners can walk away from their loans without fear of being pursued by the creditors.

The regulations provide that relief of a nonrecourse loan will be sufficient consideration received for property that is in default.3

Example 1: Taxpayer T defaults on a nonrecourse mortgage loan of $300,000. The principal residence basis is $320,000, and the FMV is $250,000. The property is considered to be sold for $300,000, and its FMV is irrelevant for purposes of determining liability relief.4 T has an unrecognized $20,000 loss because the property is personal use property. However, there are no further tax consequences as a result of the default.

The taxpayer can simply walk away from the loan. The lender issues the taxpayer Form 1099-A, Acquisition or Abandonment of Secured Property. The taxpayer does not file a Form 982 because there has been no discharge of indebtedness. The taxpayer reports the sale on a Form 1040, Schedule D, Capital Gains and Losses. Since a loss cannot be recognized, the sale price (i.e., the balance of the nonrecourse loan) and property’s basis will be the same: $300,000.

However, if the nonrecourse lender cancels part of the debt for $600 or more under the repossession (e.g., a lender cancels part of the debt and then later in the year forecloses), the lender must file Form 1099-C, Cancellation of Debt. In that case, it can report the repossession information in boxes 4, 5, and 7 of Form 1099-C instead of filing Form 1099-A.5 The taxpayer files Form 982 and Schedule D.

In the above example, if the lender has recourse against the taxpayer for property other than the property securing the loan, the treatment changes.6 The borrower automatically has discharge of indebtedness income of $50,000, the difference between the property’s FMV ($250,000) and the loan balance on the property ($300,000). The property is then considered sold for the remaining $250,000 debt securing the property. This results in a $70,000 loss that the taxpayer cannot recognize for tax purposes because the principal residence is personal use property. However, the taxpayer is allowed to treat the indebtedness discharge under the general rule of Sec. 108(a)(1)(E). The taxpayer files Form 982 showing the amount of the discharge excluded from income and also files Form 1040, Schedule D, showing a sale for $250,000 and a basis of $250,000.

Many recourse lenders are allowing taxpayers to sell their principal residences in what is referred to as a short sale.

Example 2: Taxpayer V sells her principal residence property for less than the mortgage that secures it. The lender issues Form 1099-C to V. Box 5 on the form asks whether the taxpayer is personally liable (recourse liability). If V is personally liable, she either must recognize income from the discharge of indebtedness or is allowed the exclusion from the discharge if the requirements of Sec. 108(a)(1)(E) are met.

In the above illustrations there are effectively no differences for tax purposes between the nonrecourse and recourse notes securing the property. The only difference, as noted, is how the transactions are reported when the taxpayer loses the principal residence. This situation changes if the loan balance discharged exceeds $2 million, because that is the maximum amount eligible for relief.

Example 3: Taxpayer W has a basis in her principal residence of $9 million, an FMV of $5 million, and a loan balance of $8 million. W defaults, and the property is repossessed by the lender. There are no tax consequences if this is a nonrecourse mortgage; it is simply treated as a sale of the property for $8 million. However, if the note is recourse and the lender allows W to enter into a short sale, she will have $3 million of discharge of indebtedness income, the difference between the mortgage on the property and its FMV. W has $1 million of income recognition, since she can exclude only $2 million under the general rule. The remaining $5 million is treated as consideration paid for the property. The basis of the property is reduced by the $2 million, leaving W with an unrecognized loss of $2 million ($5 million remaining loan less $7 million remaining basis).

Complications also arise if the taxpayer has borrowed against the increased value of the property during times when real estate values were high. Equity borrowing was quite common before the real estate meltdown. The relief afforded under Sec. 108(a)(1)(E) does not apply to equity borrowing.

Example 4: Taxpayer X has a nonrecourse acquisition note and a nonrecourse equity note on his property. The equity loan proceeds are not used for improvements to the principal residence. X’s basis is $500,000 (original acquisition cost), FMV is $350,000, principal acquisition residence indebtedness is $450,000, and equity debt is $150,000. Third-party holders of the debts cancel $50,000 of the acquisition indebtedness and $100,000 of the equity debt. X keeps the home and recognizes $100,000 discharge of indebtedness income on the equity debt.

Each debt discharge will be reported to X on a Form 1099-C. However, X can exclude the $50,000 of acquisition indebtedness under the general rule. In this example, the results are the same if the debt is recourse because X has not disposed of the principal residence.

However, the results change if the taxpayer gives up the principal residence either through foreclosure (nonrecourse mortgage) or a short sale (recourse mortgage). If both loans are nonrecourse and the creditors foreclose, he will have $100,000 of capital gain ($600,000 of debt relief on a principal residence with a basis of $500,000). If he meets the criteria of Sec. 121 for exclusion of gain on the sale of a principal residence, he will not have to recognize any of the gain. Even if he must recognize the gain, the taxpayer has the advantage of the long-term capital gain rates instead of the ordinary income rates on $100,000 that he would have to recognize as discharge of indebtedness income if he keeps the principal residence.

If the debts are recourse, the taxpayer will not have the benefit of capital gain recognition and Sec. 121 exclusion. If the creditors allow him to engage in a short sale for $350,000, the home’s FMV, he will have $150,000 of ordinary income on the equity debt discharge and $100,000 ordinary income on the acquisition debt discharge. He will be allowed the benefit of the Sec. 108(a)(1)(E) exclusion only on the $100,000 of acquisition debt. Thus, if the debts are nonrecourse, the taxpayer has $100,000 of capital gain potentially eligible for the Sec. 121 exclusion. If they are recourse, there is $250,000 of ordinary income of which the taxpayer can exclude only $100,000 from recognition.

Planning Opportunities

As the above examples illustrate, there are far more planning opportunities with nonrecourse as opposed to recourse mortgages. In some instances with a nonrecourse mortgage, the tax consequences of default can be more favorable than the consequences of keeping the home. This will be the case if there is a nonrecourse equity loan that will not qualify for the Sec. 108(a)(1)(E) exclusion.

Example 5: Taxpayer Y purchases a house for $550,000. At present, there is no acquisition indebtedness. Y borrows $500,000 on the house’s equity when it is worth $650,000. The house’s present value is $400,000. If the nonrecourse equity lender agrees to discharge $100,000 of the loan so that Y will owe only the house’s FMV, there will be $100,000 of discharge of indebtedness income. However, there are no tax consequences if Y defaults and the house is repossessed. Y is considered to have sold the house with a tax basis of $550,000 for the amount of the $500,000 debt relief. If the debt is recourse and there is a short sale for $400,000, there will be $100,000 of ordinary income and a $150,000 loss that cannot be recognized for tax purposes ($550,000 of tax basis less the remaining $400,000 debt relief on the sale).

There can be no Sec. 108(a)(1)(E) relief since there is no principal residence acquisition indebtedness remaining on the loan. Hence, with nonrecourse mortgages it may be advantageous for tax purposes to simply walk away from the house and allow the lender(s) to repossess it.

Qualified Real Property Business Indebtedness

General Provisions

Sec. 108(a)(1)(D) excludes from income recognition for a taxpayer, other than a C corporation, a discharge of qualified real property business indebtedness. Sec. 108(a)(2)(A) provides that the exclusion is not available if the discharge occurs in a title 11 bankruptcy case. Sec. 108(a)(2)(B) provides that the exclusion will not apply to the extent that the taxpayer is insolvent. In that case, the insolvency provisions of Sec. 108(a)(1)(B) will apply. Secs. 108(c)(1) and (2) explain the rules for the maximum amount eligible for the exclusion and the basis reductions to depreciable real property when the exclusion is used. Essentially, the maximum exclusion allowed is the amount by which the qualified acquisition indebtedness (discussed below) exceeds the property’s FMV. However, the exclusion cannot exceed the property’s adjusted basis.

Sec. 108(c)(3) defines qualified real property business indebtedness as indebtedness:

* That is incurred or assumed by the taxpayer in connection with real property used in a trade or business that is secured by the real property;

* That is incurred or assumed before January 1, 1993, or if incurred or assumed after this date is qualified acquisition indebtedness (this includes refinanced indebtedness only to the extent it does not exceed the debt being refinanced); and

* With respect to which the taxpayer elects to have the exclusion applied.

The term does not apply to qualified farm indebtedness (covered under Sec. 108(a)(1)(C)).

Sec. 108(c)(4) provides that qualified acquisition indebtedness means indebtedness incurred to acquire, construct, reconstruct, or substantially improve real property used in a trade or business. Therefore, equity debt used for purposes other than capital improvements to the property on which the borrowing is made will not qualify. The taxpayer must make the election to use the provisions on a timely filed return (including extensions) for the tax year in which the discharge occurs. The taxpayer makes the election on a Form 982.7

In the case of a partnership, the determination of whether the debt is qualified real property business indebtedness is made at the partnership level. However, the election to apply the provision is made at the partner level.8 Hence, different partners may treat the discharge differently.

One of the problems with Sec. 108(a)(1)(D) is the lack of definition of what constitutes a trade or business for the section’s purposes. For example, if a taxpayer owns a rental property on which debt is discharged due to a decline in market value, can the rental be considered a trade or business for purposes of the section? Unfortunately, there is no definitive answer. Nevertheless, looking to Sec. 469, which deals with passive losses, can give some idea of how trade or business should be interpreted in light of Sec. 108(a)(1)(D). There is precedent for looking at another Code section when attempting to ascertain the meaning of a term. For example, the Third Circuit looked to the Sec. 108 meaning of indebtedness when trying to define the term “indebtedness” for purposes of Sec. 61(a)(12).9 In another case, the Supreme Court looked to obsolete cases to define “differing materially” as used in Regs. Sec. 1.1001-1. The cases had been decided long before the regulation’s enactment.10

Passive Loss Guidance

Sec. 469 deals with the rules for the passive loss limitations. Sec. 469(c)(7) provides “special rules for taxpayers in real property business.” Sec. 469(c)(7)(B) states that a taxpayer in a real property business is one who (1) spends more than one-half his or her personal service time performed in all trades or businesses in real property trades or businesses in which he or she materially participates and (2) performs more than 750 hours of services during the tax year in real property trades or business in which he or she materially participates. The problem is that many taxpayers will not be able to meet these requirements. In addition, if a taxpayer owns multiple real estate rentals, Sec. 469(c)(7)(A) applies the above rules to each rental separately, effectively meaning that it could be impossible to meet the test.

The taxpayer can elect to treat all interests in rental real estate as one property for purposes of the two tests. Taxpayers will generally make this election when they want to avoid the limitations for deducting passive losses. However, because of the operation of the passive loss rules, making such an election would mean that all properties covered under the election would have to be disposed of before any suspended passive losses could be deducted. Secs. 469(d) and (g) provide that a taxpayer can deduct suspended passive losses only when the taxpayer has sufficient passive income to offset such losses, disposes of his or her complete interest in the property that has generated suspended passive losses, or dies.

However, under Sec. 469(c)(6), to the extent provided in the regulations, “trade or business” means:

* Any activity in connection with a trade or business; or
* Any activity for which expenses are allowable under Sec. 212.

Sec. 212 allows expenses for activities conducted for the production of income. This could include expenses for real estate rentals in certain circumstances.11 Regs. Sec. 1.469-9(b)(1) states that “[a] trade or business is any trade or business determined by treating the types of activities in §1.469-4(b)(1) as if they involved the conduct of a trade or business, and any interest in rental real estate, including any interest in rental real estate that gives rise to deductions under section 212” (emphasis added).

Case Guidance

Court cases and IRS rulings have been ambiguous as to whether renting property constitutes a trade or business. Cases dating back to the 1940s have held that renting even a single property may constitute a trade or business. In Hazard,12 the taxpayer sold for a loss a single rental property that he had converted from a principal residence. The IRS argued that the loss was capital. However, the Tax Court looked to the then equivalent of current Sec. 1231(b), which defines “property used in the trade or business” as property “of a character which is subject to the allowance for depreciation.” On this basis, the court held that the loss was ordinary, and the IRS acquiesced. Courts also have decided subsequent cases in favor of taxpayers who sought to have losses on improved real estate rental properties treated as being from a trade or business.13 Where rental property used for sharecropping was unimproved, a district court held that the rental activity did not constitute a trade or business.14 Similarly, the Tax Court disallowed unimproved rental realty from being classified as a trade or business.15

In Grier,16 a district court case affirmed by the Second Circuit, a taxpayer’s ownership of property rented for 14 years was held not to constitute a trade or business. However, in that case it was the taxpayer who said that the rental did not constitute a trade or business, while the IRS argued that it did. The court looked to the taxpayer’s minimal efforts in managing the property and noted that there was a lack of “regular and continuous activity of management.” The Tax Court cited Grier in a case where a taxpayer held inherited rental property for only three months before its sale.17 In denying a classification of the property as being held in a trade or business, the court noted that the taxpayer’s “activities with respect to the premises as rental property were almost non-existent” and that no evidence was presented that she attempted to remedy any of the problems with the property.

The IRS indicated in Letter Ruling 835000818 that it would look to a taxpayer’s efforts in managing a rental property to determine whether the rental activity constituted a trade or business. The taxpayer leased property that required the lessee to be responsible for all tax assessments, maintenance, and repairs, and “all claims and liabilities arising out of or in connection with” the rental property. Such rental agreements are known as net leases. Based on these facts, the ruling held that the rental did not constitute a trade or business because “[t]he Taxpayer-lessor engaged in little or no activity with respect to the property.”

The IRS addressed the applicability of Sec. 108(a)(1)(D) to real estate rentals in Letter Ruling 9840026.19 The taxpayer, a partnership, rented residential apartments. The partnership was actively involved in managing the rental property. This included setting the rents, arranging for necessary repairs, hiring maintenance personnel, purchasing supplies, keeping books, and collecting rents. The IRS held that the taxpayer was in a trade or business. Significantly, the IRS stated that “[t]he rental of even a single property may constitute a trade or business under various provisions of the Code.” The ruling emphasized that net leases will not qualify as a trade or business, and cited an earlier case20 and revenue ruling21 to this effect.

The substance of the cases and rulings on whether a real estate rental will constitute a trade or business is that the taxpayer must be actively involved in the rental. There is no guidance on what exactly constitutes such involvement. However, the IRS’s interpretation of Sec. 469(i), which provides a limited exception to the passive loss rules for certain rental real estate for an individual who actively participates in the rental, may provide some guidance. The IRS has defined such active participation as making “management decisions in a significant and bona fide sense.”22 This includes “approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.”

Passive Loss Definition vs. Case Definition

Recall that the passive loss definition for a rental real estate business envisages property held for the production of income as defined in Sec. 212. The cases and rulings discussed above, though not saying so directly, mean a trade or business as defined in Sec. 162, concerning “ordinary and necessary” deductions for a trade or business. In Curphey,23 the taxpayer, who was a medical doctor, took a home office deduction under Sec. 280A for managing his six rental properties. Sec. 280A(c)(1)(A) allows the deduction when the home office is the taxpayer’s “principal place of business.” His efforts included “personal efforts to manage the six units in seeking new tenants, in supplying furnishings, and in cleaning and otherwise preparing the units for new tenants. These activities were sufficiently systematic and continuous to place him in the business of real estate rental.”24

However, the court emphasized that it was allowing the expense deductions under Sec. 162, not Sec. 212. The court stated that it disallowed the deduction under Sec. 212 because that section concerned expenses for the production of income. The court did not believe that such expenditures would rise to the level of a trade or business. It stated that there is no deduction under Sec. 280A for “use of a home in connection with an activity which is merely for the production of income within the meaning of section 212 but is not a ‘trade or business’ under section 162.”25 A production of income example could be where a taxpayer used his or her principal residence to manage a stock portfolio.

Curphey and the other aforementioned cases were decided before the enactment of the passive loss rules’ definition of a trade or business as coming within the scope of Sec. 212. Hence, the courts have not decided whether Sec. 469 could create a lower threshold for purposes of a trade or business. Most likely the approach taken in Letter Ruling 9840026 and the cases it cites, discussed above, will continue to govern the definition of a trade or business for purposes of defining qualified real property business indebtedness. Moreover, it could even be argued that the test is the same whether for purposes of Sec. 162 or Sec. 212. The regulations under Sec. 212 state that “ordinary and necessary expenses paid or incurred in connection with the management, conservation, or maintenance of property held by the taxpayer as rental property are deductible.”26 Hence, there are situations when the same level of effort could be required under both sections for real estate rentals.
Differences Between Discharges for a Principal Residence and Property Used in Business

The issues surrounding qualified real property business indebtedness from the perspective of recourse and nonrecourse liabilities will be the same in some instances as those for a principal residence. Thus, a nonrecourse holder of such property will be able to default and have the reacquisition of the property by the lender treated as a sale or exchange. This result does not change when part or all of the debt on the property is equity debt. It simply will be treated as consideration for the sale of the property. However, in this instance, unlike with a principal residence, the taxpayer can recognize a Sec. 1231 ordinary loss in certain circumstances.

Example 6: Taxpayer Y borrows $400,000 on real estate rental property with a basis of $500,000. The property’s value drops to $350,000. There is no other debt on the property. Y defaults and the property is repossessed. Y recognizes a $100,000 ordinary loss. The property is treated as if it has been sold for $400,000. Y cannot recognize a loss if the property is a principal residence.

The same result occurs if the loan in the above example is recourse and the lender allows the taxpayer to engage in a short sale. In this instance, the taxpayer will have ordinary discharge of indebtedness income of $50,000, the difference between the equity debt ($400,000) and the property’s FMV ($350,000). However, the taxpayer would then recognize an ordinary loss under Sec. 1231 for $150,000, the difference between the basis ($500,000) and the remaining debt ($350,000). Thus, the taxpayer has effectively neutralized the discharge of indebtedness income. If the property was a principal residence, the taxpayer would recognize $50,000 of ordinary income but could not recognize any loss on the sale because it is personal use property.

The exceptions to income recognition for discharge of indebtedness income for a principal residence can have differing tax impacts depending upon whether the debt is nonrecourse or recourse. Obviously, there are situations in which a taxpayer will be in a more advantageous position when the debt is nonrecourse, because the property’s FMV fluctuations will not affect the tax considerations in the event of a default. The total debt, both acquisition and equity, will be treated as consideration for the sale. However, the taxpayer will have discharge of indebtedness income on equity debt relief when the loan is recourse and the lender allows a short sale. In this instance, any loss on the sale cannot be used to offset the income because the principal residence is personal use property.

When the taxpayer keeps the principal residence, the discharge will have the same impact for nonrecourse and recourse debt. In both instances, the taxpayer can reduce the basis of the principal residence by up to $2 million of the discharge for acquisition indebtedness. In both instances, the taxpayer will also have to recognize income from any discharge of equity debt.

Taxpayers may exclude from gross income qualified real property business indebtedness, not to exceed the amount by which such indebtedness exceeds the property’s FMV. The amount is further limited to the property’s adjusted basis. Real estate rental properties can qualify as a trade or business for this purpose. A single real estate rental also may qualify as a trade or business. The only issue is how much effort a taxpayer must put into the rental properties to have the activity classified as a trade or business. Though there is no fixed rule, the substance of the cases and rulings (especially Letter Ruling 9840026) suggest that the taxpayer must be actively involved in the management decisions for the property, including setting rents, approving repairs and other expenditures, and approving tenants. It is clear that debt on a property subject to a net lease, where the lessee is responsible for the property’s management and expenditures, will not qualify for the exclusion. In this case, the lessor-owner will not have performed sufficient functions to be considered to be in a trade or business for purposes of Sec. 108(a)(1)(D).

This article should help practitioners decide when to advise clients to engage in partial debt discharge, short sales, and/or outright defaults on principal residence indebtedness and qualified real property business indebtedness. Of particular concern will be whether the property is secured by a recourse or nonrecourse note and whether the debt is acquisition or equity indebtedness. In each instance the tax consequences can vary dramatically depending upon the nature of the debt and the action to be taken.


1 Mortgage Forgiveness Debt Relief Act of 2007, P.L. 110-142.

2 Emergency Economic Stabilization Act of 2008, P.L. 110-343.

3 Regs. Secs. 1.1001-2(a)(1) and (a)(4)(i).

4 Regs. Sec. 1.1001-2(b).

5 Instructions for Forms 1099-A and 1099-C (2011), p. 1. See also IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments (2010), p. 12.

6 Regs. Sec. 1.1001-2(a)(2), and see Regs. Sec.1.1001-2(c), Example (8).

7 Regs. Sec. 1.108-5(b).

8 IRS Letter Ruling 9840026 (10/2/98), citing the legislative history; Sec. 108(d)(6). See also Gershkowitz, 88 T.C. 984 (1987).

9 Zarin, 916 F.2d 110 (3d Cir. 1990).

10 Cottage Savings Ass’n, 499 U.S. 554 (1991).

11 See Bolaris, 776 F.2d 1428 (9th Cir. 1985), where real estate rental deductions, including depreciation under Sec. 167, were allowed under Sec. 212. The taxpayer was allowed to show a loss for tax purposes on a temporary rental of a principal residence.

12 Hazard, 7 T.C. 372 (1946), acq., 1946-2 C.B. 3.

13 Stratton, T.C. Memo. 1958-214; Post, 26 T.C. 1055 (1956), acq., 1958-2 C.B. 7; Schwarcz, 24 T.C. 733 (1955), acq., 1956-1 C.B. 5; Gilford, 201 F.2d 735 (2d Cir. 1953).

14 Durbin v. Birmingham, 92 F. Supp. 938 (S.D. Iowa 1950).

15 Emery, 17 T.C. 308 (1951).

16 Grier, 120 F. Supp. 395 (D. Conn. 1954), aff’d without discussion, 218 F.2d 603 (2d Cir. 1955).

17 Balsamo, T.C. Memo. 1987-477.

18 IRS Letter Ruling 8350008 (12/16/83).

19 IRS Letter Ruling 9840026 (10/2/98).

20 Neill, 46 B.T.A. 197 (1942).

21 Rev. Rul. 73-522, 1973-2 C.B. 226.

22 IRS Publication 925, Passive Activity and At-Risk Rules (2010), p. 3.

23 Curphey, 73 T.C. 766 (1980).

24 Id. at 775.

25 Id. at 770.

26 Regs. Sec. 1.212-1(h).