Archive for June, 2011

The Tax Court decided Ramig v. Commissioner, T.C. Memo 2011-147 today, holding that a shareholder’s purported loans to a corporation in which he was the CEO and minority shareholder were in fact capital contributions. As a result, the shareholder was not permitted to claim a bad debt deduction when the corporation became worthless.

Section 385 is intended to provide guidance on whether advances made from a shareholder to a corporation are debt or equity. Unfortunately, at the moment Section 385 exists mainly to provide for the future promulgation of regulations which have yet to be authored.

As a result, in analyzing the debt versus equity issue, taxpayers and their advisors must look to case law. Luckily, there are many decisions just like Ramig to reference.

In Ramig, the Tax Court examined the following factors provided for in the Ninth Circuit for determining whether an advance to a corporation gives rise to a bona fide debt as opposed to an equity investment:

1. the labels on the documents evidencing the (supposed) indebtedness,

2. the presence or absence of a maturity date,

3. the source of payment,

4. the right of the (supposed) lender to enforce payment,

5. the lender’s right to participate in management,

6. the lender’s right to collect compared to the regular corporate creditors,

7. the parties’ intent,

8. the adequacy of the (supposed) borrower’s capitalization,

9. whether stockholders’ advances to the corporation are in the same proportion as their equity ownership in the corporation,

10. the payment of interest out of only “dividend money”, and

11. the borrower’s ability to obtain loans from outside lenders.

In holding that the advances were capital contributions, the Tax Court held that the following factors indicated that the advance was equity:

  • The corporation could not obtain outside financing (factor 11)
  • The corporation could only repay the advances if they raised more capital, which looked unlikely since the corporation was on a downward track with a steady string of losses. (factor 3)
  • The corporation didn’t demand timely repayment, meaning the shareholder essentially subordinated his debt to other lenders (factor 6)
  • The shareholder failed to insist on interest payments when they were due, meaning the interest could only be paid out of “dividend money” (factor 10)

In reaching its decision, the court ruled that while factors 1, 2,4, 7 and 9 indicated debt, they were mere formalities with little non-tax significance.

The lesson? In total, five factors favored debt and only four favored equity. However, the Tax Court heavily emphasized those factors that were not in the shareholders control, such as the financial condition of the corporation and the source and likelihood of any repayment. It should be noted that an advance possessing the formal indicia of debt (maturity date, balance sheet classification, etc…) will be given little weight if the other factors are not present.

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A senior Treasury official announced today that the government is working on a number of guidance projects that will clarify the interplay between the cancellation of indebtedness (“COD”) provisions of Section 108 and the partnership tax provisions of Section 701-777, including:

1. rules on debt-for-equity exchanges under tax code Section 108(e),

2. guidance on the treatment of noncompensatory options, and

3. rules on transactions under Revenue Ruling 99-6 (a partnership converting to a SMLLC), among others.

Joking title aside, the lack of guidance in these areas when compared to the corporate COD rules has made things very difficult for tax practitioners. For example, the increasingly common transaction whereby a debtor partnership issues a partnership interest to settle a debt with a creditor has only recently addressed in Proposed Reg. Section 1.108-8. While these regulations have been helpful, they still leave a host of unanswered questions, and contain ample room for improvement.

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Hot off the presses:

The Internal Revenue Service today announced an increase in the optional standard mileage rates for the final six months of 2011. Taxpayers may use the optional standard rates to calculate the deductible costs of operating an automobile for business and other purposes.

The rate will increase to 55.5 cents a mile for all business miles driven from July 1, 2011, through Dec. 31, 2011. This is an increase of 4.5 cents from the 51 cent rate in effect for the first six months of 2011, as set forth in Revenue Procedure 2010-51.

In addition, the per mile rate is also increased for medical and moving use: from 19 cents to 23.5 cents. The mileage rate for charitable use of  a car is stuck at 14 cents, however.

In recognition of recent gasoline price increases, the IRS made this special adjustment for the final months of 2011. When you’re paying $4.00 per gallon on your way to the beach this summer, remember who loves you.

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More from the world of estate taxation from WS+B expert Hal Terr:

In Estate of Natale B. Giustina v. Commissioner, T.C. Memo 2011-141, the Tax Court used a part cash flow, part asset methodology to determine the date of death value of a 41.128% limited partnership interest included in the decedent’s gross estate.   Although the Tax Court’s valuation was more than 50% higher than the value reported on the estate tax return, the Tax Court found the estate was not subject to the 20% accuracy-related penalty because the estate met the reasonable cause exception.

In 1990, Natale Giustina’s family created the “Giustina Land & Timber Co. Limited Partnership” and transferred their interest in the family timber business to this partnership.   Natale Giustina owned a 41.128% limited partnership interest in the new entity.   At the time of Giustina passing, the value of the timberlands owned by the partnership was agreed to be $142,974,438.  On the estate tax return, the value of the limited interest was reported to be $12,678,117. 

At trial, the IRS argued that  the value of the limited interest was $33,515,000.  The estate and the IRS each had expert witnesses testify to the value of the limited partnership interest.   The Tax Court found faults in each expert’s valuation calculations. 

The court did not agree with the IRS’s determination of the discounted cash flow from the partnership, nor did it agree with the estate expert’s 25% reduction for income taxes when determining the discounted cash flow or the discount rate used.  The estate argued for a 35% marketability discount, but the Tax Court agreed with the IRS expert, and settled on a 25% marketability discount. 

The IRS expert gave a 30% weight to the cash flow method while the estate’s expert applied a 20% weight.  The Tax Court disagreed with both experts and applied a 75% weight to the cash flow method given the higher probability that the partnership would have continued its operations rather than liquidating its assets. 

In addition, the court applied a 25% weight to the valuation of the timberlands.   The result was a limited partnership interest valuation of $27,454,115.

Since the Tax Court’s value of the limited partnership was more the 50% higher than the value reported by the estate, the IRS assessed a 20% accuracy related penalty of approximately $2.5 million.  Under IRC Section 6664(c)(1), no penalty is imposed with respect to an underpayment if there was reasonable cause for the underpayment and the taxpayer acted in good faith.   The Tax Court determined that the penalty should not be assessed since the executor hired an attorney to prepare the estate tax return, a valuation firm to appraise the limited partnership interest and the executor relied on the appraisal in filing the return.  Although the appraisal did not incorporate the asset method, the Tax Court found it was reasonable for the executor to rely on the appraisal and the valuation was made in good faith and with reasonable cause.

 What can be learned from this decision by the Tax Court?   Until legislation is enacted by Congress, the IRS will continue its attack of family limited partnership and the valuation discounts for lack of marketability and control, specifically those partnerships funded with passive assets.   In addition, the decision highlights just the differing views the IRS and the taxpayer often have in valuing the same limited partnership interest.  However, by hiring the right advisors and acting in a diligent and prudent manner, tapayers can avoid application of the 20% accuracy related penalty.

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A taxpayer purchases multiple pieces of raw land. On some of the parcels, he builds homes which he immediately sells in order to capture the short-term appreciation. On the other parcels, the  taxpayer builds homes which he rents out for several years, hoping to benefit from long-term appreciation.

The taxpayer sells one of the properties. Is the taxpayer an investor or dealer with regards to the sold property? Is the resulting gain capital or ordinary? Or does it depend on which property is sold?  

The Tax Court addressed just this issue  today in Gardner, v Commissioner[i]; holding that a taxpayer  was a dealer with respect to his single-family spec homes, but an investor with respect to his multifamily rentals.

Facts: Over the past 26 years, Gardner had purchased and sold 16 parcels of real property. Often, he would buy raw land, build a single-family residence, and immediately sell the improved property. Gardner also bought raw land and constructed or improved multifamily housing. He did not immediately sell his multifamily housing properties, but rather held them for rental income.

In 2004, Gardner purchased property that had been approved for subdivision into five lots. A few months later, he sold three of the lots, generating gain of $373,841. Gardner reported the gain as short-term capital gain on his 2004 tax return.

Law: The Code does not provide a mathematical or otherwise quantifiable test[ii] to determine whether real property will be treated as inventory or a capital asset in the hands of the holder. As a result, whether an owner of real property is a dealer or investor is a heavily litigated area of the law. Throughout the years,  a series of cases have resulted in the formation of eight factors commonly used to determine a taxpayer’s intent in holding real property (commonly called the Winthrop[iii]  factors):

1. the purpose for which the property was acquired;

2. the purpose for which it was held;

3. improvements and their extent, made to the property by the taxpayer;

4. frequency, number and continuity of sales;

5. the extent and substantiality of the transactions;

6. the nature and extent of the taxpayer’s business;

7. the extent of advertising to promote sales; and

8. listing of the property for sale directly or through brokers.

It is important to note, however, that if the Winthrop factors determine that a taxpayer is a dealer in real estate, that does not preclude the taxpayer from holding other propery with an investment intent. In fact, the Court of Appeals has approved just that scenario.[iv]

Taxpayer Argument: Gardner contended that he purchased the subdivided land in 2004 with the intent of building duplex units,  but financial pressures forced him to sell.  Gardner then conceded that he was a dealer with regards to all of his spec homes, but an investor with regards to his multifamily rental properties, including the raw land purchased in 2004. To support this contention, Gardner cited the fact that he held all of his multifamily rental properties for a minimum of four years, with two held in excess of 20 years.  

IRS Argument: The IRS maintained that the taxpayer’s 20-year history of buying real properties, improving them, and selling them made him a dealer, rather than an investor, under the Winthrop factors.  As a result, Gardner’s $373,841 of gain in 2004 was properly characterized as ordinary income.

 Tax Court: The Tax Court sided with Gardner.  In holding that the raw land Gardner sold in 2004 was investment property producing capital gain, the court took a two-step approach:

1. First, the court accepted Gardner’s testimony that he purchased the raw land with the intent of building multifamily rental duplexes, making the raw land part of his multifamily rental portfolio rather than his spec home portfolio.

2. The court then bifurcated Gardner’s real estate activities into two groups: his spec homes and his multifamily rental properties. The court then concluded, based solely on Gardner’s testimony and the holding periods of the properties, that the multifamily rentals were investment properties.

In reaching its decision, the court stated:

Petitioner also convinced us that he purchased or constructed multifamily rental units not for immediate sale to customers but, rather, as an investment, for rental income and, we assume, appreciation. Certainly, he did sell two of the multifamily rental units, but only after holding them for 4 or 5 years. He has owned two other of those units for over 20 years and the fifth for 4 years. …we are persuaded that the three lots were intended for petitioner’s multifamily rental activity and not his build-and-sell activity.

In this author’s opinion, this was a rather surprising decision by the Tax Court. While I don’t disagree that a taxpayer can hold one piece of property as a dealer and another as an investor, typically the taxpayer is required to prove the investment intent. 

In Gardner, however, the taxpayer was able to convince the court that he was an investor with regards to the sold property with surprising ease. The court readily accepted Gardner’s testimony that he purchased the land with the intent to build rental duplexes, without requiring any additional evidence such as architectural plans or zoning applications. In addition, the court did not insist that Garden provide evidence as to what “financial pressures” forced him to abandon his intent to develop the land and sell the property just months after its acquisition. 

Assuming the land sold in 2004 were intended to join Gardner’s portfolio of multifamily rental properties, this would bring Gardner total number of multifamily rental purchases to six. Three of those properties were subsequently sold, with holding periods ranging from eight months to five years. I find it difficult to see how this limited a purchase history — with 50% of the properties sold in a relatively short period of time — provides such strong evidence of Gardener’s investment intent that the court was content to simply rely on his testimony, rather than performing a formal analysis. 

On a different day in a different court, I could easily envision the same set of facts as seen in Gardner yielding a vastly different result.

[i] T.C. Memo 2011-137

[ii] Aside from Section 1237, which is of limited use

[iii] 24 AFTR 2d 69-5760

[iv][iv] 315 F.2d 101 (6th Cir. 1963)

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From WS+B Estate and Trust Expert Hal Terr

In Estate of Edward Thomas Coaxum v. Commissioner, T.C. Memo. 2011-135, the Tax Court held that the executor should have included the value of six life insurance policies on which the decedent was the insured and retained the right to change the beneficiaries of the life insurance policies during his lifetime.  In addition, the Tax Court determined the estate should have included the value of an annuity owned by the decedent and did not agree with the estate’s argument that since the distribution from the annuity was subject to income tax by the beneficiary that the annuity should not be included in the gross estate.

Under IRC Section 2042, the value of the gross estate shall include the value of all property  of a decedent (1) to the extent of the amount receivable by the executor as insurance under policies on the life of the decedent and (2) to the extent of the amount receivable by all other beneficiaires as insurance under policies on the life of the decedent with respect to which the decedent possessed at death any of the incidents of ownership.   Under IRC Reg. 20.2042-1(c)(2), an incident of ownership is the power to change the beneficiary of the insurance policy.

The decedent died on October 15, 2003.  Although the estate tax return is required to be filed within 9 months after the date of death (unless granted an extension by the IRS), the executor did not file the estate tax return until February 27,2006.  The decedent was the insured of six policies with a total death benefit of $1,283,184 which he possessed the power to change the beneficiaries on all six policies until he died.  Due to the preponderance of evidence that the decedent retained the right to change the beneficiaries until his death, the estate could not overcome the burden of proof under Rule 142(a)(a) that the notice of deficiency was incorrect.

Under IRC Section 2039(a) provides that the value of annuities owned by the decedent is included in the value of the gross estate.   The estate argued that since the named beneficiary had to pay income tax on the distribution received from the annuity, the value of the annuity should be excluded from the gross estate.  Although the Tax Court did not rule since it was beyond its jurisdiction, it was found that the annuity should be included in the gross estate and the named beneficiary would receive a IRC Section 691(c) deduction for the estate tax attirbutable for the annuity’s inclusion in the gross estate to offset the income inclusion on the benficiary’s individual income tax return.

 Finally, the estate was assessed a failure to file penalty of 25% of the net estate tax due since the executor filed the estate tax return more than five months late.  The estate tax deficiency was $337,193 so the assessed penalty totaled $84,298.  The Tax Court found the executor did not meet the reasonable cause exception and the failure to file was due to willful neglect.

What can be learned from this case?   With the increased estate exemption, more and more taxable estate tax returns will be reviewed by the IRS.   In addition, since life insurance death benefits are reported by the insurance companies to the IRS on Form 712, the IRS is receiving the information from independent third parties of amounts that should be included in the gross estate of a decedent.  Since the burden of proof is on the taxpayer to prove otherwise, executors need to make sure they obtain competent advice on the items that should be included in the gross estate to avoid additional tax and penalties.

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Two-time major winner Retief Goosen, affectionately known as “Goose” or “Iceman” in golfing circles, found his way onto the Tax Court docket today. Goosen, a resident of the UK, continues to golf on both the European and the PGA Tour, subjecting him to US tax on the income earned and sourced to the United States. At issue in Goosen v. Commissioner, 136 T.C. 27 (6.9.2011), was not the golfer’s winnings on the tour, but rather whether Goosen’s considerable endorsement revenue:

 1. Constituted personal service income or royalty income for US tax purposes, and

2. Represents income effectively connected with a US trade or business (taxed in the US at graduated rates) or fixed and periodic income (taxed at a flat 30%.)

During the years at issue, Goosen had the following endorsement contracts:


  • Required Goosen to use TaylorMade clubs in all tournaments.
  • Goosen was required to make personal appearances and perform product testing.
  • To the extent Goosen didn’t play in a minimum amount of tournaments in a year, his compensation would be reduced.
  • He received a bonus based on winning certain tournaments and his world ranking.


  • Required Goosen to wear Izod during tournaments.
  • Goosen was also required to make two personal appearances per year.
  • To the extent Goosen didn’t play in a minimum amount of tournaments in a year, his base compensation would be reduced.
  • He received a bonus based on winning certain tournaments and his world ranking.


  • Required Goosen to play with Titlelist golf balls in tournaments
  • Goosen was also required to provide four days of public relations and perform product testing.
  • To the extent Goosen didn’t play in a minimum amount of tournaments in a year, his base compensation would be reduced.
  • He received a bonus based on winning certain tournaments and his world ranking.


  •  Goosen was not required to wear the watch while golfing.

Upper deck

  • Gave Upper Deck right to use Goosen’s likeness on golf cards

EA Sports

  • Gave EA Sports the right to use Goosen’s likeness on video game

This was a lengthy case, so rather than go into great detail regarding the respective positions of Goosen and the IRS, I’ll provide a summary of the Tax Court’s holdings, as they provide insight into how the court will analyze worldwide endorsement income earned by a nonresident professional athlete.

TaylorMade, Izod, Titleist:

  •  The Tax Court found that these companies were paying Goosen both to use his name and likeness and for his performance of services, and as these two items were of equal importance to these companies, the court allocated 50% of the income to personal service income, and 50% to royalty income.
  • The portion of the personal service income representing the endorsement income and tournament bonuses were allocated to US sources based on the number of days Goosen played golf in the US over total golf days for the year.
  • The portion of the personal service income representing the rankings bonuses were allocated to US sources based on Goosen’s US winnings over total winnings.
  • The 50% royalty income portion of the income generated from these companies was allocated 50% to US sourced income.
  • All of the personal service income, and the portion of the royalty income deemed to be US sourced was held to represent income effectively connected with a US trade or business, and taxed at graduated rates.

Rolex, Upper Deck, EA Sports:

  •  The Tax Court held that since no personal services were required of Goosen, these companies were paying solely for the right to use his likeness. All of this endorsement income was treated as royalty income.
  • Income received from EA Sports was allocated to US sources based on EA Sports sales of video games within the US as compared to worldwide sales, resulting in an allocation of 70% to US sources.
  • Income received from Upper Deck was allocated to US sources based on Upper Deck’s sales of golf cards within the US as compared to worldwide sales, resulting in an allocation of 92% to US sources.
  • Income from the Rolex contract was held to be 50% US sourced, similar to the contracts with TaylorMade, Izod and Titleist.
  • None of the US sourced royalty income from EA Sports, Upper Deck and Rolex was held to be effectively connected with a US trade or business.

I was surprised at the informal mannter in which the Tax Court “guessed” at several key allocations, including splitting the on-course endorsement income 50/50 between royalty income and personal service income, then again in sourcing the royalty income 50% to the U.S. Both amounts were completely arbitrary, with no quantitative analysis performed. 

Will this forgiving approach benefit US nonresidents who wish to source endorsement income outside the US in the future, or will it simply reflect a one-case anomaly?

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