On remand from the Sixth Circuit, the Tax Court has held that a deficit restoration obligation (DRO) added to the operating agreement of a limited liability company didn’t allow its member to create recourse debt. Despite the DRO, the at-risk rules under IRC § 465 barred a current deduction because the member wasn’t personally liable for the repayment of that debt, the court said.

Hubert Holding Company (HHC) owned 99% of Leasing Company LLC (LCL), a Wyoming LLC classified as a partnership for federal income tax purposes. After LCL’s tax year ended on July 31, 2000, its operating agreement was amended to state that on liquidation of the company its members were required to satisfy the negative balances in their capital accounts, thereby imposing a DRO on the members. The reasoning for this amendment was that the effect of its DRO was to obligate the members to contribute capital equal to their pro rata share of LCL’s recourse indebtedness, thus creating an “at-risk” amount under section 465.

Under section 465(b)(2), a taxpayer is considered to be at risk for amounts borrowed if the taxpayer is “personally liable for the repayment of such amounts.” However, the Sixth Circuit, in analyzing this provision, has previously applied an Emershaw standard or “payer of last resort” test. (See Emershaw v. Commissioner, 68 AFTR2d 91-5894 (1991)). Emershaw, among other cases, considered whether the taxpayer realistically had a fixed and definite obligation to use personal funds to pay a debt in a worst-case scenario. Under this test, if a taxpayer is deemed to be a payer of last resort, the taxpayer is considered at risk for purposes of section 465.

In its remand decision, the Tax Court held that HHC was not a payer of last resort of LCL’s recourse debt and therefore not personally liable for the repayment under section 465(b)(2)(A). According to the Tax Court, HHC did not make an unconditional promise to contribute additional capital to LCL, because the DRO required HHC to contribute additional capital to LCL only if (1) HHC liquidated its interest in LCL and (2) had a deficit in its capital account at the time of liquidation. Thus, the operation of the DRO hinged on the liquidation of HHC’s interest in LCL, and, under Wyoming law, a creditor of LCL had no right to recover funds directly from HHC or to compel a liquidation of HHC’s interest in LCL to force a payment under the DRO.

The Tax Court further noted that the DRO did not require LCL to pay the restored deficit to creditors. In fact, under the terms of the LLC operating agreement, the DRO could be paid to members with positive balances in their capital accounts rather than to creditors. Second, the DRO would not apply to HHC if LCL liquidated and HHC had a positive capital account following a liquidation of its interest in LCL. Third, under the DRO, HHC’s obligation to restore was limited to the amount of any deficit in its capital account. However, this amount would not necessarily be the same amount as HHC’s proportionate share of any unpaid debt owed by LCL.

When the Tax Court applied the Emershaw standard, no comparison was made to Treas. Reg. § 1.752-2(b)(1), which is used to determine a partner’s share of partnership liabilities for section 752. Under section 752, the regulations impose a “constructive liquidation” test, which also entails a worst-case result in determining a taxpayer’s basis with respect to partnership recourse liabilities. Whether this comparison needs to be made in the future remains an open argument.

For years, many practitioners have believed that a partnership or operating agreement containing a qualified DRO would achieve some form of at-risk status for the taxpayer. While the results of the Tax Court in Hubert were not necessarily at-risk-friendly, they do provide taxpayers with a road map of what a well-crafted DRO must contain to render a taxpayer the payer of last resort.

Hubert Enterprises Inc. v. Commissioner, TC Memo 2008-46

By Steven C. Thompson, CPA, Ph.D.

The widow of Joe Alioto, who served as the mayor of San Francisco from 1968 to 1976, was granted relief under section 6015(f) from paying nearly $2 million in taxes for tax years 1995 and 1996. The Tax Court had dismissed the case in September 1996 due to lack of jurisdiction. However, that decision was vacated after the Tax Relief and Health Care Act of 2006 gave the Tax Court jurisdiction over stand-alone nondeficiency cases where the liability arose or remained unpaid on or after Dec. 20, 2006.

Joe and Kathleen Alioto married in 1978 and settled in California. In addition to serving as mayor, Joe Alioto also practiced law. He handled all of the family finances, and although the couple had a loving and supportive marriage, Joe Alioto never discussed business matters with his wife. Joe Alioto had been previously married and divorced and had legally indemnified his ex-wife, Angelina Alioto, against any tax liabilities for the years 1976 and 1977, a fact Kathleen Alioto did not learn until after her husband’s death in 1998. She was also reportedly stunned when she learned that her late husband’s creditors had filed claims in excess of $74 million against his estate. The IRS was among those creditors, claiming that the couple’s 1995 and 1996 joint tax liabilities had not been satisfied. Nor had she known of her late husband’s tax liabilities stemming from 19 years earlier with his first wife.

At approximately the same time that the couple’s 1995 return was filed, Joe Alioto earned a fee of more than $2 million for legal services. Kathleen Alioto later testified that she knew about this income. She didn’t know until after her husband’s death, however, that the IRS had seized these community-property funds and applied them against Joe Alioto’s 1976 and 1977 tax liabilities with Angelina Alioto— despite his request to apply them against his and Kathleen Alioto’s 1995 and 1996 tax liabilities. In 1999, she filed for innocent spouse relief. Although relief was granted for other years, it was denied for 1995 and 1996.

When Joe Alioto died, his and Kathleen’s children were 18 and 16 years old. Kathleen’s health insurance lapsed, and she sought employment to pay her medical bills. In 2003, even though her residence was classified as community property, the probate court ordered it sold and the proceeds distributed to creditors of her late husband’s estate, including the IRS. At the time of trial, she was 64 and had approximately $7,000 in savings. She worked at a local college and would not become eligible for pension benefits for several more years.

In rehearing her case, the Tax Court granted relief under the safe harbor provisions of Revenue Procedure 2000-15 (since superseded by Rev. Proc. 2003- 61), which required the requesting spouse no longer be married to the nonrequesting spouse, that she have no knowledge or reason to know that the tax would not be paid, and that she would otherwise suffer economic hardship. The court found Kathleen’s testimony that she did not know about the 1995 and 1996 underpayments to be credible. Further, given the circumstances, such as her age, employment status and number of dependents, she would be unable to pay reasonable basic living expenses if required to pay the outstanding tax liabilities, the court said. Finding the conditions satisfied, the court concluded that the IRS abused its discretion when it denied her relief.

Alioto v. Commissioner, TC Memo 2008-185

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

SERVICE LAUNCHES LILO, SILO SETTLEMENT INITIATIVE
The IRS followed up its recent court victories against LILOs (lease in, lease out) and SILOs (sale in, lease out) with an offer to settle the estimated hundreds of the listed-transaction tax shelters still on companies’ books. The offer, sent initially on Aug. 6 to 45 large corporations known to have participated in one or both of the transactions, waives accuracy-related penalties under IRC §§ 6662 and 6662A. In exchange, taxpayers must agree to terminate the transactions by Dec. 31, 2008. If they are unable to do so, the transactions will be deemed terminated as of that date. Taxpayers may still claim any benefit of an actual termination if, after a termination is deemed, the transaction is actually terminated by the end of 2010.

Under the settlement’s terms, reported taxable rental income from the LILO or SILO will be 80% disregarded, and claimed interest expense, amortized transaction costs and head lease rent expenses will be 80% disallowed for tax years through 2007. In addition, 80% of original issue discount accrued through 2007 must be reported for 2008. Termination gain, actual or deemed, must be recognized as ordinary income in 2008 and each additional year until actual termination.

For two recent court opinions, see BB&T Corp. v. U.S. (101 AFTR2d 2008-1933, “Tax Matters: LILO Comes Up One Leg Short,” JofA, Aug. 08, page 84), and AWG Leasing Trust v. U.S. (101 AFTR2d 2008-2397, “Tax Matters: Another SILO Pulled Down,” JofA, Sept. 08, page 94).

RULES TIGHTEN CHARITABLE DONATION SUBSTANTIATION
The Service issued proposed regulations consolidating, modifying and clarifying earlier proposed regulations and other guidance on reporting and substantiation requirements introduced by the American Jobs Creation Act of 2004 and the Pension Protection Act of 2006 (PPA) for deductible charitable contributions. Comments on REG-140029-07 are requested by Nov. 5. Among its provisions are definitions of qualified appraisals that meet the requirements of IRC § 170(f)(11)(E) as amended by the PPA. A deduction of more than $5,000 for a contribution of property must be accompanied by an appraisal performed by a qualified appraiser in accordance with generally accepted appraisal standards.

The new rules, consistently with interim guidance in Notice 2006-96, define generally accepted appraisal standards as complying with the substance and principles of the Uniform Standards of Professional Appraisal Practice as developed by the Appraisal Standards Board of the Appraisal Foundation. They also address recordkeeping and substantiation requirements for donors of cash and noncash contributions, including deduction thresholds at which donors must obtain receipts or “reliable written records,” and specify information that must be recorded on each.

The IRS and the Treasury Department request suggestions of how guidelines published by charities might reflect the provision of IRC § 170(f)(16) that donated clothing and household items not requiring an appraisal must be in good used condition or better. New Prop. Treas. Reg. § 1.170A-18 further explicates this requirement.

IRS APPEALS JELKE TO SUPREME COURT
The government asked the U.S. Supreme Court to review the Eleventh Circuit’s decision in Estate of Frazier Jelke III v. Commissioner (100 AFTR2d 2007-6694, “Tax Matters: Dunn Does It Again,” JofA, March 08, page 70). The Eleventh Circuit previously declined to rehear en banc its decision overruling the Tax Court on a valuation discount for tax liability of an estate’s built-in capital gains.

In its brief to the Supreme Court, the government said the Eleventh Circuit in Jelke adopted the “categorical approach which it believed the Fifth Circuit had adopted in Estate of Dunn v. Commissioner” (90 AFTR2d 2002-5527). Following that approach, the Eleventh Circuit in Jelke rejected the Tax Court’s holding that discounted the built-in gains tax liability over a period of time. Rather, the Eleventh Circuit said, 100% of the built-in gains taxes must be taken into account under the net asset valuation method (regardless of the likelihood of liquidation), because the method assumes that all assets are liquidated as of the date of valuation. In its brief to the Supreme Court, the government argued the Eleventh Circuit had used an erroneous standard of review—it treated the selection of a valuation method as a matter of law (and therefore subject to de novo review) instead of as a matter of fact (which can be reviewed only for clear error).

The Court of Federal Claims ruled against another Son of BOSS shelter, upholding penalties despite the taxpayers’ reliance on the advice of tax attorneys

The Welles family owned Therma-Tru Corp., a leading manufacturer of insulated doors. Between 1999 and 2000 the family negotiated the sale of the corporation to a private equity firm for a $450 million taxable gain. At the family’s request, its longtime attorney suggested they employ a gain-sheltering strategy marketed by the law firm of Jenkins & Gilchrist (J&G). That strategy would become known as Son of BOSS (bond option sales strategy) and lead ultimately to J&G’s demise. For other IRS victories against the shelter, see Jade Trading LLC v. U.S. (101 AFTR2d 2008-1411, “Tax Matters: Economic Substance Prevails Against Another Son of BOSS,” JofA, March 08, page 71); also Brandon Ridge Partners v. U.S. (100 AFTR2d 2007-5347, “Tax Matters: Son of BOSS Goes Into Overtime,” JofA, Nov. 07, page 79).

This version, which the Welleses set up beginning in March 2000, used foreign currency options plus a partnership termination to increase the basis of the corporation’s stock. Five months later, the IRS issued Notice 2000-44 that held such strategies lacked economic substance. J&G and the family attorney’s firm decided the J&G shelter was not similar to those in the notice, although notes made by the family attorney indicate he was not convinced by their analysis. The taxpayer paid more than $2 million in fees to J&G and more than $1 million to the other law firm.

J&G provided the Welleses with a tax opinion letter stating that the strategy should be effective. The government audited the partnership tax return and denied the tax benefit and imposed penalties. The taxpayer paid the tax and sued for a refund.

The Court of Federal Claims first determined that the strategy was consistent with the Internal Revenue Code as it existed at the time and rulings in Helmer v. Commissioner (TC Memo 1975-160) and Coltec v. Commissioner (98 AFTR2d 2006- 5249).

Second, the court ruled Treas. Reg. § 1.752-6, issued in 2003, could not be applied retroactively to deny the tax benefit. The regulation provides that if a partnership assumes the liabilities of a partner, the partner’s basis in the partnership is reduced by the amount of the liability, but not below the value of the partnership interest. The court also ruled that the regulation was interpretive and not statutory. Thus, it was not entitled to Chevron deference (Chevron USA Inc. v. Natural Resources Defense Council Inc., 467 U.S. 837 (1984)) and could be applied retroactively only in limited situations, the court said.

For a transaction to have economic substance, it must have a reasonable possibility of profitability. The taxpayer’s experts testified there had been a realistic possibility of a profit. But the court sided with the government expert’s opposite view, saying the taxpayer’s experts’ analysis was incomplete and in one case omitted information that was contained in a preliminary report. On the other hand, the government expert’s testimony was complete, used the recognized Black-Scholes model and demonstrated the lack of profit potential resulting from the high fee paid and the excessive price charged for the options. The court also noted the attorneys’ fee was based on the gain to be shielded, not the financial investment.

The court then upheld negligence penalties. Normally, the taxpayers would have been able to avoid penalties, since they discussed this issue with their regular attorneys as well as the law firm that proposed the strategy. However, because the regular attorneys were to receive one-third of the fee and brokered the strategy for J&G, they were not independent and their advice could not be relied upon as free from any conflict of interest, the court said.

The court then turned to the application of the economic substance doctrine. In one version of the doctrine, the transaction will be ignored if it lacks economic substance and was motivated solely by tax avoidance. The other version will disregard the transaction if either condition applies. The court applied the second version, based on the Supreme Court’s decision in Frank Lyon Co. v. U.S. (41 AFTR2d 78-1142).

Stobie Creek Investments LLC v. U.S., 102 AFTR2d 2008-5442

By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

The IRS has issued Revenue Ruling 2008-41 confirming that charitable remainder trusts (CRTs) can be divided into separate but equal trusts for each recipient without adverse tax consequences. If properly divided, the separate trusts will continue to qualify as CRTs, and no private foundation termination excise taxes will apply under IRC § 507(c). Nor will the division be treated as a sale, constitute an act of self-dealing under section 4941, or constitute a taxable expenditure under section 4945. Such divisions are common when the income recipients desire to separate their interests and when joint income recipients divorce.

The ruling clarified that the division of the trust into separate trusts does not disqualify the separate trusts as CRTs under section 664(d) as long as the division is pro rata and the separate trusts have the same governing provisions, recipients, remainder beneficiaries, total remainder interests and assets as the original trust— with some exceptions. In both of two examples given, the recipients paid all the costs of the division. The IRS also said that qualifying divisions do not constitute a sale, exchange or other taxable disposition producing gain or loss.

The ruling provides greater assurance that in the case of annuitants with concurrent present interests, each party can relinquish its successor interests after the other party’s death. It also consolidates issues that have been the subject of many previous private letter rulings (PLRs) and is similar to Revenue Ruling 2002-28 and PLR 200616008.

A CRT that divides in half must split each stock 50/50 so that each new trust gets half of each stock and maintains the same cost basis in each resulting trust. That works for assets that are divisible and that have a readily ascertainable value. However, it may pose difficulties for assets that cannot be easily split due to minimum unit sizes, or for real estate or closely held interests not broken down into units or shares. Taxpayer/trustees may want to consider keeping such interests undivided and titling the property accordingly. They may also consider liquidating or otherwise converting hard-to-split assets to cash before splitting the CRT. However, the remainder beneficiaries’ interests need to be considered as well, especially in the case of a “fire sale” or a highly appreciating asset.

Revenue Ruling 2008-41, 2008-30 IRB 170 (7/8/2008)

By AICPA Technical Manager Eileen Reichenberg Sherr, CPA, M. Taxation, the staff liaison for the AICPA’s Trust, Estate and Gift Tax TRP and its CRT Task Force.

The Eleventh Circuit Court of Appeals upheld a Georgia district court decision holding that federal and state incentive payments to a local telephone company were gross income. The appellate court accepted the lower court’s analysis that the payments were not excludable as nonshareholder capital contributions.

IRC § 118(a) excludes from income taxpayer contributions to capital. Treas. Reg. § 1.118-1 states that the exclusion also applies to nonshareholder contributions. It provides an example in which the value of land given by a government to a company to locate its business there is excluded from income, but money or property given in return for goods or services is included. The Supreme Court in U.S. v. Chicago, Burlington & Quincy Railroad Co. (32 AFTR2d 73-5042), stated in 1973 that the intent or motive of the nonshareholder transferring the property determines whether the amount is excluded from income. The high court also listed five characteristics of nonshareholder capital contributions: The payment must become part of the recipient’s permanent working capital, may not be made in return for an identifiable service, must be bargained for, must result in a benefit to the recipient in an amount roughly equal to the payment and will be used to produce additional income.

In 1998, Coastal Utilities Inc., a local telephone company in southeastern Georgia, received payments from the Federal-State Joint Board on Universal Service, which operates under the jurisdiction of the Federal Communications Commission. The payments were received under federal programs that encourage telecommunication companies to extend their infrastructure into areas they wouldn’t otherwise consider because of high fixed costs and few customers. The company also received payments from Georgia to recover lost revenues due to mandated reductions in certain customer fees. All payments were initially included as income on Coastal’s tax return, but the company later received a refund when it filed an amended return excluding them. In 2004, the U.S. government filed suit in the U.S. Southern District Court of Georgia to recover that refund.

Coastal argued that the payments were contributions to capital since they were made for a public purpose and not in exchange for any specific good or service. The court rejected this argument, stating that a government payment made for a public purpose does not automatically qualify as a capital contribution; the intent of the government must be considered, in this case, a supplement to income. The payments were based on Coastal’s expenses to provide a rate of return and thus were an incentive for the company to invest in infrastructure as opposed to a direct payment for that infrastructure, the court said.

U.S. v. Coastal Utilities, Inc., 101 AFTR2d 2008-836

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

The Court of Federal Claims ruled that gain was not recognized in the sale of stock received in exchange for policy ownership interests in an insurance company’s demutualization.

A mutual insurance company is owned by the policyholders rather than shareholders. When it reorganizes as a traditional stock company, the policyholders become stockholders in the company, in a process known as “demutualization.” It has been a long-standing position of the IRS that this is an exchange of nonrecognition property under IRC § 358(a)(1). Thus, when policyholders receive stock in a demutualization, they take a zero basis, and upon a subsequent sale of the stock, the full amount of the proceeds is taxed to them as capital gain. A retired CPA in Minnesota, Charles Ulrich, had previously challenged this IRS posture (see Associated Press, “Lone Accountant Takes on IRS and Wins”) and advised the plaintiff in this case.

In June 1990, the Seymour P. Nagan Trust purchased a life insurance policy from Sun Life Assurance Co. with a face amount of $500,000. In October 1999, Sun proposed a demutualization plan to its policyholders whereby the policyholders would be given shares of stock in a new holding company that would become Sun’s corporate parent. The policyholders could instead opt for a cash election. The demutualization plan was approved in December 1999.

At the request of the insurance company, the IRS ruled in Private Letter Ruling 200020048 that because their ownership rights could not be purchased separately from an insurance contract, policyholders would not recognize gain or loss on the exchange for stock under section 354(a)(1). The Service also ruled that the basis of the holding company stock received by policyholders would be the same as the basis of the ownership rights surrendered by the policyholders in the exchange, that is, zero. The IRS did not rule on the tax treatment of the cash election option.

As a result of the demutualization, the Nagan trust was offered 3,892 shares of stock but opted for the cash election and accepted $31,759 under a formula. This amount was reported on the federal income tax return of the trust and resulted in a tax liability of $5,725, for which the trust filed a refund claim. When the refund claim was denied, the trust, through trustee Eugene Fisher, filed suit in the Court of Federal Claims.

The court noted that Treas. Reg. § 1.61-6(a) ordinarily would apply. It requires that when a portion of a larger property is sold, the basis of the entire property should be equitably apportioned among the several parts. However, this regulation works only if the component pieces of the larger property can be valued. Because the parties disagreed whether the regulation applied in this case, the court chose to examine the history of the regulation (dating back to the 1920s), which focused on cash equivalency principles.

Under these principles, referred to as the “open transaction” doctrine, the Supreme Court (in Burnet v. Logan, 283 U.S. 404 (1931)) stated that when the value of property is indeterminable, a transaction remains open and the recognition of income is postponed until the value of the property can be established.

The court ruled that the situation was one of the “rare and extraordinary” occasions when the open transaction doctrine should apply. One reason the policyholders’ ownership rights could not be valued was because they were inextricably tied to policies and thus could not be separately purchased, transferred or sold, the court noted, quoting a government expert. But the government’s conclusion that the rights therefore had a value of zero didn’t logically follow, the court said. The court also rejected as determinative the government’s argument that Sun Life had not associated any cost on its books with the policy ownership rights. It found evidence of consideration for some value in the company’s demutualization plan, specifically, for loss of voting control and loss of right to share in any residual value if the company wound up its affairs.

Accordingly, because the trust received less than its cost basis in the Sun policy on the sale of the stock, the court held that income on the sale of stock was not realized and the trust was entitled to the refund.

IRS Chief Counsel Donald Korb said soon afterward in a public forum that the IRS might appeal the decision and that new guidance is needed (Tax Notes, Sept. 5, 2008).

Eugene A. Fisher v. U.S., 102 AFTR2d 2008-5608

By Steven C. Thompson, CPA, Ph.D., McCoy Professor of Business, Texas State University, San Marcos, Texas.