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Top 12 Tax Developments of 2018

(Parker Tax Publishing January 2019)

As a result of changes in the tax law resulting from the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), the IRS released a deluge of highly consequential regulations, notices, and revenue procedures in 2018. Additionally, several court cases had a significant impact on the handling of various tax positions.

The following is a summary of some of the more important tax developments in 2018.

Taxpayers Win in the Supreme Court

Taxpayers had two tax victories in the Supreme Court in 2018. In Wisconsin Central LTD v. U.S., 2018 PTC 182 (S. Ct. 2018), the Supreme Court reversed the Seventh Circuit and held that employee stock options are not taxable compensation under the Railroad Retirement Tax Act because they are not "money remuneration." According to the Court, the term "money," as used in Code Sec. 3231, unambiguously excludes "stock" and thus several railroad companies who had been including stock options in the compensation plans of a number of employees were entitled to refunds of taxes they paid on their employees' exercise of the stock options.

In another win for taxpayers, the Supreme Court, in Marinello v. U.S., 2018 PTC 77 (S. Ct. 2018), reversed the Second Circuit and held that, in order to secure a conviction under Code Sec. 7212(a) for interference with the administration of the Internal Revenue Code, the government must show a nexus between the taxpayer's obstructive conduct and a particular administrative proceeding, such as an investigation, audit, or other targeted administrative action. The Court found that broadly applying the statute to the routine administration of the Code, including the processing and review of tax returns, would conflict with the language, history, and context of the statute and fail to give taxpayers fair warning of what conduct is subject to criminal prosecution.

Tax Court Holding on DISC/Roth IRA Arrangements Rejected by Three Circuit Courts

In a case involving an operating C corporation, its founding shareholders, a domestic international sales corporation (DISC), and Roth individual retirement accounts (IRAs), the Tax Court held that commissions from the operating corporation to the DISC, which was indirectly owned by Roth IRAs belonging to the shareholders' sons, were properly characterized as contributions to the Roth IRAs which exceeded the annual contribution limits and, thus, were subject to excise tax penalties. The Tax Court recharacterized the transactions under the substance over form doctrine, finding that the purpose was to shift funds into the Roth IRAs in violation of the statutory contribution limits.

The Tax Court found that the net effect of the DISC was to distribute export revenue to shareholders without taxing it first as corporate income. The corporation appealed to the Sixth Circuit and won (Summa Holdings v. Comm'r, 2017 PTC 58 (6th Cir. 2017)). In reversing the Tax Court, the Sixth Circuit held that, because the corporation used the DISC and Roth IRAs for their congressionally sanctioned purposes - tax avoidance - the IRS had no basis for recharacterizing transactions involving the transfer of funds from the DISC to the Roth IRAs. The founding shareholders' sons appealed to the First Circuit and the First Circuit, in Benenson v. Comm'r 2018 PTC 98 (1st Cir. 2018), also reversed the Tax Court. The First Circuit explained that, for wealthy taxpayers, Roth IRAs are strategic vehicles for investing in private companies which may pay out substantial dividends. This use of a Roth IRA, the court said, was consistent with the purpose of incentivizing long-term savings and investment for retirement. As long as the owner of the Roth IRA was qualified to make the initial contributions, the court found that it was not contrary to the statute's purpose to allow their contributions to grow through investment in qualified companies, even during periods where the taxpayers' high income disqualified them from contributing to the Roth IRA.

The founding shareholders appealed to the Second Circuit and, in Benenson v. Comm'r, 2018 PTC 431 (2d Cir. 2018), the Second Circuit also reversed the Tax Court. The Second Circuit agreed with the First and Sixth Circuits that the Tax Court's recharacterization of the transaction was not supported by the substance over form doctrine. The court found that the commission payments were legitimate DISC transactions, not sham transfers, because the commissions represented a percentage of genuine export income, and the DISC's corporate shareholder paid corporate income tax when the DISC distributed the income as dividends.

Courts Disagree on Maximum Amount of FBAR Penalty That May Be Assessed

During 2018, a difference of opinion emerged among several courts on the maximum penalty that may be assessed where a taxpayer willfully fails to file a Report of Foreign Bank and Financial Accounts (FBAR) or files an inaccurate FBAR. In Wadhan v. U.S., 2018 PTC 245 (D. Colo. 2018), a district court held that the IRS could not assess penalties in excess of $100,000 per year, the limit specified in the regulations in 31 C.F.R. Sec. 1010.820, even though the related statute (31 U.S.C. Sec. 5321(a)(5)(C)) increased the penalty in 2004 to the greater of $100,000 or 50 percent of the balance in the relevant account at the time of the violation. The court noted that its reasoning was congruous with the decision in U.S. v. Colliot, 2018 PTC 251 (W.D. Tex. 2018) and stated that, for a statute to supersede a regulation, it has to be clearly inconsistent with the regulation. The court found that the statute and regulation were not inconsistent on their face; instead, the penalty cap in the regulation was, in essence, a subset of the penalties that could be imposed under the statute and the statute did not mandate imposition of the maximum penalty.

The Court of Federal Claims, however, reached a different result. In Norman v. U.S., 2018 PTC 250 (Fed. Cl. 2018), the Court of Federal Claims held that the IRS properly assessed against a taxpayer a penalty in the amount of 50 percent of the balance of her 2007 unreported foreign account after a finding that she willfully failed to file a FBAR in connection with her Swiss bank account. In response to the taxpayer's request that the court follow the holding in U.S. v. Colliot, 2018 PTC 251 (W. D. Tex. 2018) and award her the difference between the $803,000 penalty she paid and the $100,000 limit stated in 31 C.F.R. 1010.820, the court said that the regulation cited in Colliot was no longer valid as the result of amendments to the statute in 2004. The Court of Federal Claims ruled similarly in Kimble v. U.S., 2018 PTC 450 (Fed. Cl. 2018).

Activity on Disguised Partnership Sale Rules Creates Uncertainty

In June, the IRS issued REG-131186-17, in which it withdrew previously issued proposed regulations relating to disguised partnership sales under Code Sec. 707 and proposed removing previously issued temporary regulations under Code Sec. 707 and reinstating prior Code Sec. 707 regulations relating to the allocation of liabilities for disguised partnership sale purposes. The IRS said that, while it believes that the temporary Code Sec. 707 regulations' novel approach to addressing disguised sale treatment merits further study, such a change should be studied systematically.

Proposed Regs and Draft IRS Publication Address Sec. 199A Calculation

In August, in REG-107892-18, the IRS released proposed regulations on the Code Sec. 199A qualified business income deduction. Some of the more significant provisions in the proposed regulations include:

(1) allowing taxpayers to aggregate trades or businesses, other than a specified service business, for purposes of applying Code Sec. 199A;

(2) allowing a business that pays wages to a common law employee through a third party to count such wages as being paid by the business in applying the W-2 wage limitation;

(3) for purposes of determining whether a trade or business is a specified service trade or business (SSTB), providing "performance of services in the field of consulting" means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems;

(4) limiting the meaning of the "reputation or skill" clause to fact patterns in which the individual or relevant passthrough entity (RPE) is engaged in the trade or business of (1) receiving income for endorsing products or services, including an individual's distributive share of income or distributions from an RPE for which the individual provides endorsement services; (2) licensing or receiving income for the use of an individual's image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual's identity, including an individual's distributive share of income or distributions from an RPE to which an individual contributes the rights to use the individual's image; or (3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players); and

(5) providing a de minimis rule for a specified service trade or business (SSTB) so that it is not considered an SSTB, and is thus eligible for the deduction, if gross receipts are $25 million or less and less than 10 percent of gross receipts of the trade or business is attributable to the performance of services in an SSTB.

In December, the IRS issued a Pub. 535 Draft Worksheet for tax year 2018. The publication reviews the computations necessary to calculate a taxpayer's Code Sec. 199A deduction and includes several worksheets to help with such computations, and also lists the additional information that partnerships and S corporations will need to prepare for their partners' and shareholders' 2018 Schedule K-1s.

IRS Issues Proposed Bonus Depreciation Regs That Taxpayers May Rely on Now

In August, in REG-104397-18, the IRS issued proposed regulations on the increased additional first year depreciation deduction (i.e., bonus depreciation) available under Code Sec. 168(k) as a result of changes made by TCJA.

Practitioners need to be aware that, for property placed in service after December 31, 2017, TCJA amended Code Sec. 168(e) to eliminate the 15-year MACRS property classification for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. TCJA also amended Code Sec. 168(k) to eliminate qualified improvement property as a specific category of qualified property and combined qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property into qualified improvement property, effective for property placed in service after 2017. Thus, the proposed regulations provide that MACRS property with a recovery period of 20 years or less includes the following MACRS property that is acquired by the taxpayer after September 27, 2017, and placed in service by the taxpayer after September 27, 2017, and before January 1, 2018:

(1) qualified leasehold improvement property;

(2) qualified restaurant property that is qualified improvement property; and

(3) qualified retail improvement property.

Also under the proposed regulations, qualified property includes qualified improvement property that is acquired by the taxpayer after September 27, 2017, and placed in service by the taxpayer after September 27, 2017, and before January 1, 2018. However, bonus depreciation is not available for these types of assets where they are placed in service after 2017.

While TCJA committee reports indicated that qualified improvement property was to have a 15-year life, thus making such property eligible for the bonus depreciation deduction, a drafting error prevented such property from being included in the list of 15-year property under Code Sec. 168(e)(3)(E). Thus, because qualified improvement property is not specified in Code Sec. 168(e)(3)(E) as 15-year property, such property has the recovery period specified in Code Sec. 168(c) - 39 years for nonresidential real property. As a result, until technical corrections legislation is enacted, such property does not meet the bonus depreciation criteria specified in Code Sec. 168(k)(2)(A) (i.e., its recovery period is not 20 years or less) and it is thus not eligible for bonus depreciation.

Final 263A Regs Contain Simplified Accounting Methods, Along with Revenue Procedure to Facilitate Accounting Method Changes

As Thanksgiving approached, the IRS issued regulations finalizing the simplified methods of accounting for Code Sec. 263A costs. In T.D. 9843, the IRS:

(1) provided rules for the treatment of negative adjustments relating to certain costs required to be capitalized to property produced or acquired for resale;

(2) provided new simplified methods of accounting for additional costs allocable to property produced or acquired for resale; and

(3) redefined how certain types of costs are categorized for purposes of the simplified methods.

Taxpayers should see cost savings as a result of the reduction in the computational and record-keeping burdens. At the same time, the IRS issued Rev. Proc. 2018-56 which provides procedures by which a taxpayer can obtain automatic IRS consent to change to certain accounting methods described in the regulations.

IRS Pushes Back on Taxpayer Attempts to Work Around SALT Limitation

One of the more impactful changes made by TCJA was the $10,000 limitation on the amount of state income and property taxes that may be deducted. Because there is no limit on charitable contribution deductions to Code Sec. 170(c) entities, strategies and proposals being discussed and implemented by state legislatures in order to help taxpayers get around the limitation included increased charitable contributions to states in exchange for state income tax credits.

In Notice 2018-54, and subsequent proposed regulations (REG-112176-18), the IRS limits certain charitable contribution deductions when an individual, a trust, or a decedent's estate receives or expects to receive a corresponding state or local tax credit. The general rule provides that if a taxpayer makes a payment or transfers property to or for the use of an entity listed in Code Sec. 170(c), and the taxpayer receives or expects to receive a state or local tax credit in return for such payment, the tax credit constitutes a return benefit, or quid pro quo, to the taxpayer and the charitable contribution deduction is reduced accordingly. There is a de minimis rule, however. Under that rule, a taxpayer may disregard a state or local tax credit if such credit does not exceed 15 percent of the taxpayer's payment or 15 percent of the fair market value of the property transferred by the taxpayer.

In addition, in IR-2018-178, the IRS clarified that a business taxpayer who makes a business-related payment to a Code Sec. 170(c) charitable or government entity and receives a state or local tax credit can generally deduct the payment as an ordinary and necessary business expense under Code Sec. 162 as long as the payment is made with a business purpose.

After Ten Years, IRS Finalizes Charitable Contribution Regs

Ten years after proposing regulations on the proper substantiation and reporting requirements for charitable contribution deductions, the IRS finalized the proposed rules at the end of July in T.D. 9836. The final regulations include new education and experience requirements for qualified appraisers and new requirements for qualified appraisals.

While the proposed regulations had contained a reasonable cause exception to a donor's failure to meet certain substantiation requirements, the IRS cited the Tax Court's decision in Crimi v. Comm'r, T.C. Memo. 2013-51, in excluding it from the final regulations. In Crimi, the Tax Court held that a reasonable cause inquiry is "inherently a fact-intensive one, and facts and circumstances must be judged on a case-by-case basis."

IRS Clarifies Deductibility of Business Meal Expenses

In October, the IRS issued some much needed guidance in the area of business meal deductions. After the enactment of TCJA, the tax treatment of such deductions was in question because of TCJA's elimination of entertainment expense deductions. Prior to TCJA, taxpayers could deduct 50 percent of qualified business entertainment and meal expenses. As amended by TCJA, Code Sec. 274 generally disallows a deduction for expenses with respect to entertainment, amusement, or recreation, but does not specifically address the deductibility of business meal expenses.

In Notice 2018-76, the IRS provides transitional guidance for the deduction of business meal expenses under Code Sec. 274. The guidance confirms what many practitioners thought but what was not clearly stated: not all business meals are nondeductible entertainment. Notice 2018-76 provides that taxpayers may deduct 50 percent of an otherwise allowable business meal expense if the following conditions are met:

(1) the expense is an ordinary and necessary expense under Code Sec. 162(a) paid or incurred during the tax year in carrying on any trade or business;

(2) the expense is not lavish or extravagant under the circumstances;

(3) the taxpayer, or an employee of the taxpayer, is present at the furnishing of the food or beverages;

(4) the food and beverages are provided to a current or potential business customer, client, consultant, or similar business contact; and

(5) in the case of food and beverages provided during or at an entertainment activity, the food and beverages are purchased separately from the entertainment, or the cost of the food and beverages is stated separately from the cost of the entertainment on one or more bills, invoices, or receipts and the entertainment disallowance rule may not be circumvented through inflating the amount charged for food and beverages.

Proposed Regs Resolve Confusion Caused by Temporary Increase in the Gift and Estate Tax Basic Exclusion Amount

TCJA amended Code Sec. 2010(c)(3) to provide that, for decedents dying and gifts made after December 31, 2017, and before January 1, 2026, the basic exclusion amount (BEA) is increased by $5 million to $10 million, as adjusted for inflation. On January 1, 2026, the BEA will revert to $5 million. In TCJA, the IRS was directed to issue regulations to deal with any difference between the BEA applicable at the time of the decedent's death and the BEA applicable with respect to any gifts made by the decedent.

In November, in REG-106706-18, the IRS issued proposed regulations which modify the calculation of estate tax in certain situations. The proposed regulations provide a special rule in cases where the portion of the credit as of the decedent's date of death that is based on the BEA is less than the sum of the credit amounts attributable to the BEA allowable in computing gift tax payable within the meaning of Code Sec. 2001(b)(2). In that case, the portion of the credit against the net tentative estate tax that is attributable to the BEA is based on the greater of those two credit amounts. For example, where a decedent made cumulative post-1976 taxable gifts of $9 million, all of which were sheltered from gift tax by a BEA of $10 million applicable on the dates of the gifts, and if the decedent died after 2025 when the BEA is $5 million, the credit to be applied in computing the estate tax is based on the $9 million of BEA that was used to compute the gift tax payable.

IRS Issues More Guidance as Centralized Partnership Audit Regime Rules Take Effect

Multiple items of guidance were released in 2018 relating to the centralized partnership audit regime that was enacted as part of the Bipartisan Budget Act of 2015 (2015 BBA) and that generally applies to audits of partnership returns for tax years beginning after 2017. Last year began with the issuance of a final regulation in T.D. 9829 on electing out of the centralized partnership audit regime. In it, the IRS declined to expand the types of taxpayers eligible to make the opt-out election even though Congress authorized it to do so. According to the IRS, such an expansion would increase the IRS's burden with respect to auditing such taxpayers.

In February, the IRS issued proposed regulations (REG-118067-17) in which it provided rules that were reserved in earlier proposed regulations and which specifically addressed how and when partnerships and their partners adjust tax attributes to take into account partnership adjustments under both Code Sec. 6225 and Code Sec. 6226.

In March, the Consolidated Appropriations Act of 2018 (2018 CAA) was enacted into law. It contained numerous modifications, corrections, and clarifications relating to the centralized partnership audit regime rules that were enacted in the 2015 BBA. Among the many changes, the 2018 CAA revised the definition of a "partnership adjustment" and added a new term: "partnership-related item." The 2018 CAA also introduced a "pull-in" procedure as an alternative to filing amended returns relating to an imputed underpayment of tax. The changes in the 2018 CAA to the partnership audit regime rules are effective as if included with the partnership audit provisions enacted in the 2015 BBA.

In August, in T.D. 9839, the IRS issued final regulations on the designation and authority of a partnership representative under the centralized partnership audit regime. The final regulations were revised to clarify that a disregarded entity can be a partnership representative but, because a disregarded entity is not an individual and is an entity partnership representative, the partnership must appoint a designated individual to act on behalf of the disregarded entity. The partnership must appoint the designated individual on its partnership return for the relevant tax year. Simultaneously, the IRS issued final regulations regarding the election to apply the centralized partnership audit regime to partnership tax years beginning after November 2, 2015, and before January 1, 2018.

Near the end of the year, in Notice 2019-6, the IRS announced its intention to issue proposed regulations limiting certain partnerships from opting out of the centralized partnership regime. Specifically, the IRS said the proposed regulations (1) would provide that the opt-out election generally does not apply to a partnership with a qualified subchapter S subsidiary as a partner, and (2) would also allow the IRS to determine that the centralized partnership audit regime does not apply to adjustments to partnership-related items when certain conditions are met.

And the grand finale was the issuance in late December of final regulations in T.D. 9844 under Code Sec. 6221 through Code Sec. 6241. Among other things, the final regulations clarify that:

(1) items or amounts relating to transactions of the partnership are items or amounts with respect to the partnership only if they are shown, or required to be shown, on the partnership return or are required to be maintained in the partnership's books and records;

(2) items or amounts shown, or required to be shown, on a return of a person other than the partnership (or in that person's books and records) that result after application of the Code to a partnership-related item and that take into account the facts and circumstances specific to that person are not partnership-related items and, therefore, are not determined at the partnership level under the centralized partnership audit regime;

(3) items or amounts in the partnership's book or records are items or amounts with respect to the partnership if they are "required to be maintained" in the partnership's books and records and added the phrase "required to be maintained" to account for items that may be maintained in the partnership's books and records on a voluntary basis;

(4) the term "partnership-related item" does not include items or amounts that would have been TEFRA affected items or computational adjustments;

(5) the consistency requirement under Code Sec. 6222(a) applies to each return of the partner, and the term "partner's return" includes any return, statement, schedule, or list, and any amendment or supplement thereto, filed by the partner with respect to any tax imposed by the Code, so that a partner on either an original or an amended return must treat partnership-related items consistently with how those items were treated on the partnership return filed with the IRS;

(6) the IRS has the discretion to treat adjustments as zero for purposes of determining the imputed underpayment if the effect of the adjustment under the Code is reflected in another adjustment, thus giving the IRS the discretion to treat a partnership adjustment as zero in more situations;

(7) positive and negative adjustments within the same subgrouping may only net within that same subgrouping, thus disallowing netting across subgroupings;

(8) the general subgrouping principles apply when subgrouping adjustments to creditable expenditures; and

(9) a net negative adjustment to a credit is treated as an adjustment that does not result in an imputed underpayment, unless the IRS determines otherwise.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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