Burke:Friel Taxation of Individual Income 11e 2017...

■

TAXATION OF

INDIVIDUAL INCOME

ELEVENTH EDITION

■

2017 SUPPLEMENT (JULY 2017)

J. Martin Burke

Michael K. Friel

CAROLINA ACADEMIC PRESS

Copyright © 2017 Carolina Academic Press, LLC. All rights reserved.

Copyright © 2017 Carolina Academic Press, LLC

All Rights Reserved

Carolina Academic Press 700 Kent Street

Durham, North Carolina 27701 Telephone (919) 489-7486

Fax (919) 493-5668 E-mail: [email protected]

www.cap-press.com


3

Chapter 1 INTRODUCTION TO FEDERAL INCOME TAXATION Page 12: The “basic standard deduction” for 2017 is $12,700 on a joint return and $6,350 on the return of an unmarried individual. Rev. Proc. 2016-55, 2016-45 I.R.B. 707. Page 15: The § 164(b((5) election was made permanent by the Protecting Americans from Tax Hikes Act of 2015. Page 16: For 2017 the overall limitation on itemized deductions under § 68(b) for an unmarried individual who is not a surviving spouse or head of household is $261,500. Rev. Proc. 2016-55, supra. Page 17: For 2017, the inflation-adjusted personal exemption is $4,050. Rev. Proc. 2016-55, supra. Page 18: Rev. Proc. 2016-55, supra, provides the tax rate tables for 2017. Given the assumptions made in this chapter that Caroline’s personal exemption is $4,000 and her taxable income is $180,000 and using the 2017 rate tables, Caroline’s preliminary tax liability will be computed as follows: $18,713.75 on the first $91,900 of taxable income plus 28% of the remaining $88,100 or $24,668. Caroline’s preliminary 2017 tax liability is therefore $43,381.75. Compare this figure to the slightly higher figure computed for 2015. Considering, however, the preferential tax rate applied to Caroline’s $16,000 of net capital gain under §1(h), Caroline’s 2017 tax liability would be $41,301.75 computed as follows (again using the 2017 rate tables):

(1) the regular §1(c) tax on $164,000 (i.e., $180,000 taxable income less the $16,000 of net capital gain) which is $38,901.75 plus

(2) the special tax §1(h) rate of 15% on the $16,000 of net capital which equals $2,400.


4

Chapter 5 GIFTS, BEQUESTS AND INHERITANCES Page 95: In Alhadi v. Commissioner, T.C. Memo 2016-74, the court addressed the issue of undue influence and its effect on donative intent. In that case, the taxpayer received large sums of money - at least $900,000 during the tax years in issue - from an elderly individual diagnosed with dementia and cognitive decline for whom she was the caregiver. The taxpayer failed to report the money as gross income arguing it was either a loan or a gift. The court rejected the loan argument finding there was no debtor-creditor relationship. With regard to the taxpayer’s gift argument, the court noted “there can be no detached and disinterested generosity in the presence of coercion or undue influence.” Whether the taxpayer obtained the money through undue influence is a question of state law. Applying California’s law on undue influence, the court concluded the taxpayer had exercised undue influence and, as a result, the money the taxpayer received was taxable to her. In Jackson v. Commissioner, T.C. Summary Opinon 2016-69, the taxpayer was a pastor, registered agent and director for a church with approximately 25-30 active members. Taxpayer “had informed the church's board of directors that he did not want to be paid a salary for his pastoral services but that he would not be opposed to receiving ‘love offerings,’ gifts, or loans from the church.” The taxpayer (and his spouse) managed the church’s checking account and signed checks made payable to the taxpayer “with handwritten notations such as ‘Love Offering’ or ‘Love Gift’ on the memo line.” In 2012, the church’s bookkeeper prepared and sent to the taxpayer a Form 1099-MISC, Miscellaneous Income, reporting the taxpayer’s receipt of nonemployee compensation of $4,815 from the church. The taxpayer, however, did not include that amount in his gross income asserting it had been improperly reported as nonemployee compensation. Citing Commissioner v. Duberstein, 363 U.S. 278 (1960), the Tax Court in Jackson noted the transferor's intention is the most critical consideration in determining whether a transfer constitutes a gift. The determination of the transferor’s intention must be based on the facts and circumstances of the transfer rather than on the taxpayer's subjective characterization of the transfers. Applying that standard, the court concluded the transfers amounting to $4,815 were compensation as suggested by the taxpayer’s own admission at trial that “he had informed the board of directors that he would accept ‘love offerings’ and gifts as substitutes for a salary.” The court, citing Goodwin v. United States, included in the materials, also noted “ the frequency of the transfers and the fact that they purport to have been made on behalf of the entire congregation is further objective evidence that the transfers represented a form of compensation.”


5

Chapter 6 SALE OF A PERSONAL RESIDENCE Page 124: In a recent letter ruling, the Service held the birth of a second child was an “unforseen circumstance” and allowed a reduced maximum exclusion under §121(c) to taxpayers on the sale of their two-bedroom condominium which had served as their principal residence for less than two years. Priv. Ltr. Rul. 201628002.


6

Chapter 9 DISCHARGE OF INDEBTEDNESS Page 172: In Schieber v. Commissioner, T.C. Memo 2017-32, the Tax Court rejected the Service’s argument that a taxpayer’s interest in a defined benefit pension plan could be considered an asset in determining whether the taxpayer was insolvent for purposes of the §108(a)(1) insolvency exclusion. On the date when the cancellation of debt occurred, the taxpayer was retired and was receiving monthly payments under the pension plan in question. Apart from his right to receive monthly payments, the taxpayer could not access the value in the plan, i.e., could not convert his “interest in the plan to a lump-sum cash amount, sell the interest, assign the interest, borrow against the interest, or borrow from the plan.” The IRS contended the taxpayer’s interest in the pension plan should be considered an asset because the taxpayer could use the monthly pension payments to pay debts. Relying on its decision in Carlson v. Commissioner, 116 T.C. 87 (2001), the court emphasized the test for whether the pension plan would be treated as an “asset” for purposes of §108(d)(3) is “whether the asset gives the taxpayer the ability to pay an ‘immediate tax on income’ from the canceled debt--not to pay the tax gradually over time.” Id. at 104-105. (Note the word "assets" as used in §108(d)(3) is not defined by the Code.) The court in Carlson held “a commercial fishing license could be an asset because the license could be used, in combination with other assets, to immediately pay the income tax on canceled-debt income.” By contrast, the taxpayer’s interest in the pension plan could not be used to pay immediately the income tax on the cancelled debt. Therefore, the court held the interest in the pension plan was not an “asset” within the meaning of §108(d)(3). Page 177: As a result of the Protecting Americans from Tax Hikes Act of 2015, § 108(a)(1)(E) and (h) excluded “qualified principal residence indebtedness” discharged on or after January 1, 2007 and before January 1, 2017. Congress has yet to extend this exclusion.


7

Chapter 12 BUSINESS AND PROFIT-SEEKING EXPENSES Page 362: Following the carryover paragraph, insert:

In Johnson v. Commissioner, T.C. Memo. 2016-95, the Tax Court commented that “in applying the independent investor test, the courts have typically found that a return on equity of at least 10% tends to indicate that an independent investor would be satisfied and thus payment of compensation that leaves that rate of return for the investor is reasonable. ... Indeed, compensation payments that resulted in a return on equity of 2.9% have been found reasonable.... It is compensation that results in returns on equity of zero or less than zero that has been found to be unreasonable.... We consequently find that petitioner’s returns on equity of 10.2% and 9% for [the tax years in question] tend to show that the compensation paid for those years was reasonable.”


8

Chapter 14 DEPRECIATION Pages 333-34: As a result of the Protecting Americans from Tax Hikes Act of 2015, the “additional first year depreciation” authorized by §168(k) has been extended through 2019. However, the additional first year depreciation percentage is reduced from 50% to 40% for property placed in service in 2018 and to 30% for property placed in service in 2019. Unless further extended, §168(k) will sunset after 2019. Pages 335-36: As a result of the Protecting Americans from Tax Hikes Act of 2015, the $500,000 and $2,000,000 limitations of § 179(b)(1) and (2), respectively, discussed on these pages in the text and in footnote 7, have been made permanent and, pursuant to §179(b)(6), are adjusted for inflation (to the nearest multiple of $10,000) for years beginning after 2015. For 2017, the inflation-adjusted limitations are $510,000 and $2,030,000, respectively. Rev. Proc. 2016-55, 2016-45 I.R.B. 707.


9

Chapter 15 LOSSES AND BAD DEBTS Page 367: Public Policy Considerations. Chapter 12 discusses public policy considerations and the §162(f) disallowance of deductions for fines and penalties. Section 162(f) and the regulations interpreting it are considered when determining whether deductions are allowable under §165. Thus, in Nacchio v. U.S., 2016 U.S. App. LEXIS 10507, the U.S. Court of Appeals for the Federal Circuit held that § 165 provided no deduction for amounts forfeited by a taxpayer, the former CEO of Quest Communications International, Inc., as a result of a criminal conviction for insider trading. The court stated:

... [Section 165 is subject to a "frustration of public policy" doctrine. Under this doctrine, a taxpayer cannot deduct a loss where its allowance "would frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof." Tank Truck Rentals v. Comm'r, 356 U.S. 30, 33-36 .... In Tank Truck Rentals, the Supreme Court upheld the disallowance of a deduction for fines paid by a trucking company for violations of state maximum weight laws, observing that "[w]here a taxpayer has violated a federal or a state statute and incurred a fine or penalty he has not been permitted a tax deduction for its payment." Id. at 34. We agree with the government, moreover, that prior to 1969, the deduction of trade or business expenses under § 162(a) was limited by the same public policy doctrine that precluded loss deductions under § 165 when their allowance would frustrate sharply defined public policies. Section 162(a) provides for deductions of "ordinary and necessary expenses paid or incurred . . . in carrying on any trade or business."

In 1969, Congress codified the "frustration of public policy" doctrine as part of the Tax Reform Act of 1969 ... in the form of I.R.C. § 162(f). Section 162(f) provides: "FINES AND PENALTIES.—No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law." I.R.C. § 162(f) (emphases added). Although the amendments to § 162 did not explicitly affect § 165, the "frustration of public policy" doctrine has continuing vitality with respect to § 165. See Stephens v. Comm'r, 905 F.2d 667, 671 (2d Cir. 1990) ("Although Tellier and Tank Truck Rentals were both decided pursuant to Tax Code provisions relating to business expenses, the test for non-deductibility enunciated in those opinions is applicable to loss deductions under Section 165."). See also ... Medeiros v. Comm'r, 77 T.C. 1255, 1261 n.7 (1981) ("we cannot ascribe to Congress the intent, in enacting section 162(f), to disallow the deduction of this penalty under section 162(a) but to allow it as a loss deduction under section 165(a)"); Treas. Reg. (26 C.F.R.) § 1.165-1(a) (loss deductions under § 165(a) are "subject to any provision of the internal revenue laws which prohibits or limits the amount of the deduction"). The Stephens Court, thus, looked to § 162(f) when interpreting the scope of permissible loss deductions under § 165. We do the same.


10

... The relevant question for resolving this appeal, accordingly, is whether Nacchio's criminal forfeiture is a "fine or similar penalty" under § 162(f), or if allowing a deduction in these circumstances would otherwise frustrate public policy.

We recognize that, as a general matter, we must use a flexible standard to "accommodate both the congressional intent to tax only net income, and the presumption against congressional intent to encourage violation of declared public policy." Tank Truck Rentals, 356 U.S. at 35. And "[i]ncome from a criminal enterprise is taxed at a rate no higher and no lower than income from more conventional sources." Comm'r v. Tellier, 383 U.S. 687, 691, 86 S. Ct. 1118, 16 L. Ed. 2d 185 (1966). We further understand Nacchio's argument that not being allowed to deduct his forfeited income from his taxes would result in a sort of "double sting": both giving up his ill-gotten gains and paying taxes on them. But in this case, the relevant statutes, regulations, and body of relevant case law lead us to conclude that Nacchio's criminal forfeiture must be paid with after-tax dollars, just as fines are paid with after-tax dollars. Specifically, as explained below, the government has demonstrated that Nacchio's criminal forfeiture is a "fine or similar penalty" within the meaning of § 162(f).

First, the plain language of the statutory provision under which the amount Nacchio forfeited was calculated supports the view that Congress intended the forfeiture to be paid with after-tax dollars. The Tenth Circuit held on remand that Nacchio's forfeiture should be calculated in accordance with § 981(a)(2)(B), not § 981(a)(2)(A). Nacchio, 573 F.3d at 1090. Section 981(a)(2)(B) states that:

[T]he term "proceeds" means the amount of money acquired through the illegal transactions resulting in the forfeiture, less the direct costs incurred in providing the goods or services. . . . The direct costs shall not include . . . any part of the income taxes paid by the entity.

18 U.S.C. § 981(a)(2)(B) (emphases added). Thus, the language of the statute suggests that—by design—the forfeiture amount does not account for taxes paid on the amount of money acquired through the illegal transactions.

Next, Treasury Regulation § 1.162-21(b)(1) defines "fine or similar penalty" for the purposes of § 162(f) as including, inter alia, "an amount—(I) Paid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding." 26 C.F.R. § 1.162-21. ...

... [I]in this case, Nacchio's criminal forfeiture meets the definition of a "fine or similar penalty" under Treasury Regulation § 1.162-21(b)(1). Nacchio's criminal forfeiture was imposed pursuant to 18 U.S.C. § 981(a)(1)(C) and 28 U.S.C. § 2461(c), as part of his sentence in a criminal case. Section 981(a)(1)(C), as amended by the Civil Asset Forfeiture Reform Act of 2000, Pub. L. No. 106-185, § 20, 114 Stat. 202, 224, authorizes the forfeiture of "proceeds" traceable to numerous felony offenses, including any offense constituting "specified unlawful activity" as defined by 18 U.S.C. § 1956(c)(7)(A). Section 1956(c)(7)(A), in turn, defines "specified unlawful activity" as any act or activity


11

constituting an offense under 18 U.S.C. § 1961(1)(D), which includes "any offense involving . . . fraud in the sale of securities."

28 U.S.C. § 2461(c) requires forfeiture whenever a defendant in a criminal case "is convicted of the offense giving rise to the forfeiture," in which case the court "shall order the forfeiture of the property as part of the sentence in the criminal case." This forfeiture is mandatory when the relevant prerequisites are met....

Though we have not considered the precise question posed here, other courts of appeals have done so, repeatedly concluding that forfeitures of property to the government similar to the one at issue are not deductible because they are punitive. ... For example, in Wood, the Fifth Circuit denied a loss deduction under § 165 for the civil forfeiture of proceeds from the taxpayer's drug trafficking activities. 863 F.2d at 418. The appellant pled guilty to a criminal offense, conspiracy to import marijuana and importation of marijuana, and was sentenced to serve four years in prison and pay a $30,000 fine. Id. The appellant argued, inter alia, that, because he already paid his criminal debt by means of imprisonment and the $30,000 fine, he should not have to pay taxes on proceeds he forfeited to the government. Id. at 421. The court, nevertheless, found that his drug proceeds were taxable income and that "[f]orfeiture cannot seriously be considered anything other than an economic penalty for drug trafficking." Id. See also Fuller v. Comm'r, 213 F.2d 102, 105-06 (10th Cir. 1954) (disallowing business loss deduction under the precursor of § 165 for the cost of whiskey confiscated by law enforcement agencies of a "dry" state); King, 152 F.3d at 1201-02 (no loss deduction under § 165(a) for voluntary disclosure and forfeiture of hidden drug trafficking profits).

Page 371: In Evans v. Commissioner, T.C. Memo 2016-7, the taxpayer, using the cash method of accounting, argued a loss sustained on a nonjudicial foreclosure sale on his property was deductible in the year when the proceeds of the sale were received rather than the year of the sale itself. Rejecting this argument, the Tax Court, discussing the cash method of accounting (addressed in detail in Chapter 28), noted:

Under the cash method of accounting, amounts representing deductions are deducted (or otherwise taken into account) for the year paid. [Reg. §1.461-1(a)(1).] However, if the deduction does not entail a cash disbursement (because, for example, it is a loss deduction under §165 or a depreciation deduction under §167), the deduction year is based on separate timing rules.... The timing of loss deductions is governed by §165(a) and the regulations thereunder. See Reg. §§1.165-1(d)(1), 1.461-1(a)(1).

.... We conclude that the loss was sustained (and deductible) [in the year of the foreclosure sale] regardless of the year in which Evans received proceeds from the sale or received notice that such proceeds were available to him.


12

Chapter 17 ENTERTAINMENT AND BUSINESS MEALS Page 446:

Jacobs v. Comm'r 148 T.C. No. 24 (2017)

RUWE, Judge: Respondent determined deficiencies of $45,205 and $39,823 in petitioners' Federal income tax for the taxable years 2009 and 2010, respectively. The sole issue for decision is whether Deeridge Farms Hockey Association (Deeridge), a subchapter S corporation owned directly or indirectly by petitioners, is entitled to deductions for the full amounts of expenses incurred in providing meals to professional hockey players and team personnel [the Boston Bruins (hereinafter the Bruins)] at hotels in cities other than Boston, Massachusetts, or whether the deduction for meal expenses is limited to 50% under section 274(n)(2). ... OPINION The issue for decision is whether petitioners ... are entitled to deduct the full cost of pregame meals provided to the Bruins' traveling hockey employees while at away city hotels, or, alternatively, whether section 274(n)(1) limits this deduction to 50% of the expenses for such meals. Petitioners argue that section 274(n) does not limit deductions for the cost of pregame meals provided at away city hotels because the meals qualify as: (1) a de minimis fringe under section 274(n)(2)(B)... Respondent argues that none of the exceptions to section 274(n) applies to the Bruins' provision of pregame meals and therefore the 50% limitation applies. ... Section 162(a) allows as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Section 274(a)(1)(A) disallows a deduction for certain meal and entertainment expenses otherwise deductible under section 162 unless the expenses are associated with the active conduct of the taxpayer's trade or business. Respondent does not challenge that the Bruins' pregame meal expenses are associated with the active conduct of petitioners' trade or business. If the deduction for meal expenses is not disallowed by section 274(a)(1)(A), then section 274(n) imposes a 50% limitation on the deduction for meal expenses unless an exception applies. Section 274(n) provides, in pertinent part:

SEC. 274(n). Only 50 Percent of Meal and Entertainment Expenses Allowed as Deduction.-- (1) In general.--The amount allowable as a deduction under this chapter for–


13

(A) any expense for food or beverages ... shall not exceed 50 percent of the amount of such expense or item which would (but for this paragraph) be allowable as a deduction under this chapter. (2) Exceptions.--Paragraph (1) shall not apply to any expense if-- ... (B) in the case of an expense for food or beverages, such expense is excludable from the gross income of the recipient under section 132 by reason of subsection (e) thereof (relating to de minimis fringes).

Petitioners argue that the Bruins' provision of pregame meals to traveling hockey employees at away city hotels qualifies for the de minimis fringe exception under section 274(n)(2)(B). I. De Minimis Fringe Exception Petitioners are entitled to deduct the full cost of pregame meals provided to the Bruins' traveling hockey employees if the meals meet the de minimis fringe exception. See secs. 274(n)(2)(B), 132(e). As a preliminary matter, section 132(e)(2) requires that "access to the [eating] facility is available on substantially the same terms to each member of a group of employees which is defined under a reasonable classification set up by the employer which does not discriminate in favor of highly compensated employees." For the years in issue a highly compensated employee was one who received compensation exceeding $110,000.... The Bruins provided pregame meals to all traveling hockey employees, and we find this classification (i.e., Bruins employees traveling to away cities to perform business duties) to be a reasonable classification given the nature of the team's business. Petitioners provided credible testimony that the pregame meals were made available to all Bruins' traveling hockey employees--highly compensated, nonhighly compensated, players, and nonplayers–on substantially the same terms. Petitioners also provided testimony, which we find credible, that any discrepancy between anticipated and actual meal attendees was a function of cost reduction concerns and not discrimination. We therefore hold that the Bruins' provision of pregame meals to traveling hockey employees satisfies the nondiscriminatory manner requirement of section 132(e)(2). Employee meals provided in a nondiscriminatory manner constitute a de minimis fringe under section 132(e) if: (1) the eating facility is owned or leased by the employer; (2) the facility is operated by the employer; (3) the facility is located on or near the business premises of the employer; (4) the meals furnished at the facility are provided during, or immediately before or after, the employee's workday; and (5) the annual revenue derived from the facility normally equals or exceeds the direct operating costs of the facility (the revenue/operating cost test). Sec. 132(e)(2); Boyd Gaming Corp. v. Commissioner, 106 T.C. 343, 348 (1996); sec. 1.132-7(a), Income Tax Regs. We will address each requirement in turn.


14

A. Eating Facility Is Owned or Leased by Employer For employee meals at an employer-operated eating facility to qualify as a de minimis fringe under sections 274(n)(2)(B) and 132(e), the regulations require that the employer-operated eating facility be "owned or leased by the employer". Sec. 1.132-7(a)(2)(i), Income Tax Regs. The regulations do not define the word "lease". "It is a 'fundamental canon of statutory construction' that, 'unless otherwise defined, words will be interpreted as taking their ordinary, contemporary, common meaning.'" ... A lease is commonly defined as "[a] contract by which a rightful possessor of real property conveys the right to use and occupy the property in exchange for consideration". Black's Law Dictionary 970 (9th ed. 2009). Although the BEOs [Banquet Event Orders] and hotel contracts entered into between the Bruins and the away city hotels are not specifically identified as "leases", the substance of these contracts indicates that the Bruins are paying consideration in exchange for "the right to use and occupy" the hotel meal rooms. The Bruins' execute BEOs and hotel contracts with each away city hotel to occupy meal rooms and determine what types of food are served, and the BEOs specify the dates and times of the meals and the anticipated number of attendees. The Bruins do not provide separate consideration for the rental of the meal rooms; however, the meal rooms are essential to the Bruins' away city business operations, and the hotels agree to provide the meal rooms free of charge because the Bruins spend money for lodging and food. The Bruins dictate several aspects regarding the setup of the meal rooms, such as the furnishings and the presence of audiovisual equipment or a whiteboard. The Bruins also require the hotel to keep the location of the meal room private from the general public by refraining from posting any identifying information about the Bruins' use of the room. The evidence establishes that the Bruins contract with away city hotels for the right to "use and occupy" meal rooms to conduct team business, and therefore these agreements are substantively leases. B. Operated by the Employer For employee meals at an employer-operated eating facility to satisfy the de minimis fringe exception under section 132, the eating facility must be operated by the employer. See sec. 1.132-7(a)(2)(ii), Income Tax Regs. Section 1.132-7(a)(3), Income Tax Regs., provides the following guidance:

(3) Operation by the employer. If an employer contracts with another to operate an eating facility for its employees, the facility is considered to be operated by the employer for purposes of this section. If an eating facility is operated by more than one employer, it is considered to be operated by each employer.

The Bruins contract with each away city hotel regarding the operation of the meal rooms as well as food preparation and service. Several weeks before the Bruins travel to the away city hotel they provide meal requirements to the hotel. The away city hotel then prepares a BEO setting forth the date, time, designated meal room, number of guests, menu, and per-person


15

pricing for each meal ordered. The Bruins will either (1) contact the hotel if changes to the BEO are needed or (2) accept the offer set forth in the BEO by executing the BEO and returning it to the hotel for a countersignature. The BEOs also typically provide for the furnishings and setup of the meal room and the hotel staff that will assist in preparing and serving the food. The Bruins agree to pay a fee for each meal and a service fee of up to 22% of the cost of the meals. We find that by engaging in this process with away city hotels the Bruins are "contract[ing] with another to operate an eating facility for its employees". See sec. 1.132-7(a)(3), Income Tax Regs. C. Business Premises For employee meals at an employer-operated eating facility to qualify as a de minimis fringe, section 132(e)(2) requires that the eating facility be "located on or near the business premises of the employer". See also sec. 1.132-7(a)(2)(iii), Income Tax Regs. Congress intended a commonsense approach when making a determination regarding an employer's business premises. ... An employer's business premises is a place where employees perform a significant portion of duties or where the employer conducts a significant portion of business..... It is not necessary for an eating facility to be located in an employer's principal structure for it to be considered on the business premises. Whether an eating facility is located on or near the business premises of an employer is a factual issue, and consideration must be given to the employee's duties as well as to the nature of the employer's business.... An inquiry regarding business premises "infers a functional rather than spatial unity" and is not limited by questions of geography or quantum of business activities. This is not the first time we have been asked to decide whether rented hotel space constitutes a taxpayer's business premises. In Mabley v. Commissioner, T.C. Memo. 1965-323, we held that a rented hotel suite used for daily executive lunches constituted part of a company's business premises. In Mabley, the Island Creek Coal Co. decided to hold daily executive luncheon conferences at a suite inside the Prichard Hotel to provide "for daily contact among the president and his staff members in order that all might keep informed as to the activities of all departments". The leased suite consisted of a dining room, a reception room, a toilet, and a closet. The luncheon meetings were held at 12:30 p.m. (or sometimes began earlier or later) and lasted from one to three hours (and frequently lasted longer). Each staff member was required to attend the daily meetings. The Prichard Hotel agreed to provide the company meals from the hotel kitchen during regular mealtimes at current rates charged to hotel guests. In holding that the hotel constituted the business premises of the company, we reasoned that "the rented hotel suite in which the meals were furnished was acquired and actually used for the conduct of business of the company, the furnishing of the meals being merely incidental." We conclude that away city hotels were part of the Bruins' business premises for the years in issue. In arriving at this conclusion we consider the traveling hockey employees' performance of significant business duties at away city hotels along with the unique nature of the Bruins' business (i.e., professional hockey).... First and foremost, the nature of the Bruins' business requires the team to travel to various arenas across the United States and Canada, and it is not feasible for the Bruins to be a viable NHL franchise without participating in hockey games outside of Boston. The NHL constitution and bylaws obligate each NHL team to play both home


16

and away games during the regular season and, if the team qualifies, postseason games. Not only does the NHL require teams to participate in away games, but it also requires visiting teams to arrive in an away city at least six hours before the away game commences. The CBA [Collective Bargaining Agreement binding the NHL (National Hockey League), member teams, and players of member teams] imposes an additional requirement that visiting NHL teams travel to the away city the day before game day, if travel by airplane is greater than 150 minutes. Furthermore, if an NHL team fails to participate in an away game it must forfeit the game, lose playoff points, incur financial penalties imposed by the NHL, and indemnify the home team for loss of revenue and other expenses. Therefore, an integral part of the Bruins' professional hockey business involves traveling throughout the United States and Canada to play away games as dictated by the NHL schedule. The job of the Bruins' team includes playing one-half of their regular season games away from their hometown arena, and the financial health of the NHL franchise--not to mention the NHL itself--would be adversely affected if teams refused to play away games. Staying in away city hotels is indispensable to the Bruins' preparation and is also necessary for maintaining a successful hockey operation and navigating the rigors of an NHL-mandated schedule. The Bruins are a highly respected professional hockey organization whose goals include fielding a competitive hockey team, winning as many regular season games as possible, qualifying for the postseason, and winning the Stanley Cup. The evidence adduced at trial establishes that away city hotels are essential to the Bruins' effective preparation, and like the taxpayer in Mabley, the Bruins use the hotel to conduct business. The away city hotels provide lodging so Bruins' players can obtain adequate rest, which is essential to professional athletes playing a physical sport with games scheduled in short succession. The Bruins contract with each away city hotel to set up a private meal room and to provide meals/snacks that meet the players' specific nutritional guidelines, which ensures optimal performance for the upcoming game and throughout the remainder of the season. Not only do the pregame meals provide essential nutrition for the players, but they also serve as a forum for the Bruins to maximize preparation time and conduct team business. See Mabley v. Commissioner, T.C. Memo 1965-323 (concluding that a rented hotel suite constituted business premises because the hotel suite in which the meals were furnished was acquired and actually used for the conduct of business of the company.). Like the meals provided in Mabley, the pregame meals are mandatory for players (excepting the snack) and provide an opportunity for Bruins' players to meet with coaches to strategize and review game film. The Bruins' public relations staff uses this time to prepare players for upcoming interviews and other public-facing issues. It is also a time when the players meet with staff to receive tickets for family and friends. Coaches, trainers, and management also use meal time to meet amongst themselves and make roster adjustments for a variety of reasons. Aside from the meal room, the Bruins use other areas in the away city hotels for preparation. Athletic trainers use hotel space to provide players with medical treatment, physical therapy, and massages. Players use hotel fitness centers for strength and conditioning sessions, which help decrease the chance of injury and maximize athletic performance. Given the nature of the NHL and the Bruins' game schedule, we see no way that the team's traveling hockey employees could perform all these necessary functions exclusively in Boston. The evidence at trial also establishes that the Bruins could not perform all these activities at the opponent's arena because of limited access and insufficient space and facilities. We thus conclude that away city


17

hotels are vital to the Bruins' business objective of winning hockey games and are where a significant portion of the traveling hockey employees' responsibilities and the Bruins' business is conducted.... Accordingly, we hold that the away city hotels constituted part of the Bruins' business premises for the years in issue. Respondent acknowledges that the Bruins perform business activities at away city hotels; however, respondent argues that the traveling hockey employees' activities at away city hotels are insignificant because: (1) the activities at away city hotels are qualitatively less important than playing in the actual hockey game and (2) the Bruins spend quantitatively less time at each away city hotel than they do at the team's Boston facilities. Although we agree with respondent that playing in hockey games is important to the Bruins' business, it seems that the quality of play is directly related to the team's preparation. This preparation includes business activities that occur at away city hotels, such as: eating nutritious meals, obtaining adequate rest, meeting with coaches individually or in small groups to strategize, reviewing game film, receiving athletic treatments and massages, and completing strength and conditioning workouts. The evidence at trial further indicates that the strength and conditioning workouts performed by the players at away city hotels provide important benefits to the players, not just for the immediate game but throughout the remainder of the season. Without the preparatory activities that occur at away city hotels the Bruins' performance during games would likely be adversely affected. Furthermore, respondent provides no precedent to support the argument that business premises are limited to the location where the most qualitatively significant business activity occurs. We also disagree with respondent's argument that away city hotels cannot constitute the Bruins' business premises because the team spends quantitatively less time at each individual away city hotel when compared to the team's time spent at its Boston facilities. Although the Bruins do spend quantitatively less time at each individual away city hotel than they do in Boston, this goes to the unique nature of a professional hockey team that is required to play one-half of its games away from home. It is therefore illogical for respondent to ignore the nature of the Bruins' business and the NHL and analyze the amount of time spent at each away city hotel in isolation.... Respondent also provides no precedent to support the proposition that a quantitative comparison of time is critical to determining business premises. See Adams, 585 F.2d at 1066 (stating that determinations of business premises "limited to the geographic contiguity of the premises or to questions of the quantum of business activities on the premises are too restrictive"). Accordingly, we hold that the away city hotels constituted part of the Bruins' business premises for the years in issue. D. Revenue/Operating Cost Test For employee meals at an employer-operated eating facility to qualify as a de minimis fringe, section 132(e)(2)(B) requires that revenue derived from the employer-operated eating facility equal or exceed the direct operating costs of the facility (i.e., the revenue/operating cost test). Section 132(e) provides that "an employee entitled under section 119 to exclude the value of a meal provided at such facility shall be treated as having paid an amount for such meal equal to the direct operating costs of the facility attributable to such meal." Regulations provide that an employer-operated eating facility satisfies the revenue/operating cost test if the employer can


18

reasonably determine that the meals are excludable to the recipient employees under section 119. Boyd Gaming Corp. v. Commissioner, 106 T.C. at 353; sec. 1.132-7(a)(2), Income Tax Regs. Meals are excludable to recipient employees under section 119 if they are (1) furnished for the convenience of the employer and (2) furnished on the business premises of the employer. Sec. 119(a). Whether meals are furnished for the convenience of the employer is a question of fact to be determined by an analysis of all the facts and circumstances. Sec. 1.119-1(a)(1), Income Tax Regs. Meals furnished without charge to the employee will be considered for the convenience of the employer if the meals are furnished "for a substantial noncompensatory business reason of the employer." Sec. 1.119-1(a)(2)(i), Income Tax Regs. In making this determination we are guided by section 1.119-1(a)(2)(ii), Income Tax Regs., which lists examples of substantial noncompensatory business reasons. See Boyd Gaming Corp. v. Commissioner, 106 T.C. at 349. We further remain cognizant that, if a taxpayer provides credible and uncontradicted evidence of business reasoning, the Court will refrain from second-guessing a taxpayer's business judgment. Boyd Gaming Corp. v. Commissioner, 177 F.3d 1096, 1100-1101 (9th Cir. 1999), rev'g T.C. Memo. 1997-445. The evidence establishes that the pregame meals at away city hotels are provided to the Bruins' traveling hockey employees for substantial noncompensatory business reasons. The Bruins provide pregame meals to traveling hockey employees at away city hotels first and foremost for nutritional and performance reasons. Meals are selected by the Bruins to meet the exacting nutritional needs of professional athletes, and menus are kept consistent from city to city to avoid players' experiencing unexpected gastric problems during games. The Bruins also provide pregame meals to the traveling hockey employees at away city hotels because they are subject to a busy schedule and have only limited time to prepare for an upcoming game. The Bruins play 82 regular season games, which include 41 away games at locations throughout the United States and Canada. The record establishes that the traveling hockey employees arrive at away city hotels the day before the game (or sometimes the morning of the game) and spend most of their time with preparation activities, such as: ensuring players get adequate rest; reviewing game film, strategizing, and making roster adjustments; conducting player-coach meetings; preparing for public relations inquiries; providing remedial or preventative athletic treatments; and completing strength and conditioning workouts to maintain player health and optimize performance. Providing meals to traveling hockey employees at away city hotels enables the Bruins to effectively manage a hectic schedule by minimizing unproductive time (e.g., finding and obtaining appropriate meals from restaurants in each city) and maximizing time dedicated to activities that help achieve the organization's goal of winning hockey games. Petitioners have provided credible evidence establishing the business reasons for furnishing pregame meals to traveling hockey employees at away city hotels, and we will not second-guess their business judgment. See id. Because we concluded that the away city hotels were the business premises of the Bruins, we need not repeat our discussion here. Accordingly, we hold that petitioners' provision of meals at away city hotels is for the convenience of the employer under section 119 and therefore satisfies the revenue/operating cost test of section 132(e)(2)(B).


19

E. Meals Furnished During, Before, or After Employee's Workday Section 1.132-7(a)(2)(iv), Income Tax Regs., provides that the "meals furnished at the facility are provided during, or immediately before or after, the employee's workday." Respondent concedes that petitioners have satisfied this requirement. We conclude that petitioners' provision of pregame meals and snacks to the traveling hockey employees at away city hotels qualifies as a de minimis fringe pursuant to section 274(n)(2)(B). Accordingly, petitioners are entitled to deduct the full cost of the meals without regard to the 50% limitation imposed by section 274(n)(1).


20

Chapter 18 EDUCATION EXPENSES Page 475: As a result of the Protecting Americans from Tax Hikes Act of 2015, the § 222 deduction for “qualified tuition and related expenses” was extended through 2016. Congress has yet to extend §222 beyond 2016.


21

Chapter 20 HOBBY LOSSES Page 494: The facts that no one factor is determinative and other factors may be taken into account in determining whether an activity is engaged in for profit led the Seventh Circuit in Roberts v. Commissioner, 820 F.3d 247 (7th Cir.) (April 15, 2016) (reversing the Tax Court’s decision that the taxpayer’s horse racing activity was a hobby for the years at issue) to comment:

In other words, the [nine-factor] test is open-ended - which means that the Tax Court was not actually required to apply all of those factors to [the taxpayer’s] horse-racing enterprise. It could have devised its own test, with its own factors, as long as it explained why the factors that “should normally be taken into account” were insufficient.

Roberts, 820 F.3d at 252.


22

Chapter 21 DUAL USE PROPERTY Page 522-523, footnote 11: The Protecting Americans from Tax Hikes Act of 2015 extended §168(k) through 2019, reducing the additional first year depreciation from 50% to 40% for property placed in service in 2018 and to 30% for property placed in service in 2019. While extending through 2017 the $8,000 increase in the §280F(a)(A)(1)(I) limitation provided by §168(k)(2)(F)(I), the Act reduces that increase to $6,400 for automobiles placed in service during 2018 and to $4,800 for automobiles placed in service during 2019. Unless extended, §168(k) will sunset after 2019.


23

Chapter 22

THE INTEREST DEDUCTION

Page 547:

In a split decision, the Ninth Circuit reversed the Tax Court decision in Sophy v. Commissioner, 138 T.C. 204 (2012), included in the casebook. The majority inferred from §163(h)(3)'s treatment of married individuals filing separate returns that §163(h)(3)'s debt limitsapply to unmarried co-owners on a per-taxpayer basis. Reprinted below are excerpts from boththe majority and dissenting opinions. Note: On August 1, 2016, the Internal Revenue Serviceacquiesced in the Ninth Circuit’s decision in Voss/Sophy. AOD 2016-2, 2016-31 I.R.B. 193.

Voss v. Commissioner/Sophy v. Commissioner 796 F.3d 1051 (9th Cir.) (2015)

Bybee, Circuit Judge: .... We are asked to decide an issue of first impression: When multiple unmarried taxpayers

co-own a qualifying residence, do the debt limit provisions found in 26 U.S.C. § 163(h)(3)(B)(ii) and (C)(ii) apply per taxpayer or per residence? We conclude that § 163(h)'s debt limits apply per taxpayer.1

.....

Discerning an answer from § 163(h) requires considerable effort on our part because the statute is silent as to how the debt limits should apply in co-owner situations.2 Both provisions limit "[t]he aggregate amount treated" as acquisition or home equity debt, but neither says to whom or what the limits apply. Had Congress wanted to make clear that the debt limits apply per taxpayer, it could have drafted the provisions to limit "the aggregate amount each taxpayer may treat as" acquisition or home equity debt. But it did not. Or, had Congress wanted to make clear that the debt limits apply per residence, it could have provided that the debt limits must be divided or allocated in the event that two or more unmarried individuals co-own a qualified residence. Cf. 26 U.S.C. § 36(a)(1)(C) ("If two or more individuals who are not married purchase a principal residence, the amount of the [first-time homebuyer] credit allowed . . . shall be allocated among such individuals in such manner as the Secretary may prescribe, except that the total amount of the credits allowed to all such individuals shall not exceed $8,000"). But, again, it did not.

1 The parties agree that both of petitioners' homes are qualified residences under § 163(h)(4)(A)(i), that both refinanced mortgages qualify as acquisition indebtedness under § 163(h)(3)(B)(i), and that petitioners' home equity line of credit qualifies as home equity indebtedness under § 163(h)(3)(C)(i).

2The relevant Treasury regulation, 26 C.F.R. § 1.163-10T, is also silent in this regard. The regulation provides a method of calculating qualified residence interest when the home debt exceeds the applicable debt limits in the statute, see id. § 1.163-10T(e), but it says nothing about how qualified residence interest should be calculated when there are multiple co-owners, whether married or unmarried.


24

Although Congress did neither of these things, we are not altogether without textual guidance. The statute is mostly silent about how to deal with co-ownership situations, but it is not entirely silent. Both debt limit provisions contain a parenthetical that speaks to one common situation of co-ownership: married individuals filing separate returns. See id. § 163(h)(3)(B)(ii), (C)(ii). The parentheticals provide half-sized debt limits "in the case of a married individual filing a separate return." Id.3 Congress's use of the phrase "in the case of" is important. It suggests, first, that the parentheticals contain an exception to the general debt limit set out in the main clause, not an illustration of how that general debt limit should be applied. At the same time, the phrase "in the case of" also suggests a certain parallelism between the parenthetical and the main clause of each provision: other than the debt limit amount, which differs, we can expect that in all respects the case of a married individual filing a separate return should be treated like any other case. It is thus appropriate to look to the parentheticals when interpreting the main clauses' general debt limit provisions. These parentheticals offer us at least three useful insights.

First, the parentheticals clearly speak in per-taxpayer terms: the limit on acquisition indebtedness is "$500,000 in the case of a married individual filing a separate return," id. § 163(h)(3)(B)(ii) (emphasis added), and the limit on home equity indebtedness is "$50,000 in the case of a separate return by a married individual," id. § 163(h)(3)(C)(ii) (emphasis added). And they speak in such terms even though married individuals commonly (and perhaps usually) co-own their homes and are jointly and severally liable on any mortgage debt. Had Congress wanted to draft the parentheticals in per-residence terms, doing so would not have been particularly difficult. Congress could have written, "in the case of any qualified residence of a married individual filing a separate return." Yet, once again, Congress did not draft the statute in that way. The per-taxpayer wording of the parentheticals, considered in light of the parentheticals' use of the phrase "in the case of," thus suggests that the wording of the main clause -- in particular, the phrase "aggregate amount treated" -- should likewise be understood in a per-taxpayer manner.

Second, the parentheticals don't just speak in per-taxpayer terms; they operate in a per-taxpayer manner. The parentheticals give each separately filing spouse a separate debt limit of $550,000 so that, together, the two spouses are effectively entitled to a $1.1 million debt limit (the normal limit for single taxpayers). They do not subject both spouses jointly to the $550,000 debt limit specified in the statute. Were the parentheticals to work in that way, the result would be quite anomalous. Rather than ensuring that a married couple filing separate returns is treated the same as a couple filing a joint return, the parentheticals, under a per-residence reading, would result in disparate treatment of married couples filing separate returns. The separately filing couple would have a $550,000 debt limit, whereas the jointly filing couple, and even the single individual, would have a $1.1 million debt limit.

3 For no apparent reason that we can tell, (C)(ii)'s parenthetical is worded differently. It states, "$50,000 in the case of a separate return by a married individual." 26 U.S.C. § 163(h)(3)(C)(ii) (emphasis added).


25

This is surely not what the statute intended, and we don't understand the Tax Court or the IRS to say otherwise. Quite to the contrary, both acknowledge that the parentheticals' lower limits apply per spouse -- which is just another way of saying per taxpayer. See Sophy, 138 T.C. at 212 (interpreting the married-person parentheticals to mean that "married taxpayers who file separate returns are limited to acquisition indebtedness of $500,000 each" and "to home equity indebtedness of $50,000 each" (emphasis added)); see also Bronstein v. Comm'r, 138 T.C. 382, 386 (2012) ("[T]he parenthetical indebtedness limitations of section 163(h)(3)(B)(ii) and (C)(ii) are $550,000 for each spouse filing a separate return." (emphasis added)). And if the debt limits for spouses filing separately apply per spouse, we see no reason in the statute why the debt limits for unmarried individuals should not apply per unmarried individual. The per-taxpayer operation of the debt limits for married individuals filing separately thus suggests that the general debt limits also operate per taxpayer.

Third, and finally, the very inclusion of the parentheticals suggests that the debt limits apply per taxpayer. "It is a well-established rule of statutory construction that courts should not interpret statutes in a way that renders a provision superfluous." .... If the $1.1 million debt limit truly applied per residence, as the Tax Court held it does, the parentheticals would be superfluous, as there would be no need to provide that two spouses filing separately get $550,000 each. If the $1.1 million debt limit applies per taxpayer, by contrast, the parentheticals actually do something: they give each separately filing spouse half the debt limit so that the separately filing couple is, as a unit, subject to the same debt limit as a jointly filing couple.

The Tax Court interpreted the married-person parentheticals differently. The purpose of the parentheticals, according to the Tax Court, is not to lower the debt limits for spouses filing separate returns -- the spouses are already jointly subject to the $1.1 million debt limit. Rather, the Tax Court explained,

this language simply appears to set out a specific allocation of the limitation amounts that must be used by married couples filing separate tax returns, thus implying that co-owners who are not married to one another may choose to allocate the limitation amounts among themselves in some other manner, such as according to percentage of ownership.

Sophy, 138 T.C. at 213 (emphasis added).

We find this interpretation unpersuasive. In particular, we think it unlikely that Congress would go out of its way to prevent spouses (and only spouses) from allocating § 163(h)(3)'s debt limit amounts, especially when in most cases spouses presumably own their home as equal partners. The much more likely intent of the parentheticals, we think, is to ensure that married couples filing a separate return are treated the same, for purposes of § 163(h)(3), as married couples filing a joint return -- in other words, to ensure that all married couples, not just joint filers, are treated as though they were a single taxpayer.

.... In sum, the married-person parentheticals' language, purpose, and operation all strongly

suggest that § 163(h)(3)'s debt limit provisions apply per taxpayer, not per residence. Absent


26

some contrary indication in the statute, then, we shall read the debt limit provisions as applying on a per-taxpayer basis.

.... The Tax Court rejected a per-taxpayer reading of the debt limit provisions because it

discerned in § 163(h)(3) a general "focus" on the qualified residence, Sophy, 138 T.C. at 210, and a "conspicuous absence" of "any reference to an individual taxpayer," id. at 211. Because the debt limit provisions do not speak directly to the situation of unmarried co-owners, it was reasonable for the Tax Court to look beyond those provisions in an effort to understand how the provisions should be applied. Ultimately, however, these other provisions of the statute do not sway us.

The Tax Court focused on three provisions in the statute, all definitions: first, the definition of qualified residence interest as "any interest which is paid or accrued during the taxable year on acquisition [or home equity] indebtedness with respect to any qualified residence of the taxpayer"...; second, the, definition of acquisition indebtedness as "any indebtedness which is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer"; and third, the definition of home equity indebtedness as "any indebtedness (other than acquisition indebtedness) secured by a qualified residence." In each definition, the Tax Court highlighted the reference to the qualified residence and noted that the taxpayer was only ever mentioned with respect to the residence, not with respect to the indebtedness.

We, however, do not find the statute's focus on the residence or lack of focus on the taxpayer particularly compelling. As for the repeated references to the residence, it is only natural that a statute providing a deduction on "qualified residence interest" will focus on indebtedness with respect to a qualified residence. Indeed, for the most part, the statute's references to the "qualified residence" are entirely necessary; take those references out, and the statute would change meaning or make little sense.

The Tax Court did identify a few instances where a prepositional phrase involving the residence (such as "with respect to any qualified residence") could have been safely omitted and was thus arguably superfluous, ... but the same could be said of other prepositional phrases involving the taxpayer (such as "of the taxpayer"). In all likelihood, these phrases, though technically unnecessary, were included simply to ease the reader's understanding of a complex tax statute full of technical definitions. (We certainly appreciate their inclusion.) And, in any case, if there is a plausible inference to be drawn from those few stray prepositional phrases, it is overcome by the clear implications of the married-person parentheticals discussed above. Thus, in our view the statute's focus on the residence says little about how the debt limit provisions should be applied.

Nor do we find the occasional omission of the word "taxpayer" particularly telling. To begin with, two of the three definitions identified by the Tax Court do refer to the taxpayer, and all three depend on the definition of "qualified residence," which itself refers to the taxpayer (for more on the definition of "qualified residence," see the next section below). Setting to the side those references to the taxpayer, it is true that the three definitions identified by the Tax Court -- just like the debt limit provisions in (h)(3)(B)(ii) and (C)(ii) -- do not specify who paid the interest, who incurred the indebtedness, and whose indebtedness was secured by a qualified


27

residence. But when we look at the rest of § 163 (and, we suspect, the rest of the Tax Code), the omission of the word "taxpayer" is anything but conspicuous. Note, for example, how the word "taxpayer" is missing from the first line of § 163, which states, "There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness." Id. § 163(a). There is no need for the sentence to say, "There shall be allowed as a deduction to the taxpayer all interest paid by the taxpayer within the taxpayer's taxable year on the taxpayer's indebtedness." Any reasonable reader would understand that the statute is speaking of a taxpayer.

Or take the first line of § 163(h). It states that "no deduction shall be allowed under this chapter for personal interest paid or accrued during the taxable year." Id. § 163(h)(1). Again, the reader easily intuits that the statute refers to a taxpayer's deduction, a taxpayer's personal interest payments, and a taxpayer's taxable year. Indeed, there can be no doubt that is what (h)(1) means because the statement just quoted follows the phrase, "In the case of a taxpayer other than a corporation." Id. (emphasis added).

Thus, although we do not fault the Tax Court for looking to other provisions in the statute for guidance, we would place little weight on the statute's general focus on the residence or its repeated omission of reference to the taxpayer. If anything, these other provisions reinforce our per-taxpayer reading; they reveal that the debt limit provisions' omission of the word "taxpayer" is actually quite ordinary in the context of the broader statute.

.... Not only does nothing in the statute compel the Tax Court's per-residence reading;

several of the statute's provisions point the other way. We have already noted one example: by speaking and operating in a per-taxpayer manner, the married-person parentheticals suggest that the general debt limits also apply per taxpayer. Two other provisions also warrant attention. First, we are guided by the statute's repeated references to a single "taxable year." Section 163(h) begins by stating that "no deduction shall be allowed under this chapter for personal interest paid or accrued during the taxable year." Id. § 163(h)(1) (emphasis added). Likewise, § 163(h)(3) begins by defining qualified residence interest as any interest on acquisition or home equity debt "which is paid or accrued during the taxable year." Id. § 163(h)(3)(A). Indeed, the very provisions at issue, the debt limit provisions, cap the allowable amount of home debt "for any period" -- the word "period" clearly referring to the "taxable year" mentioned earlier in (h)(3). Id. § 163(h)(3)(B)(ii), (C)(ii).

Residences do not have taxable years; only taxpayers do. And, importantly, taxpayers can have different taxable years. See 26 U.S.C. § 441(b) ..... Yet § 163(h) speaks in terms of a single taxable year, thus implying that the debt limits apply per taxpayer. If Congress truly intended to imply that § 163(h)(3)'s debt limits apply per residence by broadly focusing on the residence and consistently ignoring the taxpayer, it seems unlikely to us that it would at the same time define qualified residence interest with respect to a single taxable year.

Moreover, it is unclear how co-owners with different taxable years could even determine "[t]he aggregate amount treated as acquisition indebtedness for any period" under a per-residence approach. Does one co-owner's tax period control? Or do the co-owners have to figure out some way of accounting for both tax periods? (Keep in mind that mortgage balances usually change


28

monthly.) These difficult questions go away, however, when the debt limits are read to apply per taxpayer. Each co-owner simply determines the interest paid and the average mortgage debt during his or her own tax period.

The Tax Court's per-residence reading is also hard to square with the statute's definition of "qualified residence." Somewhat counter-intuitively, the term "qualified residence" can include one or two residences: "the principal residence (within the meaning of section 121) of the taxpayer," and "1 other residence of the taxpayer which is selected by the taxpayer for purposes of this subsection for the taxable year and which is used by the taxpayer as a residence (within the meaning of section 280A(d)(1))." Id. § 163(h)(4)(A)(I). Contrary to the Tax Court's per-residence reading of the statute, the term "qualified residence" clearly focuses on the taxpayer. The term includes the principal residence "of the taxpayer" and one other residence "of the taxpayer" that is "used by the taxpayer as a residence" and is "selected by the taxpayer." Id. The term also specifies that the taxpayer may select the secondary residence "for the taxable year," id., suggesting that a taxpayer who owns multiple secondary residences can change his or her "1 other residence" from one tax year to the next.

More than just focusing on the taxpayer, the term "qualified residence" also highlights the impracticality of the Tax Court's approach. As the term "qualified residence" is defined, it is entirely possible that two residence co-owners might each have a different "qualified residence." For example, two individuals might each have a separate primary residence but go in together on a vacation home in Maui. For such co-owners, filing tax returns under the Tax Court's per-residence approach would be like running a three-legged race. The co-owners are tied together for one home but not the other. This would mean that the two (or it could be three or four) co-owners would have to coordinate their tax returns to ensure that the aggregate amount of acquisition debt for each taxpayer's "qualified residence" does not exceed $1 million. It would also mean that one co-owner's deduction might depend on the size of another co-owner's mortgage on a home in which the first co-owner has no interest. Under a per-taxpayer approach, by contrast, determining the amount of acquisition debt is free of such difficulties. Each taxpayer can calculate the deduction with reference to his or her respective two residences.

These provisions -- the married-person parentheticals, the repeated references to the single "taxable year," and the taxpayer-specific definition of "qualified residence" -- are at odds with the Tax Court's per-residence reading of § 163(h)(3). Each provision focuses on the individual taxpayer, and the impracticality of applying the provisions under a per-residence approach suggests that Congress never intended that approach. We thus conclude that a per-taxpayer reading of the statute's debt limit provisions is most consistent with § 163(h)(3) as a whole.

.... The IRS argues that applying § 163(h)(3)'s debt limit provisions on a per-taxpayer basis

creates a marriage penalty. We agree that it does, but we do not believe the marriage penalty is as significant a concern as the IRS urges.

Congress may have had perfectly legitimate reasons for distinguishing between married and unmarried taxpayers. Married individuals, unlike unmarried individuals, have the option


29

under the Tax Code of filing a joint return. This option offers significant benefits -- in particular, lower tax rates at various levels of income. But it's not all honeymoon; filing jointly also comes with certain drawbacks. A couple filing a joint return might, for example, receive one $1,000 tax credit where the same couple filing separate tax returns might receive two $1,000 credits. It would appear that, in Congress's view, the home mortgage interest deduction is one such drawback. If two individuals who are engaged to be married each own their own house and each have their own $1 million mortgage, both get to deduct all of their interest. But if they get married and file a joint return, they are treated as one taxpayer and can then only deduct half of their interest.... This is a marriage penalty, but Congress presumably allows the marriage penalty because the couple also receives offsetting benefits available only to married couples filing a joint return.

Of course, a married couple filing separate returns does not receive the benefits of filing a joint return. Is it unfair, then, that they are treated as a single taxpayer while the unmarried couple is not? Perhaps not, for the married couple, unlike the unmarried couple, can usually elect to file a joint return. And perhaps Congress did not want separately filing married couples to have a significant advantage over jointly filing married couples.

We have already explained that the apparent purpose of the married-person parentheticals is to ensure that married couples are treated as a single taxpayer for purposes of the home mortgage interest deduction regardless of whether they file separately or jointly. And the same purpose is evident in other provisions as well. For example, the statute provides that married couples filing separate returns generally "shall be treated as 1 taxpayer" for purposes of the definition of qualified residence. 26 U.S.C. § 163(h)(4)(A)(ii)(I). Like the debt limit provisions, this provision does not explicitly say whether the same is true of married couples filing a joint return, but we can reasonably infer that Congress also intended to treat jointly filing couples as a single taxpayer. See IRS Field Service Advisory No. 200137033 (Sept. 14,2001) (opining, non-precedentially, that "[a]lthough § 163(h)(4)(A) does not specifically state that a married couple filing jointly is treated as one taxpayer for purposes of determining their mortgage interest deductions, we assume that Congress did not intend to treat married couples filing jointly differently than married couples filing separately").

We thus agree that the debt limit provisions of § 163(h)(3) result in a marriage penalty; but we are not particularly troubled. Congress may very well have good reasons for allowing that result, and, in any event, Congress clearly singled out married couples for specific treatment when it explicitly provided lower debt limits for married couples yet, for whatever reason, did not similarly provide lower debt limits for unmarried co-owners.

....

The dissent urges us to defer to the IRS's interpretation of the statute in a 2009 Chief Counsel Advice memorandum.... The memorandum, like the Tax Court below, adopts a per-residence interpretation of § 163(h)(3)'s debt limit provisions. Its statutory analysis consists of one paragraph, which reads:


30

Under § 163(h)(3)(B)(I), acquisition indebtedness is defined, in relevant part, as indebtedness incurred in acquiring a qualified residence of the taxpayer -- not as indebtedness incurred in acquiring [a] taxpayer's portion of a qualified residence. The entire amount of indebtedness incurred in acquiring the qualified residence constitutes "acquisition indebtedness" under § 163(h)(3)(A)(I). . . . [U]nder § 163(h)(3)(B)(ii), the amount treated as acquisition indebtedness for purposes of the qualified residence interest deduction is limited to $1,000,000 of total, "aggregate" acquisition indebtedness. This is evident from the parenthetical in § 163(h)(3)(B)(ii) which limits the aggregate treated as acquisition indebtedness to $500,000 for a married taxpayer filing a separate return.

IRS Chief Counsel Advice No. 200911007, at 4 (Mar. 13, 2009).

As the dissent acknowledges, the IRS's Chief Counsel Advice is only entitled to the "measure of deference proportional to the 'thoroughness evident in its consideration, the validity of its reasoning, its consistency with earlier and later pronouncements, and all those factors which give it power to persuade.'" ....

A review of these factors suggests the 2009 Chief Counsel Advice should be given limited weight. To start, the 2009 Chief Counsel Advice is hardly thorough or exhaustive -- its analysis interpreting how the statute should apply to unmarried co-owners consists of just one paragraph. It treats the question as one governed by the "plain language of the statute," ... yet as our exchange, the briefs of the parties, the Tax Court's decision, and the statute itself demonstrate, it is anything but "plain." The Chief Counsel Advice does not grapple with the statute's taxpayer-specific definition of "qualified residence" or repeated references to a taxpayer's taxable year, nor does it explain how the married-person parenthetical is anything but surplusage under a per-residence reading of the statute.

As for consistency, the situation here is a far cry from that in Hall v. United States, 132 S. Ct. 1882, 1890 (2012), a case the dissent cites.... In Hall, the Supreme Court "s[aw] no reason to depart from those established understandings" of bankruptcy courts, bankruptcy commentators, and the IRS's consistent position for over a decade in an IRS Chief Counsel Advice memorandum, the Internal Revenue manual, and an IRS Litigation Guideline Memorandum. See Hall, 132 S. Ct. at 1889-90. Here, by contrast, there is no comparable consensus. Aside from the IRS's litigation position in this case, it appears that the 2009 Chief Counsel Advice -- which is just six years old -- is the IRS's only pronouncement addressing how § 163(h)(3)'s debt limits apply to unmarried co-owners. The agency's guidance is closer to a "mere . . . litigating position" than to an "agency interpretation of 'longstanding' duration." ....

Even putting all that aside, we are not persuaded by the reasoning in the IRS's 2009 guidance. The 2009 Chief Counsel Advice reasons that "acquisition indebtedness" is defined in the statute "as indebtedness incurred in acquiring a qualified residence of the taxpayer -- not as indebtedness incurred in acquiring [a] taxpayer's portion of a qualified residence," and concludes that unmarried co-owners are "limited to $1,000,000 of total, 'aggregate' acquisition indebtedness." .... But this begs the question. As we have explained, although the statute limits


31

"[t]he aggregate amount treated" as acquisition or home equity debt, it does not say to whom or what the limits apply.

Indeed, we are not convinced the dissent is fully persuaded by the 2009 Chief Counsel Advice either. Although the dissent extols the IRS's "reasonable and persuasive" "position," ... the dissent only briefly discusses the Chief Counsel's actual reasoning. And as for the IRS's arguments on appeal, the dissent shies away from the IRS's principal argument -- i.e., that "the focus of the statute is on the residence, not on the taxpayer." We have explained why this argument fails, yet the dissent offers no response.

What is more, in one important respect, the dissent rejects the IRS's interpretation. According to the dissent, the married-person parenthetical is not superfluous because it imposes a "statutory penalty" on married individuals who decide to file separately.... Under this view, two unmarried co-owners are entitled to a total debt limit of $1.1 million, a married couple filing jointly is entitled to a total debt limit of $1.1 million, and even a single individual is entitled to a total debt limit of $1.1 million -- but a married couple filing separately is entitled to a total debt limit of $550,000.

To our knowledge, however, neither the IRS nor the Tax Court has ever adopted the dissent's interpretation. As the IRS explained in its brief on appeal, "The parenthetical language in the acquisition indebtedness limitation in § 163(h)(3)(B)(ii) provides that married taxpayers who file separate returns are limited to acquisition indebtedness of $500,000 each." (Emphasis added.) Accord Sophy, 138 T.C. at 212 ("[M]arried taxpayers who file separate returns are limited to acquisition indebtedness of $500,000 each. . . ." (emphasis added)); Bronstein, 138 T.C. at 386 ("[T]he parenthetical indebtedness limitations . . . are $550,000 for each spouse filinga separate return." (emphasis added)); IRS Chief Counsel Advice No. 200911007, at 4(explaining that the per-residence operation of the $1 million limit on acquisition indebtedness"is evident from the [married-person] parenthetical," thus implying that each separately filingspouse gets a separate $500,000 aggregate debt limit). On this issue there is a consensus, and thedissent is on the wrong side.

At bottom, although an IRS Chief Counsel Advice statement "is helpful in determining the position of the IRS," it is an internal IRS memorandum prepared by an individual IRS attorney. .... The document itself cautions that it "may not be used or cited as precedent." Indeed, the IRS could issue a memorandum taking the opposite position tomorrow, "apparently without revoking the earlier guidance."

Every factor the dissent says we should consider suggests that the IRS's interpretation should not be given significant weight. Having considered the IRS's reasoning as set out in the 2009 Chief Counsel Advice and the IRS's briefs on appeal, we decline to adopt its interpretation.

....

We hold that 26 U.S.C. § 163(h)(3)'s debt limit provisions apply on a per-taxpayer basis to unmarried co-owners of a qualified residence. We infer this conclusion from the text of the statute: By expressly providing that married individuals filing separate returns are entitled to


32

deduct interest on up to $550,000 of home debt each, Congress implied that unmarried co-owners filing separate returns are entitled to deduct interest on up to $1.1 million of home debt each. We accordingly reverse the Tax Court's decision and remand for the limited purpose of allowing the parties to determine, in a manner consistent with this opinion, the proper amount of qualified residence interest that petitioners are entitled to deduct, as well as the proper amount of any remaining deficiency.

REVERSED and REMANDED.

IKUTA, Circuit Judge, dissenting:

Today the majority interprets the Tax Code to allow unmarried taxpayers who buy an expensive residence together to deduct twice the amount of interest paid on the debt secured by their residence than spouses would be allowed to deduct. While the language of the relevant statute is ambiguous, the IRS has offered an interpretation that limits unmarried taxpayers in this situation to deducting the same amount as married taxpayers filing jointly. Because we should defer to this reasonable interpretation by the IRS, I dissent. .......

The IRS has adopted a straightforward application of [§ 163(h)] when there is a single taxpayer or a married couple filing jointly. If a qualified residence serves as security for debt that is more than the specified $1.1 million, only the interest payments on the allowed $1.1 million of the debt are deductible. In the case of an individual taxpayer, the IRS calculates the proportion of the taxpayer's total interest payments that is deductible by dividing the $1.1 million of debt by the total amount of debt secured by the qualified residence. See 26 C.F.R. § 1.163-10T(e);1 Chief Couns. Advice, IRS CCA 200911007, 2009 WL 641772. So if the qualified residence is security for $2.2 million in debt, the taxpayer can calculate the proportion of interest payments that is deductible by dividing $1.1 million (the total aggregate debt allowed by the statute) by $2.2 million (the total amount of debt secured by the qualified residence). The result is that the taxpayer can deduct one half of the interest the taxpayer paid on the total debt.

Similarly, spouses filing jointly are subject to the $1,000,000 limit on acquisition indebtedness and the $100,000 limit on home equity indebtedness.... This approach is consistent with the Tax Code's typical treatment of a married couple filing jointly as one taxpayer, who together have an aggregate debt and together are subject to the statutory limit on how much interest they may deduct....

1 26 C.F.R. § 1.163-10T discusses "qualified residence interest" in 26 U.S.C. § 163(h)(3). § 1.163-10T(e) provides a formula to determine qualified residence interest when secured debt exceeds the adjusted purchase price of a house. The parties do not dispute that it is also the applicable formula for purposes of determining what proportion of interest payments is deductible when "the average balance of the debt" exceeds the "applicable debt limit." 26 C.F.R. § 1.163-10T(e). The majority concedes that § 1.163-10T(e) applies in this context ... but argues that it "only addresses the situation of a single taxpayer," .... Nothing in the regulation supports the majority's assertion, however; rather, the IRS has concluded that the regulation does apply to co-owners. See IRS CCA 200911007, 2009 WL 641772.


33

The IRS has also explained how this methodology applies when there are unmarried co-owners of a qualified residence. See Chief Couns. Advice, IRS CCA 200911007, 2009 WL641772. Under the IRS's interpretation, regardless of the number of unmarried taxpayers who have an ownership interest in a qualified residence, only interest payments on $1.1 million of the debt encumbering that qualified residence are deductible. Therefore, the IRS applies its formula as follows: each co-owner who has an ownership interest in the qualified residence may deduct a percentage of the interest payments the co-owner paid or accrued, in proportion to the total aggregate debt allowed by the statute ($1.1 million) divided by the total amount of debt secured by the qualified residence. In other words, if a taxpayer has an ownership interest in a qualified residence that is security for $2.2 million of debt, the taxpayer can deduct one half of the interest payments that the taxpayer made on that debt ($1.1 million debt allowed by statute divided by $2.2 million debt secured by the qualified residence). The other co-owners can do the same. ....

Bruce Voss and Charles Sophy argue that we should reject the IRS's interpretation of 26 U.S.C. § 163(h) and allow them double the deductible interest that an individual taxpayer or married couple filing jointly would get....

On appeal, Voss and Sophy argue for a different interpretation of § 163(h) and therefore a different application of the IRS formula. Voss and Sophy claim that the $1.1 million "aggregate amount" of debt that can be treated as acquisition and home equity indebtedness for purposes of § 163(h)(3)(B) does not relate to the total amount of debt encumbering a qualified residence.Instead, if the total amount of debt encumbering a qualified residence exceeds $1.1 million, theco-owners may effectively divide that total amount of debt between themselves and each deductinterest payments on up to $1.1 million of their portion of the total debt. For example, if a $2.2million debt is secured by a qualified residence owned by two co-owners, Voss and Sophy claimthat the co-owners can divide the debt equally between themselves. Under this theory, Co-Owner1 could deduct interest payments made on $1.1 million of debt (i.e., 100 percent of Co-Owner 1'sinterest payments), and of course, Co-Owner 2 could do the same thing. As a result, the co-owners could deduct interest payments on $2.2 million of debt secured by their qualifiedresidence, even though a married couple filing jointly or a single taxpayer could deduct intereston only $1.1 million of debt.

Applying their interpretation, Voss argues that, because he and Sophy each have an "equal share of the mortgage," he and Sophy have divided the $2.7 million debt between themselves on a fifty-fifty basis. Therefore, Voss can deduct interest payments made on $1.1 million of his $1.35 million portion of the debt secured by his qualified residence. Dividing $1.1 million (the total aggregate debt allowed by the statute) by $1.35 million (Voss's self-apportioned amount of debt secured by the qualified residence), this means about 80 percent of his interest payments is deductible. And, the argument goes, Sophy can do the same thing. As a result, Voss and Sophy claim they can deduct 80 percent of the interest paid on $2.7 million, the total indebtedness on their qualified residence, rather than deducting 40 percent of the interest paid on that debt had they been a married couple. ....

Voss and Sophy's approach to § 163(h) should be rejected because it is contrary to the IRS's reasonable and persuasive interpretation of the statute. Voss and Sophy cannot claim that


34

the plain language of § 163(h) compels their interpretation; rather, the statute gives no indication that multiple co-owners may each "treat" $1.1 million of debt as "acquisition indebtedness" or "home equity indebtedness" for purposes of an interest deduction. In these circumstances, we can afford respect to an agency's interpretation of a statute, whether it is offered in an opinion letter, policy statement, agency manual, or even a well-reasoned legal brief.... An agency interpretation of a statute is entitled to a "measure of deference proportional to the '"thoroughness evident in its consideration, the validity of its reasoning, its consistency with earlier and later pronouncements, and all those factors which give it power to persuade.'"" ....We also consider the specialized and technical expertise of the agency ... as well as whether the agency's guidance is longstanding or merely a litigating position.... Here, the IRS's position, expressed in its legal brief on appeal and in its 2009 Chief Counsel Advice statement, is both reasonable and persuasive. First, it is consistent with the text of the statute: the language of § 163(h)(3) is reasonably read to establish that the debt limit of $1.1 million per qualified residence applies regardless whether there is one owner or two co-owners. The fact that "acquisition indebtedness" is defined as debt secured by a qualified residence suggests that Congress also contemplated that the "aggregate amount treated as acquisition indebtedness" was also defined with respect to a qualified residence. 26 U.S.C. § 163(h)(3)(B).

And the IRS's interpretation is more persuasive than Voss and Sophy's interpretation, which would result in a windfall to unmarried taxpayers.... There is no basis to infer that Congress intended to allow unmarried co-owners of a qualified residence filing separately to deduct interest on up to $2.2 million of debt, while limiting married co-owners of a qualified residence to deduct interest on only half that (only up to $1.1 million of debt). A more logical inference is that the deduction was aimed at promoting home ownership for ordinary folks, not to help wealthy individuals purchase mansions that are encumbered with more than $1.1 million of debt.

Third, the IRS has applied its expert interpretation of § 163(h) consistently for many years.... The IRS first set forth a methodology for determining what proportion of a taxpayer's interest payments is deductible in 1987, when it promulgated regulation § 1.163-10T(e). It explained how this method applied to co-owners of a qualified residence in its Chief Counsel Advice statement in 2009.... There is no dispute that the IRS's approach for calculating the deductibility of interest payments under § 163(h)(3)(B) is not merely "an agency's convenient litigating position." .... Under these circumstances, it is appropriate to defer to the IRS's specialized expertise and understanding of what best effectuates the purpose of the statute.2

In response to the IRS's reasonable interpretation of § 163(h)(3)(B), Voss and Sophy look for help in a separate section of the Tax Code governing apportioning gain based on the sale of a

2 The majority claims that it is inconsistent to defer to the IRS's position regarding the deduction for unmarried co-owners while failing to defer to the IRS regarding the deduction for married individuals filing separately.... But, as discussed below, the IRS has not expressed a position as to what deduction married individuals filing separately may claim. See infra note 5. As such, there is no interpretation to which we could defer regarding what the statute means for married individuals filing separately. By contrast, the IRS has offered a clear interpretation of the statute as it applies to unmarried co-owners. We should defer to that interpretation.


35

residence, 26 U.S.C. § 121, and its accompanying regulation, 26 C.F.R. § 1.121-2. Section 121 allows a taxpayer who sells a residence to exclude up to $250,000 of gain from gross income. 26 U.S.C. § 121(b)(1). The regulations clarify that "[i]f taxpayers jointly own a principal residence but file separate returns, each taxpayer may exclude from gross income up to $250,000 of gain that is attributable to each taxpayer's interest in the property. . . ." 26 C.F.R. § 1.121-2(a)(2). Voss and Sophy argue that because § 163(h) cross-references 26 U.S.C. § 121 for the definition of a "qualified residence," the methodology set forth in § 1.121-2(a)(2) should also apply to § 163(h). Accordingly, they argue, because they jointly own a qualified residence, and file separate returns, they should likewise be able to deduct the amount of interest each paid on $1.1 million of debt out of each co-owner's "equal share of the mortgage." But section 121 provides Voss and Sophy no support because it has nothing to do with § 163(h)(3). Other than the use of § 121 for the definition of "qualified residence," there is no indication that either Congress or the IRS contemplated that the methodology in § 1.121-2(a) should be used to determine the method of determining which interest is deductible under 26 U.S.C. § 163(h)(3). Voss and Sophy's argument merely shows the IRS knew how to authorize such a methodology when it chose to do so, which it did not when interpreting § 163(h).

In the absence of an IRS regulation interpreting § 163(h) as allowing co-owners to claim deductions attributable to more than $1.1 million of debt for a co-owned qualified residence, we should defer to the IRS's interpretation of the statute as limiting co-owners to deducting interest on $1.1 million of debt out of the total acquisition and home equity debt secured by the qualified residence....

The majority agrees that the statute is silent as to how to apply the debt limit of $1.1 million when there are co-owners of a qualified residence.... The majority therefore exerts "considerable effort," ... to find textual support for using the approach demanded by Voss and Sophy. The majority bases its ruling on the thinnest of reeds: the parenthetical in § 163(h)(3) that specifies that a married individual filing separately can deduct interest payments on half the amount of debt compared to a single individual or a married couple filing jointly. According to the majority, in order to avoid absurdity, we should read the marriage parenthetical as allowing married individuals filing separately each to deduct interest on $550,000 of debt.... If married individuals filing separately were not each able to deduct interest on $550,000 of debt through some unspecified calculation methodology, the majority asserts, spouses filing separately would receive half the deduction of spouses filing jointly. This is absurd, the majority claims, because a different debt limit for a jointly filing couple and a separately filing couple is "surely not what the statute intended." .... The majority then leaps from this inferred congressional intent to a different conclusion: Congress must also have intended to allow all unmarried individuals who co-own a qualified residence secured by debt to deduct interest on the full debt limit, $1.1 million.

This argument too fails. First, effectuating the majority's approach to the marriage parenthetical would presumably entail allowing a married taxpayer filing separately to deduct his or her own interest payments on the debt in the proportion of $550,000 divided by one half of the total debt secured by the qualified residence. See Maj. Op. ... (agreeing that the IRS's formula set out in § 1.163-10T(e) "may need to be adjusted to account for the situation of separately


36

filing co-owners, whether married or unmarried"). If each married taxpayer took this approach, married taxpayers filing separately would deduct the same amount of interest as married taxpayers filing jointly. But this approach fails for the same reason Voss and Sophy's apportionment theory fails: it flies free of the statutory language that limits the amount "treated" as acquisition or home equity indebtedness to a capped amount out of the total acquisition or home equity indebtedness secured by the residence (rather than one co-owner's half of that total debt).3 We should instead defer to the IRS's reasonable interpretation that the statute defines "acquisition indebtedness" as "indebtedness incurred in acquiring a qualified residence of the taxpayer -- not as indebtedness incurred in acquiring taxpayer's portion of a qualified residence." ....

More importantly, the majority's argumentum ad absurdum fails because imposing a penalty on married individuals for filing separately would not be not absurd. We know that Congress could reasonably decide to discourage a married couple from filing separate returns to minimize taxes, because it has imposed such penalties in other portions of the Tax Code. For example, the Tax Code prohibits married individuals filing separately from claiming certain tax credits or deducting interest on other types of loans. See, e.g., ...§ 221(e) (married individual filing separately is not eligible for deducting interest on student loans). Indeed, a tax court has already held that the plain language of § 163(h) may result in a penalty on a married couple filing separately compared to a married couple filing jointly. See Bronstein v. Comm'r, 138 T.C. 382, 383-84 (2012) (rejecting a taxpayer's argument that Congress intended for married couples filingseparately to receive the same treatment under § 163(h)(3) as married couples filing jointly).

Rather, the absurdity argument works against the majority. The majority's approach would result in spouses filing jointly (or separately) getting half the total deduction of unmarried individuals.4 The majority writes this off as a marriage penalty, supported by hypothetical policy reasons why Congress may have intended such a result.... But the majority's view that Congress intended to penalize married co-owners by giving them half the deduction allowed to unmarried co-owners seems more absurd than the view that Congress may have intended to penalize married couples filing separately. After all, it is more reasonable to think that Congress wanted to encourage married couples to file jointly to avoid a statutory penalty than it is to think that

3 The majority asserts that there is a clear consensus among tax courts and the IRS that a married couple filing separately may, in the aggregate, deduct interest on up to $1.1 million of qualifying debt.... This is incorrect. While the sources cited by the majority correctly indicate that the debt limit in the statute is $550,000 for "each" married individual filing a separate return, none of these sources explains how the IRS would apply its formula to calculate the interest deduction for a married individual filing separately. Because the meaning of the marriage parenthetical is unclear, it does not undercut the IRS's unambiguous position that unmarried co-owners may not receive double the deduction of married co-owners.

4 In other words, under the majority's theory, spouses filing jointly who own a qualified residence encumbered with a $2.2 million loan could deduct one half of their total interest payments (based on dividing the $1.1 million debt limit by the $2.2 million debt). But if two unmarried taxpayers owned a qualified residence with the same $2.2 million loan, the taxpayers could deduct 100 percent of their interest payments because each taxpayer could treat $1.1 million as acquisition or home equity debt (i.e., based on the $1.1 million debt limit divided by each taxpayer's "portion" of the debt, $1.1 million).


37

Congress wanted to encourage taxpayers not to marry (or to get divorced) in order to avoid forfeiting half the deduction they could otherwise take. Given that reasonable jurists could point to either interpretation as absurd, the better solution is to defer to the IRS's reasonable interpretation of the statute.

Finally, the majority discusses the practical difficulties that may arise if we did not allow unmarried co-owners each to deduct interest on up to $1.1 million of debt, such as the problem of determining how much interest each of multiple hypothetical co-owners may deduct.... Following the IRS's reasonable interpretation of how the statute works, each co-owner is entitled to deduct the interest payments that the co-owner actually paid, multiplied by a fraction consisting of $1.1 million divided by the total aggregate debt secured by the co-owner's qualified residence. So long as an individual co-owner knows the amount of interest the co-owner personally paid, and how much debt is secured by the qualified residence co-owned by that taxpayer, the co-owner can calculate the amount of deductible interest. If there are policy consequences of the plain language that Congress did not intend, Congress can amend the statute itself.

The majority concedes that the statute is "anything but 'plain'." .... The IRS has provided a workable approach to Congress's ambiguous statute that avoids many of the problems created by the majority's opinion. Neither the majority nor Voss and Sophy offer arguments that would compel departing from this approach. I would affirm the tax court.


38

Chapter 23

THE DEDUCTION FOR TAXES

Pages 559 and 567:

The Protecting Americans from Tax Hikes Act of 2015 made permanent the §164(b)(5) election to deduct state and local sales taxes in lieu of state and local income taxes.


39

Chapter 24

CASUALTY LOSSES

Page 573:

In Alphonso v. Commissioner, T.C. Memo. 2016-130, the Tax Court concluded the collapse of a retaining wall resulted from the progressive deterioration of the wall over a period of 20 years. As a result, the wall’s collapse did not constitute a “casualty” within the meaning of §165(c)(3). Responding to the taxpayer’s argument that excessive rainfall had accelerated thewall’s collapse, the court noted: “A loss that is accelerated by a contributing factor such as rainor wind is not a casualty if the loss is caused by progressive deterioration.”


40

Chapter 27 LIMITATIONS ON DEDUCTIONS Page 635: In the opening sentence of Problem 1, the term “undeveloped investment land” should be understood as undeveloped land Mary intended to hold for investment purposes.


41

Chapter 28

CASH METHOD ACCOUNTING

Page 683:

Insert the following as a new paragraph immediately before the section on Cash Method Prepayments:

As noted previously in the Supplement (see Chapter 15 Losses and Bad Debts), in Evans v. Commissioner, T.C. Memo. 2016-7, the cash method taxpayer argued that a losssustained on a nonjudicial foreclosure sale on his property was deductible in the year theproceeds were received and not in the year of the sale. In rejecting this argument, theTax Court noted that if a deduction does not entail a cash disbursement, the deductionyear is based, not on the year of payment, but on separate timing rules. According to thecourt, “[t]he timing of loss deductions is governed by §165(a) and the regulationsthereunder .... We conclude that the loss was sustained (and deductible) [in the year of the foreclosure sale] regardless of the year in which [the taxpayer] received proceeds from the sale or received notice that such proceeds were available to him.” Consider the year in which the taxpayer would have had income had the foreclosure sale resulted in a gain. Wouldn’t the taxpayer have recognized the income in the year the proceeds were received (or constructively received) rather than in the year of the sale - in other words, wouldn’t the receipt or constructive receipt of the proceeds be required for income recognition purposes even though payment is not required for loss purposes?


42

Chapter 29

ACCRUAL METHOD ACCOUNTING

Page 711:

Substitute the following paragraphs for the paragraph regarding the Tax Court’s decision in Giant Eagle, Inc. v. Commissioner:

In Giant Eagle, Inc. v. Commissioner, T.C. Memo 2014-146, the Tax Court applied Hughes Properties and General Dynamics in holding a taxpayer operating a chain of supermarkets and gas stations could not deduct the estimated cost of redeeming unexpired and unredeemed “fuelperks!” rewards the taxpayer had issued customers making qualifying purchases. Fuelperks! rewards were redeemable as a discount against the price of gas purchased at one of the taxpayer’s gas stations. If a customer failed to redeem the rewards within three months after earning them, the rewards expired. Rejecting the taxpayer’s contention that its liability for the fuelperks!s became fixed when customers earned them, the Tax Court found that, “because the redemption of fuelperks! was structured as a discount on the purchase price of gas.... the purchase of gas was necessarily a condition precedent to the redemption of fuelperks!.” As a result, the taxpayer’s liability became fixed only upon the redemption of the fuelperks!. The taxpayer thus failed to satisfy the all events test as articulated in §461(h)(4) and Reg. §1.461-1(a)(2)

Relying on applicable state contract law, the Third Circuit, in a 2-1 decision, reversed the Tax Court decision in Giant Eagle, concluding that, in awarding fuelperks!, Giant Eagle created a unilateral contract imposing “instant liability on the supermarket chain to its customers for the rewards they accrued.” 822 F.3d 666, 675 2016 U.S. App. LEXIS 8399. Based on both Hughes Properties and Lukens Steel Co. v. Commissioner, 442 F. 2d 1131 (3rd Cir. 1971) (holding that an accrual method employer’s obligation to make certain future payments under a collective bargaining agreement were “fixed” because the obligation could never be cancelled), the Third Circuit held the taxpayer’s liability was fixed and the taxpayer “was entitled to deduct fuelperk!-related liabilities incurred during the tax years at issue.” According to the Third Circuit majority, Giant Eagle’s liability attached at checkout when a customer made a qualifying purchase. The majority noted:

For purposes of the "all events" test's fixed liability prong, it is irrelevant that neither the total amount of Giant Eagle's anticipated liability nor the identity of all the customers who eventually applied discounts toward gasoline purchases could be conclusively identified at year's end. (Footnote omitted.) And while there remained an "extremely remote and speculative possibility" that the amount of Giant Eagle's claimed deductions would overstate the value of the rewards its customers ultimately redeemed, (footnote omitted) Giant Eagle significantly mitigated that risk by tracking its customers' monthly redemption rates and


43

offsetting the deductions accordingly to account for prospective non-redeemers. Giant Eagle amply demonstrated the existence—as of year's end—of both an absolute liability and a near-certainty that the liability would soon be discharged by payment. The chance of non-redemption had been calculated by Giant Eagle "with reasonable accuracy" as conceded by the Commissioner. The "all events" test demands no more. We hold, therefore, that following Hughes Props. and Lukens Steel, Giant Eagle was entitled to deduct fuelperks!-related liabilities incurred during the tax years at issue.

822 F.3d at 675.

The dissenting judge emphasized that Giant Eagle’s liability could not be “fixed and absolute” with respect to any individual customer because, by their terms, fuelperks! rewards expired three months after a customer earned them. The dissenting judge reasoned:

As I see it, the question for our resolution is whether Giant Eagle's liability to any individual shopper with accrued-but-not-yet-redeemed fuelperks! was certain to continue under the rules applicable to that liability until it was paid. Because one of those rules allowed for the expiration of each shopper's fuelperks! (and Giant Eagle's corresponding liability to that shopper), the answer is plainly "no." While Giant Eagle became liable to a shopper at checkout, it did not become absolutely liable to that shopper unless and until the shopper redeemed fuelperks! prior to their expiration. For that reason, I would hold that, at the close of the [taxable years before the court], Giant Eagle faced many fixed liabilities for yet-to-be-redeemed fuelperks!, but none that were "determine[d] in fact" because each was contingent upon future redemption by the shopper....

Had Giant Eagle not included an expiration provision in its terms and conditions, I would be inclined to agree with my colleagues that the company incurred a fixed and absolute liability to each shopper at checkout. In that case, we would face the difficult task of determining whether historical redemption data and other evidence reveal more than "an extremely remote and speculative possibility" that any given shopper would fail to timely redeem discounts and how much bearing, if any, the answer to that question has on whether the company's liabilities were "determine[d] in fact." Hughes Props., 476 U.S. at 601; see Gold Coast Hotel & Casino, 158 F.3d at 489 (interpreting Hughes Properties to require at least a "reasonable expectancy" that the liability will be discharged by payment of cash or its equivalent). But the fact that the store did include an expiration provision—thereby conditioning its liability to each shopper upon fuelperks! redemption at a Giant Eagle-owned gas station within approximately 3 months' time—made "redemption" a condition precedent to the establishment of an absolute liability. Because that event had not occurred by the close of the 2006 or 2007 taxable years with respect to the deductions Giant Eagle claimed on accrued-but-not-yet-redeemed fuelperks!, I would hold that the "all events" test was not satisfied and those anticipated expenses were not deductible.

822 F.3d at 678.

Page 715:


44

Regulation §1.461-4(d)(6)(ii) establishes a second exception to the economic performance requirement - the “3½ month rule” - which allows a taxpayer to accelerate the accrual of a liability into a year prior to the year that the economic performance requirement is satisfied. Pursuant to that rule, a taxpayer may treat economic performance as occurring as the taxpayer makes payment to the person providing the services “if the taxpayer can reasonably expect the person to provide the services within 3 ½ months after the taxpayer makes the payment.”

Example: Assume a calendar-year accrual method taxpayer enters into a contract with a local window washing service on December 31 to have the windows washed on the five story office building owned by the taxpayer. Pursuant to the contract, the window washing services will be performed during January 2017. The contract required the taxpayer to pay for the services in advance. On December 31, 2016, the taxpayer paid the window washing service $5,000 as required by the contract.

Analysis: Pursuant to the 3½ month rule of Regulation §1.461-4(d)(6)(ii), the taxpayer will be allowed to deduct all $5,000 in 2016 assuming the taxpayer reasonably expect the window washing service to provide the services within 3½ months of the payment.

Safe Harbor Method of Accounting for Ratable Service Contracts.

Revenue Procedure 2015-39, 2015-33 I.R.B.195 provides a safe harbor method whereby a taxpayer with respect to a so-called “ratable service contract” may treat economic performance as occurring on a ratable basis over the term of the contract. [A change in the treatment of ratable service contracts to conform to this safe harbor method constitutes a change in method of accounting to which the provisions of §§446 and 481 and the regulations thereunder apply. A taxpayer seeking to change to safe harbor method must, if eligible, use the automatic change procedures in Rev. Proc. 2015-13, 2015-5 I.R.B. 419, and Rev. Proc. 2015-14, 2015-5 I.R.B. 450, or successors.]

According to Revenue Procedure 2015-39, a ratable service contract is one that satisfies the following requirements: (1) the contract must provide for similar services to be provided on a regular basis, such as daily, weekly, or monthly; (2) each occurrence of the service must provide independent value, i.e., the benefits of receiving each occurrence of the service must not be dependent on the receipt of any previous or subsequent occurrence of the service, and (3) the term of the contract must not exceed 12 months. [Contract renewal provisions are not considered in determining whether a contract exceeds 12 months.] “If a single contract includes services that satisfy the requirements of this section as well as services (or other items) that do not satisfy the requirements of this section, the services (or other items) that do not satisfy the requirements of this section must be separately priced in the contract for the contract to qualify as a Ratable Service Contract.”

Consider the following examples based on examples included in the Revenue Procedure:


45

Example 1: On December 31, 2016, Marcella, a sole proprietor using the accrual method (including the 3½ month rule noted above) contracts with a janitorial company whereby that company will provide janitorial services to Marcella’s business on a daily basis until the end of 2017. Under the contract, Marcella agrees to pay the janitorial company $3,000 a month to clean Marcella’s business premises. Pursuant to the contract, Marcella must pay for each month's service by the end of the prior month. On December 31, 2016, Marcella makes a $3,000 payment to the janitorial company for the services to be provided in January 2017. Marcella reasonably expects the company to provide the janitorial services in January. As of December 31, 2016, all events have occurred to establish the fact of Marcella's $3,000 contractually-required payment and the amount of the liability is determinable with reasonable accuracy.

Analysis: The contract is a ratable service contract within the meaning of Revenue Procedure 2015-39 as it meets the three requirements for ratable service contracts noted above. Under the provisions of Revenue Procedure 2015-39, Marcella may treat economic performance as occurring ratably under the contract. Thus, under the 3½ month rule noted above, Marcella will be allowed to incur a liability in 2016 for the $3,000 she paid in 2016. For the services provided from February through December 2017, economic performance occurs ratably as the services are provided to Marcella each day, and a liability of $33,000 for these services will thus be incurred in 2017.

Example 2: On December 31, 2017, Connor, a sole proprietor who is a calendar-year, accrual method taxpayer, enters into a one-year service contract with Cormick whereby Cormick will provide landscape maintenance services with respect to Connor’s business facilities from January through December 2018 on a monthly basis. Under the contract Connor pays Cormick $4,000 a month for the landscape services. The contract requires Connor to prepay for the twelve months of services with the full prepayment of $48,000 due on December 31, 2017. On December 31, 2017, Connor makes the $48,000 payment to Cormick for services to be provided from January 1, 2018 through December 31, 2018. As of December 31, 2017, all events have occurred to establish the fact of Connor's $48,000 contractually-required payment and the amount of the liability is determinable with reasonable accuracy.

Analysis: The contract is a ratable service contract within the meaning of Revenue Procedure 2015-39 as it meets the three requirements for ratable service contracts noted above. Thus, Connor may treat economic performance as occurring ratably under the contract. Assuming Connor satisfies the requirements of the recurring item exception, as discussed above, and files his 2017 return on September 15, 2018, Connor will be treated as incurring a liability in 2017 of $34,000 (8.5 months/12 months x $48,000) for the services provided from January 1 through September 15, 2018. For the services provided from September 16 through December 31, 2018, the period outside of the recurring item exception, economic performance occurs ratably as the services are provided to Connor during that time and a liability for these services of $14,000 (3.5 months/12 months x $48,000) is incurred in 2018.


46

Chapter 30

ANNUAL ACCOUNTING

Page 761:

Estate of Backemeyer v. Commissioner

147 T.C. No. 17 (2016) (Most internal citations have been omitted.)

[Facts: Prior to his death, Steve Backemeyer incurred certain expenses for supplies (seeds, chemicals, fertilizer and fuel) to be used in his farming business. He appropriately deducted these items (referred to in the opinion below as “farm inputs”) when they were purchased but had not used them prior to his death. Thus, as a result of the deduction, he had a zero basis in the supplies. Following her husband’s death, his spouse, Julie Backemeyer, operated the farming business as a sole proprietor. She received a distribution of the farm supplies from a trust established in her husband’s will and claimed a §1014 stepped-up basis in those supplies. She subsequently deducted the supplies. The Service conceded that Mrs. Backemeyer’s treatment of the farm supplies (i.e., her claim of a stepped-up basis and subsequent deduction for them when used in her business) was correct. Nonetheless, citing Hillsboro Nat'l Bank v. Commissioner, 460 U.S. 370, 103 S. Ct. 1134, 75 L. Ed. 2d 130 (1983), consolidated on certiorari with Bliss Dairy, Inc. v. United States, the Service argued that the tax benefit rule required inclusion in Mr. Backemeyer’s income of amount he had previously deducted for these supplies.]

LARO, Judge

Opinion:

...

Respondent points out that the tax benefit rule requires a taxpayer to include a previously deducted amount in his current year's income when an event occurs that is fundamentally inconsistent with the claimed deduction for the previous year. Respondent contends that Bliss Dairy, a U.S. Supreme Court case on the tax benefit rule, directly applies to the facts here.

Bliss Dairy, Inc. involved a closely held corporation which used the cash method of accounting and engaged in the business of operating a dairy. Close to the end of its taxable year, the corporation deducted on purchase the full cost of cattle feed bought for use in its operations. Shortly after the beginning of its next taxable year, with a substantial portion of the feed still on hand, the corporation liquidated and distributed its assets to its shareholders in a nontaxable


47

transaction. The shareholders continued operating the dairy business in noncorporate form and in turn deducted their basis in the feed as an expense of doing business. The Supreme Court held that the liquidation of the corporation resulted in conversion of the cattle feed from a business to a nonbusiness use, representing an action inconsistent with the prior deduction and requiring application of the tax benefit rule.

Respondent argues that the facts here are nearly identical to those of Bliss Dairy. When Mr. Backemeyer died not having used the farm inputs in his sole proprietor farming operation, respondent opines, the farm inputs were converted to a nonbusiness use when they were distributed to the Backemeyer Family Trust. When Mrs. Backemeyer received the assets, she took them with a stepped-up basis and contributed them to her sole proprietor farming business. Therefore, respondent asserts, upon Mr. Backemeyer's death the farm inputs were converted from business to personal use, and Mrs. Backemeyer converted them back from personal to business use. According to respondent, this entitles Mrs. Backemeyer to a deduction under section 162 but also requires Mr. Backemeyer to recognize income related to his conversion of the property from one use to another.

... [I]n Frederick v. Commissioner, 101 T.C. 35, 41 (1993) ... we developed a four-part test applying the tax benefit rule. Under Frederick, an amount must be included in gross income in the current year to the extent that (1) it was deducted in a prior year, (2) the deduction resulted in a tax benefit, (3) an event occurs in the current year that is fundamentally inconsistent with the premises on which the deduction was originally based, and (4) a nonrecognition provision of the Code does not prevent inclusion in gross income.

III. Applicability of the Tax Benefit Rule to the Farm Input Deductions

A. Legal Background

Generally speaking, gross income is "all income from whatever source derived," except as otherwise provided in the Code. Sec. 61(a).

Under section 162(a) there is "allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business". Section 1.162-12(a), Income Tax Regs., specifies that a "farmer who operates a farm for profit is entitled to deduct from gross income as necessary expenses all amounts actually expended in the carrying on of the business of farming." Moreover, unless the farmer computes income using the crop method, "the cost of seeds and young plants which are purchased for further development and cultivation prior to sale in later years may be deducted as an expense for the year of purchase, provided the farmer follows a consistent practice of deducting such costs as an expense from year to year."

Section 180(a) allows taxpayers "engaged in the business of farming" to elect to deduct expenditures for the purchase or acquisition of fertilizer, lime, and "other materials to enrich, neutralize, or condition land used in farming," instead of charging such expenses to capital account.


48

A taxpayer using the cash method of accounting ordinarily deducts amounts for the taxable year in which those amounts were paid. Sec. 1.461-1(a)(1), Income Tax Regs. In the case of prepayment for farming supplies, a cash method taxpayer may deduct such payments in the year they were made even if the supplies are to be consumed in a subsequent year, provided that the expenditure is (1) a payment and not a deposit, (2) made for a business purpose and not tax avoidance, and (3) resulting in a deduction that will not materially distort income.

Section 1014(a) provides that "the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent" is "the fair market value of the property at the date of the decedent's death". Under section 1001(a), gain from the disposition of property is "the excess of the amount realized therefrom over the adjusted basis".

B. Tax Benefit Rule

Respondent does not dispute that petitioners' deduction of the farm input costs for tax year 2010 was appropriate at the time it was claimed. Nor does respondent dispute that Mrs. Backemeyer took the assets with a stepped-up basis under section 1014 equal to the cost of the inputs (which, considering the short time between purchase and Mr. Backemeyer's death, was identical to their fair market value) and properly deducted that basis from income when she used the farm inputs in 2011.

What respondent contends is that, in view of Mr. Backemeyer's death and the concordant transfer of the farm inputs to Mrs. Backemeyer, the tax benefit rule requires that the deductions claimed for tax year 2010 for the farm input expenditures be recovered for 2011. Respondent relies heavily on Bliss Dairy. We agree that Bliss Dairy is the keystone to resolving the issue presented here. But while respondent's reliance on the case is not misplaced, we find his interpretation of it erroneous.

In Hillsboro, the Supreme Court observed that the purpose of the tax benefit rule is "to approximate the results produced by a tax system based on transactional rather than annual accounting." It is intended "to achieve rough transactional parity in tax * * * and to protect the Government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous.” The rule's application is not automatic. It applies "only when a careful examination shows that the later event is indeed fundamentally inconsistent with the premise on which the deduction was initially based." This means that "if that event had occurred within the same taxable year, it would have foreclosed the deduction."

This Court has had occasion to interpret the tax benefit rule in the light of Bliss Dairy, as in Frederick v. Commissioner where we distilled the Bliss Dairy holding on the applicability of the tax benefit rule into a four-part test:

The tax-benefit rule consists of two components, the inclusionary component and the exclusionary component. The exclusionary component, which is partially codified in section 111(a), but which may exist outside the provisions of that section, does not


49

become an issue unless, and until, the inclusionary component of the rule is first satisfied. The inclusionary component provides that an amount deducted from gross income in one year is included in income in a subsequent year if an event occurs in the subsequent year that is fundamentally inconsistent with the premise on which the deduction had previously been based. The exclusionary component of the tax-benefit rule, by contrast, eats away at the inclusionary component by limiting the income that must be recognized in the subsequent year to the amount of the tax benefit that resulted from the deduction. Thus, to summarize the tax-benefit rule, an amount must be included in gross income in the current year if, and to the extent that: (1) The amount was deducted in a year prior to the current year, (2) the deduction resulted in a tax benefit, (3) an event occurs in the current year that is fundamentally inconsistent with the premises on which the deduction was originally based, and (4) a nonrecognition provision of the Internal Revenue Code does not prevent the inclusion in gross income. A current event is considered fundamentally inconsistent with the premises on which the deduction was originally based when the current event would have foreclosed the deduction if that event had occurred within the year that the deduction was taken.

As Bliss Dairy and our precedent demonstrate, "the tax benefit rule must be applied on a case-by-case basis." Accordingly, we "must consider the facts and circumstances of each case in the light of the purpose and function of the provisions granting the deductions." The Supreme Court has further pointed out that nonrecognition provisions of the Code present special difficulties, since there is "an inherent tension between the tax benefit rule and the nonrecognition provision." In the context of section 162, the Supreme Court in Bliss Dairy observed that the deduction for ordinary and necessary business expenses "is predicated on the consumption of the asset in the trade or business," and that "[i]f the taxpayer later sells the asset rather than consuming it in furtherance of his trade or business, it is quite clear that he would lose his deduction, for the basis of the asset would be zero, * * * so he would recognize the full amount of the proceeds on sale as gain."... Thus, "if the taxpayer converts the expensed asset to some other, non-business use, that action is inconsistent with his earlier deduction, and the tax benefit rule would require inclusion in income of the amount of the unwarranted deduction." A distribution to shareholders of expensed assets, for instance, is analogous to converting such assets to personal consumption. In ruling on the lower court's decision in Bliss Dairy, the Supreme Court reviewed the nonrecognition of corporate distributions on liquidation under section 336 as then in effect and concluded that such nonrecognition is not absolute since it is overridden by sections 1245 and 1250 for example. The Supreme Court held on balance that the tax benefit rule supersedes nonrecognition of gain under section 336, because the gain arising from application of the tax benefit rule was not the sort of gain that would have been recognized on liquidation but for the operation of section 336. Bliss Dairy and this case are similar in certain respects. Both cases involve taxpayers in the farming industry. In both cases taxpayers purchased farm inputs in one tax year, with those


50

inputs being transferred to other taxpayers in the next. In both cases taxpayers claimed deductions for their purchases of farm inputs. In both cases the transferees also claimed deductions for the transferred farm inputs. And in both cases the transfer was not subject to income tax. However, there remains a key difference: Bliss Dairy involved the nonrecognition of gain on a liquidating distribution by a corporation to its shareholders under section 336, whereas in this case the transfer occurred at death. The Supreme Court's holdings in Hillsboro Nat'l Bank and Bliss Dairy were the product of its analysis of the specific Code sections applicable in those cases. In Hillsboro, the Supreme Court recognized that its decision did not extend necessarily to transfers by gift or death:

An unreserved endorsement of the Government's formulation might dictate the results in a broad range of cases not before us. For instance, the Government's position implies that an individual proprietor who makes a gift of an expensed asset must recognize the amount of the expense as income, but cf. Campbell v. Prothro, 209 F.2d 331, 335 (CA5 1954). Similarly, the Government's view suggests the conclusion that one who dies and leaves an expensed asset to his heirs would, in his last return, recognize income in the amount of the earlier deduction. Our decision in the cases before us now, however, will not determine the outcome in these other situations; it will only demonstrate the proper analysis. Those cases will require consideration of the treatment of gifts and legacies as well as §§ 1245(b)(1), (2), and 1250(d)(1), (2), which are a partial codification of the tax benefit rule, and which exempt dispositions by gift and transfers at death from the operation of the general depreciation recapture rules. Although there may be an inconsistent event in the personal use of an expensed asset, that event occurs in the context of a nonrecognition rule, and resolution of these cases would require a determination whether the nonrecognition rule or the tax benefit rule prevails.

We look to the Supreme Court's analysis in Bliss Dairy as a guide to determine the tax benefit rule's applicability to the facts at hand, with a particular focus on the treatment of legacies as instructed in note 20 of the opinion. C. The Tax Benefit Rule and Transfers at Death While this Court has examined variations on the Bliss Dairy fact pattern involving liquidations of enterprises, see, e.g., Rojas v. Commissioner, 90 T.C. 1090 (1988) (holding that the tax benefit rule does not require the inclusion in income of expenses deducted for inputs that were used and consumed in the production of crops distributed to shareholders on liquidation), aff'd sub nom. Schwartz Rojas v. Commissioner, 901 F.2d 810 (9th Cir. 1990); Byrd v. Commissioner, 87 T.C. 830 (1986) (holding that the value of plant inventory, the expenses of growing which were deducted in prior years, transferred to the purchaser of a liquidated nursery business must be included in the transferor's income under the tax benefit rule), aff'd without published opinion, 829 F.2d 1119 (4th Cir. 1987), this case involves the applicability of the tax benefit rule to a different situation--a transfer at death. In applying the heuristic suggested by the Supreme Court in Bliss Dairy and distilled by this Court into the four-part Frederick inquiry, we


51

conclude that a transfer at death is not "fundamentally inconsistent with the premise" on which the section 162 deduction is initially based. As observed earlier, Frederick v. Commissioner, suggests a four-part test to determine whether the tax benefit rule applies to a particular situation:

[A]n amount must be included in gross income in the current year if, and to the extent that: (1) The amount was deducted in a year prior to the current year, (2) the deduction resulted in a tax benefit, (3) an event occurs in the current year that is fundamentally inconsistent with the premises on which the deduction was originally based, and (4) a nonrecognition provision of the Internal Revenue Code does not prevent the inclusion in gross income.

The first two criteria are met in this case: Petitioners did deduct the farm input expenses for a prior year, and that deduction reduced their taxable income, thereby affording them a tax benefit. However, the third and the fourth criteria are not met. 1. Fundamental Inconsistency With Original Deduction As to the third criterion, neither Mr. Backemeyer's death nor the distribution of the farm inputs to and their use by Mrs. Backemeyer was fundamentally inconsistent with the premises on which the initial section 162 deduction for tax year 2010 was based. "A current event is considered fundamentally inconsistent with the premises on which the deduction was originally based when the current event would have foreclosed the deduction if that event had occurred within the year that the deduction was taken." Had Mr. Backemeyer died and Mrs. Backemeyer inherited and used the farm inputs in 2010, the initial section 162 deduction would not have been recaptured for purposes of the income tax. The reason for this is that the estate tax effectively "recaptures" section 162 deductions by way of its normal operation, obviating any need to separately apply the tax benefit rule. When Mr. Backemeyer died, all of his assets, including the farm inputs, became subject to the estate tax, which operates similarly to a mark-to-market tax when the mark-to-market tax is imposed on zero-basis assets. Compare sec. 2001(a) (imposing a tax "on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States"), and sec. 2051 (defining the value of a taxable estate as the value of the gross estate less certain deductions provided for in the estate tax), and sec. 2031 (defining the value of a gross estate as the value at the time of decedent's death "of all property, real or personal, tangible or intangible, wherever situated"), with, e.g., sec. 877A (imposing an exit tax on U.S. citizens and long-term residents relinquishing citizenship or lawful permanent residence, respectively, by requiring that "[a]ll property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value"). The farm inputs were included in Mr. Backemeyer's estate at their fair market value, see sec. 2031, which the parties have stipulated to be equal to the farm inputs' purchase price. Since the farm inputs had a basis of zero, they were subject to the estate tax on the same


52

base as their purchase price, for which Mr. Backemeyer had claimed a section 162 deduction for 2010. Requiring recapture of the section 162 deduction by increasing taxable income on petitioners' Form 1040 for tax year 2011 would result in double taxation of the value of the farm inputs. The Supreme Court has ruled that "the same receipt" cannot be "made the basis of both income and estate tax," since "the item cannot in the circumstances be both income and corpus"... Applying the tax benefit rule here--where the farm inputs are subject to tax as part of Mr. Backemeyer's estate–is therefore impermissible. The same result obtains even if Mr. Backemeyer's estate did not actually owe any amount payable as estate tax through the operation of the unified credit, see sec. 2010, or the marital deduction for bequests to a surviving spouse, see sec. 2056, so long as his estate was subject to the estate tax regime. Furthermore, we note that the Supreme Court's approach in Hillsboro calls for a "line between merely unexpected events and inconsistent events." Whereas liquidation of a corporation or a sale of expensed business inputs entails some level of forethought and affirmative intent to act accordingly, death ordinarily does not involve such planning. As the Court of Appeals for the Eighth Circuit has observed, while death may be beneficial for tax purposes, it is difficult to regard it as a tax avoidance scheme. Estate of Peterson v. Commissioner, 667 F.2d 675, 681-682 (8th Cir. 1981), aff'g 74 T.C. 630 (1980). Under the Supreme Court's Bliss Dairy standard, death is the quintessential "merely unexpected event." Were death fundamentally inconsistent with expensing business inputs, every sole proprietor in the year of his death would face double taxation under both the income tax and the estate tax on all the inputs he had purchased for but not yet used in his business. We are loath to interpret Bliss Dairy to stand for the proposition that any time a sole proprietor dies, all of his expensed assets are subject to recapture. The Supreme Court has refused to accept such a rule, see Hillsboro, 460 U.S. at 386 n.20, as do we. Nonetheless, what evidently concerns respondent is that absent the tax benefit rule's application, petitioners would be entitled to a double deduction. "Double deductions (or their practical equivalent) for the same economic loss are impermissible absent a clear declaration of congressional intent." We do not think it proper to characterize the deduction claimed by Mr. Backemeyer for 2010 and the deduction claimed by Mrs. Backemeyer for 2011 as a "double deduction", since the estate tax intervened between the two deductions and since respondent has conceded that "Mrs. Backemeyer's Schedule F business is treated as being separate from Mr. Backemeyer's Schedule F business, as petitioners contend." The sole cause for the allowance of two deductions here is section 1014(a), which steps up the basis of property acquired from a decedent. Were section 1014 not to apply, then Mrs. Backemeyer would have received the farm inputs with a zero basis and therefore been unable to deduct them. We find it unlikely that respondent would have pursued his tax benefit rule argument were that the case. Since "Congress presumably enacts legislation with knowledge of the law," we conclude that had Congress wished to foreclose a second section 162 deduction as a result of a section 1014 basis step-up, it would have so provided. The estate tax has existed in its modern form for a century and section 1014– its basis step-up long a fixture of the Code--has


53

been frequently amended, as recently as by the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, Pub. L. No. 114-41, sec. 2004(a), 129 Stat. at 454. It is hardly unforeseeable that taxpayers would attempt to deduct previously expensed inherited assets for which they received a stepped-up basis, yet at no point has Congress acted to prevent it. Indeed, the Court of Appeals for the First Circuit has observed that the intent of section 1014 is "that unrealized gain taxed to the decedent's estate at his death shall not be subjected to another tax when it is subsequently realized by the estate or a legatee." Levin v. United States, 373 F.2d 434, 438 (1st Cir. 1967). Thus, far from resulting in a double deduction, the provision for and maintenance of a stepped-up basis under section 1014 is a deliberate legislative choice by Congress to prevent double taxation. 2. Applicability of Nonrecognition Provision Having established the inapplicability of the third Frederick criterion in this case, we now turn to the fourth criterion, which mandates that a nonrecognition provision of the Code not prevent the inclusion of the tax benefit in gross income. This requirement is not met here, since nonrecognition on death is among the strongest principles inherent in the income tax. When an individual dies, his assets are not taxed under the income tax but rather under the estate tax. Upon the assets' distribution to the decedent's heirs, section 102(a) explicitly provides that the heirs' "[g]ross income does not include the value of property acquired by gift, bequest, devise, or inheritance." And, as discussed above, section 1014 operates to provide a step-up in basis of the inherited property in the hands of the decedent's heirs; if an heir subsequently disposes of the property, gain is realized only to the extent the proceeds exceed the stepped-up basis. Sec. 1001(a). In approaching the fourth Frederick criterion, we also accept the Supreme Court's observation on the effect of sections 1245(b)(2) and 1250(d)(2), which exempt transfers at death from the application of the general depreciation rules, and from which the transfer in Hillsboro, 460 U.S. at 386 n.20, was not exempted. Section 1245(a) provides that in the case of a disposition of certain depreciable property, the lesser of the allowed depreciation deductions or realized gain should be taxed as ordinary income. Section 1250(a) establishes depreciation recapture rules for depreciable real property otherwise excluded from the operation of section 1245. Sections 1245 and 1250, along with section 111, codify the tax benefit rule as applied in certain situations. It is telling that the depreciation recapture rules, which, we are reminded, are "a partial codification of the tax benefit rule," do not extend to transfers at death. The regulations bespeak this by omitting from the list of nonrecognition Code sections overridden by the depreciation recapture provisions of sections 1245 and 1250 those sections governing the treatment of a decedent's property. In Hillsboro, 460 U.S. at 398, the Supreme Court observed that depreciation recapture under sections 1245 and 1250 was an important exception to the nonrecognition statute at issue there. This is not the case with transfers at death, to which the depreciation recapture rules do not apply. Since sections 1245 and 1250 codify the tax benefit rule as it relates to depreciated property and expressly exclude transfers at death from the rule's scope, it follows


54

that the uncodified remainder of the common law tax benefit rule, with which we are concerned in this case, operates in a similar fashion. 3. Conclusion In view of the above, we find that the tax benefit rule does not apply to recapture for 2011 upon Mr. Backemeyer's death his section 162 deductions for farm input purchases made in 2010. And respondent has conceded that Mrs. Backemeyer is entitled to a deduction under section 162 with respect to her use of the farm inputs in 2011. Therefore, we find respondent's denial of petitioners' deductions improper.


55

Chapter 31 CAPITAL GAINS AND LOSSES Pages 769 and 773: Congress has made permanent the 100% exclusion for the gain from the sale or exchange of “qualified small business stock” under § 1202.


56

Chapter 37 TAX CONSEQUENCES OF DIVORCE Page 885: In 2015, the Supreme Court in Obergefell v. Hodges, 576 U.S. _____, 135 S. Ct 2584 (2015), held that both the Due Process and Equal Protection Clauses of the Fourteenth Amendment guaranteed same-sex couples the right to marry. To reflect the holdings of Obergefell v. Hodges, 576 U.S. ___, 135 S. Ct. 2584, 192 L. Ed. 2d 609 (2015), and Windsor v. United States, 570 U.S. ___, 133 S. Ct. 2675, 186 L. Ed. 2d 808 (2013), Treasury in September 2016 promulgated final regulations providing that marriages of same-sex couples will be treated the same as marriages of opposite-sex couples for federal tax purposes. Reg. §301.7701-18, the most important of the final regulations, provides: §301.7701-18 Definitions; spouse, husband and wife, husband, wife, marriage.

(a) In general. For federal tax purposes, the terms spouse, husband, and wife mean an individual lawfully married to another individual. The term husband and wife means two individuals lawfully married to each other.

(b) Persons who are lawfully married for federal tax purposes- (1) In general. Except as provided in paragraph (b) (2) of this section regarding marriages entered into under the laws of a foreign jurisdiction, a marriage of two individuals is recognized for federal tax purposes if the marriage is recognized by the state, possession, or territory of the United States in which the marriage is entered into, regardless of domicile.

(2) Foreign marriages. Two individuals who enter into a relationship denominated as marriage under the laws of a foreign jurisdiction are recognized as married for federal tax purposes if the relationship would be recognized as marriage under the laws of at least one state, possession, or territory of the United States, regardless of domicile.

(c) Persons who are not lawfully married for federal tax purposes. The terms spouse, husband, and wife do not include individuals who have entered into a registered domestic partnership, civil union, or other similar formal relationship not denominated as a marriage under the law of the state, possession, or territory of the United States where such relationship was entered into, regardless of domicile. The term husband and wife does not include couples who have entered into such a formal relationship, and the term marriage does not include such formal relationships.

(d) Applicability date. The rules of this section apply to taxable years ending on or after September 2, 2016.


57

Note this regulation interprets the terms “spouse,” “husband” and “wife” in a neutral way to include same-sex as well as opposite-sex couples. Furthermore, as noted by the Treasury in promulgating the final regulations: “[T]he general rules regarding marital status for federal tax purposes provided in the final regulations address marital status regardless of whether the marriage is a civil marriage or a common-law marriage.” T.D. 9785. The final regulations also clarify that “the terms spouse, husband, and wife do not include individuals who have entered into a registered domestic partnership, civil union, or other similar relationship not denominated as marriage under the law of a state, possession, or territory of the United States. That section further provides that the term husband and wife does not include couples who have entered into such a relationship and that the term marriage does not include such relationship.” Id. With regard to these other legal relationships that are alternatives to marriage, the Treasury, in promulgating the final regulations, noted several reasons for not including these relationships within the term “marriage:”

First, except when prohibited by statute, the IRS has traditionally looked to states to define marriage. Second, regardless of rights accorded to relationships such as civil unions, registered domestic partnerships, and similar relationships under state law, states have intentionally chosen not to denominate those relationships as marriage. Third, some couples deliberately choose to enter into or remain in a civil union, registered domestic partnership, or similar relationship even when they could have married or converted these relationships to marriage, and these couples have an expectation that their relationship will not be treated as marriage for purposes of federal tax law. Finally, no Code provision indicates that Congress intended to recognize civil unions, registered domestic partnerships, or similar relationships as marriages.

T.D. 9785. The final regulations obsolete Revenue Ruling 2013-17 as of September 2, 2016.


58

Chapter 44 THE ALTERNATIVE MINIMUM TAX Page 1112: In Hardy v. Commissioner, T.C. Memo 2017-16, the Tax Court concluded a plastic surgeon’s ownership interest in a surgery center was an economic activity separate from the surgeon’s medical practice and constituted a passive activity. In reaching these conclusions, the court relied on a number of facts including: (a) the taxpayer was a minority owner in the surgery, had no management or day-to-day responsibilities with respect to the surgery center and had no input into management decisions including hiring or firing of personnel; (b) the taxpayer’s medical practice did not share any building space, employees, billing functions, or accounting services with the surgery center; (c) the taxpayer provides medical care for patients while the surgery center provides space and associated services; (d) the taxpayer is limited in the care he can provide at his office, i.e., the procedures in his office are limited to those requiring local anesthesia while the surgery equipped for procedures requiring local or general anesthesia; (e) the taxpayer’s patients who opt for surgery in the surgery center are directly billed by the surgery center for use of the facility and are directly billed by the taxpayer for his surgical services; and (f) the taxpayer receives a share of the surgery center’s earnings (the center’s fees less expenses) but that share is unrelated to whether the taxpayer performs any surgeries at the surgery center. Page 1119: For 2017, the tentative minimum tax for individuals is generally equal to 26% of the first $187,800 in “taxable excess” plus 28% thereafter. (For married individuals filing separate returns, the 26% rate applies to the first $93,900.) Rev. Proc. 2016-55, 2016-45 I.R.B. 707. Page 1120: For 2017, the exemption amount is $84,800 on joint returns (or for surviving spouses), $54,300 for an individual not married and not a surviving spouse, and $42,250 for married individuals filing separately. For 2017, the exemption begins to phase out with respect to a single taxpayer when that taxpayer’s alternative minimum taxable income exceeds $120,700. Rev. Proc. 2016-55, supra. Page 1122: Congress has made permanent the 100% exclusion for the gain from the sale or exchange of “qualified small business stock” under § 1202.


Burke:Friel Taxation of Individual Income 11e 2017...

Documents

Transcript of Burke:Friel Taxation of Individual Income 11e 2017...