Code Section 752 Liabilities Include Obligations Under Construction Contract

Partners in a partnership receive adjusted basis in their partnership interests for their allocable share of partnership liabilities. Since basis will allow for distributions to be made to partners without gain, losses to be deducted by partners, and gain reduction on a sale of a partnership interest, such basis is often advantageous.

When thinking about what partnership liabilities count for this purpose, most practitioners will first think of promissory notes, mortgages, and other major booked liabilities of the partnership. A recent private letter ruling points out that other esoteric liabilities can enter this computation.

In the PLR, the partnership received “notice to proceed” payments from customers before it started with a construction project or a phase of a project. Such payments were not fully included in income when received because the partnership was reporting its construction income on the percentage of completion method – that method ties into the percent of work completed and not the receipt of payments.

So the partnership was receiving advance payments for services it would render. Since the partnership would have liability for failing to perform the work it had been paid for, the IRS allowed the notice to proceed payments to be treated as Section 752 liabilities to the extent not yet included in income.

PLR 201608005

Uniform Voidable Transactions Act (UVTA) Threatens Asset Protection Planning

The UVTA has been enacted in several states. The Act is a reworking of fraudulent conveyance law, which allows a creditor to avoid transfers made that attempt to put property beyond the reach of a creditor. A number of attorneys and others are beginning to realize that the UVTA is a threat to debtor protections that might exist outside of the UVTA.

For example, Section 10(b) of the Act reads "[a] claim for relief in the nature of the claim for relief under this Act is governed by the local law of the jurisdiction in which the debtor is located when the transfer is made or the obligation is incurred.” Thus, if a resident of a state without domestic asset protection trust provisions settles such a trust in another state, the settlor may not be able to rely on the law of that other state to protect himself or herself against a voidable transaction claim - Section 10(b), if applicable, would arguably require that the law of the home state of the debtor would instead apply. If that home state fraudulent conveyance or voidable transaction law was not as favorable as the law in the state of the asset protection trust, the assets of the asset protection trust may be exposed by reason of the UVTA. Likewise, a debtor that moves to a state with favorable exemption laws (e.g., Florida as to its homestead protections) may be unable to use those favorable exemption laws against claims of creditors for debts incurred before the debtor moved. This may push asset protection trust planning offshore.

Other concerns are being raised about how the UVTA may interfere with other business and tax planning, such as its potential application to swap powers in grantor trusts (which may be used to obtain a step up in basis at death) and transfer of property to business entities by debtors.

New FIRPTA Regulations

As previously noted, the Protecting Americans from Tax Hikes Act of 2015 modify the withholding provisions under FIRPTA. The Service has now issued regulations implementing the statutory changes. Key among them are:

     A. The increase of the withholding rate on dispositions of US real property interests from 10% to 15%;

     B. Implementation of a new reduced 10% rate of withholding when the US real property interest transferred will be used by the transferee as a residence and the amount realized for the property does not exceed $1 million;

     C. Eliminating from the cleansing rule (relating to the cessation of US real property holding company status for US corporations after they have disposed of all US real property interests) corporations that are or were formerly regulated investment companies or real estate investment trusts (see new Treas. Regs. §1.897-2(f)(2)(iii));

     D. Eliminating from the application of Code §897 real property interests owned directly or indirectly by qualified foreign pension funds (see new Code §897(l)); and

     E. Directions to use mailing addresses provided in the Instructions for Form 8288 for various FIRPTA filings.

T.D. 9751

Applicable Federal Rates - March 2016

Law Firm Hit by IRS After Paying out All Earnings as Deductible Compensation to Shareholders

A Chicago law firm operating as a corporation regularly zeroed out its taxable income by making year-end bonuses to its shareholders and deducting such payments as compensation. The IRS attacked the reasonableness of the compensation, seeking to convert some of the payments to taxable dividends, and thus increasing the corporation’s taxable income and income taxes. The Tax Court agreed.

The Tax Court applied the “Independent Investor Test” to attack the amount of deductible compensation. This test is based on the premise that the owners of an enterprise with significant capital are entitled to a return on their investments - they would not agree to the corporation paying out all of the net revenues of the company to employees on a regular basis since that would leave no net income to pay to the shareholders a return on capital (via dividends). Since the law firm had over $8 million in paid in capital, this was an open door for the IRS and Tax Court to convert some of the payments to nondeductible dividends.

In determining the amount of capital, the Tax Court declined to add to it intangible assets not on the books,such as the firm’s reputation and customer lists - a good thing for the corporation.

So a lesson from the case is to look closely if a corporation is regularly paying out all of its net revenue as compensation to its shareholders.

Of course, if the operating business is not a ‘C’ corporation (i.e., it is an ‘S’ corporation, LLC, or other pass-through entity), then the issue of deductibility of the compensation is minimized since the entity does not pay any income tax.

This case was also interesting since the law firm sought to avoid penalties based on reasonable cause and good faith per its reliance on an accounting firm to prepare its tax returns. This was rejected because the law firm did not specifically advise the law firm on the deductibility of the bonuses, and that the law firm did not provide accurate information to the accountants.

A question discussed was whether the law firm’s silence on the issue of deductiblity (i.e., its failure to discuss it with the law firm) constituted “advice” upon which the taxpayer could reasonably rely to avoid penalties. Silence is not advice, said the Tax Court:

In prescribing detailed rules regarding the content of professional advice on which a taxpayer can rely, the regulations necessarily contemplate advice that, in some form, involves an explicit communication. Silence cannot qualify as advice because there is no way to know whether an adviser, in failing to raise an issue, considered all of the relevant facts and circumstances, including the taxpayer's subjective motivation. Indeed, an adviser's failure to raise an issue does not prove that the adviser even considered the issue, much less engaged in any analysis, or reached a conclusion. As we observed in Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 100 (2000), aff'd, 299 F.3d 221 [90 AFTR 2d 2002-5442] (3d Cir. 2002): “The mere fact that a certified public accountant has prepared a tax return does not mean that he or she has opined on any or all of the items reported therein.” Thus, we conclude that McGladrey's failure to raise concerns about the deductibility of [*33] the yearend bonuses did not constitute “advice” within the meaning of section 1.6664-4(c), Income Tax Regs.

Brinks Gilson & Lione A Professional Corporation, TC Memo 2016-20

Delay in Need to Report Basis

Currently, taxpayers have until February 29, 2016 to file Forms 8971 for estate tax returns previously filed. Form 8971 is used to report basis to beneficiaries of inherited assets, pursuant to provisions that came into law in 2015.

The IRS is providing taxpayers with a further breather – such forms now need not be filed with the IRS nor furnished to a beneficiary until March 31, 2016.

Notice 2016-19

Form 8971 Filing Unhappiness

The IRS has now issued a final Form 8971 and instructions. If you recall, this Form is newly required by executors of estates filing a Form 706 (federal estate tax return). The Form requires a schedule for each beneficiary which lists the assets received by the beneficiary and the estate tax value of those assets. The purpose is to put documentation in the hands of the beneficiary to allow it to calculate basis in the received assets. This will allow the beneficiary to calculate gain or loss on a subsequent sale of the assets received.

The form must be completed within 30 days of the filing of the Form 706. Unfortunately, many estates and related trusts will not have wound down their administration by that point and may not have identified (or be capable of identifying) assets that will be given to each beneficiary. So how should the Form 8971 be filed if the assets going to each beneficiary cannot be identified by the due date?

The instructions give us the unhappy direction to report all potential assets that could go to the beneficiary in this circumstance. More particularly, the instructions provide:

All property acquired (or expected to be acquired) by a beneficiary must be listed on that beneficiary's Schedule A. If the executor has not determined which beneficiary is to receive an item of property as of the due date of the Form 8971 and Schedule(s) A, the executor must list all items of property that could be used, in whole or in part, to fund the beneficiary's distribution on that beneficiary's Schedule A.

Then, when more precise information is known about the allocation of assets, an updated Form 8971 is then filed.

Sounds like fun times for practitioners!

Besides the difficulties in preparing such schedules, can you imagine the questions and concerns that beneficiaries will have upon receiving such a large and misleading schedule? Surely, some of them will think that they are going to receive all the assets listed on the schedule.

Since this is a known problem with the new statute that requires the disclosure form, and the IRS does not provide any real relief in its instructions, perhaps Congress might take up an amendment to the law that the due date for the Form 8971 is deferred until either actual distribution is made to the beneficiary or the assets to be distributed to the beneficiary can be precisely identified.

Form 8971; Form 8971 Instructions