The Tax Court upheld as having economic substance a partnership’s nearly $12 million distribution of notes to redeem partners’ interests in real estate on which the partnership claimed a step-up in basis. The IRS had denied the partners’ resulting nonrecognition of gain on grounds that the distribution consisted of either cash or marketable securities and that the partnership was not entitled to step up its basis.

The partnership, Countryside Limited Partnership, was owned by Arthur M. Winn, Lawrence H. Curtis and others. Countryside owned a 448-unit residential property in New Hampshire that it planned to sell at a gain. Before the sale, Countryside and a limited liability corporation it indirectly owned borrowed a total of $11.9 million at the London Interbank Offered Rate (LIBOR) plus 175 basis points. The LLC used the cash to purchase four privately issued notes paying interest at LIBOR minus 55 basis points. The partnership distributed its interest in another LLC indirectly holding the notes to redeem the partnership interests of Winn and ­Curtis. The partnership made a section 754 election and increased the basis of the real estate, eliminating the gain on its sale. The Service concluded, however, in a final partnership administrative adjustment that the distribution created taxable gain to Winn and Curtis. Winn sought a partial summary judgment on that issue, which the Tax Court granted and issued a memorandum opinion.

Section 731 generally provides for nonrecognition of gain or loss on partnership distributions that don’t exceed a partner’s outside basis. One method previously used to avoid excess gain was to purchase and distribute marketable securities instead of cash. In response, Congress enacted section 731(c), which treats marketable securities as cash for purposes of section 731.

The government argued that the notes were marketable. To be marketable securities, notes must either be traded on an exchange or subject to an arrangement to convert them into marketable securities. These notes were not traded on an exchange, and the fact that their terms could be modified wasn’t sufficient to ­constitute an arrangement for conversion to marketability, the court said.

The government secondarily argued that the distribution lacked economic substance. It stated that the interest expense on the borrowed funds would always exceed the interest income on the notes purchased with those funds. But the Tax Court said the Service was evaluating the wrong transaction. The distribution, not the loan, was at issue. Since the distribution of the notes terminated the partners’ interests in the partnership and the real estate, it had economic substance and could not be disregarded.

In similar cases, courts have ruled against taxpayers (see, for example, ACM Partnership v. Commissioner, TC Memo 1997-115, on contingent installment sales). This case awaits a final decision, and it was unclear whether the IRS will file an appeal, which would be to the District of Columbia Circuit.

n Countryside Limited Partnership v. Commissioner, TC Memo 2008-3

Prepared by Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accountancy and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

The Tax Court recently held that a couple could exclude gain from the sale of one of their two residences, since during the five-year period preceding the home’s sale, it was used as the couple’s principal residence for the requisite two-year period. The taxpayers were not allowed to exclude the gain from the sale of an adjacent lot, however, because that property was titled to a family partnership.

Married taxpayers are permitted to exclude up to $500,000 of gain from the sale of a home if, during the five years preceding the sale, the residence was owned by either spouse and used by both spouses as their principal residence for periods totaling at least two years. Generally, only one sale every two years can qualify for the exclusion. Under Treas. Reg. § 1.121-1(b)(2), other factors used to determine a taxpayer’s principal residence are where the taxpayer works and banks; where the taxpayer’s family lives; the location of the taxpayer’s religious and recreational organizations; and the mailing address listed on the taxpayer’s tax returns, driver’s license, voter and driver’s registration, bills and correspondence. The gain from the sale of land adjacent to a principal residence that is owned by a taxpayer and used as part of that residence can also be excluded if the sale occurs within two years before or after the sale of the residence and all other section 121 requirements have been satisfied.

Dr. J. Ramsay Farah and his wife, Elizabeth, lived in Hagerstown, Md., where Dr. Farah operated a medical practice. In 1989 they purchased a vacation home in Berlin, Md., ultimately to be used as a retirement home. In 1991, a family partnership in which the Farahs each owned a 35% interest bought a 2.39 acre lot next to the Berlin home that they used as an additional yard. When the couple’s daughter attended college near Berlin in 1997, Mrs. Farah moved to the Berlin residence.

Meanwhile, Dr. Farah stayed largely on the road. He sold his medical practice in Hagerstown in 1998 and from May 1998 to May 2001 worked three days a week in Baltimore, 75 miles from Hagerstown and 138 miles from Berlin. He also traveled to clinics and medical facilities along the East Coast from Virginia to Maine. During that time, he lived at the Berlin home on non-workdays and weekends and returned to the Hagerstown home only about once a month.

In early 2001, after Mrs. Farah was diagnosed with cancer, the couple decided to move back to their Hagerstown home and sell the Berlin property. They listed it for sale that March and sold it in October for $1.3 million.

The IRS argued that the Hagerstown home was Dr. Farah’s principal residence from June 1998 to May 2001, since it was closest to his Baltimore work location and the Hagerstown address was used as a mailing address for tax returns, driver’s licenses and vehicle and voter registrations.

The court was not persuaded. It instead held the Berlin home was Dr. Farah’s principal residence during that period, accepting his testimony that he had spent a greater amount of time there and that he used the Hagerstown mailing address only to provide a stable appearance for his business and professional activities.

The court did reject the Farahs’ contention that since they owned the adjacent lot in substance, the gain from its sale should also be excluded. The court held that the Farahs had the freedom to title the property under the partnership’s name but must also accept the consequences of that choice. They had 10 years to alter the form of ownership but chose not to and named the partnership as the owner when listing the property with a real estate agent.

The case illustrates how a dwelling originally held as a vacation or retirement home may, under the proper circumstances, qualify as a primary residence eligible for the gain exclusion of section 121, despite a homeowner’s distant work location and frequent absences.

n J. Ramsay and Elizabeth Farah v. Commissioner, TC Memo 2007-369

Prepared by Charles J. Reichert, CPA, ­professor of accounting, University of Wisconsin–Superior.

The Ninth Circuit has affirmed a district court and held that termination payments received by a retiring insurance agent were not capital gain but were taxable as ordinary income. The court thus joins the Seventh Circuit in so ruling on similar facts. See Warren L. Baker Jr. v. Commissioner, 92 AFTR2d 2003-5640.

Charles Trantina retired after working 38 years as a State Farm agent in Phoenix. Under his agency’s contract, the insurer provided forms, manuals and records and assisted Trantina with some advertising costs. In return, the agency solicited and serviced insurance policies, which also belonged to State Farm. State Farm paid Trantina commissions and, upon his retirement and the dissolution of the agency’s corporation, termination payments.

Trantina originally reported these termination payments as ordinary income on his individual tax return but later amended his return to recharacterize them as long-term capital gain. He claimed they resulted from the sale or exchange of a capital asset—the agreement with State Farm—that was held longer than one year. The IRS denied the refund, and Trantina sued in district court. The court granted summary judgment for the IRS, finding that the agreement was not a capital asset and that no exchange or sale of it had occurred. Trantina appealed.

The Ninth Circuit reasoned that to realize a capital gain, there must be ownership of a capital asset. However, under the terms of the agreement with State Farm, Trantina had no property that could be sold or exchanged. All manuals, forms, records and policies were the property of State Farm. Trantina countered that the agreement itself was a capital asset that he exchanged with State Farm for the termination payments. The court responded that the termination payments were made pursuant to, not in exchange for, the agreement. Trantina was not entitled to the termination payments unless he complied with two requirements—that he return all State Farm property and that he not compete with State Farm for 12 months.

Taxpayers will not have success in achieving capital gain treatment unless the asset in question meets the definition of a capital asset. Under IRC § 1222(3), to classify income as a long-term capital gain, the payments must arise from the sale or exchange of a capital asset held longer than one year and must be given in consideration of this sale or exchange.

n Charles E. Trantina v. U.S, 101 AFTR2d 2008-443

Prepared by Karen M. Cooley, CPA, MPA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., McCray Professor of Business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.

The Court of Appeals for the Federal Circuit ruled a U.K. bank was entitled to a $65 million refund because the IRS applied a regulation that increased the institution’s income by $155 million in violation of the U.S.-U.K. tax treaty of 1975.

In the tax years 1981–1987, National Westminster Bank PLC (NatWest), a U.K. corporation engaged in international banking activities, conducted wholesale banking operations in the U.S. through six permanently established branch locations (the “U.S. Branch”). On its U.S. federal income tax returns for the years at issue, NatWest claimed deductions for accrued interest expenses as recorded on the books of the U.S. Branch.

The IRS used the formula of Treas. Reg. § 1.882-5 to recompute the U.S. Branch’s interest expense deduction. The formula excludes consideration of interbranch transactions for the determination of assets, liabilities and interest expenses under section 1.882-5(a)(5). The formula also imputed or estimated the amount of capital held by the U.S. Branch based on either a fixed ratio or the ratio of NatWest’s average total worldwide liabilities to average total worldwide assets under section 1.882-5(b)(2).

At the trial court level, the Court of Federal Claims granted summary judgment for NatWest, ruling that the application of section 1.882-5 violated the 1975 U.S.-U.K. tax treaty, Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains. The Federal Circuit upheld the ruling that NatWest was entitled to the refund of $65,723,053 plus interest.

The IRS argued that it was permitted to attribute capital to the U.S. Branch based on regulatory and marketplace capital requirements that apply to U.S. bank corporations, called the “corporate yardstick.” NatWest said the 1975 treaty did not allow the imputation of capital to the U.S. Branch based on capital requirements to which it was not subject. The appeals court agreed with NatWest that the “separate enterprise” principle of Article 7, paragraph 2 of the treaty barred the IRS from disregarding interbranch transactions when computing the interest expense properly deductible by a permanent establishment and from imputing capital on a basis other than an as-necessary adjustment of the U.S. Branch’s books to reflect actually allotted capital.

The appeals court also noted that this interpretation was in accord with a U.K. ruling that caused the U.K. to abandon a formula imposed by its tax authorities because it violated the treaty’s separate-enterprise principle.

n National Westminster Bank v. U.S., 101 AFTR2d 2008-490

Prepared by JofA staff member Jeffrey Gilman, Esq.

The Third Circuit Court of Appeals joined other jurisdictions in affirming IRC § 2055(e)’s prohibition of charitable deductions from an estate for transfers of interests in trust property that are not definitely divided between charitable and noncharitable beneficiaries, even where the arrangement shows little likelihood of being abusive in the way the subsection was enacted to prevent.

In its June 2007 opinion, the Third Circuit upheld the ruling of the District Court for the Western District of Pennsylvania and noted similar facts and holdings previously by the Fifth Circuit (Estate of Johnson v. U.S., 68 AFTR2d 91-6049); the Tax Court (Estate of Edgar v. Commissioner, 74 TC 983); and a Nebraska district court (Zabel v. U.S., 82 AFTR2d 98-6334).

James D. Galloway created a trust naming his son, granddaughter and two charitable entities as equal beneficiaries. The trust directed that residual distributions would be paid in an installment of half of each beneficiary’s share in 2006 and the remainder in 2016. After Galloway’s death in 1998, the estate tax return included a nearly $400,000 deduction for the anticipated charitable distributions. The IRS disallowed the deduction, citing section 2055(e). The estate, with the son as trustee, paid the nearly $160,400 additional assessment, for which it filed a refund claim, complaint and, ultimately, appeal.

The government pointed to the statute’s plain language that allows no deduction for a transfer to a charitable beneficiary where an interest in the same property also passes to a noncharitable beneficiary, except in the case of a charitable remainder annuity trust, charitable remainder unitrust or a pooled income fund. The estate argued that the statute’s phrase “in the same property” was sufficiently vague to seek its meaning in the provision’s legislative history, which indicated it was meant to apply only to charitable remainder trusts. By contrast, the estate said, because the Galloway trust designated equal shares, its terms effectively amounted to separate trusts for the charitable and noncharitable beneficiaries. Otherwise, to allow the government to elevate form so far above substance would ignore and harm the trust’s charitable intent and effect, it said.

The court acknowledged that the kind of split-interest trust that appeared to have been uppermost in the congressional mind was one in which a noncharitable beneficiary held a life interest and the charitable beneficiary a remainder interest. The life interest could be exploited to the hazard of the charitable remainder by high-return, high-risk investments. Thus, Congress allowed such splits only for annual distributions of fixed sums (charitable remainder annuity trust) or percentages of trust assets (unitrust), or for an irrevocable interest to the charity with a life interest retained by the donor (pooled income fund). But it was plain, if regrettable, that the statute itself left no choice: “We recognize the unfortunate result in this case,” since “the abuses Congress sought to protect against are not present here,” the court said. Also, the court found no evidence the estate even attempted to divide the trust property.

Financial advisers are thus put on notice that failure to separate charitable and noncharitable trust interests or distribute trust proceeds in the manner allowed by the statute will most likely result in disallowance of any claimed deductions for charitable transfers.

n Edmond C. Galloway v. U.S., 99 AFTR2d 2007-3412

Prepared by JofA staff member Paul Bonner.

The Tax Court ruled that a criminal defense attorney who donated case materials in a prominent case to the University of Texas did not have sufficient ownership rights to the materials to claim a charitable deduction under IRC § 170. Even if the taxpayer did exhibit proper ownership, section 170(e)(1)(A) would limit his deduction to zero—his cost basis in the materials. Based on the disallowed deductions, the taxpayer was found liable for deficiencies in 2000 and 2001.

Leslie Stephen Jones represented accused Oklahoma City bomber Timothy McVeigh from May 1995 until Jones withdrew from the case in August 1997. McVeigh was convicted in June 1997 and subsequently executed for the bombing of the Alfred P. Murrah Federal Building, which killed 168 people. Jones donated to the university materials in his possession, which included FBI case notes, ­witness interviews, medical examiner reports, photographs and computer disks, among many other materials tied to the case.

Based upon an appraiser’s valuation, Jones and his wife claimed a charitable deduction of $294,877 in 1997, which was carried over from their 1997, 1998 and 1999 joint federal income tax returns. The IRS denied the deduction and assessed deficiencies of $3,675 for 2000 and $11,110 for 2001.

Since state law controls the nature of a taxpayer’s legal interest in property, the court first examined whether Jones had a property interest in the donated materials under Oklahoma state law. In denying Jones’ assertion that he owned the materials, the court noted the unique fiduciary relationship between an attorney and a client. The rules of ethics charge an attorney in that role with the safekeeping of a client’s property.

The court said the attorney-client relationship is fundamentally one of agency, and the delivery of materials to Jones by various investigating government agencies occurred within the scope of that agency relationship. Though Oklahoma courts have not ruled on this specific fact pattern, the court cited cases showing the weight of authority supports the notion that clients are the legal owners of their case files, including the attorney’s work product. Furthermore, the rules of ethics would prevent Jones from disclosing or capitalizing on any information related to his representation of McVeigh absent an explicit waiver of the attorney-client ­privilege. No proof of waiver was presented.

The court further noted that even if Jones could prove ownership, section 170(e)(1)(A) requires the deduction be reduced by the amount of gain that would not have been long-term gain if the property contributed had been sold at its fair market value. Since the property would be work product that fell under the letter, memorandum or ­similar property exclusion from long-term gain treatment under section 1221(a)(3), Jones would have been left to deduct only his basis in the property, which was zero.

This case should highlight for tax practitioners the close intersection of state law and federal tax law when property rights are at issue. It should also give attorneys pause to consider the ethical implications of divulging to third parties any information obtained in the course of the attorney-client relationship—for tax benefit or otherwise.

n Sherrel and Leslie Stephen Jones v. Commissioner, 129 TC no. 16

Prepared by JofA staff member Jeffrey Gilman, Esq.

National Taxpayer Advocate Nina Olson presented her annual report to Congress in January recommending dozens of issues for the IRS and Congress to resolve this year. The report analyzes issues in 26 categories, including ­collection and tax services, privacy protection and tax preparer standards.

Late tax-law changes. Olson said paper and electronic filers may not be claiming deductions because Form 1040 and its instructions are often ­finalized after tax preparation software packages have been completed. She recommended the IRS create a formal process to update Congress’ taxwriting committees, starting June 30, about how tax filing might be slowed by late changes to the Tax Code.

Tax gap. The report recommended the IRS establish a “cash economy program office” to improve compliance in the cash economy. The IRS has already rejected this suggestion. The report said the cash economy accounts for about $100 billion of the estimated annual tax gap of between $290 billion and $345 billion, as determined by a 2001 IRS analysis.

Private debt collection. Olson called for repeal of the use of private debt ­collection agencies to collect back taxes. She estimated the $7.35 million appropriated to this program in fiscal 2008 would result in $30 million in collections, compared with $146 million that could be collected through the IRS’s Automated Collection System.

Apology payments. Taxpayers should be given nontaxable “apology payments” of between $100 and $1,000 if they ­suffer undue burdens or excessive expenses caused by IRS mistakes or inaction.

Circular 230. The report called on the IRS Office of Professional Responsibility to clarify some aspects of Circular 230, particularly whether tax advice is a “covered opinion,” what constitutes “willful” conduct, and whether a statute of limitations applies to violations.

Tax preparer standards. The report highlighted the risk created by heightened preparer standards of “more likely than not” under IRC § 6694. This change gives a preparer the incentive to choose a course that protects the ­preparer’s own interests rather than the taxpayer’s.

Tax strategy patents. Olson also called on Congress to pass pending ­legislation banning tax strategy patents or barring their enforcement (see “On Equal Terms”). If Congress does not outlaw such patents, it should require the U.S. Patent and Trademark Office to refer them to the IRS to review whether their strategies are abusive.

Most-litigated issues. Congress should expand the spousal protections of sections 66 and 6015. The proposed changes would allow defenses under those sections to be raised in a collections action in district court. Current law allows the defenses in district court only in a refund action. Joint and several liability under section 6015 was the ninth most-litigated issue in the past year.

The third most-litigated issue involved summons enforcement under sections 7602, 7604 and 7609. The report listed several cases to illustrate the Service’s more aggressive stand in such matters, including the recent Textron case, in which a lower court granted work product protection to third-party workpapers (see “Tax Matters: Work Product Stands Up to IRS Summons,” JofA, Nov. 07, page 80).

The report is available at www.irs.gov/advocate/article/0,,id=177301,00.html.

Despite the IRS’s eight-year-old qualified intermediary (QI) program, billions of dollars in U.S.-source income continue to flow overseas without proper tax withholding, the Government Accountability Office said. QIs are foreign financial institutions that contract with the IRS to provide withholding of U.S. tax and administer treaty provisions. However, they figure in a relatively small portion of U.S. money going offshore—only about 12.5% of the $293 billion that left the country in 2003, according to the most recent data available, the GAO said. Income flowing through U.S. financial institutions or other “withholding agents” may be more vulnerable to offshore tax evasion by U.S. taxpayers, since, unlike QIs, those institutions don’t always require direct documentary verification of account owners’ identities, the GAO said.

But despite their more stringent identification requirements and smaller volume, QIs handled more money with unknown tax jurisdictions ($11.3 billion) than did U.S. withholding agents ($7.8 billion). The average withholding rate by both conduits combined was 2.7%. IRS officials were unable to explain why that rate was so much lower than the statutory withholding rate, barring any exemption or treaty reduction, of 30%. They said the unknown jurisdictions for QI accounts could be a byproduct of a feature intended to make them more attractive—accounts may be pooled for reporting to the IRS rather than listed individually.

Practitioners hope to see a state tax court started in Georgia, one of 27 states lacking a dedicated tax court or administrative appeals forum fully independent of a state revenue agency. Besides removing proceedings from any appearance of bias, an independent tax tribunal offers several other advantages including a less crowded docket, greater tax expertise from the bench, more uniformity and published decisions, proponents say. The State Bar of Georgia’s Taxation Law Section has drafted a proposed bill to establish the court, which would hear appeals from the state Department of Revenue. Filing a petition would stay an enforcement or collection action, eliminating the “pay to play” requirement currently in effect.

Under Georgia’s present system, taxpayers not satisfied with a state revenue assessment may appeal to a state superior court or the Office of State Administrative Hearings, whose decisions are not binding on the Department of Revenue. The proposed legislation would grant the tax court and superior courts concurrent jurisdiction to hear appeals. The new court would also include a small-claims venue.

Proponents hope to introduce legislation in the state’s 2009 legislative ­session. The court will require a pilot ­program, with approval by two-thirds of each legislative chamber required to become a permanent body, said Peter Stathopoulos, managing director of state and local taxes of Atlanta-based accounting firm Bennett Thrasher PC, and John Allan, tax partner at law firm Jones Day’s Atlanta office. Allan chairs, and Stathopoulos is a member of, the State Bar of Georgia’s task force that drafted the proposed legislation. Both are CPAs and attorneys.

In its 2007 publication of The Best and Worst of State Tax Administration, the Council on State Taxation listed 21 states as lacking an independent tax dispute forum and gave another six an intermediate ranking. The study can be read here.

The IRS delayed implementation and provided transitional guidance for proposed regulations under new provisions of the Pension Protection Act of 2006 that relate to funding requirements and benefits of single-employer defined-benefit pension plans. Prop. Treas. Reg. §§ 1.430(f)-1 and 1.430(h)(3)-2, which address maintaining certain funding balances and use of substitute mortality tables, respectively, were originally proposed to apply to plan years beginning on or after Jan. 1, 2008.

In Notice 2008-21, the IRS announced a one-year delay in their effective date. For plan years beginning during 2008, taxpayers should note that they may use mortality tables that are sub­stitutes for the standard tables of IRC § 430(h)(3)(A) only if those tables are approved pursuant to Revenue Pro­cedure 2007-37. The guidance also covers other interim considerations including a transition rule for calculation of benefit limitations under IRC § 436.