The doctrine of equitable recoupment applies to both assessment by the IRS (in Section 6501) and refunds by taxpayers (in Section 6511) where the IRS or taxpayer may characterize a transaction, item, or event in a different way in open tax years than it was characterized in a closed year. Inconsistencies between open and closed tax years may whipsaw either the government or the taxpayer. The courts, recognizing potential abuse, have provided a defense against this potential inconsistent treatment through the doctrine of equitable recoupment.
Pursuant to Rev. Proc. 2001-43, recipients of unvested profits interests are treated as partners on the date of grant regardless of whether they make Section 83(b) elections. Therefore, when the profits interest later vests, there is no additional income provided the parties meet the requirements of Rev. Proc. 2001-43 and Rev. Proc. 93-27. Since the owners of profits interests are treated as partners, they can be allocated income and loss prior to vesting despite the ultimate substantiality of such allocations under the Section 704(b) regulations being unclear at the time of the allocation. That creates a potential problem: What happens if the profits interest is forfeited after such allocations? That is a common occurrence, as employers often require forfeiture of unvested profits interests upon the partner’s leaving the employment of the partnership.
Rev. Proc. 2001-43 does not address forfeiture. The forfeiture of a partnership interest could be taxable to the remaining partners if they are treated as receiving a share of partnership assets from the forfeiting partner under an aggregate theory of partnership. See Treas. Reg. § 1.721-2(e) (authorizing treatment of partnerships as an aggregate of its partners where appropriate). However, the taxation of capital shifts is unsettled.
In 2005, Treasury issued proposed regulations under Section 704(b) to clarify the treatment of the forfeiture of unvested profits interests. Under the proposed regulations, a capital shift that occurs upon forfeiture is taxable to the other partners only to the extent taxable income was previously allocated to the forfeiting partner. The proposed regulations would require allocations of loss to the forfeiting partner in the year of forfeiture equal to the excess of prior non-taxed distributions over the amount paid for such interest (typically zero) minus the cumulative net income allocated to the forfeiting partner during prior years. Prop. Reg. § 1.704-1(b)(4)(xii)(c). These special allocations work to undo the prior tax treatment of the profits interest holder with offsetting allocations. Similarly, offsetting allocations to the remaining partners are required by the proposed regulations, usually income allocations that offset loss allocations made to the forfeiting partner. Thus, the proposed regulations sometimes treat the forfeiture of a nonvested profits interest as a taxable event for the remaining partners. Although the proposed regulations have not been finalized, many operating agreements incorporate their rules to resolve the treatment of a forfeiture of a nonvested profits interest.
John G. Hodnette is an attorney with Fox Rothschild, LLP in Charlotte.
I. Conservation Easement Charitable Deduction Limited to Taxpayer’s Basis in Ordinary Income Property; Oconee Landing Property vs. Commissioner, TC Memo 2024-25.
Oconee Landing Property, LLC claimed a charitable contribution deduction of almost $21 million for its donation of a conservation easement on property it owned in Georgia. The IRS disallowed the entire deduction. The Tax Court held the charitable contribution failed in its entirety for two reasons. First, the appraisers were not qualified appraisers, which meant Oconee failed to attach a qualified appraisal to its tax return. Second, because the property on which the easement was granted was ordinary income property, the amount of the charitable contribution was limited to Oconee’s basis in the donated property. Because Oconee could not prove its tax basis in the property exceeded zero, its charitable contribution was zero.
The assignment of income doctrine was established in Lucas v. Earl, 281 U.S. 111 (1930). It is a judicial doctrine that requires income earned by a taxpayer to be taxed to the taxpayer regardless of to whom it is paid. In Lucas, the taxpayer assigned to another individual his right to receive a payment for services. In Blair, 300 U.S. 5 (1937), the Supreme Court confirmed the doctrine applies to income arising from property as well as service income.
The anticipatory assignment of income doctrine is a longstanding “first principle of income taxation.” Commissioner v. Banks, 543 U.S. 426, 434 (2005) (quoting Commissioner v. Culbertson, 337 U.S. 733, 739–40 (1949)). The doctrine ensures income is taxed “to those who earn or otherwise create the right to receive it,” Helvering v. Horst, 311 U.S. 112, 119 (1940). Tax cannot be avoided “by anticipatory arrangements and contracts however skillfully devised,” Lucas v. Earl at 115.
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Section 409A addresses the taxation of nonqualified deferred compensation plans. A nonqualified deferred compensation plan is any arrangement that provides for the deferral of compensation, subject to exceptions. Section 409A is a response to executive compensation practices Congress felt were inappropriately beneficial.
Amounts deferred that do not meet the requirements of Section 409A generally are immediately includible in gross income (to the extent not subject to a substantial risk of forfeiture or previously included in income). Additionally, a 20% excise tax is imposed on the amount included in income. Interest at the federal penalty rate plus 1% is charged from the date of each failure. All such amounts are charged to the employee, rather than for the employer.
Tax practitioners are familiar with Subchapter C (C corporations), Subchapter K (partnerships), and Subchapter S (S corporations) but are generally less familiar with Subchapter T (§§ 1381-1388), which governs the taxation of cooperatives.
A cooperative is an association otherwise taxable as a C corporation that markets, purchases, or performs business functions for its patrons on a cooperative basis. The means of production and distribution are owned in common. The earnings revert to the members in proportion to their patronage (i.e., in proportion to the amount of business each member transactions with it). The predominant features of a cooperative are: (i) subordination of capital, (ii) democratic control, and (iii) proportionate allocation of profits. Cooperatives developed as a legal concept in 19th century England. In the United States, cooperatives were exempted from taxation as far back as 1916. The policy behind such exemption is cooperatives, unlike traditional corporations, are merely agents or conduits of their patrons so income should flow directly to patrons rather than being taxed to the cooperative.
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I trust everyone is having a good summer and finding enjoyable ways (aside from work) to avoid the heat and the daily downpours. We were fortunate this year to have wonderful weather during our annual CLE at Kiawah Island. Our CLE co-chairs, Kristin King and Jordan Fieldstein, did an outstanding job finding a slate of spectacular speakers, and we had a fine turnout of attendees in person and online. Jordan will be staying on as a CLE Committee co-chair, joined by Helen Herbert. Please plan to join us over Memorial Day weekend in 2025 for another wonderful weekend of sun and tax topics.
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I. Thanksgiving Holiday Extends the Due Date for Filing Tax Court Petition; Sall vs. Commissioner, 161 T.C. No. 13 (2023).
Mr. Sall received a notice of deficiency dated August 25, 2022, which was sent to Mr. Sall by certified mail on August 26. The 90th day after August 26 was Thursday, November 24, Thanksgiving Day. The face of the notice of deficiency stated that “the last day to file a petition with the US Tax Court” was Friday, November 25, 2022. Although the Tax Court’s electronic filing system through Dawson was operational and accessible throughout the entire Thanksgiving week, the Tax Court was closed from Thanksgiving Day until the following Monday. Mr. Sall mailed his petition to the court on Monday, November 28, 2022. The court received Mr. Sall’s petition on Thursday, December 1, 2022.
The IRS filed a motion to dismiss on the basis that the petition was filed late, since according to the IRS, the filing deadline was November 25, 2022. The court, however, concluded the petitioner’s due date was no earlier than Monday, December 12, 2022, which was long after the court received Mr. Sall’s petition. The court navigated the rules of Section 7451 to conclude the filing deadline was extended from Friday, November 25 through Monday December 12, 2022. Even though the electronic Dawson filing system was operational throughout Thanksgiving week, the court was officially closed on Thursday, November 24 and Friday, November 25. Under Section 7451(b), the statute of limitations for filing a Tax Court petition is tolled by “the number of days within the period of inaccessibility, plus an additional fourteen days.” Section 7451(b)(1).
Section 1032 provides no gain or loss is recognized by a corporation on the issuance of its stock to a new owner, whether in exchange for cash or otherwise. Similarly, a shareholder’s acquisition of stock for cash is not a taxable event but is instead an investment creating a cost basis under Section 1012 on which gain or loss can be calculated when the stock is sold or becomes worthless. However, often (particularly at the initial formation of a business), property other than cash is contributed to a corporation in exchange for stock of that company. In such cases, absent the application of Section 351, the default treatment would be a taxable sale or exchange. The new shareholder would recognize gain or loss equal to the difference between the adjusted basis of the property contributed and the value of the stock received.
Section 351 is the key exception to that taxable treatment. Section 351(a) provides the transferor shareholder recognizes no gain or loss on transfer of property solely in exchange for stock if the transferor (or transferors joining in such contribution in exchange for stock) are in control of the corporation immediately after the exchange. Section 368(c) defines control in the Section 351 context to mean “the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.” Importantly, Section 351(a) contemplates transfers by one or more persons allowing for a control group to be formed where multiple owners (typically at the formation of the new corporation) join together. For example, if owner A and owner B form a new corporation, and A contributes $50 of cash for 50 shares while B contributes equipment with a fair market value of $50 and a tax basis of $10 for 50 shares, the entire transaction can be a tax-free contribution under Section 351(a). A and B together received 100% of the new corporation’s shares even though separately they each received only 50%. That A contributed cash while B contributed other property does not prevent them from being a control group.
I. 2023 Audit Statistics; Chances of Being Audited.
The 2023 Internal Revenue Service Data Book released in April 2024 contains audit statistics for years 2013 through 2021, as of the fiscal year ended September 30, 2023 (FY 2023). For years before 2020, the statute of limitations had generally expired as of September 30, 2023. However, for 2020 and later returns, the statute of limitations has yet to expire, so additional returns for those years may be audited.
For 2013 through 2021, audit rates dropped significantly. For example, individual tax returns had an audit rate of 0.6% for 2013 returns versus 0.2% for 2021. For individuals with income between $1 million and $5 million, the audit rate dropped from 3% for 2013 returns to 0.5% for 2021 returns.
The overall audit rate for C corporations dropped from 1.2% for 2013 returns to 0.3% for 2021 returns. For partnerships and S corporations, the audit rate for 2013 returns was 0.3% compared to 0.1% for 2021 returns.
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