Taxpayer Met Material Participation Standard Based on the "Facts and Circumstances" Test (Wade v. Commissioner, TC Memo , 8/20/14)...

Transcription

1 Taxpayer Met Material Participation Standard Based on the "Facts and Circumstances" Test (Wade v. Commissioner, TC Memo , 8/20/14)... 2 Failure to Show Taxpayer Had Either More Hours in Real Estate Than at Other Job and More Than 750 Hours in Real Estate Fatal to Claimed Real Estate Professional Status (Graham v. Commissioner, TC Summary , 8/19/14)... 3 IRS Makes Revision to LCM Retail Inventory Method and Provides for Automatic Accounting Method Change (TD 9688 and Revenue Procedure , 8/15/14)... 4 Bank Liable for Failure to Honor Levy, Despite IRS Putting Taxpayer on Notice of Intent to Levy Bank Account and Taxpayer Taking Funds Less Than 2 Hours After Levy Served on Bank (United States v. JPMorgan Chase, 2014 TNT , Docket No. 2:13-cv-03291, US DC Central District of California, 8/15/14)... 5 CFO Still Responsible Person Despite Lender's Refusal to Advance Funds to Pay Payroll Taxes, Rather Demanding Payment of Other Expenses (In re: Cherne, Bankruptcy Court of Idaho, Bankruptcy Case No JDP, 8/7/14)

2 Wade v. Commissioner The Tax Court found an application for the facts and circumstances test for material participation in an activity for purposes of IRC 469 s passive activity rules in the case of Wade v. Commissioner, TC Memo , In the case in question the IRS was treating over $3 million in losses of the taxpayer as passive losses, while the taxpayer claimed to meet the material participation standard. The main issues involved two related S corporations, shares of which were held by the couple in question. Mr. Wade had founded the original company in question in 1980, and developed the processes used by both companies in their manufacturing process and established and managed their industrial facilities. In 1994 Mr. Wade s son left his job with Lockheed Corp., moved to Sulphur, Louisiana where the companies were located. and became involved with the business. The son received stock and handled the day to day management of the entities. Mr. Wade moved away to Florida and concentrated primarily on product and customer development from his (now remote) location. In the economic crisis of 2008 the company s began to struggle financially. To boost morale, Mr. Wade made three trips to the company s facilities to assure employees the company would continue to operate. He also increased his research and development activities during this time, inventing various new techniques of use to the businesses. He also obtained a new line of credit for the companies to assure that there would be adequate cash available. The IRS argued this was all well and good, but Mr. Wade failed to show he had material participation in the activity. While the court doesn t directly explain the IRS s conclusion, most likely the IRS decided that when Mr. Wade left the area and moved to Florida, he no longer was materially participating in the activity. Mr. Wade argued that he met the 500 hour test in 2008 and, as well, met the facts and circumstances test. The Court did not address the first test because it found he clearly met the second test. To meet the facts and circumstances test of Reg T(a)(7) the taxpayer have a minimum of 100 hours of participation and show that he participated in the activity on a regular, continuous and substantial basis. 2

3 The Court found he had shown 100 hours of activity and, concluding that without Mr. Wade s actions the company would have failed that the actions met the regular, continuous and substantial basis test for Specifically the Court found: TSI and Paragon are complex businesses that Mr. Wade built from the ground up and in which he continued to play a vital role. He was not merely a detached investor, as has often been the case when we have found that a taxpayer did not materially participate. Graham v. Commissioner The IRS continued its generally successful crusade in the Tax Court against taxpayers who have regular jobs not related to real estate in attempting to claim real estate professional status in the case of Graham v. Commissioner, TC Summary , Mr. Graham worked as a salaried employee for two wireless phone carriers in the year in question in addition to owning a number of rental properties. He claimed a deduction for the rental losses by claiming he qualified as a real estate professional under the provisions of IRC 469(c)(7) and therefore those losses were not subject to limitation as being passive activity losses. In order to qualify as a real estate professional, Mr. Graham has to meet the twopronged test found at IRC 409(c)(7)(B) which provides: Taxpayers to whom paragraph applies. This paragraph shall apply to a taxpayer for a taxable year if (i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and (ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates. 3

4 In this case, Mr. Graham must show he spent more time on the real estate activities each year than he did as a salaried employee of the two wireless carriers and that his hours in the real estate activities exceeded 750 hours. The Court found Mr. Graham failed to demonstrate that he met either of the two tests. The taxpayer argued that, being a salaried employee, the carriers did not maintain time sheets on his activity. And, as well, he did not maintain a time log, rather estimating his time. His initial estimate for 2008 had him performing 917 hours in the real properties and 1,640 hours working for a wireless carrier. However, he later discovered this was an error and reduced his hours working for the carrier and found additional rental time. He also introduced letters from other employees at the carrier to attempt to document that he really didn t work that much there but these letters included some from individuals who admitted they did not work at the carriers during the years in question. As well, even though he had a W-2 from the second carrier in 2009, he did not include any hours working for the second carrier in his other activities summary. The records for hours at the rentals were reconstructed during the exam and the Court found a number of entries that appeared to claim excessive hours for the claimed work, found unlikely a claim that he met with the tenant of a property five times during the year when no rent was received on that property and that every entry for showing a property ended up with a recorded time of exactly two hours. Thus the Court found neither set of records persuasive to prove the points that Mr. Graham had to show and the passive losses in excess of passive income were disallowed on the returns. The IRS has issued final regulations (TD 9688, under 471 (Reg ) that modify the calculation of inventory under the lower of cost or market retail inventory under IRC 471. Under the retail inventory method, a taxpayer computes the value of inventory at its retail price and then multiplies that by a factor that is computed based on purchase costs contained in beginning inventory and acquired during the year, based on the following formula: 4

5 퐵푒푔푖푛푛푖푛푔퐼푛푣푒푛푡표푟푦 퐶표푠푡표푓푃푢푟푐h푎푠푒푠푓표푟푌푒푎푟 푅푒푡푎푖푙푃푟푖푐푒표푓퐵푒푔푖푛푛푖푛푔퐼푛푣푒푛푡표푟푦 퐼푛푖푡푖푎푙푅푒푡푎푖푙푃푟푖푐푒표푓푃푢푟푐h푎푠푒푠 The final regulations prohibit a taxpayer from reducing the numerator of the above equation sales-based vendor chargebacks this is related to or intended to compensate for a permanent markdown of retail selling prices. The regulations apply to tax years beginning after December 31, The IRS also issued Revenue Procedure , modifying Revenue Procedure , which provides for the exclusive method a taxpayer may use to conform its use of the retail inventory method to the final regulations. A new automatic method change (number 204) is added at section of the Appendix to Revenue Procedure to allow for this required change. The adjustment is to be made on a cut-off basis thus there will not be 481(a) adjustment computed, but the entire adjustment will be picked up in the year of change. Due to the nature of computation used for retail method, not allowing a cut-off method would have effectively required taxpayers to go back to the first year the taxpayer used the retail method and then recompute ending inventory for each intervening year. Chase United States v. JPMorgan A bank ended up being found liable for failing to act within two hours to freeze a taxpayer s accounts after being served with a jeopardy levy in the case of United States v. JPMorgan Chase, 2014 TNT , Docket No. 2:13-cv-03291, US DC Central District of California. The situation started when the IRS issued a refund check of $78,169 to a taxpayer that it later determined owed the IRS a significant amount of money. The IRS approved the issuance of a jeopardy levy. An IRS Revenue Officer went to the taxpayer s house at 9:30 am with a levy in hand, and told the taxpayer that he owed the IRS roughly $93,000 and demanded payment. 5

6 When the taxpayer did not pay the amount in question the Revenue Officer served the taxpayer with various documents, including notice that the IRS intended to levy his bank accounts. The Revenue Officer then went to a local bank branch and delivered a levy to an employee of the bank at 9:50 am. At the time the taxpayer had two accounts with the bank, one with just over $40,000 in it and other with a balance of $7,325. The taxpayer, deciding that he who hesitates may very well be lost in this case, went to a branch of the bank before noon and withdrew $40,000 from the larger account. The bank did not actually freeze his accounts until two days later and, at that time, sent over the remaining balance. The IRS, not surprisingly, did not succeed in collecting from the taxpayer, so it sought to collect $40,000 from the bank, arguing that it was liable as it had given the funds to the taxpayer after being served with the levy. The bank argued that it was unreasonable to hold them liable in a case like this when the taxpayer moved so quickly to withdraw the funds in question. Also, the Bank pointed out that while the IRS was required to make a demand for payment to the taxpayer before serving the levy on the bank, the agency was not required to notify the taxpayer that it was going to levy against his assets. The IRS not only did that, but informed the taxpayer which asset (the bank accounts in this case) it would move against. In the bank s view it should be granted a reasonable time to comply with the levy and, in any event, the IRS agent s ill-advised disclosure of where he was going immediately after being turned down for payment by the taxpayer clearly contributed to the loss of the funds The Court did not agree. The Court noted: Nevertheless, while telling Waterman of the levy itself was clearly improper, there are only two defenses to a violation of 26 U.S.C. 6332, which holds parties liable for failing to surrender property subject to a levy. First, that the defendant "did not possess any property or rights to property of the taxpayer," and second, that "the property was subject to a prior attachment or execution." United States v. Hemmen, 51 F.3d 883, (9th Cir. 1995). The Court noted that both parties agreed neither of those situations existed in this case. The Court rejected the bank s alternative claims for equitable relief. 6

7 Specifically looking at the issue that the IRS should be held culpable for alerting the taxpayer of the need for speed, the Court noted: The fact of the matter, though, is that the IRS was required to tip Waterman off no matter what. Even when jeopardy assessments are made, the IRS must provide notice of demand for immediate payment before any levy may be imposed. 26 U.S.C. 6331(a). While this notice does not necessarily inform the taxpayer that bank accounts will soon be levied, it certainly lets them know that something is afoot. As well, the Court found that there is also no reasonableness rule applicable to such levys. The Court noted: Moreover, Section 6332 does not contain any reasonableness element that would delay the vesting of the United States' interest in property under a bank's control. The only requirement is that a bank "surrender any property... subject to levy" or risk being held liable for the disappearance of that property. 26 U.S.C. 6332(d)(1). While it is true that the bank need not immediately "surrender" the property, it must upon being given notice preserve that property or run the risk of paying the depositor's tax bill. That is the state of affairs here. Waterman's money was "property... subject to levy," the IRS agent served the bank with the levy giving it notice of the government's claimed interest in the property, and Chase allowed it to slip away. Section 6332 is therefore applicable. The Court goes on to note that while the law doesn t mention reasonableness in being liable for the unpaid tax, it does allow a reasonableness defense against penalties for the failures to turn the assets over, meaning that it s clear the law contemplates it s possible for a taxpayer to be liable for the failure to turn over the money but not liable for the penalty the situation found here. re: Cherne In The fact that a lender stated it would only advance a hospital funds to pay bills if it was allowed to approve all disbursements did not allow the CFO to escape a trust fund penalty in the case of In re: Cherne, Bankruptcy Court of Idaho, Bankruptcy Case No JDP. The individual in question was a CPA who was serving as CFO of a financially troubled hospital in which he had an interest. Mr. Cherne kept the accounting for the hospital, 7

8 advanced it $500,000 of his own funds and personally guaranteed $30 million in hospital debts. Mr. Cherne negotiated loans on behalf of the hospital and had signature authority over all of the hospital s bank accounts. He prepared regular financial statements which dutifully disclosed that the hospital was not current in paying its payroll tax obligations. The hospital fell into default with the lender who had given it $10 million for its construction. The lender agreed to loan the hospital additional money, but only if the lender could exercise significant control over the hospital s spending. The hospital, not seeing an alternative (apparently just closing shop wasn t considered a possible solution), appeared to agree to such an arrangement. Although not reduced to writing, the parties agreed that the hospital would prepare a list of outstanding bills which it sent to the lender. The lender would then pick the payments it decided should be made, and would then advance the hospital funds to pay those bills. As the situation worsened, the hospital began to pay only the most urgent bills and the payroll taxes were not on the most urgent list of bills the lender was approving for payment. Eventually (and not surprisingly) the hospital failed when, one would suppose, even most urgent bills were not able to be paid. At that point there were $900,000+ of unpaid The taxpayer argued, as you might expect, that the payment of taxes was out of his control. Unfortunately neither the IRS nor the Court accepted that view. The Court found that Mr. Cherne was a responsible party from inception of the hospital, and that he could not delegate that responsibility by entering into the loan arrangement with the lender. Effectively by entering into that arrangement he, effectively, agreed to allow payroll taxes to go unpaid if the lender decided against paying them. Mr. Cherne, as conveniently documented by his financial statements disclosing the problem with payroll taxes, was aware the taxes were not being paid currently. Nevertheless he continued to participate in the process by which other bills were paid in preference to the trust fund tax liability that was outstanding. The court quips: Although the payment of a company's most pressing expenses and debts at any given time arguably constitutes a reasonable, legitimate business practice for an officer of the company attempting to keep the business operating, such a decision nonetheless is clothed with serious consequences for that officer if employee taxes eventually remain unpaid. Put bluntly, Mr. Cherne and other officers of Florence Hospital and its affiliates gambled that, to bridge the critical 8

9 financial needs of the hospital, it was best to leave taxes, as opposed to other debts unpaid. As things turned out, they lost that bet. Applying the Ninth Circuit (the relevant circuit for this Idaho case) decision in the Nakano case (742 F.3d at 1212) the Court found that the encumbrance of the funds was not relevant. Here, there was no written lock box agreement, but rather, an informal arrangement apparently existed between Florence Hospital and Clearwater that resembled that type of agreement discussed in In re Premo, under which the restrictions on the hospital's funds were imposed by the creditor with the promise of additional funding for the fledgling hospital. Florence Hospital, as well as Mr. Cherne through his compliance and cooperation, voluntarily entered into the agreement with Clearwater to obtain additional funding, and continued with the arrangement even when it became clear the funding needed to pay the withholding tax arrearage would not be forthcoming. 9