I. Background and Overview. INTRODUCTION
Today's discussion will focus on some of the more interesting or important tax developments that have transpired over the last year or so. The new developments addressed in this presentation will include numerous tax court cases, decisions of various federal circuit courts, as well as IRS pronouncements, revenue rulings and regulatory changes.
PART ONE
IRS AUDIT STATISTICS
I. Audit Statistics; What Are Your Chances of Being Audited?
The 2023 Internal Revenue Service Data Book released in April 2024 contains audit statistics for years 2013 through 2021, as of the fiscal year ended September 30, 2023 (FY 2023). For tax years 2019 and earlier, the statute of limitations for audits had generally expired as of September 30, 2023. However, for 2020 and later returns, the statute of limitations has yet to expire, so additional returns of those years may be audited.
For 2013 through 2021, audit rates dropped significantly. For example, individual tax returns had an audit rate of 0.6% for 2013 returns versus 0.2% for 2021. In addition, for individuals with income between $1 million and $5 million, the audit rate dropped from 3% for 2013 returns to .5% for 2021 returns.
The overall audit rate for C corporations dropped from 1.2% for 2013 returns to .3% for 2021 returns. For partnerships and S corporations, the audit rate for 2013 returns was 0.3% and 0.3%, respectively, compared to 0.1% and 0.1% for 2021 returns.
In FY 2023, 22.7% of audits were field audits. The others were correspondence audits.
Below are the FY 2023 audit statistics for 2021 tax returns:
A. Audit Rates for Individual Tax Returns. During FY 2023, only 0.2% of individual income tax returns filed for 2021 were audited (same as for 2020 returns).
Total 2021 Individual Returns Audited in FY 2023: 0.2%
(1) No positive income 0.3%
(2) $100,000 to $200,000 0.1%
(3) $500,000 to $1 million 0.3%
(4) $1 million to $5 million 0.5%
(5) $5 million to $10 million 1.4%
(6) $10 million or more 2.9%
B. Audit Rates For Partnerships and S Corporations: For partnership and S corporations, the FY 2023 audit rate for 2021 returns was .1% (same as for 2020 returns).
C. Audit Rates for C Corporations. C corporation returns filed for 2021 had an audit rate of 0.3% during FY 2023 (down from .6% for 2020 returns).
Total 2021 C Corporation Returns Audited in Fiscal Year 2023: 0.3%
(1) Assets $1 million to $5 million .4%
(2) Assets $5 million to $20 million 6.5%
(3) Assets $20 million or more 15.8%
D. Schedule C Returns. Not surprisingly, the audit rates for Schedule C returns are much higher than for other individual returns. According to Internal Revenue Service Data Book 2019, Schedule Cs filed for 2018 with receipts of $100,000-$200,000 had a 1.6% audit rate. Schedule C returns filed for 2018 with income over $200,000 had a 1.4% audit rate. Since 2019, the IRS has not published similar Schedule C audit statistics for tax returns after 2018.
II. Offers in Compromise and Criminal Case Referrals
A. Offers in Compromise. For FY 2023, the IRS received around 30,000 offers in compromise but accepted only about 12,700.
B. Criminal Case Referrals. The IRS initiated 2,676 criminal investigations for FY 2023 and completed 2,584 cases. The IRS referred 1,838 cases for criminal prosecutions (484 for legal source tax crimes, 874 for illegal source financial crimes, and 480 for narcotics– related financial crimes) and obtained 1,508 convictions. For convictions, 1,167 were incarcerated.
PART TWO ORDINARY INCOME OR CAPITAL GAIN ON THE SALE OF REAL PROPERTY?
I. Background and Overview.
A. Summary of Tax Differences. When a taxpayer sells real estate, often the IRS and the taxpayers are at odds as to whether the sale should be treated as the sale of investment property or as the sale of ordinary income "inventory" property. The tax differences can be significant for both the taxpayer and the IRS.
If the transaction is treated as a sale of "investment" real property, then any gain on the sale will be taxed at the capital gain tax rates. And the gain recognized by the investor will not be subject to self-employment taxes.
In addition to the capital gain tax and self-employment tax benefits available to the real estate investor, such investors also can benefit from:
(i) Section 1031 nontaxable exchanges;
(ii) Section 1033(g) (relating to condemnation of real property held for productive use in a trade or business or for investment); and
(iii) Section 453 installment sale reporting.
These are tax benefits that are not available to dealers of real property.
On the other hand, investors in rental real estate must be cognizant of (i) the passive activity loss limitations of Section 469 and (ii) the capital loss limitations applicable to investment property (since, if the sale generates a loss, then the taxpayer's loss will be limited by the capital loss limitation rules - that is, the capital loss can only offset other capital gains income and another $3,000 of ordinary income for the year).
If the sale is treated as a sale of inventory by a developer, then any gain will be treated as ordinary income, and thus will be subject to the ordinary income tax rates as well as subject to self-employment tax. On the other hand, if the sale of the deemed inventory generates a tax loss, then the tax loss will be fully deductable against other ordinary income as well as capital gains
B. Past Case Law.
The issue of whether the sale of real property should be treated as the sale of investment property versus inventory property has generated much litigation in the past. Throughout various court cases analyzing these issues, most courts cite the "investor versus dealer tests" analyzed under Biedenharn Realty Company v. United States, 526 F.2d 409 (5th Cir. 1976); Suburban Realty Co. v. US, 615 F.2d 171 (5th Cir. 1980). Under these cases, the courts have focused on the question of whether the property is held primarily for sale to customers in the ordinary course of the taxpayer's business versus whether the taxpayers held the property purely for investment purposes.
Because gain or loss from the disposition of real property is capital if it was held as an investment and ordinary if it was held "primarily" for sale to customers, the identification of a particular parcel of real property as investment property or as property held primarily for sale to customers is critical.
According to the court in Malat v. Riddell (383 U.S. 569 (1966)), the term "primarily" means of "first importance" or "principally," so that the issue turns on the taxpayer's intent with respect to holding of the property, which is obviously a factual issue.
Accordingly, a taxpayer's position, that an investment in real estate is merely being disposed of in the most economically profitable manner is a sustainable argument, despite the taxpayer's engagement in activities traditionally conducted by a real estate dealer, provided that the taxpayer otherwise manages his property holdings in a manner substantially similar to that of an investor. Further, the taxpayer must be careful not to reinvest in substantially similar property shortly after the liquidation of the investment if he seeks to avoid ordinary income characterization.
Unfortunately, no definitive trend has arisen that identifies which factors will guarantee investor treatment. As the court in Biedenharn Realty Co., Inc. v. U.S. (526 F.2d 409 (1976)) noted, resolving this question is often a "vexing and ofttimes elusive" task. Obviously, however, the greater the degree of development and sales activities undertaken by the taxpayer, the more likely the taxpayer will be unsuccessful in sustaining its argument that the property is investor rather than dealer property.
Cases that have addressed the issue have emphasized various factors in different contexts, in a manner that makes it difficult to construct a pattern from which outcomes in other situations can be predicted with any degree of confidence. For example, the court in Kirschenmann v. Comr. (24 T.C.M. 1759 (1965) held that frequent sales of lots undertaken by the taxpayer because the property was no longer suited for its intended purpose did not make the property investment property, while the court in Austin v. U.S. (116 F. Supp. 283 (1953) reached the opposite conclusion on similar facts. Similarly, capital gain treatment was allowed to the taxpayer in Brenneman v. Comr. (11 T.C.M. 628 (1952)), who sold his lots after an ordinance was enacted that barred the taxpayer's original plans, while the taxpayer in Shearer v. Smyth (116 F. Supp. 230 (1953)) was required to pay tax at ordinary rates under similar circumstances.
C. Factors Reviewed By The Courts. The Court in Ada Belle Winthrop, (CA-5) 24 AFTR 2d 69-5760, rev'g (DC) 20 AFTR 2d 5477, (October 22, 1969) established a set of criteria which have been cited frequently by the courts addressing these dealer vs. investor arguments. In the order of frequency cited in other cases, these seven factors, known as the "seven pillars of capital gain," are as follows:
1. Nature and purpose of the acquisition and duration of ownership.
2. Extent and nature of the efforts of the owner to sell the property.
3. Number, extent, continuity and substantiality of the sales.
4. Extent of subdividing, developing and advertising to increase sales.
5. Time and effort devoted to sales.
6. Character and degree of supervision over sales representatives.
7. Use of a business office to sell the property.
Other courts have applied a nine (9) factor test as follows:
1. The taxpayer's purpose in acquiring the property;
2. The purpose for which the property was subsequently held;
3. The taxpayer's everyday business and the relationship of the income from the property to the total income of the taxpayers.
4. The frequency, continuity, and substantiality of sales of property;
5. The extent of developing and improving the property to increase sales revenue;
6. The extent to which the taxpayer used advertising, promotion, or other activities to increase sales;
7. The use of a business office for sale of the property;
8. The character and degree of supervision or control the taxpayer exercised over any representative selling the property; and
9. The time and effort the taxpayer habitually devoted to sales.
Moreover, the Court of Appeals for the 5th Circuit has noted that "frequency of sales" is especially important to review because "the presence of frequent sales ordinarily runs contrary to the taxpayer's position" for investment. Suburban Realty Company.
II. Conservation Easement Charitable Deduction Limited To Taxpayer's Adjusted Basis In Ordinary Income Property and Further Reduced to Zero When the Taxpayer Couldn't Prove Current Basis Figures. Also, Informal Understanding Between the Appraiser and Taxpayer Disqualified the Appraiser From Being a "Qualified Appraiser" Under Section 170; Oconee Landing Property vs. Commissioner, TC Memo 2024-25 (February 21, 2024).
Oconee Landing Property, LLC claimed a charitable contribution deduction of almost $21 Million on its partnership tax return for the 2015 tax year for its donation of a conservation easement over property it owned in Georgia. The IRS disallowed the entire charitable contribution deduction.
In siding with the IRS, the Tax Court held that the charitable contribution failed in its entirety for two distinct reasons. First, the real estate appraisers, assisting Ocenee, were not "qualified appraisers", which meant that Oconee had failed to attach a "qualified appraisal" to its 2015 tax return. Second, because the property on which the easement was granted was "ordinary income" property, the amount of the charitable contribution was limited to Oconee's tax basis in the donated property. And, because Oconee could not prove that its tax basis in the donated property exceed zero, its charitable contribution was limited to zero.
In 2015, Oconee donated a conservation easement over a tract of land it owned in Georgia (the "Easement Tract"), which was located near Lake Oconee. Oconee acquired the Easement Tract through a capital contribution from one of its partners, known as Carey Station, LLC.
The principals of Carey Station, LLC were members of the Reynolds family and were real estate developers. The Reynolds family held the Easement Tract as part of a much larger tract acquired in 2003 by the Reynolds family (the "Carey Tract"). The Reynolds family had hoped to develop the Carey Tract.
Originally, the Reynolds family had held the Carey Tract and the surrounding acreage and made extensive efforts to either develop the Carey Tract themselves or, when they eventually ran out of cash, they attempted unsuccessfully to find a joint venture partner that would provide the capital to assist them in developing a "master infrastructure" for the Carey Tract, including roads and sewer facilities.
During these intervening years (between 2007 and 2014), the Reynolds family approached different venture capital groups with no success. At times, the Reynolds family sold small tracts from the larger Carey Tract, usually to buyers who would acquire adjoining tracts with a view to facilitating amenities that would be synergistic with the Reynolds' larger development ideas. For example, the Reynolds family sold portions of the Carey Tract for the construction of a fire station, a church, a school, a skilled nursing/assisted-living facility and a residential community. In all these cases, the Reynolds reported their profits from the sales as ordinary income on their own tax returns.
In 2014, the Reynolds family formed Carey Station, LLC and contributed to it 980 acres of the Carey Tract. They then unsuccessfully attempted to sell the Carey Station property at prices between $6.7 Million and $7.9 Million.
After the Reynolds family became frustrated with their attempts to find a joint venture partner or to sell the Carey Tract, they decided to form a syndicated conservation easement joint venture for the Cary Tract. The idea was for the Reynolds family to sell units in a newly-formed syndicated joint venture partnership that would provide the buyers with a $1.00 charitable contribution deduction for every $4.35 paid by the buyers.
The Reynolds family wanted to generate almost $7 Million in proceeds from the sale of partnership units. This required that the Oconee joint venture secure a valuation of over $60 million for the Carey Station property. However, the Reynolds family had been unsuccessful in finding potential buyers willing to pay more than $7 million for the entire easement tract. Ultimately, Oconee secured a valuation of the Carey Tract at almost $60 Million.
The Reynolds family decided to "carve out" 82 acres from the Carey Tract and retain ownership of that acreage in Carey Station, LLC. This reduced the Carey Tract to 874 acres. The Reynolds family ultimately caused Carey Station to contribute only 355 acres to the Oconee,,LLC, the new syndicated easement venture, and Carey Station kept the remaining acres. The appraisers valued the contributed property at around $60,000 per acre.
After contributing the 355 acres to Oconee, LLC, Carey Station, LLC received 95% of the Oconee units which it then sold to investors for $3.7 Million, a valuation far less than at $60,000 per acre.
The Tax Court struck down the charitable contribution deduction on numerous grounds.
First, the Tax Court held that the Easement Tract (the 355 acres) had been "inventory" in the hands of Carey Station, LLC that had contributed the Easement Tract to the Oconee, LLC syndicated easement joint venture, which meant that Oconee's charitable deduction would be limited to Oconee's adjusted tax basis in the Easement Tract.
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