TAX MATTERS

TAX BRIEFS

BLENDED FAMILY AN “UNFORESEEN CIRCUMSTANCE” FOR HOME SALE
he IRS said a marriage that resulted in a large, combined new ­family was an “unforeseen circumstance” provided for in IRC § 121(c)(2)(B) that allowed a taxpayer to benefit from the capital gain exclusion on the sale of his principal residence. Letter Ruling 200725018 said the taxpayer could take advantage of the exclusion even though he owned the residence for less than two years.

Normally, a taxpayer must reside in a home as a principal residence for at least two of the previous five years before taking advantage of the capital gains exclusion of IRC § 121(a) on the sale of the home. A taxpayer may exclude up to $250,000 of gain; married taxpayers filing a joint return may exclude up to $500,000 of gain if they meet the conditions of section 121(b)(2).

The ruling involved a taxpayer called “Bill,” who has two children. He married “Andrea,” who has three children. Bill and Andrea each sold their principal residences so they could buy a larger home to accommodate the larger combined family. Bill owned his residence for less than two years.

The IRS said that under Treas. Reg. § 1.121-3(e)(1) the marriage and combining of families was an event the taxpayer could not reasonably have anticipated before buying his old residence. The event also altered “the suitability of the property as the taxpayer’s principal residence” under Treas. Reg. § 1.121(b)(2). The IRS agreed that a larger home with more bedrooms was needed to suitably accommodate a blended family that includes adolescent children of the opposite sex.

The ruling does not say how long Bill owned the residence or the amount of any gain he had from the sale. In any case, he would only be allowed to claim a pro rata portion of the $250,000 exclusion, as calculated under IRC section 121(b)(1).

FOREIGN TAX CREDIT FORM REVISED
he IRS is requesting comments to proposed changes to Form 1118, Foreign Tax Credit—Corporations. U.S. corporate taxpayers use the form to compute the foreign tax credit for certain taxes paid or accrued to foreign countries or U.S. possessions. As noted in IRS Announcement 2007-62; 2007-29 IRB 1, the changes are a response to amendments to IRC § 904 relating to the number of ­separate foreign tax credit limitation ­categories and the effect of overall domestic losses.

The changes, contained in the American Jobs Creation Act (AJCA) of 2004, generally reduced the number of separate categories under section 904(d) from eight to two, effective for tax years be­ginning after Dec. 31, 2006. The AJCA also added section 904(g), which provides for recharacterization of U.S.-source income as foreign-source income in cases in which a taxpayer’s foreign tax credit limitation has been reduced in an earlier year as the result of an overall domestic loss.

Comments on the revised Form 1118 can be mailed to Tax Products Coordinating Committee, Internal Revenue Service, SE:W:CAR:MP:T, Room 6406, 1111 ­Con­sti­tution Ave., N.W., Washington, DC 20224, or e-mailed to tfpmail@publish.no.irs.gov. Comments must be received by Sept. 10. The proposed revisions can be viewed at www.irs.gov/taxpros/lists/0,,id=97782,00.html.

TAX CASE

SETTLEMENT DOESN’T LEGITIMIZE SHAM
he U.S. District Court of New Hampshire ruled that a taxpayer couldn’t claim losses stemming from partnerships’ transactions that lacked economic substance, even though a settlement with the IRS had allowed some of their claims.

Richard Nault invested in several agricultural limited partnerships between 1984 and 1986 that reported significant losses the first year and small amounts of income subsequently. In 1987, the IRS audited the partnerships and rejected the losses. In 2001, the partnerships and IRS settled the case, disallowing 72% of the losses as lacking economic substance but permitting the partnerships to retain investment tax credits. The IRS also adjusted Nault’s returns for the three years, and he paid additional taxes. Meanwhile, the partnerships terminated as a result of the controversy.

In 2002, Nault filed amended returns for six years claiming ordinary loss deductions under section 165 by “restoring” his basis in the partnerships based on the disallowed losses and the partnership interests having become worthless. The IRS denied Nault’s refund claims, saying since the partnerships’ settlement had conceded that the transactions had lacked economic substance, Nault was not entitled to a loss deduction stemming from them. The taxpayer countered that since the partnerships had been allowed to keep the investment credit and he had to pay tax on some income, there was the requisite profit motive. In rejecting Nault’s argument, the district court also noted that results of unified partnership audit procedures under the Tax Equity and ­Fiscal Responsibility Act could not be litigated at the partner level.

Richard M. Nault v. U.S., 99 AFTR2d 2007-1027.

Prepared by Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accountancy and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

TAX CASE

YOU SAY OMIT, I SAY UNDERSTATE
he Tax Court recently held that an understatement of gain by a partnership due to overstating its basis on a section 754 election did not result in an omission of gross income. Thus a proposed gain adjustment by the IRS was not timely, since it occurred after the expiration of the normal three-year statute of limitations period. The extended six-year limitations period of IRC §§ 6501(e)(1)(a) and 6229(c)(2) did not apply because there was no substantial omission of gross income, the court said.

Generally, the IRS must assess additional tax within three years of the later of the due date of the return or the date of its filing. A substantial omission of gross income—defined as exceeding 25% of reported gross income—extends the period to six years. (No time limit applies to a fraudulent return or failure to file.)

Bakersfield Energy Partners sold oil and gas properties in 1998, reporting a gain of nearly $5.4 million. In 2005, before the six-year statute of limitations period had expired, the IRS issued a Notice of Final Partnership Administrative Adjustment reducing the basis of the property to zero, thereby increasing Bakersfield’s gain by more than $16 million. The IRS claimed the understated gain was a substantial omission of Bakersfield’s gross income, which permitted the application of the six-year period.

Bakersfield argued the 1998 tax year was closed, based on Colony Inc. v. Commissioner, 357 U.S. 28 (1958), in which the Supreme Court held that the longer statute of limitations period did not apply when a taxpayer in the land development business understated its income from the sale of lots in a subdivision by overstating their basis. In that case, the Court held that gross income was not omitted, since the word omission implies “left out,” not understated. When income is omitted, it is much more difficult for the IRS to detect errors, since nothing is reported, and the additional three years helps the IRS overcome that difficulty. The Court reasoned that the additional time is unnecessary for an understated amount, since the IRS has something to question and examine.

The IRS argued that the holding in Colony applies only to situations involving the sale of goods or services during the ordinary course of business and does not apply to Bakersfield, since it sold business property used to sell goods or services. The Tax Court disagreed with that limitation, adopted Colony’s reasoning on the statute of limitations period and granted summary judgment against the IRS.

After the Bakersfield decision, the Court of Federal Claims ruled on a ­similar fact pattern in Grapevine Imports Ltd. v. U.S., 100 AFTR2d 2007-5065 (7/17/07), and likewise concluded that an overstatement of basis is not an omission that triggers the six-year statute. The decision cited and closely followed the rationale of Bakersfield and also relied heavily on the Colony precedent.

Bakersfield Energy Partners LP v. Commissioner, 128 TC no. 17.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.

TAX CASE

D.C. CIRCUIT SWITCHES POSITION IN MURPHY
he Court of Appeals for the D.C. Circuit recently reissued its opinion in Murphy, Marrita v. IRS (see “Tax Matters,” JofA, Feb. 07, page 70). The original opinion was released in August 2006, and vacated in December 2006, after the IRS requested a rehearing en banc. The request was denied; however, the same panel agreed to rehear the case, this time reaching a different decision.

The case arose after the taxpayer sued her former employer when she was blacklisted for being a whistleblower. The administrative law judge awarded her damages for emotional distress and injury to professional reputation. Although the taxpayer suffered physical ailments as a result of her emotional distress, none of the damages were specifically labeled as being for such physical injuries. The taxpayer attempted to exclude the damages under IRC § 104(a)(2), and the IRS disallowed the exclusion because the damages were not paid on account of physical injuries. The taxpayer argued that because physical injuries resulted from her emotional distress, the damages were excludable.

Consistent with its original opinion, the D.C. Circuit held that the damages could not be excluded under section 104(a) because they were not paid “on account of” physical injury. This time the court elaborated on its position. Citing the Supreme Court in O’Gilvie v. U.S., the court stated that there must be a strong causal connection between the physical injury and the damages. Since the taxpayer could not demonstrate that the damages were a direct result of the physical injuries, she was not entitled to the exclusion.

Exclusion aside, the taxpayer alternatively argued that the damages did not constitute income within the 16th Amendment, and taxation of such damages was therefore unconstitutional. The taxpayer likened damages for nonphysical injuries to a return of human capital, and under this view the damages do not fit within the Supreme Court’s often-cited definition of income in Glenshaw Glass, as an accession to wealth. Contrary to its original opinion, the D.C. Circuit now disagrees with this position.

In its latest opinion, the court noted that IRC § 61 defines income broadly, and accordingly the Glenshaw Glass definition is not the only way an item can be considered income. The court focused on the 1996 amendment to section 104, which narrowed the exclusion by adding the specific language “emotional distress shall not be treated as a physical injury or physical sickness.” The court reasoned that the amendment to section 104 would have no effect unless damages for emotional distress are income within section 61. The amendment is therefore evidence that Congress considers such damages to be income.

The court did not attempt to discern whether such damages would have been considered income by the framers of the 16th Amendment, as it had in its August 2006 opinion. The court’s constitutional analysis instead focused on a new argument raised by the government in the rehearing—that the tax is constitutional because it is not a direct tax but rather an excise tax. The court agreed, finding the tax was more like a tax on a transaction than a capitation tax, and since the tax is imposed uniformly, Congress has the power to tax such damages under Article 1 of the Constitution.

Murphy, Marrita v. IRS, 100 AFTR2d 2007-5075.

Prepared by Laura Lee Mannino, CPA, LL.M., assistant professor of accounting and taxation, St. John’s University, Jamaica, N.Y.

TAX CASE

MATCHING ASSET VALUES FOR INCOME AND ESTATE TAX
wo recent cases confirm that the income tax basis of inherited property is the same as the amount agreed upon for estate tax purposes. The Second and Ninth circuit courts of appeals held that two brothers, as heirs of their father’s estate, must use as their income tax basis the discounted fair market value that was used on the estate tax return.

Sidney Janis transferred ownership of his New York City art gallery and its assets to a trust, with himself and his sons, Carroll and Conrad, as the co-trustees. Upon the elder Janis’ death, the sons inherited the estate, including the trust assets. The sons were also co-executors of their father’s estate, and they chose the alternate valuation date for the 464 pieces of artwork, which Sotheby’s appraised individually for a total of $25,876,630. The co-executors took a 52% blockage discount for the artwork on the estate tax return and valued it at $12,403,207. The IRS audited the estate tax return, and the IRS Art Auditing Panel reviewed most of the pieces of art. The panel arrived at a value of $36,636,630, but applied a 37% discount for blockage, arriving at a final value of $22,955,077.

The co-executors and the IRS agreed to a value of $14.5 million in 1994, and estate taxes were paid on that value. The sons then amended the trust income tax returns for 1990, 1991 and 1992 to reflect the Art Advisory Panel’s fair market value of $36,636,630, which increased the cost of goods sold and reduced the gain on their sale. The IRS audited the sons’ personal income tax returns for 1995, 1996 and 1997, when they were operating as a partnership, and issued deficiencies for each year. The sons and their wives petitioned the U.S. Tax Court, which agreed with the IRS.

Carroll and Conrad Janis appealed to the Second and Ninth circuits, respectively. They argued that policies motivating the application of the blockage discount to determine the fair market value of estate assets do not justify using the same market value when the asset is sold. Both circuits disagreed and affirmed the Tax Court’s decision.

The Second Circuit stated that using the same basis for estate tax purposes and later for income tax purposes avoids double taxation. The estate tax, based on the fair market value at date of death, taxes any unrealized capital gain. To avoid double taxation, the cost basis of inherited property that is later sold is the fair market value at the time of death, resulting in a step-up in basis. If the inherited property is later sold, the only gain that is taxed is on any increase in value after date of death. The court pointed out that the sons benefited from a lower fair ­market value as of date of death for estate tax purposes. They then attempted to reduce income taxes on the sale of the inherited property by using an undiscounted value as the cost basis for determining gains/losses.

The Ninth Circuit found the Tax Court correctly required Conrad Janis to use the artwork’s discounted value as the basis for calculating cost of goods sold from 1990 through 1997 because the duty of consistency promotes fairness and the administration of justice. The court found that the sons agreed with the IRS on a valuation of $14.5 million but took a different position after the limitation period.

Carroll Janis v. Commissioner, 98 AFTR2d 2006-7836.
Conrad Janis v. Commissioner, 98 AFTR2d 2006-6075.

Prepared by Gary D. Rider, J.D., instructor of business, and Darlene Pulliam, CPA, Ph.D., McCray professor of business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.