2015 FT. WORTH CPA TAX INSTITUTE

Transcription

1 ROBERT D. PULLIAM, C.P.A. with Pulliam & Cable, P.C N. Central Expressway, Suite 1000 Dallas, Texas (FAX) 2015 FT. WORTH CPA TAX INSTITUTE

2 I. ABANDONMENT, WORTHLESSNESS AND RETIREMENTS. A. Abandonment of Non-depreciable Property Capital Loss/Ordinary Loss. 1. Partnership Interest abandonment Revenue Ruling a. Situation 1 General partnership with A, B & C as equal partners. During the year, partnership becomes insolvent, with only nonrecourse liabilities owed and shared equally among the partners. Partner C abandons the partnership interest. Because of the nonrecourse liabilities, there is a deemed distribution under Section 752(b) resulting in a sale/exchange. Therefore, the loss is a capital loss. b. Situation 2 Limited partnership with F as the only limited partner. Partnership became insolvent, but Partner F did not bear any economic risk of loss. Abandonment was an ordinary loss (Section ). c. Sale/exchange based upon the liabilities of the partnership (recourse/non-recourse) and share of the liabilities by the partners. Recourse liabilities generally allocated to the general partner. Non-recourse liabilities allocated to all partners generally based upon the partners interest in the partnership. (Even a de-minimis amount of liabilities would classify the transaction as a sale i.e., unpaid trade payables. Citron v. Commissioner, 97 T.C. 200,216 N.14(1991)). 2. Partnership Interest reporting requirements. a. Sale or exchange. 1) Schedule D Capital Loss. 1

3 2) Form 4797 Section 751 Ordinary income recapture for Section 1245 and b. Abandonment Loss Form 4797, Page 1, Part II. 3. Overriding Royalty Interests (ORRI). a. ORRI carved out of the working interest. b. When the working interest is terminated for whatever reason, the ORRI ceases. c. ORRI is a capital asset and in a sale or exchange would produce a capital gain/loss. d. Section 165 Non-depreciable property used in a trade or business or in a transaction entered into for profit. An abandonment is an ordinary loss, if the transaction is not a sale or exchange. 1) Ordinary loss treatment applies even if a capital asset (Section 165(f)). 2) Does not apply to worthless securities (165(g)). B. Abandonment of Depreciable Property. 1. Ordinary loss or Section 1231 loss depends on whether there is a sale or exchange. 2. Ordinary loss without a sale or exchange. Therefore, the ordinary loss avoids: a. Netting against Section 1231 gains. b. Recapture of Net Section 1231 losses for five years to offset future Section 1231 gains. C. Timing Issues and Documentation. 1. Non-producing leases. 2

4 a. Non-payment of delay rentals. b. Dry holes drilled on the lease or offsetting leases and internal documents prepared reflecting abandonment. c. Quit claim deed back to the land owners. d. No requirement to relinquish title (Echols v. Commissioner 935 F.2d 703 (5 th Circuit, 1991). However, taxpayer must demonstrate that abandonment has taken place.) 2. Depreciable property. a. Shut down of operations due to economic conditions. b. Drilling of a dry hole and equipment is not recoverable, even though actual plugging of the well is done in a subsequent year. 3. Worthlessness versus abandonment. a. Per Regulation (a) The taxable year in which the loss is sustained is not necessarily the taxable year in which the real act of abandonment, or loss of title to the property, occurs. b. Echols v. Commissioner 935 F.2d 703 (5 th Circuit, 1991). 1) Differentiates worthlessness and abandonment. Per the case, actual abandonment is not required in order to take a worthless loss. The court explained that the concept of worthlessness and abandonment are separate but equal grounds for loss deductions. 2) Based upon Regulation (a) and the Echols case, a loss deduction is not determined by abandonment. The IRS, in the Echols case, argued that the court was allowing the taxpayer to select the year of the deduction. However, the 3

5 case stated that the taxpayer may not arbitrarily deduct a loss in any year he chooses. Rather, the worthlessness is deductible in a year the property is worthless to him provided the worthlessness is demonstrable by identifiable events or closed transactions. 4. Events that do not constitute abandonment. a. Mere decline in value, unless 100%. b. Non-use, partial use or temporary idling of the asset. II.COST DEPLETION. A. Computation of Cost Depletion. 1. Regulation (a) Taxpayer computes reserves for cost depletion purposes by reference to the total recoverable reserves for each property. 2. Reserves estimate, under Regulation (c)(1). a. Recoverable mineral products reasonably known to exist. b. Calculation based upon current methods used in the industry. 3. Reserves estimates include a. Proved reserves, both developed and undeveloped. b. Probable. c. Prospective (possible). 4. Revision of reserves Regulation (c)(2). 4

6 a. No change in facts then end of the year reserves from the preceding year are the beginning of the year reserves for the current year. b. Estimated of reserves are revised only as a result of operations and development work that indicate greater or lesser units from prior estimates. c. Revision is made only if a material change in reserves is determined from the operational or development work. 5. Formula. a. Cost at end of period, less, accumulated depletion (percentage of cost allowed) at the beginning of the year. b. Units remaining at end of prior year, unless revision based upon operational or development factor. c. Cost per unit multiplied by units sold during period, based upon accounting method. 6. Analysis of formula. a. Cost at end of period automatically adjusts for costs incurred during the year. b. If reserves are changed, use units remaining at end of year; plus, current year production. Therefore, formula automatically adjusts for additional reserves discovered or lost during the year. B. Field Directive on Cost Depletion Determination of Recoverable Reserves July 30, 2004 Revenue Procedure Rules relate to 105% election for reserves but examples demonstrate the tax principles regarding overall tax reserves. 2. Situation #1 5

7 Beginning reserves Revisions Produced End of year 110 Units 0 Units -10 Units 100 Units No indication of development or operational work. Therefore, no change in reserves. 3. Situation #3 Beginning reserves 85 Units Revisions operational/development 0 Units Revisions economic Sales End of year -15 Units -10 Units 60 Units The revision due solely to change in economic conditions is not permissible for determining recoverable units. C. Internal Revenue Manual October 1, Regulation (a) IRS has traditionally allowed the use of dominant product or barrel of oil equivalent. 2. Taxpayers not permitted to adjust reserves based solely on economic factors, without operational or development work indicating materially different quantity. See Martin Marietta Comp v. United States, 7 C1 CT 586,85-1 USTC Note Coordinated Issue Papers dated January 13, 1997, states the same probation of changing reserves strictly on changes in price. D. Depletion Property by Property Computation Small Company Scenarios. 1. Royalties purchased 60 properties 6

8 Cost $600,000 Income $150,000 15% of gross $ 22,500 Reserves produced 5% Depletion for the year? 2. Working Interest 5 properties Cost $125,000 Income gross $ 30,000 Net income $ 12,000 15% of gross $ 4,500 Reserves produced 4% Depletion for the year? III. RECAPTURE OF 1254 and 1245 SALE OF S CORPORATION STOCK A. Sale of Stock and Potential Recapture 1. Section 1254 recapture Depletion and intangible drilling costs are treated as ordinary income on the sale of oil and gas properties by an S Corporation. 2. Per Regulation (b)(1), recapture under Section 1254 is calculated at the shareholder level. The regulation is consistent with the treatment of depletion and IDC calculated at the shareholder level. a. Gain is calculated on a property by property basis as if the shareholder had sold the property directly b. See examples under Regulation (b)(2) 7

9 3. Sale of S Corporation stock. a. Shareholder has to compute recapture under Section 1254 when stock is sold. Per Section 1254(b)(2), rules are similar to Section 751 assets (hot assets) for a sale of a partnership interest. b costs are recaptured as ordinary income to the extent of the gain. c. Exceptions to the general rule Regulation (c)(2). 1. Shareholder can demonstrate that the gain is not attributable to Section 1254 costs. a. Gain is calculated on a property by property basis b. Gain is calculated by property as if the corporation had sold all of its properties at fair market value 2. Contribution of property to an S Corporation before a sale of stock, pursuant to a plan to avoid recapture. In essence, the IRS unravels this transaction and taxes the shareholder as if he sold the properties directly. Therefore, this exception is of little, if any, value. B. Acquiring Shareholder Regulation (e)(f)&(g) 1. Section 1254 recapture items are zero at the date of acquisition if acquired by reference to cost under Section 1012 or by inheritance. 2. Gift Section 1254 recapture carries over. 3. Former C Corporation Section 1254 recapture as of the end of the year of the C Corporation, is allocated pro-rata to the S Corporation shareholders. 8

10 4. For certain reorganizations described in Section 368 or 351 transactions, reallocation of the aggregate of Section 1254 is reallocated among the shareholders. C. Section 1245 Recapture 1. Sale of stock none 2. Sale of properties by S Corporation Recaptured by the entity. Section 754 election is not applicable to purchased or inherited interests of S Corporation stock. IV. RECAPTURE OF 1254 AND 1245 DEDUCTIONS SALE OF A PARTNERSHIP INTEREST A. Step one Determine amount of unrealized Section 751 assets (751 gain). Gain on Section 751 assets is the amount of income or loss that would have been allocated to the partner if the partnership had sold all of its assets for cash equal to the fair market value of all the assets B. Gain on Section 751 assets is ordinary income. The gain is treated like a separate sale of the assets; therefore, the 751 gain is then added to the partnership basis as if the 751 assets were sold immediately before the sale of the partnership interest C. Example 1 Regulation (g)-AB Partnership A & B Partners Adjusted Basis Market Value Cash $ 3,000 $ 3,000 Loans 10,000 10,000 Corporate Assets 7,000 5,000 Unrealized Receivables 0 14,000 $ 20,000 $ 32,000 Notes Payable $ 2,000 $ 2,000 Capital A 9,000 15,000 9

11 - B 9,000 15,000 $ 20,000 $ 32, C buys B s interest for $15,000 B would recognize $7,000 in ordinary gain if AB sold all of its assets. 2. B recognizes $7,000 ordinary gain on the sale for the 751 gain. 3. B s recomputed partnership basis including the $7, gain is $16,000 ($9,000 + $7,000) producing a capital loss of $1,000 on the sale. D. Key issue Fair Market Value (FMV) of the partnership assets versus the sale proceeds of the partnership interest. If the sales proceeds of the partnership interest has been discounted for lack of marketability, minority interest and/or other discounts, then the FMV of the inside assets may be greater than the discounted sales proceeds. E. Gain or loss of the sale of public traded partnership interests are calculated in the same manner F. Section 751 assets - Regulation (c) oil and gas entities a. Unrealized accounts receivable b. Section 1245 and 1254 recapture amounts. c. See the regulation for possible other 751 gain assets. G. Sale of an inherited partnership interest or sale of partnership property after inheritance 1. Section 1254 costs Regulation (c)(2)(ii) a. If transferee acquires partnership interest from a decedent and the basis is determined by the fair market value of the interest 10

12 then the Section 1254 costs is zero on the acquisition date. b. Regulation (a)(s) treats surviving spouse s one-half share of community property as acquired from a decedent. c. Section 754 election would not be required to avoid 1254 recapture of decedent. 2. Section 1245 Recapture a. Section 754 election would be required to avoid 1245 recapture of decedent b. Election required for both a sale of a partnership interest or property sale by the partnership. H. Installment Sale - Recapture of Section 1245 and 1254 Amounts 1. Section 1245, depreciation recapture, reported in the year of sale, regardless of cash received. Recapture amount is then included in basis for subsequent payments. 2. Section 1254, depletion and intangible drilling costs, taxable as cash in received. However, the 1254 recapture applies until all the recapture has been reported. Regulation (d) 3. Applies to sale of individual properties or sale of a partnership or S Corporation interest. V. SECTION 59(e) ELECTION 60 MONTH AMORTIZATION. A. General Rules Final Regulation. 1. Previous election to expense IDC under Section 263(c) required. 2. Amortization period 60 months beginning in the month the expenditure was paid or incurred. 11

13 3. Election available for each individual partner or S Corporation shareholder if partnership or S Corporation made the election under Section 263(c). 4. Formal election under Section 59(e) required on a timely filed return, including extensions. 5. Election is irrevocable without the consent of the IRS. Per the regulations, consent will only be given in rare and unusual circumstances. 6. Purpose of law avoid tax preference on IDC. However, can be used for other tax planning. 7. Amortization is part of operating expenses to compute the limitation of percentage depletion. 8. Any portion of the IDC can be capitalized. Part or all of any property may be capitalized. 9. Sale of properties Amortized amount under 59(e) is recaptured at the time of sale. B. Sale of Property Basis. 1. Adjustments to basis Section 1016(a)(20). a. Basis adjusted for amounts allowed under 59(e). b. Unamortized costs would be written off in a sale or abandonment. 2. S Corporation shareholder. a. IDC reduces shareholder s basis. b. Sale of stock S Corporation shareholder recaptures under Section 1254 amounts to the extent of gain. VI. PERCENTAGE DEPLETION LIMITATION 65% OF TAXABLE INCOME, BEFORE DEPLETION. A. The taxable income is calculated without regard to: 12

14 1. Any depletion allowed under Section 613(c) (i.e. percentage depletion that exceeds cost depletion on a property-by-property basis). 2. Any net operating loss carryback to the taxable year. 3. Any capitol loss carryback to the taxable year. 4. In the case of a trust, any distributions to its beneficiaries. B. Taxable income is reduced by cost depletion that exceeds percentage depletion on a property-by-property basis. Cost depletion computed on transfers of proven property before October 11, 1990, would always be deducted for percentage depletion would always be zero. C. Interaction with other computational limitations i.e., medical deductions, contributions, etc. Two options. 1. Prioritize the deductions, using the unlimited depletion deduction to figure the adjusted gross income and then the medical deduction and taxable income. Then add back the unlimited percentage depletion to determine the 65% limitation and then re-compute the medical deduction and taxable income. 2. Simultaneous equations. See Revenue Ruling , C.B. 122 for computation involving percentage depletion and dividends received deduction. This method is more accurate but more complex. D. Example Interaction between cost and percentage depletion Example 1 Regulation 1.613A-4(a)(2). 1. Properties M, N & O. 2. Depletion: Cost Percentage M $40 $ 60 13

15 N 0 90 O Taxable income - $100. $50 $ Allowable percentage depletion - $ Allocate $65 back to properties on a pro-rata basis and compare again to cost depletion. Cost Percentage M $40 $19.50 N O $50 $ Since cost depletion on M of $40 is greater than the allocate percentage depletion of $19.50, the cost depletion is deducted. 7. Recomputed total depletion. M $ N O $ Carryover to subsequent year - $95 ($200 - $105). E. Other Issues. 1. Property disposed of with percentage depletion carryover. Reduce carryover by basis deducted from the sale and carry forward the balance. 14

16 Example: Sale of property 2014(ignoring any equipment application) XYZ lease Proceeds $300,000 Original cost $130,000 Accumulated depletion deducted Against taxable income 120,000 Net book value(nbv) $ 10,000 XYZ lease - Percentage 12/31/14 carryforward due to 65% of taxable income limitation before adjustment for sale of property $ 60,000 Computation of gain Proceeds $300,000 NBV 10,000 Gain $290,000 Recapture of depletion $120,000 Carryforward of percentage depletion Per above $ 60,000 Less, NBV deducted against sales Proceeds 10,000 Carryforward to 2015 $ 50, and subsequent years- depletion carried forward on sold property in 2014 subject to same limitation on percentage depletion as properties still owned. (i.e. can take depletion in 2015 and beyond on an asset sold in a prior year). 15

17 16