Complimentary Issue: Parker's Federal Tax Bulletin August 28,2013

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Issue 44

August 28, 2013

Tax Briefs

Kansas EITC Exemption Is Constitutional; Court Can't Consider Refund Claim Where Trustee Did NotFile Form 843; Bankruptcy Court Reversed; Tax Refunds Aren't Property of Bankruptcy Estate; LILOsand SILOs Don't Pass Economic Substance Test ...

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Proposed Regs Provide Guidance on the Small Employer Health Insurance Credit

The IRS issued proposed regulations on the tax credit under Code Sec. 45R for small employersproviding health insurance to their employees. The regulations provide details on the requirement topurchase insurance through an exchange, and explain the uniform contribution rules. REG-113792-13(8/26/13).

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Rev. Proc. Expands Time for Applying Corrective Procedures to Late S Corp Elections

The IRS released a new simplified revenue procedure that expands the time period taxpayers haveto request relief from late S corporation elections. Rev. Proc. 2013-30.

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Proposed Regs Remove Two-Year Deadline for Filing for Innocent Spouse Relief

The IRS issued proposed regulations that provide that the two-year deadline applicable to requestsfor innocent spouse relief under Code Sec. 6015(b) and Code Sec. 6015(c) does not apply toequitable relief requests under Code Sec. 6015(f). REG-132251-11 (8/13/13)

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S Corporation Shareholder Retained Beneficial Ownership of Shares

A physician was required to report the business and interest income from his S corporation sharesbecause he retained the beneficial ownership of the shares and his rights were not given awayfollowing a dispute with another shareholder. Kumar v. Comm'r, T.C. Memo. 2013-184 (8/13/13).

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Former Employee Was in the Trade or Business of Prosecuting FCA Lawsuit

An accountant who brought a False Claims Act (FCA) suit against his former employer was allowed toreport the qui tam award he received as business income on his Schedule C and deduct his legalfees as ordinary and necessary business expenses. Bagley v. U.S. 2013 PTC 233 (C.D. Calif. 8/5/13).

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CPA Properly Convicted of Failing to File FBARs and Filing False Tax Returns

A CPA, who was the managing director of three foreign corporations and who had signature authorityover several foreign bank accounts, was properly convicted of failing to file reports of foreign bankaccounts and filing false income tax returns. U.S. v. Simon, 2013 PTC 242 (7th Cir. 8/15/13).

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Motor Home Loan Interest Was Qualified Residence Interest

A couple who operated a consulting business was entitled to deduct the interest they paid on a loansecured by their motor home because the interest was qualified residence interest; however, theirdeduction for a laptop computer was disallowed for failure to establish its business use, and

unsubstantiated deductions were also disallowed. Dunford v. Comm'r, T.C. Memo. 2013-189 (8/20/13).

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Frivolous Return Penalty Doesn't Apply to Quaker Who Expressed Conscientious Objection to Tax

The frivolous return penalty should not apply to a Quaker who conscientiously objects to war and onlysubmitted part of her federal tax liability with her otherwise completed tax return. CCM 20133303F.

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Taxpayer Whose Spouse Was Temporarily Absent from Household Does Not Qualify as HOH

Where a taxpayer is not a surviving spouse and meets the applicable requirements for head-of-household filing status, but the taxpayer's spouse is away because of business and plans to share acommon household with the taxpayer in the future, the taxpayer cannot be considered a head of ahousehold. CCA 201334041.

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Suit Alleging Unequal IRS Enforcement of Prohibition on Political Campaigning by 501(c)(3)s is Allowedto Proceed

A suit alleging that the IRS has a policy of not enforcing the prohibition against political campaigningagainst churches and religious organizations was allowed to proceed; the organization had standingto file the suit. Freedom From Religion Foundation, Inc. v. Shulman, 2013 PTC 252 (W.D. Wisc. 8/19/13).

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S Corporation Liable for Employment Taxes and Penalties for Not Paying Salary to Owner

The Tax Court held that an S corporation owed employment taxes on the salary that it should havepaid to its president, and was liable for penalties for failing to timely file employment tax returns andfailure to timely deposit employment taxes. Sean McAlardy Ltd, Inc. v. Comm'r, T.C. Summary Opinion2013-62 (8/12/13).

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IRS Denies Tax-Exempt Status to Medical Marijuana Cooperative

The IRS ruled that an organization's primary activity of facilitating and organiz ing transactions betweenmembers who cultivate and possess cannabis is illegal under federal law and, thus, the organizationdid not qualify for tax-exempt status. PLR 201333014.

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Bankruptcy

Kansas EITC Exemption Is Constitutional: In In re Lea, 2013 PTC 251 (D. Kan. 8/16/13), a district courtaffirmed a bankruptcy court decision and held that the Kansas earned income tax credit (EITC)exemption, which excludes a debtor's EITC benefits from the debtor's bankruptcy estate, is apermissible exercise of state power.

Court Can't Consider Refund Claim Where Trustee Did Not File Form 843: In In re Enesco Group, Inc.,2013 PTC 241 (N.D. Ill. 8/8/13), a bankruptcy court held that, under Bankruptcy Code Section

505(a)(2)(B), it could not consider a bankruptcy estate's penalties refund request because thebankruptcy trustee did not properly request the refund from the IRS or wait 120 days from the date arefund was properly requested. The trustee needed to file Form 843 rather than request a refund byletter.

Bankruptcy Court Reversed; Tax Refunds Aren't Property of Bankruptcy Estate: In In re BankunitedFinancial Corporation, 2013 PTC 243 (11th Cir. 8/15/13), the Eleventh Circuit reversed a bankruptcycourt's judgment and directed the bankruptcy court to vacate its decision declaring that certain taxrefunds were the property of the bankruptcy estate.

Deductions

LILOs and SILOs Don't Pass Economic Substance Test: In John Hancock Life Insurance Company v.Comm'r, 141 T.C. No. 1 (8/5/13), the Tax Court agreed with the Second, Fourth, and Federal CircuitCourts and held that transactions involving LILOs or SILOs do not pass the substance-over- form test.Thus, deductions related to such transactions were disallowed. [Code Sec. 467].

IRS Employee Can't Deduct Cash Donations: In Payne v. Comm'r, T.C. Summary 2013-64 (8/13/13), theTax Court held that charitable cash donations deducted by an IRS employee were not deductible. Thecourt stated that it appeared highly probable that the taxpayer, in concert with her longtime friend andfellow IRS employee, cut and pasted stationery from a church and provided the same to the IRS agentexamining her returns in an attempt to support the claimed charitable deductions. That attempt failed,the court noted, when the IRS agent attempted to verify the reported contributions with the church'spastor, who made clear that he did not authorize the receipts to be prepared or issued on his church'sstationery, nor did he sign any such receipts. [Code Sec. 170].

Employment Taxes

Taxpayer Can Pursue Refund Claim for Trust Fund Penalties: In Ransier v. U.S., 2013 PTC 244 (D.Idaho 8/12/13), a district court held that the taxpayer could proceed with her refund claim for certaintrust fund tax penalty assessments that the IRS took from her tax refunds. According to the taxpayer,she was not a responsible person, and the trust fund taxes should be abated and refunded. [CodeSec. 6672].

Estates, Gifts, and Trusts

Disclaimers Will Not Result in Taxable Gifts: In PLR 201334001, the IRS ruled that a taxpayer'sproposed disclaimers of his interests in four trusts, if made by the proposed disclaimer date, will bemade within a reasonable time after the taxpayer learned of the existence of the transfers that createdhis interests in the trusts under Reg. Sec. 25.2511-1(c)(2). Further, provided that the disclaimers arevalid under state law and assuming the other requirements of Reg. Sec. 25.2511-1(c)(2) are met, thetaxpayer's disclaimer of his interests in the trusts will not be taxable gifts. [Code Sec. 2511].

Gross Income

Taxpayers Were Not True Owners of Property; Weren't Taxed Sale: In Hessing v. Comm'r, T.C. Memo.2013-179 (8/5/13), the Tax Court held that a married couple were agents for husband's father. Taken atface value, the court said, the testimony presented a young man who acceded to his father's requestto lend his credit reputation to facilitate the acquisition of real estate to be used in his father'sconstruction businesses. While the couple's names appeared on transactional documents, the courtconcluded they were in no other respect "owners" of the properties and/or entitled to the benefits orsubject to the burdens of the properties. Ultimately, the court found the husband's and his father'stestimony to be credible and, on that basis, held that the couple did not have unreported grossincome for the year and that the statute of limitations on assessment had expired. [Code Sec. 61].

Nontaxable Exchanges

Chief Counsel Advises on Livestock Replacement: In CCA 201333010, the Office of Chief Counseladvised that a taxpayer can replace livestock with "other property . . . used for farming" under CodeSec. 1033(f), if replacing the livestock with "property similar or related in use" is not feasible due toweather- related conditions or environment contamination. The Chief Counsel's Office also advised thata taxpayer can't replace livestock with "other property . . . used for farming" because of marketconditions, for example. [Code Sec. 1031].

Paragraph in IRS Pub. 225 Incorrect: In CCA 201333011, the Office of Chief Counsel points out that aparagraph in IRS Pub. 225, Farmer's Tax Guide, which discusses sales caused by weather- relatedconditions is inaccurate. The Chief Counsel's Office noted that the Publication says the reason ataxpayer sells has to be because of weather- related conditions. Code Sec. 1033(f) says the reason ataxpayer can't replace converted property with similar or related-use property is because of weather-related conditions. Code Sec. 1033(e) looks at why a taxpayer sold livestock. Code Sec. 1033(f) looksat why a taxpayer can't replace it with property similar or related in use. [Code Sec. 1033].

Procedure

Refunds Barred by Statute Where Taxpayer Waited 10 Years to File Claims: In Williams v. U.S., 2013PTC 245 (S.D. Tex. 8/13/13), the court held that because the taxpayer did not request refunds for the1999, 2000, and 2001 tax years until late in 2011, his refund claims were barred by the statute oflimitations. The court rejected the taxpayer's claim that he was financially disabled because he wasincapable of managing his financial affairs and did not have a spouse to act on his behalf. [Code Sec.6511].

Information on 1120S Was Not Considered Disclosed on 1040: In CCM 201333008, the Chief Counsel'soffice concluded that where a taxpayer filed a Form 1040 showing a certain amount of income from anS corporation, and then more than three years later, and outside of the ordinary three-yearassessment period, the S corporation filed a Form 1120S showing that the taxpayer's distributiveshare of S corporation income was in excess of 125 percent of the sum reported on the Form 1040,only the pro- rata share of S corporation income attributed to the amount disclosed on the originalForm 1040 is considered to be disclosed on that form in determining whether there is a substantialunderstatement of gross income for purposes of applying the six- year statute under Code Sec.6501(e). The Form 1120S does not constitute a disclosure for that purpose merely because it wasreferenced in the Form 1040 because the IRS cannot be considered to be on notice of informationcontained in documents, incorporated by reference, that do not yet exist or have not yet been filed.[Code Sec. 6501].

Tax Exempt Organizations

IRS Revokes Tax-Exempt Status of Gun Club: In PLR 201333019, the IRS determined that, because agun club exceeded the allowable percentage of gross receipts for nonmember income on acontinuous basis for at least two years, it was no longer eligible for tax-exempt status. [Code Sec.501].

Proposed Regs Provide Guidance on Insurance ExchangeRequirement for Small Employers Taking Health InsuranceCredit

Last week, the IRS issued proposed regulations on the tax credit under Code Sec. 45R for small

employers providing health insurance to their employees. The credit, which is effective for tax yearsbeginning in 2010, was part of the Patient Protection and Affordable Care Act (PPACA) . Theregulations provide details on the requirement to purchase insurance through an exchange, andexplain the uniform contribution rules.

For 2010-2013, the maximum credit is 35 percent of a taxable eligible small employer's premiumpayments taken into account for purposes of the credit. For a tax-exempt eligible small employer, themaximum credit is 25 percent of the employer's premium payments taken into account for purposes ofthe credit. For tax years beginning in 2014, these percentages change to 50 percent instead of 35percent for taxable eligible small employers, and 35 instead of 25 percent for tax-exempt eligiblesmall employers. In addition, beginning in 2014, the credit is available only to a qualified smallemployer that purchases health insurance coverage for its employees through a state exchange, andis available only for a maximum coverage period of two consecutive tax years beginning with the firstyear in which the employer or any predecessor first offers one or more qualified plans to itsemployees through an exchange.

In 2010, the IRS issued Notice 2010-44 and Notice 2010-82, both of which provided guidance on theemployee health insurance tax credit. The new proposed regulations (REG-113792-13 (8/26/13))generally incorporate the provisions of Notice 2010-44 and Notice 2010-82, as modified to reflect thedifferences in the rules applicable to years before 2014 and those applicable to years after 2013.Additionally, however, the regulations provide details on the requirement relating to the purchase ofinsurance coverage through an exchange, explain the requirement that an employer must generallypay a uniform percentage (not less than 50 percent) of the premium for each employee, and provideexamples of how the uniform percentage rules work.

Pract ice Tip: An eligible small employer may use the credit to reduce estimated tax payments. Aneligible small employer may also use the credit to offset the employer's alternative minimum tax(AMT) liability for the year, if any, subject to certain limitations. However, an eligible small employermay not reduce its deposits and payments of employment tax during the year in anticipation of thecredit.

Eligibility for the Credit

As noted above, the health insurance credit is a percentage of an eligible small employer's premiumpayments. An eligible small employer is defined as an employer that has no more than 25 full- timeemployees (FTEs) for the tax year, whose employees have average annual wages of less than$50,000 per FTE (as adjusted for inflation for years after December 31, 2013), and that has aqualifying arrangement in effect that requires the employer to pay a uniform percentage (not less than50 percent) of the premium cost of a qualified health plan (QHP) offered by the employer to itsemployees through a Small Business Health Options Program (SHOP) Exchange. A tax-exempteligible small employer is an eligible small employer that is described in Code Sec. 501(c) and that isexempt from tax.

Observat ion: There is no requirement that, for an employer to be an eligible small employer, theemployees perform services in a trade or business. Thus, an employer that otherwise meets therequirements for the credit does not fail to be an eligible small employer merely because theemployees of the employer are not performing services in a trade or business. For example, ahousehold employer that otherwise satisfies the requirements is an eligible small employer forpurposes of the credit.

Under Code Sec. 45R(d), to be an eligible small employer with respect to any tax year, the employermust have in effect a contribution arrangement that qualifies under Code Sec. 45R(d)(4). A contributionarrangement qualifies if it requires an eligible small employer to make a nonelective contribution onbehalf of each employee who enrolls in a qualified health plan (QHP) offered to employees by theemployer through an Exchange in an amount equal to a uniform percentage (not less than 50 percent)of the premium cost of the QHP (referred to as the uniform percentage requirement). The proposedregulations provide that, for purposes of Code Sec. 45R, an Exchange refers to a Small BusinessHealth Options Program (SHOP) Exchange, established pursuant to PPACA, Section 1311. Acontribution arrangement that meets these requirements is referred to as a "qualifying arrangement."

An employer located outside the United States (including a U.S. Territory) may be an eligible smallemployer if the employer has income effectively connected with the conduct of a trade or business inthe United States, otherwise meets the requirements of the regulations, and is able to offer a QHP toits employees through a SHOP Exchange.

Employees for Which Credit Can Be Taken

In general, all employees who perform services for the employer during the tax year are taken intoaccount in determining FTEs and average annual wages, including those who are not performingservices in the employer's trade or business.

However, certain individuals are not considered employees when calculating the credit, and hours andwages of these individuals are not counted when determining an employer's eligibility for the credit.The following individuals are not employees or are otherwise excluded for this purpose: independentcontractors (including sole proprietors); partners in a partnership; shareholders owning more than 2percent of an S corporation; owners of more than 5 percent of other businesses; family members ofthese owners and partners, including a child (or descendant of a child), a sibling or step sibling, aparent (or ancestor of a parent), a step-parent, a niece or nephew, an aunt or uncle, or a son- in- law,daughter- in- law, father- in- law, mother- in- law, brother- in- law, or a sister- in- law. A spouse is alsoconsidered a family member for this purpose, as is a member of the household who is not a familymember but qualifies as a dependent on the individual income tax return of an excluded individual.

Seasonal employees who work for 120 or fewer days during the tax year are not consideredemployees when determining FTEs and average annual wages, but premiums paid on behalf ofseasonal workers may be counted in determining the amount of the credit. Seasonal workers includeretail workers employed exclusively during holiday seasons and workers employed exclusivelyduring the summer.

Special rules apply to ministers because of the nature of their employment. If under the common law aminister is not an employee, the minister is not taken into account in determining an employer's FTEs.If under the common law a minister is an employee, the minister is taken into account in determiningan employer's FTEs. However, because a minister performing services in the exercise of his or herministry is treated as not engaged in employment for FICA purposes, compensation paid to a ministeris not considered wages and so is not included for purposes of computing an employer's averageannual wages for purposes of the health insurance premium credit.

It is important to determine the number of hours an employee works to establish whether or not theemployee is an FTE for which the employer is eligible to take the credit. The proposed regulationsprovide that an employee's hours of service for a year include hours for which the employee is paid,or entitled to payment, for the performance of duties for the employer during the employer's tax year.Hours of service also include hours for which the employee is paid for vacation, holiday, illness,incapacity (including disability), layoff, jury duty, military duty, or leave of absence.

Observat ion: Hours of service do not include the hours of seasonal employees who work for 120 orfewer days during the tax year, nor do they include hours worked for a year in excess of 2,080 for asingle employee.

These proposed regulations describe three methods for calculating the total number of hours ofservice for a single employee for the tax year:

(1) actual hours worked;

(2) days-worked equivalency; and

(3) weeks-worked equivalency.

Pract ice Tip: Employers do not have to use the same method for all employees and may applydifferent methods for different classifications of employees if the classifications are reasonable andconsistently applied. For example, an employer may use the actual hours worked method for allhourly employees and the weeks-worked equivalency method for all salaried employees.

The proposed regulations define wages, for purposes of the credit, as wages defined under CodeSec. 3121(a) for FICA purposes, determined without considering the social security wage baselimitation. To calculate average annual FTE wages, an employer must figure the total wages paidduring the tax year to all employees, divide the total wages paid by the number of FTEs, and if theresult is not a multiple of $1,000, round the result to the next lowest multiple of $1,000. For example,$30,699 is rounded down to $30,000.

Calculating the Credit

For tax years beginning during or after 2014, the maximum credit for an eligible small employer otherthan a tax-exempt eligible small employer is 50 percent of the eligible small employer's premiumpayments made on behalf of its employees under a qualifying arrangement for QHPs offered througha SHOP Exchange. For a tax-exempt eligible small employer for those years, the maximum credit is35 percent. The employer's tax credit is subject to the following adjustments and limitations:

(1) the average premium limitation;

(2) the credit phaseout;

(3) the state subsidy and tax credit limitation;

(4) the payroll tax limitation for tax-exempt employers; and

(5) the two-consecutive- tax year credit period limitation.

For purposes of calculating the credit for tax years beginning after 2013, the employer's premiumpayments are limited by the average premium in the small group market in the rating area in which theemployee enrolls for coverage through a SHOP Exchange. The credit will be reduced by the excessof the credit calculated using the employer's premium payments over the credit calculated using theaverage premium.

Example: ABC Corporation pays 50 percent of the $7,000 premium for family coverage for itsemployees ($3,500), but the average premium for family coverage in the small group market in therating area in which the employees enroll is $6,000. For purposes of calculating the credit, ABC'spremium payments are limited to $3,000 (50 percent of $6,000).

The credit phases out for eligible small employers if the number of FTEs exceeds 10, or if theaverage annual wages for FTEs exceed $25,000 (as adjusted for inflation for tax years beginning afterDecember 31, 2013). For an employer with both more than 10 FTEs and average annual FTE wagesexceeding $25,000, the credit is reduced based on the sum of the two reductions.

Observat ion: This may reduce the credit to zero for some employers with fewer than 25 FTEs andaverage annual FTE wages of less than double the $25,000 dollar amount (as adjusted for inflation).

Some states offer tax credits to a small employer that provides health insurance to its employees.Some of these credits are refundable credits and others are nonrefundable credits. In addition, somestates offer premium subsidy programs for certain small employers under which the state makes apayment equal to a portion of the employees' health insurance premiums. Generally, the state paysthis premium subsidy either directly to the employer or to the employer's insurance company (oranother entity licensed under state law to engage in the business of insurance). If the employer isentitled to a state tax credit or premium subsidy that is paid directly to the employer, the amount ofemployer premiums paid is not reduced for purposes of calculating the health insurance premiumcredit, but the amount of the credit cannot exceed the net premiums paid, which are the employerpremiums paid minus the amount of any state tax credits or premium subsidies received.

If a state makes premium payments directly to the insurance company, the state is treated as makingthese payments on behalf of the employer for purposes of determining whether the employer hassatisfied the "qualifying arrangement" requirement to pay an amount equal to a uniform percentage(not less than 50 percent) of the premium cost of coverage. Also, these premium payments by thestate are treated as an employer contribution for purposes of calculating the credit, but the amount ofthe credit cannot exceed the premiums actually paid by the employer.

Observat ion: If a state-administered program, such as Medicaid, makes payments on behalf ofindividuals and their families who meet certain eligibility requirements, these payments do not reducethe amount of employer premiums paid for purposes of calculating the credit.

For a tax-exempt eligible small employer, the amount of the credit cannot exceed the amount of thepayroll taxes of the employer during the calendar year in which the tax year begins.

The proposed regulations provide that the first year for which an eligible small employer files Form8941, Credit for Small Employer Health Insurance Premiums, claiming the credit, or files Form 990-T,Exempt Organization Business Income Tax Return, with an attached Form 8941, is the first year of thetwo-consecutive- tax year credit period. Even if the employer is only eligible to claim the credit for partof the first year, the filing of Form 8941 begins the first year of the two-consecutive- tax-year credit

period.

Beginning in 2014, the credit is available only for a maximum coverage period of two consecutive taxyears beginning with the first year in which the employer or any predecessor first offers one or morequalified plans to its employees through an exchange. Special transition rules apply in determining theapplication of the two-consecutive- tax year credit period for tax years beginning in 2014 where theeligible small employer offers coverage on a plan year that begins on a date other than the first day ofits tax year. In such a case, if an eligible small employer has a health plan year beginning afterJanuary 1, 2014, but before January 1, 2015 (2014 health plan year) that begins after the start of its firsttax year beginning after January 1, 2014 (2014 tax year), and the employer offers one or more QHPsto its employees through a SHOP Exchange as of the first day of its 2014 health plan year, then theeligible small employer is treated as offering coverage through a SHOP Exchange for its entire 2014tax year for purposes of Code Sec. 45R if the health care coverage provided from the first day of the2014 tax year through the day immediately preceding the first day of the 2014 health plan year wouldhave qualified for a credit under Code Sec. 45R using the rules applicable to tax years beginningbefore January 1, 2014. If the eligible small employer claims the credit in the 2014 tax year, the 2014tax year begins the first year of the credit period.

Example: ABC Corporation is an eligible small employer (and is not a tax-exempt organization) andhas a 2014 tax year that begins January 1, 2014, and ends on December 31, 2014, and a 2014 healthplan year that begins July 1, 2014 and ends June 30, 2015. ABC offers a QHP through a SHOPExchange the coverage under which begins July 1, 2014. ABC provides coverage from January 1,2014, through June 30, 2014, that would have qualified for a credit using the rules applicable to taxyears beginning before January 1, 2014. ABC may claim the credit at the 50 percent rate for the entire2014 tax year. Accordingly, in calculating the credit, ABC may count premiums paid for coverage fromJanuary 1, 2014 through June 30, 2014, as well as premiums paid from July 1, 2014, throughDecember 31, 2014. If ABC claims the credit for the 2014 tax year, that tax year is the first year of thecredit period.

Applying the Uniform Percentage Requirement

To be eligible for the credit, an eligible small employer must generally pay a uniform percentage (notless than 50 percent) of the premium for each employee enrolled in a QHP offered to its employeesthrough a SHOP Exchange. Prop. Reg. Sec. 1.45R-4 sets forth the rules for applying this requirement inseparate situations depending on (1) whether the premium established for the QHP is based on listbilling or is based on composite billing; (2) whether the QHP offers only self- only coverage, or othercoverage (such as family coverage) for which a higher premium is charged; and (3) whether theemployer offers one QHP or more than one QHP. The uniform percentage rule applies only to theemployees offered coverage and does not impose a coverage requirement.

The term "composite billing" is defined to mean a system of billing under which a health insurercharges a uniform premium for each of the employer's employees or charges a single aggregatepremium for the group of covered employees that the employer may then divide by the number ofcovered employees to determine the uniform premium. In contrast, the term "list billing" is defined as abilling system under which a health insurer lists a separate premium for each employee based on theage of the employee or other factors.

For an eligible small employer offering self- only coverage and using composite billing, the employersatisfies the applicable requirements if it pays the same amount toward the premium for eachemployee receiving self- only coverage under the QHP, and that amount is equal to at least 50 percentof the premium for self- only coverage.

For an eligible small employer offering one QHP providing at least one tier of coverage with a higherpremium than self- only coverage and using composite billing, the employer satisfies the applicablerequirements if it either:

(1) pays an amount for each employee enrolled in that more expensive tier of coverage that is thesame for all employees and that is no less than the amount that the employer would have contributedtoward self- only coverage for that employee, or

(2) meets the requirements of an employer offering self- only coverage and using composite billing(see above) for each tier of coverage that if offers.

For an eligible small employer offering one QHP providing only self- only coverage and using listbilling, the employer satisfies the applicable requirements if either:

(1) the employer pays toward the premium an amount equal to a uniform percentage (not less than 50percent) of the premium charged for each employee, or

(2) the employer converts the individual premiums for self- only coverage into an employer- computedcomposite rate for self- only coverage, and, if an employee contribution is required, each employeewho receives coverage under the QHP pays a uniform amount toward the self- only premium that is nomore than 50 percent of the employer computed composite rate for self- only coverage.

If an employer offers more than one QHP through a SHOP Exchange, the uniform percentagerequirement may be satisfied in one of two ways. The first is on a plan-by-plan basis, meaning thatthe employer's premium payments for each plan must individually satisfy the uniform percentagerequirements stated above. The amounts or percentages of premiums paid toward each QHP do nothave to be the same, but they must each satisfy the uniform percentage requirement if each QHP istested separately. The other permissible method to satisfy the uniform percentage requirement isthrough the reference plan method. Under the reference plan method, the employer designates one ofits QHPs as a reference plan. Then the employer either determines a level of employer contributionsfor each employee such that, if all eligible employees enrolled in the reference plan, the contributionswould satisfy the uniform percentage requirement as applied to that reference plan, or the employerallows each employee to apply the minimum amount of employer contribution determined necessaryto meet the uniform percentage requirement toward the reference plan or toward coverage under anyother available QHP.

Example 1: An eligible small employer, ABC Corporation, offers a QHP on a SHOP Exchange, PlanA, which uses composite billing. The premiums for Plan A are $5,000 per year for self- only coverage,and $10,000 for family coverage. Employees can elect self- only or family coverage under Plan A. ABCpays $3,000 (60 percent of the premium) toward self- only coverage under Plan A and $6,000 (60percent of the premium) toward family coverage under Plan A. ABC's contributions of 60 percent of thepremium for each tier of coverage satisfy the uniform percentage requirement.

Example 2: The facts are the same as in Example 1, except that ABC pays $3,000 (60 percent of thepremium) for each employee electing self- only coverage under Plan A and pays $3,000 (30 percent ofthe premium) for each employee electing family coverage under Plan A. ABC's contributions of 60percent of the premium toward self- only coverage and the same dollar amount toward the premium forfamily coverage satisfy the uniform percentage requirement, even though the percentage is not thesame.

Example 3: ABC Corporation offers two QHPs, Plan A and Plan B, both of which use composite billing.The premiums for Plan A are $5,000 per year for self- only coverage and $10,000 for family coverage.The premiums for Plan B are $7,000 per year for self- only coverage and $13,000 for family coverage.Employees can elect self- only or family coverage under either Plan A or Plan B. ABC pays $3,000 (60percent of the premium) for each employee electing self- only coverage under Plan A, $3,000 (30percent of the premium) for each employee electing family coverage under Plan A, $3,500 (50 percentof the premium) for each employee electing self- only coverage under Plan B, and $3,500 (27 percentof the premium) for each employee electing family coverage under Plan B. ABC's contributions of 60percent (or $3,000) of the premiums for self- only coverage and the same dollar amounts toward thepremium for family coverage under Plan A, and of 50 percent (or $3,500) of the premium for self- onlyof coverage and the same dollar amount toward the premium for family coverage under Plan B,satisfy the uniform percentage requirement on a QHP-by-QHP basis; therefore, ABC's contributions toboth plans satisfy the uniform percentage requirement.

[Return to Table of Contents]

New S Corp Procedure Expands Time for Applying Corrective Procedures to Late Elections

Late S corporation elections, such as the election to become an S corporation, or the election bycertain trusts to become an eligible S corporation shareholder, can result in additional taxes if notproperly corrected. In what is good news for practitioners, the IRS issued Rev. Proc. 2013-30, which willgreatly simplify obtaining relief for these various late S corporation elections. The procedure is moreliberal in that it expands the time period taxpayers have in which to request relief from late Scorporation elections. The new procedure provides corrective actions for various late S corporationelections and eliminates compliance with a number of prior procedures that taxpayers had to navigateto obtain such relief. The guidance is in lieu of requesting an IRS ruling and, thus, there is no user feefor requests filed under Rev. Proc. 2013-30. While there may still be some taxpayers that do not fallwithin the new procedure and will have to request an IRS ruling and pay a user fee, the number of

such taxpayers is minimized under the new procedure.

Observat ion: Under the prior corrective procedures, taxpayers had to apply for relief within 24months of the due date of the election. Under Rev. Proc. 2013-30, a taxpayer has three years and 75days from the date the election was to be effective to apply for relief.

Rev. Proc. 2013-30 supersedes Rev. Procs. 2003-43, 2004-48, and 2007-62 and applies to taxpayersmaking late S corporation elections, late electing small business trust (ESBT) elections, late qualifiedsubchapter S trust (QSST) elections, late qualified subchapter subsidiary (QSub) elections, and latecorporate classification elections which the taxpayer intended to take effect on the same date that thetaxpayer intended than an S corporation election for the entity to take effect. Additionally, Rev. Proc.2013-30 obsoletes portions of Rev. Proc. 97-48 and Rev. Proc. 2004-49.

Pract ice Tip: Practitioners can request a refund of user fees paid for any letter ruling request seekingrelief for a late election covered by Rev. Proc. 2013-30 that is still pending at the IRS National Office onSeptember 3. However, the National Office will process such letter ruling requests unless, before theearlier of October 18, 2013, or the issuance of the letter ruling, the practitioner notifies the IRS that theentity will rely on Rev. Proc. 2013-30 and withdraw its letter ruling request.

General Requirements for All Late Elections

Rev. Proc. 2013-30 lays out specific requirements for relief for each of the various late elections.However, taxpayers must also meet the following general requirements for relief for each late election:

(1) The entity must have intended to be classified as an S corporation, must have intended for the trustto be an ESBT, must have intended for the trust to be a QSST, or must have intended to treat asubsidiary corporation as a QSub as of the date on which the election was intended to be effective(i.e., the effective date).

(2) The entity must request relief within three years and 75 days after the effective date (except in thecase where the corporation is not seeking late corporate classification election relief concurrently witha late S corporation election and the corporation failed to qualify as an S corporation solely becausethe Form 2553 was not timely filed).

(3) The failure to qualify as an S corporation, ESBT, QSST, or QSub as of the effective date wassolely because the election was not timely filed.

(4) In the case of a request for relief for a late S corporation or QSub election, the entity hasreasonable cause for its failure to make the timely election and acted diligently to correct the mistakeupon its discovery. In the case of a request for relief for an inadvertently invalid S corporation electionor an inadvertent termination of an S corporation election due to the failure to make the timely ESBT orQSST election, the failure to file the timely election was inadvertent and the S corporation and theperson or entity seeking relief acted diligently to correct the mistake upon its discovery.

Pract ice Tip: The supporting statement describing the reasonable cause for not timely filing theelection and the diligent actions taken to correct the mistake must be signed under penalties ofperjury, using the following wording: "Under penalties of perjury, I (we) declare that I (we) haveexamined this election, including accompanying documents, and, to the best of my (our) knowledgeand belief, the election contains all the relevant facts relating to the election, and such facts are true,correct, and complete." This declaration must be signed by an officer of the S corporation authorizedto sign, the trustee of the ESBT, the current income beneficiary of the QSST, or a shareholder, asapplicable.

Relief for Late S Corporation Elections

A taxpayer can obtain relief under Rev. Proc. 2013-30 for a late S corporation election by: (1) filing acompleted Form 2553 that is signed by (a) an officer of the corporation authorized to sign, and (b) allpersons who were shareholders at any time during the period that began on the first day of the taxyear for which the election is to be effective and ends on the day the completed Form 2553 is filed;and (2) filing statements from all shareholders during the period between the date the S corporationelection was to have become effective and the date the completed Form 2553 is filed that they havereported their income on all affected returns consistent with the S corporation election for the year theelection should have been filed and for all subsequent years.

In the case of a late corporate classification election intended to be effective on the same date that the

S corporation election was intended to be effective, the completed Form 2553 must also include thefollowing representations, signed under penalties of perjury:

(1) that the entity is one that is eligible for relief;

(2) that the entity intended to be classified as a corporation as of the effective date of the Scorporation status;

(3) that the entity failed to qualify as a corporation solely because Form 8832 was not timely filed, orForm 8832 was not deemed to have been filed;

(4) that the entity failed to qualify as an S corporation on the effective date of the S corporation statussolely because the S corporation election was not timely filed; and

(5) that the entity timely filed all required federal tax returns and information returns consistent with itsrequested classification as an S corporation for all of the years the entity intended to be an Scorporation and no inconsistent tax or information returns have been filed by or with respect to theentity during any of the tax years, or the entity has not filed a federal tax or information return for thefirst year in which the election was intended to be effective because the due date has not passed forthat year's federal tax or information return.

The requirement that relief be requested within three years and 75 days of the date the election wasintended to be effective does not apply in the following situations:

The corporation is not seeking late corporate classification election relief concurrently with alate S corporation election under this revenue procedure;The corporation fails to qualify as an S corporation solely because the Form 2553 was nottimely filed;The corporation and all of its shareholders reported their income consistent with S corporationstatus for the year the S corporation election should have been made, and for everysubsequent tax year (if any);At least six months have elapsed since the date on which the corporation filed its tax return forthe first year the corporation intended to be an S corporation;Neither the corporation nor any of its shareholders was notified by the IRS of any problemregarding the S corporation status within six months of the date on which the Form 1120S for thefirst year was timely filed, andThe completed election form includes the statement(s), signed under penalties of perjury, fromall shareholders during the period between the date the S corporation election was to havebecome effective and the date the completed election form is filed that they have reported theirincome on all affected returns consistent with the S corporation election for the year the electionshould have been filed and for all subsequent years.

Relief for Late ESBT and QSST Elections

A taxpayer can obtain relief under Rev. Proc. 2013-30 for late ESBT and QSST elections by:

(1) having the trustee of the ESBT sign or file the appropriate statements, or having the current incomebeneficiary of a QSST sign and file Form 2553 and separate statements. The completed form mustinclude the following statements, signed under penalties of perjury:

(2) in the case of a QSST, filing a statement from the trustee that the trust satisfies the QSSTrequirements and that the income distribution requirements have been and will continue to be met;

(3) in the case of an ESBT, a statement from the trustee that all potential current beneficiaries meet theshareholder requirements of Code Sec. 1361(b)(1) and that the trust satisfies the requirements of anESBT under Code Sec. 1361(e)(1) other than the requirement to make an ESBT election; and

(4) statements from all shareholders during the period between the date the S corporation electionwas to have become effective or was terminated and the date the completed election form is filed thatthey have reported their income on all affected returns consistent with the S corporation election for theyear the election should have been made and for all subsequent years.

Relief for Late QSub Elections

A taxpayer can obtain relief under Rev. Proc. 2013-30 for late QSub elections by filing Form 8869,Qualified Subchapter S Subsidiary Election, and including with the form a statement signed by anofficer of the S corporation, under penalties of perjury, that the subsidiary corporation satisfies theapplicable QSub requirements, and that all assets, liabilities, and items of income, deduction, andcredit of the QSub have been treated as assets, liabilities, and items of income, deduction, and creditof the S corporation on all affected returns consistent with the QSub election for the year the electionwas intended to be effective and for all subsequent years.

Effective Date

Rev. Proc. 2013-30 is effective September 3, 2013. It applies to requests pending with the IRS ServiceCenter pursuant to Rev. Procs. 97-48, 2003-43, 2004-48, and 2007-62 on September 3, 2013, and torequests received thereafter. It also applies to all ruling requests pending in the IRS national office onSeptember 3, 2013, and to requests for relief received thereafter.

If an entity has filed a request for a letter ruling seeking relief for a late S election covered by Rev.Proc. 2013-30 that is pending in the IRS National Office on September 3, 2013, the entity may rely onRev. Proc. 2013-30, withdraw that letter ruling request, and receive a refund of its user fee. However,the National Office will process letter ruling requests pending on September 3, 2013, unless, beforethe earlier of October 18, 2013, or the issuance of the letter ruling, the entity notifies the National Officethat it will rely on Rev. Proc. 2013-30 and withdraw its letter ruling request.

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Proposed Regs Remove Two-Year Deadline for Filing for Innocent Spouse Relief

A recent tug-of-war among the IRS, the Tax Court, and several appellate courts over the appropriatedeadline for filing for innocent spouse relief under Code Sec. 6015(f) (i.e., the equitable reliefprovision) ended when the IRS gave in and published Notice 2011-70, which loosened the deadline.The IRS has now issued proposed regulations (REG-132251-11 (8/13/13)) that formally provide thatthe two-year deadline applicable to requests for relief under Code Sec. 6015(b) and Code Sec.6015(c) does not apply to equitable relief requests under Code Sec. 6015(f). The IRS also extendedthe new rules to certain married taxpayers in community property states. Additionally, the proposedregulations are retroactive to the date Notice 2011-70 was issued.

Background

When spouses file a joint income tax return, both spouses are responsible for the entire tax liability.This is known as joint and several liability, and it applies to the tax liability shown on the joint return, aswell as to any additional tax liability the IRS determines to be due. The IRS can collect these taxesfrom either spouse, even if they later divorce and the divorce decree states that one of the formerspouses will be solely responsible for the tax. In some cases, however, a spouse (or former spouse)will be relieved of the tax, interest, and penalties on a joint tax return.

Code Sec. 6015 provides three types of relief from joint and several liability:

(1) full or apportioned relief (i.e., innocent spouse relief) under Code Sec. 6015(b) (¶260,560.10);

(2) proportionate relief for divorced or separated taxpayers (i.e., separation of liability relief) underCode Sec. 6015(c); and

(3) equitable relief under Code Sec. 6015(f) when relief is unavailable under either Code Sec. 6015(b)or Code Sec. 6015(c).

Code Sec. 6015(b) and Code Sec. 6015(c) both have explicit time limits for requesting relief. Absent arequest being submitted within two years of the first collection action against the requesting taxpayer,no relief is available.

Additionally, Code Sec. 66(c) provides two avenues for married taxpayers who do not file a jointfederal income tax return in a community property state to request relief from the operation of the statecommunity property laws. Under state law, each spouse generally is responsible for the tax on one-half of all the community income for the year. Traditional relief under Code Sec. 66(c) allows therequesting spouse to avoid liability for tax on community income of which the requesting spouse didnot know and had no reason to know. If a requesting spouse does not satisfy the requirements fortraditional relief, the IRS may grant equitable relief. The IRS uses the same procedures for determining

eligibility for equitable relief under Code Sec. 66(c) as it does for equitable relief under Code Sec.6015(f).

Initially, in Rev. Proc. 2003-61, the IRS spelled out the conditions a taxpayer needed to meet to qualifyfor the equitable relief election under Code Sec. 6015(f). One of the conditions was that the taxpayerhad to request relief no later than two years after the date of the IRS's first collection activity withrespect to the taxpayer. This requirement was then incorporated into Reg. Sec. 1.6015-5(b)(1).

Subsequently, in Lantz v. Comm'r, 132 T.C. 131 (2009), the Tax Court held Reg. Sec. 1.6015-5(b)(1) tobe invalid. The Seventh Circuit then reversed that decision. In Hall v. Comm'r, 135 T.C. 374 (2010), theTax Court reconsidered the matter but did not change its position. In Mannella v. Comm'r, 631 F.3d 115(3d Cir. 2011), the Third Circuit reversed the Tax Court and held the two-year deadline to be valid.Subsequently, in Pullins v. Comm'r, 136 T.C. 432 (2011), the Tax Court again held the two-yeardeadline to be invalid.

The IRS reconsidered the issue and released Notice 2011-70, in which it announced that the two-yeardeadline would no longer apply to requests for equitable relief under Code Sec. 6015(f). Instead,under Notice 2011-70, to be considered for equitable relief, a request must be filed within the statute oflimitations period for collection of tax or, within the statute of limitations for any credit or refund of tax.Notice 2011-70 specified transitional rules that applied until the IRS amended the regulations underCode Sec. 6015. Under the transitional rules, the two-year deadline did not apply to any request forequitable relief filed on or after July 25, 2011 (the date Notice 2011-70 was issued) or any requestalready filed and pending with the IRS as of that date.

Deadline for Requesting Equitable Relief under the Proposed Regulations

Under Prop. Reg. Sec. 1.6015-5(b)(2), a requesting spouse must file Form 8857, Request for InnocentSpouse Relief, or other similar statement with the IRS within the statute of limitations period oncollection of tax in Code Sec. 6502 or within the statute of limitations period for credits or tax refunds inCode Sec. 6511, as applicable to the joint tax liability. If a requesting spouse files a request forequitable relief under Code Sec. 6015(f) within the statute of limitations period, the IRS will consider therequest for equitable relief, but the requesting spouse will be eligible for a credit or refund of tax only ifthe limitation period for credit or refund of tax is open when the request is filed, assuming all otherrequirements are met.

Alternatively, if a requesting spouse files a request for equitable relief after the statute of limitations hasexpired on collecting tax but while the statute of limitations on the credit or refund of tax remains open,the IRS will consider the request for equitable relief insofar as tax was paid by or collected from therequesting spouse, and the requesting spouse will be eligible for a potential credit or refund of tax. Ifneither limitations period is open when a requesting spouse files a request for equitable relief, the IRSwill not consider the request for equitable relief.

Example: Harry and Wendy timely filed a joint federal income tax return for tax year 1999. The IRSselected the 1999 return for audit and determined a deficiency in tax of $10,000. The IRS assessed thetax on December 1, 2001. Harry and Wendy were divorced in 2005. On her separate federal incometax return for 2005, Wendy reported an overpayment of $2,500, which the IRS applied on May 3, 2006,to the joint liability for 1999. On her separate federal income tax return for tax year 2009, Wendyreported an overpayment of $1,750, which the IRS applied on May 15, 2010, to the joint liability for1999. On May 1, 2012, Wendy filed Form 8857 with the IRS requesting relief under the innocent spouseprovisions of Code Sec. 6015. The IRS will not consider whether Wendy is entitled to any relief underCode Sec. 6015(b) or Code Sec. 6015(c) because Wendy's election is untimely, as her Form 8857was filed after the end of the two-year period running from the offset of Wendy's overpayment from her2005 return. Although the collection period expired on December 1, 2011, the IRS will consider whetherWendy is entitled to equitable relief under Code Sec. 6015(f) for 1999 because Wendy filed Form 8857within the two-year period for claiming a credit or refund of tax under Code Sec. 6511(a). Under CodeSec. 6511(b)(2), the amount of any refund to which Wendy might be entitled is limited to $1,750 (theamount paid within the two years preceding the filing of Wendy's Form 8857), and the $2,500 collectedin May 2006 is not available for refund.

Example: The facts are the same as in the previous example, except that Wendy's separate federalincome tax return for 2009 did not report an overpayment, and there was no offset against the jointliability for 1999. The IRS will not consider whether Wendy is entitled to any relief under Code Sec.6015(b) or Code Sec. 6015(c) because Wendy's election is untimely, as her Form 8857 was filed afterthe end of the two-year period running from the offset of Wendy's overpayment from her 2005 return.Further, as the collection period expired on December 1, 2011, and the period for claiming a credit or

refund of tax under Code Sec. 6511(a) expired on May 3, 2008, IRS will not consider whether Wendy isentitled to equitable relief under Code Sec. 6015(f) for 1999.

Premature Elections Will Not Be Considered

As provided for in the current regulations, the proposed regulations state that the IRS will not considerany election or request for relief from joint and several liability that is premature. A premature electionor request for relief is an election or request, other than a request for relief for a liability that is properlyreported on a joint federal income tax return but not paid, that is filed for a tax year prior to the receiptof a notification of an examination or a letter or notice from the IRS indicating that there may be anoutstanding liability with regard to that year.

Additional Relief Provided for Married Taxpayers in Community Property States

Because the IRS uses the same procedures for determining eligibility for equitable relief under CodeSec. 66(c) as it does for equitable relief under Code Sec. 6015(f), the proposed regulations also adda rule similar to Prop. Reg. 1.6015-1(b) to Reg. Sec. 1.66-4 for claims for equitable relief under CodeSec. 66(c).

Prop. Reg. Sec. 1.66-4(j)(2)(ii) provides that the earliest time for submitting a request for equitablerelief from the federal income tax liability resulting from the operation of community property law is thedate the requesting spouse receives notification of an audit or a letter or notice from the IRS statingthat there may be an outstanding liability with respect to that year. A request for equitable relief from thefederal income tax liability resulting from the operation of community property law for a liability that isproperly reported but unpaid is properly submitted with the requesting spouse's individual federalincome tax return, or after the requesting spouse's individual federal income tax return is filed.

Compliance Tip: To request equitable relief under Prop. Reg. Sec. 1.66-4, a requesting spouse mustfile Form 8857, Request for Innocent Spouse Relief, or other similar statement with the IRS within thestatute of limitations period for collection of tax or within the statute of limitations for any credit or refundof tax, whichever applies.

If a requesting spouse files a request for equitable relief under Prop. Reg. Sec. 1.66-4 within theapplicable period, the IRS will consider the request for equitable relief, but the requesting spouse willbe eligible for a credit or refund of tax only if the statute of limitations period for credit or refund of tax isopen when the request is filed. Alternatively, if a requesting spouse files a request for equitable reliefafter the period of limitation on collection of tax has expired but while the limitation period on credit orrefund of tax is still open, the IRS will consider the request for equitable relief insofar as tax was paidby or collected from the requesting spouse, and the requesting spouse will be eligible for a potentialcredit or refund of tax. If neither statute of limitations period is still open when a requesting spouse filesa request for equitable relief, the IRS will not consider the request for equitable relief.

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Physician Who Retained Beneficial Ownership of S Corp Stock Is Taxed on Income Never Received

A physician was required to report the business and interest income from his S corporation sharesbecause he retained the beneficial ownership of the shares and his rights were not given awayfollowing a dispute with another shareholder. Kumar v. Comm'r, T.C. Memo. 2013-184 (8/13/13).

Dr. Ramesh Kumar, a physician, and Dr. Woody, another physician, agreed to provide radiationoncology services to patients through three business entities: Okeechobee Business Ventures, Inc.(OBV), Mid-Florida Radiation Oncology, P.A. (MFRO), and Port St. Lucie Ventures, Inc., (PSLV). PSLVwas an S corporation. Dr. Kumar owned 40 percent of the shares of PSLV and Dr. Woody owned 60percent of the remaining shares. Dr. Kumar, Dr. Woody, and a third physician each owned one- third ofthe outstanding shares of stock in OBV.

A dispute arose between Dr. Kumar and Dr. Woody resulting in Dr. Kumar being shut out of PSLV'soperations and management. In 2004, Dr. Kumar filed a complaint against Dr. Woody and PSLV,seeking court-ordered inspection of corporate records, dissolution of PSLV, and reinstatement of hismedical privileges at PSLV. The lawsuit was settled in 2012, and the parties agreed that Dr. Woodywould sell his OBV stock to Dr. Kumar and Dr. Kumar would transfer his PSLV stock to PSLV in totalredemption of his interest. The settlement agreement also provided that the transactions close onDecember 31, 2011, and as of that date, Dr. Woody would no longer be a shareholder of OBV and Dr.Kumar would no longer be a shareholder of PSLV.

PSLV made no distributions to shareholders in 2005. Dr. Kumar did not receive any wages or take partin the operation or management of PSLV in 2005 or any year thereafter. PSLV issued a Schedule K-1,Shareholder's Share of Income, Deductions, Credits, etc., to Dr. Kumar for the 2005 tax year andreported his share of PSLV's ordinary business income as $215,920 and interest income as $2,344.Dr. Kumar, and his wife, Pushparani, filed their 2005 Form 1040, Individual Income Tax Return, andlisted on their attached Schedule E, Supplemental Income and Loss, PSLV as an S corporation inwhich they held an interest. They did not report any income from Dr. Kumar's Schedule K-1 on theirSchedule E. The IRS determined a $78,760 deficiency in the couple's federal income tax for theunreported business and interest income from Dr. Kumar's shareholder interest in PSLV.

Under Code Sec. 1366(a), an S corporation's items of income, gain, loss, deduction, and credit -whether or not distributed - flow through to the shareholders, who must report their pro rata shares ofsuch items on their individual income tax returns.

For purposes of determining a shareholder's pro rata share of income loss, deduction, or credit for atax year, the beneficial owners of an S corporation are treated as the shareholders of the corporation.

Observat ion: To determine if beneficial ownership has passed from one person to another, it isimportant to determine whether the transferee has more attributes of ownership than the transferor.

Dr. Kumar argued that he was not liable for tax on PSLV's income because he was not the beneficialowner of his shares in 2005. When the record owner of S corporation stock holds the stock for thebenefit of another, as a nominee, agent or passthrough entity, then the income, losses, deductions,and credits of the corporation are passed through to the beneficial owner of the stock and not to therecord owner under Reg. Sec. 1.1361-1(e). Thus, he argued, a taxpayer is the beneficial owner of theproperty if the taxpayer controls the property or has the economic benefit of ownership of the property.

The Tax Court held that Dr. Kumar retained beneficial ownership of his PSLV stock and was requiredto report his share of the PSLV business and interest income on his individual tax return. The courtnoted that a previous case, Hightower v. Comm'r, T.C. Memo. 2005-274, applied the beneficialownership test when the parties had some agreement or understanding regarding their relationshipwith each other. In that case, the court found that when one shareholder merely interferes with anothershareholder's participation in the corporation as a result of a poor relationship between theshareholders, the interference does not amount to deprivation of the economic benefit of the shares.

The court rejected Dr. Kumar's claim that he was not the beneficial owner of the PSLV stock in 2005because he was improperly excluded from the benefits of ownership of the stock. He cited noprecedent where a shareholder took beneficial ownership of stock away from another shareholderabsent an agreement between the two shareholders. There was no agreement to give Dr. Woody anyrights to Dr. Kumar's PSLV stock and Dr. Woody's interference with Dr. Kumar's participation in PSLVdid not deprive him of the economic benefit of his shares. Thus, the court concluded that the beneficialownership test did not relieve Dr. Kumar from his obligation to report his share of PSLV's profits andinterest income.

Pract ice Tip: This is a potential trap for the unwary. It may seem logical that if a shareholder is shutout of the operation and management of an S corporation and is precluded from receiving anydistributions from the S corporation by the other shareholders, the shareholder would not be taxableon the income allocated to him or her. However, this is not the case and like the situation in Kumar, theshareholder may find him or herself with taxable income and no way to pay the tax on that income. If,in Kumar, the S corporation's governing articles provided that such situations (i.e., where a shareholderis shut out of the operations and management of the S corporation and not entitled to distributions)would result in a beneficial transfer of stock from the excluded shareholder to the other Sshareholders, Dr. Kumar may have been successful in arguing that there was a transfer of beneficialownership.

For a discussion of rules for determining an S shareholder's pro rata share of S corporation income,see Parker Tax ¶31,935.

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A Former Employee's FCA Award Was Business Income; Legal Fees Were Deductible as Ordinaryand Necessary Business Expenses

An accountant who brought a False Claims Act (FCA) suit against his former employer was allowed toreport the qui tam award he received as business income on his Schedule C and deduct his legal

report the qui tam award he received as business income on his Schedule C and deduct his legalfees as ordinary and necessary business expenses. Bagley v. U.S. 2013 PTC 233 (C.D. Calif. 8/5/13).

Richard Bagley, an accountant, worked for TRW, Inc. in a variety of positions. From 1987 through 1992,Richard was Chief Financial Officer for TRW's Space and Technology group and was responsible forcontract proposal pricing, indirect budgeting and control, and accounting. From 1989 through 1991,Richard became aware of false claims made by TRW to the government.

In 1990 and 1991, Richard signed government certifications, under the penalty of perjury, that TRW'sindirect expense claims for the Space and Technology group were reimbursable costs even thoughhe did not believe that was correct. In 1993, Richard was laid off from TRW and took documentspertaining to the false claims issue with him when he left. In 1994, Richard met with private attorneysand filed two lawsuits, as a relator, on behalf of the United States. The suits were filed against TRWunder the False Claims Act (FCA). The False Claims Act establishes liability for any person whoknowingly presents or causes to be presented to an officer or employee of the U.S. government afalse or fraudulent claim for payment or approval. Both the Attorney General and private citizens areauthorized to bring civil actions to enforce the FCA.

Richard claimed in the FCA lawsuits that TRW allocated certain costs to the government as indirectexpenses when those costs were not properly pooled as indirect costs and not allowable as chargesto the government. From 1994 through the settlement of the FCA claims in 2003, Richard workedexclusively on his FCA prosecution activity and was not otherwise employed. Richard maintained acontemporaneous log of the hours he worked in relation to the litigation. Richard attended meetingswith his and the government's counsel, provided written summaries of information regarding TRW'sfalse claims, commented on draft documents prepared by his attorneys, and identified key documentsof TRW.

Richard considered himself to be in a trade or business, with his occupation as a private attorneygeneral. He issued Forms 1099-MISC to his private attorneys for legal fees he paid to them. Richarddid not (1) file any business tax returns for his FCA relator activity, (2) file any business registrationswith any city or state, (3) do any advertising of his business, or (4) keep accounting books or recordsfor his qui tam relator activity.

In 2003, Northrup Grumman Corp., the successor of TRW, agreed to pay the United States to settle theFCA suit. The United States awarded Richard $27,244,000 and issued Richard a Form 1099-MISC,reporting the FCA award as Other Income. Richard paid his private attorneys approximately$8,990,500 as a contingency fee. In September 2003, Northrup paid Richard's private attorneysapproximately $9,400,000 as payment of the statutory attorneys' fee award and issued Richard a Form1099-MISC, reporting the statutory fee as gross proceeds paid to an attorney.

Richard filed his Form 1040, Individual Income Tax Return, and reported over $36,650,000 as grossincome, comprised of the FCA award and statutory fee. On his Schedule C, Profit or Loss FromBusiness, Richard deducted legal fees paid to his private attorneys in the amount of approximately$18,478,000. Richard paid federal income taxes and interest of $10,363,000 and filed a claim forrefund. The IRS denied Richard's refund claim on the basis that the $36,650,000 was other incomeunder Code Sec. 212, and the amount paid to his private attorneys was an itemized deductionreportable on Schedule A.

Code Sec. 162 provides a deduction for all ordinary and necessary expenses paid or incurred duringthe tax year in carrying on any trade or business.

Observat ion: An activity is a trade or business only if the taxpayer's primary purpose for engaging inthe activity is for profit, and the taxpayer is involved in the activity with continuity and regularity.

Richard argued that the court should apply the standard set forth in case law for determining whetherhis activities as a qui tam relator were a trade or business and whether the litigation fees wereordinary and necessary expenses under Code Sec. 162.

The government contended that Richard disclosed the fraudulent claims only after he did not find anyfurther employment, removed TRW documents in violation of his employment contract, and soughtimmunity from criminal prosecution before litigating the FCA lawsuit. The government also argued thatthe court should apply the origin-of- the-claim test to determine whether the origin and character of theclaim to which the litigation expense was incurred was a business or personal expense.

A district court held that Richard was engaged in the trade or business of prosecuting an FCA lawsuitand, thus, could report the FCA award on his Schedule C and deduct the legal fees paid to his private

attorneys as ordinary and necessary business expenses. The court noted that, under the FCA, arelator who properly brings a claim is entitled to a share of the recovery and that share is dependentupon the importance of the relator's participation in the suit. Since Richard received 24.5 percent ofTRW's FCA settlement award, the highest percentage award possible, the court determined thatRichard made a substantial contribution to the prosecution of the claim and the information heprovided to the government was meaningful.

The court stated that Richard devoted significant time investigating and prosecuting the FCA claim andactively participated in the prosecution of the suit by reviewing documents, attending meetings, andproviding his attorneys with his expertise regarding the regulations governing federal contracts andpricing, which indicated a good- faith effort to make a profit in a trade or business under Reg. Sec.1.183-2(b). In rejecting the government's claim that the legal fees were personal in nature because theorigin of the claim was the government's fraud claim, the court stated that Richard's services wereprovided to protect the government's interest and he was not pursuing a personal claim.

For a discussion of the rules relating to qui tam payments under the FCA and associated expenses,see Parker Tax ¶74,140.

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CPA Properly Convicted of Failing to File FBARs and Filing False Tax Returns; Ineligible forAdministrative Relief

A CPA, who was the managing director of three foreign corporations and who had signature authorityover several foreign bank accounts, was properly convicted of failing to file reports of foreign bankaccounts and filing false income tax returns. U.S. v. Simon, 2013 PTC 242 (7th Cir. 8/15/13).

James Simon was a CPA, accounting professor, and business entrepreneur. Along with his wife,Denise, and a family trust, James owned a Colorado limited partnership, JAS Partners. James wasalso managing director with signature authority for three foreign companies that were owned by his twosisters and brother. From 2003 through 2006, the Simon family received approximately $1.8 millionfrom the three foreign companies and another corporation, most of which was recorded as loans inJames's personal financial records. During the same time period, the Simon family spent $1.7 million.James paid $328 in income taxes in 2005 and claimed refunds for the other three years. James alsopleaded poverty to financial aid programs to gain need-based scholarships for his children at privateschools.

The government charged James with filing false income tax returns, failing to file reports relating toforeign bank accounts, mail fraud, and financial aid fraud.

A district court ruled that evidence relating to the funding of James's business entities with third-partyloans would be excluded from the trial except to the extent James personally provided that funding. Ajury found James guilty of the charges, and James appealed.

The Bank Secrecy Act, 31 U.S.C. Section 5314, requires that certain individuals disclose their interestsin foreign bank accounts by filing Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts(FBAR). The due date for filing FBARs is June 30 for each foreign account exceeding $10,000maintained during the previous calendar year.

Observat ion: Although the FBAR is received and processed by the IRS, it is not part of the incometax return or filed in the same IRS office as that return. As a result, for purposes of the Internal RevenueCode, the FBAR is not considered return information and its distribution to other law enforcementagencies is not limited by the nondisclosure rules of Code Sec. 6103.

James argued that the money he received from the various entities were loans and thus not taxable. Inthe alternative, he characterized the money as partnership distributions that were not taxable becausethey did not exceed his basis in the partnership. Although he conceded that he failed to timely file theFBARs, James claimed that, since he filed the required forms by the extended due dates provided inNotice 2009-62 and Notice 2010-23, he could not be convicted of failing to file the required forms. Healso contested the district court's decision to limit the evidence he could present in his defense of thefalse income tax return counts.

The government argued that James was not entitled to administrative relief under the two noticesbecause the notices were not intended to relieve from criminal liability taxpayers who willfully failed tofile their FBARs. Further, the notices did not apply to taxpayers who did not report all their taxable

income and pay all taxes due.

The Seventh Circuit affirmed James' conviction for failing to file reports of foreign bank accounts andfiling false income tax returns. The court noted that IRS Notices 2009-62 and 2010-23 provide relief fortwo groups of taxpayers: (1) taxpayers who failed to report all their taxable income could belatedlyreport their income and resolve their tax liabilities through the Voluntary Disclosure Program; and (2)persons who properly reported their income and paid all taxes due but merely failed to timely file theirFBARs could file the delinquent FBARs along with a statement explaining why the FBARs were late.

James conceded that he was not eligible for the Voluntary Disclosure Program and that he never fileda statement explaining why his FBARs were late. The court said that James did not properly report allof his taxable income or pay all of his taxes and, thus, he was not entitled to the relief from criminal orcivil penalties provided in the notices. When the IRS extended the FBAR due dates in the notices forotherwise compliant taxpayers, the court observed, James was already under investigation by theIRS.

The court also concluded that the district court properly excluded evidence relating to the funding ofJames's business entities except for his personal contributions to the partnership. The court rejectedJames's position that loans by third parties to JAS Partners were loans to him as a general partnerthat increased his basis in the partnership. The court noted that James failed to provide any legalsupport that a loan to the partnership is a loan to the general partner.

For the years in issue, James conceded that he failed to indicate on Form 1040, Schedule B, Interestand Ordinary Dividends, that he had access to foreign bank accounts even though he had signatureauthority over several foreign accounts during those years. Because James was not entitled to reliefunder the IRS notices and he presented no evidence to rebut the claim that his tax returns were false,in part due his failure to check the proper box on his Schedule B, the court affirmed James convictionsfor failing to file FBARs and filing false returns.

For a discussion of information reporting for foreign bank accounts, see Parker Tax ¶203,170.

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Motor Home Loan Interest Was Qualified Residence Interest; Unsubstantiated Business DeductionsResult in Penalties

A couple who operated a consulting business was entitled to deduct the interest they paid on a loansecured by their motor home because the interest was qualified residence interest; however, theirdeduction for a laptop computer was disallowed for failure to establish its business use, andunsubstantiated deductions were also disallowed. Dunford v. Comm'r, T.C. Memo. 2013-189 (8/20/13).

Keith and Ena Dunford operated a consulting business, Exam Group, LLC. The couple maintained ahome in Illinois and did much of their consulting work at various locations around the United Stateswhile living in their motor home. For 2005 and 2006, the Dunfords filed joint tax returns and, on theirSchedules C, Profit or Loss From Business, they reported income and expenses from Exam Group,LLC. In 2002, the Dunfords purchased a motor home, which they used for both business and personaltravel during the years in issue. As security for the loan on the motor home, the bank had a lien on themotor home.

For 2005 and 2006, the Dunfords conducted most of their consulting work away from Illinois, andtraveled and stayed in their motor home during this time. The dominant motive for their travel waspersonal, and the couple kept no contemporaneous logs that showed the business character of theirtravel. The Dunfords did not maintain books or records for Exam Group; however, they kept numerousreceipts of their business and personal expenses for 2005 and 2006. The couple also billed theirclients for most of the business expenses they incurred and deducted all their reimbursed expensesas travel and meal expenses on their tax returns.

After auditing the couple's returns, the IRS allowed deductions for the business expenses that theDunfords' billed to clients but disallowed most of the non-billed expenses. The IRS also disallowedinterest deductions on the motor home loan, disallowed the deduction for a laptop computer, anddisallowed deductions relating to the business use of the motor home, as well as many othermiscellaneous deductions. The IRS determined that the couple had tax deficiencies of approximately$32,600 for 2005 and $40,400 for 2006, and that they were liable for accuracy- related penalties foreach year. The Dunfords took their case to the Tax Court.

Code Sec. 6001 requires taxpayers to keep sufficient records to substantiate their gross income,deductions, credits, and other tax attributes. Reg. Sec. 1.6001-1(e) provides that taxpayers must retaintheir books and records as long as they may become material in the administration of any internalrevenue law. Certain expenses are subject to the strict substantiation rules of Code Sec. 274(d). Thoserules apply to expenses for travel, meal and entertainment, and certain listed property, such aspassenger automobiles and computers. Taxpayers must substantiate with adequate records the: (1)amount of the expense, (2) time and place the expense was incurred, (3) business purpose of theexpense, and (4) business relationship of the taxpayer to other persons who benefited from theexpense.

Code Sec. 163(h)(3) allows a deduction for interest paid on acquisition indebtedness incurred toacquire a qualified residence. The total amount a taxpayer can treat as acquisition debt at any timeon the taxpayer's principal residence and a second home cannot be more than $1 million ($500,000 ifmarried filing separately).

The Tax Court held that the Dunfords were entitled to deduct the loan interest on their motor home asqualified residence interest. The interest was qualified residence interest because the Dunfordsincurred the loan to acquire the motor home and the loan was secured by the motor home. The courtdetermined that the Dunfords used their motor home as a residence, did not rent it out, and lived in themotor home for more than 14 days for each of the two years in issue.

Compliance Tip: Code Sec. 163(h)(4)(A)(i)(II) requires that a qualified residence be "selected" bythe taxpayer for purposes of Code Sec. 163(h) mortgage interest deduction. The Dunfords did not"select" the motor home as their second residence on their returns; but Code Sec. 163(h) does notrequire selection on the return. Reg. Sec. 1.163-10T(p)(3)(iv) permits a taxpayer to "elect" a secondresidence; but there is no provision in the Code or the regulations that fixes the time or the manner bywhich a taxpayer makes the selection. The Tax Court concluded that making that selection in litigationis acceptable.

The court disallowed the Dunford's deduction for the purchase of a laptop computer. The computerwas a capital expenditure that could only be deducted if the Dunfords made an election under CodeSec. 179, which they neglected to do. Because the computer was not used exclusively at a regularbusiness establishment and because the Dunfords did not provide any logs or other evidence toshow the percentage of the laptop's business use, no deduction was allowed.

Finally, the court concluded that the Dunfords were liable for accuracy- related penalties forsubstantially understating their tax because they did not have reasonable cause for theunderstatements and did not act in good faith in relying on the advice of their return preparer. Althoughthe couple did not have specific training in tax or accounting, they were reasonably sophisticatedbusiness people who could tell the difference between a personal expense and a business expense.

For a discussion of the deductibility for mortgage interest on a second home, see Parker Tax ¶83,515.

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Frivolous Return Penalty Doesn't Apply to Quaker Expressing Conscientious Objection to Tax

The frivolous return penalty should not apply to a Quaker who conscientiously objects to war and onlysubmitted part of her federal tax liability with her otherwise completed tax return. CCM 20133303F.

A taxpayer timely filed an income tax return listing all items of income and applicable deductions andcredits. The taxpayer correctly calculated the tax due, but did not make a payment with the return.Instead, the taxpayer enclosed a letter describing a conscientious objection to the full payment offederal income tax. As a member of the Religious Society of Friends (Quakers), the taxpayeropposes war and the support of war. The taxpayer enclosed a letter with her return explaining thisposition. In the letter, the taxpayer recited statistics to claim that a certain percentage of federal incometax dollars supports the military. The taxpayer then used this percentage to calculate the amount of taxshe is willing to pay; she "withheld" payment of the rest of the tax due.

Code Sec. 6702(a) imposes a $5,000 penalty on a person if two requirements are met. First, theperson files what purports to be a tax return that does not contain information on which the substantialcorrectness of the self- assessment may be judged or contains information that on its face indicatesthat the self- assessment is substantially incorrect. Second, the information the person includes on thereturn or the lack of information on the return is based on a position that the IRS has identified asfrivolous or a position that reflects a desire to delay or impede the administration of federal tax laws.

The Office of Chief Counsel advised that while the assessment of the Code Sec. 6702 penalty againsta taxpayer who presents a frivolous "conscientious objection" does not violate any constitutionalprovision or amendment, a Code Sec. 6702 penalty was not applicable in the instant situation.

The Chief Counsel's Office noted that courts have consistently held as frivolous arguments that ataxpayer does not need to pay the full amount of federal income tax due based on a "conscientiousobjection" argument. Accordingly, in Notice 2010-33, the IRS included in its notice of frivolousarguments the contentions that (1) the First Amendment permits a taxpayer to refuse to pay taxesbased on religious or moral beliefs and (2) that the Ninth Amendment exempts those with religious orother objections to military spending from paying taxes to the extent the taxes will be used for militaryspending.

For a discussion of the frivolous return penalty, see Parker Tax ¶262,145.

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Married Taxpayer Does Not Qualify for HOH Filing Status Where Husband Lives Elsewhere Due toWork

Where a taxpayer is not a surviving spouse and meets the applicable requirements for head-of-household filing status, but the taxpayer's spouse is away because of business and plans to share acommon household with the taxpayer in the future, the taxpayer cannot be considered a head of ahousehold. CCA 201334041.

In CCA 201334041, an IRS auditor asked the Chief Counsel's Office whether a married taxpayer waseligible to file a tax return as a head of a household for years during which the taxpayer's spouse wasliving apart from the taxpayer due to the spouse's employment situation. The taxpayer and thetaxpayer's spouse were never legally separated and did not intend to live apart permanently.

The Chief Counsel's Office noted that an individual is considered a head of a household only if suchindividual is unmarried at the close of tax year, is not a surviving spouse, and satisfies requirementsunder Code Sec. 2(b). In determining whether a person is unmarried, Code Sec. 7703(b) provides thatindividuals who are married are considered unmarried if all of the following conditions are met:

(1) An individual who is married (within the meaning of subsection (a)) and who files a separate returnmaintains as his home a household that constitutes for more than one half of the tax year the principalplace of abode of a child (within the meaning of Code Sec. 152(f)(1)) with respect to whom theindividual is entitled to a deduction for the tax year under Code Sec. 151 (or would be so entitled butfor Code Sec. 152(e));

(2) The individual furnishes over one-half of the cost of maintaining that household during the tax year;and

(3) During the last six months of the tax year, the individual's spouse is not a member of thathousehold.

With respect to the third condition, the Chief Counsel's Office noted, Reg. Sec. 1.7703-1(b)(5) providesthat an individual's spouse is considered to be a member of the household during temporaryabsences from the household due to special circumstances. A nonpermanent failure to occupy thehousehold as his abode by reason of illness, education, business, vacation, or military service isconsidered a mere temporary absence due to special circumstances.

Accordingly, the Chief Counsel's Office concluded that, even if the taxpayer is not a surviving spouse,meets the requirements under Code Sec. 2(b) and Code Sec. 7703(b)(1) and (2), if the taxpayer'sspouse was away by reason of business and planned to share a common household with thetaxpayer in the future, the taxpayer cannot be considered a head of a household. In such cases, thespouse's absence from the household is considered a mere temporary absence due to specialcircumstances, and the taxpayer is not eligible to file as head of household.

For a discussion of the requirements to file as head of household, see Parker Tax ¶10,550.

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Nonprofit Tests IRS Prohibition on Political Campaigning by 501(c)(3)s; Court Allows Challenge toProceed

A suit alleging that the IRS has a policy of not enforcing the prohibition against political campaigningagainst churches and religious organizations was allowed to proceed; the organization had standingto file the suit. Freedom From Religion Foundation, Inc. v. Shulman, 2013 PTC 252 (W.D. Wisc. 8/19/13).

Entities that are organized and operated exclusively for religious, charitable, scientific, or otherspecified purposes are exempt under Code Sec. 501(c)(3) from having to pay federal income taxes.As a condition of obtaining a tax exemption under Code Sec. 501(c)(3), an entity must not participatein, or intervene in, any political campaign on behalf of, or in opposition to, any candidate for publicoffice. The Freedom from Religion Foundation (i.e., the Foundation), brought suit in a district courtalleging that the IRS has a policy of not enforcing this condition to tax-exempt status against churchesand religious organizations. At the same time, the Foundation alleges, the IRS fully enforces thecondition against other tax-exempt organizations. The Foundation, which is itself a Code Sec.501(c)(3) organization, contends that the IRS's policy of disparate treatment violates the Foundation'srights under both the Establishment Clause and the equal-protection component of the FifthAmendment. As a result, the Foundation asked the district court for declaratory and injunctive relief.

The IRS moved to dismiss the complaint for two reasons. According to the IRS, the Foundation lacksstanding to sue, and the suit, which is really a suit against the United States, is barred by sovereignimmunity.

The district court rejected the IRS's move to dismiss and allowed the Foundation's suit to proceed. Toprove that it has standing to seek injunctive relief, the court said the Foundation had to show that it isunder threat of suffering "injury in fact" that is concrete and particularized; that the threat is actual andimminent, not conjectural or hypothetical; that the threat is fairly traceable to the challenged action ofthe IRS; and that it must be likely that a favorable judicial decision will prevent or redress the injury.According to the court, the Foundation showed all of these things in its suit. If it is true that the IRS hasa policy of not enforcing the prohibition on campaigning against religious organizations, the court said,then the IRS is conferring a benefit on religious organizations (the ability to participate in politicalcampaigns) that it denies to all other Code Sec. 501(c)(3) organizations, including the Foundation. Thecourt found that, as a victim of the IRS's alleged discrimination, the Foundation has suffered an injury infact. Moreover, the court observed, because the Foundation alleged that the IRS's policy is ongoing,the injury is more than actual and imminent - the court found that the Foundation is being deprived ofequal treatment right now. This injury, the court noted, is fairly traceable to the actions of the IRS, sinceit is the IRS's own policy that is causing the alleged unequal treatment. Finally, an injunction prohibitingthe IRS from continuing this policy of unequal treatment will prevent any further injury, the court said.Thus, the court concluded that the Foundation had standing to sue. The IRS made a number ofarguments against the Foundation's having standing, all of which the court rejected as having no merit.

With respect to the IRS's second argument, that because the suit is against the United States, theFoundation must point to a waiver of sovereign immunity, the Foundation pointed to the secondsentence of 5 U.S.C. Section 702, which is part of the Administrative Procedure Act (APA). Thatsentence says: An action in a court of the United States seeking relief other than money damages andstating a claim that an agency or an officer or employee thereof acted or failed to act in an officialcapacity or under color of legal authority shall not be dismissed nor relief therein be denied on theground that it is against the United States or that the United States is an indispensable party.

The IRS did not dispute that the Foundation's suit met all the requirements specified in the abovesentence. However, it contended that the suit did not fall within Section 702's waiver of sovereignimmunity for three reasons: (1) the Foundation did not have standing to sue; (2) the Foundation hadidentified no "final agency action" that could be reviewed under the APA; and (3) the challengedagency action, to the extent it is final, is not reviewable under the APA because it is committed toagency discretion by law. The court noted that it had already rejected the IRS's first argument. Withrespect to the IRS's second and third arguments, the court said they failed because they dependedon the false premise that the Foundation was challenging the IRS's policy pursuant to the APA. In fact,the court observed, the Foundation was challenging that policy pursuant to the Fifth Amendment'sequal-protection component and the Establishment Clause. Thus, the limitations on claims broughtpursuant to the APA- including the requirement that the claim involve a final agency action and therequirement that the claim not involve a matter committed to agency discretion by law-did not apply.However, the second sentence of Section 702, the court said, still waives the United States' sovereignimmunity in this case because that sentence is not limited to claims brought under the APA itself butgenerally applies to any action for prospective relief, including an action involving a constitutionalchallenge.

For a discussion of the requirements to maintain tax-exempt status under Code Sec. 501(c)(3), see

Parker Tax, ¶60,510.

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S Corporation Liable for Employment Taxes and Penalties for Not Paying Salary to Owner

The Tax Court held that an S corporation owed employment taxes on the salary that it should havepaid to its president, and was liable for penalties for failing to timely file employment tax returns andfailure to timely deposit employment taxes. Sean McAlardy Ltd, Inc. v. Comm'r, T.C. Summary Opinion2013-62 (8/12/13).

Sean McAlary obtained a California real estate sales license in 2002 and began earning commissionsselling residential real estate in Southern California. He got his real estate broker's license in 2004.Sean hired a tax return preparer to provide business advice and services in connection with his realestate activity. The return preparer organized Sean's business as an S corporation, Sean McAlardyLtd, Inc., and the minutes of the business stated in part that:

"Annual Compensation for Sean McAlary, President of the Corporation, shall be based on the numberof Revenue Generating Real Estate Agents and Associate Brokers (Affiliates) associated with theCorporation. The Annual Base Compensation shall be $24,000 when the number of Affiliates is notmore than ten (10). Annual Additional Compensation in the amount of $10,000 shall be earned for eachincrement of ten (10) Additional Affiliates. No Additional Compensation shall be earned for any partialincrement of ten (10) Affiliates."

In 2006, the S corporation's sales agents operated as independent contractors, and they earnedbetween 60 to 85 percent of the sales commissions generated on real estate sales they initiated andclosed, with the S corporation retaining the balance. During 2006, Sean supervised eight salesagents, four of whom generated sales commissions for the corporation that year.

Sean filed a Form 1120S for Sean McAlardy Ltd, Inc. on December 11, 2007, reporting gross receiptsof $518,000, various deductions totaling $287,000, and net income of $231,000. The S corporation didnot issue a Form W-2, Wage and Tax Statement, to Sean, nor did it claim a deduction for any amountpaid to Sean as wages or compensation for services. Nor did the S corporation file Form 940 for 2006or Form 941 for any quarterly period ending in 2006. Sean did not report any amount for wages orsalaries on his form 1040, nor did he report or pay any self- employment tax during 2006. On ScheduleE, Supplemental Income and Loss, Sean reported a loss of $15,000 on Part I, Income or Loss FromRental Real Estate and Royalties, income of $201,000 on Part II, Income or Loss From Partnershipsand S Corporations, and total income of $186,000 on Part V, Summary. During 2006, Sean transferreda total of $240,000 from the S corporation's account to his personal account.

The IRS asserted that $100,755 of the $240,000 Sean received from the S corporation during 2006should be treated as his wages. According to the IRS, Sean, acting in his capacities as the Scorporation's sole officer and real estate broker, performed a variety of services that were essential tothe corporation's operations and overall success and should have been paid a salary. The IRSassessesed deficiencies for underpayments of employment taxes and also assessed penalties forfailing to timely file employment tax returns and failure to timely deposit employment taxes.

An employee in the IRS's engineering and valuation program opined that $100,755 representedreasonable compensation. In computing Sean's reasonable compensation for 2006, the IRSemployee first concluded that Sean's primary job function was that of a real estate broker supervisingreal estate agents. He then consulted the California Occupational Employment Statistics Survey for2006, determined that the median wage for a real estate broker in southern California was $48.44 perhour, and multiplied that amount by 2,080 hours (40 hours per week x 52 weeks per year) to arrive attotal annual compensation of $100,755. In support of his conclusion that $100,755 representedreasonable compensation for Sean's services during 2006, the IRS employee compared the Scorporation's financial performance with that of its peers in the real estate industry. He consulted theRisk Management Association Annual Statement Studies and noted that the S corporation's 44.7percent profit margin for 2006 far surpassed the 21.9 percent average profit margin for the industry. Itwas noted during the trial, however, that the 44.7 percent profit margin did not account for the Scorporation's obligation to pay Sean's reasonable compensation. Assuming reasonablecompensation of $100,755, the S corporation's profit margin only slightly exceeded the industryaverage.

The S corporation argued that the court should respect the salary agreement between it and Sean,which set his annual base pay at $24,000 and provided for increased compensation if Sean was able

to recruit additional sales agents and associate brokers. Sean testified that he provided the Scorporation's tax information to the tax return preparer, and that he counted on him to properlycompute the corporation's tax liabilities. Reliance on the advice of a tax professional may establishreasonable cause and good faith.

The Tax Court held that Sean should have been paid a salary and that the S corporation owedemployment taxes on the salary that should have been paid. The court was not persuaded that thesalary agreement represented a sound measure of the value of the services that Sean provided to hisS corporation during 2006. The court was skeptical of the agreement inasmuch as Sean sat on bothsides of the table when the agreement was executed, occupying the positions of both employer andemployee. The agreement, the court noted, clearly was not the product of an arm's- length negotiation.Instead, the court concluded that $40 an hour (or annual compensation of $83,200) representedreasonable compensation for the various services that Sean performed for the S corporation.

Considering all the facts and circumstances, the Tax Court was not persuaded that the S corporationexercised ordinary business care and prudence and was nonetheless unable to file Forms 940 and941 by the date prescribed by law or unable to remit the proper amount of employment taxes to theIRS. Thus, the court upheld the IRS's additional tax and penalty assessments.

For a discussion of reasonable compensation for S corporation shareholders, see ¶31,927.

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IRS Denies Tax-Exempt Status to Medical Marijuana Cooperative

The IRS ruled that an organization's primary activity of facilitating and organiz ing transactions betweenmembers who cultivate and possess cannabis is illegal under federal law and, thus, the organizationdid not qualify for tax-exempt status. PLR 201333014.

Three individuals formed a state nonprofit cooperative association. Its Articles of Incorporation statedthat it was formed for the pleasure, recreation, and other nonprofit purposes authorized under CodeSec. 501(c)(16); however, its website noted that the state had classified its corporate status as"suspended."

The stated purpose of the organization is to facilitate and organize transactions between memberswho collectively cultivate and possess marijuana for medical purposes. This includes promoting,advocating, and financing the safe and legal access of medical marijuana for therapeutic and medicalpurposes as well as research. The organization will limit access to any marijuana it owns orpossesses to its members who, under state law, are qualified medical marijuana patients and/orprimary caregivers. Any person or entity that is a qualified patient or caregiver, as defined by statelaw, may submit a membership application to become a member of the cooperative.

The cooperative may enter into marketing, crop purchase, or other agreements with any member orpatron. The agreements may incorporate provisions relating to the harvesting, handling, packing,processing, selling, shipping, delivery, or title transfer of cannabis produced by the member or patron.After delivery, the organization may receive unqualified power to take title over and process, sell,dispose, or transfer the cannabis.

The incorporators are engaged in the production of cannabis and have associated themselvestogether to form a nonprofit cooperative association. The incorporators are not organizations exemptfrom federal income tax under Code Sec. 521, or members of such organizations.

The organization applied to the IRS for exemption from tax under Code Sec. 501(c)(16). Code Sec.501(c)(16) describes corporations organized to finance the ordinary crop operations of its members orother producers. The corporation must be organized by a Code Sec. 521 farmers' cooperative, or thecooperative's members, and operated in conjunction with the Code Sec. 521 farmers' cooperative thatorganized it.

The IRS denied tax-exempt status to the organization. The IRS stated that, while the organizationappeared to satisfy the applicable provisions relating to capital stock and a reserve, it did not satisfythe other organizational requirements of Code Sec. 501(c)(16) because (1) the state had suspendedits corporate status and thus it did not meet the first organizational requirement of Code Sec.501(c)(16); (2) it did not show that it was created by a Code Sec. 521 farmers' cooperative; or (3) thatits incorporators were members of a Code Sec. 521 exempt farmers' cooperative. The IRS also notedthat the organization's articles of incorporation stated that it was "formed for the pleasure, recreation

and other non-profit purposes listed under Code Sec. 501(c)(16)." As "pleasure" and "recreation" arenot exempt purposes listed under Code Sec. 501(c)(16) or the accompanying regulations, the IRSconcluded that the organization did not completely satisfy the organizational requirements of CodeSec. 501(c)(16).

Finally, the IRS observed that the organization's activities violate the general principle that taxdeductions and exemptions are not applicable to activities that are illegal. The cooperative's primaryactivity of facilitating and organiz ing transactions between members who cultivate and possesscannabis, the IRS stated, is illegal under federal law. Congress, the IRS said, has made adetermination that marijuana has no medical benefits worthy of an exception to the general rule thatthe manufacture and distribution of cannabis is illegal.

For a discussion of the requirements that must be met to be a tax-exempt Code Sec. 501(c)(16)organization, see Parker Tax ¶60,510.

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