TAXFAX

IRS OFFERS SETTLEMENT TERMS FOR SYNDICATED CONSERVATION EASEMENT CASES

By Samuel G. Graber Taxpayers can generally deduct the fair market value of a donated conservation easement that preserves land in perpetuity if a number of technical requirements are satisfied. See IRC § 170(f)(3)(B)(iii) and (h); Treasury Regulation § 1.170A-7(b)(5) and § 1.170A-1(c)(1). In order to claim a deduction, a taxpayer must, among other things, obtain a qualified appraisal to determine the easement’s fair market value. Treasury Regulation § 1.170A-13(c). Where there is a lack of comparable easement sales on which to base a valuation (as will generally be the case), an appraiser will determine the highest and best use and fair market value of the property without regard to the easement and then will determine the property’s value after it is encumbered with the easement. The value of the charitable contribution deduction equals the reduction in the property’s fair market value due to the easement restrictions. See Treasury Regulation § 1.170A-14(h)(3).

The Internal Revenue Service (the “IRS”) has been concerned for a number of years with syndicated conservation easement transactions that it views as abusive. In Notice 2017-10, the IRS identified certain syndicated conservation

TAXFAX EDITOR George W. Benson Counsel McDermott Will & Emery LLP 444 West Lake Street Suite 4000 Chicago, IL 60606 (312) 984-7529 gbenson@mwe.com

easement transactions as GUEST WRITERS Samuel G. Graber Tax Attorneytax avoidance Frost Brown Todd LLC transactions 400 West Market Street and provided 32nd Floor that such Louisville, KY 40202 transactions (and substantially tel: (502) 568-0248 fax: (502) 581-1087 sgraber@fbtlaw.com similar Tara Guler, CPA, MST transactions) Senior Manager are listed Baker Tilly Virchow Krause, LLP transactions. Ten Terrace Court In a listed syndicated Madison, WI 53718 Tel: (608) 240-6714 Fax: (608) 249-8532 conservation tara.guler@bakertilly.com easement transaction, a promoter syndicates ownership interests in real property through a partnership, using promotional materials to suggest that prospective investors may be entitled to a share of a conservation easement contribution deduction that equals or exceeds two and a half times the investment amount. The promoter obtains an appraisal that greatly inflates the value of the conservation easement based on a fictional and unrealistic highest and best use of the property before it was encumbered with the easement. Often, the unrealistic valuation of the conservation

easement is attributable to unreasonable conclusions about the development potential of the real property. After the investors invest in the partnership, the partnership donates the conservation easement to a land trust. Investors in the partnership then claim deductions based on the appraisal’s inflated value, which grossly multiplies their actual investment in the transaction. The IRS considers transactions that are substantially similar to those identified above to be syndicated conservation easement transactions as well.

The effect of Notice 2017-10 is to subject participants, material advisors, and others involved in syndicated conservation easement transactions to additional reporting, due diligence and record-keeping requirements, including having to provide information about such transactions to the IRS on either Form 8886 (for participants) or Form 8918 (in the case of material advisors). If followed by affected taxpayers, these reporting requirements should make it relatively easy for the IRS to identify participants in listed syndicated conservation easement transactions.

In light of the fact that syndicated conservation easements are listed transactions, it is not surprising that a number of these cases are currently pending before the U.S. Tax Court. In IR-2020-130 dated June 25, 2020, the IRS Office of Chief Counsel announced a limited time settlement offer for certain taxpayers with pending docketed U.S. Tax Court cases involving syndicated conservation easements. An IRS representative subsequently indicated that the settlement offer applied to approximately 80 such cases. Under the terms of the settlement offer: (i) the deduction for the contributed easement is disallowed in full; (ii) all partners must agree to settle, and the partnership must pay the full amount of tax, penalties, and interest before settlement; (iii) investors who are partners can deduct their cost of acquiring their partnership interests and pay a reduced penalty of 1020% depending on the ratio of the deduction claimed to the partnership investment; and (iv) partners who provided services in connection with any syndicated conservation easement transaction must pay the maximum penalty assessed by the IRS (typically 40%) with no deduction for costs.

The IRS release also notes that taxpayers should not expect to settle their docketed Tax Court cases on better terms, and that based on the existing state of the law, taxpayers should not later expect a better result than what is being provided in the settlement offer. This is consistent with the IRS viewpoint that the appraised values in these transactions have been enormously exaggerated and so will not withstand scrutiny and that, if the settlement offer is not accepted, a taxpayer can expect that the final resolution of his or her case will be the denial of the charitable contribution deduction and the imposition of substantial penalties and interest.

Subsequently, in IR-2020-152 dated July 13, 2020, the IRS announced that on July 9, 2020, the U.S. Tax Court struck down four abusive syndicated conservation easement transactions, which disallowed close to $21 million in conservation easement deductions. The IRS then urged any taxpayer involved in syndicated conservation easement transactions who has received a settlement offer to accept it soon.

The settlement offer terms raise several questions for affected taxpayers and their advisors. First, the requirement that all partners in a partnership must agree to the settlement precludes partners from participating in the settlement initiative if even one partner refuses to participate. However, on July 14, 2020, an IRS representative stated in a public forum that the IRS would be willing to entertain settlement discussions with less than all the partners in a partnership, but that settlement terms would be more favorable to the IRS than those announced in IR-2020-130.

It also is not entirely clear how the mechanics of the settlement offer will operate in practice. The procedures for settling with the IRS differ depending on whether the relevant tax years fall under the centralized partnership audit rules

enacted under the Bipartisan Budget Act of 2015 (“BBA”) or under the former audit regime of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). It has been noted that most of the docketed Tax Court cases appear to involve years governed by TEFRA; however, for cases involving more recent years where the BBA applies, requiring that all partners consent to the settlement offer appears to be inconsistent with the BBA rules which give the partnership representative the sole power to act on behalf of the partnership. As a result, the logistics for settling a case may be somewhat cumbersome in light of the fact that the BBA appears to provide a different framework for settlement than the IRS initiative.

The conservation easement settlement offer affords benefits and efficiencies to both the IRS and taxpayers. It allows the IRS to address a substantial number of docketed cases on comparable terms, thereby reducing the IRS’ administrative burden while at the same time providing taxpayers assurance that they are receiving substantially the same settlement terms as other similarly situated taxpayers.

CORONAVIRUS RELIEF LEGISLATION EMPLOYMENT TAX DEFERRAL AND TEMPORARY PAYROLL TAX CREDITS

Tara Guler, CPA, MST

As the COVID-19 pandemic pushes on, it is important to take advantage of the various stimulus package incentives offered to help businesses during this trying time. Many of the businesses may be eligible for certain payroll tax credits. In addition, all businesses are allowed to defer 2020 payroll tax deposits into 2021 and 2022.

The Families First Coronavirus Response Act (FFCRA) was enacted March 18, 2020 and contains two payroll tax credits designed to reimburse employers for amounts required to be paid employees under the Act: 1) The Emergency Paid Sick Leave Credit, and 2) The Emergency Family and Medical Leave Credit (FMLA). The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) was enacted March 27, 2020 and contains a third credit, the Employee Retention Credit, intended (as its name suggests) to incent employers to retain employees. The CARES act also enacted the employment tax deferral provision.

Emergency Paid Sick Leave Credit

The Emergency Paid Sick Leave Credit is available to employers with fewer than 500 employees who are required to pay an employee’s wages under the Paid Sick Leave Act.

This Act requires employers to pay 80 hours of wages, which include qualified health plan expenses, to an employee if any one of the following conditions apply: 1. Employee experiences quarantine or selfisolation due to a COVID-19 diagnosis 2. Employee has been advised by a healthcare professional to self-quarantine 3. Employee experiences symptoms of

COVID-19 and is seeking medical diagnosis 4. Employee is caring for an individual who is under quarantine or self-isolation order 5. Employee is caring for child because of school closure or unavailability of child care provider due to COVID-19

An employee is eligible to receive up to two weeks of pay at their regular pay rate due if the reason for the absence is under 1-3 above. The maximum amount an employee may receive per day is $511. This amount is reduced to $200 if the absence is due to 4 or 5 above.

The employer is allowed to recoup what it pays employees through a credit against the employer’s share of Social Security taxes (i.e., 6.2% times wages, capped at the wage base) for the amount paid for sick leave. The credit is refundable to the extent it exceeds the relevant payroll tax liability. Wages paid beginning April 1, 2020 through December 31, 2020 are eligible for this credit. In addition, the employer is eligible for advance payment of the credit via Form 7200.

Emergency Family and Medical Leave Credit

The FMLA Credit is available to employers with fewer than 500 employees who are required to pay an employee’s wages under the FFCRA’s

amendments to the FMLA. This amendment requires that an employee be employed for at least 30 days and that the employee be unable to work due to school or day care closures as a result of COVID-19.

Under the FFCRA, the first 10 days of absence do not require the employer to pay compensation. After 10 days, employees receive two-thirds of regular pay, capped at $200 per day (maximum $10,000 per employee). Wages include qualified health plan expenses. The amount of the credit is equal to the total family leave paid to the employee. The employer is allowed a credit against the employer’s share of Social Security taxes (i.e., 6.2% times wages, capped at the wage base). The credit is refundable to the extent it exceeds the relevant payroll tax liability. Wages paid beginning April 1, 2020 through December 31, 2020 are eligible for this credit. In addition, the employer is eligible for advance payment of the credit via Form 7200.

The Employee Retention Credit

The Employee Retention Credit is available to an “eligible employer” who paid “qualified wages” between March 13, 2020 and December 31, 2020.

An eligible employer is one who: ● Carried on a trade or business in 2020, and ● Had operations fully or partially suspended as a result of a governmental order due to

COVID-19 or endured a “significant decline in gross receipts.” A significant decline means a 50% decline in gross receipts compared to the same quarter in the prior year. Eligibility for employers experiencing a significant decline in gross receipts continues until the quarter following the quarter where gross receipts are greater than 80% of the gross receipts in the same quarter of the prior year.

Employers with forgiven loans under the Payroll Protection Plan are not eligible for this credit.

The definition of qualified wages differs for companies with more than 100 employees and those with 100 or less employees, based on their 2019 average employee count. For a company with more than 100 employees, qualified wages are those wages paid to an employee who is receiving compensation but is NOT providing services because the company fully/partially suspended operation or experienced a significant decline in gross receipts. For a company with 100 or less employees, all wages paid are qualified, regardless of whether the employee is providing services or not. This means that an employee can continue to work and the employer may still be eligible for the credit.

The credit is equal to 50% of qualified wages and must be reduced by any payroll credits claimed for the same employee under the two credits described above. Qualified wages include qualified health plan expenses and may not exceed $10,000 per employee. The employer is allowed a credit against the employer’s share of Social Security taxes (i.e., 6.2% times wages, capped at the wage base) and the credit is refundable to the extent it exceeds the relevant payroll tax liability. In addition, the employer is eligible for advance payment of the credit via Form 7200.

Payroll Tax Deferral

The CARES Act allows employers to defer their 6.2% share of the Social Security tax on wages paid from March 27, 2020 to December 31, 2020. Half of the deferred payment amount is due by December 31, 2021, with the other half due by December 31, 2022. This deferral takes into account all cash taxes due to the IRS on Form 941, including the above mentioned credits. Form 941 intends to simplify the calculation of the amount of payroll tax balance due or overpayment and in doing so nets the tax credits against the employer share of social security. As a result, if the payroll tax credits are in excess of the employer share of social security then no amount will be eligible for deferral for the quarter.

MORE ON THE TREATMENT OF TAXES RESULTING FROM PROPERTY SALES IN FARM BANKRUPTCY REORGANIZATIONS

By George W. Benson

Prior TAXFAX columns have discussed a 2005 amendment to Chapter 12 of the Bankruptcy Code intended to facilitate farm reorganizations. See, Winter, 2012 and Fall, 2019. Farm bankruptcy reorganizations often involve the sale of part, but not all, of a farming operation to raise money to pay creditors, triggering significant gains for tax purposes. Before the amendment, the Government had a priority claim for federal income taxes resulting from such sales. This often gave the Government power to prevent confirmation of any plan of reorganization. The intent of the amendment was to deprioritize the Government’s claim, treating the Government as an unsecured creditor.

In debates leading up to the adoption of the 2005 amendment, Senator Grassley described its purpose as follows:

“The bill lets farmers in bankruptcy avoid capital gains tax. This is very important because it will free up resources to be invested in farming operations that otherwise would go down the black hole of the Internal Revenue Service. Farmers need this chapter 12 safety net.”

Disputes arose as to the scope of the language of the actual 2005 amendment. In Hall v. United States, 566 U.S. 506 (2012), the Supreme Court concluded that the amendment applied only to sales before commencement of bankruptcy proceedings. This frustrated the purpose of the amendment. It led to efforts to amend the Bankruptcy Code yet again to make it clear that the provision applied to sales both before and after a farmer filed for bankruptcy. Ultimately, the further amendment was enacted in 2017.

The Chapter 12 bankruptcy process is as follows:

In a Chapter 12 proceeding, the farmer proposes a plan to repay the secured debt, to the extent of the value of the collateral, and to utilize the farmer’s disposable income for the period of the plan, generally three to five years from the date the plan is confirmed, towards paying unsecured creditors (including any secured debt in excess of value of the collateral). … In general, secured creditors need not approve the plan, and a qualifying plan can be confirmed over the objection of creditors.

The debtor can retain assets, without the approval of the unsecured creditors, even when the unsecured creditors are projected to not be paid in full, so long as the debtor’s disposable income during the plan period goes to payments under the Chapter 12 plan, and the total payments are not less than what the unsecured creditors would receive upon a liquidation. Disposable income reflects a reduction for not only expenditures necessary to the operation of the business, but also for expenditures necessary for the support of an individual debtor and the debtor’s family.

Further, in determining what is available on a liquidation to unsecured creditors, the individual debtor can exempt certain assets, such as a homestead and retirement accounts in certain states. By claiming as many assets as exempt as possible, the Chapter 12 plan can enable the debtor to retain those assets, and yet be relieved from large unsecured debt, including, as described below, those income taxes that are treated as unsecured debt.”

“Eliminating the Inevitability of Farm Debt and Taxes through Chapter 12 Bankruptcy,” Alan S. Lederman, Bloomberg Law: Tax (July 6, 2020).

The Lederman article goes on to describe the importance of de-prioritizing tax claims to the success of farm bankruptcy reorganizations:

“The key income tax advantage of a Chapter 12 bankruptcy is provided in 11 U.S.C. Section 1232(a). That section provides generally that unsecured federal and state income taxes imposed on the pre-petition, and on the postpetition, pre-discharge, gains of the Chapter 12 debtor, which arise from the sale, transfer, exchange or other disposition of any property used in the debtor’s farming operation, are to be treated as pre-petition unsecured claims. Such taxes are thus potentially subject to discharge without being fully paid.”

While the 2017 amendment ended debate as to what is de-prioritized, disputes regarding the scope of de-prioritization have continued. A number of cases have concluded that de-

prioritizing applies not only to sale of farmland, but also to sale of almost any property used in the debtor’s farming business. After discussing those cases, one bankruptcy court recently went so far as to apply de-prioritization to the proceeds of the sale of a crop insurance policy. See, In re Pedersen, 593 B.R. 785 (Bankr. N.D. Iowa 2018).

In another recent case, the Government conceded that its claim for taxes on asset sales was de-prioritized, but argued that it nevertheless had the right under another section of the Bankruptcy Code to set a tax refund due to a farmer debtor off against a claim against the farmer for taxes resulting from an asset sale. The bankruptcy court held against the Government. See, In re Davies, 2020 BL 160451 (Bankr. N.D. Iowa 2020):

As all of this Legislative history shows, Congress intended the priority stripping provision to be interpreted to promote successful reorganizations of family farming operations – by limiting the impact of the substantial capital gains taxes that tend to follow the sale of farm land or equipment – and to put that capital into the farmers’ hands – not the taxing authorities. Allowing taxing entities to setoff withheld taxes against these capital gains taxes runs directly counter to these objectives.”

The Lederman article describes the reorganization plan in Davies. The article concludes that after three years the Davies would likely emerge with their farming business intact (but reduced) and with significant assets. The Davies planned to sell a portion of their farm and related assets and to use the proceeds to pay secured debt. It was estimated that the sale would trigger almost $1 million of gain and approximately $221,000 of tax for federal and Iowa tax purposes. Those taxes would be de-prioritized and have the status of unsecured debt. It was projected that only about $4,000 would be paid during the workout period with remaining unpaid taxes discharged after three years.

In farm bankruptcies another tax issue needs to be considered, namely whether the ultimate discharge of any de-prioritized tax liability in the bankruptcy gives rise to cancellation of indebtedness income or a reduction of tax attributes under Section 108. This short article does not address that question, but interested readers are directed to the Lederman article, cited above, for his views on the question.

PROPOSED REGULATIONS FOR EXCISE TAX ON EXEMPT ORGANIZATION COMPENSATION IN EXCESS OF $1 MILLION

By George W. Benson

The Tax Cuts and Jobs Act of 2017 added imposed an excise tax (currently at a rate of 21%) on “applicable tax exempt organizations” paying compensation (including excess parachute payments) in excess of $1 million per year to any covered employee. This new excise tax adds to other provisions in the Code penalizing companies for paying “high” levels of compensation to key executives, such as Section 162(m) (disallowing a deduction for certain corporations that file with the SEC for applicable compensation to certain employees in excess of $1 million), Sections 280G and 4999 (disallowing a deduction by the corporation and imposing an excise tax on an employee with respect to certain golden parachute payments) and Section 4004 of the Cares Act limiting compensation that may be paid to certain employees if a corporation chooses to participate in certain coronavirus relief loan programs (other than the Payroll Protection Program) such as the Main Street Lending Program.

Section 521 cooperatives are commonly referred to as “exempt” cooperatives, but they have not truly been exempt from federal income tax since 1951. Nevertheless, Treas. Reg. § 1.1381-2(a)(1) provides that “[f]or purposes of any law which refers to organizations exempt from income taxes [a Section 521 cooperative] shall… be considered as an organization exempt under section 501.”

The basis for treating Section 521 cooperatives as exempt under Section 501 is unclear. In Certified Grocers of California, Ltd.

v. Commissioner, 88 T.C. 238 (1987), the Tax Court 4960. The preamble states that the proposed By Barbara A. Wechquestioned treatment of Section 521 cooperatives regulations are expected to apply to 261,000 as exempt under Section 501 for consolidated applicable tax exempt organizations, of which 600 return purposes: are Section 521 cooperatives. This number of

“Whatever the situation may be with respect to Section 521 cooperatives seems high, but it has cooperatives exempt under section 521 – whether been years since the IRS released information as respondent may decree that such cooperatives to numbers of Section 521 cooperatives so there are to be treated as exempt under section 501, is no way to check its accuracy. the statute being silent, and are therefore not Because it is reasonable to expect that very permitted to file consolidated returns because of few Section 521 cooperatives will be subject to the prohibitions of section 1504(b)(1), except for the excise tax under Section 4960, this article the narrow exception of section 1504(e), see secs. will not describe Section 4960 and the proposed 1.1381-2(a)(1), 1.1502-100, Income Tax Regs. – is regulations in detail. Any Section 521 cooperative a matter which we may leave to another day and that pays any top executive in excess of $1 million another case.” per year should study these rules. Cooperatives

Since Certified was nonexempt, it was not potentially covered should be aware that the necessary for the Tax Court to address this statute and regulations take a broad view of what question in rendering its decision, and so its constitutes compensation for purposes of the $1 questioning of the of the treatment of Section million threshold and under certain circumstances 521 cooperatives as exempt under Section 501 is compensation for services rendered to related dictum (not authority). The validity of this portion entities is included. of the regulations has not since been addressed by the Tax Court or any other court. However, successfully challenging a regulation is difficult, PROPOSED REGULATIONS UNDER SECTION particularly where, as here, the regulation is 512(A)(6) WRESTLE WITH EXPENSE longstanding. ALLOCATIONS BETWEEN ACTIVITIES

Over the years, when enacting new provisions By George W. Benson applicable to exempt organizations, Congress has often specifically excluded Section 521 Nonexempt Subchapter T cooperativesare subject cooperatives where appropriate (and where to tax on net earnings from business done with someone brings the necessity to do so to the or for patrons who are not entitled to share in drafters’ attention). There is no exception from patronage dividends (“nonmember business”) Section 4960 for Section 521 cooperatives. In and on net earnings from nonpatronage activities fact, Section 521 cooperatives are specifically (“nonpatronage business”). Because of this, it included in the definition of “applicable tax is often necessary for cooperatives to allocate exempt organizations” for purposes of Section expenses between patronage and nonmember/ 4960. See Section 4960(c)(1)(B). nonpatronage activities.

The legislative history gives no clue as to why In the case of mixed activities (those serving the drafters of Section 4960 felt it appropriate to members on a patronage basis and nonmembers impose an excise tax on excess compensation on a nonpatronage basis), it has long been paid by Section 521 cooperatives. Likely they established that, absent evidence to the contrary, were not familiar with Section 521 cooperatives, it can be assumed that business done with or simply swept them in without much thought, and for members and nonmembers are equally no one complained. There are not many Section profitably (which has the effect of allocating gross 521 cooperatives, most are small, and few, if any, income and expenses between those activities in pay compensation to an executive in excess of $1 proportion to the member/nonmember business million per year. ratio). For this purpose, the member/nonmember

On June 11, the Treasury/IRS released a set business ratio is normally based on a physical of proposed regulations implementing Section measure of products handled or on a pre-

patronage measure of gross receipts (amounts paid members and nonmembers for products marketed by the cooperative or amounts paid by members for supplies or services provided by the cooperative). See, A.R.R. 6967, III-1 C.B. 287 (1924), restated and superseded by Rev. Rul. 68-228, 1968-1 C.B. 385.

Recently, the Treasury released proposed regulations implementing Section 512(a) (6), which was added to the Code by the Tax Cuts and Jobs Act of 2017. Section 512(a) (6) requires exempt organizations engaged in several unrelated trades or businesses to silo each unrelated business for net operating loss carryover purposes. While Section 512(a)(6) and these proposed regulations are not applicable to nonexempt Subchapter T cooperatives, the proposed regulations provide some insight as to the Treasury/ IRS current thinking about the allocation of expenses between exempt and nonexempt activities which might of interest to nonexempt Subchapter T cooperatives.

Currently, Treas. Reg. § 1.512(a)-1(c) provides that, where facilities and personnel are used in both exempt and nonexempt activities, expenses related to the facilities and personnel “shall be allocated between the two uses on a reasonable basis.” It appears that many exempt organizations have used gross receipts for this purpose. However, the preamble to the proposed regulations indicates that the Treasury/IRS has reservations with respect to the use of the gross receipts method when an exempt organization charges less to users of its exempt function than to users of its nonexempt function.

As a consequence, the Treasury proposes to modify existing Treas. Reg. § 1.512(a)-1(c) by adding the following language:

“However, allocation of expenses, depreciation, and similar items using an unadjusted gross-to-gross method is not reasonable. For example, if a social club charges nonmembers a higher price than it charges members for the same good or service, it must adjust the price of the good or service provided to members for purposes of determining the allocation of indirect expenses to avoid overstating the deductions allocable to the unrelated business activity of providing goods and services to nonmembers.”

However, the preamble indicates that the Treasury/IRS is thinking further about allocations:

“The Treasury Department and the IRS are concerned that permitting allocation methods based solely on reasonableness is difficult for the IRS to administer and may not provide certainty for taxpayers. Whether an allocation method is ‘reasonable’ depends on all the facts and circumstances. See Rensselaer Polytechnic Institute v. Commissioner, 79 T.C. 967 (1982), aff’d 732 F.2d 1058 (2d Cir. 1984) (finding an allocation method based on actual use to be ‘reasonable’ within the meaning of § 1.512(a)-1(c)). The Treasury Department and the IRS continue to consider the allocation issue and intend to publish a separate notice of proposed rulemaking providing further guidance on this issue.”

This statement is not surprising since the IRS has been studying expense allocation issues for exempt organizations for some time. It has received some input from interested parties. For instance, in a letter to the IRS dated February 23, 2017, the AICPA recommended the following framework for expense allocations:

Guidelines for allocation of indirect expenses 1. Deductible expenses must bear a proximate and primary relationship to the conduct of the activity.

2. Deductible expenses include both direct costs and indirect costs.

3. Indirect costs include fixed expenses (those which do not change when the unrelated activity is conducted or not conducted) and variable expenses (those which increase or decrease when the unrelated activity is conducted or not conducted).

4. The methodology for allocating expenses relating to dual use facilities/personnel is reasonable and consistently followed from

year to year, and should not cause the double-counting of any expense.

5. The methodology for allocating expenses relating to dual use facilities/personnel is based on the character of the expense involved.

a. Facility costs (rent, mortgage interest, insurance, taxes, security, and utilities) apportioned based on portion of facility used (square footage and time) for each activity.

b. Personnel costs (salary, benefits, and taxes) apportioned based on time spent on each activity.

c. Information technology costs (software, computer services, and internet) apportioned based on allocation of personnel to activity.

d. Office expenses (supplies, printing, postage, and subscriptions) are apportioned based on allocation of personnel to activity.

6. The AICPA recommends that the IRS permit the use of gross revenue, from each respective activity, to allocate direct and/or indirect expenses if there is no difference in the prices charged to earn unrelated versus related revenue. This provision is intended for use by organizations that are unable, or for which it is administratively impractical, to maintain or create records with respect to activities in which dual use facilities/ personnel are used and the associated expenses are clearly distinguished as related or unrelated.

7. The AICPA recommends that the IRS provide a simplified method for small businesses to determine expenses which are deductible against unrelated business income. Small organizations lack the resources to adequately document the information needed to identify expenses pertaining to dual use facilities/personnel used in related and unrelated activities.”

What the IRS has done in the proposed regulations might be viewed as a back-door affirmation of the reasonableness of the gross receipts method where an exempt organization deals with users of exempt and nonexempt functions on the same basis and an approval, at least for now, of the AICPA’s recommendation 6.

This is an area worth monitoring though, as noted above, the Section 512 regulations do not apply to nonexempt Subchapter T cooperatives.

PROPOSED REGULATIONS NARROW EXCEPTIONS TO DISALLOWANCE OF DEDUCTION FOR FINES AND PENALTIES

By George W. Benson

Section 162(f) (fines, penalties and other amounts) was substantially rewritten by the Tax Cuts and Jobs Act of 2017, and reporting requirements were added to the Code. See, Section 6050X. On May 13, the IRS released a set of proposed regulations implementing the TCJA revisions. See Prop. Treas. Reg. §§ 1.162-21 and 1.6050X-1.

Section 162(f)(1) provides that amounts paid to “a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of a law” are not deductible. Section 162(f)(2) excepts any amount which “(i) constitutes restitution (including remediation of property) for damages or harm which was or may be caused by violation of any law or the potential violation of any law, or (ii) is paid to come into compliance with any law which was violated or otherwise involved in the investigation or inquiry described in paragraph (1)” provided certain conditions are met.

The proposed regulations provide guidance as to the scope of the exceptions. For instance, they provide that “forfeiture and disgorgement” are not included. The preamble explains:

“Forfeiture and disgorgement focus on the unjust enrichment of the wrongdoer, not

the harm to the victim…In Nacchio v. United States, 824 F.3d 1370 (Fed. Cir. 2016), cert. denied, 137 S. Ct. 2239 (2017), the United States Court of Appeals for the Federal Circuit noted that, ‘[w]hile restitution seeks to make victims whole by reimbursing them for their losses, forfeiture is meant to punish the defendant by transferring his ill-gotten gains to the United States Department of Justice.’ …

Section 162(f)(2)(A)(i)(I) provides that restitution and remediation payments relate to the damage or harm caused, or that may be caused, by the violation, or the potential violation, of a law. The statute does not characterize restitution or remediation in connection with an unjust enrichment to a wrongdoer. Consistent with the statutory language, proposed § 1.162-21(f)(3)(i) provides that the purpose of restitution or remediation is to restore the person or property, in whole or in part, to the same or substantially similar position or condition as before the harm caused by the taxpayer’s violation, or potential violation, of a law.”

The bright line the proposed regulations draw between disgorgement and restitution/ remediation is controversial. It may have been muddled (at least in cases involving violations of the federal securities law) by a Supreme Court decision that came down shortly after the proposed regulations were released. See, Liu v. SEC, 591 U.S. (2020). In that case, the Supreme Court concluded that the SEC had authority to require disgorgement as an allowable equitable remedy under the federal securities law, but placed limits on permitted disgorgement (at least under federal securities laws) that make it more difficult to distinguish disgorgement from restitution. The Supreme Court may again focus on the nature of the equitable remedies of disgorgement and restitution in its next term. Certiorari has been granted in a case which concluded that Federal Trade Commission does not have authority to assert disgorgement or restitution as a remedy under applicable federal law. See, FTC v. Credit Bureau Center LLC, 937 F.3d 764 (7th Cir. 2019).

The treatment of disgorgement and forfeiture will almost certainly get close scrutiny before the proposed regulations are put in final form. One critic has written:

“The IRS’s proposed rule, issued in May, prohibits companies that settled enforcement actions from deducting from their taxes not only fines and penalties – or their equivalents under alternative resolution mechanisms – but also disgorgement and forfeiture… At the same time, it allowed deductions for amounts ordered paid in restitution to victims or in upgrading and implementing remedial compliance programs. In doing so, however, the Service ignores the very different legal underpinnings of disgorgement and forfeiture from fines and penalties and imposes concealed additional penalties upon settling companies by both depriving the settling companies of their ‘illicit’ gains or property while keeping the taxes paid on such gains or property in previous tax years – thus, in contrast to the Liu rule, the Service’s proposed rule effectively allows the government collectively to take more than the net gain from the offense through disgorgement. This approach is a step too far.”

“A Step Too Far? The IRS Proposes NonDeductibility of Disgorgement,” Philip Urofsky and Richard Gagnon, Bloomberg Law: Tax (July 7, 2020).

The proposed regulations also provide that amounts paid to reimburse the government or governmental entity for investigation costs or litigation costs are not deductible. The restitution and remediation exception also does not apply to payments that are, at the payer’s election, in lieu of a fine or penalty.

In order to be deductible, payments must meet two additional requirements – the “identification requirement” and the “establishment requirement.” Generally the “identification requirement” requires that there be a “court order (order) or an agreement [which] identifies a payment by stating the nature of, or purpose for, each payment each taxpayer is obligated to pay and the amount of each payment identified.” Prop. Treas. Reg. § 1.162-21(b)(2)(i). The “establishment requirement” requires “the taxpayer [to

substantiate], with documentary evidence, the taxpayer’s legal obligation, pursuant to the order or agreement, to pay the amount identified as restitution, remediation, or to come into compliance with a law, the amount paid, and the date the amount was paid or incurred.” Prop. Treas. Reg. §1.162-21(b)(3)(i).

Section 162(f) does not apply “to any amount paid or incurred by reason of any order of a court in a suit in which no government or governmental entity is a party.” Section 162(f)(3). Note however, the definition of “government or governmental entity” includes nongovernmental entities which exercise self-regulatory powers in connection with a qualified board or exchange. Note also that the Code contains other provisions limiting the deductibility of amounts paid in connection with litigation such as Section 162(g) (relating to treble damages paid under the antitrust laws) and Section 162(q) (payments relating to sexual harassment and sexual abuse).

Section 6050X imposes a reporting obligation on the government and governmental entities receiving payments described in section 162(f). Section 6050X(a)(1) requires reporting of:

“(A) the amount required to be paid as a result of the suit or agreement to which paragraph (1) of section 162(f) applies, (B) any amount required to be paid as a result of the suit or agreement which constitutes restitution or remediation of property, and (C) any amount required to be paid as a result of the suit or agreement for the purpose of coming into compliance with any law which was violated or involved in the investigation or inquiry.”

Prop. Treas. Reg. § 1.6050X-1 fleshes out the rules. A form (Form 1098-F) has been developed for this purpose.

Pending final regulations, rules for complying with the changes made by the TCJA are contained in Notice 2018-23, which is described in the preamble to the proposed regulations as follows:

“On April 9, 2018, the IRS published Notice 2018-23, 2018-15 I.R.B. 474, to provide transitional guidance on the identification requirement of section 162(f)(2)(A)(ii) and the information reporting requirement under section 6050X. Notice 2018-23 provides that information reporting is not required until the date specified in proposed regulations under section 6050X. Notice 2018-23 also provides that, until the Treasury Department and the IRS issue proposed regulations, the identification requirement is treated as satisfied if the order or agreement specifically states on its face that an amount is paid or incurred as restitution, remediation, or to come into compliance with a law.”

While the final Section 162(f) regulations will be applicable to years beginning after they are published in the Federal Register, the proposed regulations provide:

“Until that date, taxpayers may rely on these proposed rules for any order or agreement, but only if the taxpayers apply the rules in their entirety and in a consistent manner.”

The proposed section 6050X regulations provide that the reporting obligation in the final regulations will be applicable “only to orders and agreements that become binding under applicable law on or after January 1, 2022.”

These rules apply to cooperatives just as they do to other business entities.

For a cooperative, the resulting impact of a disallowed deduction for a fines or penalty on the cooperative’s patronage dividend deduction must also be considered. The impact of such a disallowance is to create a permanent book-tax (Schedule M) difference. Should a cooperative paying patronage based on book income simply ignore the tax disallowance because the fine or penalty continues to be a book expense? Presumably a cooperative paying patronage dividends based on taxable income should reduce its patronage dividend by the portion, if any, of the expense that is patronage. Should it go further and reduce its patronage dividend by a gross-up for any resulting tax expense reported for book purposes? Generally, Treas. Reg. § 1.1388-1(a)(1) provides generally that net

earnings for patronage dividend purposes shall not be reduced by federal income taxes.

2019 IRS DATA BOOK By George W. Benson

The IRS recently released the 2019 Data Book describing activities of the Internal Revenue Service during its fiscal year ended September 30, 2019. See, 2019 Internal Revenue Service Data Book, Publication 55B (June 2020) (the “2019 Data Book”). The information pertinent to cooperatives is largely consistent with what was reported for prior years. However, the IRS continues to mask a significant portion of the data.

The reported number of cooperative tax returns (Form 1120-C) has been little changed over the past few years: 8,973 in calendar 2014; 9,043 in calendar 2015; 9,303 in calendar 2016; 9,294 in calendar 2017; 7,500 (?) in calendar 2018; and 9,263 in calendar 2019. The number of cooperative returns is tiny compared to the number of other kinds of returns. It appears that the IRS has doubts as to whether all organizations qualifying as Subchapter T cooperatives are properly filing Form 1120-Cs since it added the following question to the 2018 Form 1120: “Is the corporation operating on a cooperative basis?” See, 2018 Form 1120, Schedule K, question 20. This question has not led to a material change in the number off Form 1120-C filers.

The reported audit rate for cooperative returns continues to be low. The 2016 Data Book reported that there were 44 audits of cooperative tax returns (0.5% of returns filed). The 2017 Data Book reported 40 audits (0.4% of returns filed). The 2018 Data Book reported 20 audits (0.2% of returns filed). This year, there were 24 reported audits (0.3% of returns filed). The 2019 Data Book reports that the audits concluded with proposed deficiencies of $734,000. The 2019 Data Book masks the breakdown between how much was agreed and how much was unagreed.

The 2019 Data Book also does not disclose how many amended returns were filed. Nor does it contain any information as to what portion of refunds claimed was granted and what portion was audited and denied. This information was provided a couple of years ago but has not been provided in recent years. The stated reason is that detail is “not shown to avoid disclosure of information about specific taxpayers.”

The audit coverage rates are calculated using fiscal-year audits in the numerator and calendar-year tax returns in the denominator. This approach is designed to reflect overall trends in audit activity. The reports have consistently reported a very low level of audit activity.

PROPOSED REGULATIONS IMPLEMENT TCJA CHANGE TO LIKE-KIND EXCHANGE RULES

By George W. Benson

The Tax Cuts and Jobs Act of 2017 revised Section 1031 to limit the like-kind exchange rules to exchanges of real property held for productive use in a trade or business or for investment for real property of like kind. Real property held for sale does not qualify for Section 1031 treatment.

For this purpose, “like kind” has been interpreted very broadly. Almost any kind of real estate is regarded as “like kind.” Treas. Reg. § 1.1031-1(b) provides:

“As used in section 1031(a), the words ‘like kind’ have reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale.”

Treas. Reg. § 1.1031-1(c) lists examples of

real property exchanges that qualify as “like kind.” Included are: “a taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for real estate, or exchanges improved real estate for unimproved real estate.” There are some limits. Section 1031(h) provides that real property located in the United States and real property located outside the United States are not “like kind.”

The Section 1031 regulations have never contained a definition of “real property.” Given the new limitation of Section 1031 to exchanges of real property, the Treasury has proposed regulations defining the term for the first time for Section 1031 purposes. These regulations are in addition to existing regulations dealing with such things as the treatment of boot and deferred like-kind exchanges. The preamble notes that there are definitions of “real property” in the Code and regulations for other purposes but believes that it is appropriate to adopt a definition designed specifically for Section 1031 purposes. This definition appears designed to minimize future disputes over what does and what does not qualify as “real property.”

Prop. Treas. Reg. § 1.1031(a)-3(a)(1) provides:

“The term real property under section 1031 and §§ 1.1031(a)-1 through 1.1031(k)-1 means land and improvements to land, unsevered natural products of land, and water and air space superjacent to land. Under paragraph (a)(5) of this section, an interest in real property of a type described in this paragraph (a)(1), including fee ownership, co-ownership, a leasehold, an option to acquire real property, an easement, or a similar interest, is real property for purposes of section 1031 and this section.”

For this purpose, “improvements to land” include “inherently permanent structures and the structural components of inherently permanent structures.”

“Inherently permanent structures” include “any building or other structure that is a distinct asset within the meaning of paragraph (a)(4) of this section and is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time.” The proposed regulations list a number of structures that qualify and principles to apply to determine whether items not on the list nevertheless qualify. These principles trace back to a Tax Court decision many years ago that concluded that billboards were not inherently permanent structures for purposes of the investment tax credit. See, Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975).

The term “structural component” means “any distinct asset, within the meaning of paragraph (a)(4) of this section, that is a constituent part of, and integrated into, an inherently permanent structure. If interconnected assets work together to serve an inherently permanent structure (for example, systems that provide a building with electricity, heat, or water), the assets are analyzed together as one distinct asset that may be a structural component.” Here, as well, the proposed regulations list a number of items which qualify as structural components and principles to apply to determine whether items not on the list nevertheless qualify.

In addition, the proposed regulations contain a number of examples illustrating what is and what is not real property for purposes of Section 1031.

Unsevered natural products of land (such as growing crops, plants and timber) are regarded as real property. However, once harvested, they become personal property.

A special rule applies to mutual ditch (irrigation) companies exempt under Section 501(c)(12). The stock of such companies is regarded as real property “if, at the time of the exchange, the shares have been recognized by the highest court of the State in which the company was organized, or by a State statute, as constituting or representing real property or an interest in real property.”