Tag: tax court

2016 Tax Court Opinions – A Year In Review

tax court opinionsSeveral notable tax court opinions were issued 2016 dealing with a variety of substantive and procedural matters. In our previous post –  Year in Review: Court Procedure and Privilege – we discussed some of these matters. This post addresses some additional cases decided by the court during the year and highlights some other cases still in the pipeline.

Transfer Pricing

Transfer pricing remains a hot topic in litigation. As discussed here, here and here the Tax Court accepted and rejected taxpayer arguments in several high-profile cases.

We have also written frequently on the 3M case, which involves whether the Internal Revenue Service’s (IRS) blocked income regulations are valid. That case has been submitted fully stipulated to the Tax Court and all briefs have been filed. For prior coverage, see here, here, and here.

Point: Transfer pricing is a point of emphasis with the IRS. Given that slight changes to a taxpayer’s transfer pricing methodologies can produce substantial adjustments, taxpayers need to continue to monitor judicial developments in the area. This includes not only how courts view the arm’s length standard, but also taxpayer challenges to the IRS’s rulemaking authority.

The Administrative Procedures Act and Deference to IRS Interpretations

Following the Supreme Court’s 2011 Mayo opinion, taxpayers have increasingly turned to the Administrative Procedures Act (APA) to challenge IRS actions. In addition to the posts linked above regarding APA challenges in transfer pricing cases, we have written about the QinitiQ and Ax cases dealing with whether an explanation provided in a notice of deficiency is insufficient under the APA. See here and here]. Additionally, the Supreme Court provided guidance in a non-tax case regarding the proper application of the APA in the analysis of the validity of agency regulations.

Another area we have frequently posted on is the level of deference afforded to IRS interpretations. Discussions of general deference principles and cases decided in 2016 can be found here, here, here, here, and here]. Additionally, as we noted here, the Supreme Court recently granted certiorari to decide the limits of Auer deference.

Practice point: Whether the IRS’s position in published or unpublished guidance is afforded deference, and, if so, the appropriate level of deference, is important to taxpayers both in planning their transactions and defending them before the IRS and the courts. This area continues to evolve, particularly in the area of Auer deference, and taxpayers need to be aware of new developments.

Information Reporting Requirements

The IRS’s Offshore Voluntary Disclosure Program remains a tool for noncompliant taxpayers to come to the IRS to resolve outstanding tax reporting matters. For an update on this subject, see here. The release of the Panama Paper in April 2016, which we wrote about here received considerable attention. A recent opinion out of a district court in California also provided more guidance on the willful standard for failure to file foreign information reporting forms. See here.

Practice point: OVDP remains open, but it could be closed by the IRS at any time. Noncompliant taxpayers need to consider all options in this area, and should consider which option might be best depending on their specific situation.

Penalties

The IRS has been increasingly asserting penalties in cases. We recently discussed here some of the penalty procedural rules at issue in the Graev case. We also discussed the substantial authority defense, as applied by the Fifth Circuit in Chemtech Royalty Associates. See here.

Point: Taxpayers who are facing penalty determinations and assessments should consider whether they may have any procedural challenges to the IRS’s method of approval and assessment of penalties, in addition to considering the more standard, substantive defenses like reasonable cause and substantial authority. It is important to adequately document your position prior to taking a tax return position to avoid any initial assertion of penalties by the IRS.

ARTICLE BY Todd Welty, P.C., Laura L. Gavioli, P.C., Elizabeth Erickson, Andrew R. Roberson & Kevin Spencer of McDermott Will & Emery
© 2016 McDermott Will & Emery

Tax Court Holds that a Trust can Qualify for the "Real Estate Professional Exception" of Section 469(c)(7)

Proskauer

The Tax Court recently handed down its decision in Frank Aragona Trust v. Commissioner, ruling that a trust can qualify for the real estate professional exception of Section 469(c)(7). By taking into account the actions of the trustees, a trust can be considered to be materially participating in real estate activities. This means that losses from real estate activities can be treated as nonpassive and therefore deductible in determining the trust’s taxable income. This decision is especially relevant to trusts that own business as it affects the application of the passive activity loss rules in Section 469 and whether income from those activities is subject to the new 3.8% net investment income Medicare surtax under Section 1411.

The Frank Aragona Trust (the “Trust”) was a Michigan trust that owned several pieces of real property and was also involved in the business aspects of developing and maintaining the property. The Trust had six trustees, three of whom were also employees of Holiday Enterprises, LLC (the “LLC”). The LLC was owned 100% by the Trust. The LLC also employed other professionals.

The Trust had losses in 2005 and 2006 from its real estate activities and deducted those losses(on the basis that they resulted from nonpassive activities) on its income tax returns. In issuing a notice of deficiency for those tax years, the Service determined that the real estate activities were passive under Section 469 and therefore any related losses were not deductible.

In general, real estate rental activity is considered passive regardless of whether the taxpayer materially participates in the real estate business. However, there is an exception for “real estate professionals” under Section 469(c)(7). Before the Tax Court, the Trustees argued that the Trust was a “real estate professional” as defined in Section 469(c)(7) so that the losses were considered to be from nonpassive activities and therefore deductible. To qualify for the real estate professional exception, a taxpayer must pass two tests. First, more than one-half of the personal services performed in a taxable year must be performed in real property trades or businesses in which the taxpayer materially participates. Second, the taxpayer must perform more than 750 hours or services during the taxable year in real property trades or businesses in which the taxpayer materially participates. The Service argued that the regulations to Section 469(c)(7) define “personal services” as “work performed by an individual in connection with a trade or business [emphasis added].” Because the trust was not an individual, it could not perform personal services and therefore did not fall under the Section 469(c)(7) exception.

The Tax Court rejected the Service’s argument that the trust could not be considered an individual under Section 469(c)(7) and the associated regulations. Further, the Court found that the Trustees’ participation in the real estate activities met the material participation requirements of Section 469(c)(7) because they were regular, continuous and substantial. The Court determined that the participation of the Trustees should be considered in determining whether the taxpayer (the Trust) materially participated in the real estate activities. The Service argued that the activities of the Trustee should only apply if they are performed in their capacity as Trustees (as opposed to employees of the LLC). Here, the Court looked to Michigan law, under which trustees are required to administer trusts solely for the benefit of the trust beneficiaries. The Court explained that the Trustees could not simply stop acting as Trustees because they were also employees of the LLC, so that their activities in other capacities could be considered in whether the Trust was a material participant in the real estate activities.

In summary, a trust may be able to qualify for the real estate professional exception of Section 469(c)(7). If the trust qualifies for the exception, losses from the associated real estate activities may be deductible on the trust’s income tax return. This distinction has increased importance with the application of the new 3.8% net investment income Medicare surtax under Section 1411.

Article By:

Albert W Gortz
George D Karibjanian
David Pratt
Mitchell M Gaswirth
Andrew M Katzenstein
Henry J Leibowitz
Of:
Proskauer Rose LLP