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Domestic production activities deduction disallowed  
By Charles J. Reichert, CPA
March 2014

The Tax Court disallowed a corporate taxpayer’s domestic production activities deduction because, it determined, the taxpayer did not possess the burdens and benefits of ownership of the property produced. The court developed a nine-factor test of the burdens and benefits of ownership that it applied to the facts and circumstances of this case.

Under Sec. 199(a), taxpayers are allowed a deduction equal to the lesser of 3% of taxable income or their qualified production activities income, defined as the gross receipts from the sale of qualified production property (QPP) minus the cost of the QPP sold and minus any expenses allocable to the QPP. The deduction cannot exceed 50% of the W-2 wages of the taxpayer’s employees for the year. Generally, QPP is tangible personal property manufactured, produced, grown, or extracted in the United States. Only one taxpayer can take a Sec. 199 deduction for a manufactured product. When a taxpayer has a contract with an unrelated third party to manufacture the product, the taxpayer must possess the benefits and burdens of ownership during the production process to take the deduction.

ADVO Inc. distributed direct-mail advertising materials of its clients to residential addresses. For some of its clients, ADVO would design the advertising materials and then use third-party printers to print the advertisements. The printing contracts required the printers to use certain paper the printers purchased directly from brokers specified by ADVO. ADVO never took possession of the paper, and it did not guarantee that it would pay the brokers if a printer defaulted. The contracts also required the printers to insure the work in process and specifically stated that the title to and the risk of loss of the printed materials would pass to ADVO when printers delivered the materials to the taxpayer. ADVO deducted $1,515,992 under Sec. 199 on its 2006 federal tax return and $151,047 on its 2007 short-year return. The IRS disallowed the deductions, arguing that ADVO did not manufacture the advertising materials. The taxpayer disagreed and petitioned the Tax Court for relief.

The court stated that to be eligible for the Sec. 199 deduction, “the alleged manufacturer must establish that it is the only taxpayer who may be determined to be the owner of the property with the benefits and burdens of ownership.” After examining the examples in the Sec. 199 Treasury regulations and the factors used by courts when applying the benefits-and-burdens test for Sec. 263A and Sec. 936, the court listed nine factors to be examined when determining the benefits-and-burdens test for Sec. 199: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity interest is acquired; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser and which party has control of the property or process; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; (8) which party receives the profits from the operation and sale of the property; and (9) whether the taxpayer actively and extensively participates in the management and operations of the activity.

The court applied the factors to the facts and circumstances and determined that ADVO was not eligible for the Sec. 199 deduction because: (1) The legal title factor favored the IRS. Despite ADVO’s always possessing the legal title to the intangible ad design property, the contracts clearly stated that legal title to the printed material did not transfer to ADVO until after it was produced. (2) The parties intended that the printers produce the tangible paper advertising material using ADVO’s intangible ad design property and deliver it to ADVO, not that ADVO merely provide printing services, so this factor favored the IRS. (3) The equity interest, present obligation, and property tax factors were neutral because they did not apply in this case. (4) The possession-and-control factor favored the IRS because ADVO never exercised any control over the day-to-day printing operations and did not have the right of possession of the printed material until it was delivered to ADVO. (5) The factor of risk of loss and damage to the property was neutral because the risk that ADVO’s reputation would be damaged due to its untimely delivery of inferior advertising materials was offset by its not bearing any risks while the material was being printed. (6) The profits factor favored the IRS because the printing companies, not ADVO, received the profits from the sale of the printed material upon its delivery to ADVO. (7) The factor of active and extensive participation favored the IRS because ADVO did not extensively participate in the operation of the printing process, a production activity, but rather, extensively participated in the distribution of the printed materials, a service activity.

  ADVO, Inc., 141 T.C. No. 9 (2013)

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

Supreme Court resolves circuit split on gross-valuation-misstatement penalty  
By Sally P. Schreiber, J.D.
March 2014

The U.S. Supreme Court held that the 40% penalty for a gross valuation misstatement applied when the partnerships at issue had been determined to be shams that lacked economic substance, and, as a result, the partners’ outside basis in the partnerships was zero (Woods, No. 12-562 (U.S. 12/3/13), rev’g 471 Fed. Appx. 320 (5th Cir. 2012)).

The decision resolved a split among the circuit courts, with most courts holding that the penalty applied. The Fifth Circuit, in which this case originated, and the Ninth Circuit have held that the penalty does not apply when the entire transaction is disregarded on economic substance grounds. It also addressed a disagreement among the courts over whether district courts have jurisdiction to determine whether the penalty applies in a partnership-level proceeding.

In this case, two taxpayers took part in a tax shelter called COBRA. The tax shelter generated large paper losses that the taxpayers sought to use to offset taxable income. The shelter artificially inflated the taxpayers’ outside bases in two partnerships, which ultimately allowed the taxpayers to claim losses many times greater than the amount of their investment.

In a unanimous opinion written by Justice Antonin Scalia, the Court explained that a substantial-valuation-misstatement penalty of 20% applies under Sec. 6662 to any portion of an underpayment attributable to a substantial valuation misstatement. Under the version of Sec. 6662 then in effect, if the reported value or adjusted basis of a property exceeded the correct amount by at least 400%, the 20% penalty increased to 40%. (The current threshold is generally 200% of the correct amount.) Under Regs. Sec. 1.6662-5(g), if property is found to have a basis of zero, the 40% penalty applies.

The taxpayer argued against the penalty primarily on the grounds that value and valuation are factual, rather than legal, issues and that the penalty applies to factual misrepresentations of an asset’s worth or cost, not to legal determinations of whether a partnership existed. The Court, however, was not convinced that value was strictly a factual issue, and it further noted that the penalty also refers to adjusted basis, which “plainly incorporates legal inquiries.” Therefore, the Court held that the valuation-misstatement penalty encompasses legal as well as factual issues.

In the alternative, the taxpayer argued, as the Fifth and Ninth Circuit had held in prior cases, that any underpayment of tax in this case would be attributable not to the misstatements of outside basis but rather to the determination that the partnerships were shams, which was an independent legal ground. In rejecting this argument, Scalia quoted a concurring opinion in a Fifth Circuit decision, stating that, with the type of tax shelter at issue, “the basis misstatement and the transaction’s lack of economic substance are inextricably intertwined, so attributing the tax underpayment only to the artificiality of the transaction and not to the basis overvaluation is making a false distinction” (slip op. at 15–16, quoting Bemont Investments, LLC, 679 F.3d 339, 354 (5th Cir. 2012)).

The Court also found that the district court had jurisdiction to determine whether the penalty applied in the partnership-level proceeding. The taxpayer argued that the issue of the partners’ outside basis in their partnership interests was not a partnership-level item that fell under unified audit provisions in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L. 97-248. But the Court agreed with the IRS that the TEFRA partnership rules would be undermined if penalties could be determined only at the partner level rather than at the partnership level.

  Woods, No. 12-562 (U.S. 12/3/13)

By Sally P. Schreiber, J.D., a JofA senior editor.

Safe harbor offered for allocating rehab credits  
By Paul Bonner
March 2014

In the wake of an appellate decision denying allocations of Sec. 47 credits to investor partners in a historic rehabilitation project, the IRS issued guidance including a safe harbor for such allocations.

The guidance, Rev. Proc. 2014-12, had been anticipated after the IRS won reversal of a Tax Court opinion in Historic Boardwalk Hall, LLC, 694 F.3d 425 (3d Cir. 2012), cert. denied, No. 12-901 (U.S. 5/28/13). The Third Circuit held that a limited liability company created by a New Jersey state authority with a corporate investor member to rehabilitate and operate a historic theater on Atlantic City’s Boardwalk was not a valid partnership and the corporation was not a bona fide partner. For previous coverage, see “Tax Matters: Supreme Court Declines to Hear Historic Boardwalk Hall,” JofA, Aug. 2013, page 63.

The safe harbor requires (1) allocations of rehabilitation credits under a partnership agreement to satisfy the requirements of Sec. 704(b) and the regulations and (2) the rehabilitation credit to be allocated in accordance with Regs. Sec. 1.704-1(b)(4)(ii). The principal partner and the investor partners in the partnership are required to hold certain minimum interests in each material item of partnership income, gain, loss, deduction, and credit throughout the partnership’s existence. There are also a host of other requirements for the safe harbor regarding the investors’ partnership interests and contributions, guarantees and loans, and purchase and sale rights.

The revenue procedure is effective for allocations made on or after Dec. 30, 2013. It specifically does not apply to any federal credit other than Sec. 47 or to any transfer or disguised sale of state credits. Thus, it would not apply to facts similar to those in another recent partnership case denying historic rehabilitation tax credits, Virginia Historic Tax Credit Fund 2001, LP, 639 F.3d 129 (4th Cir. 2011), since that case involved allocations of state credits that the Fourth Circuit held were properly recharacterized as sales.

  Rev. Proc. 2014-12

By Paul Bonner, a JofA senior editor.

IRS: Terminating partnerships may not accelerate amortized startup expenditures  
By Sally P. Schreiber, J.D.
March 2014

The IRS issued proposed regulations aimed at preventing partnerships from using technical terminations to accelerate their deductions of startup and organizational expenses (REG-126285-12). When finalized, the regulations will apply to technical terminations of partnerships that occur on or after Dec. 9, 2013.

Under Sec. 708(b)(1), a partnership terminates if (1) no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership, or (2) within a 12-month period there is a sale or exchange of 50% or more of the total interest in partnership capital and profits. The second form of termination is called a technical termination.

Under Sec. 195(b)(1)(B), startup expenditures that are not fully deductible under Sec. 195(b)(1)(A) must be amortized over a 180-month period (15 years). Sec. 195(b)(2) allows taxpayers that completely dispose of a business before the end of the 15-year period to deduct the remaining expenses to the extent allowed under Sec. 165 as a loss. A similar rule applies under Sec. 709(b)(2) to the organizational expenditures of partnerships.

In response to reports that some taxpayers have taken the position that a technical termination of a partnership permitted an accelerated deduction of unamortized amounts of startup and organizational expenditures, the IRS issued the new proposed regulations to disallow these accelerated deductions upon a partnership’s technical termination and require a new partnership resulting from a technical termination to continue amortizing the expenses over the same amortization period as the terminating partnership. According to the proposed regulations’ preamble, this rule would bring the treatment of startup and organizational expenditures in line with the treatment of Sec. 197 intangibles. Under Regs. Sec. 1.197-2(g)(2), when a technical termination occurs, the new partnership continues to amortize the Sec. 197 intangible over the terminated partnership’s 15-year amortization period.


By Sally P. Schreiber, J.D., a JofA senior editor.

District court rules “parsonage allowance” unconstitutional  
By Alice A. Upshaw, CPA and Darlene Pulliam, CPA, Ph.D.
March 2014

A U.S. district court in Wisconsin struck down the long-standing exclusion from gross income under Sec. 107(2) of a housing allowance paid to ministers as violating the Establishment Clause of the First Amendment. However, the court stayed its injunction of enforcement of Sec. 107(2) pending appeal of the case. The issue of the constitutionality of Sec. 107(2) has never been decided by a federal appeals court or the Supreme Court.

The plaintiffs, Freedom From Religion Foundation Inc. (FRF) and its two co-presidents, brought suit against the government, claiming that the income exclusion violates the Establishment Clause of the First Amendment, which states, “Congress shall make no law respecting an establishment of religion.” Analyzing the statute under a modified version of a test formulated in Lemon v. Kurtzman, 403 U.S. 602 (1971), the court agreed, finding that it lacks a secular purpose or effect and that a reasonable observer would view it as endorsing religion.

Sec. 107(2) excludes from gross income a rental allowance paid to a “minister of the gospel ... as part of his compensation,” to the extent used to provide a home and by the home’s fair rental value, including furnishings, plus the cost of utilities.

The government argued the defendants did not have standing to sue because they had not claimed the exemption and been denied it by the IRS. The court, however, found that the plaintiffs had standing because they were excluded from claiming an exemption granted to others and thereby suffered an injury the court could redress.

The suit originally challenged Sec. 107(1) as well, which allows a minister to exclude from gross income the rental value of a home, or “parsonage,” furnished to him or her, but the plaintiffs dropped that claim in their response to the government’s motion for summary judgment.

The government noted that the legislative history of Sec. 107(2) showed it was intended to provide equal treatment of ministers who could not claim the existing Sec. 107(1) exclusion. Both provisions are based on the “convenience of the employer doctrine,” the government argued, which holds that housing should not be viewed as compensation if it is provided by the employer to enable the employee to do his or her job properly. Rejecting these arguments, the court found that because Sec. 107(2) “does not include any limitations on the type or location of the housing … it cannot be described as being related to the convenience of the employer doctrine.” The court also noted that the sponsor of the 1954 statute told a congressional committee hearing that the measure was necessary “in these times when we are being threatened by a godless and anti-religious world movement.”

The court cited the Supreme Court’s holding in Texas Monthly, Inc. v. Bullock, 489 U.S. 1 (1989). Though Texas Monthly concerned a state sales tax exemption for religious literature, it established that a tax exemption provided only to religious persons violates the Establishment Clause when it results in preferential treatment of religious messages, the court held. It concluded that because the primary function of a “minister of the gospel” is to disseminate religious messages, a housing exclusion provided only to ministers treats religious messages preferentially over secular ones.

  Freedom From Religion Foundation, Inc. v. Lew, No. 11-cv-626-bbc (D. Wis. 11/21/13)

By Alice A. Upshaw, CPA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.

Individual mandate hardship exemption expanded  
By Dayna E. Roane, CPA/ABV, M.Tax.
March 2014

In December, the U.S. Department of Health and Human Services expanded hardships eligible for exemption from the Sec. 5000A shared-responsibility payment to include individuals whose policies were canceled by their previous insurers and who find that other coverage options are more expensive than their canceled policies.

The shared-responsibility payment, popularly known as the “individual mandate” of health care coverage under the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, also provides a wide range of other hardships and taxpayer groups and circumstances qualifying for exemption (see “Tax Practice Corner: Calculating the Health Care Individual Mandate Penalty,” Jan. 2014, page 54).

A taxpayer whose policy was canceled for any reason and who feels that procuring a different policy is unaffordable may now apply for a hardship exemption on the grounds that it is more expensive to buy a different plan. Such taxpayers are permitted to buy “catastrophic coverage” plans rather than PPACA-compliant health plans in 2014. A taxpayer who wishes to apply for this exemption must fill out a hardship exemption form and provide supporting documentation indicating that the previous policy was canceled. “Unaffordable,” in this case, does not refer to a health insurance policy whose premiums for self-only coverage exceed 8% of household income (a statutory exemption), but is measured with respect to the taxpayer’s canceled policy’s premium costs. The exemption may be granted by a health insurance exchange.

  Department of Health and Human Services, “Options Available for Consumers With Cancelled Policies” (Dec. 19, 2013), available at

By Dayna E. Roane, CPA/ABV, M.Tax., Perry & Roane PC, Niwot, Colo.

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