A taxpayer’s passive losses can be deducted only to the extent of passive income. Under § 469(c)(2), any rental activity is considered passive unless, during the year, the taxpayer materially participates in a real property trade or business and performs more than 750 hours of personal services, which represents more than 50% of the personal services the taxpayer performed in all trades or businesses. Also, an activity is nonpassive if, under a lease entered into after Feb. 18, 1988, the taxpayer rents property to a trade or business in which the taxpayer materially participates (self-rental rule). Taxpayers may deduct passive losses up to $25,000 from a rental real estate activity if the taxpayer owns at least a 10% interest and actively participates in the activity. The entire $25,000 limit is available only when adjusted gross income (AGI) is less than $100,000, and is gradually phased out as AGI increases to $150,000.

In one case, Carolyn Fenderson owned 10 rental housing units, which generated an aggregate loss of $57,906. In 2005 she submitted an amended 2002 return listing the rental income and deductions on Schedule C. She had no other passive income, and her AGI was above $150,000. So, to deduct the $57,906 loss, it was necessary to treat the activity as a nonpassive real property trade or business. The Tax Court scrutinized her calendar records and allowed only 759 of her claimed 1,062 hours of personal service for the rental activity, versus 780 hours on her other job as a software sales account manager. Thus, the activity failed the 50% test.

In the other case, a partnership in which Gregory Farris had a 50% interest rented three buildings in 1985 to his law firm (also a partnership). A new lease was executed in 1990 due to the destruction of the original document; another was executed in 1992 due to the incorporation of the law firm. Yet another new lease was executed in 2000 when Farris became the sole owner of the rental property. In 2000, 2001 and 2002, Farris claimed that net passive income from the property of $34,839, $46,168, and $48,391, respectively, enabled him to deduct equal passive losses. The IRS disallowed the loss deductions, claiming he had no passive income against which to offset them, since the self-rental rule recharacterized the rental income as nonpassive.

Farris argued in Tax Court that the lease in effect during 2000 to 2002 was simply a continuation of the 1985 lease which, if accepted by the court, would exempt the income from being recharacterized as nonpassive. The Tax Court held the lease could not be a continuation because neither of the parties to the 1985 lease was a party to the 2000 lease. Any attempt to consider the law corporation to be a continuation of the law partnership would be at odds with both federal income tax law and state law.

The two cases illustrate how the classification of an activity as passive or nonpassive can be a double-edged sword. When taxpayers have income from activities that are passive, another activity with a loss needs to be passive to get a current deduction. However, when taxpayers do not have any other passive income, an activity with a loss needs to be nonpassive to receive a current deduction.

Carolyn D. Fenderson v. Commissioner , TC Summary Opinion 2007-191
Gregory J. Farris v. Commissioner , TC Summary Opinion 2007-192

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

PSB Holdings is the parent of an affiliated group that includes Peoples State Bank, which is based in Wausau, Wis. It also includes Peoples’ wholly owned subsidiary, PSB Investments Inc., which handles investment of the bank’s stock and bond portfolio. Code section 265(b) requires financial institutions to allocate a pro rata portion of their interest expense to the average adjusted bases of their tax-exempt obligations acquired after Aug. 7, 1986. In calculating its nondeductible interest under the section, Peoples included in its consolidated returns for 1999 through 2002 the value of the stock of PSB Investments in its assets but excluded the tax-exempt obligations purchased and owned by PSB Investments. The government asked the Tax Court to include the tax-exempt investments owned by the subsidiary in the pro rata computation. The court ruled for the bank, saying it had no adjusted bases in the tax-exempt obligations of its subsidiary.

The court noted that the subsidiary was formed to improve efficiency, safeguard and manage the investment portfolio, and—organized in Nevada—minimize state taxes. The court also noted the IRS accepted these reasons as reflecting a sufficient business purpose to avoid any sham or economic substance arguments.

In applying section 265(b), the court said the wording of the Code shall be followed directly unless the wording is ambiguous or the result would be absurd or thwart congressional intent. The congressional intent behind section 265(b) was to raise revenue, prevent abuse and provide certainty and reasonableness in calculating an interest deduction, which the taxpayer’s narrow reading of the section did not thwart, the court said. The court also pointed out that Congress used the singular noun “taxpayer,” which limits the computation solely to the bank corporation’s assets. The court also noted a subparagraph of § 265(b) refers to a corporation and its affiliates, thus proving, the court said, that Congress was aware of the correct wording to combine corporations.

Perhaps most significantly, the court refused to follow Revenue Ruling 90-44, which provides guidance on section 265(b). According to the court, revenue rulings are entitled only to the deference paid them under Skidmore v. Swift & Co. , 323 U.S. 134 (1944): The court will honor the government’s interpretation only to the extent its reasoning is persuasive, analysis complete and results consistent with prior rulings and decisions. In effect, the Tax Court treated the revenue ruling as the government’s litigation position.

This decision can have far-reaching implications, given the change in section 6694 to requiring a more-likely-than-not standard of tax return preparers for undisclosed items. It authorizes minimizing the weight given to revenue rulings and permits taxpayers to argue that where the words of the Code are not ambiguous they can be followed exactly as written, even if the results are not completely in step with the broadest interpretation of congressional intent. It may also permit taxpayers to argue that state tax savings are a valid business purpose to avoid sham transactions and economic substance issues.

PSB Holdings Inc. v. Commissioner , 129 TC no. 15

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.

When Tony Sowder died in 1995, he was survived by his wife, Marie Sowder, and three adult children. Sowder had prepared his own will in 1983, leaving his children a total of $600,000—the amount that could be passed tax-free to a non-spouse at the time. The will required that the remainder pass to Marie “if she survives me, and if she does not survive me, or dies before my estate is distributed to her, to my issue me surviving, in equal shares per stirpes.” Later handwritten notes to the will by Sowder did not contain the language “if she does not survive me, or dies before my estate is distributed to her.”

Code section 2056(b) denies the marital deduction for terminable interests, which include conditioning a bequest on the spouse’s survival until distribution. Under § 2056(b)(3), however, that rule does not apply where the period is limited to not more than six months and the spouse in fact survives such period. In the instant case there was no limitation of the period of survival. However, state law in Washington, where Sowder died, provides that if the testator is determined to have intended a marital deduction bequest, “the governing instrument shall be construed to comply with the marital deduction provisions of the Internal Revenue Code in every respect.”

Evidence that Sowder so intended included that he was a professional businessman who had demonstrated the desire and ability to complete careful tax planning. Four years before his death, the Sowder Family Trust had purchased “last-to-die” insurance on the Sowders, indicating a perceived need for cash to pay deferred taxes after the second spouse died. The court also was persuaded by the fact that Sowder did not change his handwritten will after the insurance was purchased.

The unlimited marital deduction was created by a 1981 change in the tax law. A 1981 article concerning the change was found in Sowder’s papers after his death, and the court decided that he probably read it.

Marie L. Sowder v. U.S. , 100 AFTR2d 2007-6379

Prepared by Sharon Burnett , CPA, Ph.D., lecturer of accounting, Oklahoma State University–Stillwater, and Darlene Pulliam , CPA, Ph.D., McCray Professor of Business and professor of accounting, College of Business, West Texas A&M University, Canyon, Texas.

The Court of Federal Claims denied the taxpayer’s argument that the assessment was subject to the three-year statute of limitations of IRC § 6501(a). The court said the six-year extended period of § 6501(e)(1)(A) applied because the overstated basis resulted in an over-25% omission from gross income.

The ruling is in accord with a Florida district court’s ruling in Brandon Ridge Partners v. U.S. , 100 AFTR2d 2007-5347 (“ Tax Matters,” JofA, Nov. 07, page 79). On the other hand, decisions in Bakersfield Energy Partners v. Commissioner , 128 TC no. 17, and Grapevine Imports Ltd. v. U.S. , 100 AFTR2d 2007-5065 (Court of Federal Claims), this past summer said an overstatement of basis was not sufficient to extend the three-year period.

In Salman , the partners entered into a suspected Son of BOSS transaction (so called because it is a variant of a shelter known as “Bond and Options Sales Strategy”) involving a short sale of U.S. Treasury notes. Based on the undisclosed short sale, the partners reported a stepped-up basis of $6,850,276 on sale proceeds of $7,188,588 for Salman Ranch in New Mexico. The gain of $338,312 was reported on the partnership’s 1999 return. On April 10, 2006, the IRS issued a Final Partnership Administrative Adjustment that increased the capital gain on the sale by $4,567,949. The IRS said this represented the amount by which the basis was inflated because of the partnership’s failure to reduce the basis by the liability necessary to close the short position on the undisclosed Treasury sale.

The court agreed that this was an omission from gross income. The judge wrote that such an omission “encompasses not only situations where an item of income is completely left out, but also situations where the…gross income is understated due to an error in calculation.” The court concluded that “gross income” in the context of a sale of property refers to the calculation of the gain by subtracting the basis from the proceeds of the sale.

The partnership was also not entitled to take advantage of the “safe harbor” provision of section 6501(e)(1)(A)(ii) because the Treasury short sale and the transfer to the partnership of the obligation to close the short position were not disclosed in the return.

The recent conflicting rulings on the interpretation of omissions of gross income under section 6501(e)(1)(A) assure this issue will continue to generate much discussion at the trial court level—at least until higher courts weigh in on the matter.

Salman Ranch v. U.S. , 100 AFTR2d 2007-6654

Prepared by JofA staff member Jeffrey Gilman, Esq.

6015 provides relief from joint and several liability arising from the filing of a joint return where one of the spouses did not know and had no reason to know of a deficiency on the return. The IRS cannot assert the deficiency against a taxpayer granted this relief but can enforce collection only from the other, nonelecting spouse. Section 6015(e)(4) gives the nonelecting spouse the unconditional right to become a party to the proceeding to determine whether to grant relief.

The IRS determined that the 1999 joint return of Robert and Suzanne Fain reflected a deficiency of approximately $15,000. Following the couple’s separation, Mrs. Fain asked the IRS for innocent spouse relief in 2006. When her request was denied, she filed a petition with the Tax Court. The IRS was required to notify Mr. Fain within 60 days of the filing of the petition of his right to intervene. There was only one problem: He had died in 2002.

Although the Tax Court has previously held that a deceased spouse’s estate may request innocent spouse relief, it had never addressed the posthumous rights of a nonelecting spouse. The court noted that the decedent’s heirs and beneficiaries could be affected by the outcome of innocent spouse proceedings, in that if such status was granted, the estate would be the only remaining source of payment. Accordingly, the court held that such interests should be protected by granting the estate a right to intervene. Further, where the nonelecting spouse is deceased, both the requesting spouse and the IRS must provide the court with the names and addresses of the decedent’s heirs at law, so that the court may give notice of the right to intervene.

Fain v. Commissioner , 129 TC no. 11

Prepared by Laura Lee Mannino , CPA, LL.M., assistant professor of accounting and taxation, St. John’s University, Jamaica, N.Y.

The IRS has issued transition relief and guidance for correcting operational failures under nonqualified deferred compensation plans. Following the methods outlined in the guidance will avoid income inclusion under § 409A(a).

The second section of the guidance explains how to obtain relief for unintentional operational failures corrected in the same taxable year as the failure occurs. Relief is not available for intentional failures or in the case of the exercise of a stock right that would otherwise result in a failure to comply with § 409A. The guidance is contained in Notice 2007-100.

Media reports highlighting the hazards of so-called stranger-originated (also known as stranger-owned) life insurance (STOLI) prompted U.S. House tax writers to ask Treasury Secretary Henry Paulson to investigate the practice as well as consider issuing guidance on its tax implications and help Congress notify “elderly taxpayers of the adverse tax consequences of investing in a product that is in fact ‘too good to be true.’ ” Reps. Richard E. Neal, D-Mass., and Phil English, R-Pa., the chairman and ranking member, respectively, of the Select Revenue Measures Subcommittee of the House Committee on Ways and Means, wrote Paulson in November. Aggressively promoted life insurance policies purchased by investors in the secondary market may in some instances subject those insured to unexpected inclusion of taxable income, the congressmen said.

The IRS issued proposed regulations to simplify and clarify rules governing accounting methods to be used after corporate reorganizations and tax-free liquidations under IRC section 381(a).

The proposed amendments to Treas. Reg. §§ 1.381(c)(4)-1 and 1.381(c)(5)-1 are intended to provide greater consistency between the corresponding Code paragraphs. They provide that the accounting method of an acquiring corporation after a § 381(a) transaction generally will depend on whether the trades or businesses of the parties to the transaction are combined. Comments on REG-151884-03 are requested by Feb. 14.

Churches and other exempt organizations (EOs) must abide by laws prohibiting them from direct or indirect involvement in political candidates’ campaigns, the IRS reminded in a news release. Revenue Ruling 2007-41, issued last summer, provides scenarios of how the ban may be observed. Generally, tax-exempt organizations are forbidden to promote or oppose political candidates, although they may, with certain restrictions, speak out concerning issues.