Estate and Property Tax Law

The Tax Court docket in Temporary – February 2021 #2 | Freeman Regulation

February 20, 2021

The Tax Court in Brief

Freeman Law’s “The Tax Court in Brief” covers every substantive Tax Court opinion, providing a weekly brief of its decisions in clear, concise prose.

For a link to our podcast covering the Tax Court in Brief, download here or check out other episodes of The Freeman Law Project.

The Week of February 8 – February 12, 2021

BM Construction v. Comm’r, T.C. Memo. 2021-13 | February 8, 2021 | Urda, J. | Dkt. No. 24352-17L

Short Summary: The IRS initiated an examination of the tax liabilities associated with Mr. Bernotas and his sole proprietorship, BM Construction. After issuing an initial report on May 7, 2014, the examination officer issued two Letters 950-D: (1) to Mr. Bernotas with respect to his income taxes on June 6, 2014; and (2) to BM Construction with respect to backup withholding tax liabilities on June 13, 2014. The examination officer detailed these actions in the file’s activity log and noted that neither of the mailed letters were returned. At more than one subsequent in-person meeting, Mr. Bernotas was notified of his appeal rights—particularly that he had 30 days from the date of Letter 950-D.

Mr. Bernotas did not file an official protest, and the examination officer closed BM Construction’s tax file. The IRS then assessed withholding taxes, penalties, and interest and issued a Notice of Intent to Levy and Notice of Your Right to a Hearing to BM Construction. Mr. Bernotas requested a Collection Due Process Hearing, and a CDP Hearing was held between a settlement officer and Mr. Bernotas’ CPA. The CPA attempted to dispute the underlying liability. The settlement officer noted that BM Construction was precluded from challenging the underlying liability and ultimately sustained the levy notice. BM Construction petitioned the Tax Court for review.

Key Issues:

  • (1) Whether BM Construction received a Letter 950-D with respect to the 2012 backup withholding tax liability; and
  • (2) Whether the settlement officer abused his discretion in sustaining the notice of intent to levy.

Primary Holdings:

  • (1) The examination officer mailed Letter 950-D to BM Construction on June 13, 2014, and BM Construction subsequently received that letter. BM Construction and/or Mr. Bernotas failed to offer credible rebutting evidence.
  • (2) The settlement officer did not abuse his discretion in sustaining the proposed levy action.

Key Points of Law:

  • Sole proprietorships and their owners, as well as single-member LLCs and their members, are a single taxpayer for federal tax purposes to whom notice is given. See Med. Practice Sols, LLV v. Comm’r, 132 T.C. 125, 127 (2009), aff’d without published opinion sub nom.
  • With respect to employment tax liabilities, “An opportunity to dispute the underlying liability includes a prior opportunity for a conference with Appeals that was offered either before or after the assessment of the liability.” See 26 C.F.R. § 301.6330-1(e)(3), Q&A-E2, Proced. & Admin. Regs.
  • The mailing of a properly addressed letter creates a “presumption that it reached its destination and was actually received by the person to whom it was addressed”, which a taxpayer must rebut with “credible” evidence. Rivas v. Comm’r, T.C. Memo. 2017-56, at *20.
  • A “taxpayer’s self-serving claim that he did not receive the notice of deficiency will generally be insufficient to rebut the presumption.” Klingenberg v. Comm’r, T.C. Memo. 2012-292, at *12, aff’d, 670 F. App’x 510 (9th Cir. 2016).
  • The determination by an appeals officer shall take into consideration the following: (1) verification that the requirements of any applicable law or administrative procedure have been met; (2) consideration of any relevant issues raised by the taxpayer; and (3) consideration of whether any proposed collection action balances the need for the efficient collection of taxes with the legitimate concern of the person that any collection action be no more intrusive than necessary. SeeR.C. § 6330(c)(3).

Insight: Notices and letters issued by the IRS are presumed to reach their ultimate destination unless credible evidence can rebut the presumption. BM Construction highlights the fact that self-serving statements from the taxpayer are not enough to overcome this presumption. Additionally, taxpayers should dispute a proposed tax liability during the examination process. Waiting to challenge the tax liability at issue until the taxpayer’s case is turned over to IRS collections will likely prove to be a problem.

Complex Media, Inc. v. Comm’r, T.C. Memo. 2021-14 | February 10, 2021 | Halpern, J. | Dkt. Nos. 13368-15 and 19898-17

Short Summary: Taxpayer-corporation (Corp.) acquired the assets of a business from a third-party partnership (P’ship). In exchange for the transferred assets, Corp. issued approximately 5 million shares of common stock. Immediately thereafter, Corp. redeemed 1.875 million of the common shares held by P’ship in exchange for $2.7 million in cash and Corp’s obligation to make an additional payment of $300,000 a year later. P’ship paid the cash and assigned its right to the additional payment to one of its partners in redemption of that partner’s interest in P’ship. Corp. claimed an increased basis of $3 million in intangible assets it acquired from P’ship and amortized that additional basis under I.R.C. § 197(a). The IRS disallowed the deductions under I.R.C. § 197(a).

Key Issues: Whether Corp. is entitled to the amortization deductions under I.R.C. § 197(a)?

Primary Holdings: Yes, in part, because: (1) Corp’s issuance and immediate redemption of 1,875,000 common shares had no economic substance and should be disregarded under the step transaction doctrine, with the cash and the deferred payment right treated as additional consideration for the assets Corp. acquired from P’ship; (2) the parties agree that I.R.C. § 351 governs the tax consequences of the transactions at issue and accordingly, P’ship recognized gain in the transaction to the extent of the $2.7 million cash it received and the fair market value of its right to the additional $300,000 payment; this increases the basis of the assets transferred to Corp.; and (3) when assets transferred in an I.R.C. § 351 exchange with taxable boot constitute a trade or business, the residual method of allocation prescribed by I.R.C. § 1060 can appropriately be used to allocate the boot among the transferred assets; consequently, P’ship’s gain in amortizable I.R.C. 197 intangibles, and the corresponding increase in asset bases allowed to Corp., is determined by subtracting from the agreed total asset value the estimated values of those assets other than amortizable I.R.C. § 197 intangibles.

Key Points of Law:

  • Section 197(a) allows taxpayers amortization deductions in respect of intangible assets that qualify as “amortizable section 197 intangible(s).” A taxpayer can recover its adjusted basis in an amortizable section 197 intangible over 15 years beginning with the month of acquisition. 197(a).
  • Section 197(d) identifies a broad range of assets as “section 197 intangible(s)”, including goodwill, going-concern value, workforce-in-place, business books and records, patents, copyrights, know-how, government licenses and permits, customer and supplier relationships, covenants not to compete, franchises, trademarks, and trade names. To qualify as “amortizable section 197 intangibles,” most section 197 intangibles have to meet three conditions. First, the taxpayer must have acquired the asset after August 10, 1993. 197(c)(1)(A). Second, the taxpayer has to hold the asset in connection with the conduct of a trade or business or other income-producing activity. Sec. 197(c)(1)(B). And third, subject to enumerated exceptions, the asset cannot have been created by the taxpayer. Sec. 197(c)(2). The exclusion for self-created intangibles does not apply to governmental licenses or permits, covenants not to compete, franchises, trademarks, or trade names. Id.
  • Section 351 generally provides nonrecognition treatment to incorporations and other transactions in which the controlling shareholders of a corporation transfer property to it in exchange for its stock. In particular, section 351(a) provides as a general rule: “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control * * * of the corporation.” Section 368(c) defines “control,” for purposes of section 351 and other specified sections, to mean “the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.” If a shareholder receives nonstock consideration in an exchange that would otherwise qualify for nonrecognition treatment under section 351(a), the shareholder cannot recognize any loss but has to recognize any realized gain in an amount not in excess of the sum of the money and the fair market value of any other nonstock property (collectively, boot) the shareholder receives. 351(b). The transferee corporation’s basis in property received in a section 351 exchange is “the same as it would be in the hands of the transferor, increased in the amount of gain recognized to the transferor on such transfer.” Sec. 362(a).
  • If a section 351 exchange includes a section 197 intangible, the transferee corporation is treated as the transferor shareholder “with respect to so much of the adjusted basis in the hands of the * * * (corporation) as does not exceed the adjusted basis in the hands of the transferor.” 197(f)(2)(A). The corporation, in effect, steps into the transferor’s shoes and can “continue to amortize its adjusted basis, to the extent it does not exceed the transferor’s adjusted basis, ratably over the remainder of the transferor’s 15-year amortization period.” Treas. Reg. § 1.197-2(g)(2)(ii)(B). Any increase in the basis of the section 197 intangible allowed by section 362(a) as a result of gain recognized by the shareholder is treated as though the corporation acquired the assets other than in a section 351 exchange (i.e., by the purchase). Treas. Reg. § 1.197-2(g)(2)(ii)(B).
  • For Section 351 purposes, and in applying the “control-immediatley-after” requirement of Section 351(a), Tax Court jurisprudence requires us to take the effects of the redemption into account—even if, as respondent would have us do, we were to treat the redemption as separate from the asset transfer. As explained in Intermountain Lumber Co., 65 T.C. 1025 (1976), a determination of “ownership” as that term is used in Section 368(c) and for purposes of control under section 351 depends upon the obligation and freedom of action of the transferee with respect to the stock when he acquired it from the corporation. Such traditional ownership attributes as legal title, voting rights, and possession of stock certificates are not conclusive.
  • A taxpayer owes the Commissioner the duty to be consistent in the tax treatment of items and will not be permitted to benefit from the taxpayer’s own prior error or omission. Cluck v. Comm’r, 105 T.C. 324, 331 (1995). This duty applies when, after the expiration of the period of limitations on assessing tax for an earlier year, the taxpayer, for the purpose of determining its tax liability for a later year, seeks to take a position on an issue of fact contrary to reporting or representations on which the Commissioner relied, or to which he acquiesced, in regard to the earlier year. See LeFever v. Comm’r, 103 T.C. 523, 543-44 (1994), supplemented by C. Memo. 1995-321, aff’d, 100 F.3d 778 (10th Cir. 1988). The duty of consistency is usually understood to encompass both the taxpayer and parties with sufficient identical economic interests. LeFever v. Comm’r, 100 F.3d at 788.
  • While a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not. Comm’r v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. at 149. Thus, a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof in which an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc. Comm’r v. Danielson, 378 F.2d at 775. Although Danielson itself did not involve a choice between the form of a transaction and its alleged substance, the Tax court and others have extended the Danielson rule to limit a taxpayer’s eligibility to challenge not only the terms of the contracts governing a transaction but also the form of the transactions as established by those contractual terms. And the Tax Court has long accepted that both the Danielson rule and Ullman’s “strong proof” test “apply beyond the confines of allocating payments to a convenant not to compete.” Coleman v. Comm’r, 87 T.C. 178, 202 (1986), aff’d without published opinion, 833 F.2d 303 (3d Cir. 1987).
  • But to the extent the Danielson rule limits a taxpayer’s eligibility to disavow the form of its transactions as well as the terms of the contracts that govern those transactions, the rule has no application to these cases because the Tax Court has never accepted the Danielson See Schmitz v. Comm’r, 51 T.C. 306, 316 (1968), aff’d sub nom. Throndson v. Comm’r, 457 F.2d 10122 (9th Cir. 1972).
  • As the Tax Court’s caselaw has evolved, it has become more hospitable to taxpayers seeking to disavow the form of their transactions. But, the taxpayer has to meet an additional burden in attempting to disavow transactional form, and such burden relates not to how much evidence but what that evidence must show. In these cases, the Commissioner can succeed in disregarding the form of a transaction by showing that the form in which the taxpayer cast the transaction does not reflect its economic substance. For the taxpayer to disavow the form it chose (or at least acquiesced to), it must make that showing and more. In particular, the taxpayer must establish that the form of the transaction was not chosen for the purpose of obtaining tax benefits (to etierh the taxpayer itself or a counterparty) that are inconsistent with those the taxpayer seeks through disregarding that form. When the form that the taxpayer seeks to disavow was chosen for reasons other than providing tax benefits inconsistent with those the taxpayer seeks, the policy concerns articulated in Danielson will not be present.
  • Much ink has been spilled on the question of how proximate various steps must be, in time or intention, for them to be combined under the step transaction doctrine. See, e.g., Andantech, LLC v. Comm’r, T.C. Memo. 2002-97. If the step transaction doctrine has any potency, it necessarily applies to combine a first step that occurs when a preexisting obligation requires the immediate execution of a second step that undoes the first.
  • Because the character of any gain recognized in a Section 351 exchange may differ depending on the nature of the transferred assets, a transferor who receives taxable boot in addition to stock of the transferee corporation must determine gain on an asset-by-asset basis. See Easson v. Comm’r, 33 T.C. 963, 975 (1960); see also Rul. 68-55, 1968-1 C.B. 140. The transferee corporation’s basis in each asset equals the transferor’s basis in the asset increased by the gain recognized by the transferor in the exchange of that asset for stok and boot. Easson v. Comm’r, 33 T.C. at 975.
  • The Tax Court looks with disavor on any effort by the IRS to take a position contrary to one of its reveue rulings. See, e.g., Rauenhorst v. Comm’r, 119 T.C. 157, 171 (2002) (rejecting the proposition that the Commissioner is not bound to follow his revenue rulings in Tax Court proceedings).
  • The Cohan rule allows the Tax Court to estimate the amounts of allowable deductions when there is evidence that the taxpayer incurred deductible expenditures. Ashkouri v. Comm’r, T.C. Memo. 2019-95. To do so, however, the Tax Court must have some basis on which to make an estimate. The Tax Court has relied on Cohan to estimate a taxpayer’s basis in property. See, e.g., Huzella v. Comm’r, T.C. Memo. 2017-210.
  • Under the residual method of Section 1060, the assets in each of seven classes are assigned, in succession, a portion of the purchase price equal to their fair market value. Reg. § 1.1060-1(a)(1). Any value not attributable to assets in the first five classes is assigned to Section 197 intangibles. Treas. Reg. § 1.338-6(b).
  • By its terms, Section 1060 applies to “applicable asset acquisitions.” Section 1060(c) defines “applicable asset acquisition” to mean “any transfer (1) of assets which constitute a trade or business, and (2) with respect to which the transferee’s basis in such assets is determined wholly by reference to the consideration paid for such assets.” Despite the statutory definition, Treas. Reg. § 1.1060-1(b)(8) provides: “A transfer may constitute an applicable asset acquisition notwithstanding the fact that no gain or loss is recognized with respect to a portion of the group of assets transferred.”

Insight: Complex Media is a 103 page reminder of the potential federal income tax complexities inherent in certain taxable or tax-free transactions. As discussed in the opinion, in many cases, taxpayers are bound to the transactional form they choose, even to their peril. This can lead to surprising tax results, particularly if not vetted by tax counsel.

Little Sandy Coal Company, Inc. v. Comm’r, T.C. Memo. 2021-15 | February 11, 2021 | Halpern, J. | Dkt. No. 17431-17

Short Summary: Little Sandy Coal Company, Inc. (the “Petitioner”) owns a shipbuilding subsidiary, Corn Island Shipyard, Inc. (“CIS”). In the course of developing 11 separate vessels, Petitioner claimed a research credit under Sections 38 and 41(a) for its taxable year ended June 30, 2014. CIS’s projects included, in part: Project 720 (building a tank barge under contract with Apex Oil, Inc.); Project 730 (building a dry dock for Detyens Shipyard); and Projects 749 and 750 with Tell City Boat Works.

The Internal Revenue Service disallowed the research tax credit noted above related to CIS’s developing the 11 vessels. As a result, the Internal Revenue Service determined a deficiency in federal income taxes and also assessed an accuracy-related penalty under Section 6662 for the same year.

The Petitioner ultimately petitioned the Tax Court. The Petitioner argued, in part, that substantially all of the activities of its subsidiary’s research in developing the vessels constituted elements of a process of experimentation for purposes of I.R.C. § 41(d)(1)(C) and Treas. Reg. § 1.41-4(a)(6) because more than 80 percent of the elements of each vessel differed from those of vessels CIS had previously developed.

Prior to trial, both the Petitioner and the Internal Revenue Service agreed to treat two of the vessels—Projects 720 and 730—as representative of the others in regard to the common issues. For purposes of this opinion, the Tax Court only addressed the specific issues below related to the four projects outlined above.

Key Issues:

  • (1) Whether the Petitioner conducted qualified research under I.R.C. § 41(d) with respect to the business components identified for Project 720 (Apex tanker) and Project 730 (dry dock);
  • (2) Whether any exclusion found in I.R.C. § 41(d)(4) applies with respect to the business components identified for Projects 720 and 730;
  • (3) The includible amount of qualified research expenses for the business components identified for Project 720 and Project 730; and
  • (4) The Tell City Boat Works (“TCBW”) issues with respect to Projects 749 and 750.

Primary Holdings:

  • (1) The Petitioner did not conduct qualified research under I.R.C. § 41(d) with respect to Projects 720 or 730;
  • (2) Because the Petitioner did not conduct qualified research, the Tax Court need not consider the applicability to either project of the exclusions provided in Section 41(d)(4);
  • (3) Because the Petitioner did not conduct qualified research, the Tax Court need not determine the includible amount of qualified research expenses for the business components identified for Projects 720 and 730; and
  • (4) Because the parties agreed to treat Projects 720 and 730 as representative in regard to the general issues common to all of the development projects, the issues related to Projects 749 and 750 are rendered moot.

Key Points of Law:

  • A taxpayer’s research credit includes 20 percent of any excess of the taxpayer’s “qualified research expenses (“QREs”) for the taxable year” over a prescribed “base amount.” I.R.C. § 41(a)(1).
  • A taxpayer’s QREs include any “in-house research expenses” and “contract research expenses” “paid or incurred by the taxpayer during the taxable year in carrying on any trade or business of the taxpayer.” I.R.C. § 41(b)(1).
  • Qualified services mean “services consisting of—(i) engaging in qualified research, or (ii) engaging in the direct supervision or direct support of research activities which constitute qualified research.” I.R.C. § 41(b)(2)(B).
  • Research is qualified research if it meets the four requirements provided in Section 41(d)(1) and is not covered by an exclusion provided in Section 41(d)(4). The four requirements are as follows: (1) the research expenditures must be eligible for treatment as expenses under Section 174; (2) the research must be undertaken to discover technological information; (3) the application of that information must be intended to be useful in the development of a new or improved business component of the taxpayer; and (4) substantially all of the activities of research must constitute elements of a process of experimentation for a purpose related to a new or improved function, performance, or reliability or quality. I.R.C. § 41(d)(1).
  • The fourth requirement of Section 41(d)(1) is arguably the most stringent requirement. See Union Carbide Corp. & Subs. v. Comm’r, T.C. Memo. 2009-50 (2009). The Regulations provide an arithmetic test for determining when “substantially all” of a taxpayer’s otherwise qualifying research activities in regard to a business component involve a process of experimentation. See Reg. § 1.41-4(a)(6).

Insight: The Little Sandy case emphasizes the importance of the fourth requirement of Section 41(d)(1) with respect to qualified research. The fourth requirement focuses on a taxpayer’s activities, not the physical components, supplies, or supervisors related to the research. Further, it appears that the taxpayer ultimately hampered its own case here where it agreed to treat two of its projects (vessels) as representative of the others. This foreclosed the Tax Court’s ability to separately evaluate the taxpayer’s other projects, such as the TCBW issues.

(View source.)