Highlights of 2013 Tax Court Decisions
By Danielle Buchbauer
NYS MCTMT Tax Constitutional
On January 14, 2014, the New York Court of Appeals, the state’s highest court, declined to hear a challenge to the Metropolitan Commuter Mobility Tax, the payroll tax levied in counties served by the Metropolitan Transit Authority. The decision permits the continuance of the tax, which was enacted in 2009, and helps fund the region’s mass transportation.
The MCTMT/MTA Tax is imposed on certain employers, self-employed individuals and partners in a partnership conducting business within the Metropolitan Commuter Transportation District. This district includes the boroughs of New York City and the counties of Nassau, Rockland, Suffolk, Orange, Putnam, Dutchess and Westchester. The highest effective rate is .34% of net earnings for self-employed individuals, partners, and on an employer’s payroll expense for covered employees.
The New York State Supreme Court previously ruled on August 22, 2012 that the Metropolitan Transportation Authority (“MTA”) Payroll Mobility Tax was unconstitutional because it was passed in violation of the New York State Constitution. On August 24, 2012, the New York State Department of Taxation and Finance released a statement that it would continue to fight the ruling and advised taxpayers to continue to file and pay timely. As a result of the court of appeals decision, this tax law is now permanent.
Research & Development Tax Credits
A number of recent court cases between the IRS and taxpayers have resulted in taxpayer-favorable rulings. Most of the IRS cases challenge what constitutes Qualified Research Expenditures (QREs). A specific case that exemplifies this point is Eric G. Suder et al. v. Commissioner (TC Memo 2014-201). Estech Systems, owned by Eric Suder, provided telephone systems for small to midsize businesses. The court ruled in favor of Suder, determining that a technical uncertainty does exist when “building significantly larger phone systems than it had ever undertaken.” This was in contrast to the IRS claim that large projects always have an “inherent level of uncertainty,” which in their argument, would not qualify as a QRE. Suder also introduced the fact that Estech Systems added innovative software and hardware components to the phone systems, in which numerous uncertainties existed. The court also ruled in favor of Suder when regarding the application of the process of experimentation. A process of experimentation involves “evaluating alternatives to improve function, performance, reliability or quality through trial and error and must be used to attempt to accomplish a result that it is uncertain.” The IRS presented that Estech Systems simply “evaluated processes by using engineering know-how, common knowledge, and committees,” and that these activities were not processes of experimentation. Ultimately, Suder correctly argued that Estech Systems had implemented “a very detailed, multi-level, and systematic system for phone systems development. Included in this process were hypothesizing which alternatives would be most effective, testing these alternatives, analyzing the results, and repeating the first 3 steps if needed.”There are many businesses eligible for the R&D tax credit that do not take advantage of this valuable incentive. Taxpayers manufacturing, application software development, telecommunications, biotechnology, and engineering, among others, commonly qualify for the federal R&D credit. To be considered qualified research, an activity needs to meet prongs of the “fourpart” test. (See pyrmid to right)
The R&D tax credit may be calculated in one of two ways, and the method used can be changed each year depending on which produces the greater benefit. Because the R&D tax credit is an incremental credit, costs incurred in prior years can increase a current year credit calculation.
Note that the tax provision for R&D tax credits expired at the end of 2013; however, it may be extended.
In addition, in June the IRS announced changes to the R&D Tax Credit allowing the ASC (Alternative Simplified Credit) calculation methodology for amended tax returns. Surprisingly, this taxpayer beneficial change is critical for taxpayers who have not previously taken advantage of the credit.
The Frank Aragona Trust Case
In March 2014, the Tax Court in the Frank Aragona Trust held that a trust can qualify as a real estate professional under the passive activity loss rules. Possibly one of the most important IRC Section 469 passive loss case in years, this decision extends beyond loss deductibility under the passive loss rules impacting the determination of whether trust income will be subject to the net investment income tax.
The IRS challenged this through an audit, deeming real estate losses subject to the passive activity loss rules, not deductible against non-passive income. They argued that “personal services” refers to the acts of individuals and cannot apply to an entity, such as a trust.
The IRS’ position was that a trust could not satisfy the requirements for real estate professional status since it must demonstrate that more than one-half of its “personal services” performed in the tax year were in real propertyrelated trades or businesses. Historically, the passive loss rules did not explicitly exclude trusts nor did they specifically limit the rules to natural persons, therefore making it necessary to apply the qualitative standard of “regular, continuous and substantial” in determining whether a trust is a material participant in an activity. In this case, the Tax Court reasoned that Congress would have to explicitly exclude Trusts under the definition of real estate professional.
The participation of the trustees was critical, as three of the six trustees materially participated daily in real estate operations, working full time as paid employees by the trust’s wholly owned LLC operating in the real estate industry. Two trustees also owned minority direct interests through flow through entities. Additionally, all six trustees acted as a management board meeting regularly to make major decisions regarding the trust’s business. The trust treated losses from the real estate rental activities as deductible and not subject to the passive activity loss rules. The trust claimed that it should be treated as a real estate professional and that the trust materially participated in its real estate rental activities.
The Trust’s winning argument was that it should be able to count the hours worked by certain trustees as employees of the business. It also argued that it should be able to count the hours of non-trustee employees and agents in demonstrating material participation. The trust’s real estate operations were substantial, and it had practically no other types of operations. The trustees handled no other businesses on behalf of the trust, thus the trust’s fees were expenses of the trust’s rental real estate activities. The Court stated that the time the trustees spent as employees of the businesses owned by the trust should be used in determining material participation. From all the facts of the case, it was clear that the trustees materially participated in the business activities.
The Tax Court ultimately determined that services performed by the trustee in any capacity, not just as trustee in a traditional fiduciary capacity, count for purposes of measuring material participation. This passive loss activity decision becomes applicable to a broad range of businesses and is not limited to real estate rentals. This case offers a number of planning opportunities for trusts to maximize the benefits of business losses and to avoid the new investment income tax.
U.S. Tax Court Denies MBA
Tuition Deduction Hart v. Commissioner. The issue at hand was whether or not the taxpayer, an MBA student, could deduct tuition expenses for his degree. As many students qualify for miscellaneous education deductions, it is important to note that the degree must be required by the employer, and as such, the expenses must be necessary and ordinary to improve the employee’s professional skills.
The primary focus in denying these deductions was that the student had very limited professional work experience and, in addition, was unemployed while enrolled in some of his MBA classes. The taxpayer argued that he was in the business of selling pharmaceuticals and that the MBA classes enabled him to obtain employment. The IRS contended that Hart was not established in a trade or business and that his employers did not require him to enroll in an MBA program.
Masters degrees, specifically MBA’s, are high in demand with few jobs available for young people right out of school. This ruling has serious implications for other taxpayers with little work experience who already have or plan on deducting tuition costs for their MBA program.
Date Placed in Service Crucial to Depreciation
The 2013 Tax Court decision in Michael D. Brown and Mary M. Brown v. Commissioner of Internal Revenue stressed the importance of determining the proper date for when an asset is placed in service. Here, the Court disallowed bonus depreciation and regular MACRS depreciation claimed on a plane the taxpayer acquired and used in December of 2003.
When the taxpayer purchased an airplane to facilitate sales meetings with wealthy clients, he had the plane modified to include items such as a conference table and upgraded audio visual equipment. The plane was purchased in December 2003; however the more than $500,000 worth of modifications to the plane were not completed until the beginning of January 2004. On its tax return for the year ended 2003, the taxpayer claimed both regular and bonus depreciation totaling in excess of $11 million on this new asset.
The timeline of the aircraft purchase was the pertinent fact in this case. To qualify for bonus depreciation, property must be placed in service in the year of the deduction. The IRS specifies “property is first placed in service when it is in a condition or state of readiness and available for a specifically assigned function.” While the taxpayer had taken possession of the aircraft and used it for business, by the taxpayer’s own admission there were additional modifications required to make the plane complete for his business purposes. Since the modifications did not occur in the initial year 2003, the Tax Court concluded that the aircraft was not put into service until 2004. The Court therefore disallowed the regular MACRS depreciation and $11 million of bonus depreciation taken in 2003.
This case stresses the importance of taxpayers considering the date property is placed in service versus utilization. It does not necessarily mean that an asset is placed in service if it is being utilized. If assets are being used in the business, but require additional modifications or development in order to fully meet the needs of their ultimate uses, the Internal Revenue Service may disallow costs recovered through depreciation or other cost recovery methods until the asset is fully ready for its intended purpose.