RC section 1033 requires a taxpayer (either an individual or a business) to make a timely election and a timely replacement to defer gain on property following an involuntary conversion—when property is completely or partially destroyed, for example, by fire or natural disaster. A gain often results when the taxpayer receives an insurance settlement for more than the property’s cost basis. Taxpayers may make elections after they have filed the tax return for the year in which they receive the insurance proceeds—subject to time constraints. Here are the rules CPAs can follow in helping clients and employers make these delayed elections.
In September 2001 the IRS released field service advice (FSA) 200147053, which examines the validity of delayed section 1033 elections. Taxpayers also face timing issues concerning replacement property when the election is not delayed or when the taxpayer revokes an election. Questions that CPAs will find answered here and in the exhibit on page 92, include the following: Which year’s return (gain year or replacement year) should a taxpayer amend? How does the statute of limitations apply to claims and replacements? Under what circumstances can a taxpayer extend the statute for claims or replacements? When do designations of replacement property become irrevocable?
An individual or business taxpayer elects a section 1033 deferral simply by omitting a gain from its return for the year it realizes that gain as a result of an involuntary conversion. This easy rule does not come without a cost. When electing section 1033 deferral (either by showing details on the return or by omitting them in a “deemed election”), all tax years in which the taxpayer realized a gain will remain open until three years after the individual or business notifies the IRS it has or has not replaced the property. Thus, a taxpayer making a section 1033 election has an indefinite statute of limitations.
If a taxpayer designates qualified replacement property on a return within the required period and purchases the property at the anticipated price within two years of the end of the gain year (three years—if section 1033(g) applies), a valid election is complete. If the purchase price is lower than anticipated, resulting in additional gain, taxpayers should report this income by amending the gain(election)-year return. Taxpayers aren’t required to designate replacement property on the election-year return as long as they do so on the replacement-year return and acquire the property within the statutory time constraints. If the taxpayer does not purchase qualifying replacement property within the required two- or three-year window, it must amend the gain-year return to report the gain.
Some commentators believe the mere purchase of any qualifying replacement property makes a section 1033 election irrevocable. They base this belief on the fact that neither McShain , 65 TC 686 (1976), nor revenue ruling 83-39 appears to attach much significance to notifying the IRS or designating property on the return. But FSA 200147053 seems to contradict this assumption. In the announcement the IRS appears to place considerable emphasis on notification by stating that a taxpayer demonstrates its intent to replace by designating the property to the IRS. This point may be crucial. If designation is a hard-and-fast requirement, a taxpayer that wants to back out of an election may be able to do so simply by not designating qualifying replacement property.
In McShain a taxpayer notified the IRS he intended to construct specific replacement property and followed through on his promise. The Tax Court would not allow him to revoke his election. Would a taxpayer be allowed to revoke an election if it replaced property but did not notify the IRS? The emphasis on notification in the FSA appears to allow this. However, McShain refers only to actual replacement so the answer to this question remains unclear.
A taxpayer can elect section 1033 deferral after reporting the gain on an involuntary conversion by filing a refund claim on an amended gain-year return. The FSA clearly distinguishes between this claim and the election itself: The upshot is the statute of limitations differs for each. The FSA says the taxpayer must make the election within the replacement period but does not have to file the refund claim within that time. Rather the taxpayer is bound by the normal statute of limitations for claims.
Example. A fire destroys Techcorp’s building on July 15, 2001. The insurance recovery the company receives results in a gain. Techcorp reports the gain on its calendar year 2001 tax return. If Techcorp later decides to seek deferral of all or part of the gain, it must make the delayed election by December 31, 2003 (two years from the end of the gain year, as section 1033(a)(2)(B) requires). The company must acquire qualifying replacement property by December 31, 2003, and report the details on its 2003 tax return due March 15, 2004. The deadline for filing a claim for refund of 2001 taxes is March 5, 2005 (three years from the due date of the 2001 return, according to IRC section 6511).
Can a taxpayer get an extension of time to make a section 1033 election? The IRS carefully distinguishes between requests to extend the election and requests to extend the replacement period. It says the extension possibility in Treasury regulations section 1.1033(a)-2(c)(3) refers to the replacement period only. Presumably this means it will reject requests to extend the time within which a taxpayer may file a claim (see technical advice memorandum 9138002). CPAs will find the terminology the IRS uses in FSA 200147053 to be confusing. It says the statute differs for an election and a claim; then it says an election period cannot be extended when it appears to mean a claim cannot be extended.
FSA 200147053 reflects the IRS’ concern about whether taxpayers purchase replacement property with an intent to replace. This concern is well-founded because section 1033(1)(2)(A) clearly provides deferral only for a replacement made for “the property so converted.” But the IRS and the courts have struggled to find a way to determine intent. In Feinberg (45 TC 635 (1966), aff’d, 337 F2d 21 (CA-8, 1967)) the Tax Court held that a taxpayer failed to prove intent when its designation of replacement property occurred several years after it acquired the property. This kind of delay makes it difficult to argue the taxpayer intended to purchase replacement property. What if a taxpayer quickly reverses its failure to designate property and there are extenuating circumstances? In most areas of the law, intent is determined by looking at all the facts and circumstances. But CPAs will find the IRS is taking a more inflexible position in this FSA than in previous guidance.
According to the FSA, the IRS has established a “bright-line” intent test. It says “a taxpayer once having filed a return in which replacement property is not designated may not later designate property acquired during that year as qualified replacement property.” This clearly eliminates the possibility of amending a return to designate replacement property. Admittedly, the last sentence of regulations section 1.1033(a)-(2)(C)(2) clearly says a taxpayer should report all details of the replacement on the replacement year tax return. But to say that failure to include those details defeats the taxpayer’s intent appears to stretch the statute.
At first glance FSA 20014703 appears to be a distillation of IRS policy on section 1033 elections developed over several decades. Yet this policy remains unclear. The IRS obviously is aware its agents are having difficulty with the nuances of delayed and revoked section 1033 elections. Unfortunately for CPAs and their clients, these interpretive difficulties will continue because the FSA is difficult to read.
Rather than characterize FSA 200147053 as a distillation of previous positions, it probably would be more accurate to say it reflects the continued evolution of IRS policy—not all of it taxpayer friendly. For example, letter ruling 8424026 allowed a taxpayer to amend a return to designate replacement property. But FSA 200147053 unequivocally says a taxpayer “may not later designate property … as … replacement property by amended return.”
CPAs who have clients or employers dealing with section 1033 elections should advise them, if in doubt, to keep their options open. A taxpayer uncertain whether deferral is advantageous may find it easier to change direction after initially reporting the gain. Reversing the decision to report the gain is easier than reversing the decision to defer the gain. Once the taxpayer defers the gain and designates and acquires qualifying property, the IRS allows no wiggle room.
In designating replacement property, there appear to be three guidelines CPAs can advise taxpayers to follow:
Taxpayers must designate property to complete an election. Merely acquiring otherwise qualifying property is not sufficient.
Ex post facto designations are not effective for either delayed or nondelayed elections. According to the FSA, a taxpayer cannot amend a return to designate replacement property.
If a taxpayer wants to revoke a section 1033 election, a designation on a previously filed return may be a roadblock. This guideline is less certain than the others for two reasons. The FSA does not deal with revoked elections, and McShain , the key court case, is not clear on this point.
LARRY MAPLES, CPA, DBA, is professor of accounting at Tennessee Technological University in Cookeville. His e-mail address is email@example.com . MELANIE EARLES, CPA, DBA, is associate professor of accounting at Tennessee Technological University. Her e-mail address is firstname.lastname@example.org .