IRS PROVIDES PROCEDURES FOR RETROACTIVE REINSTATEMENT OF SECTION 501(c)(3) STATUS

Code Section 6033(j) provides for the automatic revocation of Section 501(c)(3) status for organizations that fail to file the requisite annual returns or notices for three years. Despite IRS warnings of its intent to implement such revocations, many organizations did not get the message and have suffered such revocations.

Rev.Proc. 2014-11 now provides for mechanisms to obtain retroactive reinstatement of tax-exempt status. The procedures generally involve submitting a new Form 1023 and user fee, and filing missing returns. If the procedures are complied with, status will be restored retroactively and no penalties imposed for the late/missed annual returns. The Revenue Procedure also describes how to apply for non-retroactive reinstatement (which presumably will be undertaken mostly by those that do not otherwise qualify for retroactive reinstatement.

A mindmap that summarizes the various alternative mechanisms and other aspects of these filings is available online at this link (hint: click the icon in the upper right hand corner of the map with two arrows on it to view the map full screen).

Rev.Proc. 2014-11, 2014-3 IRB

FAILED CHALLENGE TO INTEREST REPORTING REGULATIONS

In 2012, regulations were issued that require banks to report interest paid on deposits of nonresident alien individuals who reside in countries with an exchange of information agreement with the U.S. (even though such bank interest is usually not subject to U.S. income tax). The Florida Bankers Association and the Texas Bankers Association challenged the regulations. The D.C. District Court has dismissed their action.

One objection voiced by the bankers was that the information disclosed to the foreign governments could be disseminated and thus would injure the privacy interests of their customers. The court was unsympathetic, since the foreign governments would “pledge” to protect the privacy of the customer information.

Another objection was that there would be major capital flight as foreigners would close their accounts to keep this information out of the hands of their home country governments. The court was not convinced about this either.

Most real world practitioners will tell you that such accounts are being closed. In the policy debate between encouraging investment capital to enter and reside in the U.S. vs. tax enforcement concerns, and as evidenced by this provision and FATCA, the pendulum has clearly swung to the latter.

Florida Bankers Association, et al (DC Dist Col 01/13/2014) 113 AFTR 2d ¶ 2014-358

IRS TO FORECLOSE TAX-FREE BASIS STEP-UP IN CHARITABLE TRUST PLANNING

In Notice 2008-99, the IRS signaled its concern about a planning arrangement involving sales of interests in charitable trusts that could give rise to tax-free increases in basis. Treasury has now issued proposed regulations specifically addressed at avoiding such a step-up in basis.

Several years ago, the IRS became aware of an interesting planning arrangement whereunder holders of a term interest in a charitable remainder unitrust or annuity trust could claim and benefit from a basis step-up in their term interest without anyone paying taxes on the increased amount. In Notice 2008-99, the IRS designated the methodology as a “transaction of interest” that is subject to enhanced disclosure requirements.

The Treasury Department has now issued proposed regulations that revise Treas. Regs. §1.1014-5 to provide special basis adjustment rules to eliminate this basis step-up. To best understand the proposed regulations, let’s start with the steps of the abuse that the regulations address:

A. A charitable remainder annuity or unitrust (“charitable trust”) is funded with appreciated assets. The grantor retains a term interest with a charity as the remainder beneficiary. The grantor recognizes no gain or loss on the funding, and receives a charitable deduction for the portion of the assets allocable to the charitable remainder.

B. The charitable trust sells the appreciated assets and reinvests them. As a charitable trust, the trust recognizes no gain on the sale. As distributions are made to the term interest holder, the term interest holder will eventually be taxable on such gains, but that is in the future (and as described below, may never occur if the sale described below occurs prior to such distributions).

C. The term interest holder and the charitable trust sell their trust interests to an unrelated third party. The term interest holder has an amount realized equal to what he or she will receive for the interest. What is the basis of the term interest holder in the sold term interest for purposes of computing his or her gain?

     1. Generally, under Treas. Regs. §1.1014-5(a) (commonly referred to as the uniform basis rules), a term interest beneficiary in a trust will be allocated a portion of the trust’s basis in its assets, based on the actuarial portion of the value allocable to the term interest beneficiary.

     2. Notwithstanding that general rule, Code §1014(e)(1) will impose a $0 basis on such a term interest that is acquired by gift or a transfer in trust (or by transfers from a decedent or under Code §1041). Thus, at this point in the analysis, it appears that the selling term interest beneficiary has a $0 basis and will recognize 100% of the sales price as gain.

     3. However, it is likely that our beneficiary will seek to apply Code §1014(e)(3). This provision is an exception to the $0 basis rule of Code §1014(e)(1) above. It will reimpose the general basis allocation rule described in 1. above if the sale is “part of a transaction in which the entire interest in property is transferred to any person or persons.”

D. So where are we? The selling taxpayer will likely assert that under Code §1014(e)(3), he or she has a portion of the trust’s basis in its assets (based on the term interest holder’s actuarial share of the trust value). Since the trust has a fair market value basis in its assets or something close to that (having recently sold the contributed appreciated assets and reinvested the sale proceeds), if the term interest is sold for its fair market actuarial value the seller recognizes no gain on the sale. Since the trust is merged out of existence in the hands of the buyer, there will be no further distributions on the term interest – thus the opportunity for the government to receive taxable income from the trust’s prior sale of the appreciated property is lost forever, and the term interest holder effectively receives a free step-up in basis.

Pretty neat! Perhaps the IRS has no tools to foreclose such treatment for transactions to date, but the new proposed regulations will avoid the above result if and when the regulations are finalized. The proposed regulations will initially apply the foregoing allocation of trust basis to the term interest holder, but under a modification to Treas. Regs. §1.1014-5 will then reduce that basis by the term interest holder’s actuarial percentage of the trust’s undistributed net ordinary income and undistribute net capital gains under Code §§664(b)(1) & (2) and Treas. Regs. §§1.664-1(d)(1)(ii)(a)(1) & (2).

The fix is a fairly simple method for Treasury to close the loophole without radical revision of the uniform basis rules. To the extent there has been trust income that is undistributed, the term interest holder will have his or her basis reduced on a sale or other disposition of that interest. Thus, to the extent the trust has incurred tax-free gain or income and not distributed out that income, no basis step-up from that income occurs to the term holder.

As most regulations drafted to address a specific abuse do, it will catch in its net taxpayers that did not enter into abusive planning. For example, these rules will apply to all charitable trusts, including those that were not funded with appreciated property and that did not do a quick turnaround sale of the term interest. Thus, it will apply to all combined term and remainder interests and will reduce basis to the term interest holder for any undistributed income, even where there was no tax avoidance motive or planning.

Helpfully, the new rules are slated to only apply to charitable remainder annuity trusts and charitable remainder unitrusts, although the IRS has asked for comments on expansion to other charitable trusts. Thus, the rules are of no concern on dispositions of interests in noncharitable trusts. This is as it should be, since there is no avoidance of tax on the income of the trust via charitable status, which is what gives rise to the potential for a tax-free step-up in basis.a

GETTING THE TREASURY TO UNDERWRITE YOUR TRAVEL

Trade or business expenses are deductible. Does this mean you can travel the world as a travel writer and deduct your expenses? You can, if you can demonstrate that  you undertook your travel and writings to earn a profit, you are regularly and actively involved in the activity, and you actually commenced the activity.

Michael Oros tried it. He took a four month sabbatical from his job at Intel starting in 2006 and visited South America, Asia, Africa, and Australia. He took voluminous photographs and notes, and intended to write a book about the trip. He deducted his travel expenses as a trade or business. Unfortunately, neither the Tax Court nor the 9th Circuit Court of Appeals could accept that Mr. Oros was in the trade or business of travel writing, and his deductions were denied.

Some Favorable Facts. Mr. Oros prepared a business plan. He took thousands of pictures. He kept a detailed journal. He arranged his itinerary based on events he wanted to photograph. He had a profit motive.

The Unfavorable Facts. No prior, continuous, or repeated activity as an author. By 2011 he still had not published or completed the travel book or any other book. This was his first book. He had other full time employment. No intent to keep on writing so as to distinguish the activity from being an isolated venture for personal satisfaction.

Is not having written before fatal? The Tax Court said no, but it is not a favorable fact.

Is having another trade or business fatal? The Tax Court said no, but it is not a favorable fact.

Is not having completed the book fatal? No, but it is not a favorable fact.

There were just too many unfavorable facts. Given the right facts and circumstances, deduction of travel expenses for travel writing is workable for those actually in the business of travel writing.

Oros v. Comm., 113 AFTR 2d 2014-xxxx (CA9), 12/31/13

TEMPORARY TAX BENEFIT PROVISIONS THAT HAVE NOW EXPIRED

A number of provisions of the Code that favor taxpayers expired at the end of 2013. Historically, Congress usually gets around to reinstating such expired provisions, but in today’s partisan environment, nothing should be assumed. Indeed, in December Sen. Harry Reid introduced a bill to provide a one-year extension of nearly all of the provisions that were set to expire at year-end. The bill failed to advance.

Here is a list of most of the key provisions that are now expired, and that may (or may not) be extended retroactively.

INDIVIDUAL PROVISIONS:

-the deduction for state and local sales taxes;
- the above-the-line deduction for certain expenses of teachers;
-the above-the-line deduction for qualified tuition and related expenses;
-the deduction for mortgage insurance premiums deductible as qualified interest; 
-the exclusion of discharge of principal residence indebtedness from gross income;
-the credit for health insurance costs.

BUSINESS PROVISIONS:

  -the research and experimentation credit; 
  -the work opportunity tax credit; 
  -the increase in expensing to $500,000 / $2,000,000 and expanded definition of Section 179 property; 
  -the bonus depreciation; 
-the exceptions under Subpart F for active financing income; 
-the look-through treatment of payments between controlled foreign corporations;
  -the special rules for qualified small business stock;
-the reduction in S corporation recognition period for built-in gains tax; 
-the election to accelerate alternative minimum tax (AMT) credits in lieu of additional first-year depreciation;

OTHER PROVISIONS:

-the tax-free distributions from Individual Retirement Accounts (IRAs) for charitable purposes;
-the basis adjustment to stock of S corporations making charitable contributions of property;
-the special rules for contributions of capital gain real property for conservation purposes.

UPDATED PFIC AND CFC DEFINITIONS AND REPORTING RULES

The IRS has issued updated reporting regulations under Code Sections 1291, 1298, 6038 and 6046. A lot of the changes are technical definitions, and relate to updates from proposed regulations going back to 1992. A few highlights to alert readers to look further if these rules affect them, include:

a. Definitions of “pedigreed QEF,” “1291 fund,” and “shareholder” and “indirect shareholder” for Code Section 1291 purposes;

b. Rules relating to the application of the PFIC rules when estates and trusts are involved, including taking into account excess distributions under Code §1291;

c. Details regarding annual PFIC Form 8621 filing requirements, including how they relate to trusts and estates. Interestingly, an exception from reporting for PFIC stock that is worth under $25,000 ($50,000 for joint returns) has been provided; and

d. Updates to Form 5471 filing requirements.

TD 9650. Definitions and Reporting Requirements for Shareholders of Passive Foreign Investment Companies; Insurance Income of a Controlled Foreign Corporation for Taxable Years Beginning After December 31, 1986

CONTINUOUS EMPLOYMENT NEEDED TO DEDUCT MBA EXPENSES

Subject to certain exceptions, a taxpayer can deduct education expenses if (a) made to maintain or improve skills required in his business or employment, or (b) to meet the express requirements of his employer, or the requirements of law or regulations, imposed as a condition to retaining his salary, status or employment.

A taxpayer enrolled in an MBA program in 2009, and deducted his expenses. He claimed that that he was in the business of selling pharmaceuticals and that the MBA classes enabled him to obtain employment. His work history in 2009 was:

(a) January 1  to April 30 – oncology account specialist;

(b) May 1 to August 10 – unemployed;

(c) August 11 to October 1 – oncology account manager;

(d) October 2 to October 11 – unemployed;

(e) October 12 and after – professional for Walgreens (unrelated to drug sales).

Under the above rule, the taxpayer must be in business or be employed. This is why most students who go on to law school or business school after college cannot deduct their professional school costs.

Here, the Tax Court found that the taxpayer was not established in a trade or business before beginning the MBA program.  The Tax Court noted that carrying on a trade or business requires considerable continuous and regular activity – the sporadic employment of the taxpayer was not continuous enough for this purpose. While the taxpayer was “qualified” to engage in the business of selling pharmaceuticals, that is not the same thing as actually carrying on the business, either during the classes or before enrolling.

Hart, TC Memo 2013-289