Under the claim of right doctrine, a taxpayer who receives income under a claim of right that is free of restrictions must include the amount in income in the year of receipt. That is the case even if the taxpayer may, in a future year, be required to return to the payor the amount included in income. If the amount is returned within the same tax year, the rescission doctrine can apply to prevent taxation. Where the amount included in income is repaid after the year of inclusion, a deduction may be available to reduce current year income for the amount repaid. In some cases a deduction in the year of repayment does not produce as much reduction in tax liability as the amount of tax paid in the year of inclusion (due to changes in tax rates or limits on the use of the deduction). Section 1341 addresses that potential whipsaw by allowing taxpayers to elect to reduce the tax liability in the current year by the amount of tax generated in the previous year by the inclusion of such amount in income.
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I. No Reasonable Cause Penalty Defense where CPA did not Give Specific Advice about Erroneous Items; Johnson v. Commissioner, TC Memo 2023-116
Mr. and Mrs. Johnson hired a CPA to prepare their tax returns for 2015-2018. From 2006 to 2013, Mr. and Mrs. Johnson improperly claimed depreciation deductions on certain commercial buildings by using a seven-year depreciation life, rather than the 39-year life applicable to commercial property. As a result, the Johnsons overstated their depreciation deductions between 2006 and 2013 by $1.5 million.
The Johnsons sold their property in 2016 for $5 million. Because of the improper depreciation deductions claimed between 2006 and 2013, the IRS made a Section 481 accounting method adjustment of almost $2 million for 2015. In addition, for 2015, the Johnsons claimed a charitable contribution deduction. However, they filed an incomplete Form 8283 (Non-cash Charitable Contributions) that was fatally defective in numerous respects.
Congress adopted new partnership audit rules as part of Bipartisan Budget Act of 2015 (“BBA”), replacing the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). As part of that change, the role referred to as the tax matters partner has been replaced by the partnership representative.
The partnership representative can take a number of actions on behalf of the partnership, including (i) entering into a settlement agreement; (ii) agreeing to a notice of final partnership adjustment; (iii) requesting modification of an imputed underpayment; (iv) extending the modification period; (v) waiving the modification period; (vi) agreeing to adjustments and waiving the final partnership adjustment; (vii) extending the statutory periods for making adjustments; and (viii) making a push out election.
The allocation of income when the ownership of an S corporation changes is discussed in my previous article Section 1377(a)(2) Elections for S Corporations. That article explains the default method for allocations of income when an ownership change occurs as to an S corporation is the proration method. However, one can make a Section 1377(a)(2) election and instead use the closing of the books method. In contrast, in the case of partnerships, the default is the opposite.
Pursuant to Reg. § 1.706-4(a)(3)(iii), “absent an agreement of the partners . . . to use the proration method, the partnership shall use the interim closing method.” Reg. § 1.706-4(f) defines “agreement of the partners” to mean either (i) an agreement of all the partners to select the method in a dated, written statement maintained with the partnership’s books and records or (ii) a selection made by a person authorized to make such selection under state law or the partnership agreement, provided that person’s selection is in a dated, written statement maintained with the partnership’s books and records. The interim closing method is similar to the S corporation closing of the books method. The interim closing method generally treats each change in partnership ownership as the time to close the books for such interim period. That means only partners who were owners in such period are allocated income and loss that occurred during the period. However, the regulations provide great flexibility in determining the length of interim periods.
https://ncbarblogprod.wpengine.com/wp-content/uploads/2018/06/Blog-Header-1-1030x530.png00TAXhttps://ncbarblogprod.wpengine.com/wp-content/uploads/2018/06/Blog-Header-1-1030x530.pngTAX2024-02-20 08:41:392024-03-13 13:29:44Allocation of Income When a Partner Leaves a Partnership
Revenue Ruling 99-5 discusses the tax treatment of the purchase of some but not all of the membership interests in a wholly-owned LLC. Pursuant to Reg. § 301.7701-3(b)(1)(ii), unless electing otherwise, a domestic LLC with only one owner is treated as an entity disregarded as separate from its owner for income tax purposes. However, that raises the issue of how to treat an acquisition of less than 100% of the membership interests in the LLC. This is not an unusual circumstance, particularly because the Rev. Rul. 99-5 structure is often used in S corporation F reorganization transactions.
Rev. Rul. 99-5 explains two situations involving a wholly-owned LLC that is disregarded for income tax purposes. It is assumed in both situations that the resulting partnership is not treated as an investment company, all of the assets are capital assets or Section 1231 property, and there is no indebtedness.
The tax benefit rule was originally established by case law but later codified as Section 111. It provides a taxpayer is not permitted to retain the tax benefit of a deduction when later events demonstrate she is not entitled to it. The rule prevents taxpayers from receiving the benefit of a deduction in one year, but upon an unexpected change of circumstances in a later year, receiving a recovery of items that were deducted as a loss in the prior year (and without treating that recovery as income).
An example of the rule is where a taxpayer takes a deduction for a bad debt in year one under Section 166(a). Without the tax benefit rule, the repayment of the bad debt in year two (which would be a nontaxable return of capital) is not a taxable event. Thus, the taxpayer would have had the benefit of the deduction while also receiving the benefit of the recovery of nontaxable cash. To prevent that double benefit, the tax benefit rule requires the taxpayer to recognize income from the receipt of the unexpected payment in year two to offset the tax benefit of the deduction in year one.
Employers often issue incentive stock to employees to promote retention and performance. Restricted Stock Units or “RSUs” are one of many ways to do so. Unlike similarly named restricted stock, an RSU does not initially provide the recipient with any ownership in the corporation. Rather, they are a contractual obligation of the employer to issue stock to the holder of the RSU once the RSU vests. It is only upon the issuance of stock that the RSU holder is taxed. Therefore, a Section 83(b) election is not possible or necessary for RSUs, unlike restricted stock.
Once an RSU vests, the corporation issues stock to the RSU holder. That results in compensation income equal to the fair market value of the issued stock at the time of issuance. The corporation receives a corresponding deduction. Like other compensation income, the issuance of stock is subject to withholding of income and FICA taxes.
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I. Termination of S Corporation Status was Inadvertent where Shares were Owned by an IRA.
In PLR 202319003, the IRS again demonstrated its willingness to grant amnesty to inadvertent S corporation terminations. The IRS waived an S termination where shares were issued to an IRA. The corporation elected to be an S corporation, but the election was invalid because one of its shareholders was an IRA. Apparently, when the S election was filed, the officers of the S corporation and the owner of the IRA did not know an IRA is not an eligible S corporation shareholder.
After the corporation learned the IRA was an ineligible shareholder, the stock was transferred from the IRA to its owner. The IRS waived the inadvertent termination and permitted the S corporation’s status as of its original incorporation date. However, as a condition of the favorable PLR, for all open years in which the S corporation had positive income, the IRA owner had to be treated as the shareholder for all purposes. Also, for any open years in which the corporation had a net loss, the IRA had to be treated as the owner of the stock.
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Section 1239 provides gain on the sale or exchange of certain depreciable property between related taxpayers is taxed at ordinary income rates rather than the more typical capital gain or unrecaptured 1250 gain rates. Section 1239 applies to property that, in the hands of the transferee, is subject to depreciation under Section 167. It includes depreciable real property as well as depreciable intangibles. Section 1239 discourages related taxpayers from taking advantage of the tax arbitrage between depreciation deductions that can offset ordinary income and more favorable capital gains rates that might otherwise be available on the sale of such depreciable property. Without Section 1239, related taxpayers might continuously sell or exchange depreciable property to repeatedly depreciate the property. Section 1239 removes that tax arbitrage strategy.
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The Tax Cuts and Jobs Act of 2017 made changes effective in 2022 for the R&D deduction under Section 174 as well as the interaction between that deduction and the R&D credit under Section 41, as provided in Section 280C. Although the changes generally reduce the deduction in the first year by requiring capitalization and amortization over 5 years, they also reduce certain limits on the Section 41 credit.
For years prior to 2022, Section 174 provided a deduction for qualifying R&D expenses. Section 41 provided a credit based on qualifying R&D expenses. However, because both the deduction and the credit arise from the same activities, Section 280C(c) provides a limit on either the credit or the deduction so taxpayers are not double dipping tax benefits from the same R&D expenses.
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