The Tax Court held that a woman’s work as an independent contractor for a real estate agency enabled her and her husband to deduct losses because they were incurred from a real property trade or business rather than a passive activity. According to the court, the taxpayers’ real estate activities met the requirements of a real property brokerage trade or business under IRC § 469(c)(7)(C). The fact that the wife was not a licensed broker under California state law was irrelevant in determining whether she operated a real property brokerage trade or business for federal income tax purposes.

Taxpayers’ losses from passive activities generally are deductible only to the extent of their passive income. A passive activity is one where a taxpayer does not materially participate—that is, is not involved in the activity’s operations on a regular, continuous and substantial basis. Generally, real estate rental activity is passive; however, it can qualify as a real property trade or business if the taxpayer satisfies a twofold test: The amount of personal services performed in real property trades or businesses by taxpayers in which they materially participate must exceed 750 hours and 50% of personal services performed in all trades or businesses during the taxable year (section 469(c)(7)(B)). For a married couple filing jointly, the test can be satisfied by either spouse, but only if that person meets both tests. Section 469(c)(7)(C) lists various activities that can be a real property trade or business, including a real property brokerage.

In 2001 and 2002, Shri Agarwal was employed as an engineer while his wife, Sudha, was a full-time real estate agent at a Century 21 agency in California. She was an independent contractor with the company, and her duties included selling, exchanging, leasing and renting properties. In addition, she was required to attract new listings and clients. During each of the years 2001 and 2002, the couple also spent 170 hours managing two rental properties they owned. In 2001 and 2002, Sudha spent 1,400 hours and 1,600 hours, respectively, performing her Century 21 activities and managing the two rental properties. The couple’s rental properties generated losses of $40,105 in 2001 and $19,656 in 2002, which they deducted on their federal income tax returns for those years. The IRS disallowed the deductions, prompting the taxpayers to petition the Tax Court for relief.

The IRS claimed that Sudha did not satisfy the section 469(c)(7)(C) definition of a real property trade or business because she was not in a brokerage trade or business. Since she was not a licensed real estate broker in California, the IRS argued, she could not be in the brokerage trade or business, and thus the activity was passive.

The Tax Court rejected this argument, stating neither section 469 nor its legislative history defines “brokerage,” and thus the common meaning of the term should be used. The court concluded that the business of a real estate broker includes “(1) selling, exchanging, purchasing, renting, or leasing real property; (2) offering to do those activities; (3) negotiating the terms of a real estate contract; (4) listing of real property for sale, lease, or exchange; or (5) procuring prospective sellers, purchasers, lessors, or lessees.” Since her duties at Century 21 included selling, exchanging, leasing and renting real property and finding new listings, the court concluded she was engaged in a brokerage trade or business at Century 21 within the meaning of section 469(c)(7)(C). Thus, Sudha spent sufficient time in real property trades or businesses in 2001 and 2002 to be able to deduct the losses.

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

The IRS has issued internal memoranda setting forth procedures for consideration of tax return preparer penalties in taxpayer examinations. A memorandum by the Large and Mid-Size Business Division (LMSB) describes procedures for tax return preparer penalty cases, and two audit technique guideline memos by the Small Business/Self-Employed Division (SB/SE) explain similar procedures for excise and employment tax examinations. The memos reflect the expanded application of the preparer penalties under IRC §§ 6694 and 6695 as amended by the Small Business and Work Opportunity Tax Act of 2007 (PL 110-28) to other types of tax returns and claims for refunds besides income taxes. They require examiners to consider the appropriateness of asserting preparer penalties in all taxpayer examinations involving a paid tax return preparer and to document consideration of the issue in the workpapers. They also emphasize that a potential preparer penalty case is separate from a taxpayer examination and requires that files for these matters be maintained separately.

In addition, they prescribe required supervisory approval and procedures for imposing a preparer penalty and for making referrals to the IRS Office of Professional Responsibility. The memos can provide practitioners with useful insights into administrative guidelines examiners are expected to follow in determining and imposing penalties and, therefore, best practices practitioners may follow to avoid incurring penalties.

For example, in an attachment to the LMSB memo (and in a shorter form in the SB/SE excise tax memo) the Service suggests questions for examiners to ask taxpayers in connection with potential preparer penalties, including:

• Are you aware of any errors, omissions or mistakes on the return under examination?
• Did you disclose this transaction on your tax return? Why or why not? 
• Was there any discussion regarding whether the transaction is subject to disclosure under Revenue Procedure 94-69?
• Were there any concerns about how the transaction was reported? What sort of process is used to address those concerns, and on what basis are decisions made?
• Was there any discussion regarding potential penalties?

These questions underscore how important it is for preparers to:

• Exercise due diligence in gathering and assembling facts that are potentially relevant to a return position and in determining whether section 6694 standards are satisfied. Although a preparer generally may rely in good faith without verification on information furnished by the client, the preparer must inquire further if the information appears inaccurate, inconsistent or incomplete (Treas. Reg. § 1.6695-2(b)(3)).
• Clearly communicate with the client any concerns about potential reporting positions. This would include discussions with clients about the potential taxpayer penalty consequences of a return position and the opportunity to avoid penalties by disclosure, where relevant.
• Contemporaneously document discussions with clients in these and other areas.

Practitioners also should remain alert to the fact that they may be subject to section 6694 as nonsigning preparers. In addition, tax advice may be subject to section 6694 standards even if the advice is not subject to the covered-opinion rules of Circular 230.

By Eve Elgin, Esq., LL.M., Washington, D.C., principal in KPMG’s Washington National Tax Office.

The Fifth Circuit Court of Appeals rejected an S corporation owner’s argument that the corporation’s payments to her father, one of the company’s founders, had created a second class of stock that had terminated the S election. The daughter had unsuccessfully sought by that reasoning to exclude from her gross income a distributive share of the corporation’s income. The appeals court thus upheld a holding by the Tax Court that there was no proof of any binding agreement that gave the father rights that were not identical to those of other shareholders.

Long’s Preferred Products Inc. was incorporated in Louisiana by Julian and Alma Long in 1975 to sell janitorial and paper supplies. The company properly elected to be treated by the IRS as an S corporation. In 1986 the Longs, their daughter, Linda Minton, and their son, Julian “Dooksie” Long, agreed that the parents would receive distributions of $4,000 a month as the children took over the business. In 1990, following Alma’s death, the distribution was reduced to $2,000.

By 1996 Linda and Dooksie had acquired complete ownership of the corporation. A dispute arose between them that led to a question of ownership that Linda litigated in state court. As part of this litigation, Linda’s attorney determined that the monthly distributions were preferential distributions and not stock purchase payments. The attorney then concluded that the corporation had a second class of stock outstanding and under IRC § 1361(b)(1)(D) had ceased in 1986 to be an S corporation. On that basis, Linda did not report her share of the corporation’s income for 1998 and filed refund claims for the two prior years omitting it. The IRS determined the distributions did not create a second class of stock and assessed tax against Linda. The Tax Court sided with the IRS.

In the Fifth Circuit, Linda again based her argument on Treas. Reg. § 1.1361-1(l), which provides that outstanding stock differs in class if it confers different rights to distributions or liquidation proceeds. The right to these distributions or proceeds can be contained in the articles of incorporation, bylaws, applicable state law or binding agreements. Although Linda argued that the $4,000 monthly payments to her parents were paid under a binding agreement, the Tax Court noted that she testified it was an oral, informal understanding not attested to by any formal corporate action.

The Fifth Circuit agreed with the Tax Court that there was insufficient evidence of a binding agreement. However, the Fifth Circuit said that if the burden of proof had been on the government, the outcome might have been different.

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

The IRS has issued proposed regulations that propose a comprehensive approach for stock basis recovery.

The regulations, if adopted as final, would apply across a broad spectrum of transactions. They will create a single model for stock basis recovery if a shareholder receives a dividend under IRC § 301. These transactions are labeled “dividend-equivalent transactions.” Another model would apply to sale and exchange transactions under section 302(a). These transactions are labeled “non-dividend-equivalent transactions.”

The proposed regulations, which add or revise 11 sections in all, would treat a distribution under IRC § 301 as received by a shareholder on a pro rata, share-by-share basis. A surprising effect of the new basis-tracing system of Prop. Treas. Reg. § 1.301-2 is that a distribution under section 301(c)(1) (a distribution in excess of earnings and profits and of basis) could result in a gain for a portion of the shares in a class and unrecovered basis in other shares in that same class.

Dividend-equivalent redemptions would be treated in much the same way. Such redemptions would result in the same pro rata, share-by-share reduction of a shareholder’s stock held immediately before the redemption. Again, this determination could result in a gain from some shares while other shares of the same class could have unrecovered basis.

Reorganization treatment will depend upon whether the reorganization exchange is dividend-equivalent or not. To determine whether the transaction is dividend-equivalent, the overall exchange must be taken into account. Thus, an exchange of one class of stock solely for “boot” and another class of stock solely for nonqualifying property must be considered as a whole. (Boot is money or any other property that doesn’t qualify for nonrecognition of gain in an otherwise nontaxable exchange.)

If the reorganization is treated as dividend-equivalent because different classes of stock are distinct and have specific legal rights, the exchange of a class of stock solely for boot would be an exchange to which section 302(d) applies, and the reorganization provisions of section 356(a)(2) would not apply. If it is determined that the reorganization is not dividend-equivalent, section 302(a) would still require the recognition of gain to the extent that boot is received.

The proposed regulations also address capital contributions. Under Prop. Treas. Reg. § 1.1016-2, capital contributions are treated as being made in exchange for shares followed by a recapitalization into the remaining shares. The principles of Prop. Treas. Reg. § 1.358-2(g)(3) (allocation of basis in a section 351 transaction in which stock is deemed received) apply.

The proposed regulations represent an attempt to develop a comprehensive system for capital contributions to and distributions from a corporation. However, as proposed, the identification of the basis for each individual share may require an excessive amount of recordkeeping to achieve the benefits of a comprehensive system.

By Laura Jean Kreissl, Ph.D., assistant professor 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.

From fitting a home with energy-efficient windows to harnessing the power of waves and tides, activities that conserve energy or produce it from clean and renewable sources enjoy new or expanded tax credits in the American Recovery and Reinvestment Act of 2009 (ARRA). The next generation of electric vehicles gets a jump-start, as do efforts to reduce greenhouse gases by capturing and “sequestering” carbon dioxide. The available pool of a new type of bond, one redeemable as a tax credit, is expanded to finance more energy conservation measures and more research and development into obtaining electricity from greener sources.

Here are some of the act’s more notable provisions, starting with those most likely to benefit individual taxpayers:

Energy property credit. For 2009 and 2010, the act extends and increases the IRC § 25C credit for qualified energy- efficient equipment or building components installed in the taxpayer’s principal residence. The overall credit is tripled from 10% to 30% of qualifying expenditures, subject to a lifetime cap of $1,500 (formerly $500). Caps on certain heating and cooling equipment placed in service during the tax year—such as $50 for an energy-conserving furnace circulating fan, $150 for a natural gas furnace or $300 for a heat pump—are lifted, as is a lifetime cap of $200 on energy-efficient windows. Expenditures formerly ineligible for the credit because they were funded by subsidized energy financing are now eligible.

Credits for plug-in electric vehicles. The act introduces two new credits for electric vehicles and modifies, starting next year, the section 30D credit for plug-in electric cars (introduced for the 2009 tax year by the Emergency Economic Stabilization Act of 2008). The section 30D credit is changed to between $2,500 and $7,500, depending on the vehicle’s kilowatt-hour rating, for vehicles purchased after Dec. 31, 2009. Plug-ins aren’t expected to be generally available in the U.S. before then.

The ARRA also refines the definition of a qualifying plug-in vehicle: one with at least four wheels that is designed primarily for use on public streets and highways and is powered “to a significant extent”— meaning a new generation of plug-in hybrids will qualify—by an electric motor with a rechargeable battery of at least four kilowatt-hours’ capacity. A phaseout threshold based on the number of vehicles sold for use in the U.S. is lowered from 250,000 vehicles to 200,000, but the credit is made permanent in place of a prior-law sunset at the end of 2014.

The ARRA also introduced a credit of 10% up to a maximum of $2,500 of the cost of low-speed and two- and three-wheeled plug-in electric vehicles and another 10% credit, up to a maximum of $4,000, for costs of converting a non-plug-in hybrid or conventional-fuel vehicle into a plug-in electric one. These two credits are available for vehicles bought or converted between Feb. 17, 2009, and Dec. 31, 2011.

Renewable energy production credit. Previously authorized for wind facilities placed in service before 2010 and for other sources before 2011, the section 45 renewable energy production credit is extended three more years (two years for marine and hydrokinetic sources).

Advanced energy manufacturing project credit. Investment in qualified property used in a qualified advanced energy manufacturing project (section 48C) is allowed a new 30% credit. Such projects are those to establish, expand or re-equip a manufacturing facility to produce property designed to produce energy from certain alternative sources including solar and fuel cells, or to capture and sequester carbon dioxide, or to produce qualified plug-in electric vehicles.

Clean renewable energy bonds. The ARRA triples the authorized maximum issuance amount of so-called CREBs (clean renewable energy bonds) to $2.4 billion from the previous limit of $800 million. CREBs are still new, having been introduced (section 54C) by the 2008 Energy Act. Unlike more conventional tax-exempt bonds, they accrue a tax credit the bondholder may apply against income tax (and alternative minimum tax) liability. The amount of credit is determined by a rate multiplied by the face amount of the bond. State and local governments, mutual or cooperative electric companies, and not-for-profit electric utilities may issue them to finance development of electrical generation from wind, biomass, geothermal, solar, hydropower, municipal solid waste, “marine and hydrokinetic” (for example, waves and tides) and other novel energy sources.

Qualified energy conservation bonds. The qualified energy conservation bond volume limit is quadrupled, from $800 million to $3.2 billion. Like CREBs, these are tax-credit bonds. They may be issued by state and local governments to fund qualified conservation purposes including reducing energy consumption in publicly owned buildings by at least 20%, implementing “green community programs” and conducting other research, development and demonstration projects described in section 54D(f).

Carbon dioxide sequestration. A $10 per metric ton credit established by prior law for capture of carbon dioxide used as a “tertiary injectant” in a qualified enhanced oil or natural gas recovery project is modified to require “secure geological storage” of the gas (section 45Q).

Other new, expanded or extended credits. The ARRA repeals the $4,000 cap on the 30% general business credit as it pertains to “small wind energy property” (section 48), increases the alternative fuel vehicle refueling property credit (section 30C), and repeals the basis reduction rule for the general business credit as applied to certain alternative energy property financed by subsidized energy financing or private activity bonds (section 48(a)(4)(D)).

By Tax Matters Editor Paul Bonner.

A return filing date is not the only benchmark for measuring the six-year time limit within which the government must begin a prosecution for tax evasion under IRC § 7201. Criminal defendant Leonard Widman found that out when the U.S. District Court for the District of Connecticut denied his motion to dismiss the government’s case alleging criminal tax evasion.

The statute of limitations of IRC § 6531 requires the government to bring an indictment for a charge of tax evasion under section 7201 within six years “after the commission of the offense.” The district court said the Second Circuit Court of Appeals (which includes Connecticut) has ruled that a prosecution under section 7201 “is timely if commenced within six years of the day of the last act of evasion, whether it is the failure to file a return or some other act in furtherance of the crime” (emphasis added). See U.S. v. DiPetto (936 F.2d 96 (1991)). The court cited several other circuits that agree with this view.

Widman, who was charged with criminal tax evasion for returns filed for 1997, 1998 and 1999, argued the court should dismiss the government’s case because the returns were filed on or before March 27, 2002—more than six years prior to the indictment, which was filed on Sept. 24, 2008. His motion argued the filing of the returns was the last affirmative act of evasion that completed the alleged crimes. The government’s indictment, however, asserted that Widman made material misrepresentations to IRS special agents on March 28, 2003, April 2, 2003, and Aug. 5, 2004.

The court said the Second Circuit in U.S. v. Klausner (80 F.3d 55 (1996)) recognized false statements to Treasury officials as an affirmative act of evasion that triggers the statute of limitations. The assertion of false statements in the indictment, if proved beyond a reasonable doubt at trial, would place the charges within the limitations period. Therefore, the court rejected the motion to dismiss the case on its face. The court did grant Widman leave to renew the motion in the context of a motion for judgment of acquittal at trial.

By JofA staff member Jeffrey Gilman, Esq.

The Ponzi loss safe harbor recently set forth in Revenue Procedure 2009-20 and Revenue Ruling 2009-9 brought welcome clarity to permissible treatment of such losses as well as the possibility of expedited theft loss deductions, practitioners said.

“It’s about as taxpayer-friendly as one could have hoped for,” said Rick Klahsen, managing director of the National Tax Department at RSM McGladrey.

The revenue procedure allows qualified investors to elect to take a deduction in the tax year of discovery of a qualified theft loss of 75% of the amount of loss if the investor is pursuing a third-party recovery, or 95% of the amount if the investor is not. Such third parties include the Securities Investment Protection Corp., which can pay claims of up to $500,000 per investor in a failed brokerage firm. In either case, the allowed deduction is minus any actual recovery received. Future recoveries will result in additional deductions or in gross income under the tax benefit rule.

Without the safe harbor, taxpayers generally must show they have no remaining claim for reimbursement on any portion of a loss for which they have any reasonable prospect of recovery before they may deduct it as a theft loss.

“Allowing things to go through the legal process until you have that reasonableness of determining how much you’re going to be able to recover can take years,” Klahsen said. “And to try and figure out when you have enough of a sense of what the recovery might or might not be to make that claim—obviously it doesn’t help investors in a lot of circumstances.”

Qualified investors are those whose loss otherwise qualifies for the theft loss deduction under section 165 and related regulations. These include that the loss must meet the definition of theft or fraud under the law of the jurisdiction in which it occurred. Beyond that, the “lead figure” in a “specified fraudulent arrangement” (Ponzi scheme) must have been charged with the theft or fraud under state or federal law in an indictment or information.

Alternatively, a qualified loss is one in which either (a) the lead figure has admitted the fraud, as alleged or attested by affidavit in a state or federal criminal complaint, or (b) a receiver or trustee has been appointed with respect to the scheme, or its assets have been frozen. Qualified investors also must not have had actual knowledge of the fraudulent nature of the scheme before it became known to the public. Furthermore, the scheme must not have involved a tax shelter under section 6662(d). Only primary investors in the Ponzi scheme, including funds or similar vehicles, may take advantage of the safe harbor.

The revenue ruling laid to rest some theories of tax treatment of Ponzi losses but approved others that had been suggested by practitioners after Bernard Madoff’s arrest and admission that his once celebrated investment firm was in reality a $50 billion Ponzi scheme. For instance, the ruling said a deduction under section 1341 for restoration of an amount held under a claim of right would not apply to a theft loss because the theft does not give rise to an obligation by a bilked investor to restore previously reported taxable income to another party.

On the other hand, even an individual taxpayer’s 2008 theft loss can be eligible for the five-year carryback provision for 2008 for operating losses of small businesses (defined as having up to $15 million in gross annual receipts) under the American Recovery and Reinvestment Act of 2009 rather than the usual three years under section 172(b)(1)(F). The reason is that section 172(d)(4)(C) treats a deduction for casualty or theft losses allowable under section 165(c)(2) or (3) as a business deduction, including for a noncorporate taxpayer. Thus an individual taxpayer who meets the gross receipts test for an applicable 2008 net operating loss that is also a theft loss from a specified fraudulent arrangement may carry the loss back up to five years. See Issue 5 of Revenue Procedure 2009-20.

The guidance came five days after Madoff’s guilty plea in the U.S. District Court for the Southern District of New York in Manhattan and after months of requests to the Service on behalf of his victims for such relief, although the guidance did not refer to Madoff specifically.

By Tax Matters Editor Paul Bonner.