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TAX MATTERS
Self-employed can deduct Medicare premiums, IRS Chief Counsel advises  
October 2012

Explaining a recent reversal of a long-held IRS stance, the Office of Chief Counsel advised IRS attorneys that self-employed individuals may deduct Medicare premiums from their self-employment income. Chief Counsel Advice (CCA) 201228037 clarifies an IRS position that previously has appeared only in instructions to Form 1040, U.S. Individual Income Tax Return, and IRS publications for tax years 2010 and forward allowing the deduction.

Taxpayers who failed to deduct Medicare premiums for prior tax years within the statute of limitation period may file amended returns to claim the deduction.

Before tax year 2010, Form 1040 instructions for line 29 stated, “Medicare premiums cannot be used to figure the [self-employed health insurance] deduction.” Before 2010, Publication 535, Business Expenses, stated that Medicare Part B premiums were not deductible as a business expense, in keeping with Field Service Advisory (FSA) 3042, issued in 1995.

For the 2010 Form 1040, the instructions for line 29 were changed to specify that “Medicare Part B premiums can be used to figure the deduction.” The 2010 version of Publication 535 was similarly amended, but the IRS offered no guidance or explanation for the change.

Sec. 162(l)(2)(A) limits the deductible amount of payments made for health insurance to the taxpayer’s earnings from the trade or business “with respect to which the plan providing the medical care coverage is established.” FSA 3042 stated that this meant that payments under a plan that is not established with respect to the taxpayer’s trade or business (specifically including Medicare Part B, because it is a federal program) are not deductible.

The CCA, however, states that because Medicare is insurance that constitutes medical care under Sec. 162(l), it is similar to other health insurance and its premiums can similarly be deducted, including for coverage of a self-employed taxpayer’s spouse and qualifying child or other dependent. Children can include those up to age 27 (effective March 30, 2010).

The CCA states that premiums for all Medicare parts are deductible.

Besides a sole proprietor, a self-employed individual for purposes of the deduction can be a partner or S corporation employee who is a more-than-2% shareholder on whose behalf the partnership or S corporation pays the premium. Or the partner or S corporation employee-shareholder may pay the premium directly and be reimbursed by the partnership or S corporation. In either case, the amount must be properly reported and included in the partner’s or employee-shareholder’s gross income.


TAX MATTERS
Tax Court’s denial of easement deduction deemed unreasonable  
By Janet A. Meade, CPA, Ph.D.
October 2012

The First Circuit recently held that a Tax Court decision disallowing a couple’s deduction for a qualified conservation contribution of a facade easement was an unreasonable and overly restrictive interpretation of the extinguishment provision of Regs. Sec. 1.170A-14. The First Circuit viewed the Tax Court’s reading of the regulation as contrary to the intended purpose of the associated statute. The First Circuit’s decision is relevant because the Tax Court has applied its own reading of the extinguishment provision in a number of other opinions disallowing conservation easement deductions, and these may be appealed. Also uncertain is whether the Tax Court will alter its interpretation in cases pending before it but appealable to other circuits.

Gordon and Lorna Kaufman granted the National Architectural Trust (NAT) an easement restricting alterations to the facade of their row house in a Boston historic preservation district. NAT required the Kaufmans to make a cash contribution of approximately 10% of the estimated value of the facade easement to create an endowment for future monitoring and administration. It also required the Kaufmans to acquire a subordination agreement from the bank that held a mortgage on the property to satisfy the perpetuity provision of the Code. The Kaufmans complied with both requirements, but the bank limited its subordination by reserving first claim to all insurance proceeds from any casualty.

Under Sec. 170(h) and the associated regulations, an easement grant must be protected in perpetuity for it to be deductible. The regulations further add that no deduction is allowed for an interest in property subject to a mortgage unless the mortgagee subordinates its rights to those of the donee organization. When a change in conditions results in extinguishment of a perpetual conservation restriction, the donee organization “must be entitled to a portion of the proceeds at least equal to the proportionate value” of the conservation restriction (Regs. Sec. 1.170A-14(g)(6)(ii)).

The IRS denied the Kaufmans’ deduction for the easement grant and cash contribution. The Tax Court upheld the IRS’s determination, finding that the deduction failed to comply with the perpetuity requirement because extinguishment of the easement arising from a casualty would place the bank’s claim to insurance proceeds above that of NAT. The court interpreted “entitled” in the regulations to mean an absolute right.

The First Circuit characterized the Tax Court’s interpretation as foreclosing practically all deductions for easements because, under this reading, the superpriority of tax liens would “doom practically all donations of easements,” which was not Congress’s intent. The First Circuit also rejected the IRS’s denial of the deduction for failure to comply with recordkeeping and reporting requirements. According to the First Circuit, the minor defects in the appraisal summary did not, by themselves, doom the deduction.

The First Circuit remanded the case to the Tax Court for further review of the value of the easement grant. Although the valuation issue was not in dispute on appeal, the First Circuit commented that the Kaufmans’ easement grant might be worth “little or nothing,” given the severe restrictions on facade alterations in the historic district of the Kaufmans’ home. Thus, it left open the question of whether the Kaufmans gave away any rights beyond those already limited by preexisting municipal restrictions.

Kaufman, No. 11-2017 (1st Cir. 7/19/12), vacating in part and remanding 134 T.C. 182 (2010)

By Janet A. Meade, CPA, Ph.D., University of Houston.


TAX MATTERS
No deduction for bringing down the house  
By Charles J. Reichert, CPA
October 2012

The Tax Court disallowed the taxpayers' charitable contribution deduction for the value of a donated house that would later be destroyed in a training exercise by a county fire department. The court held that a deduction should not be allowed since the taxpayers did not transfer an undivided portion of an entire interest in the property.

Contributions to nonprofit volunteer fire departments are deductible under Sec. 170(c)(1). Generally, contributions of partial interests in property are not deductible; however, contributions of an undivided portion of the taxpayer’s entire interest in property, a qualified conservation contribution, or a remainder interest in a personal residence or farm are deductible. An undivided portion of an entire interest in property consists of a portion of each and every substantial right in the property and extends over the whole term of the taxpayer’s interest in the property. State law determines the nature of the rights.

In 2006, Upen and Avanti Patel purchased a house on a half-acre lot in Vienna, Va., with the intent of razing it and building a new one. The couple entered into an agreement with the Fairfax County Fire and Rescue Department (FCFRD) that permitted the department to burn down the existing house as part of its training exercises. In October 2006, the FCFRD destroyed the house, and subsequently the taxpayers had the debris removed and began building their new home. The Patels reported a noncash charitable contribution of $339,504, the value they assigned to the house donated to the FCFRD, on their 2006 joint federal income tax return, of which $92,865 was deducted in that year. The IRS disallowed the entire $339,504 contribution, stating a partial interest in property had been donated that did not meet one of the three allowed exceptions. The taxpayers petitioned the Tax Court for relief, arguing that they had donated their entire interest in the house.

The court held that the donation was a gift of a partial interest since, under Virginia law, the house was considered part of the land, in which the taxpayers retained a substantial interest. The court held the donation was not a qualified conservation donation or a gift of a remainder interest in a personal residence or farm; therefore, it would have to be a donation of an undivided portion of property to be deductible.

Under common law, a building is considered part of the land until it is severed from the land. The court held that giving the FCFRD the right to burn down the house did not sever the building from the land but instead gave the FCFRD the right to use the house. According to the court, severance occurred when the house was destroyed; however, since the taxpayers were still liable for the removal of debris and any injuries on the property until it was removed, the taxpayers still had a substantial ownership interest in the house after it was destroyed. Because the taxpayers had retained a substantial ownership interest, the court held, an undivided portion had not been transferred and no deduction should be allowed for the donation.

Seven judges joined in a dissenting opinion, stating when the house was destroyed, it was severed from the land and became personal property in which the taxpayers retained only insubstantial rights (the debris). Furthermore, according to the dissent, any burdens of the taxpayers were because of their ownership of the land, not the house; therefore, the taxpayers had transferred their entire interest in the house.

Patel, 138 T.C. No. 23 (6/27/12)

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.


TAX MATTERS
Prop. regs. clarify application of meal and entertainment deduction limit  
October 2012

The IRS released proposed regulations under Sec. 274 clarifying which party is subject to the Secs. 274(a) and (n) limit on deductions for meals and entertainment to 50% of the expenses incurred (REG-101812-07). As the IRS emphasized, only one party is intended to be subject to the limitation when multiple parties are involved.

The proposed regulations are intended to settle issues raised in Transport Labor Contract/Leasing, Inc., 461 F.3d 1030 (8th Cir. 2006), rev’g 123 T.C. 154 (2004), acq. in result, Rev. Rul. 2008-23.

Sec. 274(a) limits the amount of entertainment, amusement, or recreation expenses that are deductible to those of activities directly related to the active conduct of the taxpayer’s trade or business (or immediately preceding or following a substantial and bona fide business discussion). Deductions for meals and entertainment are further limited to 50% of the expenses incurred (Sec. 274(n)). Under Sec. 274(e)(2)(A), employers are not subject to the limitation to the extent they treat the expenses as compensation to the employees.

Sec. 274(e)(3) provides two exceptions from the Secs. 274(a) and (n) limits for reimbursed expenses. Sec. 274(e)(3)(A) excepts expenses an employee pays or incurs in performing services for an employer under a reimbursement or other expense allowance arrangement where the employer does not treat the reimbursement as compensation to the employee. In that case, the employee does not have additional compensation or a deduction for the expense, but the employer deducts the expense and is subject to the deduction limit. If the employer treats the reimbursement as compensation, the employee may be able to deduct the expense as an employee business expense. In that case, the employee bears the expense and is subject to the deduction limit. The employer deducts the expense as compensation, which is not subject to the deduction limit under Sec. 274.

Sec. 274(e)(3)(B) applies if the taxpayer performs services for a person other than an employer and the taxpayer accounts (substantiates, as required by Sec. 274(d)) to that person. The Eighth Circuit applied this subsection in the Transport Labor case. In that case, the taxpayer, a leasing company that provided truck drivers to its clients, charged the clients for the wages and the per diem allowance it paid the truckers. Because the taxpayer provided services to its clients under a reimbursement or other expense allowance arrangement and accounted to the clients, it qualified under Sec. 274(e)(3)(B) for the exception from the Sec. 274(n) limit with respect to the per diem expense and, instead, the clients were subject to the limit.

The proposed regulations set out a new definition of reimbursement or other expense allowance arrangement for purposes of Sec. 274(e)(3). This definition is independent of the definition for accountable plan purposes in Sec. 62(c). The proposed regulations also clarify that the rules for applying the exceptions to the Secs. 274(a) and (n) deduction limits apply to reimbursement or other expense allowance arrangements with employees, whether or not a payor is an employer. Any party that reimburses an employee is a payor and bears the expense if the payment is not treated as compensation and wages to the employee.

The regulations also permit taxpayers involved in multiparty arrangements involving nonemployees (i.e., independent contractors) to provide by agreement who will be subject to the 50% limit. Absent an agreement, the limit will apply to an independent contractor if he or she does not account for the expense under Sec. 274(d), and to the client or customer if the independent contractor meets the substantiation requirements.

The proposed regulations include an example illustrating how the rules apply to multiparty reimbursement arrangements, such as the one in Transport Labor. Multiparty reimbursement arrangements are separately analyzed as a series of two-party reimbursement arrangements.

The proposed regulations will be effective on the date they are published as final in the Federal Register. However, taxpayers may apply these regulations to tax years still open under Sec. 6511.


TAX MATTERS
TIGTA recommends identity theft safeguards  
October 2012

The Treasury Inspector General for Tax Administration (TIGTA) reported that the IRS had failed to detect 1.5 million tax returns with potential identity-theft-related fraudulent tax refunds exceeding $5.2 billion for the 2011 filing season (TIGTA Rep’t No. 2012-42-080). The IRS itself reported that it detected 938,664 returns with fraudulent tax refunds of $6.5 billion in the same period. TIGTA also reported that known instances of tax-related identity theft more than doubled from 2009 to 2011 (see related graphic).

TIGTA recommended that the IRS make the following changes to its procedures to reduce the problem:

1. Develop processes to use the National Directory of New Hires (NDNH), a database containing information on all newly hired employees, to verify wage and other information. (Currently, the IRS is not permitted to access this information for this purpose.) The IRS should also use prior-year third-party income and withholding information to identify fraudulent returns. The IRS agreed with this recommendation.

2. Develop processes to analyze characteristics of fraudulent tax returns resulting from identity theft and to refine the IRS’s existing tax processing filters. TIGTA used as an example its discovery that a large number of fraudulent tax returns came from the same address, noting that this was one method to flag suspicious returns. The IRS also agreed with this recommendation.

3. Seek legislation authorizing the IRS to obtain information from the NDNH frequently and regularly. The IRS agreed with this recommendation.

4. Develop a process to detect false Social Security benefit income and withholding claims at the time tax returns are processed, using Form SSA-1099 information from the Social Security Administration. That information is received each December, and the IRS should be using information from those forms earlier in the year, before it issues refunds. The IRS agreed and said that it had used the information in January this year while processing 2011 tax returns.

5. Develop a process with federal agencies and banks to ensure that tax refunds issued by direct deposit are made only to an account in the taxpayer’s name. The IRS said it will discuss with the government’s Financial Management Service whether such restrictions can be implemented.

6. Limit the number of refunds that can be deposited to the same account. The IRS has resisted having only one refund permitted per account because it is concerned about situations in which an account is in the name of multiple individuals. TIGTA countered by presenting evidence that at least 10 accounts had each received more than 300 refund direct deposits—one with 590 deposits totaling $909,267. The IRS agreed to work with the Financial Management Service to determine whether these limits are feasible.

7. Work with Treasury to ensure financial institutions and debit card administration companies authenticate the identity of individuals purchasing a debit card and prevent the direct deposit of tax refunds to debit cards issued or administered by financial institutions and debit card administration companies that do not take reasonable steps to authenticate individuals’ identities. The IRS agreed to work with Treasury’s Financial Crimes Enforcement Network (FinCEN) to develop procedures to ensure individuals’ identities are authenticated.

Other issues raised in the report included the IRS’s efforts to reduce the number of fraudulent returns filed using deceased taxpayers’ Social Security numbers by placing a lock on these taxpayers’ accounts. As of March 31, 2012, the IRS placed a deceased lock on more than 164,000 tax accounts and prevented approximately $1.8 million in fraudulent tax refunds using deceased individuals’ identities.

The IRS issues an identity protection personal identification number (PIN) to protect victims of identity theft from further losses and make sure their refunds are not needlessly delayed. TIGTA had found that the process was not working well and many victims’ refunds were delayed. The IRS fixed the problem before the start of the 2012 filing season. The IRS issued an identity protection PIN to 251,568 individuals for this filing season, up from 53,799 last year.


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