Tax Developments in the Second Quarter of 2012

This letter highlights some of the more important tax developments that have come out during the second three months of 2012. Most are documents from the Internal Revenue Service, but some are important cases and legislative changes you might want to be aware of for you or your business.

Individual Mandate to Buy Health Insurance: In National Federation of Independent Business v. Sebelius, , No. 11-393 (U.S. 6/28/12), the U.S. Supreme Court, in a 5-4 opinion, upholds the individual mandate under Affordable Care Act (ACA) as within Congress's taxing power, stating that the ACA's “requirement that certain individuals pay a financial penalty for not obtaining health insurance may reasonably be characterized as a tax.”

Pension Smoothing: As part of the highway funding bill (MAP-21), effective for plan years beginning after December 31, 2011, the Act amends §430(h) to revise rules for determining the segment rates under single-employer plan funding rules by adjusting a segment rate if the rate determined under the regular rules is outside a specified range of the average of the segment rates for the preceding 25-year period (“average” segment rates). The Act also requires additional information to be included in the annual funding notice that defined benefit plans must provide to participants and beneficiaries, labor organizations representing such participants or beneficiaries, and the Pension Benefit Guaranty Corporation.

S Corporation Shareholder Basis: In Maguire v. Comr., T.C. Memo 2012-160 (6/6/12), the U.S. Tax Court held that shareholders in two related S corporations are not prohibited from receiving a distribution of assets from one of their S corporations and then contributing those assets to another of their S corporations in order to increase their bases in the latter to absorb losses otherwise unavailable due to the basis limitation of §1366(d)(1). The fact that the two S corporations had a synergistic business relationship and were owned by the same shareholders did not preclude this result because the distributions and contributions actually occurred. Shortly thereafter, the IRS issued Prop. Regs. §1.1366-2, REG-134042-07, 77 Fed. Reg. 34884 (6/11/12), which would clarify the requirements for increasing basis of indebtedness and to assist S corporation shareholders in determining with greater certainty whether their particular arrangement creates basis of indebtedness. The IRS explained that the proposed regulations would require that loan transactions represent bona fide indebtedness of the S corporation to the shareholder in order to increase basis of indebtedness; therefore, an S corporation shareholder would need not otherwise satisfy the “actual economic outlay” doctrine for purposes of §1366(d)(1)(B). According to the IRS, the proposed regulations' key requirement would be that purported indebtedness of the S corporation to a shareholder must be bona fide indebtedness to the shareholder.

COD Income Under §108: In Rev. Rul. 2012-14, 2012-24 I.R.B. 1012, the IRS ruled that to measure a partner's insolvency under §108(d)(3), each partner treats as a liability the amount of the partnership's discharged excess nonrecourse debt based on allocation of cancellation of indebtedness income to the partner under §704(b).

Earnings and Profits: In REG-141268-11, 77 Fed. Reg. 22515 (4/16/12), the IRS issued proposed regulations under §312 regarding allocation of earnings and profits in tax-free transfers from one corporation to another. The proposed regulations would clarify that, except as provided in Regs. §1.312-10, if property is transferred from one corporation to another and no gain or loss is recognized, no allocation of the earnings and profits of the transferor is made to the transferee unless the transfer is described in §381(a).

Deferral of Losses on Sale or Exchange of Property Between Controlled Group: In T.D. 9583, 77 Fed. Reg. 22480 (4/16/12), the IRS issued final regulations that provide that to the extent a selling member's loss would be redetermined to be a noncapital, nondeductible amount under Regs. §1.1502-13, but is not redetermined under Regs. §1.267(f)-1(c)(2) (which generally renders the attribute redetermination rule inapplicable to sales between members of a controlled group), the selling member's loss continues to be deferred.

UNICAP Avoided Cost Rule: The Federal Circuit Court of Appeals, in Dominion Resources Inc. v. U.S., No. 2011-5087 (Fed. Cir. 5/31/12), held that the associated property rule laid out in Regs. §1.263A-11(e)(1)(ii)(B), as applied to property temporarily withdrawn from service, is not reasonable interpretation of the avoided cost rule in §263A. At issue in the case was the amount of interest Dominion Resources must capitalize, rather than deduct, from its taxable income as a result of burner improvements in its power plants.

Defense of Marriage Act Held Unconstitutional: The First Circuit Court of Appeals, in (Massachusetts v. HHS, No. 10-2204 (1st Cir. 5/31/12), held that the Defense of Marriage Act, 1 USC §7, is unconstitutional, that provisions in the Act, which deny numerous benefits, including tax benefits, to same-sex couples lawfully married in Massachusetts, impermissibly undercut choices made by same-sex couples and states in deciding who can be married to whom. However, the court stayed enforcement of the decision until the Supreme Court has the opportunity to issue its own ruling on the case, citing the likely appeal of the First Circuit's holding.

Deduction for Local Lodging Expenses: The IRS issued proposed regulations, REG-137589-07, 77 Fed. Reg. 24657 (4/25/12), that would allow taxpayers to deduct local lodging expenses as ordinary and necessary business expenses in appropriate circumstances. The proposed regulations would not apply Regs. §1.262-1(b)(5) to expenses for local lodging of an employee that an employer provides to the employee or requires the employee to obtain, if: (1) the lodging is provided on a temporary basis; (2) the lodging is necessary for the employee to participate in or be available for a bona fide business meeting or function of the employer; and (3) the expenses are otherwise deductible by the employee, or would be deductible if paid by the employee, under §162(a).

Overstatement of Basis for Extended Statute of Limitations: The U.S. Supreme Court ruled, in (U.S. v. Home Concrete & Supply LLC, No. 11-139 (U.S. 4/25/12), that the extended six-year statute of limitations period in §6501(e) does not apply to overstatement of basis as an overstatement of basis is not an omission from gross income. The Court's ruling decides a circuit split in favor of the Fourth and Fifth Circuits versus the Seventh, Federal, D.C., and Tenth Circuits, which all held that an overstatement of basis is an omission of gross income triggering the extended six-year statute of limitations.

Reporting of Interest Paid to Foreigners: While reporting of interest to foreigners is controversial enough in its own right, final regulations (T.D. 9584, 77 Fed. Reg. 23391 (4/19/12)) are particularly notable in that the regulations will provide the IRS with information that can be exchanged with foreign authorities under information exchange arrangements to help the IRS under FATCA. The final rules ostensibly have been “simplified,” by requiring reporting only when interest is paid to a resident of a country with which the United States has an information sharing agreement; this in effect requires financial institutions to parse their customer base to identify customers to get reports and customers who don't need reports.

Draft Forms W-8: The IRS released draft Forms W-8 to comply with new FATCA requirements. Separate versions of Form W-8BEN are proposed for individuals (draft W-8BEN) and entities (draft W-8BEN-E), the latter of which is now six pages long instead of one. The forms can be found in the lower right corner of this URL: http://www.irs.gov/businesses/corporations/article/0,,id=236667,00.html

Inversions: The IRS, in T.D. 9592, 77 Fed. Reg. 34785 (6/12/12), and REG-107889-12, 77 Fed. Reg. 34887 (6/12/12), finalized and proposed regulations governing inversions. The most controversial provision is one that defines a “substantial business” in a foreign country by objective tests looking at whether 25% of assets, payroll and income are earned in a country. Since passing this test excuses a foreign company from the inversion rules, this is an important test.

Program-Related Investments of Private Foundations: The IRS issues proposed rules (REG-144267-11, 77 Fed. Reg. 23429 (4/19/12)) providing guidance to private foundations on program-related investments. The proposed regulations provide a series of new examples illustrating investments that qualify as program-related investments and do not modify existing regulations. Instead, they provide additional examples that illustrate the application of the existing regulations, IRS said. The charitable activities illustrated in the new examples are based on published guidance and on financial structures described in private letter rulings, IRS said. Aside from private foundations, the proposed regulations affect foundation managers participating in the making of program-related investments.

Delay in Basis Reporting of Debt Instruments: The IRS, in Notice 2012-34, 2012-21 I.R.B. 937, in response to concerns about approaching deadlines, states that brokers will have until 2014 to begin basis reporting on debt instruments and options. The change is in response to worries voiced by brokers and other interested parties who complained to the IRS that the proposed effective date of Jan. 1, 2013, did not give them enough time to build and test the systems required to implement the reporting for debt instruments and options. The Energy Improvement and Extension Act of 2008 amended the broker reporting rules in §6045 for certain securities, including debt instruments and options.

Proving IRS Deficiency Notices: The Federal Circuit Court of Appeals, in Welch v. U.S., No. 2011-5090 (Fed. Cir. 5/18/12), lays out a test for determining whether evidence submitted by the IRS is sufficient to demonstrate the mailing of a deficiency notice. “Use of the form prescribed in the Internal Revenue Manual for establishing compliance with the notice of deficiency mailing requirement — PS Form 3877 — is not a prerequisite to the government demonstrating mailing of a notice of deficiency, but some corroborating evidence of both the existence and timely mailing of the notice of deficiency is required,” explained the Federal Circuit

First-Time Homebuyer Credit: The U.S. Tax Court, in a case of first impression (Trugman v. Comr., 138 T.C. No. 22 (5/21/12)), holds that an individual may not claim the First-Time Homebuyer Credit for a principal residence purchased through a Subchapter S corporation. The court examined the term “individual” within the context of §36, and “read the term ‘individual' in section 36 to exclude S corporations.” The court stated “S corporations are not individuals for purposes of section 36” and the corporations remain freestanding entities “independently recognizable” from their shareholders.

Substantial Risk of Forfeiture: The IRS, in REG-141075-09, 77 Fed. Reg. 31783 (5/30/12), addresses points of confusion surrounding the “substantial risk of forfeiture” provision under §83. The proposed rules would, among other clarifications, provide that a such a risk can be established only through a service condition, or a condition related to the purpose of the transfer. The general concept of the provision is that property (such as stock options) is not to be included in the gross income of a service provider (such as an employee) if there is a risk that the conditions on which the property transfer are based could fail to materialize and the property thus forfeited.

Health FSA Salary Reduction Limits: The IRS, in Notice 2012-40, 2012-26 I.R.B. 1046, stated that the $2,500 limit on salary reduction contributions to health flexible spending arrangements set by a provision of the 2010 federal health care law does not apply for plan years starting before 2013. Notice 2012-40 fleshes out the details of the $2,500 cap on salary reduction contributions to cafeteria plan health FSAs under §125(i). The notice defines the term “taxable year” under §125(i) as the plan year of a cafeteria plan, a clarification that employers sponsoring plans with fiscal years not lining up with the calendar year have been anxiously awaiting.

Fee for Renewing PTIN: The Eleventh Circuit Court of Appeals held, in Brannen v. U.S., No. 11-14138 (11th Cir. 6/7/12), that the Treasury Department has the statutory authority to charge fees for issuing and renewing preparer tax identification numbers.

Portability of Deceased Spousal Unused Exclusion Amount: The IRS issued temporary and proposed regulations (T.D. 9593, 77 Fed. Reg. 36150 (6/18/12); REG-141832-11, 77 Fed. Reg. 36229 (6/18/12)) providing guidance on the estate and gift tax applicable exclusion amount and the applicable requirements for electing portability of a deceased spousal unused exclusion (DSUE) amount to the surviving spouse. The temporary rules also provide guidance on the applicable rules for the surviving spouse's use of the DSUE amount. The portability rules affect married spouses where the death of the first spouse occurs on or after Jan. 1, 2011.