TREATMENT OF PROPERTY THAT IS BOTH RENTED AND SOLD

A taxpayer in the business of selling property holds it in inventory. A taxpayer that rents property does not. In many circumstances, rental treatment is superior to inventory treatment – such property can be depreciated (and thus generate depreciation deductions), and it can be swapped in tax-free exchanges under Code Section 1031 for other like-kind property.

What if the taxpayer BOTH sells and rents property? In a recent Chief Counsel Advice, the taxpayer acquired property. Pending sale of the property, it rented it out. In selling property, it would typically swap the property for other property so as to minimize gain recognition on the swaps. The question was whether the taxpayer could depreciate the property and use Code Section 1031, or must the taxpayer hold the property as inventory instead.

There is no fixed rule in these circumstances. Instead, the taxpayer should examine its PRIMARY PURPOSE for holding the asset to determine whether it is inventoriable. In the situation that was analyzed, the IRS concluded the property belonged in inventory. Some of the factors noted by the IRS that tipped the scales towards inventory were (1) 91% of the taxpayer’s income came from sales with only 9% from rental operations, and (2) much of the new equipment was sold before it could be rented out. Of course, in this situation it was probably in the IRS’ interest to conclude the property was inventory, so as to deny the depreciation deductions and the gain deferral under Code Section 1031. Nonetheless, per the above facts it was probably a reasonable conclusion as to the taxpayer’s PRIMARY purpose.

Chief Counsel Advice 201025049

SUMMARY OF KEY PROVISIONS OF SMALL BUSINESS JOBS ACT OF 2010

Congress has now passed the Small Business Jobs Act of 2010. The Act provides some welcome tax relief to business that hopefully will spur growth and job creation. However, Congress was stingy, with most of the tax benefits expiring after 2011. I remember, even though it was many years ago, when if a tax benefit was a good idea, it was enacted permanently because it was a good idea, and would not expire after a few years. These days, tax legislation tends to make increases in penalties and compliance obligations permanent, while tax benefits and reductions are only temporary. If Congress was really serious about these issues, it would make the changes on a permanent basis (or at least as permanent as a law that could be changed at any time in the future can be).

Below is a summary of the key new provisions.

I. Expensing

     A. Increase of §179 annual expensing to $500,000 from $250,000 for 2010 and 2011

          1. Increase threshold for beginning of phase-out to $2,000,000

          2. Will allow expensing of some types of depreciable real property

          3. Reducing back to $25,000 in 2012

     B. Extension of 50% bonus first year depreciation for qualified real property

     C. First year depreciation cap for autos and trucks increased by $8,000 for 2010

     D. Deduction for start-up expenses increased to $10,000 from $5,000 for 2010 and 2011

II. Credits

     A. Eligible small business credits can be carried back 5 years instead of one year, and extension of carryforward periods

III. Gain Exclusions

     A. Gains from the disposition of qualified small business stock can now be 100% excluded (up from 75%) and will not be an AMT tax preference item for stock acquired before 2011

     B. S Corporation built-in gains period reduced to 5 years for 2011

IV. Misc.

     A. 2010 health insurance expenses are deductible in computing self-employment tax

     B. Substantiation requirements for cell phones and similar equipment are elimianted by removing them from being "listed property"

     C. Recipients of rental real estate income are deemed to be in a trade or business for information reporting requirements (and thus must report all expenditures of $600 or more)

     D. Increased penalties for failure to file information returns

V. Retirement Plans

     A. Roth options added to Section 457 plans

     B. Retirement plan distributions may be rolled over to Roth IRA accounts (other than periodic distributions, minimum required distributions, and hardship distributions)

VI. International

     A. Guaranty fees paid by a U.S. person are U.S. source income, as well as fees paid by a foreign person if effectively connected with a U.S. trade or business (overides Container Corp., 134 TC No. 5 (2010))

SEPTEMBER 20 IS NOT A FREE PASS TO REFORMING DESIGNATED BENEFICIARY TRUSTS

In a recent Private Letter Ruling, the IRS addressed a trust established by a decedent that was a beneficiary of the decedent's IRA. It was clear from the trust instrument that the decedent desired that the IRA payouts be based on the age of the designated beneficiary so as to defer distributions and income taxes, pursuant to applicable tax rules. However, the subject trust allowed for the appointment of a charitable beneficiary, which power prevented there from being a designated beneficiary that would allow for the "stretch" of the post-death IRA payouts. To address this situation, a state court action was filed and an order obtained that removed the problem power to appoint a charitable beneficiary. The question before the IRS was whether this state court reformation would be given retroactive effect so as to allow for a designated beneficiary.

Generally speaking, state court reformation of dispositive instruments will be respected by the IRS only if there is a specific tax statute authorizing such reformation. There is no such specific statutory authorization in regard to determining if there is a designated beneficiary of an IRA trust. However, the beneficiaries of an IRA are measured/determined on September 30 of the year following the death of the decedent. This would imply that if a reformation is undertaken prior to such September 30 date, such reformation should be given tax effect. Indeed, this reasoning was followed in Private Letter Rulings in the past that allowed qualification of a designated beneficiary through state court reformation actions.

In this most recent ruling, the IRS has changed its analysis, and it denied effective retroactive effect to the change to the trust. Thus, the state court reformation was not effective to allow the subject trust to have a designated beneficiary for IRA purposes.

It would appear that the IRS had legal wiggle room to provide a favorable result for the trust, as evidenced by its prior rulings. It will be interesting to see if the taxpayer under the subject ruling, or some similarly situated taxpayer, litigates this issue in the hopes that the court will adopt the IRS' earlier analysis of the issue.

PLR 201021038