Tax





IRS LTR: Foundation's Website Is a Periodical.

The IRS ruled that a private operating foundation’s website that publishes material that used to be in the organization’s now-defunct print publication is a periodical for purposes of the unrelated business income tax cost allocation rules.

Contact Person: * * *

Identification Number: * * *

Contact Number: * * *

FAX Number: * * *

Uniform Issue List: 511.00-00, 512.05-00

Release Date: 1/31/2013

Date: November 8, 2013

Employer Identification Number: * * *

Dear * * *:

This is in response to the ruling request dated November 21, 2011, submitted by your authorized representative regarding whether your website constitutes a “periodical” for purposes of the unrelated business income tax costs allocation rules of section 1.512(a)-1(f) of the Income Tax Regulations.

FACTS

You are an organization described in section 501(c)(3) of the Code. You are classified as a private operating foundation described in section 4942(j)(3), operated for educational purposes.

For several years your primary activity has been publishing an educational magazine. Originally, you published a print version every other month. More recently, to reduce costs and increase readership, you discontinued the print version and now publish the content exclusively on your website, free of charge. The website includes essentially the same kind of content, addressing the same or similar subjects that appeared in the print version of the magazine. The website contains all of the material available in the former print version, plus new features such as documentary videos that can only exist in an online form. All past articles are archived and searchable on your website. You represent that the website is updated regularly, at least weekly. It appears from recent posts on the website that it is updated ordinarily every business day. Each article shows its publication date.

Although you receive grants and contributions, you are supported, in part, by advertising revenues. You employ and/or contract with writers, researchers, a creative director and an editorial director to produce the editorial content of the website (as you did for the print magazine). You also incur expenses for website maintenance and overall administration.

LAW

Section 511 of the Code imposes a tax on the unrelated business taxable income of exempt organizations described in section 501(c).

Section 512(a)(1) of the Code defines the term “unrelated business taxable income” as the gross income derived by any organization from any unrelated trade or business regularly carried on by it, less the allowable deductions which are directly connected with the carrying on of such trade or business, both computed with the modifications provided in section 512(b).

Section 513(a) of the Code defines the term “unrelated trade or business” as any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its exempt purpose or function.

Section 513(c) of the Code provides that the term “trade or business” includes any activity, which is carried on for the production of income from the sale of goods or the performance of services.

Section 1.512(a)-1(d)(1) of the regulations provides, in pertinent part, that in certain cases, gross income is derived from an unrelated trade or business which exploits an exempt activity. One example of such exploitation is the sale of advertising in a periodical of an exempt organization which contains editorial material related to the accomplishment of the organization’s exempt purpose. Except as specified in subparagraph (2) of this paragraph and paragraph (f) of this section, in such cases, expenses, depreciation and similar items attributable to the conduct of the exempt activities are not deductible in computing unrelated business taxable income.

Section 1.512(a)-1(d)(2) of the regulations provides, in pertinent part, that where unrelated trade or business activity is of a kind carried on for profit by taxable organizations and where the exempt activity exploited by the business is a type of activity normally conducted by taxable organizations in pursuance of such business, expenses, depreciation and similar items which are attributable to the exempt activity qualify as directly connected with the carrying on of the unrelated trade or business activity.

Section 1.512(a)-1(f) of the regulations provides that under section 513 and 1.513-1, amounts realized from the sale of advertising in a periodical constitute gross income from an unrelated trade or business activity involving the exploitation of an exempt activity, namely the circulation and readership of the periodical developed through the production and distribution of the readership content of the periodical. Thus, subject to the limitations of paragraph (d)(2) of this section, where the circulation and readership of an exempt organization periodical are utilized in connection with the sale of advertising in the periodical, expenses, depreciation, and similar items of deductions attributable to the production and distribution of the editorial or readership content of the periodical shall qualify as items of deductions directly connected with the unrelated advertising activity. Subparagraphs (2) through (6) of this paragraph provide rules for determining the amount of unrelated business taxable income attributable to the sale of advertising in exempt organization periodicals.

Section 1.513-4 of the regulations provides rules for qualified sponsorship payments, and excepts from such rules the income from the sale of advertising or acknowledgements in exempt organization periodicals. A “periodical” is defined as regularly scheduled and printed material published by or on behalf of an exempt organization that is not related to and primarily distributed in connection with a specific event conducted by the organization. For this purpose, printed material includes material that is published electronically.

In section 1.513-4(f) of the regulations, Example 11, W, a symphony orchestra, maintains a Web site containing pertinent information and its performance schedule. The Music Shop makes a payment to W to fund a concert series, and W posts a list of its sponsors on its Web site, including the Music Shop’s name and Internet address. W’s Web site does not promote the Music Shop or advertise its merchandise. The Music Shop’s Internet address appears as a hyperlink from W’s Web site to the Music Shop’s Web site. W’s posting of the Music Shop’s name and Internet address on its Web site constitutes acknowledgment of the sponsorship. The entire payment is a qualified sponsorship payment, which is not income from an unrelated trade or business.

In section 1.513-4(f) of the regulations, Example 12, X, a health-based charity, sponsors a year-long initiative to educate the public about a particular medical condition. A large pharmaceutical company manufactures a drug that is used in treating the medical condition, and provides funding for the initiative that helps X produce educational materials for distribution and post information on X’s Web site. X’s Web site contains a hyperlink to the pharmaceutical company’s Web site. On the pharmaceutical company’s Web site, the statement appears, “X endorses the use of our drug, and suggests that you ask your doctor for a prescription if you have this medical condition.” X reviewed the endorsement before it was posted on the pharmaceutical company’s Web site and gave permission for the endorsement to appear. The endorsement is advertising. The fair market value of the advertising exceeds 2% of the total payment received from the pharmaceutical company. Therefore, only the portion of the payment, if any, that X can demonstrate exceeds the fair market value of the advertising on the pharmaceutical company’s Web site is a qualified sponsorship payment.

ANALYSIS

Advertising income derived by exempt organizations in connection their periodicals is subject to the tax on unrelated business income. As noted above, rules for the determination of unrelated business taxable income derived from the sale of advertising in exempt organization periodicals are contained in section 1.512(a)-1(f) of the regulations.

Section 1.513-4 of the regulations holds that the term periodical means regularly scheduled and printed material published by or on behalf of an exempt organization that is not related to and primarily distributed in connection with a specific event conducted by the exempt organization, and for this purpose, printed material includes material that is published electronically. In section 1.513-4(f), Examples 11 and 12, the rules for qualified sponsorship payments rather than periodical advertising were applied to the exempt organization’s website, indicating that a website is ordinarily not regarded as a periodical. In your case, however, you argue for treatment of your website as a periodical so that you may use your excess readership costs to offset your advertising income like commercial publications do.

We agree. Your primary purpose and function is to publish educational information, which you do on the website. Your prior print periodical has in effect moved onto the website. The website is operated similarly to that of many newspapers and magazines with an online presence, with new material published regularly and old content also readily available. Under the circumstances, the website serves the function of a traditional periodical and should be treated as such.

RULING

Based on your representations, we rule that your website meets the definition of the term “periodical” which appears at section 1.513-4 of the regulations. Thus, the website constitutes a periodical for purposes of the unrelated business income tax cost allocation rules of section 1.512(a)-1(f).

This ruling is based on the understanding that there will be no material changes in the facts upon which it is based.

Except as specifically ruled upon above, no opinion is expressed concerning the federal income tax consequences of the transactions described above under any other provision of the Code.

Pursuant to a Power of Attorney on file in this office, a copy of this letter is being sent to your authorized representative. A copy of this letter should be kept in your permanent records.

If there are any questions about this ruling, please contact the person whose name and telephone number are shown in the heading of this letter.

Sincerely,

Theodore R. Lieber

Manager, EO Technical Group 3

Citations: LTR 201405029




IRS Withdraws, Reissues Proposed Regs on UBTI Determinations for Some Exempt Organizations.

The IRS has withdrawn proposed regulations published in 1986 and reissued proposed regulations that provide guidance on how some exempt organizations providing employee benefits must calculate unrelated business taxable income. (REG-143874-10)

http://www.gpo.gov/fdsys/pkg/FR-2014-02-06/pdf/2014-01625.pdf




IRS LTR: Organization Formed to Promote Conservation Easements Loses Exemption.

The IRS revoked the tax-exempt status of an organization established to encourage the donation of conservation easements after concluding the organization operated as a conduit for its president — a CPA — to help the president’s clients obtain sizable deductions.

Person to Contact/ID Number: * * *

Contact Numbers:

Telephone: * * *

Fax: * * *

UIL Code: 501.03-00

Release Date: 1/31/2014

Date: February 18, 2009

Taxpayer Identification Number: * * *

Form: * * *

Tax Year(s) Ended: * * *

LEGEND:

ORG = * * *

ADDRESS = * * *

Dear * * *:

We have enclosed a copy of our report of examination explaining why we believe revocation of your exempt status under section 501(c)(3) of the Internal Revenue Code (Code) is necessary.

If you accept our findings, take no further action. We will issue a final revocation letter.

If you do not agree with our proposed revocation, you must submit to us a written request for Appeals Office consideration within 30 days from the date of this letter to protest our decision. Your protest should include a statement of the facts, the applicable law, and arguments in support of your position.

An Appeals officer will review your case. The Appeals office is independent of the Director, EO Examinations. The Appeals Office resolves most disputes informally and promptly. The enclosed Publication 3498, The Examination Process, and Publication 892, Exempt Organizations Appeal Procedures for Unagreed Issues, explain how to appeal an Internal Revenue Service (IRS) decision. Publication 3498 also includes information on your rights as a taxpayer and the IRS collection process.

You may also request that we refer this matter for technical advice as explained in Publication 892. If we issue a determination letter to you based on technical advice, no further administrative appeal is available to you within the IRS regarding the issue that was the subject of the technical advice.

If we do not hear from you within 30 days from the date of this letter, we will process your case based on the recommendations shown in the report of examination. If you do not protest this proposed determination within 30 days from the date of this letter, the IRS will consider it to be a failure to exhaust your available administrative remedies. Section 7428(b)(2) of the Code provides, in part: “A declaratory judgment or decree under this section shall not be issued in any proceeding unless the Tax Court, the Claims Court, or the District Court of the United States for the District of Columbia determines that the organization involved has exhausted its administrative remedies within the Internal Revenue Service.” We will then issue a final revocation letter. We will also notify the appropriate state officials of the revocation in accordance with section 6104(c) of the Code.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate assistance is not a substitute for established IRS procedures, such as the formal appeals process. The Taxpayer Advocate cannot reverse a legally correct tax determination, or extend the time fixed by law that you have to file a petition in a United States court. The Taxpayer Advocate can, however, see that a tax matter that may not have been resolved through normal channels gets prompt and proper handling. You may call toll-free 1-877-777-4778 and ask for Taxpayer Advocate Assistance. If you prefer, you may contact your local Taxpayer Advocate at:

* * *

If you have any questions, please call the contact person at the telephone number shown in the heading of this letter. If you write, please provide a telephone number and the most convenient time to call if we need to contact you.

Thank you for your cooperation.

Sincerely,

Renee B. Wells

Acting Director, EO Examinations

Enclosures:

Publication 892

Publication 3498

Report of Examination

* * * * *

LEGEND:

ORG = Organization name

EIN = ein

XX = Date

State = state

Agent = agent

President = president

RA-1 & RA-2 = 1st & 2nd RA

CO-1 THROUGH CO-5 = 1st THROUGH 5TH COMPANIES

PRIMARY ISSUE

Whether the IRC Section 501(c)(3) tax exempt status of ORG should be revoked because it is not operated exclusively for tax exempt purposes.

FACTS

ORG (the “Organization” or “ORG”) was incorporated in the State of State on October 16, 20XX. The purposes of the Organization as stated in the Articles of Incorporation are “exclusively for charitable, educational, religious or scientific purposes, within the meaning of Section 501(c)(3) of the Internal Revenue (or corresponding section of any future Federal tax code).”

The Articles state that the Organization will not have members. The Articles contain a proper dissolution clause and address the prohibition on political activity and limited legislative activity in a general way by stating that the Organization shall not carry on any activities that are not allowed by a section 501(c)(3) organization.

The Bylaws do not contain a stated purpose for the Organization. The Bylaws do state that there shall be four initial board members and that number may increase or decrease at the Board’s discretion. The Bylaws call for regular meetings, at a time and place to be determined by the Board. Officers of the corporation are chosen by the Board and consist of a President, Vice President, Treasurer, and Secretary. The Bylaws further state that at each annual meeting, the Board would pick the officers for the coming year.

The Bylaws further address the fact that the President, initially and currently President, Certified Public Accountant, would be the chief executive and administrative officer of the corporation. The President may execute all deeds, bonds, mortgages and conveyances in the name of the Organization.

President was the Organization’s sole incorporator, was and is a member of the board of directors and has served as president since the Organization’s inception. President solicits and receives all cash and non-cash contributions from donors and operates the Organization at his own discretion.

President is a member of the American Institute of Certified Public Accountants and a member of the State Association of Certified Public Accountants. President’ vast knowledge and experience in the field of public accounting is demonstrated in his being one of less than 250 non-lawyers, nationwide, to be admitted to practice before the United States Tax Court.

Beginning in 20XX President has been a member of the State State Board of Certified Public Accountant Examiners, which is the governing body for licensing certified public accountants in State. President was the president of this organization during 20XX-20XX, and was again elected president for the organization in 20XX. President is a current member of the executive committee and is a former member of the Professional Standards Committee.

President is a member of the State General Assembly’s Revenue Laws Study Committee, and is a member of the Ethics committee of the National Association of state Boards of Accountancy.

The Organization, through President, applied for tax exempt status under section 501(a) of the Internal Revenue Code as an organization described in section 501(c)(3) on October 20, 20XX. In the Application for Recognition of Exemption filed with the Internal Revenue Service (the “Service”), the corporation stated that the purpose of the Organization was to accept, hold and enforce conservation easements. It also stated that it was concentrating on getting hunting clubs to donate conservation easements. Financial support was to come from contributions made by the general public and from contributions received from donors of conservation easements.

On November 24, 20XX, the Organization was issued a Determination Letter stating that the Organization was found to be exempt from federal income tax under section 501(a) of the Internal Revenue Code as an organization described in section 501(c)(3). As a newly formed organization, the Service did not make a final determination of foundation status, but did determine that the Organization would be treated as a publicly supported organization as described in sections 509(a)(1) and 170(b)(1)(A)(vi). The advance ruling period was to run from October 16, 20XX to May 31, 20XX.

The Determination Letter further states that if after the advance ruling period ends the organization does not meet the public support requirements, then the organization will be classified as a private foundation for future periods. The Determination Letter also states that if the organization is classified as a private foundation, the organization will be treated as a private foundation from its beginning date for purposes of sections 507(d) and 4940 of the Code.

Form 8734, Support Schedule for Advance Ruling Period, was received from President on May 29, 20XX. On the form, President calculated the public support percentage under section 509(a)(1) as * * *% and under section 509(a)(2) as * * *%.

An interview was conducted with President on January 3, 20XX. In that interview President stated that the purpose of the Organization was to accept, hold and enforce conservation easements. The objective from the Organization’s beginning was to convince owners of hunting land to make conservation easement donations to protect the land in a relatively natural state.

During the January 3, 20XX interview, President was unclear as to why the idea of donating conservation easements began. He stated that he came up with the idea to start ORG after conducting some research. At first he approached a conservation organization that accepted conservation easements, but that did not go through because that organization wanted too much control over the land and wanted $* * * as a contribution. It was at that time that President decided to start ORG.

President performs all of the baseline studies and performs all of the annual inspections of each property. During the January 3, 20XX interview, President acknowledged that he has not received any specialized training or even general training in any area relating to the accurate or general analysis of land, conservation aspects relating to a potential donation or any area relating to the environment. President further acknowledged in the January 3, 20XX interview that he does not possess any specialized experience that would qualify him to perform these studies and inspections. However, he believes that the studies and inspections conform to the law as written.

During the January 3, 20XX interview, President acknowledged that contrary to what is required in the Organization Bylaws, there have not been any meetings of the Board of Directors since the initial meeting to start the corporation. Whereas the Organization Bylaws call for annual appointment of officers, the officers have remained the same since the Organization’s inception in 20XX. There is no indication that any of the board members have special expertise or training in the area of environmental conservation.

During the January 3, 20XX interview, President acknowledged that the Organization has never solicited contributions from the general public, does not perform any educational services, does not produce any brochures or newsletters describing the Organization’s purpose and has little activity with regard to acquiring conservation easements. The Organization uses printed materials distributed by the Land Trust Alliance, a national conservation organization, for the purpose of providing information to prospective conservation easement donors.

From the Organization’s inception in 20XX, through January, 20XX, the Organization has received two conservation easements and one outright property transfer. The first conservation easement received was donated by CO-1. (CO-1) on December 31, 20XX.

CO-1:

During the January 3, 20XX interview, President stated that at one time he hunted on the CO-1 land as a guest of two members. Due to health concerns, President stopped hunting on the land sometime before he created ORG. President prepares the annual tax returns for two of the partners of CO-1. At the time that he created this Organization, and for the year that the donation was made from CO-1 to the Organization, he did not prepare the CO-1 partnership return. President did prepare the CO-1 partnership return for the year after the donation was made.

The CO-1 covers 1807 acres of forested land located near the coast of State and was granted in perpetuity. CO-1 is a partnership of sixteen individuals who use the land exclusively for hunting.

The land has been used for hunting for generations and the intention is to keep the land in a natural state to continue hunting. The stated purpose of the conservation easement is “to assure that the Protected Property will be retained in perpetuity predominately in its natural, scenic, and open condition, as evidenced by the Report.”

The easement does not allow public access and the recreational hunting is for members only. The easement does not allow any building on the property except for a 20XX square foot shed. Dividing or sub-dividing is not allowed. The grantor does have the right to convey easements and rights of way over and across roads and easements, to include the conservation easement.

Under grantor’s reserved rights, the grantor is allowed to lease the Property for any use permitted under the easement. The grantor is also allowed to build and maintain one dock for use by the grantor and can have two burrow pits, not to exceed two acres each. The burrow pits would be used for providing fill material for road repair on the property. The grantor is permitted to construct a well at the dock and at the storage shed and has the right to develop and maintain those water resources and wetlands necessary for wildlife, private recreation, farming, and other agricultural uses permitted under the easement.

The grantor is also given the right to engage in not-for-profit and for-profit agricultural, farming, and aqua cultural activities. The grantor is allowed to construct and maintain watering facilities and ponds and can encumber the property with agricultural easements to meet their agricultural objectives. The grantor can use agrichemicals to accomplish agricultural and residential activities permitted by the easement. To the extent that the property is restored back to its natural state, the grantor reserves the right to extract minerals, gases, oil, and other hydrocarbons.

During the January 3, 20XX interview, President expressed surprise at the favorable rights retained by the donor. He stated that CO-1 attorney prepared the conservation easement deed document and that he did not review it prior to his signing for the Organization.

The first appraisal of the property was performed by CO-2, certified land appraisers in State. That appraisal valued the conservation easement at $* * *. President stated in the January 3, 20XX interview that he requested that CO-1 obtain a second appraisal because he thought the appraised value was too high. A second appraisal of the land was performed by CO-3, certified land appraisers in State. The second appraisal was performed on February 5, 20XX and the appraised value of the conservation easement was $* * *.

The baseline study for the CO-1 was conducted by President on December 28, 20XX. The baseline study is a one page document that states that the only man-made structures on the property are deer stands, feeders, foot bridges and fiber glass wraps around some trees. It also describes the trails on the property, the one main access road and it also states that there are no recent signs of timber cutting. Attached to the baseline study is a hand drawn map. This map does not set forth the boundaries of the property, or provide any descriptive information beyond identifying fields, trails and a duck pond. The baseline study does not meet the requirements imposed in the Treasury Regulations.

The conservation easement deed states that “the specific conservation values of the Protected Property on the date of this easement are documented in the Baseline Documentation Report.” The deed further states that both “parties agree the Report provides an accurate representation of the Protected Property and the condition of the same as of the date of this Easement as required by Treasury Reg. 1.170A-14(g)(5), and is intended to serve as an objective informational baseline for monitoring compliance with the terms of this easement.”

President signed the Form 8283 acknowledging the donee’s gift, sent the required gift acknowledgement letter and has performed annual monitoring of the property. The monitoring reports consist only of written statements referencing the lack of changes on the property. The reports do not reference the baseline study and do not mention specific findings of any kind.

In a meeting at the property with Revenue Agent Agent, President had trouble identifying the exact or approximate boundaries of the property encumbered by the easement. In a January, 20XX meeting at the property between this agent and President, he appeared to be familiar with the boundaries, even though they were not marked in any way.

The CO-1 partnership tax return for the year ended December 31, 20XX was examined by the Small Business/Self-Employed Division of the Internal Revenue Service and it was determined that the conservation easement had zero value as the proposed plan to build on the property was severely flawed. The entire deduction for the conservation easement was denied. CO-1 acknowledged the Service’s findings and signed an agreement with the Service as to the Service’s determinations. Subsequent to the Service’s findings and CO-1 agreement, CO-1 requested that the conservation easement donated to the Organization be returned.

CO-4 Property Transfer:

The second transaction that the Organization conducted was the acceptance of 12.624 acres of land donated by CO-4. (CO-4) on December 18, 20XX. In a letter from CO-4 to the Organization, dated November 26, 20XX * * * stated that his group was interested in donating 12.8 acres of land to the Organization. The letter did not mention the term conservation easement.

Per the Warranty Deed, the purpose of the conveyance was to ensure that the land is utilized for conservation purposes as defined in section 170(h)(4) of the Internal Revenue Code.

During the January 3, 20XX interview, President was asked about this transaction in relation to the Organization’s stated purpose of receiving conservation easements. President stated that he was unsure how the Organization received the entire property instead of just a conservation easement. He stated that there was a miscommunication between the donor and himself. President believed this transaction was to be a conservation easement donation and was surprised when he received the Warranty Deed showing a complete transfer of the property.

President, in his capacity of Certified Public Accountant, prepares the annual tax returns for one of the two partners in CO-4. For 20XX he received $* * * for that service. President performed the baseline study and it is composed of a single piece of paper with one paragraph describing the land. The paragraph states; “The land upon which the conservation easement was given to ORG by CO-4 * * * is in a natural wooded state, with no signs of recent timbering, and no man made structures.” Just as was the case with the CO-1, the baseline study for CO-4 does not meet the standards imposed in the Treasury Regulations.

President signed the Form 8283 and on February 20, 20XX, President sent CO-4 the required donor acknowledgement letter. In that letter he acknowledged receiving the land and $* * * as a cash donation for performing inspections and enforcing the easement. As this transaction was for the transfer of the entire property and not just a conservation easement, President was asked in a telephone interview, on or about May 15, 20XX, why CO-4 provided a contribution for inspections and enforcement. President had no answer.

In a May 28, 20XX letter from President to the examining agent, President stated that “there are no written inspection reports. I often go by this property when riding my bicycle, but never made notes about it. The important thing is nothing has been disturbed.” This admission is in stark contrast to the requirements for annual monitoring and inspection reports. With no reports of any kind, there is no way to tell if the property has been disturbed since the original baseline study was completed.

CO-5 Conservation Easement:

The third and final transaction for the Organization for the period of October, 20XX through January, 20XX was the acceptance of a conservation easement consisting of 1.52 acres donated by CO-5 (CO-5) on December 30, 20XX.

President, in his capacity as Certified Public Accountant, prepares the annual tax return for one of the two partners in CO-5. For 20XX, he received $* * * for those services.

The only baseline documentation provided by President is a one page, unsigned and undated document that was attached as exhibit “A” to the conservation easement deed. The document states that the easement area is currently vacant land and consists of undeveloped wetlands, woodlands and vegetation. It further states that no disturbances nor construction is anticipated nor allowed within the easement area. As is the case with the baseline documentation for the first two transactions the Organization entered into, the baseline documentation for this transaction fails to meet the standards imposed in the Treasury Regulations.

The conservation deed states that the characteristics of the property, its current use and state of improvement are described in Exhibit “A,” and that Exhibit “A” is the appropriate basis for monitoring compliance with the objectives of preserving the conservation and water quality values.

The conservation easement deed does not contain a specific conservation purpose, but rather uses a broad approach by stating that; “The property shall be maintained in its natural, scenic, wooded and open condition and restricted from any development or use that would impair or interfere with the conservation purposes of this conservation easement set forth above.”

The wording of the preceding paragraph indicates that the Organization could intend the conservation easement to cover both; 1) Protection of a significant relatively natural habitat in which a fish, wildlife, or plant community, or similar ecosystem normally lives, and 2) The preservation of open space.

Article III of the conservation easement deed stipulates that there will be no industrial, commercial or residential use. There will be no agricultural, timber harvesting, grazing or horticultural uses permitted. The vegetation is not to be disturbed and there is to be no mining, excavation or dredging. There shall be no diking, draining or other alteration of the land that would be detrimental to water purity or alter the natural water levels or drainage.

There is to be no dumping, construction or any disturbance of natural features. There are to be no signs unless said signs relate to; no trespassing signs, signs identifying the conservation values of the property, signs giving directions or proscribing rules for use of the land.

The conservation easement deed does not mention public access or any restriction to public access. The abbreviated baseline study does not address this area, and there is no indication as to what access is allowed or not allowed.

The grantee is allowed to prevent any activity which is not consistent with the purposes of the easement. The grantee is allowed to inspect the property to determine if any violations have occurred. If enforcement is necessary to correct a violation, the grantor agreed to bear the cost of enforcing the terms of the easement to include any restoration necessary.

President provided a letter dated May 26, 20XX which was addressed to RA-1 and RA-2 that acknowledged the CO-5 conservation easement donation and receipt of $* * * from each party.

On January 3, 20XX, at the initial meeting between President and this agent, President was unable to provide the baseline study for either the CO-4 donation or for the CO-5 easement. He also could not produce the Form 8283 for either donation. He stated that he would have to get a copy of those documents from the donors.

President was asked by this agent on several occasions from January 3, 20XX through mid-May, 20XX to produce these documents and failed to do so until May 30, 20XX. President provided the excuse that he was too busy and had health issues. As of the issuance date of this report, the Form 8283 for CO-4 has not been provided and the Form 8283 provided for CO-5 shows that it was not signed by the Organization.

With regard to books and records, the Organization does not maintain any except for the bank statements for the Organization’s one account. President stated that with the limited transactions involved and with the low levels of income received, he didn’t see the need to maintain books and records that detail every transaction.

Specific Examination Findings

The Organization did not file Form 990, Return of Organization Exempt From Income Tax, for the tax years ending May 31, 20XX, 20XX, 20XX or 20XX. The reason supplied by President was that the income level was below the $25,000 threshold required for filing. The examination of the Organization covered the tax years ending May 31, 20XX and May 31, 20XX.

The financial documentation provided by President supports his claim that filing was not required for either year ending May 31, 20XX or 20XX. President submitted Form 8734, Support Schedule for Advance Ruling Period, and the information contained therein matched the financial information in the Organization bank statements. The information submitted by the Organization on Form 8734 is summarized below;

On the Form 8734 that President submitted he claims that the Organization qualifies for Foundation status of 509(a)(2). The form shows the public support percentage under section 509(a)(2), as calculated by President, as * * *%.

Calculation of Public Support under Section 509(a)(1) of the Code:

Total support received for the five year period from June 1, 20XX through May 31, 20XX, as reported by the Organization on Form 8734 was $$* * *. Two percent of total support equals $$* * *. There were four substantial contributors, all of whom contributed in excess of the $$* * * two percent threshold. Therefore, the percentage of public support to total support is zero. Subsequently, the Organization fails to qualify for foundation status under section 509(a)(1) of the Code.

Calculation of Public Support under Section 509(a)(2) of the Code:

Total support received for the five year period from June 1, 20XX through May 31, 20XX, as reported by the Organization on Form 8734 was $$* * *. Of that amount $$* * * came from interest income and $$* * * came from substantial contributors. Neither of those sources of income qualifies for public support, and as such the percentage of public support to total support is zero. Subsequently, the Organization fails to qualify for foundation status under section 509(a)(2) of the Code.

The Organization does not include any non-cash contributions on the form 8734. That stance is consistent with the lack of reporting conservation easements as assets on the Form 990.

LAW

IRC § 501(c)(3) exempts from Federal income tax: corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting to influence legislation and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of any candidate for public office.

Treasury Regulation § 1.501(c)(3)-1(c)(1) provides that an organization will be regarded as “operated exclusively” for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in § 501(c)(3). An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.

Treasury Regulation § 1.501(c)(3)-1(c)(2) provides that an organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals. The words “private shareholder or individual” refer to persons having a personal and private interest in the activities of the organization per Treas. Reg. sec. 1.501(a)-1(c)

Treasury Regulation § 1.501(c)(3)-1(d)(1)(ii) provides an organization is not organized or operated exclusively for one or more exempt purposes unless it serves a public rather than a private interest. Thus, to meet the requirement of this subdivision, it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.

Treasury Regulation 1.170A-14(c) provides that to be considered an eligible donee, an organization must be a qualified organization, have a commitment to protect the conservation purposes of the donation, and have the resources to enforce the restrictions. For purposes of this section, the term qualified means:

(i) a governmental unit described in section 170(b)(1)(A)(v);

(ii) An organization described in section 170(b)(1)(A)(vi);

(iii) A charitable organization described in section 501(c)(3) that meets the public support test of section 509(a)(2);

(iv) A charitable organization described in section 501(c)(3) that meets the requirements of section 509(a)(3) and is controlled by an organization described in paragraphs (c)(1)(i), (ii), or (iii) of this section.

Treasury Regulation 1.170A-14(d)(2) provides that a donation to preserve land areas for the outdoor recreation of the general public or for the education of the general public will meet the conservation purposes of this section. The preservation of land areas for recreation or education will not meet the test of this section unless the recreation or education is for the substantial and regular use of the general public.

Treasury Regulation 1.170A-14(d)(3), Protection of environmental system — provides that the donation of a qualified real property interest to protect a significant relatively natural habitat in which fish, wildlife, or plant community, or similar ecosystem normally lives will meet the conservation purposes of this section. Alteration of the land will not result in a deduction being denied under this section if the fish, wildlife, or plants continue to exist there in a relatively natural state. The example provided in this section refers to land alteration that is allowed if the lake or pond were a nature feeding area for a wildlife community that included rare, endangered, or threatened native species. This section allows for the denial of public access.

Treasury Regulation 1.170(A)-14(d)(4), Preservation of open space — provides that the donation of a qualified real property interest to preserve open space will meet the conservation purposes test of this section if such preservation is:

(A) Pursuant to a clearly delineated federal, state, or local government conservation policy and will yield a significant public benefit, or

(B) For the scenic enjoyment of the general public and will yield a significant public benefit.

Treasury Regulation 1.170(A)-14(d)(4)(B) — Illustrations, The preservation of an ordinary tract of land would not in and of itself yield a significant public benefit, but the preservation of ordinary land areas in conjunction with other factors that demonstrate significant public benefit or the preservation of a unique land area for public enjoyment would yield a significant public benefit.

Treasury Regulation 1.170(A)-14(g)(5) — Protection of conservation purpose where taxpayer reserves certain rights. In the case of a donation made after February 13, 1986, of any qualified real property interest when the donor reserves rights the exercise of which may impair the conservation interests associated with the property, for a deduction to be allowable under this section the donor must make available to the donee, prior to the time the donation is made, documentation sufficient to establish the condition of the property at the time of the gift. Such documentation is designed to protect the conservation interests associated with the property, which although protected in perpetuity by the easement, could be adversely affected by the exercise of the reserved rights. Such documentation may include:

(A) The appropriate survey maps from the United States Geological Survey, showing the property line and other contiguous or nearby protected areas;

(B) A map of the area drawn to scale showing all existing man-made improvements or incursions (such as roads, buildings, fences, or gravel pits), vegetation and identification of flora and fauna (including, for example, rare species locations, animal breeding and roosting areas, and migration routes), land use history (including present uses and recent past disturbances), and distinct natural features (such as large trees and aquatic areas);

(C) An aerial photograph of the property at an appropriate scale taken as close as possible to the date the donation is made; and

(D) On-site photographs taken at appropriate locations on the property. If the terms of the donation contain restrictions with regard to a particular natural resource to be protected, such as water quality or air quality, the condition of the resource at or near the time of the gift must be established. The documentation, including the maps and photographs, must be accompanied by a statement signed by the donor and a representative of the donee clearly referencing the documentation and in substance saying “This natural resources inventory is an accurate representation of [the protected property] at the time of the transfer.”.

In Better Business Bureau v. United States, 326 U.S. 279 (1945), the United States Supreme Court held that regardless of the number of truly exempt purposes, the presence of a single substantial non-exempt purpose will preclude exemption under section 501(c)(3).

In Benedict Ginsberg and Adele W. Ginsberg v. Commissioner, 46 T.C. 47 (1966), the United States Tax Court held that the organization used its funds primarily to foster private interests and the benefit to the general public was only incidental. As such, the organization was denied exemption under section 501(c)(3).

In Charles Glass et ux. v. Commissioner, 124 T.C. 16 (2005), the United States Tax Court held that the conservation easement was donated exclusively for conservation purposes. The Tax Court also stipulated that the donee organization operated at arms length and was a qualified organization.

In Turner v. Commissioner, 126 T.C. 16 (2006), The United Sates Tax Court held that the voluntary restriction to develop less land in and of itself does not meet the qualifications necessary for a charitable deduction. To be a qualified conservation contribution under section 170(h)(1), the conservation easement has to be exclusively for conservation purposes.

In Rev. Rul. 70-186 it was held that the organization was exempt from Federal income tax under section 501(c)(3) of the Code because the benefits derived from their activities flowed principally to the general public and benefits to private landholders did not lessen the public benefit received.

In Rev. Ruls. 76-204 and 78-384 it was held that the land must be “ecologically significant” and that preservation of ordinary farmland was not sufficient to justify charitable status.

GOVERNMENT’S POSITION

The IRC § 501(c)(3) tax exempt status of ORG and * * * (the “Organization”) should be revoked because it is not operated exclusively for tax exempt purposes.

The facts show that the Organization is not operated exclusively for a tax exempt charitable purpose. Rather, the Organization has operated as a conduit for President, CPA to help his clients obtain sizable deductions on their tax returns.

All three land transactions that the Organization has entered into were with entities that are in some way connected to President and his accounting practice. For CO-1, President prepared the annual tax returns for two of the sixteen partners. For CO-4, President prepared the annual tax returns for one of the two partners. For CO-5, President prepared the annual tax returns for one of the two partners.

This type of pattern is not coincidental. Instead it shows President’ intent and goals are not concerned with environmental or conservation issues, but rather that he has used the Organization as a vehicle for the enrichment of his clients. This type of private benefit runs counter to the requirements set forth in IRC Section 501(c)(3) with regard to private benefit.

President is considered an expert in the field of public accounting. This position is evidenced by his membership on at least one ethics committee, membership on a revenue laws study committee, and former membership on a professional standards committee, as well as being admitted to practice before the United States Tax Court. In addition, all of these qualifications demonstrate that President is an accountant who understands how to utilize the tax laws for the benefit of his clients.

In stark contrast to his vast experience and knowledge as a certified public accountant, President does not possess the knowledge, training or experience to make educated decisions on whether each conservation easement serves a conservation purpose under section 170(h)(4)(A).

Moreover, he has no expertise in valuing land for conservation purposes. He has acknowledged that he read a few articles and conducted some research on how an organization that accepts conservation easements should perform. The lack of knowledge and experience are strong indicators that the Organization does not possess the level of commitment required under section 1.170A-14(c) of the Treasury Regulations and is not operated a charitable purpose.

As is evidenced by his baseline documentation and inspection reports, President has chosen to follow his own path. Neither the baseline reports nor the inspection reports conform to the requirements set forth in the Treasury Regulations. These documents do not in any way provide the necessary information that the Organization would need to enforce the conservation easements received. These documents and the lack of substantial information contained therein show that the main concern of President was not the protection of open space or natural habitats, but the amount of deductions he could claim for his clients.

The baseline documentation for all three transactions consists of the barest of facts and is not substantiated by pictures, analysis, or expert opinion. There is no description of flora or fauna and each report contains a generic statement that references the natural characteristic of the land. President states that the baseline documentation is in accordance with Treasury Regulation 1.170A-14(g)(5) because the regulation uses the word “may” instead of “shall” with regard to what should be contained in a baseline report.

President reliance on performing the bare minimum with regard to the protection of conservation values is an indication that the Organization does not pursue conservationism as a primary goal. The lack of detail in the baseline studies shows that the Organization does not possess the level of commitment required under section 1.170A-14(c) of the Treasury Regulations.

The monitoring or annual inspection reports are less descriptive than the baseline documentation. The inspection reports for CO-1 contain one or two handwritten sentences that state that no changes were noted.

For CO-4, there are no inspection or monitoring reports. After several months of inquiring as to the inspection report whereabouts, President wrote that: “there are no written inspection reports. I often go by this property when riding my bicycle, but never made notes about it. The important thing is nothing has been disturbed.” This statement reflects the fact that monitoring for compliance was not and is not a top priority for President. This lack of vital documentation also demonstrates that the Organization does not possess the commitment necessary for accepting, holding and monitoring conservation easements.

For CO-5, the inspection reports are available but do not indicate what was done by President in the way of ensuring compliance. For the inspection visit on September 28, 20XX, the report states the following; “For sale sign on adjacent property. According to * * * only 2 buildings could be put on property. Called building inspector to make sure he knew of easement.” The inspection report for April 12, 20XX was extremely brief and stated; “Walked by property. OK.”

Baseline documentation reports and annual inspection reports that do not contain more descriptive information as to the type, quality or full description of the land as well as the boundaries, are indicators of an organization that is not operating for conservation or environmental purposes and do not meet the requirements of section 1.170(A)-14(g)(5) of the Treasury Regulations.

With the CO-1, President stated in the January 3, 20XX interview that he did not review the easement deed prior to signing. Since he did not read the document, he was unaware as to the rights granted and retained by the donor. President was unaware of the extensive rights retained by the donor until it was brought to his attention by this agent. This situation shows that President does not possess the knowledge, experience or willingness to follow the Treasury Regulations as written with regard to the commitment necessary. This situation also demonstrates a business practice that could be described as poor.

For the CO-4 transaction, President failed to secure a conservation easement deed, but instead received title to the land in its entirety. President has no explanation that would demonstrate how this transaction was a proper business practice for a conservation organization. What this transaction does demonstrate is President lack of experience, knowledge and willingness to act as a proper fiduciary for the Organization. Again, like the CO-1 transaction, President has failed to demonstrate the proper commitment required by section 1.170(A)-14(c) of the Treasury Regulations.

The Organization is not run as a section 501(c)(3) charitable organization. There are no financial records beyond what is contained in the bank statements. There are no solicitations from the general public for support, no receipts, no expense vouchers, and no balance sheets prepared at year end. Considering the fact that President is a certified public accountant, and is considered an expert in this field, this situation is disturbing at best, and at worst demonstrates that President has not been working in the best interests of the Organization.

Considering that the Organization has only received two conservation easements and one land transfer in four plus years shows that the commitment to perform as a conservation organization as described in the Treasury Regulations is not present.. There are no educational events developed and sponsored by the Organization. The Organization does not appear to hold itself out to the public as a charitable conservation organization, except through word-of-mouth, and of course, President’ clients.

The Organization has not been operated in accordance with the Organization Bylaws. There are no meetings of officers or board members, and there are no elections. In essence, President has sole control and is operating his own business under his own terms. There are no internal controls and only the bare minimum with regard to records and recordkeeping.

President’ lack of expertise in the area of conservation easements and the lack of detail in the baseline studies and inspection reports show that the Organization does not have clear established criteria for accepting easements, nor adequate procedures in place for enforcing the easements. President prepares the baseline studies and makes decisions on whether or not easements qualify as valid conservation easements. Neither of the two conservation easement deeds state exactly what the purpose of the easement is. Instead there are generic statements that do not provide a clear representation as to the purpose as stated under section 1.170(A)-14 of the Regulations. The Organization does not take the steps necessary to ensure that each easement accepted serves a conservation purpose under section 170(h)(4)(A) of the Code. There is no one associated with the Organization that has any formal education, training or expertise in conservation matters and it is not known whether the appraisers that appraised the donated easements had qualifications in valuing conservation easements. However, any mention of conservation purposes in the appraisals does not aid the Organization because no one on the Organization’s governing body has any formal education on conservation matters. The Organization’s monitoring activities (such as they are) cannot further a charitable purpose uner these circumstances where there is no knowledge as to whether the easements the Organization has accepted serve the conservation purposes under section 170(h)(4)(A). Moreover, there is no evidence that the Organization possesses sufficient resources to enforce easement restrictions in instances where any donor were to use an underlying property contrary to a conservation purpose.

The Organization fails to meet the requirements set forth in Regulation § 1.501(c)(3)-1(c)(1), in that it is not operated exclusively for an exempt purpose. More than an insubstantial part of its activities are the acceptance of conservation easements or property transfers for which there is not proper documentation. The organization has failed to establish that the acceptance of these easements furthers an exempt purpose under section 501(c)(3) of the Code. In short, ORG fails to operate for a charitable conservation purpose.

The Organization also fails to meet the requirements set forth in Regulation § 1.501(c)(3)-1(d)(1)(ii), in that they are not operated exclusively for one or more exempt purposes because it serves the private interests of President and his clients.

The presence of a single substantial non-exempt purpose precludes exemption under section 501(c)(3). See Better Business Bureau v. United States, 326 U.S. 279 (1945). This Organization exists not to serve the greater good of the general public, but rather fits the needs of President clients to have sizable deductions on their tax returns.

President, who is a certified public accountant, submitted Form 8734, Support Schedule for Advance Ruling Period and it was calculated incorrectly. On the form he calculated the public support percentage for foundation status 509(a)(1) as * * *% and for foundation status 509(a)(2) as * * *%. President failed to take into account that all monies that were received came from substantial contributors, which by definition are disqualified persons. Any income received from disqualified persons is excluded from the calculation of public support, both for 509(a)(1) and 509(a)(2).

When the monies received from substantial contributors is removed from the calculation, public support under both 509(a)(1) and 509(a)(2) equal zero. As such, the Organization can not be considered publicly supported and if revocation of exempt status is not pursued, reclassification to a private foundation should occur.

The first year under examination is the first year that the Organization operated, the fiscal year ending May 31, 20XX. The Organization’s status as an organization described under § 501(c)(3) should be revoked, effective October 16, 20XX, because it did not operate exclusively for exempt purposes. If revocation of exempt status is not upheld, then the Organization should be reclassified as a private foundation and be subject to Chapter 42 excise taxes.

TAXPAYER’S POSITION

The taxpayer wishes to keep its exempt status and believes its activities serve a significant public benefit with regard to preservation and conservation of natural land areas.

President also believes that if the Organization is reclassified to a private foundation based on not meeting the public support requirements, then the Organization would still be able to hold the conservation easements already in the Organization’s possession. President has stated that there is no mention in either the Code or the Treasury Regulations that would prohibit a private foundation from holding conservation easements that were acquired during an Organization’s advance ruling period.

CONCLUSION

The Organization is not being operated as an exempt IRC § 501(c)(3) organization. The charitable exempt status should be revoked effective October 16, 20XX.

ALTERNATIVE ISSUE #1

Should ORG be reclassified as a private foundation?

FACTS

President submitted Form 8734, Support Schedule for Advance Ruling Period, and the information contained therein matched the financial information in the Organization bank statements. The information submitted by the Organization on Form 8734 is summarized below;

On the Form 8734 that President submitted it purports that the Organization qualifies for Foundation status of 509(a)(2). The public support percentage as reflected on the form shows * * *%.

Calculation of Public Support under Section 509(a)(1) of the Code:

Total support received for the five year period from June 1, 20XX through May 31, 20XX, as reported by the Organization on Form 8734 was $$* * *. Two percent of total support equals $$* * *. There were four substantial contributors, all of whom contributed in excess of the $$* * * two percent threshold. Therefore, the percentage of public support to total support is zero. Subsequently, the Organization fails to qualify for foundation status under section 509(a)(1) of the Code.

Calculation of Public Support under Section 509(a)(2) of the Code:

Total support received for the five year period from June 1, 20XX through May 31, 20XX, as reported by the Organization on Form 8734 was $$* * *. Of that amount $$* * * came from interest income and $$* * * came from substantial contributors. Neither of those sources of income qualifies for public support, and as such the percentage of public support to total support is zero. Subsequently, the Organization fails to qualify for foundation status under section 509(a)(2) of the Code.

The Organization does not include any non-cash contributions on the form 8734. That stance is consistent with the lack of reporting conservation easements as assets on the Form 990.

LAW

IRC § 509 Private Foundation Defined:

509(a) GENERAL RULE — For purposes of this title, the term “private foundation” means a domestic or foreign organization described in section 501(c)(3) other than —

509(a)(1) an organization described in section 170(b)(1)(A) (other than in clauses (vii) and (viii));

509(a)(2) an organization which —

509(a)(2)(A) normally receives more than one-third of its support in each taxable year from any combination of —

509(a)(2)(A)(i) gifts, grants, contributions, or membership fees, and

509(a)(2)(A)(ii) gross receipts from admissions, sales of merchandise, performance of services, or furnishing of facilities, in an activity which is not an unrelated trade or business (within the meaning of section 513), not including such receipts from any person, or from any bureau or similar agency of a governmental unit (as described in section 170(c)(1)), in any taxable year to the extent such receipts exceed the greater of 5,000 or 1 percent of the organization’s support in such taxable year,

from persons other than disqualified persons (as defined in section 4946) with respect to the organization, from governmental units described in section 170(c)(1), or from organizations described in section 170(b)(1)(A) (other than in clauses (vii) and (viii)).

IRC § 170 Charitable, Etc., Contributions and Gifts:

170(b)(1)(A)(vi) an organization which normally receives a substantial part of its support (exclusive of income received in the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption from a governmental unit referred to in subsection or from direct or indirect contributions from the general public,

IRC § 4946: Definitions and Special Rules

4946(a) DISQUALIFIED PERSON. —

4946(a)(1) IN GENERAL — for purposes of this subchapter, the term “disqualified person” means, with respect to a private foundation, a person who is —

4946(a)(1)(A) a substantial contributor to the foundation,

Treasury Regulation § 1.507-6. Substantial contributor defined

(a) Definition

(1) In general. — the term “substantial contributor” means, with respect to a private foundation, any person (within the meaning of section 7701(a)(1)), whether or not exempt from taxation under section 501(a), who contributed or bequeathed an aggregate amount of more than $5,000 to the private foundation, if such amount is more than 2 percent of the total contributions and bequests received by the private foundation before the close of the taxable year of the private foundation in which a contribution or bequest is received by the foundation from such person.

GOVERNMENT’S POSITION

As set forth above, it is the government’s primary position that the tax exempt status of ORG should be revoked. Alternatively, ORG should be reclassified as a private foundation.

The Organization was created in 20XX and since that time has failed to meet the requirements for public support as outlined in the Code. The Organization has only received contributions from substantial contributors which by definition are disqualified persons. Public support does not include any receipts from disqualified persons as defined in IRC section 4946. As such, the Organization does not qualify for foundation status under sections 509(a)(1) or 509(a)(2) of the Code.

If revocation of exempt status is not achieved, then the Organization should be reclassified as a private foundation effective June 1, 20XX, the end of the advance ruling period, as it fails to qualify for any foundation status as described in section 509(a) of the Code.

TAXPAYER’S POSITION

President also believes that if the Organization is reclassified to a private foundation based on not meeting the public support requirements, then the Organization would still be able to hold the conservation easements already in the Organization’s possession. President has stated that there is no mention in either the Code or the Treasury Regulations that would prohibit a private foundation from holding conservation easements that were acquired during an Organization’s advance ruling period.

CONCLUSION

ORG does not qualify for tax exempt status under IRC section 501(a) as an organization described in section 501(c)(3) of the Code. The lack of any qualified exempt activity indicates that the Organization should not be allowed to continue as a tax exempt organization. Revocation of the tax exempt status of ORG is proposed with an effective date of October 16, 20XX.

Alternately, ORG should be reclassified as an organization that is a private foundation as defined in section 509(a) of the Code effective June 1, 20XX, the end of the advance ruling period.

A closing conference was held by telephone with President, president of ORG on July 28, 20XX

Citations: LTR 201405018




The First Amendment and the Parsonage Allowance: A Response.

Kenneth H. Ryesky responds to Edward A. Zelinsky’s article, making the case for allowing the parsonage exemption as socially beneficial to productivity.

To the Editor:

In his well-reasoned article regarding the constitutionality of the section 107 parsonage exemption, prof. Edward A. Zelinsky states that “as a matter of tax policy, there is a strong argument for taxing cash parsonage allowances.” (Prior coverage: Tax Notes, Jan. 27, 2014, p. 413 .)

There are also some strong policy arguments for exempting parsonage allowances from taxation.

Section 107 is part of IRC Subchapter B, Part III items specifically excluded from gross income. Other exclusions to be found in Part III include, but are not limited to, combat pay for military members (section 112), foster care payments for foster parents (section 131), and payments to adoptive parents to cover qualified adoption expenses (section 137).

There is practical reason to accord parsonage allowances a favored exemption from gross income. In 1909 the Country Life Commission, constituted by President Theodore Roosevelt, found the productivity of America’s farming sector to be dependent upon the functionality of its social systems, and further found that churches (of whatever denomination) played a key role in the vitality and productivity of the rural society. The commission specifically noted that:

There should be better financial support for the clergyman. In many country districts it is pitiably small. There is little incentive for a man to stay in a country parish, and yet this residence is just what must come about. Perhaps it will require an appeal to the heroic young men, but we must have more men going into the country pastorates, not as a means of getting a foothold, but as a permanent work. [Report of the Country Life Commission, S. Doc. No. 705, at 60-63 (60th Cong., 2d Sess., 1909).]

Generically favoring the provision of living quarters for clergy, without regard to the particular religion, can thus be justified on productivity grounds as socially beneficial. For similar reasons of productivity and morale, the military services commission chaplains as officers.

Kenneth H. Ryesky

Queens College CUNY

Jan. 28, 2014




Priest, Church Allowed to Intervene in Suit to Enforce Church Political Activity Restrictions.

A U.S. district court granted a priest and his church’s motion to intervene in an organization’s suit seeking declaratory and injunctive relief against the IRS for nonenforcement of section 501(c)(3) political campaign restrictions against churches and religious organizations.

FREEDOM FROM RELIGION FOUNDATION, INC.,

Plaintiff,

v.

JOHN KOSKINEN, COMMISSIONER OF THE INTERNAL REVENUE SERVICE,

Defendant.

UNITED STATES DISTRICT COURT

WESTERN DISTRICT OF WISCONSIN

DECISION AND ORDER

Section 501(c)(3) of the Internal Revenue Code exempts entities that are organized and operated exclusively for religious, charitable, scientific, or other specified purposes from having to pay federal income taxes. A condition of this exemption is that the entity not participate or intervene in any political campaign on behalf of, or in opposition to, any candidate for public office. 26 U.S.C. § 501(c)(3). The plaintiff in this case, the Freedom from Religion Foundation, alleges that the Internal Revenue Service has a policy of not enforcing this condition to tax-exempt status against churches and religious organizations. At the same time, the Foundation alleges, the IRS enforces the condition against other tax-exempt organizations. The Foundation, which is itself a § 501(c)(3) organization, contends that the IRS’s policy of disparate treatment violates its rights under both the Establishment Clause and the equal-protection component of the Due Process Clause of the Fifth Amendment. For relief, the Foundation seeks a declaratory judgment stating that the IRS’s alleged policy of providing preferential treatment to churches and religious organizations is unlawful, as well as an injunction requiring the IRS to abandon that policy. The IRS denies that it has a policy of not enforcing § 501(c)(3)’s electioneering restrictions against churches and religious organizations.

Before me now is a motion to intervene filed by Father Patrick Malone and the Holy Cross Anglican Church. The church is a tax-exempt organization that does not obey the electioneering restrictions of § 501(c)(3). See Decl. of Father Patrick Malone ¶¶ 4, 29. In particular, Father Malone, the vicar of the church, regularly makes statements during worship services and church gatherings in which he urges members of the congregation to vote for or against certain candidates for public office. Id. ¶¶ 11-12, 20. So far, however, the IRS has not taken any action in response to the church’s activities. Id. ¶ 29. But the church and Father Malone are concerned that if the Foundation obtains the relief it seeks in this lawsuit, then the IRS will be required to “punish” them for having engaged in political activity. Id. ¶¶ 25-26. Thus, the church and Father Malone claim that they have an interest in this suit and seek to intervene as defendants. They seek intervention as of right under Federal Rule of Civil Procedure 24(a)(2) or, in the alternative, permissive intervention under Rule 24(b)(1)(B). If allowed to intervene, the movants would argue that they have a legal right to participate in political campaigns without forfeiting their tax-exempt status. The movants contend that their position is supported by the Religious Freedom Restoration Act (“RFRA”) and the Free Speech, Free Exercise, and Establishment Clauses of the First Amendment.

For a movant to have a right to intervene under Rule 24(a)(2), the movant must claim “an interest relating to the property or transaction that is the subject of the action” that might be “impair[ed] or imped[ed]” by the disposition of that action. Fed. R. Civ. P. 24(a)(2). In the present case, the interest that the movants seek to protect is their interest in having Father Malone preach to the church about whom to vote for without jeopardizing the church’s tax-exempt status. They believe that if the Foundation obtains an injunction requiring the IRS to enforce § 501(c)(3)’s electioneering restrictions against churches and religious organizations, the IRS will be required to initiate proceedings to possibly revoke the church’s tax-exempt status on the ground that Father Malone has and will continue to preach about candidates for political office. However, the threat to this interest is at least one step removed from this lawsuit. If the Foundation prevails, it will not obtain an order requiring the IRS to immediately investigate whether Father Malone and Holy Cross have violated § 501(c)(3)’s electioneering restrictions. Rather, because the IRS does not have infinite resources and must exercise discretion in choosing which tax-exempt entities to investigate, it is uncertain whether the IRS, if compelled to enforce the electioneering restrictions against churches, would ever take any action against Father Malone or Holy Cross.

Still, in litigating this lawsuit, the Foundation will advance legal arguments that if accepted would impair or impede the movants’ interests. The Foundation intends to argue that any policy of non-enforcement of § 501(c)(3)’s electioneering restrictions against churches and religious organizations violates the Establishment Clause. The movants contend that the IRS’s enforcing those restrictions against churches and religious organizations would violate the Establishment Clause. So if the Foundation prevails, a cloud would be cast over the movants’ argument that the Establishment Clause prevents the IRS from enforcing the electioneering restrictions against churches and religious organizations. The movants should be permitted to intervene in this case for the purpose of protecting their argument.

It is true that even if the Foundation prevails, the movants will still have a chance to litigate the issue of whether the Establishment Clause and other laws grant them a right to both preach about candidates for office and maintain their tax-exempt status. Because the movants, if denied intervention, would not be bound by any of the orders entered in this case or be precluded from advancing contrary legal arguments in the future, they will be free to assert the Establishment Clause as a defense in any IRS action to revoke their tax-exempt status. “But the possibility that the would-be intervenor if refused intervention might have an opportunity in the future to litigate his claim has been held not to be an automatic bar to intervention.” City of Chicago v. Fed. Emergency Mgmt. Agency, 660 F.3d 980, 985-86 (7th Cir. 2011). Rather, “[c]ases allow intervention as a matter of right when an original party does not advance a ground that if upheld by the court would confer a tangible benefit on an intervenor who wants to litigate that ground.” Id. Here, the movants wish to advance the argument that the IRS may not enforce the electioneering restrictions of § 501(c)(3) against churches and religious organizations, an argument that the original party, the IRS, does not intend to advance and which, if successful, would confer a tangible benefit on the movants.

The Foundation points out that the Tax Anti-Injunction Act, 26 U.S.C. § 7421(a), generally forbids courts from entertaining suits to prevent the IRS from enforcing the Tax Code, and that therefore the movants could not commence a separate action against the IRS to obtain a ruling that they may engage in political campaigning without jeopardizing their tax-exempt status. The Foundation contends that the movants should not be permitted to use intervention to obtain relief that would otherwise be barred by § 7421(a). But the movants are not intervening for the purpose of obtaining relief against the IRS; they are intervening for the purpose of preventing the Foundation from obtaining relief against the IRS that would be inconsistent with their argument that the IRS may not enforce the electioneering restrictions of § 501(c)(3) against them. Even if the movants are successful in showing in this action that they have a legal right to both participate in political campaigns and keep their tax-exempt status, they would not obtain any relief against the IRS. Indeed, the movants propose to intervene as defendants — on the side of the IRS — and have not indicated that they would bring a cross-claim against the IRS. Really what the movants seek is not to establish their right to engage in political activity while maintaining their tax-exempt status, but to prevent the Foundation from obtaining relief that would be inconsistent with, and therefore impair or impede, their later establishing that right. Thus, allowing the movants to intervene would not implicate the Tax Anti-Injunction Act.

To have a right to intervene, the movants must show not only that the disposition of the suit could impair or impede their interests, but also that the existing parties will not adequately represent their interests. See Fed. R. Civ. P. 24(a)(2). In the present case, the IRS will adequately represent the movants’ interests to some extent. Like the movants, the IRS wishes to prevent the Foundation from obtaining an order requiring it to enforce § 501(c)(3)’s electioneering restrictions against churches and religious organizations. But the IRS’s defense is that it does not have a policy against enforcing those restrictions against churches and religious organizations in the first place. The IRS does not intend to argue that, if it is determined that it has such a non-enforcement policy, the policy is justified or compelled by the Establishment Clause and other laws. Thus, the IRS does not fully represent the movants’ interests. However, unless the Foundation is able to prove that the IRS has a policy of not enforcing the electioneering restrictions against churches and religious organizations, the movants will have no occasion to advance their legal arguments. As discussed, the movants do not (and because of the Tax Anti-Injunction Act probably cannot) assert a cross-claim against the IRS. So if the IRS succeeds in showing that it does not have a policy against enforcing § 501(c)(3)’s electioneering restrictions against churches and religious organizations, the case will be over and the movants will have nothing to do. Still, this does not mean that the movants cannot intervene now and wait on the sidelines in case there comes a time in the suit when their legal interests require protection.

A final requirement for intervention is that the motion to intervene be timely, and the Foundation contends that the present motion is untimely. However, the Foundation has not pointed to any prejudice caused by the timing of the motion, and I cannot detect any. The primary issue in this case is the factual one of whether the IRS has a policy of not enforcing the electioneering restrictions of § 501(c)(3) against churches and religious organizations. As noted, only if this issue is resolved in favor of the Foundation will the movants have any need to present their legal arguments. The earliest time to present those arguments would be summary judgment, and motions for summary judgment are not due until April 1, 2014. The movants have not indicated that they wish to take any discovery, and because the issues they seek to litigate are pure legal issues, it is hard to envision them having a need to take discovery. Here, the motion to intervene was filed on December 12, 2013, well in advance of the summary-judgment deadline, and in the context of this case that was early enough to render the motion timely.

Accordingly, the motion to intervene is GRANTED.

Dated at Milwaukee, Wisconsin this 3rd day of February, 2014.

Lynn Adelman

District Judge




FASB Rule on Tax Credit Investments Won't Create Deferred Taxes.

Financial Accounting Standards Board guidance on the accounting for investments in low-income housing tax credits would not require companies to record deferred taxes for the book-tax basis differences related to those investments, practitioners said February 5.

Financial Accounting Standards Board guidance on the accounting for investments in low-income housing tax credits (LIHTCs) would not require companies to record deferred taxes for the book-tax basis differences related to those investments, practitioners said February 5.

Angie Storm of KPMG LLP said during a webcast hosted by her firm that deferred taxes generally will not be recorded for basis differences under the new FASB standard because the tax benefits resulting from the LIHTC investments will be recognized in the financial statements in the same period they are also reflected on the tax return. As a result, a basis difference shouldn’t arise relative to the period of recognition regarding the amortization of the investment and the tax benefit received on the tax return, she said.

Issued January 15, Accounting Standards Update (ASU) No. 2014-01, “Investments — Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects,” allows a reporting entity to account for an investment in a qualified affordable housing project using the proportional amortization method when specific conditions are met.

ASU 2014-01, developed by FASB’s Emerging Issues Task Force (EITF), directs entities to amortize the initial cost of the investment in proportion to the tax credits and other tax benefits allocated to the investor, and to recognize the net investment performance amortization in the income statement as a component of income taxes.

Storm said that under the new standard, LIHTC investments will be accounted for similarly to the purchase of tax benefits under EITF Issue No. 98-11, “Accounting for Acquired Temporary Differences in Certain Purchase Transactions That Are Not Accounted for as Business Combinations.” According to KPMG, that guidance is also provided in the accounting standards codification topics on the purchase of future tax benefits.

EITF member Mark Bielstein of KPMG said that although ASU 2014-01 fails to provide a specific citation stating that companies should not record deferred taxes for those basis differences, an example included in the standard detailing the application of the proportional amortization method doesn’t illustrate the recognition of deferred taxes.

ASU 2014-01 will be effective for the annual and interim reporting periods of public entities beginning after December 15, 2014, and for the annual periods of all other entities beginning after that date. Early adoption will be permitted.

Bielstein said that several companies have expressed interest in early adoption of the new standard because it will help improve the financial statement presentation of their LIHTC investments.

by Thomas Jaworski




ABA Tax Section Suggests Changes to Proposed Arbitrage Restriction Regs.

Michael Hirschfeld of the American Bar Association Section of Taxation, in comments on proposed regulations (REG-148659-07) on the section 148 arbitrage investment restrictions applicable to tax-exempt bonds and other tax-advantaged bonds, has suggested changes to the rules on the allocation of tax-exempt bond proceeds to working capital expenditures.

The tax section believes the proposed regs adopt a reasonable approach for issuers and the IRS to determine definitively if bonds for working capital remain outstanding longer than necessary. While supporting the general framework of requiring periodic testing and an unburdening action, section members suggest modifying the proposed rules for longer-term working capital financings so that an issuer can test “available amounts” under reg. section 1.148-6(d)(3)(iii) as of a date other than the first day of a fiscal year. Pointing out that testing as of the first day of each fiscal year does not work well for most issuers because their fiscal year does not coincide with their cash flow needs, members propose three alternative methods to implement testing as of dates appropriate to the issuer.

The current regs allow bonds to be issued for some extraordinary noncapital expenditures such as large tort settlements but provide no guidance on how long those bonds may remain outstanding. The tax section recommends expanding the definition of extraordinary working capital and establishing a safe harbor based on weighted average maturity for longer-term extraordinary working capital financings.

While acknowledging that the proposed regs provide an appropriate framework for the treatment of tax-exempt bond proceeds allocated to grants, the tax section requests additional guidance on the treatment of grants. Section members also suggest clarifying the definition of available amount to exclude proceeds of any issue and providing examples to show why this is important.

January 30, 2014

Hon. John Koskinen

Commissioner

Internal Revenue Service

1111 Constitution Avenue, NW

Washington, DC 20024

Re: Comments Concerning Tax Exempt Working Capital Financing, Grants, and Qualified Hedges

Dear Commissioner Koskinen:

Enclosed are comments concerning tax exempt working capital financing, grants, and qualified hedges. These comments represent the view of the American Bar Association Section of Taxation. They have not been approved by the Board of Governors or the House of Delegates of the American Bar Association, and should not be construed as representing the policy of the American Bar Association.

Sincerely,

Michael Hirschfeld

Chair, Section of Taxation

American Bar Association

Washington, DC

Enclosure

cc:

Mark J. Mazur,

Assistant Secretary (Tax Policy),

Department of the Treasury

William J. Wilkins,

Chief Counsel,

Internal Revenue Service

Emily S. McMahon,

Deputy Assistant Secretary (Tax Policy),

Department of Treasury

* * * * *

AMERICAN BAR ASSOCIATION SECTION OF TAXATION

COMMENTS ON PROPOSED REGULATIONS: TAX EXEMPT WORKING

CAPITAL FINANCING, GRANTS, AND QUALIFIED HEDGES

These comments (“Comments”) are submitted on behalf of the American Bar Association Section of Taxation (the “Section”) and have not been approved by the House of Delegates or Board of Governors of the American Bar Association. Accordingly, the Comments should not be construed as representing the position of the American Bar Association.

Principal responsibility for preparing these Comments with respect to the portions on working capital financings and grants was exercised by David Cholst of the Committee on Tax-Exempt Financing (the “Committee”). Substantive contributions in this area were made by Irving G. Finkel, Charles C. Cardall, Carol L. Lew, Christie L. Martin and Mark O. Norell. Principal responsibility for preparing the portions of these Comments with respect to qualified hedges was exercised by George G. Wolf. Substantive contributions in this area were made by Arthur M. Miller, Mark O. Norell and John T. Lutz. The Comments were reviewed by Nancy M. Lashnits, Chair of the Committee, by Frederic L. Ballard, Jr., reviewer for the Section’s Committee on Government Submissions, and by Bahar Schippel, Council Director for the Committee.

Although the members of the Section of Taxation who participated in preparing these Comments have clients who might be affected by the federal tax principles addressed by these Comments, no such member (or the firm or organization to which such member belongs) has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matters of these Comments.

Contact Persons:

Working Capital and Grants:

David J. Cholst

(312) 845-3862

[email protected]

Qualified Hedges:

George C. Wolf

(415) 883-5988

[email protected]

Date: January 30, 2014

* * * * *

WORKING CAPITAL FINANCINGS AND GRANTS

EXECUTIVE SUMMARY

The Committee thanks the Internal Revenue Service (the “Service”) and the Department of the Treasury (“Treasury”) for endeavoring to provide helpful proposed regulations related to working capital. The Service and Treasury have shown that they understand the need of state and local governments to finance non-capital expenditures with bonds that have maturities in excess of two years. The Existing Regulations1 already have extensive rules relating to the allocation of tax-exempt bond proceeds to working capital (i.e., non-capital) expenditures. The Service, Treasury and practitioners, for the most part, appear to believe those rules work relatively well. The Committee agrees with this assessment. As stated below, the Service and Treasury addressed some deficiencies in those rules by making certain modest changes. The Committee suggests certain additional modest changes. Missing from the Existing Regulations is a relatively definitive way to determine if tax-exempt bonds issued for such purposes will be outstanding longer than necessary. When tax-exempt bonds are left outstanding longer than necessary, an arbitrage concern is raised. The Proposed Regulations2 adopt a reasonable approach for issuers and the Service to determine definitively if bonds for working capital remain outstanding longer than necessary.

No modifications are needed to the proposed changes in computing the reasonable working capital reserve or the length of temporary periods. Existing Regulations allow bonds to be issued for certain extraordinary non-capital expenditures (e.g., large tort settlements), but provide no guidance on how long such bonds may remain outstanding.

The Proposed Regulations provide an appropriate framework for allowing longer term tax-exempt bonds for working capital purposes. The general regime of requiring periodic testing and an unburdening action is a reasonable and workable approach. The Committee recommends, however, that the Service and Treasury modify the proposed rules for longer term working capital financings so that an issuer can test “available amounts”3 as of a date other than the first day of a fiscal year. Testing available amounts as of the first day of each fiscal year will not work for most issuers because the fiscal year does not coincide with the cash flow needs of most issuers. The Committee proposes three alternative methods to implement testing as of dates appropriate to the issuer. The Committee believes that any of the three methods will address the difficulties created by the proposed start of fiscal year testing date.

The Committee also recommends establishing a maturity safe harbor for extraordinary working capital, and expanding the definition of extraordinary working capital. Existing Regulations allow bonds to be issued for certain extraordinary non-capital expenditures (e.g., large tort settlements), but provide no guidance on how long such bonds may remain outstanding.

The Committee suggests a clarifying modification to the definition of available amount to exclude proceeds of any issue and provide examples to show why this is important.

The Proposed Regulations provide an appropriate framework for treatment of tax-exempt bond proceeds allocated to grants. State and local governments do make grants for a variety of purposes. States and their agencies and instrumentalities often grant money to local governments as well. Local governments often grant moneys to both for-profit and non-profit organizations to encourage certain activities. These Comments request clarification of the treatment of grants. The Committee finds the changes included in the Proposed Regulations useful, but in need of clarification.

These Comments provide detailed regulatory language (including language for examples). The Committee believes that the examples provided will explain the Regulations when finalized as applied to most transactions.

I. Ordinary Working Capital Provisions

The Existing Regulations contain a structure for state and local governments to finance certain cash flow shortfalls resulting from a variety of causes, generally tax and other revenues that are collected only a few times during the year. The Proposed Regulations are generally very helpful to issuers of tax-exempt bonds to finance these cash flow deficits. It is clear that these proposed rules act as a whole and that the different parts need each other for proper operation. For example, the elimination of a two-year temporary period for debt to be paid from a single tax collection might be very disruptive if not for the proposed provisions allowing longer term financings. Taken together, however, these two provisions should not seriously disrupt common financing techniques.

The Committee commends the Service and Treasury for the proposed simplification related to the reasonable working capital reserve. An amount of five percent (5%) of the prior fiscal year’s expenditures should provide an adequate reserve. Current law restrictions on financing a reserve are difficult to administer and create perverse incentives.

The Committee is also pleased with proposed rules that create a framework for longer term working capital financing based on formal guidance.4 The Committee believes that the proposed rules are intended to capture the concept that longer term restricted working capital be allowed where an issuer takes steps to assure that the market will not be burdened any more than it would be as a result of a series of permitted one year short-term restricted working capital issues, such as annual tax and revenue anticipation notes (“TRANs”). The Committee appreciates the notion that unburdening may be achieved by the purchase of tax-exempt investments or redemption of bonds other than those financing the working capital expenditures.5 The Committee recommends that final Regulations clarify that demand deposit series state and local government series certificates of indebtedness (“Demand Deposit SLGS”) be treated as non-AMT tax exempt investments for this purpose.

While these proposed rules are generally welcome, some changes and clarifications are recommended to improve their application. As described in section A below, the most important change required to the Proposed Regulations concerns testing for available amounts at the start of the fiscal year. The Committee also suggests certain changes to other regulatory provisions so that the rules work better together.

A. Longer Term Working Capital Financings

The Proposed Regulations create a structure for longer term working capital deficit financings that requires annual testings of available amounts coupled with remediation to avoid overburdening the market. Testing under the Proposed Regulations is not, however, on the appropriate date in most circumstances. Additionally, certain clarifications are needed.

1. Measurement Date Problem

When any restricted working capital bonds (including TRANs) are issued, the first testing date under both the Existing Regulations and the Proposed Regulations is as of a date that the issuer experiences or expects to experience low cash balances. The expected available amount on such date is used to size the issue. The following example may help to understand the process.

Bond issuer M is a municipality that maintains its financial records using a calendar year as a fiscal year. M provides police, fire protection, residential trash collection and snow removal services to its residents. Payrolls are paid every other Friday. M receives sales tax collections from the state on the 15th day of each month based on sales occurring during the previous month. The largest sales tax receipts are on December 15 and January 15. Because of overtime expenses, the first payroll in January is usually the largest payroll of any two week period. Real estate taxes are received semiannually on March 15 and September 15 (in roughly equal amounts). Assume M has longer term working capital bonds outstanding. For the last part of December 2018, the payroll is payable on Friday, January 4, 2019. On January 1, 2019 (the first day of the fiscal year), M has a substantial surplus, which is largely consumed by the January 4 payroll. If the balance on January 1, 2019, is used to determine whether an unburdening action is required, M may need to use a significant amount to redeem bonds or invest in non-AMT tax exempt investments. This would be true even though the issuer may also need to dip into its reasonable working capital reserves to meet payrolls in February (or in fact may be unable to meet such payrolls without further borrowings).

Fiscal years have been established in order to report financial data consistently. Fiscal years may be unrelated to timing when expenditures must be paid. Appropriately, both the current Regulations and the Proposed Regulations use a fiscal year (rather than a bond year) to compute a reasonable working capital reserve. That use of a fiscal year conveniently allows an issuer to determine a reserve based on the total amount spent over a one-year period using data commonly prepared for other purposes. Use of fiscal years for computation of the applicable reasonable working capital reserve should not imply the use of fiscal years for measuring cash flow short falls.

2. Yearly Available Amount

The Proposed Regulations use the concept of a computed “yearly available amount.” As defined in Proposed Regulations section 1.148-1(c)(4)(ii)(A)(2)6 , this is the available amount on the first day of the fiscal year of the issuer. The Committee suggests that this definition be modified.

A governmental unit may experience low available balances on specific dates during each year. Often these occur on the dates of large payroll disbursements (payrolls are generally the largest routine working capital expenditures of most governmental units). “Low balance dates” may vary year to year, but are often clustered around a particular calendar date.

Certain governmental units (e.g., school districts) experience significant fluctuations in cash balances within a year. Both revenues and expenditures are often unevenly distributed throughout a year. For example, real estate tax receipts may be received once or twice a year. If, for example, one semiannual real estate tax installment is due in June, then as of July 1, the local government may have relatively full coffers at the start of its fiscal year. On the other hand, the balance on May 31 may be very low and this unit of government might want to borrow to meet an end-of-May payroll that it could not otherwise meet because it had no available funds.

3. Suggested Modification of Proposed Regulations to Accommodate More Appropriate Testing dates

Instead of computing a yearly available amount as of the start of a fiscal year, the Committee suggests that the available amount be measured as of a date that the issuer expects to need to spend bond proceeds to meet deficits. The Committee sees three possible alternative ways to achieve this goal.

First Method — Fixed Measurement Date. An issuer with a June 30 fiscal year might expect that its biggest cash flow needs would be in February of each year (as mentioned above). Under this alternative, annual periods would be used for testing, but the periods would not be tied to fiscal years. Under existing rules, the issuer can select a bond year (as defined in Regulations section 1.148-1(b)) beginning each, say, March 1. Under this first alternative approach, yearly available amount could be defined in terms of an arbitrary annual period (e.g., a bond year) rather than a “fiscal year.” Beginning on the first testing year, the bond issuer would compute a “yearly available amount” applicable to each such annual period using the available amounts as of the first day of the annual period. The actions required under the Proposed Regulations section 1.1481(c)(4)(ii)(B) would then be required for that annual period. A slightly more complicated rule would create a new category of year, a “cash flow calculation year.” Like a bond year, it would be up to the issuer to select the start and end date for such a year. The Committee notes that bond years are already used for such tasks as determining whether a fund is a bona fide debt service fund and, for variable rate bond issues, for computing yield periods and rebate. Since those tasks are unrelated to available amount testing, the Committee thinks it better to create a new category of issuer selected year. However, use of a “bond year” for defining yearly available amount would work fairly well. If such approach were to be used, issuers of bonds for working capital expenditures would very likely select bond years based on cash flow projections, then accept whatever effect that provides for bona fide debt service funds, rebate and variable rate yield computations. If the fixed date method is adopted, the Committee thinks that a separate category of annual period should be used rather than bond year to avoid inefficient selections of bond year for other purposes.

Because the date with the lowest available amount is very likely to be different in different years, this fixed measurement date approach is likely to result in slightly greater unburdening actions than would be required if the issuer could select its lowest balance date each year.

Second Method — Variable Measurement Date. The expected low balance date is usually not exactly the same calendar date each year. For example, payrolls may be every other Friday. An issuer might appropriately want to test on different dates each year. Our preference is that instead of using fixed one-year periods for testing and unburdening, the issuer should be permitted to declare the date when each cash flow period would end and the date the next one begin. Each cash flow calculation period would be limited to 13 months or shorter in duration. Testing periods could be shorter than one year. If an issuer decides that it would have a significant cash flow deficit five months after the start of a cash flow period, the next testing date could be set at five months later. A tax collection agent (usually a state or county) may change the date on which it turns over tax and other revenue receipts to the issuer (e.g., a municipality or school district) or the due date for taxes may be changed by law. In such a situation, a bond issuer might want to change the date on which available amounts are tested. By testing more often in one year, the issuer could return to a reasonable schedule of testing.

If this variable testing date approach is accepted, the defined term “period available amount” would replace “yearly available amount” and would apply to each “cash flow calculation period.” Otherwise, the same rules provided in Proposed Regulations section 1.148-1(c)(4)(ii)(B) would apply.7

The Committee thinks that this second method would be the optimal method. It would allow an issuer to select testing dates that most closely matches its needs. This method would also be relatively simple to administer.8 Unlike the third method described below, the test results would be verifiable based on financial records.

The Committee notes that if this variable measurement date method is adopted, an issuer would have the option of selecting a single calendar date to begin and end all testing periods. An issuer might choose to do so to simplify its procedures. Effectively, the fixed measurement date method is included as an option in the variable measurement date method.

Third Method — Projection Method. Under this method, once each year, based on either bond year or fiscal year, the issuer would project the lowest cash position date expected during the year beginning on that date. (This is similar to how an issuer would size a TRANs issue.) The yearly available amount would be the available amount expected (as of the start of the year) on the expected low balance date that year. The required unburdening action would then be taken at the start of the year (after an initial period) based on these projections. Unlike the first two methods, this method would base actions on reasonable expectations as of the start of the year. While the Committee thinks this method could work, it recognizes the imprecision inherent in a projection method as compared to a method based on actual facts. The first two methods described above are simpler to administer and simpler to enforce.

Proposed Regulations section 1.148-1(c)(4)(ii)(A)(2) should be modified to replace fiscal year references with references to bond year, cash flow year or cash flow calculation period as described above. Alternatively, the yearly available amount could reference a projected cash flow deficit date. In any event, testing should not be mandated as the first day of the fiscal year.

4. Determination of First Testing Year

As worded in Proposed Regulations section 1.148-1(c)(4)(ii)(A)(1), the issuer of bonds must determine the first year in which it expects to have available amounts for the financed working capital expenditures. What should be determined is the first start of a cash flow year or cash flow calculation period in which the issuer expects to have amounts available for expenditures of the type financed. Clearly the actual financed expenditures will be paid (or would at least be expected to be paid) during the temporary period, before any such testing is likely to occur.

Clarification is also needed about the first testing year (or period). In Proposed Regulations section 1.148-1(c)(4)(ii)(A)(1), the first testing year may not be later than five years after the issue date. This requirement is imprecise because it measures the length of time from a specific date to a period. Either the start of the first testing year (or period) (the first testing date) or the end of the first testing period must be within this five years. The Committee does not express a preference for either the start of the period or the end of the period, but the Committee recommends that the Proposed Regulations clarify which is meant. In our attached suggested language, the Committee has arbitrarily used the start of the first testing year (period). The Committee believes that issuers would generally prefer that the rule be based on the start of the period.

Note that, as a result of the five year rule, bond issues that are shorter than five years to final maturity might not require a proper showing of expectations for any post issuance tests (other than for rebate compliance). The Committee expects that many issuers will structure their bonds to avoid post issuance testing. The Committee thinks that this is appropriate for relatively short term (e.g., five year) financings.

5. Durations of Remediation

Proposed Regulations section 1.148-1(c)(4)(ii)(B) is currently drafted to state that if tax-exempt investments are used to lessen the burden on the market, such investments should be maintained “for as long as the applicable portion9 of the issue remains outstanding.”

The annual testing and unburdening actions are designed to mimic a series of properly sized TRANs. Accordingly unburdening actions should only apply during the period covered by the test. On the next testing date the process should be repeated.

If expenditures exceed receipts so that available cash is reduced, the issuer should be able to liquidate and spend amounts invested in tax-exempt investments so long as available amounts are not invested in other (taxable) investments. Denial of the right to make such liquidations would only encourage more working capital borrowing. Upon the next testing date, the issuer will be required to test again. If there are no available amounts on that testing date, then for the entire subsequent cash flow year (period), the issuer should not be required to make such investment. If there are available amounts on that testing date, the amount to be invested in eligible tax-exempt investments should be re-determined as of that testing date. Finally, if the issuer chooses to redeem bonds to meet its obligation under Proposed Regulations section 1.148-1(c)(4)(ii)(B), it should be able to liquidate tax exempt investments and use the proceeds to redeem bonds.

6. Use of Conduit Issuers For Working Capital Borrowings

While most bonds financing working capital are issued directly to the public (or are privately placed directly with a bank), some units of local government issue such debt using conduit issuers, often state authorities.10 Because Proposed Regulations section 1.148-1(c)(4)(ii) requires action by the issuer, it is important to clarify that references to the issuer may be treated as references to the conduit borrower. The current definition of issuer in Regulations section 1.148-1(b) does accommodate this. It would be useful for the IRS to clarify that actions required under Proposed Regulations section 1.148-1(c)(4)(ii) can be taken by a conduit borrower. This may be done by a simple discussion of this issue in the preamble, an addition to the definition of issuer, or the inclusion of an example where the unburdening actions are taken by a conduit borrower.

II. Extraordinary Working Capital

Existing Regulations include an exception to the working capital restrictions for extraordinary working capital not customarily payable from current revenues. The Proposed Regulations provide a temporary period applicable to financings of extraordinary working capital but do not change the definition of “extraordinary items” set forth in Regulations section 1.148-6(d)(3)(ii)(B). The current definition is limited to items that are “not customarily payable from current revenues, such as casualty losses or extraordinary legal judgments in amounts in excess of reasonable insurance coverage.” The Proposed Regulations also include: (i) the addition of extraordinary working capital to the list of items that may justify a bond term beyond the maturity safe harbors against the creation of replacement proceeds, and (ii) broadening the application of the 13-month temporary period exception to yield restriction for restricted working capital to include all working capital expenditures. The Proposed Regulations do not provide any safe harbor to avoid the creation of replacement proceeds, or to establish that bonds issued for extraordinary working capital purposes are not outstanding longer than necessary. Of course, an issuer could apply the rules created for restricted working capital financings to extraordinary working capital financings, but that does not seem appropriate.

Therefore, the Committee suggests providing an additional safe harbor based on weighted average maturity for longer term extraordinary working capital financings. Bonds financing extraordinary working capital expenditures generally finance casualty losses, judgments or other unexpected significant payments. Often these are a result of tragic tort liability for the governmental unit or arise from natural disaster.

By definition, extraordinary working capital expenditures are non-recurring and relatively unusual events. Because the triggering events are expected to occur infrequently, it makes sense to allow a reasonably long time to repay such borrower amounts. The Committee thinks that bonds financing such expenditures should not be considered outstanding longer than necessary if the weighted average maturity date of the bonds is not more than 15 years after the issue date. While tragedy can strike a single governmental unit multiple times, units of government experiencing such extraordinary items need to use revenues from many years to make such payments. Because such expenditures are non-recurring, financing these expenditures is most like financing capital expenditures.

If a 15-year weighted average maturity safe harbor is adopted, the rule should acknowledge that a longer period may be appropriate if the financed expenditures are so large that they exceed an amount that can reasonably be repaid in 15 years. For example, if the financed catastrophe costs exceed 75% of the total annual operating budget of the unit of government, the amount of principal to be retired each year would average more than five percent of the operating budget for an average year if the debt were repaid over only 15 years.

The Committee believes that there are circumstances where, because of their magnitude and the time it took to generate the cash flow need, payments should be classified as extraordinary non-recurring expenditures even if there is no judgment or single catastrophe event. For example amounts that a bankruptcy court orders a bankrupt unit of government to pay should be treated as extraordinary. Just as deferred maintenance can lead to required capital expenditures that could have been avoided with proper maintenance, deficits that have built up over many years should be treated as creating extraordinary non-recurring expenditures, so long as the unit of government adopts a plan to balance its future expenditures and receipts.

The Committee recommends moving the definition of extraordinary items to Regulations section 1.148-1(b) and broadening the definition of extraordinary working capital to include financing certain large accumulated deficits or amounts ordered paid by a bankruptcy court. The expenditure rules of Regulations section 1.148-6(d) should not be changed in this respect.

III. Clarify Available Amount Definition

Confusion exists if the proceeds of one issue of working capital obligations are treated as available amounts for purposes of a second issue of working capital obligations. Generally, available amounts are those available for working capital expenditures of the type financed by a bond issue. The definition in Regulations section 1.148-6(d)(3)(iii)(A) contemplates that the proceeds of any debt (including working capital obligations) are not available amounts. However, the Service has ruled that for purposes of spending the proceeds of a tax-exempt working capital issue, the proceeds of a second, taxable issue of working capital obligations are available amounts. 11 This leads to absurd results, particularly for issuers of long term working capital financings.

For example, in 2015 an issuer might issue $10 million eight-year bonds to finance working capital expenditures. The issue could be sized so that the issuer would not expect to need to take actions under Proposed Regulations section 1.1481(c)(4)(ii)(B) because it did not expect to have available amounts in each of the eight years.

However, if the issuer’s fiscal situation were to deteriorate in 2021, it may need to issue an additional $2 million of bonds for restricted working capital purposes (which could be short-term or long-term bonds). Suppose that even after such borrowing, the issuer will exhaust all of its funds to pay a payroll on a given testing date after 2021. If proceeds of the 2021 bond issue are “available” when testing for the 2015 bonds, an action might be required that would not even be possible. If the $2 million of proceeds of the 2021 Bonds were considered available for purposes of testing the 2015 Bonds, Proposed Regulations section 1.148-1(c)(4)(ii)(B) might require investing that $2 million in tax-exempt investments despite being needed to pay bills. The issuer could not solve this problem by issuing taxable short-term bonds in 2021 unless it is clear that proceeds of the 2021 bonds (whether tax-exempt or taxable) are not considered available for the testing required for the 2015 bonds.

The Committee proposes that the Proposed Regulations clarify that proceeds of an issue are not treated as available amounts for purposes of applying the proceeds spent last rule (or the unburdening rule of Proposed Regulations section 1.148-1(c)(4)(ii)) to that issue, or to any other issue of obligations to be used for working capital expenditures. This could be accomplished with a simple change to Proposed Regulations section 1.1486(d)(3)(iii)(A) so that the second sentence refers to proceeds of “any” issue rather than just proceeds of “the” issue.12

IV. Look-Through Treatment of Grants

A. Tax-exempt bonds may be issued to finance grants from State and local governments either to other governmental entities or to non-profit or other entities to further governmental purposes. The arbitrage rules for grants relate to when and whether bond proceeds used for grants are expended and how any repayments of grants (e.g., because the grant was not used for the intended purpose) are characterized. Generally, the Committee agrees with the intent of the Proposed Regulations that an issuer should look through a grant to determine what was financed for certain purposes under the Code, that is, what the actual grant monies are spent on by the ultimate recipient; this so-called “look-through” approach makes particular sense with respect to private activity analysis and specifically the private business use test of section 141(b)(1).13 However, the Committee believes that a general look-through provision may be too broad, if applied to certain other Code sections, and clarification is therefore needed.

B. The Committee believes that the intent of the Proposed Regulations, like that of the current Regulations, is that for purposes of sections 148 (including reimbursement) and 149(g), grant proceeds are spent upon the making of a grant. Thus (as clarified by Proposed Regulations section 1.150-1(f)(2) and notwithstanding the gross proceeds spent last rules), if a grantee uses grant proceeds for working capital purposes, the bond proceeds must be considered spent for arbitrage and hedge bond purposes when the grant is made. Similarly, bond proceeds should be considered spent for section 148 purposes where a grant is made to an unrelated third party to cover the cost of a project paid for by that grantee outside the allowable reimbursement window of Regulations section 1.150-2. The Committee also believes that look-through treatment is inconsistent with the definition of a refunding under Regulations section 1.150-1(d). Grant proceeds should be considered spent when the grant is made under section 149(d). Bonds used to make such grants should not be considered refunding bonds. The Committee is concerned that there are other instances where look-through treatment would not be appropriate and clarification is needed. Clarifying language either in the Preamble, the Regulations as finalized, or in an Example would be very helpful. Such clarification should demonstrate that look through treatment does not apply for purposes of reimbursement or refundings.

C. For purposes of assuring that bonds financing grants are not outstanding longer than necessary (including the limitation of section 147(b)), an issuer should be given the alternative of using the useful life of facilities to which the grantee has allocated grant proceeds, or be able (by facts and circumstances) to establish that a grant has a longer useful life than the facilities of the grantee to which the grant proceeds are allocated. For example, a grantor (e.g., a city) may make a grant to an entity (e.g., a for profit housing developer) for a new capital facility (e.g., a new apartment building). To ease the administration, and to be consistent with the nature of the reasonable expectations test of section 147(b), this issuer should be able to rely on the bona fide purpose of the grant for purposes of determining maturity limitations and overburdening regardless of the actual expenditures by the grantee. Such bona fide purpose of the grant may involve a facility paid for by the grantee earlier than would be permitted under the reimbursement rules of Regulations section 1.150-2. The Committee also notes that grants might be made where, from the issuer’s perspective, the grant has a longer life than the assets to which the grantee allocates the proceeds of the grant. For example, a grant might be made by a city to a business to induce the business to locate in that city. The grant, by its terms, might require the recipient to operate a business in the jurisdiction for a designated period (e.g., ten years). In such instance, it seems reasonable that bonds financing the grant be permitted to have a weighted average maturity based on 120% of such “purpose of the grant” life (e.g., 12 years in this case) even if the grantee spends the grant proceeds for operations. It seems appropriate, for this purpose, to look at the facts and circumstances of the grant, to make this determination. Consequently, the Committee believes that the best approach to dealing with maturity limitations for grants is to add a separate provision to Regulations section 1.148-1(c)(4)(i)(B) dealing with bonds financing grants.

V. Inclusion of Regulatory Examples Beneficial

The Committee suggests that Treasury and the Service add examples to Proposed Regulations section 1.148-1 to show how the rules on longer term working capital financings would be applied. The Committee provides some examples below in these Comments.

VI. Proposed Regulatory Language

A. Changes to Proposed Regulations section 1.148-1

Below the Committee has reproduced the existing Regulations section 1.148-1 as proposed to be modified by Proposed Regulations section 1.148-1 and further modified by our suggested changes. To avoid clutter, the portions of Regulations section 1.148-1 and Proposed Regulations section 1.148-1 not relating to working capital matters have been omitted. The Committee does not distinguish between existing Regulations and proposed changes in Proposed Regulations section 1.148-1, but all language the Committee proposes to insert or replace is in bold.14

1.148-1(a) In general. The definitions in this section and the definitions under section 150 apply for purposes of section 148 and §§ 1.148-1 through 1.148-11.

(b) Certain definitions. The following definitions apply:

Available amount means available amount as defined in § 1.148-6(d)(3)(iii).

Bond year means, in reference to an issue, each 1-year period that ends on the day selected by the issuer. The first and last bond years may be short periods. If no day is selected by the issuer before the earlier of the final maturity date of the issue or the date that is 5 years after the issue date, bond years end on each anniversary of the issue date and on the final maturity date.

 

Cash flow period means, in reference to an issue, each period of no more than 13 months, which begins on the date that the previous cash flow period ends and ends on the day selected by the issuer. The final cash flow period ends when the bonds are paid in full. If no ending date is selected by the issuer before the date that is 90 days after the start of the cash flow period, the cash flow period will end one year after it starts. The first cash flow period begins on the closing date.15

Cash flow year means, in reference to an issue, each 1-year period that ends on the day selected by the issuer. The first and last cash flow years may be short periods. If no day is selected by the issuer before the earlier of the final maturity date of the issue or the date that is 5 years after the issue date, cash flow years will be the same as bond years.16

Extraordinary working capital expenditure means an expenditure for an extraordinary, non-recurring item that is not customarily payable from current revenues, such as casualty losses or extraordinary legal judgments in amounts in excess of reasonable insurance coverage. Payments ordered by a bankruptcy judge will generally be extraordinary working capital expenditures. Additionally, expenditures occurring during a single fiscal year are extraordinary and non-recurring if (i) in total they are no more than the amount by which annual expenses for the fiscal year exceed annual revenues for the fiscal year preceding the expenditure, (ii) there are no available amounts to pay the expenditures, (iii) the expenditures total at least seven percent (7%) of annual revenues for the fiscal year preceding the issue date, and (iv) the total amount of tax-exempt bonds outstanding that financed extraordinary non-recurring working capital is no more than 30% of the actual working capital expenditures for the fiscal year preceding the issuance of such bond issue.17

Restricted working capital expenditures means working capital expenditures that are subject to the proceeds-spent-last rule in § 1.148-6(d)(3)(i) and are ineligible for any exception to that rule.

(c) Definition of replacement proceeds.

(1) In general.

(2)

(3)

(4) Other replacement proceeds.

(i) Bonds outstanding longer than necessary.

(A) In general. Replacement proceeds arise to the extent that the issuer reasonably expects as of the issue date that

(1) The term of an issue will be longer than is reasonably necessary for the governmental purposes of the issue, and

(2) There will be available amounts during the period that the issue remains outstanding longer than necessary. Whether an issue is outstanding longer than necessary is determined under § 1.148-10. Replacement proceeds are created under this paragraph (c)(4)(i)(A) at the beginning of each fiscal year during which an issue remains outstanding longer than necessary in an amount equal to available amounts of the issuer as of that date.

(B) Safe harbor against creation of replacement proceeds. As a safe harbor, replacement proceeds do not arise under paragraph (c)(4)(i)(A) of this section

(1) For the portion of an issue that is to be used to finance restricted working capital expenditures, if that portion is not outstanding longer than the temporary period under § 1.148-2(e)(3) for which the proceeds qualify;

(2) * * *

(3) * * *

(4) For the portion of an issue that is to be used to finance extraordinary non-recurring items as permitted under § 1.1486(d)(3)(ii)(B), if that portion has a weighted average maturity that does not exceed 15 years, or such longer period as may be appropriate under all facts and circumstances.

(5) For the portion of an issue that is to be used to finance or refinance a grant, if that portion has a weighted average maturity that does not exceed 120% of the life of the grant. For this purpose, the life of a grant is the greater of the average reasonably expected economic life of facilities to which the grant proceeds are allocated, or a longer life attributed to the grant by the grantor based upon the facts and circumstances of the grant.

(6) For an issue that is to be used to finance working capital expenditures and that is outstanding for a period longer than the temporary period under § 1.148-2(e)(3) or for an issue that is to be used to finance extraordinary working capital expenditures that is outstanding longer than permitted under § 1.148-1(c)(4),18 if that portion satisfies paragraph (c)(4)(ii) of this section.

(ii) Safe harbor for longer-term working capital financings. A portion of an issue used to finance working capital expenditures satisfies this paragraph (c)(5)(ii) if the issuer meets the requirements of paragraphs (c)(4)(ii)(A) and (c)(4)(ii)(B) of this section.

(A) Determine expected available amounts. An issuer meets the requirements of this paragraph (c)(4)(ii)(A) if —

(1) On the issue date, the issuer determines the first bond year19 (if any) following the applicable temporary period (determined under § 1.148-2(e)) at the start of which it reasonably expects to have available amounts for expenditures of the type of the financed working capital expenditures (first testing year), but in no event can the first testing year begin later than five years after the issue date; and

(2) Beginning with the first testing year and for each subsequent bond year for which the issue remains outstanding, the issuer determines its available amounts20 for expenditures of the type of the financed working capital expenditures as of the first day of the bond year (yearly available amount).

(B) Application of yearly available amount to reduce burden on tax-exempt bond market. An issuer meets the requirements of this paragraph (c)(4)(ii)(B) if, within 90 days after the start of each bond year in which it determines a yearly available amount, the issuer applies an amount equal to the yearly available amount for such year to redeem or invest in tax-exempt bonds that are excluded from investment property under § 148(b)(3) (that is, tax-exempt bonds that are not subject to the alternative minimum tax)(eligible tax-exempt bonds) For this purpose, a certificate of indebtedness issued by the United States Treasury pursuant to the Demand Deposit State and Local Government Series Program described in 31 CFR part 344 is an eligible tax-exempt bond. The maximum amount required to be applied in such manner shall equal the outstanding principal amount of the issue subject to the safe harbor in this paragraph (c)(4)(ii), determined as of the date of such redemption or investment. Any amounts invested in eligible tax-exempt bonds shall be invested or reinvested continuously in such tax-exempt bonds, except during a permitted reinvestment period of no more than 30 days in a bond year until allocated to an expenditure for which no other available amounts exist, or the end of the then current bond year.

C) Example 1: School district D experiences both seasonal and long term deficits and it expects to be unable to meet its operating expenses unless it borrows $10,000,000. D maintains a fiscal year beginning on July 1 and ending on June 30 of each year. Because of timing of receipts of real estate taxes and state aid, D generally expects that its balances of available funds will be lowest at the end of October or the beginning of November of each year. During the fiscal year ending June 30, 2015, D spent $40,000,000 from current revenues and, therefore, determines that during the Fiscal year ending June 30, 2016, its reasonable working capital Reserve is $2,000,000. On August 1, 2015, D determines that it does not expect to have sufficient available funds to make its payroll on Friday October 30, 2015, and projects that absent any borrowing, it would be unable to pay ordinary working capital expenditures in the amount of $8,000,000 after exhausting all available amounts and its reasonable working capital reserve. On September 15, 2015, state authority A issues $10,000,000 of bonds and lends all of the proceeds to D. D uses the proceeds of the bonds in the amount of $10,000,000 to meet its payroll and to pay other operating expenses. The bonds are issued at par and mature $2,500,000 each year beginning September 1, 2016, through September 1, 2019. D selects November 1 as the start of its bond year21 for this issue. D projects that its spending will increase from year to year so that its reasonable working capital reserve will be at least $2,000,000 in each subsequent year. Furthermore, it projects that its total cash balance as of November 122 of each year from 2015 through 2019 will be less than $2,000,000. Based on the above, D determines that its first testing year23 for this bond issue will be the bond year beginning November 1, 2019,24 by which date all of the bonds will have matured. Neither A nor D is required to test actual cashflows on any future date because no bonds will be outstanding on any future testing date. Both A and D are required, however, to determine whether the bonds meet the six month exception to rebate (because D has spent all proceeds on the bonds at times when D had no available cash). If the rebate exception is not met, D will need to compute and pay rebate at the times required under § 1.148-3 (60 days after final maturity of the bonds, which will have been outstanding for less than five years).

Example 2. The facts are the same as in example 1, except that the bonds mature $1,000,000 each year beginning December 1, 2021, through December 1, 2030. The bonds maturing on or after December 1, 2026, are callable at par (plus accrued interest) on any day on or after December 1, 2025. Based on the above, D determines that its first testing year for this bond issue will be the bond year beginning November 1, 2019. Unlike Example 1, bonds will be outstanding on this date, so testing is required.

Example 3. The facts are the same as in example 2. On December 15, 2019, D determines that on November 1, 2019, its total cash position (not including any restricted amounts) was under $2,000,000. D also determines that during the fiscal year ending June 30, 2019, it actually spent $50,000,000 from current revenues, so that its reasonable working capital reserve was at least $2,500,000 on November 1, 2019. As a result, no action will be required for the first testing year. D had no available amounts on the first day of the first testing year. The yearly available amount for the first testing year was $0.

Example 4. The facts are the same as in examples 2 and 3. On December 20, 2020, D determines that as of November 1, 2020, its unrestricted balance including its reasonable reserve was $4,000,000, but for that same date its reasonable working capital reserve was $2,000,000. No later than 90 days after November 1, 2020 (i.e., no later than January 30, 2021), it must take an appropriate action to reduce the burden on the tax-exempt market. To do so, D purchases $2,000,000 U.S. Treasury Certificates of Indebtedness of the Demand Deposit State and Local Government Series. These certificates of indebtedness are eligible tax-exempt investments. On April 30, 2021, D finds that its unrestricted cash position is reduced to $3,000,000, including its eligible tax-exempt investments and its reasonable reserve. To meet expenditures on April 30, it liquidates part of the investment in eligible tax-exempt investments, reducing its eligible tax-exempt investments to $1,000,000. This is permitted because D had no other available amounts with which to pay these expenses. On May 1, 2021, D decides to liquidate its certificates of indebtedness and purchase in their place $1,000,000 of tax-exempt governmental (non-AMT) general obligation bonds of State S. D may liquidate the certificates of indebtedness on May 1, 2021, and purchase the general obligation bonds on May 30, 2021, because up to 30 days may be used each testing year to facilitate reinvestment. For this purpose, D is treated as the bond issuer and A need take no action.

Example 5. The facts are the same as in examples 2, 3 and 4. On November 15, 2021, D determines that as of November 1, 2021, its reasonable working capital reserve was at least $3,000,000 and its unrestricted cash on hand was $2,500,000. No action is required during the testing year beginning November 1, 2021 to unburden the market. Any remaining eligible tax-exempt investments may be liquidated at the option of D. D makes similar determinations at the start of each bond year (November 1). When necessary, D purchases the appropriate amount of eligible tax-exempt investments during the first 90 days of each bond year.

Example 6. The facts are the same as in examples 2 through 5. On November 15, 2026, D determines that its unrestricted cash exceeds its reasonable working capital reserve by $2,000,000. D uses this $2,000,000 on December 1, 2026, to redeem bonds of this issue that would otherwise have matured in 2029 and 2030. After the redemption the outstanding amount of bonds is reduced to $2,000,000 ($6,000,000 matured, and $2,000,000 called early.) The redemption is a sufficient action to unburden the tax-exempt market.

Example 7. The facts are the same as in examples 2 through 6. On November 15, 2027, D determines that its available amount on November 1, 2027, was $20,000,000 (in part because real estate taxes historically collected in November were collected in October.) D only needs to take an action to unburden the market with $2,000,000 because only $2,000,000 of bonds remain outstanding on November 1, 2027. On November 15, 2027, D redeems $2,000,000 of bonds that would otherwise have matured on December 1, 2027, and December 1, 2028. After this redemption, no bonds of this issue remain outstanding, and no more testing is required.

B. Changes to Regulations section 1.148-6

The highlighted change to Regulations section 1.148-6 indicated below should be made. The bold phrase “all issues” is intended to replace the current “the issue”.

§ 1.148-6(d)(3)(iii) Definition of available amount.

(A) In general. For purposes of this paragraph (d)(3), available amount means any amount that is available to an issuer for working capital expenditure purposes of the type financed by an issue. Except as otherwise provided, available amount excludes proceeds of all issues [debt obligations] but includes cash, investments, and other amounts held in accounts or otherwise by the issuer or a related party if those amounts may be used by the issuer for working capital expenditures of the type being financed by an issue without legislative or judicial action and without a legislative, judicial, or contractual requirement that those amounts be reimbursed.

* * * * *

QUALIFIED HEDGES

EXECUTIVE SUMMARY

The qualified hedge Regulations for tax-exempt bonds provide the rules for when and how an interest rate hedge is taken into account for purposes of computing the arbitrage yield on hedged bonds. A hedge that meets certain specific rules will be a qualified hedge. These rules relate to, among other things, the modification of risk of interest rate changes, the lack of investment element in the hedge contract, and the identification of the hedge contract on the issuer’s books and records. A hedge that meets these rules is eligible for so-called integrated hedge treatment.25 The Committee thanks the Service and Treasury for several helpful changes to the Regulations on qualified hedges. In addition, we have the following comments and recommendations.

Regarding the changes in the Proposed Regulations in connection with certain deemed terminations of qualified hedges, the Committee recommends that the hedge not be required to meet the interest rate correlation test in the 2007 Proposed Regulations26 , as defined below (in addition to the proposed new rule that the fact that the hedge is off-market is disregarded). Requiring the hedge to be modified to meet a simplified interest rate correlation test serves no purpose and substantially reduces the utility of the proposed new rules.

Regarding the changes in the Proposed Regulations to the 2007 Proposed Regulations dealing with the fair market value standard in connection with an actual termination of a qualified hedge, the Committee urges the Service and Treasury to withdraw these proposed changes, and to revert to the 2007 Proposed Regulations on this section, with certain suggested modifications. The Committee believes the proposed new rule for a specific hedge provider certificate is unwarranted. If the hedge provider certificate is retained, we have some suggested modifications.

Certain other clarifying recommendations are also made.

I. Proposed Regulations section 1.148-4(h)(3)(iv)(C)-(D) — Changes in accounting for qualified hedges in connection with deemed terminations

Proposed Regulations section 1.148-4(h)(3)(iv)(C) provides that the modification of a qualified hedge that otherwise would result in a deemed termination of the hedge (e.g., when hedged bonds are actually redeemed, or treated as reissued under Regulations section 1.1001-3) will not be treated as a termination if the modified hedge meets the requirements for a qualified hedge, determined as of the date of the modification. Proposed Regulations section 1.148-4(h)(3)(iv)(D) provides that what otherwise would be a deemed termination of a qualified hedge as a result of redemption of the hedged bonds will not be treated as a termination, and the hedge will be treated as a qualified hedge of the refunding bonds, if it meets the requirements for a qualified hedge as of the issue date of the refunding bonds. In both cases, the fact that the existing hedge is off-market as of the date of the modification or refunding, as the case may be, is disregarded. In addition, the new certification requirement is waived, and the identification requirement is measured as of the new testing date.

These proposed changes are helpful. However, when read in conjunction with other aspects of the still-pending 2007 Proposed Regulations, they are incomplete. As the Service and Treasury know, the 2007 Proposed Regulations would amend the qualified hedge rules by modifying the interest based contract rule to require, in the case of an interest rate swap based on a taxable interest rate, that the difference between the rate on the swap and the rate on the hedged bonds cannot exceed 25 basis points both at the time the issuer enters into the hedge and for a three-year period prior thereto (the “interest rate correlation test”).

While not entirely clear, the Committee reads the rule in the Proposed Regulations on potential deemed terminations to require testing for compliance with the interest rate correlation test at the time of the modification or refunding to determine whether the modified or existing hedge is a qualified hedge.27 That will greatly limit the utility of the new rules.

The Committee believes that the interest rate correlation test for qualified hedges generally is unnecessary in light of other rules. But the Committee also suggests that, if some form of interest rate correlation will be required, that correlation be limited to a three-year historical correlation. Assuming the interest rate correlation test (with a three-year historical correlation) is the rule finally adopted, the Committee urges the Service and Treasury not to require its application in connection with potential deemed terminations as a result of a modification or refunding. One of the great benefits of the Proposed Regulations is that an issuer will not need to negotiate with an existing hedge provider to maintain the qualified status of its hedge when the potential deemed termination occurs. This is most commonly the case in connection with refundings of hedged bonds (including deemed reissuances), but it can also occur in connection with deemed modifications as a result of new interest rate positions entered into with a counterparty different from the original hedge provider. If the interest rate correlation test must be satisfied as of the date of modification or refunding, the issuer will almost certainly have to deal with the original hedge provider to ensure compliance.

The Committee submits that interest rate correlation in these circumstances is unnecessary, because a single rate correlation test can always be satisfied with a meaningless adjustment to the rate formula. For example, assume an issuer’s three-year historical interest rate for a particular rate period has averaged two percent, and it has an existing interest rate swap where the issuer pays four percent fixed and receives 67% of LIBOR (which satisfied the interest rate correlation test at the time it was entered into). If LIBOR for the three-year test period prior to a refunding has averaged 2.46%, then 67% of LIBOR for that period would have averaged 1.60% — more than 25 basis points different from two percent. That difference can be eliminated by changing the interest rate formula on the swap by adding 40 basis points to each side of the equation, to make the fixed rate 4.40% and the variable rate 67% of LIBOR plus 40 basis points. Simple algebra will prove that those two rate formulas will always produce the same net number, and the same will be true for virtually any other set of rate formulas. That is easy enough to do when the swap is being entered into, when both parties to the contract are at the table. But it is needless expense in time and money to force the issuer to do that when the contract is not otherwise being touched.

As an alternative to abandoning the interest rate correlation test altogether, the Committee suggests that the issuer be permitted to satisfy that test by maintaining documentary evidence that the test could have been satisfied with an adjustment to the interest rate provisions in the swap that would have produced no net change in payments under any set of interest rate assumptions.

The Committee suggests that the Service clarify that these rules, if and when finally adopted, will supersede section 5.1 of Notice 2008-41, dealing with modifications of qualified hedges.

II. Proposed Regulations sections 1.148-4(h)(3)(iv)(A)-(B) — Definitions of modification and termination for qualified hedges

While the Committee has no specific comments to these provisions, it does have the following observations.

The removal of the phrase “acquisition by the issuer of an offsetting hedge” from the definition of a termination is an improvement to the rules.

The assignment of a hedge provider’s remaining rights and obligations under the hedge to a third party is treated as a modification under Proposed Regulations section 1.148-4(h)(3)(iv)(A), but it is also treated as a termination under Proposed Regulations section 1.148-4(h)(3)(iv)(B) only if that causes a realization event to the issuer under section 1001. Presumably that covers an assignment that is not treated as an exchange under Regulations section 1.1001-4, as recently modified. If the assignment rule is intended to have some other application, please clarify.

The Committee understands that under the Proposed Regulations a partial redemption of hedged bonds results in a partial deemed termination of a qualified hedge.

The Committee also understands that the Proposed Regulations allow an issuer to modify a qualified hedge by executing a second hedge and integrating the two hedges with the bonds without the need for a hedge provider’s certificate (assuming the other integration requirements are met).

III. Proposed Regulations section 1.148-4(h)(3)(iv)(E) — Fair market value standard for termination of qualified hedge

The 2007 Proposed Regulations would modify the Existing Regulations (which provide a safe harbor for allocating certain hedge termination payments), to provide that the amount of any termination payment or deemed termination payment taken into account for arbitrage yield calculations equals the fair market value of the hedge on the termination date. The current Proposed Regulations leave the fair market value standard for deemed terminations unchanged from the 2007 Proposed Regulations and add the rule that, in the case of an actual termination, the amount taken into account cannot be more than fair market value if the termination payment is paid by the issuer and cannot be less than fair market value if the termination payment is paid by the hedge provider. Although the Preamble to the Proposed Regulations states that these changes were made in response to comments, there is no further explanation on what issues the Proposed Regulations are intended to address. The Committee is unsure of the object of this proposal.

In most cases hedge termination payments are determined initially by the provider based on its pricing models and typically reflect the “bid side” of the hedge provider’s quotation system. Standard swap documentation usually provides for a market quotation procedure if the issuer disagrees with the provider’s termination amount, which will again be based on the “bid side.” This is the same system used for interest rate swaps for non municipal counterparties, and the Committee is unaware of any suggestion that the system produces off-market results. Especially in the case of an actual termination payment, the termination amount is a real number to the issuer, either a real cost or a real revenue; a bond yield adjustment will at best only partially compensate an issuer for an off-market termination amount.

In view of standard practice throughout the hedge market and the administrative development of this new proposed rule, the Service and Treasury should make clear the implication of the Proposed Regulations’ treatment of termination amount values. Fair questions include whether Treasury and the Service think every termination value determination is suspect; whether Treasury and the Service think hedge parties are burying other costs into swap termination values. In the latter case, the questions would be a proper subject of an audit challenge under the current rules.

Moreover, the landscape for derivatives has changed tremendously since 2007, most notably by enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. 111-203) (“Dodd-Frank”). Under the price transparency rules for interest rate swaps under Dodd-Frank, municipal issuers and their advisors (and all municipal issuers are required under Dodd-Frank to have swap advisors) have real time pricing information to help them determine the true value of their swaps.

The Committee urges Treasury and the Service to revert to the 2007 Proposed Regulations statement of the fair market value rule, with the following changes:

(i) in the case of an actual termination of a qualified hedge, the termination amount is the amount paid by or to the issuer in respect of such termination, and

(ii) in the case of a deemed termination of a qualified hedge, the termination amount is the fair market value determined by the issuer (taking into account any quotation of such value obtained from the hedge provider and any quotation obtained from a reasonably comparable provider).

`In either case, Treasury and the Service should recognize that real world termination values reflect the “bid side” of the market.

Finally, it is unlikely that there will be a single universally agreed-upon fair market value for a hedge, because different buyers will be willing to pay different prices for the same product. In other contexts (e.g., fair market value for issue price), industry practice has developed to permit parties to certify that a price represents “a fair market value.” The Proposed Regulations should be modified to use the words “a fair market value” or simply “fair market value” in place of “the fair market value.”

IV. Proposed Regulations section 1.148-4(h)(2)(viii)(A) and (B) — Requires specific hedge provider certifications for qualified hedge treatment

The Proposed Regulations would impose a hedge provider’s certification requirement for qualified hedges. This requirement seems unnecessary for several reasons. First, it would impose a requirement on qualified hedges that is not present for other financial contracts that are includable in yield. For example, there is no similar requirement for bond insurance or letters of credit, although we acknowledge similar provisions relating to investment of bond proceeds in guaranteed investment contracts. Issuers have strong legal, market and economic incentives to seek the most qualified swap counterparties.

Second, interest rate swaps and other hedges function as a form of interest rate protection, similar to the credit risk protection provided by a guarantee. Under the Regulations, if an issuer acquires a qualified guarantee, the fees includable in bond yield cannot exceed a reasonable arm’s-length charge for the transfer of credit risk.28 Importantly, in complying with this requirement, the issuer may not rely on representations of the guarantor. It would be inconsistent for the qualified hedge regulations to have disparate treatment between qualified hedges and qualified guarantees.

Third, hedge integration is not unique to the tax-exempt bond area, and the requirement in the Proposed Regulations for a hedge provider’s certificate is unprecedented. More specifically, none of the hedge integration regulations set forth under sections 446, 988, 1221 and 1275 contain a requirement for a hedge provider’s certificate. In addition, issuers have been integrating hedges with tax-exempt bonds for more than 20 years without this requirement. There should be compelling reasons for imposing a different requirement in the tax-exempt bond area than in under general tax law.

If the Service and Treasury seek to set forth an explicit “fair market price” concept to qualified hedges, the Proposed Regulations should be modified to provide for alternative methods of establishing fair pricing, which could include a hedge provider’s certificate, internal analysis, or a report of a qualified independent representative meeting the standards of the Commodity Futures Trading Commission. Moreover, where interest rate swaps are bid, with the issuer specifying the variable rate leg and the swap being awarded to the lowest fixed rate bidder, the awarded price should conclusively establish fair market price.

The Committee recognizes, of course, that most issuers (at the instigation of bond counsel) already require hedge provider certifications. It is unlikely to be coincidence that the content of the provider’s certificate in the Proposed Regulations reflects to some degree a standard form of such certification. Nonetheless, we believe the Proposed Regulations should set forth only the substantive requirements for qualified hedge treatment and should allow the market to develop appropriate standards for implementing those requirements.

If the Service and Treasury decide to retain the certification requirement, the four representations currently in Regulations section 1.148-4(h)(2)(viii)(B) should be clarified. As a general matter, the Committee believes that the form of the certificate and the precise phraseology should not dictate the tax result. The issuer should be required to demonstrate that it used its best efforts to establish that (1) the rate payable by the issuer does not include compensation for underwriting services, and (2) the rate was comparable to the rate that the hedge provider would charge for a similar hedge with a counterparty similar to the issuer (if one exists). The lack of a comparable hedge or comparable hedge counterparty should not preclude hedge integration.

Specifically, the Committee sees little value in a representation that the terms of the hedge were agreed to between a willing buyer and willing seller in a bona fide, arm’s length transaction. Hedges are typically (although not always) negotiated transactions, and issuers frequently use swap advisors (or internal expertise) to evaluate transactions. As drafted, the representation is a legal conclusion that appears to create a “foot fault” to deny integration (or create potential liability for the hedge provider) if the Service disapproves of the integrated hedge transaction.

The rate comparability representation in Proposed Regulations section 1.148-4(h)(2)(viii)(B)(2) is generally fine, but the reference to “debt obligations other than tax exempt bonds” should be deleted. Many tax exempt bond issuers do not issue taxable debt obligations. Moreover, the legal, credit and other market factors present in hedges with tax exempt issuers are materially different from the same factors when a taxable entity is a counterparty.

The Committee has a minor comment to the disclosure of third party fees as required by Proposed Regulations section 1.148-4(h)(2)(viii)(B)(3). This section should clarify that it only requires third party fees paid at the request (or for the benefit) of the issuer to be disclosed in the certificate. Third party fees, such as legal and accounting fees, paid by the hedge provider for the benefit of the hedge provider should be not be required to be disclosed. This clarification would be consistent with current market practice.

Proposed Regulations section 1.148-4(h)(2)(viii)(B)(4) is unclear. From its perspective, the hedge provider is offering to enter into a bilateral contract with the issuer. It is inappropriate for the hedge provider to address whether the hedge modifies the issuer’s risk of interest rate changes. Similarly, it is inappropriate for the hedge provider to represent that the payments are reasonably allocated to the hedge provider’s overhead. The Committee assumes that the Service and Treasury are concerned about hedge providers embedding fees for other services within a hedge. Market practice has addressed this issue effectively. In general, bond counsel have asked hedge providers whether amounts payable by the issuer pursuant to a qualified hedge include payment for underwriting or other services provided by the hedge provider. If the swap contains a significant investment element or the hedge provider makes payments on behalf of the issuer (e.g., a financial advisor or swap advisor to the issuer), those “services” are typically disclosed. As drafted the Proposed Regulations would not allow an issuer to integrate a hedge with a separately stated investment element or fee. If the Service and Treasury retain the hedge provider’s certificate requirement, we recommend that Proposed Regulations section 1.148-4(h)(2)(viii)(B)(4) be replaced with a requirement that the hedge provider represent either (1) that there are no underwriting or other services unrelated to the hedge provider’s obligations under the hedge, or (2) state the nature of the services and the rate that the hedge provider would have quoted to the issuer to enter into the hedge absent such services.

V. Proposed Regulations section 1.148-4(h)(2)(viii) — Identification

Most of the requirements for qualified hedge treatment apply to the “issuer,” which in the case of a conduit financing means either the actual issuer or the conduit borrower, depending on the context.29 In Regulations section 1.148-4(h)(2)(viii), however, the identification of a hedge must be made by the actual issuer. That is, the actual issuer must identify the specific hedging transaction within a short time-period after the transaction is executed. Especially in the case of anticipatory hedges, however, a conduit borrower may not even know for sure what entity will be the actual issuer of the bonds. In conduit financings, the Regulations should permit the identification to be made on the books and records of the conduit borrower. The actual issuer would still be required to identify the existence of the hedge on the information return filed with respect to the issue. Listing the hedge on the information return should be treated as inclusion in the issuer’s books and records and address any concerns that the Service may have regarding the issuer being familiar with the hedge.

VI. Proposed Regulations section 1.148-4(h)(4)(iv) — Applies section 1.148-4(h)(4)(iii) to section 1.148-4(h)(3)(iv)(C)

The Proposed Regulations would add a new section 1.148-4(h)(4)(iv) to read as follows —

Consequences of certain modifications. The special rules under paragraph (h)(4)(iii) of this section regarding the effects of terminations of qualified hedges of fixed yield hedged bonds also applies in the same manner to modifications of a qualified hedge under paragraph (h)(3)(iv)(C) of this section. Thus, for example, a modification may result in a prospective change in the yield on the hedged bonds for arbitrage rebate purposes under § 1.148-3.

This section is proposed to be added to the so-called super integration rules, which provide that certain hedged variable yield bonds will be treated as fixed yield bonds. In general, the rules under Regulations section 1.148-4(h)(4)(iii) provide in connection with termination of a super integrated hedge that (A) the hedged bonds are treated as reissued on the termination date in determining yield for purposes of Regulations section 1.148-3 (dealing with rebate), (B) if the termination occurs within five years of the issue date of the hedged bonds, the bonds are treated as variable yield bonds from their issue date, and (C) the termination rule does not apply to a termination if, based on the facts and circumstances (e.g., taking into account both the termination and any qualified hedge that immediately replaces the terminated hedge), there is no change in yield.

The Committee understands that the purpose of this proposed rule is to ensure that a qualified hedge super integrated under existing Regulations section 1.148-4(h)(4)(i) is retested for super integration after a modification that would not be treated as a termination under Proposed Regulations section 1.148-4(h)(3)(iv)(C) (modification does not result in a deemed termination if the fact of its being off-market is disregarded). If that understanding is correct, we suggest the rule could be clarified if the first sentence were rewritten as follows —

Notwithstanding the rule on modification of a qualified hedge under paragraph (h)(3)(iv)(C) of this section, modification of a qualified hedge that would result in a termination in the absence of the rule in paragraph (h)(3)(iv)(C) will be treated as a termination for purposes of this paragraph (h)(4)(iii) unless the rule in subparagraph (h)(4)(iii)(C) applies.

FOOTNOTES

1 References to the Existing Regulations are to those Regulations currently effective under I.R.C. § 148.

2 References to the Proposed Regulations are to those Regulations published in 78 Fed. Reg. 56,842 REG-148659-07 (Sept. 16, 2013), unless otherwise stated.

3 For purposes of these Comments, “available amounts” has the meaning set forth in Reg. § 1.148-6(d)(3). Available amounts must generally be spent before bond proceeds are spent on “restricted working capital” items. Restricted working capital expenditures are non-capital expenditures for which no exception to the bond-proceeds-spent-last rule applies.

4 The only guidance for this topic has been in private letter rulings.

5 We observe that the flexibility of allowing an issuer to invest in tax-exempt obligations to address, in whole or in part, overburdening concerns could be made to apply to any tax-exempt financing.

6 References to a “section” are to a section of the Internal Revenue Code of 1986, as amended (the “Code”), unless otherwise indicated.

7 Under Prop. Reg. § 1.148-1(c)(4)(ii)(B) an issuer is given 90 days after the start of the testing period to take certain actions. It might be appropriate to measure this “grace period” as a percentage of the testing period if periods significantly shorter than one year are allowed -for example, 25% of the testing period.

8 The Committee acknowledges that any annual testing requirement may require outside consultants to assist certain issuers.

9 The Committee notes that the “portion of” language is used in multiple places in the current and proposed versions of Reg. § 1.148-1(c). The Committee believes that the wording could be simplified because of the treatment of the multi-purpose Reg. § 1.148-9(h)-(i).

10 Some of these are stand alone financings and some are bond bank or pooled financings.

11 See PLR 200446006 (Nov. 11, 2004).

12 See section IV: Proposed Regulatory Changes

13 We assume, however, that there is no intent to change the historical interpretation of the private security or payment test of I.R.C. § 141(b)(2) such that if proceeds are granted to an unrelated third party and neither the issuer (nor a related party) receives any payments, directly or indirectly with respect to the applicable financed project, that the private activity bond test is not satisfied. For example, a grant of proceeds to a multifamily, for-profit developer, by a city, for a housing project, would not satisfy the private activity bond test of I.R.C. § 141 merely if the developer receives rent from the housing project, provided that neither the city (nor a related party) receives such rent.

14 Certain numbering and headings are also in bold because that is how they appear in the regulations. We do not expect that this will cause any confusion.

15 Cash flow period only needs to be defined if the variable date method is used.

16 Cash flow year only needs to be defined if the fixed date method is used, and the IRS does not want to use “bond year” for this purpose.

17 We recognize that this comment letter does not explain the rationale for these numerical constraints.

18 We believe that these testing and unburdening provisions can and perhaps should logically be applicable to any tax-exempt financing, including capital project financings. Of course, those bond issues subject to § 147 of the Code would also need to comply with that provision.

19 Bond year may be replaced with “cash flow year” or “cash flow period” throughout this paragraph. Definitions of “cash flow year” or “cash flow period” would then be required and would be limited to no more than 13 months.

20 For the projection method, this definition would read: “the Issuer determines its reasonably expected available amount as of a date of its choosing occurring during such bond year (yearly available amount).” Under this method, the term fiscal year could be used instead of bond year throughout.

21 If a variable date method is adopted, this might be re-worded as “the first Friday of November as the start of each cash flow period beginning with the second cash flow period.” If a fixed measurement date method based on cash flow years is used, substitute cash flow year for bond year throughout the examples.

22 If the final regulations use the term “cash flow year” or “cash flow period,” then this should be modified accordingly.

23 Period if a variable method is used.

24 Earlier bond years or cash flow years begin less five years after the bonds are issued. The expectations of the issuer at closing are that there would not be any available amounts on any of these testing dates because the reserve was increasing and balances were staying the same. If a variable testing date method is used, substitute “the cash flow period beginning Friday, November, 2019.”

25 That is, payments and receipts under the hedge are integrated as part of the bond yield.

26 72 Fed. Reg. 54,606 REG-106143-07 (Sept. 26, 2007) (the “2007 Proposed Regulations”).

27 Disregarding any off-market aspect of the modified or existing hedge might be interpreted to include any noncompliance with the interest rate correlation test, but that seems an unlikely intent.

28 See Reg. § 1.148-4(f)(4)(i).

29 Regs. § 1.148-1(b)




ABA Tax Section Seeks Withdrawal of Proposed Issue Price Definition for Tax-Exempt Bonds.

Michael Hirschfeld of the American Bar Association Section of Taxation has submitted comments on proposed regulations (REG-148659-07) on arbitrage investment restrictions applicable to tax-exempt bonds and other tax-advantaged bonds, requesting that proposed changes to the current definition of issue price be withdrawn and that any other changes to the current regs be reproposed.

According to the tax section, the proposed changes to the issue price definition don’t reflect a cost-benefit analysis of replacing the “reasonable expectations” provision of the current regs with the “actual facts” approach of the proposed regs. Section members believe that the changes to long-established market practices will harm intergovernmental comity and will increase rather than diminish uncertainty for issuers and other market participants.

Thus, the tax section suggests that the proposed regs should not replace the current regs, which could be improved as suggested by the tax section in its November 2010 comments on the determination of issue price applicable to tax-exempt bonds and all tax credit and Build America Bonds. If Treasury and the IRS decide to retain the actual facts approach, the tax section suggests many changes and additions to the applicable provisions of the proposed regs to retain some critical benefits of the current regs.

January 23, 2014

Hon. John Koskinen

Commissioner

Internal Revenue Service

1111 Constitution Avenue, NW

Washington, DC 20024

Re: Comments Concerning the Definition of Issue Price for Tax-Exempt Bonds and Other Tax-Advantaged Bonds

Dear Commissioner Koskinen:

Enclosed are comments concerning the definition of issue price for tax-exempt bonds and other tax-advantaged bonds. These comments represent the view of the American Bar Association Section of Taxation. They have not been approved by the Board of Governors or the House of Delegates of the American Bar Association, and should not be construed as representing the policy of the American Bar Association.

Sincerely,

Michael Hirschfeld

Chair, Section of Taxation

American Bar Association

Washington, DC

Enclosure

AMERICAN BAR ASSOCIATION

SECTION OF TAXATION

COMMENTS CONCERNING THE DEFINITION OF ISSUE PRICE FOR

TAX-EXEMPT BONDS AND OTHER TAX-ADVANTAGED BONDS

These comments (the “Comments”) on certain portions of Proposed Treasury Regulation section 1.148-1 are submitted on behalf of the American Bar Association Section of Taxation (the “Section”) and have not been approved by the House of Delegates or Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association.

Principal responsibility for preparing these Comments was exercised by Arthur Anderson of the Committee on Tax-Exempt Financing (the “Committee”). Substantive contributions were made by Faust Bowerman, Stefano Taverna, Christie Martin, Robert Kaplan and Mark Norell. The Comments were reviewed by Nancy M. Lashnits, Chair of the Committee, and by Frederic L. Ballard, Jr., reviewer for the Committee on Government Submissions, and Bahar Schippel, Council Director for the Committee.

Although the members of the Section who participated in preparing these Comments have clients who might be affected by the Federal tax principles addressed by these Comments or have advised clients on the application of such principles, no such member (or the firm or organization to which such member belongs) has been engaged by a client to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these Comments.

Contact: Arthur E. Anderson II

Phone: (804) 775-4366

Email: [email protected]

Date: January 23, 2014

EXECUTIVE SUMMARY

On September 16, 2013, the Internal Revenue Service (the “Service”) and the United States Treasury (the “Treasury”) published in the Federal Register proposed regulations1 on the arbitrage restrictions under section 1482 applicable to tax-exempt bonds and other tax-advantaged bonds. These Comments relate only to the portions of the proposed regulations related to the changes to the current definition of issue price, which is found in Regulations section 1.148-1 (the “Existing Regulations”).3 Hereinafter such portions of the proposed regulations will be referred to as the “Proposed Regulations.” The Section is submitting separate comments on other aspects of the proposed regulations, including provisions relating to working capital expenditures, grants and treatment of qualified hedges.

As used herein, the terms “tax-advantaged bonds” and “bonds” encompass all of the tax-exempt and other tax-advantaged bonds to which the Proposed Regulations will apply, if finalized.4

For the following reasons, the Committee respectfully requests that the Proposed Regulations be withdrawn and that any other changes to the Existing Regulations be re-proposed. The Proposed Regulations do not properly assess the significance of the perceived problems with the Existing Regulations nor do they reflect a cost-benefit analysis of replacing the “reasonable expectations” provision of the Existing Regulations with the “actual facts” approach of the Proposed Regulations. The Committee believes that the changes to long-established market practices will harm intergovernmental comity and will increase rather than diminish uncertainty for issuers and other market participants. Therefore, the Existing Regulations should not be replaced by the Proposed Regulations. However, the Existing Regulations could be improved as recommended in comments submitted by the Section in 2010 and attached hereto as Appendix A.

If the Service and Treasury decide to adhere to an actual facts approach, the Committee suggests a number of changes and additions to be made to the Proposed Regulations to retain certain critical benefits of the Existing Regulations.

I. RETAIN THE EXISTING REGULATIONS

A. Introduction.

For all types of tax-advantaged bonds, the issue price is the starting point for determining compliance with all arbitrage-related matters. It is also the starting point for determining compliance with other key requirements applicable to certain types of tax-advantaged bonds, including those relating to volume cap, private business use limitations and the restrictions on bond-financed costs of issuance. For “direct pay” tax-advantaged bonds such as “build America bonds” issued under section 54AA and section 6431, issue price determines whether an issuer has complied with the premium limit and, thus, along with other provisions, whether the issuer is entitled to receive the subsidy from the U.S. Treasury.5

Section 148(h) provides that the “yield on an issue shall be determined on the basis of the issue price (within the meaning of sections 1273 and 1274).” The Existing Regulations define issue price as follows:

Issue price means, except as otherwise provided, issue price defined in section 1273 and 1274. Generally, issue price of bonds that are publicly offered is the first price at which a substantial amount of bonds is sold to the public. Ten percent is a substantial amount. The public does not include bond houses, brokers, or similar persons or organizations acting in the capacity of underwriters or wholesalers. The issue price does not change if part of the issue is later sold at a different price. The issue price of bonds that are not substantially identical is determined separately. The issue price of bonds for which a bona fide public offering is made is determined as of the sale date based on reasonable expectations regarding the initial public offering price. If a bond is issued for property, the applicable Federal tax-exempt rate is used in lieu of the Federal rate in determining the issue price under section 1274. The issue price of bonds may not exceed the fair market value as of the sale date.6

The “reasonable expectations” provision of Existing Regulations allows the final determination of the issue price of an issue of tax-advantaged bonds on the sale date. Thus, the issuer will know, on the sale date, whether the tax-advantaged bonds will satisfy the many requirements that depend on the issue price. Having a final issue price on the sale date also enables the issuer to make many calculations required for compliance with tax law (such as the yield on the bonds), which can be critical if yield-restricted investments are being purchased.

The Proposed Regulations would amend the issue price definition in a number of significant respects. Most importantly, the Proposed Regulations would base the determination of issue price on actual sale prices to the public instead of on reasonably expected sale prices. The Proposed Regulations would also remove the definition of “substantial amount” as ten percent. Instead, the Proposed Regulations would provide a safe harbor under which an issuer may treat the first price at which a minimum of 25 percent of the bonds of a maturity is actually sold to the public as the issue price, so long as all orders at this price received from the public during the offering period are filled (to the extent that the public orders at such price do not exceed the amount of bonds sold). The actual facts approach would eliminate, for a standard publicly-offered, tax-advantaged bond issue, the ability to determine with certainty whether the issue complies with tax provisions dependent on the issue price until after the sale date.

The “reasonable expectations” standard of the Existing Regulations does not require an issuer to delve into the intent of any particular purchaser of its tax-advantaged bonds. Issuers can form and rely on reasonable expectations about both the price at which the bonds will be sold and the identity and intent of the potential bond purchasers. In apparent recognition of this problem, in the Proposed Regulations the Service and Treasury attempt to clarify and simplify the distinction between a purchaser who is a member of the public and a purchaser who is not. The Proposed Regulations define the term “public” to mean any person other than an “underwriter.” “Underwriter” is defined to mean any person that purchases bonds from the issuer for the purpose of effecting the original distribution of the bonds, or otherwise participates directly or indirectly in the original distribution. An issuer will find it fairly easy to identify as underwriters the financial firms with which it has a contractual relationship, such as, for example, through a bond purchase agreement. Under the Proposed Regulations, however, issuers would be required to determine intent in assessing purchases by security dealers and others who are not part of the underwriting syndicate, who may be acting “for the purpose of effecting the original distribution of the bonds.”

B. Identifying the Problems and Assessing Their Significance.

The legislative history of Section 148(h) is clear. In enacting the provision as part of the Tax Reform Act of 1986, Congress intentionally overturned State of Washington v. Commissioner, 692 F.2d 128 (D.C. Cir. 1982), which held that an issuer’s calculation of arbitrage yield should reflect the “all-in” costs of its borrowing, including the underwriter’s compensation and the other costs of issuance. The underwriter’s discount or commission is a major component of the costs of issuance for the issuer of any publicly-offered, tax-advantaged bond issue. Including costs of issuance in the issue price raises the issue price, and a higher issue price for a given principal amount of tax-advantaged bonds lowers the arbitrage yield thereon. Section 148(h) in effect prohibits an issuer from increasing the arbitrage yield on its bonds to recover the costs of issuance through the investment of bond proceeds at the higher yield.

The preamble to the Proposed Regulations identifies the problems the Service and Treasury see with the Existing Regulations. First, the preamble asserts that the ten percent standard does not always produce a representative price for tax-advantaged bonds due to the execution by underwriters of the first ten percent of the sale of a maturity of the bonds at the lowest price (and thus the highest yield) of the range of prices being offered. In other words, there is not a “bona fide public offering” of all of the bonds of the maturity at the stated issue price. Second, the public availability of certain actual pricing information on the Internet — most importantly through the Electronic Municipal Market Access (“EMMA”) platform developed by the Municipal Securities Rulemaking Board (the “MSRB”) — has led the Service and Treasury to question the ability of the reasonable expectations standard of the Existing Regulations to produce a representative issue price. The reported trade data has shown, in certain instances, actual sales to the public that differ significantly from the reasonably expected issue price. Third, the reported trade data has also shown sales to underwriters and security dealers being counted as sales to the public. Essentially, the Service and Treasury believe that the Existing Regulations are facilitating the understatement of the issue price of tax-advantaged bonds and the underwriter’s compensation, producing an arbitrage yield higher than Section 148(h) permits.

Although the problems are adequately identified, the preamble fails to assess the significance of the problems.7 For example, it does not assess the loss to the Federal government resulting from lower rebate payments or higher subsidy levels. An underwriter who is holding back a portion of a maturity of tax-advantaged bonds may be faced with selling at a loss if the market moves away from it. An intermediary purchasing bonds on the sale date with the intent to “flip” them before the issue date may be in the same position. The reality is that markets go down as well as up.

Compounding the failure to assess the significance of the problems is the mislaying of the burden of fixing the problems. All three of the problems identified in the preamble — not making a bona fide public offering of all of the bonds of a maturity at their stated issue price, significantly different actual sale prices, and sales to “flippers” being counted as sales to the public — stem from the actions of underwriters and securities dealers. Issuers have little incentive or ability to control or alter the actions of these other market participants. The Existing Regulations should not be abandoned without a complete consideration of whether there are other tools available (such as MSRB or SEC rules) to address the problems without placing the burden on issuers.

C. Cost/Benefit Analysis.

The Service and Treasury should ascertain whether the benefits of the Proposed Regulations would be greater than the costs.8 If an issuer decides to eliminate the possibility of unsold maturities on the sale date, it will be forced to accept lower prices and higher yields in negotiated underwritings. In order to ensure that no unsold maturities exist, underwriters will have less incentive to market bonds aggressively. They will instead accept lower prices and higher yields just so bonds can be “put away” on the sale date. Due to the nature of competitive sales, it is virtually impossible to eliminate the possibility of unsold maturities. Underwriters in competitive sales cannot know whether they will have the opportunity to purchase bonds until the sale date, which discourages pre-sale marketing of those bonds. Alternatively, if the issuer determines to continue to sell its bonds as such sales occur in the current market, where the possibility of unsold maturities exists, the issuer will be forced to incur additional legal and financial advisory costs in attempting to determine issue price based on actual sales to the public. Additional bonds are likely to be issued to cover the higher costs. The Service and Treasury should determine whether the benefits of ascertaining what they believe to be a more accurate representative price of bonds may be offset by (i) the higher bond interest rates produced by discouragement of market pricing through competitive sales and the other ways in which the Proposed Regulations may narrow the market, and (ii) the higher fees paid to financial advisors and legal counsel because of the additional analyses that will need to be performed under the Proposed Regulations.

D. Effects on State and Local Governments.

Recent years have been difficult for State and local governments. Their finance staffs are currently thin and suffer from high rates of turnover. The Service and Treasury should consider the administrative burden that would be imposed on State and local finance officials if they are required to obtain, evaluate and apply the information about the identity of bond purchasers and pricing necessary to satisfy the actual sales standard in the Proposed Regulations.9

The burden could be particularly acute, and compliance may be impossible in the short-term, if issuers are required to determine the intent of a market participant (including participants with whom there is no privity of contract) in purchasing bonds — in other words, whether the purchaser is purchasing bonds for the purpose of effecting the original distribution of the issue. Although EMMA has clearly made pricing in the tax-advantaged bond market more transparent, it is not possible to ascertain a purchaser’s intent through EMMA. The Committee’s understanding is that EMMA was designed to provide general market transparency and that it was not designed to serve as a tool to establish issue price. The use of EMMA to gauge issue price can lead to erroneous conclusions. Therefore, State and local governments will likely be forced to add personnel or spend more money on lawyers and financial advisors to perform the due diligence needed to make the determinations of intent. These issues must be viewed in light of the fact that for governmental bond issues, only the yield would change as a result of the application of the Proposed Regulations. Neither the amount nor the timing of the debt service to be paid by the issuer nor the net proceeds to be received by the issuer at issuance would be affected by assigning bonds a higher issue price and thus a lower arbitrage yield for events occurring after the sale date.

In addition, the Committee believes that competitive sales will be difficult under the Proposed Regulations. Competitive sales generally ensure the lowest cost of capital for issuers (and hence minimize the arbitrage yield). Competitive sales are also required by the law of a significant number of States.10

The actual facts regime of the Proposed Regulations requires a protracted and continual tracking of actual sales of bonds and the determination of which purchasers are or are not underwriters. The possibility that the arbitrage yield on an issue could change after the sale date will require issuers to put additional cushion in the savings and other parameters in their authorizing resolutions if they are so permitted by State law. Furthermore, while the Proposed Regulations permit issuers to make a yield reduction payment in connection with advance refunding escrows the yield of which would exceed the yield on the bonds, issuers will certainly face additional costs in computing the yield reduction payments and many issuers may not have the funds to make any such payments. Overburdening State and local governments with the actual facts regime of the Proposed Regulations would be harmful to intergovernmental comity.

E. Reducing Uncertainty.

The greatest virtue of the Existing Regulations is certainty. Issuers are able to calculate the issue price and arbitrage yield on the sale date. Advance refunding issues can be verified, and refunding escrow securities can be locked in well before the closing date. Practitioners have also relied on the Existing Regulations to test compliance with many other tax and structuring requirements, such as whether the issuer has sufficient volume cap or has properly sized a debt service reserve fund. Official statements can be finalized in a timely manner. Furthermore, the certainty provided by the Existing Regulations allows issuers to proceed to closing with the knowledge that the sale date number runs would conclusively show compliance with the bond authorization parameters. For example, under the Existing Regulations an issuer can award bonds and purchase a refunding escrow on the sale date with the certainty of compliance with an authorizing resolution that requires a showing of a three percent present value debt service savings. The Proposed Regulations do not provide such level of certainty, and the Committee does not believe that the Service and Treasury have made the case that the savings either to the Federal government or to issuers will be sufficient to justify the loss of certainty.

F. Section II Conclusion: Retain the Existing Regulations.

The Committee believes that the Proposed Regulations should not be adopted.

The Committee acknowledges that the Existing Regulations would benefit from additional guidance to make them work more effectively. In this regard, the Committee references the comments on the definition of issue price submitted by the Section in 2010, a copy of which is attached as Appendix A. The Committee would welcome the inclusion in a re-proposed issue price definition of any or all of the suggestions set forth in the 2010 comments.

II. COMMENTS ON THE PROPOSED REGULATIONS

A. Introduction.

If the Service and Treasury decide to abandon the Existing Regulations, the Committee proposes the changes to the Proposed Regulations set forth below. The Committee respectfully requests that the market be given an opportunity to comment on any of these changes the Service and Treasury may determine to make and that such changes, along with the Proposed Regulations modified thereby, be re-proposed.

B. Twenty-Five Percent versus Ten Percent.

The 25 percent “substantial amount” safe harbor threshold is too high. Issuers will strive to achieve as much finality on the sale dates of their bonds as they can. The actual facts regime of the Proposed Regulations will result in issuers insisting on a demonstration by the underwriters that 25 percent of each maturity of an issue is actually sold to the public on the sale date. At times in the current market, the underwriter will not have actual sales of ten percent of each maturity on the sale date, much less 25 percent. The Committee believes that the narrowing of the market will result from the higher threshold, particularly when combined with the requirement to fill all orders for bonds at the safe harbor threshold price, and will drive up yields. The ten percent figure has been used for more than two decades by practitioners and market participants in the taxable market as well as by the tax-exempt market to establish how much of a particular maturity is a “substantial amount.”11 The removal of the substantial amount definition, therefore, affects not just the tax-exempt bond market, but also the taxable market. The Committee urges that the threshold remain at ten percent.

When a large number of substantially similar products, commodities or financial instruments (for example, multiple bonds of the same maturity) are offered for sale, there are likely to be multiple prices for such products, commodities or financial instruments. An increase in the substantial amount threshold from ten percent to 25 percent exacerbates this problem. If the Service and Treasury settle on the higher threshold, then it will be critically necessary to provide guidance on how issue price for a maturity is to be determined when multiple prices occur and less than 25 percent is actually sold at one price.

C. Competitive Sale Safe Harbor.

The Proposed Regulations surprisingly lack accommodation for competitive sales. Many issuers are required by the laws of their states to sell bonds competitively, and many others prefer competitive sales because they are believed to result in better bond pricing and streamlined procurement. Moreover, in competitive sales the issuer and the purchasers of the bonds do not have the same privity and contractual relationship that issuers enjoy in negotiated underwritings. This lack of accommodation is particularly surprising in light of past indications from the Service that the abuses observed in the determination of issue price, which were perceived occurring in negotiated transactions, were not apparent with competitive sales.

Given the compressed time periods and lower underwriting spreads in the competitive sale arena, the Committee believes that few competitive sales as currently configured will be able to satisfy the 25 percent safe harbor on the sale date. This may encourage issuers to choose the negotiated sale or private placement routes, if possible. This may have the unfortunate effect of raising tax-advantaged bond yields, harming both the Federal government and issuers.

The Committee urges the Service and Treasury to retain the basic reasonable expectations rules under the Existing Regulations for bond issues sold in competitive sales that meet requirements analogous to those for the establishment of fair market value prices for yield-restricted escrows and guaranteed investment contracts.

The Committee also urges the Service and Treasury to set the “substantial amount” threshold in competitive sales at the current market expectation — that is, ten percent — and to eliminate the requirement that all orders be filled at the stated offering price during the offering period. The nature of competitive sales simply does not permit the kind of pre-sale market testing that would encourage a bidder to take risks with the initial offering prices. Again, the Committee fears that yields will go up and harm both the Federal government and issuers.

D. Authorize Reliance on Certain Certificates.

The goal of an issuer in selling tax-advantaged bonds is to obtain the best possible pricing of debt instruments to finance a school, a municipal building or a road system. The issuer sells its bonds through underwriters and securities dealers because these intermediaries are in the business of finding bond purchasers and dealing with them. The Committee urges the Service and Treasury to add a provision to the Proposed Regulations, if finalized in their current form, authorizing an issuer to rely in good faith on a certificate from the managing underwriter or successful bidder regarding (i) the first price at which 25 percent of a maturity of tax-advantaged bonds is sold, (ii) the filling of all orders from the public at the first price during the offering period, and (iii) the identity of each underwriter of the bonds (including each “related party” underwriter). “Good faith” would mean the absence of abuse (for example, bid rigging, pay-to-play, or price-fixing) or actual contrary knowledge by the issuer.

In fact, underwriters, who are best positioned to know the facts surrounding any particular pricing, are already bound by MSRB standards dealing with factual representations. The standards provide that “all representations made by underwriters to issuers of municipal securities in connection with municipal securities underwritings (e.g., issue price certificates and responses to requests for proposals), whether written or oral, must be truthful and accurate and may not misrepresent or omit material facts.”12 Obtaining issue price representations, mostly written, is part of a well-established practice of bond tax counsel. In addition, the Committee supports specific identification rules, similar to those of section 1236(b) relating to dealer’s identification of securities held for investment, so long as the responsibility for making the specific identification resides with the underwriters and securities dealers.13 Those identification requirements should remain with the market participants and can be used as evidence of truthfulness about the underwriter’s representations.

The underwriters of a tax-advantaged bond issue have, or can cost-effectively obtain, the background needed to make the certifications necessary to satisfy the safe harbor issue price rule. Policing mechanisms exist to assure the veracity of the certifications. The Committee urges the Service and Treasury to make it clear that an issuer can satisfy the safe harbor issue price rules through good faith reliance on an underwriter’s certificate.

E. Need for Actual Sales Price Data.

Although technological improvements (such as EMMA) are mentioned in the preamble to the Proposed Regulations, the text of the Proposed Regulations does not specify where an issuer is to obtain the information about the actual sales of its bonds. EMMA in its current form does not provide a viable solution, because of its various timing and misidentification problems, which have been mentioned above and discussed with the Service and Treasury in other contexts. EMMA can only serve as a tool to verify in some, but not all, cases, the certifications provided by paid professionals that are supposed to comply with securities laws. If the Service and Treasury require that the issue price of sales be based on actual facts, they should first make sure that issuers have access to the necessary data to comply or to verify the certifications of the underwriters. Prior to requiring that prices be based on actual sales prices, the Committee recommends that significant lead time be provided so as to ensure that databases (whether from EMMA, from underwriters or by other means) exist to ensure transparent and accurate information for compliance with the tax law. Additionally, the Committee recommends that prior to effectiveness of the Proposed Regulations, the Service review those databases to ensure that it is satisfied with the quality and sufficiency of the data.

F. Defined Safe-Harbor Offering Period.

The Proposed Regulations have the potential to create enormous uncertainty by the requirement to track — possibly long after the closing date of a bond issue — the actual sale prices of the bonds. This tracking may be necessitated by (i) the need to assure that even if the required portion of a maturity of bonds is actually sold at the initial offering price, all orders for bonds of the maturity at the initial offering price during the “offering period” are filled, and (ii) situations in which less than the required threshold of the maturity is sold at the initial offering price. The Proposed Regulations do not define “offering period,” but most market participants assume that it has the same meaning as under the securities laws. This means, for a particular maturity of bonds, a period ending on the date the underwriters no longer retain an unsold balance of the bonds for sale to the public. The end date need not correspond to the closing date of the issue.

In order to provide issuers some finality and certainty in the process of determining issue price, the Committee urges the Service and Treasury to include the concept of a defined safe-harbor offering period. This is, admittedly, a rough-justice approach, but it reflects the undeniable fact that markets go down as well as up in the two-week to four-week period between the sale date and the closing date of a typical governmental bond issue and certainly fluctuate after the closing date. The Service and Treasury should consider whether any net loss in terms of overstated yields will be negated by the cost of the bonds that will have to be issued to cover the additional issuance costs.

The Committee recommends that the offering period end six business days after the sale date. The six-day period is chosen for two reasons. First, six business days would always require the holding of the initial offering price or a position in the to-be-issued bonds over a weekend. Second, six business days would allow the final determination of issue price in time for the issuer to meet its obligation under SEC Rule 15c2-12 to deliver the final official statement within seven business days after the sale date. Such a rule would not only promote certainty but would also reflect that tax laws related to issue price do not operate in a vacuum. It would promote intergovernmental comity by dovetailing with the other regulatory guidelines with which issuers and underwriters must comply.

The Service and Treasury could alternatively consider defining the offering period by reference to the 13-day or 15-day periods established under Regulations Section 1.1275-1(f) or 1.150-1, even though this approach would not work as well with existing market requirements and practices as the six business day offering period. If two bond issues that are sold 15 days apart from each other are deemed to be separate issues, the Service and Treasury should view the sale of the second bond of a maturity 15 days after the sale of the first bond of the same maturity as not affecting each other.

The concept of a definite safe harbor offering period would also facilitate addressing the situation in which less than 25 percent (or ten percent) of a maturity can be sold at the initial offering price (or at the “first price,” if different). If by the end of the safe-harbor period less than 25 percent (or ten percent) of a maturity is actually sold to the public, the issue price of that maturity should be the initial offering price at which that maturity was marketed to the public on the sale date in a bona fide public offering.

G. Bifurcated Rule.

If the concern of the Service and Treasury is that the yield on new money financings is too high based on the Existing Regulations, then they should consider finalizing the Proposed Regulations with a bifurcated rule under which refunding escrows would be subject to one rule and new money transactions, which include longer term investments in construction and acquisition funds, as well as reserve funds, would be subject to a different rule.

H. Non-Yield-Related Consequences of the Actual Facts Regime.

The Committee does not believe that issuers can adequately assess the potential consequences of the Proposed Regulations without knowing how the Service and Treasury intend to address the many other provisions of the Code the compliance with which is determined based on the issue price of the bonds. For example, the actual facts regime may not allow an issuer to secure adequate volume cap. In addition, the limits on costs of issuance may also be violated if the issue price becomes less than originally anticipated. This is the most important reason for the Committee’s request that any change in the issue price definition be re-proposed.

FOOTNOTES

1 Prop. Reg. § 1.148-1, 78 Fed. Reg. 56,842 (2013).

2 References to a “section” are to a section of the Internal Revenue Code of 1986, as amended, unless otherwise indicated.

3 Reg. § 1.148-1.

4 Prop. Reg. § 1.150-1(b), 78 Fed. Reg. 56,842 (2013), defines a “tax-advantaged bond” to mean:

[A] tax-exempt bond, a taxable bond t hat provides a Federal tax credit to the investor with respect to the issuer’s borrowing costs, a taxable bond that provides a refundable Federal tax credit payable directly to the issuer of the bond for its borrowing costs under section 6431, or any future similar bond that provides a Federal subsidy for any portion of the borrowing costs. Examples of tax-advantaged bonds include qualified tax-credit bonds under section 54A(d)(1) and build America bonds under section 54AA.

5 I.R.C. § 54AA(d)(2)(C) (for “build America bonds”) and Notice 2010-35, 2010-19 I.R.B. 660 (for qualified tax-credit bonds).

6 Reg. § 1.148-1(b).

7 The Committee will make several references to Exec. Order No. 12,866, 58 Fed. Reg. 51,735 (October 4, 1993) (“EO 12866”). In EO 12866 President Clinton set forth the principles to which Federal agencies are to adhere in promulgating regulations. One of these principles requires Federal agencies not only to identify the problem intended to be addressed by a regulation, but also to assess the significance of that problem. On January 18, 2011, President Obama issued Exec. Order No. 13,563, 76 Fed. Reg. 3821 (January 21, 2011), to reaffirm and supplement EO 12866. President Obama made no substantive changes to any of the regulatory principles of EO 12866.

8 In developing a regulation, EO 12866 requires a Federal agency to:

[A]ssess both the costs and the benefits of the intended regulation and, recognizing that some costs and benefits are difficult to quantify, propose or adopt a regulation only upon a reasoned determination that the benefits of the intended regulation justify its costs. . . .

9 EO 12866 requires Federal agencies to be sensitive to the views of State, local and tribal governmental entities. In developing a regulation, an agency must:

[A]ssess the effects of Federal regulations on State, local, and tribal governments, including specifically the availability of resources to carry out those mandates, and seek to minimize those burdens that uniquely or significantly affect such governmental entities, consistent with achieving regulatory objectives. In addition, as appropriate, agencies shall seek to harmonize Federal regulatory actions with related State, local, and tribal regulatory and other governmental functions. . . .

10 See, e.g., Thomas A. Schweich, Missouri State Auditor, General Obligation Bond Sales Practices (November 2013), http://www.auditor.mo.gov/Press/2013116769245.pdf.

11 David C. Garlock, Federal Income Taxation of Debt Instruments, ¶ 203.03 (6th ed. 2010).

12 See, MSRB Notice 2012-25 (May 7, 2012) (providing interpretive notice on the application of MSRB Rule G-17).

13 Reg. § 1.1236-1 clearly imposes the responsibility for identification of a security as “held for investment” on the securities dealer.




IRS Cancels Hearing on Proposed Regs on Arbitrage Rebate Overpayments on Tax-Exempt Bonds.

The IRS has canceled the February 5 public hearing on proposed regulations (REG-148812-11) that provide guidance on the recovery of overpayments of arbitrage rebate on tax-exempt bonds and other tax-advantaged bonds. No one asked to speak at the hearing.

Arbitrage Rebate Overpayments on Tax-Exempt Bonds;

Hearing Cancellation

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-148812-11]

RIN 1545-BK80

AGENCY: Internal Revenue Service (IRS), Treasury

ACTION: Cancellation of a notice of public hearing on proposed rulemaking.

SUMMARY: This document cancels a public hearing on proposed regulations that provide guidance on the recovery of overpayments of arbitrage rebate on tax-exempt bonds and other tax-advantaged bonds.

DATES: The public hearing originally scheduled for February 5, 2014 at 2 p.m. is cancelled.

FOR FURTHER INFORMATION CONTACT: Oluwafunmilayo Taylor of the Publications and Regulations Branch, Legal Processing Division, Associate Chief Counsel (Procedure and Administration) at (202) 622-7180 (not a toll-free number).

SUPPLEMENTARY INFORMATION: A notice of proposed rulemaking and a notice of public hearing that appeared in the Federal Register on Monday, September 16, 2013 (78 FR 56841) announced that a public hearing was scheduled for February 5, 2014, at 2 p.m. in the IRS Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW. Washington, DC. The subject of the public hearing is under section 148 of the Internal Revenue Code.

The public comment period for these regulations expired on December 16, 2013. The notice of proposed rulemaking and notice of public hearing instructed those interested in testifying at the public hearing to submit a request to speak and an outline of the topics to be addressed. As of January 17, 2014, no one has requested to speak. Therefore, the public hearing scheduled for February 5, 2014 at 2 p.m. is cancelled.

Martin V. Franks

Chief

Publications and Regulations Branch

Legal Processing Division

Associate Chief Counsel

(Procedure and Administration)

[FR Doc. 2014-01388 Filed 01/23/2014 at 8:45 am; Publication Date: 01/24/2014]




Bond Dealers Seek Substantial Changes to Proposed Issue Price Rules for Tax-Exempt Bonds.

Michael Nicholas of Bond Dealers of America has commented on proposed regulations (REG-148659-07) on arbitrage investment restrictions applicable to tax-exempt bonds, addressing the rules on determining the issue price of a bond that the group says are unworkable, will result in higher interest costs for tax-exempt bond issuers, and should be substantially revised and reproposed.

December 16, 2013

Internal Revenue Service

1111 Constitution Avenue, N.W.

Washington, DC

RE: CC:PA:LPD:PR (REG-148659-07): Arbitrage restrictions on tax-exempt bonds

On behalf of the Bond Dealers of America (“BDA”), I am submitting these comments in response to the IRS’ notice of proposed rulemaking (the “Proposed Rules”) related to the arbitrage rules under section 148 of the Internal Revenue Code. Although the Proposed Rules would make a number of changes to the regulations, our comments are focused on the rules related to the determination of the “issue price” of a bond. While the BDA appreciates the efforts of the IRS and Treasury to provide clarification in this area, for the reasons described below, we believe that the Proposed Rules are unworkable, will result in higher interest costs for issuers of tax-exempt bonds, and should be substantially revised and reproposed.

We believe that the BDA and its members provide a unique perspective with regard to the Proposed Rules: the members of the BDA are largely focused on “middle market” transactions in the $10-25 million range that make up a large percentage of the issues that come to market each year, both in competitive and negotiated offerings. This experience and the related expertise cannot be found elsewhere in the municipal market. Our comments on the proposed issue price rules will focus on the following aspects of the proposal: First, the rules must take into account the reality that municipal securities are bought and sold within the context of a fluid marketplace with capital at risk; the removal of the reasonable expectations standard ignores this reality. Second, the IRS must identify its policy goals and weigh the costs of any solution to issuers of municipal bonds. Third, the Proposed Rules do not offer a workable means of determining issue price if the “safe harbor” is not satisfied. Fourth, we believe that the proposed safe harbor rule for determining issue price will lead to unnecessarily higher interest rates as market participants are compelled to use the safe harbor to establish the issue price in each transaction. As a result, we believe that in lieu of the proposed approach that abandons the existing issue price rules, the IRS should make modest changes to those existing rules and couple those changes with appropriately targeted enforcement of those modified rules. The Proposed Rules have been in development for several years. During the course of this process, GFOA, BDA and other industry groups met with IRS and Treasury officials to discuss the rules related to issue price. These discussions culminated with a submission by this joint industry group of proposals related to the issue price rules on August 5, 2010, which is attached hereto. We continue to believe that the August 5, 2010 letter offers the best approach to dealing with the issue price rules. In particular, the August 5, 2010 letter called on the IRS to retain an approach to issue price determinations that is based on reasonable expectations when a bona fide public offering of the bonds is made. We stand by that recommendation.

As set forth below, the Proposed Rules would make dramatic changes to the regulations that would impose substantial costs on nearly every issuer of municipal bonds. Despite IRS personnel having frequently spoken out on the problems with the existing rules, we have yet to see evidence of the type of substantial abuses in numerous transactions that would justify such a dramatic change in the rules.

The rules must take into account the realities of the marketplace. A key shortcoming of the Proposed Rules is the failure to take into account the reality that the municipal bond market, like all public securities markets, is constantly changing. The price of every security is subject to fluctuation from the moment it is offered to the time that it is retired. Further, most municipal issues, unlike other issues in the equity or corporate bond market, are comprised of multiple maturities, often from 20 to 30 different maturities, that take a longer period of time to sell. For this reason, it can take days and even weeks to make an initial sale of all of the maturities of an issue. During this time, however, an underwriter and issuer are subject to market fluctuations. The issue price of a bond should be defined by the reasonable expectations at a defined point in time for both competitive and negotiated sales. For example, this point would be “at the time of sale” in a competitive issue and “at final pricing” on a negotiated issue, and should not encompass the amounts — whether gains or losses — that the underwriter absorbs because it takes the risk of changes in the market. An approach based on reasonable expectations is the only way to isolate the real underwriters’ compensation from changes in bond pricing due to external factors so as to properly reflect the correct issue price for arbitrage purposes. Your proposal would define the issue price based not only on the initial expectations but also on the value of the market fluctuations that take place between the initial pricing and the eventual sale, a period that could last over a month. Clearly, this would not be accurate for anyone’s purposes.

Identification of the IRS’ policy goals. When Congress amended the Code to require that the issue price of a bond be determined on the basis of the price paid for the bonds by the public, it had a simple goal in mind: issuers should not be able to compute bond yield in a manner that permitted them to earn back their issuance costs, including underwriters’ compensation1, through the investment of the bond proceeds. Thus, the issue price of a bond must be determined in a manner that captures the compensation earned by the underwriters’ in underwriting the bonds. The IRS and Treasury Department performed a wholesale revision of the arbitrage regulations in 1993 with a view towards simplifying those rules and adopting a “rough justice” approach to the rules rather than seeking to capture every dollar that could potentially be viewed as arbitrage without regard to the costs related to compliance and complexity. However, the IRS and Treasury coupled this approach with the adoption of broad anti-abuse rules and the creation of a tax-exempt bond audit program. This approach was intended to reverse two decades of increasing regulatory complexity that resulted from frequent amendments to the regulations in order to capture the latest perceived abuse. The IRS and Treasury have remained true to this approach for the past 20 years, in large part due to the existence of an effective audit program. One result of this approach has been the elimination of the need to make changes to the regulations that affect every issuer of the tax-exempt bonds in order to address an abuse being perpetrated by a minority of transaction participants. The Proposed Rules abandon this approach and we believe that this is not the way that the IRS should regulate in this area. Instead, we believe that the IRS should identify the conduct that it believes is problematic and enforce the law under its existing authority. For example, if underwriters are executing issue price certificates in an untruthful manner, the IRS has the tools to punish that behavior. Similarly, if the IRS believes that there are broker/dealers who are effectively part of the initial issuance of a bond issue but not being treated as such, the IRS should identify the problematic behavior and either enforce the existing rules or make modest clarifying changes to those rules.

However, as we stated above, the IRS must take these steps in a manner that is consistent with the policy behind the issue price rules: identifying the costs paid by bond issuers in issuing their bonds and including those costs as part of the issue price. By definition, those costs do not include changes in the price of bonds due to interest rate or other changes that occur after the initial sale of a bond issue. Finally, the rules should provide issuers and their advisors with certainty and should not impose unnecessary additional borrowing costs on the entire market place. The Proposed Rules go beyond what is necessary to capture the underwriters’ compensation paid by the issuer.

It is also important that the use of issue price under section 148 has a very different policy rationale than do the original issue discount rules. Since 1989, the tax-exempt bond rules for determining issue price have had substantial differences from the “OID” rules for that very reason, In this case, attempting to make those two sets of rules consistent is unnecessary and harmful and changes the approach employed since shortly after the Tax Reform Act of 1986.

The history of the issue price rules being based on reasonable expectations is also noteworthy because it occurred during a period when Congress and the IRS were abandoning the use of reasonable expectations in favor of an actual facts approach in a wide variety of tax-exempt bond compliance contexts. The Tax Reform Act of 1986 gave the IRS statutory authority to take into account intentional acts to earn arbitrage and the IRS availed itself of this authority throughout the 1993 re-write of arbitrage regulations. Yet as part of that re-write of the arbitrage regulations, the IRS made clear that a bond’s issue price was based on the issuer’s reasonable expectations. The reason for this, we believe, is that when there is a bona fide offering of a bond at an agreed upon initial offering price, the parties have agreed on the compensation for that underwriting and that is the amount that matters for arbitrage issue price and yield determination purposes. What happens after that offering price is agreed to is a risk that the underwriter has taken on, and not part of the issue price determination. The Proposed Rules reflect a failure to take the policy of the issue price rules into account.

The general rule of the Proposed Rules is unworkable. The Proposed Rules, as drafted, do not provide an effective way to determine issue price outside of the new, proposed safe harbor. Trying to define issue price based on sales over an extended period of time completely ignores the reality of financial markets and the risks that underwriters take to provide the lowest cost of borrowing to municipal issuers. An issue price needs to be defined at a specific point in time, not over a period of time.

To state the obvious, a regulation that does not have a workable general rule will compel compliance with any safe harbor that is provided. In the case of the Proposed Rules, both the general rule and the safe harbor are defective. Further there is no effective or completely accurate way for an issuer to track the prices of its bonds so that it could ever comply with the rules. For example, the MSRB’s EMMA database lacks sufficiently specific details of trades to provide a solution to the problem. The Proposed Rules are also defective in that they fail to distinguish changes in bond prices that result from changes in interest rules and other external factors.

The Proposed Rules are particularly unworkable for competitive bond sales. In competitive sales the bidders will typically not make any sales of the bonds at the time that they bid on the bonds. Accordingly, the only way to comply with the Proposed Rules will be to lower yields so as to ensure that the safe harbor is satisfied. The difficulties with competitive sales will encourage issuers and underwriters to reduce the use of this underwriting method.

The ability of an issuer to comply with the rules by making rebate-like “yield reduction payments” is not an effective way to deal with these other problems. Yield reduction payments will require certainty as to the issue price taking into account the reasonable expectations at the time of the initial offering. Requiring an issuer to make a yield reduction payment as a result of a sale that that may have taken place 30-40 days after the initial pricing completely ignores the impact of market volatility and other factors that would have influenced the price at which the sale was eventually executed. Yield reduction payments also presume that the issuer will have the funds to make those payments. Since the issue price can only be determined after the sale of the bonds (if ever), issuers will be unable to size their borrowings to cover this cost. Moreover, the need to make yield reduction payments could cause an issuer to violate the authorizing resolution for a bond issue (e.g., where a transaction is approved provided that certain savings targets are met). The requirement to make these yield reduction payments will make issuers responsible for costs that go far beyond what the Tax Reform Act was intended to accomplish.

The safe harbor will increase borrowing costs of state and local governments. For the reasons described above, the Proposed Rules will compel issuers to satisfy the new issue price safe harbor. The safe harbor, by its terms, only applies if at least 25 percent of each maturity of a bond issuer is sold to the “public.” Therefore, in order to satisfy the safe harbor and establish a bond’s issue price, 25 percent of that bond must be sold to the public. Thus, the issuer and underwriters must set the interest rates high enough (or the prices low enough) that the issuer will essentially be guaranteed that it will meet the 25 percent safe harbor for each separate maturity of an issue. Moreover, the issuer and the underwriters must make these sales to buyers who they are certain will not resell the bonds in a manner that results in them being viewed as dealers. The result is that issuers will have to sell their bonds “cheap” enough that they can be assured that a subset of the municipal bond market will buy at least 25 percent of each maturity. These problems will be magnified in the not unusual situation where an issuer has difficulty selling a particular maturity. Under the current rules, the underwriter would typically purchase that bond rather than lower its price since that could affect the pricing of a number of other maturities in that bond issue. Under the Proposed Rules, the issuer will be compelled to reduce the price of the “problem” maturity, potentially forcing it to reduce the price of some or all of the earlier and later maturities in the bond issue. Again, this will result in higher borrowing costs for the issuer. These results stem from the fact that the safe harbor makes no provision for situations in which a bond pricing is not successful, necessitating that the underwriter purchased the bonds. This is an unworkable regulatory approach that will result in virtually every issuer having higher borrowing costs.

Underwriters and flippers. We understand the IRS’ desire to ensure that the issue price of a bond is determined in a manner the takes into accounts sales of bonds by underwriters and by so-called “flippers”. The BDA believes that it is a difficult distinction but clarity is needed if the IRS believes that this is an important distinction for tax purposes. At a minimum, we believe that it is critical that the regulations distinguish between two types of purchasers of bonds and that the breadth and vagueness of the Proposed Rules be eliminated in order for our members (and bond issuers) to be confident in their compliance efforts. Further, as with defining the price based on sales, defining customer in a restrictive way will also increase issuance and borrowing costs as a result of the subsequent administrative burdens and the limits on permitted bond purchasers. The Proposed Rules include as an underwriter “any person that purchases the bonds for the purpose of effecting the original distribution of the bonds or that otherwise participates directly or indirectly in such original distribution.” This definition is simply unreasonable: it uses extremely broad terms and requires that issuers determine the intent of bond purchasers. Even with the ability to cure bond yield-related problems through yield reduction payments, it will be impossible for an issuer and its bond counsel to determine the parties that the IRS might view as an underwriter with the sort of certainty necessary to conclude that a bond issue is tax-exempt.

We understand the IRS concern with purchasers who intend to immediately resell the bonds that they purchased as part of the initial offering regardless of other market factors (for example, regardless of whether interest rates increase or decrease). However, a separate category of purchaser are those who maintain substantial portfolios of municipal bonds and who do not purchase with the intent to resell those bonds but who may, depending on a variety of facts and circumstances, determine to resell the bonds over a period of time that may begin within a very few days after the initial public offering of the bonds but which typically take several days or weeks to complete. These purchasers may analyze the state of the market to determine whether there is an opportunity to resell those bonds at a profit, taking into account a variety of factors including movements in interest rates after the initial offering of the bonds, the supply of tax-exempt bonds in the market, how the pricing of other tax-exempt bonds compares to the prices of the newly purchased bonds, whether they need to sell bonds as a result of their investors wanting to reduce their positions in the funds maintained by these bond purchasers, etc. This latter type of investor should not be viewed as a “flipper” and their resales of tax-exempt bonds should not be viewed as affecting the issue price of a bond.

The Proposed Rules use the term “dealer” as defined under section 475 of the Code as a part of the identification of sales that are counted in determining a bond’s issue price. The precedent under that definition of dealer indicates that a dealer expects to profit based purely on the mark-up that they can earn as a middle-man or wholesaler. An investor with a portfolio of municipal bonds that buys more bonds and subsequently determines to resell some or all of those bonds is looking to profit based on the municipal bond market and changes in that market. While the concept of using this definition of under section 475 may be good, the law regarding “dealer” status is not sufficiently developed to provide the type of certainty that is needed for purposes the tax-exempt bond rules that use “issue price” as part of the analysis. For this reason, we believe that the rules must clarify that mutual funds, insurance companies, and other investors that do not purchase bonds in the initial offering with an expectation that they will immediately begin reselling those bonds are not “dealers” for this purpose.

Suggested approach. We believe that the IRS should issue new proposed rules that retain the basic framework of the existing final regulations with the following modifications:

(a) Improve the general rule. The general rule should be that issue price is determined based on the issuer’s reasonable expectations at a specific time provided that a bona fide public offering of all of the bonds is made. The regulations should provide greater detail on the requirements for the making of a “bona fide public offering.” And, this time should be defined as a specific time, not a period of time. The August 5, 2010 letter contained a number of suggestions for providing greater detail for establishing that a bona fide public offering has been made. The IRS should use its available enforcement tools to ensure that abuses are not occurring and should work with the SEC, FINRA, and MSRB to enforce the municipal securities regulations.

(b) Consider maintaining the 10 percent threshold. The BDA believes that the reasonable expectations general rule must be in place and should be coupled with a workable safe harbor. The existing 10 percent rule has served that function for the last 20 years, but can not work in the absence of the reasonable expectations rule that is essential to recognizing that the rules interact with a fluid marketplace in which capital is at risk. Should the IRS consider an increase in this threshold, it should be coupled with a clear rationale for the anticipated benefit any such increase would produce.

(c) Require acceptance of all orders. We believe that the requirement in the Proposed Rules that all orders received from the public during the offering period are filled (to the extent of the amount of bonds sold) is a good proposal that should be retained. We would suggest, however, that the IRS further make clear that the order period during the underwriting process is synonymous with the term used under the proposed regulations, “offering period” so that there is general understanding that any trade after the bond purchase agreement is signed shall not be considered part of the initial public offering. This proposal combined with the suggested minor clarification should address some of the concerns with the existing rules that the IRS has noted.

(d) Clarify who is a “dealer.” As indicated above, while the “dealer” concept is a good one, clarification of its application is needed. The Proposed Rules state that a person that buys and holds bonds for investment is not an underwriter but additional guidance is needed.

(e) Clarify the length of the underwriting period. The Proposed Rules state that sales by a dealer during an order period (as understood to coincide with the term “offering period” as suggested above in (c)) are taken into account if it purchases bonds for the purpose of effecting the original distribution of the bonds. This is another example of an aspect of the Proposed Rules that is good in concept but that does not provide enough certainty in the context of the tax-exempt bond rules.

(f) Safe harbor for competitive sales. We believe that the rules should be drafted reflecting the fact that competitive underwritings reduce the concerns that the IRS should have regarding the determination of issue price. A safe harbor for competitive sales should be provided and should state that the issue price for a competitive sale is determined by reasonable expectations at the time of sale.

(g) De minimis rules are needed. In drafting its rules the IRS should recognize that special consideration is appropriate for both small issues of bonds and smaller maturities within a longer issue. In both of these situations, it will often be difficult to establish actual sales of a substantial percentage of the bonds. Given that these transactions are smaller in size, the risk for abuse of the arbitrage rules is greatly reduced. We suggest that greater flexibility be provided in the case of smaller bond issues and smaller bond maturities and would offer our assistance in working with the IRS to establish the appropriate thresholds.

(h) Other uses of “issue price.” The Code and regulations use “issue price” for a number of other aspects of the tax-exempt bond requirements. The concerns that seem to be the rationale for the Proposed Rules do not apply in these other contexts. For those other purposes, than “issue price” should be exclusively based on reasonably expectations.

We believe that the municipal bond industry works best when the industry and regulators work together to develop practical solutions that address issues in a manner that does not create unnecessary costs or burdens for the industry. The industry provided substantial input regarding the issue price rules in meetings with the IRS and Treasury and in the August 5, 2010 letter. This input does not seem to have impacted the development of the Proposed Rules. Further, we believe that a cost/benefit analysis of the Proposed Rules would demonstrate that the costs that would be imposed on issuers of tax-exempt bonds far outweigh the compliance benefits that the IRS is seeking to obtain.

Although our comments are focused on the aspects of the Proposed Rules related to issue price, we are generally supportive of the other clarifications that the IRS has proposed. We recognize, however, that these rules raise complex technical issues that should be resolved before the rules are finalized. In addition, the changes proposed should be made available more broadly on a retroactive basis. We are, however, concerned with the proposed change to the anti-abuse authority of the Commissioner. Throughout the history of the arbitrage regulations, the anti-abuse rules have been appropriately targeted so as not to provide the Commissioner with unlimited discretion. Thus, for example, the regulations prohibit transactions that involve a material financial advantage related to arbitrage but only if there is a related burden on the market for tax-exempt bonds. The regulations permitted wider discretion to the Commissioner related to arbitrage-driven transactions but limited that discretion to making modifications to properly reflect the economic substance of the transaction. In contrast, while Congress provided the IRS with broader authority in the context of advance refundings, no such broad authority was provided under the arbitrage rules. For this reason, we believe that the IRS should reconsider the proposed changes to the anti-abuse rules under the arbitrage regulations.

The BDA greatly appreciates the effort undertaken by the IRS and Treasury to clarify the issue price rules. We believe that the opportunity to comment on the Proposed Rules and an ongoing dialogue between the federal government and industry participants is necessary to ensure that a workable set of rules if promulgated. The BDA offers its assistance in this process.

Sincerely,

Michael Nicholas, CEO

Bond Dealers of America

Washington, DC

Enclosure: August 5, 2010 Letter to Department of Treasury and Internal Revenue Service

FOOTNOTE

1 For these purposes, we use “underwriters’ compensation” to include both the compensation for the actual underwriting of a bond and the other services provided by the firms acting as the underwriters of a bond issue.




Bond Counsel Group Suggests Changes to Proposed Bond Arbitrage Regs.

The American College of Bond Counsel has commented on proposed regulations (REG-148659-07) on arbitrage investment restrictions applicable to tax-exempt bonds, urging the IRS to withdraw the provision that proposes a new definition of issue price and suggesting improvements and clarifications to the remaining provisions.

December 9, 2013

CC:PA:LPD:PR (REG-148659-07)

Internal Revenue Service

PO Box 7604

Ben Franklin Station

Washington DC 20044

This letter contains comments on the September 16, 2013 proposed arbitrage regulations [REG-148659-07] submitted on behalf of the American College of Bond Counsel (the “College”).

The College was formed in 1995 and now has nearly 300 lawyer Fellows who have been recognized by their peers for their skill, experience and high standards of professional and ethical conduct in the practice of bond law and for their accomplishments and achievements in the practice of bond law. The College serves to promote high standards of professional and ethical responsibility in the practice of bond law; improve bond law and practice; provide authoritative educational materials in the field of bond law; speak upon matters of interest and importance to bond law and practice before legislative, administrative and regulatory bodies, to provide forums for its membership to meet and exchange ideas and professional experience; and to cooperate and consult with national, state and local bar organizations, government agencies, issuer organizations, and other groups which have an interest in bond law and practice. These comments were prepared by a committee of the College consisting of Philip C. Genetos, of Ice Miller LLP; Charles S. Henck, Ballard Spahr, LLP; Lisa P. Soeder, Soeder & Associates, LLC and John K. Van Duys, Haynsworth Sinkler Boyd, P.A. These comments represent the views of the committee and have not been approved by the Board of Directors of the College. If you have any questions regarding this letter, please contact John Van Duys at (803) 779-3080.

The comments of the College consist of two parts. The first part relates to the proposed new definition of “issue price” and urges the proposed regulations to be withdrawn. The second part relates to the rest of the provisions in the proposed regulations, with suggestions for improvement and clarification.

PART ONE

Issue Price.

The College submits that the Service has not made the case that the “expectations” test of the Existing Regulations should be abandoned. Although proposed to provide “greater certainty”, we suggest that the opposite will be the case, to the detriment of the State and local governments. The proposed issue price regulation suffers from a type of “false precision” that loses sight of the very objective sought by the rule, namely, “certainty.”

The College submits that certainty is more important in this context than precision since almost every substantive measurement under Sections 103-150, 265 and 1001 depends on knowing, on or before the issue date of such obligations, the issue price of an issue of tax exempt debt obligations. These provisions, of course, include yield restriction, rebate and multi-purpose issue allocations. But they also include volume cap allocations and carry-forwards, TEFRA approval, private use and payment analyses, cost of issuance limitations, computation of weighted average maturity, information reporting, advance refunding limits, bank qualification and re-issuance. All of these rules are written with the unstated expectation that the issue price of the bonds is a known quantity at or before closing.

Further, Treasury has not provided a compelling reason for abandoning a rule that has been in place for decades. What are the practical failings of the current issue price rule? There has been no indication that the issuers have gamed the current rules to obtain a material financial benefit. The preamble states that “increasing transparency about pricing information in the municipal bond market . . . has led to heightened scrutiny of issue price standards.” Treasury appears concerned that the current process by which municipal bonds are marketed allows the interposition of speculators and other intermediaries between the issuer of the bonds and the final long-term investor. Any mark-ups along the way are taxable ordinary income to the market participants. There is no indication that this is a recent development, only that as pricing is more transparent it is easier to notice. Underwriters who sell bonds at a loss are not long in business.

The proposed regulations appear to be premised upon a concern that the issuers and underwriters have colluded to price the bonds at a higher yield than the market requires. There is no evidence of that provided. Further, there is ample reason to believe that the issuers have considerable reason to seek to achieve the best pricing, as reinvestment rates for at least the last five years have afforded no opportunity to arbitrage proceeds, whether the issue price was correct or marginally off market. And the increased market transparency, albeit imperfect, has provided issuers with some capacity to assure themselves of the fair-pricing by the underwriters and allow competing underwriters to bring any past instances of unfair pricing to the attention of issuers for future issues.

The proposed issue price rule does not purport to dictate to the municipal underwriting community that they sell directly to retail “buy-and-hold” owners. Instead, the rule provides a safe harbor for municipal bonds issued for money. Under the safe harbor, the issuer “may treat” the first price at which a minimum of 25% of the bonds is sold to the Public as the issue price; but only if all orders at such sale price during the offering period are filled, and “Public” excludes a broad range of market participants directly or indirectly participating in the distribution or related to such a direct or indirect participant. There are many practical problems with this structure.

First, and most significantly, it sacrifices certainty on the altar of precision. Even if all of the information necessary to actually determine the issue price of an issue of municipal bonds under the safe harbor is accessible by the issuer (which it is not), the structure of the regulation makes it impossible to ascertain that figure on the issue date, not to mention the pricing date on which plans must be settled in order to efficiently close the bond sale. The proposed regulations realize this flaw and attempt to assuage it by allowing yield reduction payments to “true up” the actual and expected issue price. This is an inadequate solution because it only affects one aspect of the role issue price may have in a bond issue. Due to trading activities in the municipal market, over which the issuer has no control, the search for precision calls into question a host of substantive tax restrictions before the actual issue price is determined. The higher issue price may have blown through the cost of issuance limitation, required additional volume cap or exceeded the bank qualification limit. All the multi-purpose issue allocations may be incorrect, resulting in advance refunding portions larger than permitted under Section 149. The proposed regulations have no solution for these problems.

Secondly, it assumes a level of transparency and cooperation between antagonistic market participants that does not now and may never exist. Even the Treasury has admitted that the MSRB EMMA or other reporting services do not provide sufficiently reliable information to provide the certainty needed. Issuers of debt obligations have an interest in minimizing their cost of funds and have strong reasons to require the underwriters to sell their bonds at the lowest yield possible. Underwriters make their living by selling municipal bonds at prices higher than they paid. These interests are diametrically opposed. Both parties rely on market competition to ensure that their interests are protected. The increased information on bond pricing has afforded the issuers a greater opportunity to inform themselves about the process. Nevertheless, the proposed issue price regulation requires the issuer to determine the identity of the purchasers of its municipal bonds and whether those purchasers are (i) direct or indirect participants in the underwriting, or (ii) related to such direct or indirect participants. Our experience is that after issuers sell their bonds to underwriters, either in competitive transactions (in which the issuer has effectively no leverage to extract information from the buyers) or in negotiated sales (in which the issuer has bargained hard to sell the bonds at the lowest yield), the underwriters are not interested in telling the issuer about their resales and the lead underwriter is often in no position to require other broker/dealers who acquire bonds to disclose how those bonds have been resold. How major securities firms deal with their own property is their own business and their distribution channel is a trade secret. There is no reliable public source for the information needed by an issuer to apply the safe harbor contained in the proposed issue price regulation. There is currently no expectation that such information will become available in the future. Far from bringing “more certainty” the proposed issue price regulation is unworkable. Furthermore, there is no means by which the issuer could demonstrate that all aspects of the safe harbor are satisfied, other than from a certificate or representation of the lead underwriter. The proposed regulations do not permit that form of documentation as being dispositive of those conditions.

Third, given the import of providing certainty to the issuer and its bond counsel, the proposed regulations will force the pricing and marketing of the bonds to be driven by the need to satisfy these restrictions, i.e., to assure that all of the bonds are sold on the sale date, rather than to provide the issuer with the best pricing available at the time, which may mean that the underwriter holds unsold bonds for resale when market conditions require.

This is not the first time Treasury has attempted to fine tune this definition to make it more precise. Par. 11 of Notice 89-78, Arbitrage Restrictions on Tax-Exempt Bonds Under Section 148 of the Code, 1989-2 C.B. 390; 1988-27 I.R.B. 6; 1989-30 I.R.B. 6; added the following to Regulation 1.148-8T(c)(2)(ii):

“(ii) Bonds offered at a discount. If substantially identical bonds are initially offered at one price to the general public and at a discount from that price to institutional or other investors, the issue price of each bond shall be the average offering price of all the bonds. For purposes of the preceding sentence –

(A) The offering price of each bond sold to institutional or other investors at a discount on or before the date of issue (as defined in § 1.150-1T(c)(2)) is the discounted initial offering price at which the bond was sold, and

(B) The offering price of every other bond is determined on the basis of the initial offering price to the general public at which price a substantial amount of the bonds was sold.”

This language was removed by T.D. 8345 after “much comment.” Such removal was prudent.

Treasury should consider the purpose of the issue price definition as it applies to Sections 103 – 150, 265 and 1001, the practical necessities of tax compliance and the current relationships in State and local government finance. The “expectations” standard is not perfect and the actual trade information could result in a more precise number. This proposal does not purport to establish the issue price of the purchased bond for purposes of the holder’s tax liability. The fact that the issue price under Section 148 may be different from that under 1273 should not be repugnant to the Service.1 The expectations standard has stood the test of time, is capable of implementation in the current market and addresses the legitimate concerns of the Treasury. Absent collusion between the issuer and its underwriter, the expected re-offering price should be sufficient.

The College urges the Treasury to withdraw the proposed issue price regulation.

PART TWO.

Working Capital.

The College applauds the elimination of the provision in the Existing Regulations preventing the direct or indirect financing of a working capital reserve as the previous lesser of average amount maintained and 5 percent of prior year expenditures regime penalized those issuers in the greatest financial distress. The College also supports the imposition of a 13-month maturity safe-harbor for short-term working capital financings (making the regulation consistent with Rev. Proc. 2002-31 and the temporary period rules) and strongly supports the new safe harbor for long-term working capital financings (which makes the regulation consistent with relevant private letter rulings in the working capital arena). We suggest that the final regulations include a modification to the definition of Available Amounts in Section 1.148-6(d)(3)(iii) to ignore any amounts invested in municipal obligations not subject to alternative minimum tax. This is consistent with the approach taken by the proposed regulation, but simpler, leaving the redemption of bonds as a possible remedial action.

Qualified Hedges.

Section 1.148-4(h)(3)(iv)(B) of the Proposed Regulations states that a deemed termination of a qualified hedge occurs, inter alia, “if the hedge ceases to meet the requirements for a qualified hedge of the hedged bonds; . . .” Read literally, this requires a continuous monitoring of the hedge to determine that the requirements of Section 1.148-4(h)(2) are met. Most of the requirements for qualified hedge status are clearly accomplished one time at the time the hedge is identified to the Bonds. Under the 2007 Proposed Regulations, Section 1.148-4(h)(2)(v)(1)(i) requires analysis of the correlation between the variable rate on the hedged Bonds and the variable leg of the hedge (i.e., 25 basis points) on a “snap shot” and a 3-year historical basis. We do not believe that this correlation must be continuously monitored and suggest that the quoted language in the Proposed Regulations be revised. Such sentence also states that a deemed termination occurs when the issuer makes a modification “that results in a deemed exchange of the hedge and a realization event to the issuer under Section 1001; . . .” As written, the sentence is circular and provides little practical guidance. It is also unclear whether or not a deemed exchange under 1001 is a necessary prerequisite for any deemed termination. We assume the Treasury intended such provision to result in a deemed termination if the hedge is modified (within the meaning of the prior paragraph) and the modified hedge does not meet the requirements for qualification (which is provided in the next paragraph). We suggest the sentence be revised to clearly indicate its intent.

Section 1.148-4(h)(3)(iv)(B) of the Proposed Regulations provides that a modification of a qualified hedge does not result in a deemed termination if the hedge would quality on the modification date and “the fact that the existing qualified hedge is off market as of the date of the modification is disregarded.” We interpret this as meaning that the integrated yield of the hedged bond is not changed, i.e., that the off market component is included in the yield computation. The Existing Regulations are unclear as to the precise meaning of an “off market” component. In a typical variable to fixed rate swap, the “off market component” usually refers to the fixed leg of the swap. Is it the intent of this provision to excuse compliance with 2007 Proposed Regulation Section 1.148-4(h)(2)(v)(1)(i) in determining whether the modified hedge is qualified? An example would clarify the intent of this provision. If the proposed regulation requirement of close correlation of the variable leg is intended to apply, the example would be similar to the following: “On June 1, 2010, Issuer entered into a 15 year variable to fixed swap agreement with Bank under which Issuer will pay a fixed rate of 3.75% on a notional amount of $10,000,000 and the Issuer will receive from Bank payments equal to 70% of one month LIBOR plus 25 basis points on such notional amount. On June 15, 2010 Issuer properly identified the swap as a qualified hedge of its $10,000,000 variable rate Series 2010 Bonds maturing June 1, 2025. On June 1, 2015 Issuer refunded the Series 2010 Bonds in whole with its new variable rate Series 2015 Bonds. On June 15, 2015, Issuer identified the swap to the Series 2015 Bonds. At that time, the variable component of the swap and the expected variable rate on the Series 2015 Bonds were closely correlated within the meaning of Section 1.148-4(h)(2)(v)(1)(i). At such time, the fixed leg of the swap for its remaining 10 year term would be 3.15%. The swap is a qualified hedge of the Series 2015 Bonds and all payments under the swap will be taken into account for purposes of computing the yield on the Series 2015 Bonds.”

Recognizing that this was part of the 2007 Proposed Regulation Section 1.148-4(h)(3)(4)(E), how is the fair market value of the hedge to be determined?

Section 1.148-5(c)(3) of the Proposed Regulations states “(i) through (ix) [Reserved].” Does this mean that such sections of the Existing Regulations and the 2007 Proposed Regulations will be removed? Surely not! See Part One of these comments for our reasons to eliminate subparagraph (x).

In section 1.148-5(d)(3)(ii) of the Proposed Regulations “exclusively” is no longer necessary.

The College questions the validity of Proposed Regulation Section 1.148-10(e) as written which may not comply with substantive due process by providing meaningful guidance to comply with federal tax laws.

Grants.

The Proposed Regulations move the definition of a “grant” from Section 1.148-6(d)(4)(iii) to Section 1.150-1(f) and make it applicable for all purposes of taxation of municipal bonds. The definition continues to provide that “The transfer must not impose any obligation or condition to directly or indirectly repay any amount to the transferor or a related party. Obligations or conditions intended solely to assure expenditure of the transferred moneys in accordance with the governmental purpose of the transfer do not prevent a transfer from being a grant.” The College interprets this to mean that a return of any portion of the grant due to failure to meet the grant conditions is not a private payment for purposes of Section 141(b). Section 1.148-6(d)(4)(2) provides such amounts are “treated as unspent proceeds of the issue.” Many complex issues arise from this. For example, assume City issues bonds to provide a grant to a private, for-profit company to build and operate a health care clinic. The grant requires the grantee to operate the clinic on a qualifying basis for 10 years after completion and to repay scheduled amounts to the City (which may be equivalent to the debt service on the Bonds funding the grant) if the grantee ceases qualifying operation during such period. After 5 years, the company decides to cease qualifying operation and repays one-half of the grant to the City. If City uses the repayment to originate another grant or to partially redeem the Bonds issued to fund the grant, the College contends that the remaining Bonds should not be private activity bonds. There are no rules governing the application of the expenditure tests for temporary period and rebate expenditure exceptions to grant repayments that are used to make additional grants. The College would recommend a springing temporary period similar to the one provided in current regulations for loan repayments, which begins on the date the grant funds are repaid to the issuer. The College would also request that a new expenditure exception from arbitrage rebate begin to run at such time as any grant proceeds are repaid to the issuer.

In summary, the College appreciates the dedication and hard work of the Treasury officials responsible for the drafting and review of the proposed arbitrage regulations and recognizes how difficult it is to navigate the turbulent waters of the arbitrage regulations in a manner that pleases everyone. The College respectfully requests that the redraft of such proposed regulations take into account the principles and concerns set forth in the College’s comments, the industry’s need for pre-issuance clarity and certainty in the issue price regime, and the fact that the vast majority of market participants are simply trying to comply with the rules governing the municipal industry (rather than attempting to sidestep them).

FOOTNOTE

1 The OID Regulations contain provisions allowing issuers and holders to have inconsistent tax positions. These rules include: Section 1.1273-2(h)(2) permitting issuers and holders to take inconsistent positions regarding the allocation of the issue price of investment units; Section 1.1274-3(d) permitting the holder to take a position inconsistent with the issuer regarding whether the debt obligation is issued in a potentially abusive situation, Section 1.1275-2(h)(5) permitting the holder to take a position inconsistent with the issuer regarding whether a contingency is remote or incidental and Section 1.1275-4(b)(4)(iv) permitting the holder to take a position inconsistent with the issuer regarding the prospective payment schedule for a CPDI whether a contingency is remote or incidental.




Bond Lawyers Suggest Withdrawal of Proposed Issue Price Definition.

Allen Robertson of the National Association of Bond Lawyers has commented on proposed regulations (REG-148659-07) on arbitrage investment restrictions applicable to tax-exempt bonds, suggesting that the definition of issue price be withdrawn and that any other change in the issue price definition be reproposed.

December 16, 2013

Internal Revenue Service

CC:PA:LPD:PR (REG-148659-07)

P.O. Box 7604

Ben Franklin Station

Washington, DC 20044

www.regulations.gov (IRS REG-148659-07)

Re: Proposed Arbitrage Regulations Addressing Definition of “Issue Price” for Tax-Exempt Bond Purposes (REG-148659-07)

Ladies and Gentlemen:

The National Association of Bond Lawyers (“NABL”) respectfully submits the enclosed comments relating to the definition of “issue price” in the proposed arbitrage regulations, REG-148659-07, which were published in the Federal Register on September 16, 2013 (the “Proposed Regulations”). NABL is separately submitting comments on other aspects of the Proposed Regulations. These comments were prepared by members of NABL’s Tax Law Committee listed on Appendix I, and were approved by the NABL Board of Directors.

NABL appreciates the substantial efforts made by the Department of the Treasury and the Internal Revenue Service in the preparation of the Proposed Regulations and, as explained in its separate comments, believes that other aspects of the Proposed Regulations should be finalized as soon as possible; however, as explained in the enclosed comments, NABL respectfully suggests that the proposed definition of “issue price” be withdrawn and that any other change in the issue price definition be re-proposed.

NABL requests an opportunity to speak at the public hearing to be held on February 5, 2014 at 10:00 AM. An outline of the topics to be discussed is attached as Appendix II.

NABL exists to promote the integrity of the municipal market by advancing the understanding of and compliance with the law affecting public finance. We respectfully provide this submission in furtherance of that mission.

If you have any questions regarding the enclosed comments, please contact Bill Daly in our Washington, D.C., office at (202) 503-3300.

Sincerely,

Allen K. Robertson

President

National Association of Bond

Lawyers

Washington, DC

* * * * *

COMMENTS OF THE NATIONAL ASSOCIATION OF BOND LAWYERS

ON THE DEFINITION OF “ISSUE PRICE”

IN THE PROPOSED ARBITRAGE REGULATIONS

PUBLISHED ON SEPTEMBER 16, 2013

EXECUTIVE SUMMARY

On June 18, 1993, the Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) published comprehensive final regulations on the arbitrage investment restrictions and related provisions for tax-exempt bonds under sections 103, 148, 149 and 150 of the Internal Revenue Code of 1986, as amended (the “Code”).

On September 16, 2013, Treasury and IRS published proposed regulations that would amend the existing regulations in a number of respects, including significant revisions to the definition of “issue price” that eliminate the “reasonable expectations” standard for determining the issue price of publicly offered municipal bonds as of the sale date in favor of an “actual sales” approach.

For the following reasons, the National Association of Bond Lawyers (“NABL”) respectfully suggests that the definition of “issue price” in the proposed regulations be withdrawn and that any other change in the issue price definition be re-proposed.

The proposed definition of “issue price” is not required or appropriate to address the policy objectives and stated concerns of Treasury and IRS.

The preamble to the proposed regulations, the proposed definition of “issue price” in the proposed regulations and public comments made by Treasury and IRS officials after publication of the proposed regulations emphasize that the amendments to the issue price definition are intended to make that definition more consistent with current regulations under sections 1273 and 1274 of the Code, which implies that such consistency, including an “actual sales” approach, is required by the cross-reference to sections 1273 and 1274 in section 148(h) of the Code. A review of the history and purpose of the arbitrage statutes and regulations, including the existing regulations, confirms that an “actual sales” approach is not required.

In the preamble to the proposed regulations, Treasury and IRS also state that the significant amendments to the issue price definition would “address [certain] concerns” and “provide greater certainty.” As discussed below, NABL believes that the proposed definition is not administrable by issuers and, therefore, will result in less certainty. The concerns described in the preamble generally relate to the manner in which municipal securities are offered and distributed, and imply that the conduct of municipal underwriters is sometimes inappropriate and perhaps illegal. Concerns about the offering and distribution process for municipal securities should be addressed by working with municipal securities regulators, not through tax policy. Treasury and IRS should share their concerns with the Securities and Exchange Commission, the Municipal Securities Rulemaking Board and the Financial Industry Regulatory Authority and request that they investigate and take appropriate regulatory and enforcement action.

The proposed definition of “issue price” is not administrable by issuers under existing law and market practices.

The proposed definition of “issue price” is not administrable by issuers because issuers and bond counsel do not have access to the information necessary to determine issue price based on actual sales to the “public” as defined under the proposed regulations.

The proposed definition of “issue price” also is not administrable by issuers because it does not assure that the issue price of publicly offered municipal bonds can be determined as of the sale date. To be administrable by issuers, any definition of “issue price” of publicly offered municipal bonds must enable issue price to be determined as of the sale date, when the terms of the issue are established. Determination of issue price as of the sale date is important for three reasons. Issuers may violate applicable State law, policy or authorizing resolutions if issue price cannot be determined as of the sale date. Because compliance with numerous other provisions of federal tax law depends on the determination of issue price, issuers may unintentionally violate those provisions if issue price cannot be determined as of the sale date. Finally, bond counsel must confirm on the sale date whether they can give an unqualified approving opinion at closing.

Attempts to comply with the proposed definition of “issue price” will impose substantial additional expense on issuers and alter longstanding practices in the municipal market.

If the proposed definition is adopted and municipal bonds continue to be marketed in ways that result in unsold maturities on the sale date, issuers will bear substantial additional expense attempting to determine issue price based on actual sales to the public. To eliminate unsold maturities on the sale date in negotiated underwritings, issuers would be forced to accept lower prices and higher yields. Because issuers may not be able to eliminate the possibility of unsold maturities in competitively sold deals, the ability of issuers to sell bonds competitively may be limited.

INTRODUCTION

Under section 103(a) of the Code, interest on a State or local bond (i.e., an obligation of a State or political subdivision thereof) is excludable from the gross income of the owner thereof; however, section 103(a) does not apply to any “arbitrage bond” within the meaning of section 148.

The original and principal purpose of the restrictions relating to arbitrage bonds is to prevent issuers from earning a profit by investing the proceeds of tax-exempt bonds in higher yielding taxable investments (e.g., Treasury securities). In light of this purpose, section 148(a) defines “arbitrage bond” as follows:

For purposes of section 103, the term “arbitrage bond” means any bond issued as part of an issue any portion of the proceeds of which are reasonably expected (at the time of issuance of the bonds) to be used directly or indirectly —

(1) to acquire higher yielding investments, or

(2) to replace funds which were used directly or indirectly to acquire higher yielding investments.

For purposes of this subsection, a bond shall be treated as an arbitrage bond if the issuer intentionally uses any portion of the proceeds of the issue of which such bond is a part in a manner described in paragraph (1) or (2). [Emphasis added.]

Under section 148(a), the prima facie determination regarding whether a bond is an arbitrage bond must be made no later than the date on which the bond is issued, based on the issuer’s contemporaneous reasonable expectations.

Section 148(b)(1) defines “higher yielding investments” as any “investment property which produces a yield over the term of the issue which is materially higher than the yield on the issue.”

To determine whether bond proceeds have been used to acquire higher yielding investments, one must compare the yield on the bond issue to the yield on the investments. Section 148(h), which was added to the Code as part of the Tax Reform Act of 1986,1 provides that:

For purposes of [section 148], the yield on an issue shall be determined on the basis of the issue price (within the meaning of sections 1273 and 1274).

On June 18, 1993, Treasury and IRS published comprehensive final regulations on the arbitrage investment restrictions and related provisions for tax-exempt bonds under sections 103, 148, 149 and 150, which generally became effective in 1993.2 Since that time, those final regulations have been amended in certain limited respects. The regulations issued in 1993 and the amendments thereto are collectively referred to herein as the “Existing Regulations.”

In § 1.148-1(b) of the Existing Regulations, “issue price” is defined as follows:

Issue price means, except as otherwise provided, issue price as defined in sections 1273 and 1274. Generally, the issue price of bonds that are publicly offered is the first price at which a substantial amount of the bonds is sold to the public. Ten percent is a substantial amount. The public does not include bond houses, brokers or similar persons or organizations acting in the capacity of underwriters or wholesalers. The issue price does not change if part of the issue is later sold at a different price. The issue price of bonds that are not substantially identical is determined separately. The issue price of bonds for which a bona fide public offering is made is determined as of the sale date based on reasonable expectations regarding the initial public offering price. If a bond is issued for property, the applicable Federal tax-exempt rate is used in lieu of the Federal rate in determining the issue price under section 1274. The issue price of bonds may not exceed their fair market value as of the sale date. [Emphasis added.]

The issue price definition under the Existing Regulations generally follows the issue price definition used for computing original issue discount on debt instruments under sections 1273 and 1274, with certain modifications. Specifically, consistent with section 148(a), the issue price definition under the Existing Regulations applies a reasonable expectations standard, determined as of the sale date, for determining the issue price of bonds that are publicly offered, not a standard based on actual sales. Under this standard, the first price at which a substantial amount (using ten percent as a safe harbor) of the bonds is reasonably expected to be sold to the public is treated as the issue price and is used in determining the yield on the issue, provided that all of the bonds of that maturity (and with the same terms) are offered to the public in a bona fide public offering.

In 1995, the Municipal Securities Rulemaking Board (“MSRB”)3 began the limited dissemination of prices for the municipal securities market, and increased price transparency in a series of measured steps. By 2000, MSRB was making all trade data public with a one-day delay. On January 31, 2005, MSRB began disseminating “real-time” (or more accurately, contemporaneous) municipal bond prices (within 15 minutes of a trade).4 The resulting public availability of trading data enabled municipal market participants and academics to analyze trading and pricing in newly issued municipal bonds.5 Analysis of the trading data confirmed two general conclusions: (1) for many municipal new issues, it takes some amount of time (days or weeks) for the bonds to settle into the hands of investors, such as individual or “retail” buyers, whose intent is to “buy and hold”; and (2) during this “settling out” process in the secondary market, there is an often an upward trend in the prices of the bonds (referred to as “trading up”). Analysis of the trading data also confirmed that some investors (generally institutional investors) purchase bonds from the underwriters and then, a short time after that initial sale (including prior to the closing of the bond issue, or even prior to the date of the signing of the bond purchase agreement between the issuer and the underwriters (the “BPA”)), resell some or all of the bonds they purchased to broker/dealers (who may or may not have been part of the original underwriting group) or other investors. These resales are referred to as “flipping.”6

By 2006, IRS, in certain audits of publicly offered municipal bonds, began to challenge the determination of issue price, questioning the accuracy of certificates regarding issue price customarily provided by underwriters in connection with the issuance of the bonds. The resulting uncertainty among issuers and bond counsel led NABL to create an issue price study group, which in August 2006 submitted to Treasury and IRS its recommendations for changes to the Existing Regulations that would provide clarification regarding the determination of issue price in light of existing practices and potential interpretation of the Existing Regulations. The August 2006 recommendations of the NABL issue price study group are attached hereto as Exhibit A. The principal recommendation was that the reasonable expectations provisions of the Existing Regulations be given substantive meaning by providing guidance and/or safe harbors as to what constitutes a bona fide public offering, as well as greater clarity around sales to parties that are not clearly members of the “public.”

For municipal market participants, Treasury and IRS, questions about issue price naturally began to receive less attention as the credit crisis and “Great Recession” began to unfold in 2008; however, the popularity of taxable, direct-subsidy “Build America Bonds” (“BABs”), authorized to be issued in 2009 and 2010 under the American Recovery and Reinvestment Act of 20097 (“ARRA” or the “Stimulus Act”) brought the issue back to the forefront because of the requirement that BABs not be sold with more than a de minimis amount of original issue premium. The struggles of issuers and others in the municipal marketplace with matters regarding the issue price of BABs led the Government Finance Officers Association (“GFOA”), NABL, the Regional Bond Dealers Association (“BDA”) and the Securities Industry and Financial Markets Association (“SIFMA”) to jointly submit a request to Treasury for guidance regarding issue price. The August 2010 submission by GFOA, NABL, BDA and SIFMA is attached hereto as Exhibit B. This joint submission included data compiled by SIFMA that demonstrated that all markets (corporate, tax-exempt and BABs) have upticks in secondary market trading, and that compared to other markets, there was nothing unusual about trading in the BABs market. (In fact, observed changes in BABs pricing were actually lower than in other markets.) Like the 2006 NABL submission, this multi-association submission requested that separate safe harbors for competitive and negotiated transactions be established under the Existing Regulations. Again, not surprisingly, after the Stimulus Act provisions authorizing the issuance of BABs expired on December 31, 2010, concerns about issue price became somewhat less acute.8

On September 16, 2013, Treasury and IRS published proposed regulations (the “Proposed Regulations”)9 that would amend the Existing Regulations in a number of respects,10 including significant revisions to the definition of “issue price” that eliminate the “reasonable expectations” standard for publicly offered municipal bonds in favor of an “actual sales” approach. Under the Proposed Regulations, issue price would be defined as follows:

(f) Definition of issue price —

(1) In general. Except as otherwise provided in this paragraph (f), issue price is defined in sections 1273 and 1274 and the regulations under those sections. In determining the issue price under section 1274 of a bond that is issued for property, the adjusted applicable Federal rate, as computed for purposes of section 1288, is used in lieu of the applicable Federal rate in determining the issue price.

(2) Tax-exempt bonds issued for money —

(i) In general. The issue price of tax-exempt bonds issued for money is the first price at which a substantial amount of the bonds is sold to the public (as defined in paragraph (f)(3)(i) of this section). See paragraph (f)(4)(ii) of this section for an issue including bonds with different payment and credit terms.

(ii) Safe harbor for determining issue price of tax-exempt bonds issued for money. For purposes of paragraph (f)(2)(i) of this section, the issuer may treat the first price at which a minimum of 25 percent of the bonds is sold to the public as the issue price. However the preceding sentence applies only if all orders at this sale price received from the public within the offering period are filled to the extent the public orders at such price do not exceed the amount of bonds sold.

(3) Definitions. For purposes of this paragraph (f), the following definitions apply:

(i) Public. Public means any person (as defined in section 7701(a)(1)) other than an underwriter.

(ii) Underwriter —

(A) In general. Except as otherwise provided in paragraph (f)(3)(ii)(C) of this section, the term underwriter means any person (as defined in section 7701(a)(1)) that purchases bonds from an issuer for the purpose of effecting the original distribution of the bonds or that otherwise participates directly or indirectly in such original distribution. An underwriter includes a lead underwriter and any member of a syndicate that contractually agrees to participate in the underwriting of the bonds for the issuer. A securities dealer (whether or not a member of an underwriting syndicate for the issuer) that purchases bonds (whether or not from the issuer) for the purpose of effecting the original distribution of the bonds is also treated as an underwriter for purposes of this section.

(B) Certain related parties included. Except as otherwise provided in paragraph (f)(3)(ii)(C) of this section, an underwriter includes any related party (as defined in § 1.150-1(b)) to an underwriter.

(C) Holding for investment. A person (as defined in section 7701(a)(1)) that holds bonds for investment is treated as a member of the public with respect to those bonds.

(iii) Securities dealer. Securities dealer means a dealer in securities, as defined in section 475(c)(1).

(4) Special rules. For purposes of this paragraph (f), the following special rules apply:

(i) Subsequent sale at a different price. The issue price as determined under paragraph (f)(1) or (2) of this section does not change if part of the issue is later sold at a different price.

(ii) Separate determinations. The issue price of bonds in an issue that do not have the same credit and payment terms is determined separately.

The preamble to the Proposed Regulations, the proposed definition of “issue price” in the Proposed Regulations and public comments made by Treasury and IRS officials after publication of the Proposed Regulations emphasize that the amendments to the issue price definition are intended to make that definition more consistent with current regulations under sections 1273 and 1274 of the Code, which implies that such consistency, including an “actual sales” approach, is required by the cross-reference to sections 1273 and 1274 in section 148(h) of the Code. In the preamble to the Proposed Regulations, Treasury and IRS also state that the significant amendments to the issue price definition would “address [certain] concerns” and “provide greater certainty.” Treasury and IRS state that their general concern is “that certain aspects of the Existing Regulations for determining the issue price of tax-exempt bonds are no longer appropriate in light of market developments since those regulations were published.” In particular, Treasury and IRS state the following concerns:

The ten-percent test does not always produce a “representative price for the bonds,” because underwriters may be executing the first ten percent of sales at the lowest price (and thus the highest yield) and thereby causing the issue price to be a lower price than is representative of the prices at which the remaining bonds are sold;

The reasonable expectations standard may not produce a “representative issue price,” based on pricing data that shows actual sales to the public at prices that differ significantly from the issue price used by the issuer; and

Based on reported trade data, sales to underwriters and security dealers may be included as sales to the public in determining issue price in certain instances.

As discussed below, the definition of “issue price” contained in the Proposed Regulations should be withdrawn and any other change in the issue price definition should be re-proposed. To understand why the proposed definition of issue price should not be adopted, it is helpful to review the history and development of the arbitrage restrictions and some key differences between the municipal and corporate bond markets.

BACKGROUND

History and Development of the Arbitrage Statutes and Regulations

Treasury and IRS first addressed the problem of arbitrage bonds in a technical information release which announced that IRS would not issue rulings about whether interest on certain State or local bonds was exempt from federal income taxation. These bonds were:

issued by . . . governmental units where a principal purpose is to invest the proceeds of the tax-exempt obligations in taxable obligations, generally United States Government securities, bearing a higher interest yield. The profit received by the governmental units on the difference between the interest paid on the exempt obligations and the interest earned on the taxable obligations is in the nature of arbitrage.11

This release effectively resulted in a moratorium on most advance refundings, which remained in effect until the passage of the Tax Reform Act of 1969.12

As part of the Tax Reform Act of 1969,13 Congress addressed the problem of arbitrage bonds by adding section 103(d) to the Internal Revenue Code of 1954. Section 103(d) was redesignated section 103(c) in the Tax Reform Act of 1976.14 That section provided, in pertinent part, that:

the term “arbitrage bond” means any obligation which is issued as part of an issue all or a major portion of the proceeds of which are reasonably expected to be used directly or indirectly —

(A) to acquire securities . . . or obligations . . . which may be reasonably expected at the time of issuance to produce a yield over the term of the issue which is materially higher (taking into account any discount or premium) than the yield on obligations of such issue[.]

To compute yield on a bond, one must know the purchase price of the bond, its coupon (i.e., stated interest rate), the principal and interest payment dates and its stated redemption price at maturity. Following passage of the Tax Reform Act of 1969, Treasury consistently proposed that the purchase price paid to the issuer, taking into account any costs of issuing the bonds, should be used in computing yield on the bonds.15 Treasury’s earliest view, reflected in Temp. Reg. § 13.4(a)(5), was that “an amount equal to the sum of the reasonably expected administrative costs of issuing, carrying and repaying [an] issue of obligations shall be treated as a discount in the selling price of such issue” for computing “yield.” Thus, yield was initially determined based on the price paid to the issuer by the underwriter for the bonds, which already reflected the “underwriter’s spread” (also referred to as the “underwriter’s discount”), minus any other costs of issuance paid directly by the issuer (e.g., attorneys’ fees, printing and delivery costs, preparation and distribution costs).

By 1978, because States and municipalities were advance refunding bonds in increasingly large numbers, Treasury concluded that permitting an issuer in an advance refunding to earn enough arbitrage to cover “most or all” of its administrative costs encouraged issuers to advance refund bonds in marginal situations and resulted in “inflated and excessive fees to lawyers, accountants, underwriters, and others.”16 As a consequence, Treasury changed its position regarding calculation of yield and proposed, effective September 1, 1978, that yield would be computed based on the “purchase price” of the bonds, with no reduction for an issuer’s costs. For bonds that were to be publicly offered, “purchase price” would be the “initial offering price to the public (excluding bond houses, brokers, and other intermediaries).”17 The proposal was adopted in the so-called “final arbitrage regulations” of 1979.18

The 1978 change in the regulations was intended to require yield to be computed without deducting the underwriter’s spread or other costs of issuance paid directly by the issuer, Arithmetically, this meant that the purchase price would be determined by adding the underwriter’s spread back to the price paid to the issuer by the underwriter for the bonds. MSRB, in its Glossary of Municipal Securities Terms, defines “underwriter spread,” with respect to a new issue of municipal securities, as “the difference between the price paid by the underwriter to the issuer for the new issue and the prices at which the securities are initially offered to the investing public.”19 Thus, by defining purchase price to be the “initial offering price to the public,” the 1978 change in the regulations was requiring that the underwriter’s spread be included in the purchase price in computing yield on the bonds.

The State of Washington challenged the 1978 change in the computation of yield and, in State of Washington v. Commissioner, 692 F.2d 128 (D.C. Cir. 1982), the United States Court of Appeals for the District of Columbia held that the regulations went beyond the permissible rulemaking authority of the Treasury and interpreted the statute in a way that was plainly inconsistent with the purpose of Congress in enacting the statute.

In response, Treasury turned to Congress, and in the Tax Reform Act of 1986, Congress specifically overruled State of Washington by adding section 148(h) to the Code, which requires that “yield on an issue shall be determined on the basis of the issue price (within the meaning of sections 1273 and 1274).” The primary purpose of section 148(h) was to assure that an issuer would not be able to recover any of its costs of issuance (other than bond insurance and similar guarantee fees) through the investment of the bond proceeds at a higher yield. The Senate Report stated:

The committee believes that it is important for issuers of tax-exempt bonds to pay the costs associated with their borrowing. The bill provides that the costs of issuance, including attorneys’ fees and underwriters’ commissions, must be paid by the issuers or beneficiaries, rather than recovered through arbitrage profits. . . .20

The House Report described the change as requiring that yield on an issue be determined based on the issue price, “taking into account the Code rules on original issue discount and discounts on debt instruments issued for property (sections 1273 and 1274).”21 The Conference Report described the change in the following way:

Yield on bonds is determined on the basis of the original issue discount rules of the Code rather than as under the present general arbitrage restrictions. Thus, yield is determined based on the price at which a substantial number of the bonds are sold to the public and must reflect a current market price.22

By adopting section 148(h) and referencing the original issue discount provisions of sections 1273 and 1274, Congress clearly intended to prevent issuers from deducting the underwriter’s spread in computing the yield on tax-exempt bonds.23

Treasury’s first attempt at implementing section 148(h) was the temporary regulations adopted in 1989 (the “1989 Temporary Arbitrage Regulations”).24 The definition of “issue price” in the 1989 Temporary Arbitrage Regulations was revised several times before reaching its final form in 1993 in the Existing Regulations. The original definition of “issue price” in the 1989 Temporary Arbitrage Regulations took more of an “actual sales” approach, requiring the issue price for substantially identical bonds sold at one price to the general public and to institutional or other investors at a discount from that price to be determined separately.25 Importantly, however, even these initial temporary regulations provided that the issue price for bonds that were publicly offered would be determined “based on actual facts and reasonable expectations as of the sale date and shall not be adjusted to take into account actual facts after such date.”26 The scope of the reasonable expectations test for publicly offered bonds was limited by allowing it to be applied only to bonds actually offered to the general public in a bona fide public offering at those issue prices.27

The 1989 Temporary Arbitrage Regulations were viewed, in general, as being far too complex, and Treasury undertook a simplification of the regulations. Notice 89-7828 issued July 24, 1989 provided that future regulations would eliminate separate books for public and institutional sales, and instead look at the average offering price of the bonds. The notice also provided that issue price would be based upon the initial offering price at which a substantial amount of the bonds was actually sold.

In 1991 Treasury further simplified the regulations.29 The 1991 changes provided that issuers and underwriters were no longer required or permitted to identify and segregate bonds expected to be publicly offered to the general public at one price from those publicly offered to institutions at a concession. This simplification represented a trade-off for issuers: a lower arbitrage yield in exchange for a lesser administrative burden. Most significantly in the current context, the simplification was also a departure from theoretical perfect adherence to section 1273 for the apparent purpose of administrability. In making the 1991 changes, Treasury explained why a reasonable expectations test for publicly offered bonds was appropriate:

For a publicly offered bond, the issue price is the initial offering price to the general public and not the price paid by the underwriter. This is the same definition of issue price as is used in section 1273 and section 1274. A reasonable expectations test is used to determine the initial public offering price because, on the date of issue, the exact price at which the bonds subsequently will be sold to the general public may not be known. [Emphasis added.]30

In May 1992 Treasury published final arbitrage regulations (the “1992 Regulations”).31 The 1992 Regulations implemented the changes described above and adopted a definition of “issue price” that is substantially the same as in the Existing Regulations, including the reasonable expectations test for publicly offered bonds. The 1992 Regulations, however, required that the issue price of bonds be adjusted to take into account sales to the public after the date of the issue. When the Existing Regulations were published, they further simplified the determination of issue price by specifically providing that issue price would not be adjusted if portions of the issue later sold for different prices.

As discussed in the “INTRODUCTION” above, the Existing Regulations generally became effective in 1993. The definition of “issue price” has not been amended in the twenty years since then.

Differences between the Municipal and Corporate Bond Markets

The municipal bond market and the corporate bond market are different in a number of important respects.

First, on average, the aggregate principal amount of a municipal bond issue is much smaller than that of a corporate bond issue. In 2011, there were over one million different municipal bond issues outstanding, totaling $3.7 trillion in principal, in comparison to fewer than 50,000 corporate bond issues, totaling $11.5 trillion in principal (including foreign bonds).32

Second, municipal bond issues often have a 30-year final maturity, consisting of serial bonds maturing in each of the first ten years or so and two or more term bonds with required annual redemptions; these issues often provide the issuer with the option to redeem the bonds after ten years with little or no redemption premium. This structure may reflect legal requirements and/or the need of government issuers and many conduit borrowers to have relatively equal annual debt service payments on their bonds (e.g., for budgeting or covenant purposes). In contrast, corporate bond issues typically have a shorter final maturity (e.g., 5 years, 10 years), consist of a single, bullet maturity (i.e., no required principal payments prior to final maturity) and can be optionally redeemed only pursuant to a “make-whole” redemption provision which limits the ability of the issuer to refinance the debt to obtain interest savings.

Third, the essentially exclusive means by which corporate bonds are sold are negotiated underwritings and private placements.33 In contrast, a substantial portion of municipal bonds are sold through competitive bidding,34 often because some types of municipal securities, including general obligation bonds, may be required by State law to be offered under competitive bidding. For example, during 2011, 42.4% of the 13,463 municipal securities issuances were done through competitive sales,35

Fourth, underwriters of corporate bonds rarely agree to purchase the bonds unless they have orders to re-sell all of the bonds. Municipal bond underwriters, however, regularly purchase bonds for which they do not have orders (e.g., because they purchased bonds in a competitive sale for which they were able to do little or no premarketing due to the inherent uncertainty as to whether they will be successful in their bid to purchase the bonds or because insufficient or no orders were received for certain maturities in a negotiated underwriting). As discussed above, because of legal, covenant and other considerations relating to municipal bonds, an underwriter may not be able to avoid structuring a transaction with unsold maturities, whereas the maturity and other terms of a corporate bond generally can be adjusted based on prevailing market conditions and investor demand.

Finally, municipal securities, particularly tax-exempt municipal securities, are largely held by individual or “retail” investors. As of the end of 2011, approximately 50.2% of the outstanding principal amount of municipal securities was held directly by individuals and up to 25% was held on behalf of individuals by mutual, money-market, closed-end and exchange-traded funds.36 In contrast, the corporate bond market is dominated by institutional investors. For example, as of the third quarter of 2013, households held only approximately 17.7% of corporate debt.37

COMMENTS

I. The proposed definition of “issue price” is not required or appropriate to address the policy objectives and stated concerns of Treasury and IRS.

A. The issue price of publicly offered municipal bond issues is not required to be, and based on how municipal bonds are sold cannot be, determined through an “actual sales” approach.

The preamble to the Proposed Regulations, the definition of “issue price” in the Proposed Regulations and public comments made by Treasury and IRS officials after publication of the Proposed Regulations emphasize that the amendments to the issue price definition are intended to make that definition more consistent with current regulations under sections 1273 and 1274 of the Code, which implies that such consistency, including an “actual sales” approach, is required by the cross-reference to sections 1273 and 1274 in section 148(h) of the Code. In analyzing whether determination of “issue price” for purposes of the arbitrage rules should be the same as under the original issue discount rules, it is helpful to consider the very distinct purposes of section 148 and sections 1273 and 1274 and the differences between the municipal and corporate bond markets.

The original and principal purpose of the restrictions relating to arbitrage bonds is to prevent issuers from earning a profit by investing the proceeds of tax-exempt bonds in higher yielding taxable investments. The need for section 148 arose from the fact that an issuer of tax-exempt bonds could receive a yield from taxable investments (acquired with bond proceeds) that exceeded the yield being paid by the issuer on its tax-exempt bonds. The purpose of section 148(h) is to specify how the issue price of the bonds, which is an essential component of the computation of yield on the bonds, is to be determined. Thus, determining issue price under section 148, which sets the upper limit on an issuer’s permitted investment earnings, is focused on, and impacts, issuers.

Sections 1273 and 1274 were inserted into the Code to ensure that the accruals of original issue discount on taxable debt instruments are treated consistently with interest paid on taxable debt instruments; thus, the focus of a determination of issue price under sections 1273 and 1274 is on holders, not issuers. Congress recognized that, for example, a debt instrument with a zero coupon sold at a discount resulting in a yield of 6% is economically equivalent to a debt instrument sold at par with a 6% coupon; however, without current recognition of income accruing, a cash-basis holder of the instrument purchased at a discount would not only defer recognition until receipt of the principal amount at maturity (or earlier sale), but might also be able to treat the income received as capital gain. This treatment is in contrast to the holder of a par instrument, who would have ordinary income in each year. Sections 1273 and 1274 are designed to solve this disparate treatment problem by identifying original issue discount that is directly comparable to current interest and, together with sections 1271 and 1272, providing for current inclusion of accruing original issue discount (and appropriate adjustments to the holder’s basis in the instrument). By determining issue price based on purchase price paid by the original public investors in a debt instrument, instead of the purchase price paid by the underwriter to the issuer, the underwriter’s spread is not treated as original issue discount, which means investors are not required to recognize the underwriter’s spread as ordinary income. (The underwriter, of course, must recognize the spread as ordinary income.) Although the focus of the original issue discount rules is on taxable debt instruments, original issue discount on municipal bonds also must be computed under sections 1273 and 1274. Under section 1272(a)(2)(A), however, such original issue discount is treated as additional tax-exempt interest (i.e., the accruing income is not required to be included in the gross income of the owner).

Because corporate bonds are sold in relatively large principal amounts with bullet maturities, largely or even exclusively to institutional investors, in negotiated underwritings (pursuant to a “fixed price” rule)38 or private placements, it is relatively easy to apply the actual sales approach in determining issue price under the original issue discount rules. For example, in a $300,000,000 corporate debt offering that consists of a single five-year bullet maturity, it is not difficult to determine the initial offering price to the public at which a substantial amount was sold. In contrast, in a $10,000,000 municipal bond offering (whether negotiated or competitively sold) that includes serial bonds maturing in the first ten years and term bonds maturing in years 20 and 30 (with required annual sinking fund redemptions), there may be particular maturities for which no orders are received as of the sale date (“orphan maturities”) and yet, contrary to practice in corporate bond underwritings, the underwriters will agree to deploy some of their capital and purchase all of the bonds.

Treasury has been granted broad authority in the context of section 148 to draft regulations that are designed to accomplish the goals of limiting arbitrage bonds. At the time of the enactment of the Technical and Miscellaneous Revenue Act of 1988,39 the House Ways and Means Committee outlined this authority:

The bill further deletes and re-inserts the term “necessary” in the specific regulatory authority granted the Treasury Department under the arbitrage restrictions. This amendment is intended to clarify that Treasury’s regulatory authority is to be interpreted broadly, rather than in a literal, dictionary manner. . . . That regulatory authority is intended to permit Treasury to eliminate any devices designed to promote issuance of bonds either partially or wholly as investment conduits in violation of the provisions adopted by Congress to control such activities and to limit the issuance of tax-exempt bonds to amounts actually required to fund the activities for which their use specifically has been approved by Congress. Further, that regulatory authority is intended to permit Treasury to adopt rules (including allocation, accounting, and replacement rules) necessary or appropriate to accomplish the purpose of the arbitrage restrictions, which is to eliminate significant arbitrage incentives to issue more bonds, to issue bonds earlier, or to leave bonds outstanding longer.40

Over the course of four years, from 1989 to 1993, Treasury exercised this broad authority, proposing and revising the definition of “issue price” multiple times, before settling on the definition in the Existing Regulations that has now been in effect for twenty years. Beginning with the 1989 Temporary Arbitrage Regulations, Treasury recognized that a special rule was needed for the determination of issue price of publicly offered municipal bonds. As Treasury explained in making the 1991 changes to the arbitrage rules:

A reasonable expectations test is used to determine the initial public offering price because, on the date of issue, the exact price at which the bonds subsequently will be sold to the general public may not be known.41

Unless Treasury believes that it lacked authority to adopt the Existing Regulations, then determination of the issue price for publicly offered municipal bonds is not required to be determined based on an “actual sales” approach. And because section 148(a) requires that arbitrage compliance be determined as of (i.e., no later than) the issue date, any definition of “issue price” that does not ensure that issue price can be determined no later than the issue date conflicts with section 148(a).42 More importantly, as the existing issue price definition recognizes (and as discussed in more detail below), the determination of issue price of publicly offered municipal bonds must occur by the sale date (i.e., when the terms of the bonds are fixed) and, for so long as the marketing of municipal bonds continues to result in unsold maturities as of the sale date, it will be impossible to determine the issue price of such maturity (and, therefore, the issue) based on an actual sales approach. Said differently, an actual sales approach as of the sale date cannot work for maturities for which there are no actual sales as of the sale date.

B. Concerns about the offering and distribution process for municipal securities should be addressed by working with municipal securities regulators, not through tax policy.

In addition to attempting to make the determination of issue price under section 148 more consistent with the determination of issue price under sections 1273 and 1274, the preamble to the Proposed Regulations makes clear that the proposed definition of issue price is intended to “address [certain] concerns” and “provide greater certainty.” As discussed below, NABL believes that the proposed definition is not administrable by issuers and, therefore, will result in less certainty. NABL also believes that the concerns described in the preamble should be addressed by municipal securities regulators, not through tax policy.

The concerns described in the preamble generally relate to the manner in which municipal securities are offered and distributed, and imply that the conduct of municipal underwriters is sometimes inappropriate and perhaps illegal. While NABL does not have access to the information that has given rise to these concerns, NABL takes them seriously and believes that, if problematic, they should be addressed. Because the activities of municipal underwriters are regulated by SEC, MSRB and FINRA, however, NABL believes that Treasury and IRS should share their concerns with these regulators and request that they investigate and take appropriate regulatory and enforcement action. Issuers do not have the resources to police these perceived activities, nor do they benefit from the perceived manipulation; nevertheless, the Proposed Regulations would force issuers to bear the penalty for perceived misconduct of others.

We believe it may be helpful to provide an illustration of how the concerns cited in the preamble may be more appropriately addressed through municipal securities regulation than tax policy. The preamble states that one concern is that, in some cases, underwriters may make a public offering of only 10% of a maturity to establish a lower issue price, holding back the remaining 90% to be sold at higher prices. If this practice is in fact happening, then even under the Existing Regulations the use of the “reasonable expectations” test would not be permitted, since such an offering is not a “bona fide public offering” of the bonds. Moreover, it would be inconsistent with contractual obligations that underwriters generally have with issuers and may violate securities law and rules. This concern is more properly addressed by enforcement of existing law and contracts against the offending underwriters, rather than establishing a new regulatory requirement that will inevitably result in additional costs to issuers.

In attempting to address concerns about the municipal bond offering and distribution process through tax policy, the proposed definition of issue price is not only unfair to issuers, but conflicts with securities law rules governing this process. The effect of the proposed definition would be to include, as part of the underwriter’s spread, profits from sales of bonds that may be earned by entities or persons outside of the underwriting syndicate with which the issuer has contracted. This result is unfair to issuers because it would lower their arbitrage yield on the bonds (i.e., the upper limit on their investment earnings) without increasing the proceeds they receive from the sale of the bonds, as a result of actions taken by third parties with whom issuers have no contractual relationship. In some cases, this unfairness would be compounded by the fact that all or a portion of such profits resulted from fluctuations in the market after the sale date, changes over which issuers have no control. Moreover, this result conflicts with the determination of underwriter’s spread under MSRB Rule G-32 that is required to be disclosed to investors in the final official statement for a negotiated underwriting.43

II. The proposed definition of “issue price” is not administrate by issuers under existing law and market practices.

A, Issuers and bond counsel do not have access to the information necessary to determine issue price based on actual sales to the “public.”

The proposed definition of “issue price” is not administrable by issuers because issuers and bond counsel do not have access to the information necessary to determine issue price based on actual sales to the “public” as defined under the Proposed Regulations. The best way to illustrate this problem is through an example. Assume an underwriter is unable to sell a particular bond maturity to the public for any one of a variety of commonly occurring reasons (e.g., small principal amount of a particular maturity, yield curve on a particular day) and, therefore, the underwriter sells 100% of that maturity to a broker (who is not a member of the underwriting syndicate) at the initial offering price on the sale date. Under the Proposed Regulations, to determine issue price, an issuer and bond counsel would need to know to whom and at what prices that broker sold the bonds, as well as whether the persons who bought the bonds did so for the purpose of investment (i.e., were they members of the “public”). Neither the broker nor its customers are required by law or contract to provide that information to the issuer and bond counsel, so the question becomes whether the information is otherwise available.

The preamble to the Proposed Regulations does not specify any particular source for this type of information. Currently, EMMA is the only free and public platform for detailed municipal bond trading data, and the operating assumption (apparently based on the use of EMMA by the IRS, which includes access to some data that is not publicly available) appears to be that EMMA is in fact a reliable source of such data. However, EMMA data is not sufficient to determine issue price under the Proposed Regulations.44 While EMMA provides some information about actual sales, it is difficult to correctly interpret this information within the constraints of the Proposed Regulations. More importantly, EMMA does not provide all of the information required to determine issue price under the Proposed Regulations (e.g., record of orders as opposed to completed trades, true timing of trades, information necessary to determine whether a purchaser is an “underwriter” or a member of the “public”).

Before requiring that issue price be determined based on actual sales, Treasury and IRS should first make sure that issuers will have access to the data necessary to make this determination. Significant lead time (e.g., two to three years) should be provided to ensure that data bases, whether through EMMA, from underwriters or by other means, are in place to establish dates, times, and prices of actual sales to ultimate investors. Prior to effectiveness of the regulations, Treasury and IRS should review the data bases (and undertake “dry runs”) to ensure that compliance with an actual sales standard can be satisfied.

B. To be administrable by issuers, any definition of “issue price” of publicly offered municipal bonds must enable issue price to be determined as of the sale date, when the terms of the issue are established.

1. Issuers may violate applicable State law, policy or authorizing resolutions if issue price cannot be determined as of the sale date.

In agreeing to sell bonds to the underwriters in a negotiated or competitive offering, the issuer must comply with any applicable State law or policy and the authorizing resolutions it has adopted. For example, in a refunding, the issuer may be required to meet a certain threshold for debt service savings. If issue price cannot be determined as of the sale date, when the terms of the bonds are set and debt service savings are calculated, then the issuer may violate applicable law, policy or resolutions. Even if issue price can be determined after the sale date and before closing, it may not be possible to restructure the terms of the bonds, because the BPA has already been signed (or the bonds have been awarded in a competitive sale). And, if issue price cannot be determined until after closing, there may be no effective way to cure the violation.

The Proposed Regulations do provide one remedy for post-sale issue price changes by allowing yield reduction payments. While making a yield reduction payment may resolve an arbitrage problem under section 148 of the Code, the payment may result in the issuer not obtaining the required level of debt service savings, thereby violating applicable State law or policy or the issuer’s authorizing resolutions. Moreover, unlike rebate, where payments to Treasury can be made from investment earnings actually received by the issuer, an issue price-related yield reduction payment will need to come from an additional source of funds, which may not exist or be available (from either a legal and/or an economic standpoint).

2. Because compliance with numerous other provisions of federal tax law depends on the determination of issue price, issuers may unintentionally violate those provisions if issue price cannot be determined as of the sale date.

Although the term “issue price” is used specifically in relatively few places in sections 103, 141-150, and 54AA, it has become central to the meaning of “sale proceeds,” “net proceeds,” “proceeds,” “face amount”45 and “amount,” each of which is an important concept in the Existing Regulations as well as Code provisions applicable to municipal bonds. Taken together, these definitions affect most of the tests for determining whether a bond is described in section 103(b)(1), (2) or (3), and thus tax-exempt, or tax-advantaged in more limited instances.46 These tests include the 2% costs of issuance limit, private activity limitations, volume caps, output facility limits, small issue bond limits, weighted average maturity calculations and related tests, debt service reserve fund limits, small issuer status and certain transition rules. Attached as Exhibit C is a more comprehensive list illustrating where the failure to determine the issue price of bonds as of the sale date could result in lack of certainty with respect to, or even unintentional violations of, various provisions of the Code or Existing Regulations as of the issue date. The Proposed Regulations do not provide any means for issuers to remedy these violations.

3. Bond counsel must confirm whether they can give an unqualified approving opinion on the sale date.

If issue price cannot be determined as of the safe date, then, as discussed above, it will not be possible to confirm on the sale date whether the bonds will comply with all of the relevant tests for tax exemption under the Code as of the issue date. A customary condition to issuance and delivery of bonds contained in the BPA (which is signed on the sale date) is that bond counsel delivers an unqualified approving opinion on the closing date with respect to the tax-exempt status of interest on the bonds. If the BPA is signed with this condition, and issue price is determined after the sale date to be different than reasonably expected on the sale date based on the initial offering prices to the public, then in many cases bond counsel will not be able to deliver an unqualified approving opinion. And if issue price cannot be determined until after the issue date, then bond counsel would not be able to be able to deliver an unqualified approving opinion on the issue date. In either case, the bonds would not be issued and the BPA would terminate after it was signed and before closing (often referred to as the “cratering” of a deal between pricing and closing), which historically has almost never occurred in the municipal (or corporate) bond markets.47

III. Attempts to comply with the proposed definition of “issue price” will impose substantial additional expense on issuers and alter longstanding practices in the municipal market.

A. If the proposed definition is adopted and municipal bonds continue to be marketed in ways that result in unsold maturities on the sale date, issuers will bear substantial additional expense attempting to determine issue price based on actual sales to the public.

 

If the proposed definition of “issue price” were to become final, issuers would bear substantial additional expense attempting to determine issue price based on actual sales to the public if they continue to allow their bonds to be marketed in ways that result in unsold maturities on the sale date. Issuer employees, bond counsel or the issuer’s financial advisor would be required to spend additional time obtaining, reviewing and documenting the facts relating to actual sales, in order to attempt to determine issue price under the proposed definition. In certain cases, these efforts could extend from the sale date to the issue date and even beyond the issue date, until issue price is determined or it becomes clear that it cannot be determined. To the extent that issue price is determined to be different than reasonably expected on the sale date based on initial offering prices to the public, the issuer may be required to make a yield reduction payment from its own funds and bear the cost of curing noncompliance with other provisions of the Code.

As discussed above, if issuers are successful in determining issue price under the definition in the Proposed Regulations, the result may be that they are forced to accept a lower arbitrage yield based on profits earned by persons or entities with whom they had no contractual relationship and which may have resulted from fluctuations in the market after the sale date over which issuers have no control.

B. To eliminate unsold maturities on the sale date in negotiated underwritings, issuers would be forced to accept lower prices and higher yields.

To avoid the result described above, issuers may determine that they should alter the ways in which they allow their bonds to be marketed in negotiated underwritings in order to eliminate unsold maturities. Bonds would need to be marketed at lower prices/higher yields to ensure that the 25% safe harbor could be met for each maturity, resulting in higher interest costs for issuers. Further, investors will almost certainly be aware that an issuer in many cases must ensure that at least 25% of each maturity of an issue is sold; if they become aware (or suspect) that certain maturities are not in demand from other investor classes, they will be in a position to ask for — and get — lower prices/higher yields than might otherwise be available. This will fundamentally shift the dynamics of marketing by empowering investors to demand higher yields.

C. Because issuers may not be able to eliminate the possibility of unsold maturities in competitively sold deals, the ability of issuers to sell bonds competitively may be limited.

Issuers also could attempt to require that bidders in competitive sales actually sell 25% of each maturity to the public at the initial offering prices in order to satisfy the safe harbor in the Proposed Regulations. If underwriters were willing to bid under that condition, they would be forced to lower their bids (i.e., increase yields) to the point where they were confident they could satisfy this condition. And, if the winning bidder did not satisfy this condition, the issuer still would be required to bear the costs associated with attempting to determine issue price without the benefit of the safe harbor (if issue price could be determined at all). The greater likelihood of complying with the safe harbor in a negotiated underwriting would probably result in fewer competitive sales, except to the extent competitive sales are required by applicable State law, inappropriately causing issuers to adopt a method of sale based on tax policy.

IV. If Treasury and IRS continue to consider applying an actual sales approach to the determination of issue price for publicly offered municipal bond issues, a revised definition of “issue price” should be re-proposed.

A. Any re-proposed definition of “issue price” for publicly offered municipal bond issues should continue to provide that issue price is and can be determined as of the sale date.

Any re-proposed definition of “issue price” for publicly offered municipal bond issues should continue to provide that issue price is and can be determined as of the sale date. If Treasury and IRS continue to consider applying an actual sales approach to publicly offered municipal bond issues, any re-proposed definition of “issue price” based on actual sales should provide that the relevant offering period ends on the sale date; however, as discussed above, if municipal bonds continue to be marketed in ways that result in unsold maturities on the sale date, issue price cannot be determined as of the sale date based on an actual sales approach. As a result, any attempt to provide greater certainty in the determination of issue price must retain, and provide safe harbors under, the reasonable expectations test in the Existing Regulations.

B. Certain aspects of the proposed definition of “issue price” should be revised and clarified if they are to be included in any re-proposed definition.

If Treasury and IRS consider re-proposing a definition of “issue price” that incorporates aspects of the proposed definition, NABL suggests that the following revisions and clarifications to the proposed definition be considered and that certain collateral consequences be addressed.

1. Revise the Definition of “Public”

Other than the actual sales approach, the most problematic concept in the Proposed Regulations is the definition of “public.” For purposes of the section 148 definition of issue price, NABL suggests that Treasury and IRS consider defining “public” to be anyone other than the underwriting syndicate and parties related to any member of the underwriting syndicate, utilizing the concept of privity. Under this definition, as long as (1) 25% of the bonds of each maturity (and interest rate, for split coupons) was sold at the initial offering price to entities outside of the underwriting syndicate (and its related parties), and (2) all orders at the initial offering price were filled to the extent submitted by persons other than registered broker-dealers, the safe harbor under the Proposed Regulations could be met.

2. Provide for Competitive Bid Safe Harbor

As discussed in Section III.C. above, the actual sales approach is least workable for competitively bid bond issues. Because competitive bidding is required by State law in some cases and generally considered to produce a good result for issuers, NABL believes that regulations should not discourage the use of competitive bidding. In other areas where Treasury has been concerned with ascertaining fair market value in an objective manner (such as the pricing of guaranteed investment contracts and open-market securities escrows), competitive bidding was a suitable solution. Therefore, NABL suggests the creation of a safe harbor using initial offering prices for proof of issue price in competitively bid bond sales, assuming that the bonds are awarded to the highest bidder.

3. Provide for Synthetic Markup Safe Harbor

As an alternative to strict tracing of all actual sales to the ultimate investors, NABL suggests a safe harbor where a pre-determined markup could be added to the initial offering price to compute issue price for (1) maturities for which no orders have been received or maturities that would otherwise fail to meet the 25% safe harbor, or (2) sales to brokers or other persons where investment intentions were unknown, such that those sales could be treated as sales to the public.

4. Lower Safe Harbor Standard from 25% to 10%

Municipal market participants are accustomed to the 10% standard for “substantial amount” that has been in place in the Existing Regulations for the last twenty years. Moreover, 10% has long been accepted in the taxable area as a “common law” standard for purposes of sections 1273 and 1274.48 Since the Proposed Regulations already materially depart from longstanding law, NABL suggests maintaining as much constancy as possible by retaining standards where there is no clear reason for change. The tax law pertaining to State and local bonds uses a more-than-5% (and, in some cases, a more-than-10%) standard for substantial amounts in many contexts ranging from private activity tests to working capital tests to public approval amounts.

5. Accommodate Issue Price-Related Yield Reduction Payments

The Proposed Regulations would allow an issuer to make a yield reduction payment to remedy an advance refunding escrow that turns out not to be yield-restricted due to a post-sale revision to the expected issue price. Many issuers may not have funds available to make a required issue price-related yield reduction payment (“IPYRP”), which may cause issuers to choose to finance a contingency IPYRP. Absent additional exceptions to provisions of the Existing Regulations, this may not be feasible.

Currently, under the working capital general de minimis exceptions of Reg. § 1.148-6(d)(3)(ii)(A)(4), an issuer may bond-finance yield reduction payments without complying with the “proceeds spent last” rules typically applicable to the financing of working capital expenditures. Along similar lines, NABL suggests that an exception be added under “excess gross proceeds” (Reg. § 1.148-10(c)(3)) in order that an IPYRP contingency would not count as excess gross proceeds. Further, IPYRPs should be excepted from all definitions of proceeds such that they would not confound the application of other tests (e.g., private activity tests, rebate spending exceptions). Finally, in order to ensure a financed IPYRP contingency did not remain permanently unspent, Treasury and IRS could create a rule requiring all IPYRP contingency remaining after the issue price has been established and the IPYRP has been paid to be spent on debt service.

6. Clarify Offering Period and Original Distribution

The concepts of “offering period” and “original distribution” are pivotal under the Proposed Regulations, yet they are not defined. The exception for unfulfilled orders under the 25% safe harbor only applies during the “offering period,” but it is unclear when the offering period begins and ends. Similarly, an underwriter is defined, in part, as any person who participates directly or indirectly in the “original distribution,” but it is unclear whether the original distribution is coterminous with the offering period or possibly extends beyond that point. Issuers must have certainty regarding the time at which it will be appropriate to finalize the calculation of issue price under the Proposed Regulations. Therefore, NABL suggests clarification of “offering period” and “original distribution.” To maintain consistency among regulatory regimes, we also suggest the definitions equate to the current “order period” under MSRB Rule G-11 and sales that occur during that period.

7. Provide Examples of Issue Price Substantiation

As described in these comments, application of the Proposed Regulations will be confusing and difficult for many issuers. NABL suggests the addition of examples elucidating the process of substantiating issue price under the Proposed Regulations in order to alleviate uncertainty.

8. Address Collateral Consequences of Unknown Issue Price at Sale Date

Unless the Proposed Regulations are revised to ensure computation of issue price as of the sale date, NABL strongly encourages de-coupling of the definition of issue price under section 148(h) from all other tests for determining whether a bond is tax-exempt or tax-advantaged to avoid the collateral (i.e., non-yield related) consequences of an unknown issue price at the sale date.

Many of these collateral problems could be solved by revising the definition of “sale proceeds” to include only amounts actually received by the issuer plus underwriters’ discount or compensation as disclosed pursuant to federal securities laws in the final official statement, or otherwise stated. Ultimately, this would equate sale proceeds with the initial offering price rather than the new definition of issue price, eliminating concerns regarding post-sale recalculation of many required tests for tax-exemption.

An additional set of problems could be solved by clarifying prior guidance that links terms such as “face amount” and “amount” to issue price, replacing issue price in those cases with sale proceeds, as redefined.

Finally, in the cases where the term “issue price” is actually used in statutory or regulatory language, providing that “sale proceeds,” as redefined, may be used as a proxy would effectively maintain the current state of the law, thus reducing uncertainty created by the new definition of issue price.

CONCLUSION

NABL respectfully suggests that the definition of “issue price” in the Proposed Regulations be withdrawn and that any other change in the issue price definition be re-proposed. To the extent that Treasury or IRS is concerned with the manner in which municipal securities are offered or distributed, these concerns should be shared with SEC, MSRB and FINRA, so that appropriate regulatory and enforcement action may be taken. Any re-proposed definition of “issue price” for publicly offered municipal bond issues should continue to provide that issue price is and can be determined as of the sale date in a manner consistent with Congressional intent, i.e., by adding the underwriter’s spread back to the purchase price paid to the issuer by the underwriter for the bonds. Because MSRB rules govern the offering and distribution of municipal securities and require the computation and disclosure of underwriter’s spread, computation of issue price for purposes of section 148 should be consistent with what is computed and disclosed publicly for securities law purposes. If municipal bonds continue to be marketed in ways that result in unsold maturities on the sale date, issue price cannot be determined as of the sale date based on an actual sales approach. As a result, any attempt to provide greater certainty in the determination of issue price must retain, and provide safe harbors under, the reasonable expectations test in the Existing Regulations.

FOOTNOTES

1 Pub. L. No. 99-514 (1986).

2 T.D. 8476, 1993-2 C.B. 33.

3 MSRB is a self-regulatory organization created by Congress in 1975 to write rules regulating the behavior of bank and securities firm dealers in the municipal securities market in order to “protect investors and the public interest.” MSRB is subject to oversight by the Securities and Exchange Commission (“SEC”), and its rules, once approved by SEC, have the force and effect of federal law. MSRB rules are enforced by the Financial Industry Regulatory Authority (“FINRA”) for securities firms and by the various bank regulatory agencies for bank dealers, as well as SEC.

4 This real-time information was initially posted and available publicly for free on an investor education website, www.investinginbonds.com, maintained by The Bond Market Association (now known as the Securities Industry and Financial Markets Association). Subsequently, MSRB established the Electronic Municipal Market Access (“EMMA”) website, www.emma.msrb.org, to increase access to important disclosure and transparency information in the municipal securities market. EMMA provides market transparency data, which includes real-time prices and yields at which bonds and notes are bought and sold, for most (but not all) trades occurring on or after January 31, 2005.

5 See, e.g., Green, Hollifield & Schurhoff, “Dealer Intermediation and Price Behavior in the Aftermarket for New Bond Issues” (June 21, 2006). http://dev3.cepr.org/meets/wken/5/5534/papers/Schurhoff.pdf. Earlier versions of this paper were distributed in 2005.

6 Flipping is not unique to the municipal bond market. Pricing and performance of new corporate bonds has been found to be consistent with a “flipping” hypothesis. See Kozhanov, Ogden & Vaghefu “The Pricing and Performance of New Corporate Bonds: TRACE-Era Evidence” (July 6, 2011), https://secure.northernfinance.org/2011/Submissions/modules/request.php?module=oc_program&action=view.php&id=171.

7 Pub. L. No. 111-5(2009).

8 In recent years, the inability of issuers to earn positive arbitrage on investments of bond proceeds, e.g., because of historically low interest rates on Treasury securities, also has made determination of issue price and bond yield less important.

9 Notice of Proposed Rulemaking and Notice of Public Hearing, 78 Fed. Reg. 56,842 (Sept. 16, 2013).

10 NABL is separately submitting comments on the remainder of the Proposed Regulations.

11 T.I.R. 840 (Aug. 11, 1966), STAND. FED. TAX. REP. ¶ 6701 (CCH 1966).

12 See Manly W. Mumford, “Arbitrage and Advance Refunding,” 1976 Duke L. J. 1239, 1246 (1976).

13 Pub. L. No. 91-172(1969).

14 Pub. L. No. 94-455 (1976).

15 See Temp. Reg. § 13.4(a)(5)(i)(b), T.D. 7072, 35 Fed. Reg. 17,406 (Nov. 13, 1970), as amended by T.D. 7174, 16 Fed. Reg. 10,932 (Jun. 1, 1972) and T.D. 7273, 38 Fed. Reg. 10,927 (May 3, 1973); see also Prop. Reg, § 1.103-13(c)(3)(i)(b)(1972).

16 See Notice of Proposed Rulemaking, LR-1671, 43 Fed. Reg. 39,822 (Sept. 7, 1978).

17 In an earlier Notice of Proposed Rulemaking, LR-1671, 43 Fed, Reg. 19,675 (May 8, 1978), the language was explained as being the same definition of issue price as the one used in Reg. § 1.1232-3 relating to original issue discount. Note that this initial regulation did not require that a substantial amount of the bonds be sold to the public at these offering prices.

18 Reg. § 1.103-13(d)(2) (1979).

19 http://www.msrb.org/glossary/SPREAD.aspx. Note that this definition also does not require that a substantial amount of the bonds be sold to the public at these offering prices.

20 S. REP. NO. 99-313 at 828.

21 H.R. REP. NO. 99-426 at 554 (1985).

22 H.R. REP. NO. 99-841, at 11-745 (1985) (Conf. Rep.).

23 In adopting Section 148(h), Congress did not intend to abandon the “reasonable expectations” methodology. See footnote 42.

24 T.D. 8252, 1989-1 CB 25.

25 Temp. Reg. § 1.148-8T(c)(1).

26 Temp. Reg. § 1.148-8T(c)(2)(i).

27 Temp. Reg. § 1.148-8T(c)(2)(iii).

28 Notice 89-78, 1989-2 CB 390.

29 T.D. 8345, 1991-1 C.B. 33.

30 Id.

31 T.D. 8476, 1993-2 C.B. 13.

32 U.S. Securities and Exchange Commission, Report on the Municipal Securities Market (July 31, 2012) (the “SEC 2012 Municipal Market Report”), at 5.

33 For a brief description of negotiated underwriting, see Exhibit A at 3-5.

34 For a brief description of a competitive sale, see Exhibit A at 5-6.

35 SEC 2012 Municipal Market Report at 15-16 & n.75. In terms of principal amount issued in 2011, competitive sales comprised 26.3%.

36 SEC 2012 Municipal Market Report at 12.

37 See Federal Reserve Statistical Release, Z.1: Financial Accounts of the United States, Third Quarter 2013, www.federalreserve/gov/releases/z1/Currentl/z1.pdf, Table L.100, Line 14 minus Table L.100.a, Line 11, divided by the sum of Table L.2, Line 19 plus Table L.3, Line 5.

38 Publicly offered corporate bonds can be offered only at the stated public offering price to investors, not at “reduced prices,” also referred to as “concessions,” to certain investors. See FINRA Rule 5141. In 1981, one of SIFMA’s predecessors, the Public Securities Association, requested that MSRB consider adopting a “fixed price” rule for publicly offered municipal securities, which MSRB concluded was not necessary or appropriate. See MSRB Reports, Vol. 1, No.4 (November 1981).

39 Pub. L. No. 100-647, sec. 1013(a)(34)(A), 102 Stat. 3342, 3544.

40 H.R. REP. NO. 100-795 at 327-328.

41 T.D. 8345, 1991-1 C.B. 33.

42 For evidence of Congressional intent regarding the reasonable expectations test under section 148(a), see Joint Committee on Taxation General Explanation of the Tax Reform Act of 1986, JCS-10-87, at p. 1201:

The Act codifies the “reasonable expectations” test of prior law with respect to subsequent deliberate and intentional acts to earn impermissible arbitrage taken subsequent to issuance of the bonds. Under the Act (as under prior law), the determination of whether bonds are arbitrage bonds generally is based upon the reasonable expectations of the issuer on the date of issue. If such subsequent acts are taken after the date of issue to earn arbitrage, however, the reasonable expectations test does not prevent the bonds from being taxable arbitrage bonds. (See, e.g., Rev. Rul. 80-91, 1980-1 C.B. 29; Rev. Rul. 80-92, 1980-1 C.B. 31; and Rev. Rul. 80-188, 1980-2 C.B. 47.)

43 Ironically, the proposed definition may result in a different determination of issue price for municipal bonds under section 148 versus sections 1273 and 1274 because original issue discount on municipal bonds has been, and may continue to be, determined based on the initial offering prices disclosed in the final official statement and reported on EMMA.

44 MSRB rules make it unlikely that EMMA could be used “as is” to calculate issue price in most cases. Specifically, except in the case of short-term notes, MSRB Rule G-34 requires the underwriter to set a “Time to First Execution” for trades by members of the syndicate. That time must be no less than two hours after the underwriter has submitted information about the issue to DTC’s new issue information dissemination system (“NIIDS”). Indeed, the NIIDS submission process generally does not begin until after the “Time of Formal Award” (i.e., the execution of the BPA for negotiated issues or the announcement of a winner for competitive issues), Trades by syndicate members at the initial offering price are reported with an “L” (i.e., list price) indicator beginning at the Time of First Execution until the end of the day. The “L” indicator is not used for trades by non-syndicate members or even by syndicate members on subsequent days. These rules apply only to syndicate members. There are no restrictions on dealers that are not syndicate members trading securities before the Time of First Execution under MSRB rules, despite an industry convention that securities should not trade before the underwriter has declared them “free to trade.” Accordingly, it is not uncommon to see trades reported on EMMA prior to the Time of First Execution and those trades may or may not be at the initial offering price. Only syndicate members bind themselves to offer the securities at the initial offering price. Thus, there can be a curious result that secondary market trades (i.e., trades by customers or dealers that purchased securities from a syndicate member) may be displayed on EMMA as “when issued” trades (with a “W” indicator) even before the primary market trades are displayed. To add to the confusion, even when the primary market trades are reported at the Time of First Execution, the time of trade reported is the time the underwriter reports the trade to EMMA, not the time the underwriter and customer actually agree to the trade. For example, an underwriter and customer might have agreed on Tuesday at 10 a.m. to a trade at the initial offering price, but the time of trade will be no earlier than 2 p.m. that day, assuming a BPA signed by noon and a Time of First Execution of 2 p.m. In the meantime, the customer may have entered into a when-issued trade with a non-syndicate member dealer, which trade may be reported at 1 p.m.

45 In common parlance, “face amount” means stated principal amount and is not linked to purchase or offering price. However, over time in various non-precedential guidance, IRS has determined that face amount and similar terms are more appropriately equated with “issue price.” See, e.g., Letter Ruling 9431007 (Apr. 26, 1994).

46 Notice 2010-35 (2010-1 CB 660) provides that the definition of issue price under Reg. § 1.148-1(b) applies for certain purposes of direct pay bonds under sections 54A and 54AA.

47 The failure to close could have significant adverse consequences for the issuer, including liability for breach of contract and a reduced ability to market bonds in the future.

48 See James M. Peaslee & David Z. Nirenberg, Federal Income Taxation of Securitization Transactions and Related Topics 673, n. 29 (4th ed. 2011).




Bond Lawyers Comment on Proposed Bond Arbitrage Regs.

Allen Robertson of the National Association of Bond Lawyers has submitted technical comments on and corrections to proposed regulations (REG-148659-07) on arbitrage investment restrictions applicable to tax-exempt bonds, suggesting that the antiabuse rule be withdrawn but that the working capital, grants, qualified hedges, and valuation provisions be finalized as soon as possible.

December 16, 2013

Internal Revenue Service

CC:PA:LPD:PR (REG-148659-07)

P.O. Box 7604

Ben Franklin Station

Washington, DC 20044

www.regulations.gov (IRS REG-148659-07)

Re: Proposed Arbitrage Regulations (REG-148659-07)

Ladies and Gentlemen:

The National Association of Bond Lawyers (“NABL”) respectfully submits the enclosed comments relating to the proposed arbitrage regulations, REG-148659-07, which were published in the Federal Register on September 16, 20131 (the “Proposed Regulations”), except the proposed definition of “issue price.” NABL is separately submitting comments on the definition of “issue price” in the Proposed Regulations. These comments were prepared by members of NABL’s Tax Law Committee listed on Appendix I, and were approved by the NABL Board of Directors.

NABL appreciates the substantial efforts made by the Department of the Treasury and the Internal Revenue Service in the preparation of the Proposed Regulations and, as explained in the enclosed comments, believes that certain aspects of the Proposed Regulations should be finalized as soon as possible; however, as explained in our separate comments, NABL respectfully suggests that the proposed definition of “issue price” be withdrawn and that any other change in the issue price definition be re-proposed.

NABL requests an opportunity to speak at the public hearing to be held on February 5, 2014 at 10:00 AM. An outline of the topics to be discussed is attached as Appendix II.

NABL exists to promote the integrity of the municipal market by advancing the understanding of and compliance with the law affecting public finance. We respectfully provide this submission in furtherance of that mission.

If you have any questions regarding the enclosed comments, please contact Bill Daly in our Washington, D.C., office at (202) 503-3300.

Sincerely,

Allen K. Robertson

President

National Association of Bond

Lawyers

Washington, DC

* * * * *

COMMENTS OF THE NATIONAL ASSOCIATION OF BOND LAWYERS

ON THE PROPOSED ARBITRAGE REGULATIONS

PUBLISHED ON SEPTEMBER 16, 2013

EXCEPT THE DEFINTION OF “ISSUE PRICE”

INTRODUCTION

The National Association of Bond Lawyers (“NABL”) respectfully submits the following comments on the proposed arbitrage regulations published on September 16, 20131 (the “Proposed Regulations”), except the definition “issue price.” NABL is separately submitting comments on the definition of “issue price” in the Proposed Regulations.

NABL appreciates the substantial efforts made by the Department of the Treasury “Treasury”) and the Internal Revenue Service (“IRS”) in the preparation of the Proposed Regulations. The provisions in the Proposed Regulations relating to working capital, grants, qualified hedges and valuation provisions offer substantial improvements over the Existing Regulations and the technical comments and corrections we are making and suggesting below should be viewed in light of our overall appreciation of the approaches taken in these provisions.

As discussed below, NABL respectfully suggests that the proposed change in the anti-abuse rule be withdrawn. In our separate comments on the definition of “issue price” in the Proposed Regulations, we also respectfully suggest that the proposed definition of “issue price” be withdrawn. We recommend, however, that further work on these issues not delay finalizing the provisions in the Proposed Regulations relating to working capital, grants, qualified hedges and valuation provisions. We also recommend that the proposed regulations published on September 26, 2007 be finalized, subject to comments we have previously submitted, simultaneously with the provisions in the Proposed Regulations relating to qualified hedges.

COMMENTS

A. Working Capital and Grant Provisions

1. General Comments Regarding Working Capital

NABL commends Treasury and IRS for addressing and simplifying the regulations relating to working capital financing. The simplification of the working capital reserve calculation (i.e., the deletion of the rule relating to directly or indirectly financing the reserve) is very helpful. Further, we appreciate that the Proposed Regulations retain the general overburdening limitation in Reg. § 1.148-1(c)(4)(i)(A)2 and add a reference to extraordinary working capital expenditures in Reg. § 1.148-10(a)(4).

NABL neither objects to nor endorses the proposed change to the final maturity safe harbor in Reg. § 1.148-1(c)(4)(i)(B)(1) from two years to the temporary period in Reg. § 1.148-2(e)(3). The change in the safe harbor from two years to (in most cases) 13 months is not particularly significant to most issuers. We do not, however, see any significant reason for the change.

2. Requests for Changes Regarding Working Capital

Clarification Regarding Restricted and De Minimis Working Capital Expenditures

The term “restricted working capital” is used to describe working capital expenditures that are subject to the “proceeds-spent-last” rule. Bonds issued to finance extraordinary working capital expenditures under Reg. § 1.148-6(d)(3)(ii)(B) and grants under Reg. § 1.148-6(d)(4) are not restricted working capital bonds. Accordingly, NABL recommends that Prop. Reg. § 1.148-1(c)(4)(i)(B)(1) be modified to include extraordinary working capital expenditures and grants. This could be accomplished by deleting the word “restricted” from Prop. Reg. § 1.148-1(c)(4)(i)(B)(1).

Further, some clarification would be useful regarding the treatment of de minimis working capital expenditures under Reg. § 1.148-6(d)(3)(ii)(A). We believe that the proposed working capital changes are not intended to change the treatment of de minimis working capital expenditures that are part of a related capital project. No changes are proposed to the definition of the term “capital project” in Reg. § 1.148-1(b) or to the safe harbor in Reg. § 1.148-1(c)(4)(i)(B)(2) that uses the term “capital projects” rather than “capital expenditure.” Some confusion may arise, however, because the phrase “working capital expenditures” (as opposed to “restricted working capital”) is used in Prop. Reg. § 1.148-1(c)(4)(i)(B)(4), and de minimis working capital expenditures are a type of working capital expenditures. It would be helpful if the final rules, or perhaps just the preamble for the final rules, make clear that the changes to Reg. § 1.148-1 (c)(4)(ii) do not apply to de minimis working capital expenditures. While we think that extraordinary working capital expenditures and grants are intended to be covered, we also recommend that the preamble or final regulations clarify this point.

New Working Capital Financing Safe Harbor

We acknowledge that long-term working capital financings can present arbitrage compliance considerations. The structure of the existing rules in Reg. § 1.148-1(c)(4) focuses on the measurement and investment of “other replacement proceeds” to determine arbitrage compliance in the context of potential overburdening. The explicit safe harbor for issuers to invest other replacement proceeds in non-AMT tax-exempt obligations as a means to avoid overburdening is a most welcome change. NABL proposes some changes, however, to the specific rule set forth in the Proposed Regulations.

First, it is logical for the amount of other replacement proceeds to be independently measured each year and for the related amount of required non-AMT tax-exempt investments to be independently measured each year. For example, $1 million of other replacement proceeds may exist in Year One, but no other replacement proceeds may exist in Year Two. The change in the Proposed Regulations could be interpreted to require that once non-AMT tax-exempt investments are acquired, the amount of such investments must be maintained for as long as the bonds are outstanding (subject to a universal cap-like rule), even if deficits exist in future years and there are no other replacement proceeds. This will prove difficult for issuers who need to utilize the funds otherwise invested in the non-AMT tax-exempt investments for operating purposes in later years. To remedy this problem, the aggregate amount of other replacement proceeds in any year should be based on the available amounts in existence that year. Such a determination should not be based on a cumulative calculation of all prior years.

Second, and consistent with the immediately preceding paragraph, the rule should provide that any non-AMT tax-exempt investments may be sold in order to allow the issuer to pay for working capital or capital expenses. It would be unduly burdensome to require an issuer to issue additional debt rather than to simply liquidate the non-AMT tax-exempt investments to cover capital or working capital expenditures that would otherwise create or contribute to a deficit.

Third, the proposed annual testing date for measuring whether other replacement proceeds exist may prove to be unworkable in many situations and should be more flexible. There are many potential approaches that add flexibility. The approach NABL advocates is to continue testing for other replacement proceeds on the first day of the fiscal year (or possibly a different date), but to alter the test so that it focuses on whether the issuer could otherwise issue short-term tax-exempt notes for restricted working capital purposes. If a dollar of tax-exempt notes could be issued for restricted working capital purposes, then the available amounts balance on the first day of the fiscal year is not too large. We acknowledge that this is an expectations test that focuses on the maximum anticipated cumulative cash flow deficit. If a short-term tax-exempt issue would be allowed, then there should be no other replacement proceeds. If not, then the amount of other replacement proceeds should be the lowest available amount projected during the annual testing period. If an expectations test is not acceptable by itself, this new test could be coupled with an actual facts requirement that would operate similarly to the determination of whether the rebate expenditure exception is satisfied for a short-term tax-exempt issue. If the actual maximum cash flow deficit does not result in there being no other replacement proceeds, then the issuer could be required to invest the actual other replacement proceeds amount in non-AMT tax-exempt investments until the next testing date.

Fourth, the regulations should make clear that the definition of “eligible tax-exempt bonds” includes investments in regulated investment companies meeting the 95% tax-exempt-interest requirement and in demand deposit SLGS, consistent with the definition of “tax-exempt bond” in Reg. § 1.150-1(b). Taking into account the existing definition, a statement in the preamble to the final regulations should suffice.

Fifth, while the new safe harbor could apply to bonds issued to finance extraordinary working capital expenditures and grants used for working capital expenditures, we suggest a rule be added that provides an additional safe harbor for extraordinary working capital expenditures and grants used for working capital, such as one tied to the useful life (to the issuer) of the applicable expenditures. See the discussion below regarding the useful life of grants.

Sixth, the proposed rules do not explicitly apply in the refunding context. It should be relatively easy to provide a basic “step in the shoes” approach providing that a refunding that occurs during the period prior to the end of the “first testing year” could be done without reference to future deficits at that time (picking up the same requirement to redeem bonds or invest in non-AMT tax-exempt investments after the originally determined first testing year). For a refunding that takes place after the first testing year, the issuer would have the option of either (a) downsizing the refunding by any available amounts at that time (a true “step in the shoes approach” with respect to the refunded obligations) and continuing to apply the same yearly test thereafter, or (b) starting a new analysis by treating the refunding as a new transaction under the rules (i.e. doing projections based upon a first testing year, and requiring that bonds be redeemed or monies be invested in non-AMT tax-exempt investments after the first testing year, etc.).

Seventh, the proposed rules allow purchases of an issuer’s obligations with surplus amounts. This presumably includes any obligations of the issuer (not just the deficit financing issue). The rule, however, does not describe how these purchases are to be taken into account other than implying that such a purchase is an expenditure of the other replacement proceeds. It would be helpful to include a rule that treats purchases of an issuer’s other debt as a reduction in the outstanding amount of the deficit financing issue under application of the universal cap rule. For example, if an issuer purchased $1 million of the issuer’s capital project debt, the same amount of the deficit financing issue would deallocate for purposes of the other replacement proceeds testing rules, and any future required redemptions or non-AMT tax-exempt investments would be reduced accordingly.

General Blending Approach for Other Replacement Proceeds Purposes

The other replacement proceeds safe harbors should be clarified to expressly cover a single issue of bonds that finances capital and working capital expenditures. The working capital financing component should be treated as an asset with at least a zero useful life that is placed in service on the date the bonds are issued. If the weighted average maturity of the bond issue is not longer than 120% of the weighted average useful life of the financed assets (including the deemed working capital asset), then the issuer should be permitted to treat the bond issue as satisfying the other replacement proceeds safe harbor. As discussed above, this new rule would not apply to de minimis working capital expenditures.

Financing a Working Capital Reserve

As noted above in Clarification Regarding Restricted and De Minimis Working Capital Expenditures, the simplification of the working capital reserve calculation (i.e., the deletion of the rule relating to directly or indirectly financing the reserve) is very helpful. Consistent with that simplifying change, it would be beneficial if the final regulations made clear that funding a working capital reserve with proceeds will be treated as an expenditure of those proceeds. Absent that clarification, an issuer would allocate all revenues received on and after the date the working capital bonds are issued to the funding of the working capital reserve, thereby allowing proceeds to be used for all expenditures until the reserve is fully funded. That accounting solution, however, is an unnecessary complication. An alternative solution would be to treat the funding of a working capital reserve similarly to the funding of a reasonably required reserve fund and add provisions comparable to Reg. §§ 1.148-2(f)(1), 1.148-2(f)(2)(i)-(iii), 1.148-7(c)(1)(ii) and 1.148-7(c)(3)(ii).

Treatment of Unspent Proceeds of Issue A as Unavailable for Purposes of Issue B

Although the proposed regulations do not propose changes to the definition of available amounts, there is one technical change that is warranted. The phrase “available amount excludes proceeds of the issue” in Reg. § 1.148-6(d)(3)(iii)(A) should be changed to “available amount excludes unspent proceeds of an issue.” (Emphasis added.) This would allow an issuer to allocate the proceeds of a tax-exempt working capital issue to expenditures even if proceeds of another (taxable or tax-exempt) working capital issue were not spent. See the analysis in Private Letter Ruling 200446006.3

The importance of this change is best shown by example. For simplicity, we ignore the working capital reserve. City expects a deficit of $100 to occur in December but is not certain. In the previous July, to be careful, City issued only $70. A couple months later it is clear that the $100 deficit will occur, and City issues another $30. At the time of the second issue, $40 of the proceeds of the first issue are not yet spent. If the unspent proceeds of the first issue are available for purposes of spending the proceeds of the second, and the unspent proceeds of the second issue are available for purposes of spending the proceeds of the first, then none of the proceeds of either issue can be treated as spent.

3. General Comments Regarding Grants

NABL wishes to commend Treasury and IRS for addressing and clarifying the treatment of grants. We endorse the general “look-through” approach set forth the in the Proposed Regulations, subject to the comments set forth below.

4. Requests for Changes Regarding Grants

Issues Relating to Grants for Working Capital

Useful Life of Grants: While the general look-through approach for grants is a useful clarification, NABL proposes some changes relating to the interaction between the look-through approach and the overburdening and other replacement proceeds concepts. Consider a grant made to a business to induce the business to relocate into a downtown business district for urban renewal purposes. A common structure is that the grant would be used to cover operating costs of the business, and the business would commit to maintaining its presence in the downtown business district for five years. Strictly applying the look through approach, the grant is for working capital expenses incurred by the business. Viewing the grant from the issuer’s perspective, however, the grant has essentially acquired an intangible asset (the relocation of the business) with a five-year life.

It would be very helpful if a rule and some examples are added that allow issuers to establish a “useful life” for grants by reference to the time period the issuer is reasonably expected to benefit from the grant. In simple cases, like the example above, a contractual compliance period embedded in the grant could be used. But, not all working capital grants have a formal contractual compliance period. If the amount and purpose of a grant was, for example, to fund three years of operating deficits for a start up enterprise, the expected life of the grant to the issuer should be three years even if there is not a strict three-year compliance period included in the contractual terms of the grant.

As noted above, any such rule added for grants should also apply to extraordinary working capital expenditures.

General Blending Approach: If the general blending approach for other replacement proceeds (described above) is not adopted for all working capital financing purposes, it should at least be adopted for issues that finance both capital projects (funded through grants or otherwise) and working capital grants. We can think of no reason why such a blending approach is inappropriate.

Grantee Reimbursement: The final regulations should confirm that the look through approach does not require the grantee to satisfy any sort of official intent requirement to the extent a grant is made on a reimbursement basis. It is most common for issuers administering grant programs to transfer funds to grantees only after the grantee has provided documentation showing that the grantee has spent its own funds for the purposes of the grant. If an official intent requirement applied and was not satisfied in this “reimbursement” context, then a traditional grant for a capital project would transform into a working capital grant.

Refunding Analysis: The final regulations should confirm that the look through approach does not cause bonds issued to finance grants to be refunding bonds if the grantee uses the grant to pay debt service on the grantee’s obligations. This non-refunding conclusion is consistent with the refunding definition in Reg. § 1.150-1(d)(2)(ii), because the grantor will not be a related party to the grantee. Thus, the obligors on the two issues of obligations will not be related. This clarification is important because grantees frequently incur debt to finance project costs and use the grant funds to pay off that debt.

B. Qualified Hedge Provisions

1. Changes in accounting for qualified hedges in connection with deemed terminations (Prop. Reg. § 1.148-4(h)(3)(iv)(C) and (D))

By way of background, in April 2007, NABL submitted a letter to Treasury requesting guidance on the deemed termination of a qualified hedge in connection with the acquisition of an offsetting hedge. In the proposed regulations published on September 26, 2007 (the “2007 Proposed Regulations”),4 Treasury and IRS requested specific comments on this topic. NABL’s comments in December 2007 specifically requested changes to the qualified hedge rules to avoid the consequences of a deemed termination of a qualified hedge in connection with the modification of a hedge or refunding of the hedged bonds (including a deemed reissuance). The Proposed Regulations broadly respond to that request. NABL thanks Treasury and IRS.

Prop. Reg. § 1.148-4(h)(3)(iv)(C) provides that the modification of a qualified hedge that otherwise would result in a deemed termination will not be treated as a termination if the modified hedge meets the requirements for a qualified hedge, determined as of the date of the modification. Prop. Reg. § 1.148-4(h)(3)(iv)(D) provides that what otherwise would be a deemed termination of a qualified hedge as a result of redemption of the hedged bonds will not be treated as a termination, and the hedge will be treated as a qualified hedge of the refunding bonds, if it meets the requirements for a qualified hedge as of the issue date of the refunding bonds. In both cases, the fact that the existing hedge is off-market as of the date of the modification or refunding, as the case may be, is disregarded. In addition, the new certification requirement is waived, and the period in which the hedge must be identified is measured as of the new testing date.

These proposed changes are very helpful for the reasons stated in our December 2007 comment letter. When read in conjunction with other aspects of the 2007 Proposed Regulations, however, they are incomplete. The 2007 Proposed Regulations would amend the qualified hedge rules by modifying the interest based contract rule to require, in the case of an interest rate swap based on a taxable interest rate, that the difference between the rate on the swap and the rate on the hedged bonds cannot exceed 25 basis points both at the time the issuer enters into the hedge and for a three-year period prior thereto (the “interest rate correlation test”).

While not entirely clear, we are concerned that the new proposed rule on potential deemed terminations could be read to require testing for compliance with the interest rate correlation test at the time of the modification or refunding to determine if the modified or existing hedge is a qualified hedge.5 That would greatly limit the utility of the new rules.

In our December 2007 comments we suggested that the interest rate correlation test was unnecessary in light of other rules. But we also suggested that, if some form of interest rate noncompliance with the interest rate correlation test, but that seems an unlikely inference, correlation is required, it be limited to a form of three-year historical correlation. Assuming that is what is finally adopted, we urge Treasury and IRS not to require its application in connection with potential deemed terminations as a result of a modification or refunding. One of the great benefits of the new proposed rules is that an issuer will not have to negotiate with an existing hedge provider to maintain the qualified status of its hedge when a potential deemed termination occurs, This is most commonly the case in connection with refundings of hedged bonds (including deemed reissuances), but it can also occur in connection with deemed modifications as a result of new interest rate positions entered into with a counterparty different from the original hedge provider. If the interest rate correlation test must be satisfied as of the date of modification or refunding, the issuer will almost certainly have to deal with the original hedge provider to ensure compliance.

Interest rate correlation in these circumstances should be unnecessary, because a single rate correlation test can always be satisfied with a meaningless adjustment to the rate formula. For example, assume an issuer’s three-year historical interest rate for a particular rate period has averaged 2%, and the issuer has an existing interest rate swap where the issuer pays 4% fixed and receives 67% of LIBOR (which satisfied the interest rate correlation test at the time it was entered into). If LIBOR for the three-year test period prior to a refunding has averaged 2.46%, 67% of LIBOR for that period would have averaged 1.60% — more than 25 basis points different from 2%. That difference can be eliminated by changing the interest rate formula on the swap by adding 40 basis points to each side of the equation, to make the fixed rate 4.40% and the variable rate 67% of LIBOR plus 40 basis points. Simple algebra will prove that those two rate formulas will always produce the same net number, and the same will be true for virtually any other set of rate formulas. That is easy enough to do when the swap is being entered into, when both parties to the contract are at the table.6 It would entail needless expense in time and money, however, when the contract is not otherwise being altered.

As an alternative to abandoning the interest rate correlation test altogether, we suggest the issuer be permitted to satisfy that test by maintaining documentary evidence that the test could have been satisfied with an adjustment to the interest rate provisions in the swap that would have produced no net change in payments under any set of interest rate assumptions.

We also assume that these rules, if finally adopted, will supersede Section 5.1 of Notice 2008-417, dealing with modifications of qualified hedges.

2. Definitions of modification, termination for qualified hedges (Prop, Reg. § 1.148-4(h)(3)(iv)(A) and (B))

We have no specific comments to these provisions, but we do have the following observations.

The removal of the phrase “acquisition by the issuer of an offsetting hedge” from the definition of a termination is an improvement to the rules.

The assignment of a hedge provider’s remaining rights and obligations under the hedge to a third party is treated as a modification under Prop. Reg. § 1.148-4(h)(3)(iv)(A) but is treated as a termination under Prop. Reg. § 1.148-4(h)(3)(iv)(B) only if that causes a realization event to the issuer under section 1001. Presumably that covers an assignment that is not treated as an exchange under Reg. § 1.1001-4. If the assignment rule is intended to have some other application, please clarify.

We read the Proposed Regulations as providing that a partial redemption of hedged bonds results in a partial deemed termination of a qualified hedge.

We also read the Proposed Regulations as allowing an issuer to modify a qualified hedge by executing a second hedge and integrating the two hedges with the bonds without the need for a hedge provider’s certificate (assuming the other integration requirements are met).

3. Fair market value standard for termination of qualified hedge (Prop. Reg. § 1.148-4(h)(3)(iv)(E))

The 2007 Proposed Regulations would modify the existing regulations to provide that the amount of any termination payment or deemed termination payment taken into account for arbitrage yield calculations is equal to the fair market value of the hedge on the termination date. In our December 2007 comments, we asked that the proposed rule be changed to make it clear that the actual amount paid or received by the issuer be treated as the fair market termination value and that deemed termination value be based on actual market quotations. The Proposed Regulations leave the fair market value standard for deemed terminations unchanged from the 2007 Proposed Regulations and add a rule that, in the case of an actual termination, the amount taken into account cannot be more than fair market value if the termination payment is paid by the issuer and cannot be less than fair market value if the termination payment is paid by the provider. Although the Preamble states that these changes were made in response to comments, there is no further gloss on what the new proposal is intended to address.

In our December 2007 comments, we explained that in most cases hedge termination payments are determined initially by the provider based on its pricing models and typically reflect the “bid side” of the hedge provider’s quotation system. Standard swap documentation usually provides for a market quotation procedure if the issuer disagrees with the providers’ termination amount, which will again be based on the “bid side.” This is the same system used for interest rate swaps for non-municipal counterparties, and we are unaware of any suggestion that it produces off-market results. Especially in the case of an actual termination payment, the termination amount is a real number to the issuer, either a real cost or a real revenue; a bond yield adjustment will at best only partially compensate an issuer for an off-market termination amount.

In view of standard practice throughout the market and the administrative development of this new proposed rule, what is the implication of the Proposed Regulations’ treatment of termination amount values? If the concern is that costs unrelated to the hedging transaction are embedded in a swap termination value, we submit that, under the existing final regulations, this would be a proper subject of an audit challenge. If Treasury and IRS have additional concerns, we request that the preamble for final regulations provide some explanation.

Moreover, the landscape for derivatives has changed tremendously since 2007, most notably by enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act.8 Under the price transparency rules for interest rate swaps contained in Dodd-Frank, municipal issuers and their advisors (and all municipal issuers are required under Dodd-Frank to have swap advisors) have real-time pricing information to help them determine the true value of their swaps.

We urge Treasury and IRS to revert to the 2007 Proposed Regulations statement of fair market value rule, with the changes suggested in our December 2007 comments:

(i) in the case of an actual termination of a qualified hedge, the termination amount is the amount paid by or to the issuer in respect of such termination, and

(ii) in the case of a deemed termination of a qualified hedge, the termination amount is the fair market value determined by the issuer (taking into account any quotation of such value obtained from the provider and any quotation obtained from a reasonably comparable provider).

In all events, Treasury and IRS should recognize that real world termination values reflect the “bid side” of the market.

Finally, it is unlikely that there will be a single universally agreed upon fair market value for a hedge (different buyers will be willing to pay different prices for the same product). In other contexts (e.g., fair market value for issue price), industry practice has developed to permit parties to certify that a price represents “a fair market value.” The final regulation should use the words “a fair market value” or simply “fair market value” in place of “the fair market value.”

4. Requires specific hedge provider certifications for qualified hedge treatment (Prop. Reg. § 1.148-4(h)(2)(viii)(A) and (B))

The Proposed Regulations would impose a hedge provider’s certification requirement for qualified hedges. This requirement seems unnecessary for several reasons. First, it would impose a requirement on qualified hedges that is not present as a matter of law for other financial contracts that are includable in yield. For example, there is no similar requirement for bond insurance or letters of credit, although we acknowledge similar provisions relating to the investment of bond proceeds in guaranteed investment contracts. Issuers have strong legal, market and economic incentives to seek the most competitive swap counterparties.

Second, interest rate swaps and other hedges function as a form of interest rate protection, similar to the credit risk protection provided by a guarantee. Under existing final regulations, if an issuer acquires a qualified guarantee, the fees includible in bond yield cannot exceed a reasonable arm’s-length charge for the transfer of credit risk.9 Importantly, in complying with this requirement, the issuer may not rely on the representation of the guarantor. It would be inconsistent for the qualified hedge regulations to have disparate treatment between qualified hedges and qualified guarantees.

Third, hedge integration is not unique to the tax-exempt bond area, and the Proposed Regulations requirement for a hedge provider’s certificate is unprecedented. More specifically, none of the hedge integration regulations set forth under sections 446, 988, 1221 and 1275 contains a requirement of a hedge provider’s certificate. Of course, issuers have been integrating hedges with tax exempt bonds for over 20 years. There should be strong reasons for imposing a different requirement in the tax-exempt bond law than the tax law generally.

If Treasury and IRS seek to set forth an explicit “fair market price” concept to qualified hedges, final regulations should provide for alternative methods of establishing fair pricing, which could include a hedge provider’s certificate, internal analysis, or a report of a qualified independent representative meeting the standards of the Commodity Futures Trading Commission. Some interest rate swaps are bid, with the issuer specifying the variable rate leg and the swap being awarded to the lowest fixed rate bidder, which also should be enough to conclusively establish fair pricing.

We recognize, of course, that many issuers (at the instigation of bond counsel) already require some form of hedge provider certifications, and it is unlikely to be coincidence that the content of the provider certificate in the Proposed Regulations reflects to some degree a standard form of such certification. Nonetheless, we strongly believe the final regulations should set forth the substantive requirements for qualified hedge treatment and let the market develop appropriate diligence standards for implementing those requirements.

If Treasury and IRS decide to retain the certification requirement, the four representations should be clarified. As a general matter, we believe that the form of the certificate and the precise phraseology should not dictate the tax result. The issuer should be required to demonstrate that it used its best efforts to establish that (1) the rate payable by the issuer does not include compensation for underwriting or other services, and (2) the rate was comparable to the rate that the hedge provider would charge for a similar hedge with a counterparty similar to the issuer (if one exists). The lack of a comparable hedge or comparable hedge counterparty should not preclude hedge integration.

Specifically, we see little value in the representation that the terms of the hedge were agreed to between a willing buyer and willing seller in a bona fide, arm’s length transaction. Hedges are typically (though not always) negotiated transactions, and issuers frequently use swap advisors (or internal expertise) to evaluate transactions. As drafted, the representation is a legal conclusion that appears to create a “foot fault” to reverse integration.

The rate comparability representation in Prop. Reg. § 1.148-4(h)(2)(viii)(B)(2) is generally fine but the reference to “debt obligations other than tax-exempt bonds” should be deleted. Many tax exempt bond issuers do not issue taxable bonds. The legal, credit and other market factors present in hedges with tax exempt issuers are materially different from the same factors with taxable entities as a counterparty. Accordingly, the party executing the certificate often is not able to make a comparison to “debt obligations other than tax-exempt bonds” with a similar counterparty.

We have one minor comment to the disclosure of third-party fees as required by Prop. Reg. § 1.148-4(h)(2)(viii)(B)(3). This subparagraph should make clear that only third-party fees paid at the request (or for the benefit) of the issuer must be disclosed in the certificate. Third-party fees, such as legal and accounting fees, paid by the hedge provider for the benefit of the hedge provider should not be required to be disclosed. This clarification would be consistent with current market practice.

Prop. Reg. § 1.148-4(h)(2)(viii)(B)(4) is unclear. From the hedge provider’s perspective, it is offering to enter into a bilateral contract with the issuer. It is inappropriate for the hedge provider to address whether the hedge modifies the issuer’s risk of interest rate changes. Similarly, it is inappropriate for the hedge provider to represent that the payments are reasonably allocated to the hedge provider’s overhead. We assume that Treasury was concerned about hedge providers embedding fees for other services within a hedge. Market practice has addressed this issue effectively. In general, bond counsel have asked hedge providers whether amounts payable by the issuer pursuant to a qualified hedge include payments for underwriting or other services provided by the hedge provider. If the hedge provider makes payments on behalf of the issuer (e.g., to a financial advisor or swap advisor to the issuer), those services are typically disclosed. As drafted, the Proposed Regulations would not allow an issuer to integrate a hedge with a separately stated investment element or fee even if fully disclosed and properly quantified. If Treasury and IRS retain the hedge provider’s certificate requirement, we recommend that Prop. Reg. § I.148-4(h)(2)(viii)(B)(4) be replaced with a requirement that the hedge provider certify either (1) that there are no underwriting or other services unrelated to the hedge provider’s obligations under the hedge, or (2) the nature of the services and the rate that the hedge provider would have quoted to the issuer to enter into the hedge absent such services.

5. Identification (Prop. Reg. § 1.148-4(h)(2)(viii))

Most of the requirements for qualified hedge treatment apply to the “issuer,” which in the case of a conduit financing means either the actual issuer or the conduit borrower, depending on the context.10 In Reg. § 1.148-4(h)(2)(viii), however, the identification of a hedge must be made by the actual issuer. Especially in the case of anticipatory hedges, a conduit borrower may not know for sure which entity will be the actual issuer of the bonds. In conduit financings, the final regulations should permit the identification to be made on the books and records of the conduit borrower. The actual issuer would still be required to identify the existence of the hedge on the information return filed with respect to the issue. Moreover, listing the hedge on the information return should be treated as inclusion in the issuer’s books and records and address any concerns that IRS may have regarding the issuer being familiar with the hedge.

6. Prop. Reg. § 1.148-4(h)(4)(iv) Applies Reg. § 1.148-4-4(h)(4)(iii) to Reg. § 1.148-4-4(h)(3)(iv)(C)

The Proposed Regulations would add a new paragraph 1.148-4(h)(4)(iv) as follows —

Consequences of certain modifications. The special rules under paragraph (h)(4)(iii) of this section regarding the effects of terminations of qualified hedges of fixed yield hedged bonds also applies in the same manner to modifications of a qualified hedge under paragraph (h)(3)(iv)(C) of this section. Thus, for example, a modification may result in a prospective change in the yield on the hedged bonds for arbitrage rebate purposes under Reg. § 1.148-3.

This would be added to the so-called super-integration rules. In general, the rules under Reg. § 1.148-4(h)(4)(iii) provide, in connection with termination of a super-integrated hedge, that (A) the hedged bonds are treated as reissued on the termination date in determining yield for purposes of Reg. § 1.148-3 (dealing with rebate), (B) if the termination occurs within five years of the issue date of the hedged bonds, the bonds are treated as variable yield bonds from their issue date for purposes of Reg. § 1.148-3, and (C) the termination rule does not apply to a termination if, based on the facts and circumstances (e.g., taking into account both the termination and any qualified hedge that immediately replaces the terminated hedge), there is no change in yield.

We understand that the purpose of this proposed rule is to ensure that a qualified hedge that is super-integrated under Reg. § 1.148-4(h)(4)(i) is retested for super-integration after a modification that would not be treated as a termination under the Prop. Reg. § 1.148-4(h)(3)(iv)(C) rule (modification does not result in a deemed termination if the fact of its being off-market is disregarded). If that understanding is correct, we suggest the rule could be clarified if the first sentence were rewritten as follows —

Notwithstanding the rule on modification of a qualified hedge under paragraph (h)(3)(iv)(C) of this section, modification of a qualified hedge that would result in a termination in the absence of the rule in paragraph (h)(3)(iv)(C) will not be treated as a termination for purposes of this paragraph (h)(4)(iii) if the rule in subparagraph (h)(4)(iii)(C) applies.

C. Valuation of Investments

We commend Treasury and IRS for proposing changes to the valuation rules set forth in the arbitrage regulations. We believe that, with appropriate revisions prior to finalization, the changes will be helpful to issuers of tax-exempt bonds and will further the general policies behind the arbitrage rules set forth in section 148, as more specifically described in Reg. § 1.148-0: to minimize arbitrage benefits from investing gross proceeds of tax-exempt bonds in higher yielding investments and to remove arbitrage incentives to issue more bonds, to issue bonds earlier, and to leave bonds outstanding longer than is otherwise reasonably necessary.

1. Background

The Existing Regulations generally require that investments allocated to or from an issue of tax-exempt bonds in a deemed acquisition or deemed disposition must be valued at fair market value as of the date of the deemed acquisition or disposition, with exceptions for investments allocated from one issue of tax-exempt bonds to another issue of tax-exempt bonds as a result of the transferred proceeds allocation rule or the universal cap rule. As noted in the preamble to the Proposed Regulations, these valuation rules have the effect of preventing issuers from retiring outstanding tax-exempt bonds prior to their stated maturity date in cases where yield restricted investments allocable to the issue have appreciated in value to such an extent that fair market valuation at the time of deemed disposition will result in violation of applicable yield restriction limitations under section 148. This disincentive to retiring tax-exempt bonds prior to maturity is contrary to the underlying principle of the arbitrage rules because it results in tax-exempt bonds staying outstanding longer than is otherwise necessary.

One of the more common scenarios illustrating this effect involves an issuer’s taking of “remedial action” pursuant to Reg. § 1.141-12(d), in which investments allocated to the bond issue with respect to which remedial action is taken are still in place and, hence, need to be valued. In that scenario, an issuer that does not have on hand sufficient funds to effectuate the redemption or defeasance required under Reg. § 1.141-12(d) will be forced to borrow on taxable basis to provide the funds necessary to redeem or defease bond issue in question.

A second scenario, of which IRS is aware, involves the many tax-exempt bond issues that have been defeased past their first optional call date, where call rights have been retained by the bond issuer. There are numerous permutations of situations in which it may be necessary or desirable for a bond obligor to retire such bonds ahead of the date to which they have been defeased. Examples illustrating the above two scenarios are as follows:

Example 1. In June 2005, City X issues long-term fixed-rate tax-exempt bonds to finance the construction of a new 10-story office building in which the City intends to house some of its employees. The 2005 bonds are first callable at the option of City X on November 1, 2015 at par. Construction of the building is completed in June 2007. In August 2007, City X issues variable rate demand bonds, at par (and concurrently enters into a variable-to-fixed interest rate swap), to advance refund the 2005 bonds to their first optional call date, November 1, 2015. City X integrates the interest rate swap with the 2007 bonds pursuant to the rules in Reg. § 1.148-4(h). The integrated yield on the 2007 bonds, using the fixed rate on the swap, is 5.00%, and the yield on the escrow securities used to defease the 2005 bonds is 4.95%. On September 30, 2013, City X leases for fair rental value 5 of the 10 floors in the building to Company Y. City X intends to redeem 50% of the outstanding amount of the 2007 bonds within 90 days of September 30, 2013, in accordance with Reg. § 1.141-12(d)(1), and issues taxable bonds in an amount sufficient (after issuance costs) to redeem 50% of the 2007 bonds within such period. At the time of issuance of the 2013 taxable bonds, the escrow securities have a fair market value that, if sold, would cause the yield on the escrow securities to exceed the integrated yield on the 2007 bonds. Under Reg. § 1.148-9(b)(1), 50% of the investments held in the escrow established with the 2007 bonds to defease the 2005 bonds will be deallocated from the 2007 issue and become “transferred proceeds” of the 2013 taxable bonds.

Example 2.11 In 2002, City X issues tax-exempt bonds to finance eligible costs. In 2006, City X used non-borrowed funds (i.e., equity) to purchase escrow securities and create an escrow restricted to the yield on the tax-exempt bonds and defease the tax-exempt bonds to maturity. The yield on the tax-exempt bonds is 5.00% and the yield on the escrow securities is 4.95%. The early call option(s) on the tax-exempt bonds are retained by City X. In 2013, City X issues taxable bonds and uses a portion of the proceeds to redeem the tax-exempt bonds on the same date. The amount of taxable bonds that may be issued and supported by cash flows from the escrow securities exceeds the amount required to redeem the tax-exempt bonds and the excess proceeds derived from the taxable bonds are used by City X for lawful governmental purposes. At the time of issuance of the 2013 taxable bonds, the escrow securities have a fair market value that, if sold, would cause the yield on the escrow securities to exceed the yield on the 2002 tax-exempt bonds. Applying universal cap principles, at the time the 2002 tax-exempt bonds are redeemed, the escrow securities cease to be allocated as replacement proceeds of the tax-exempt bonds and, because they are used thereafter to secure the repayment of the taxable bonds, they become replacement proceeds of the taxable bonds.

In both of the above examples, an arbitrage violation would occur if the escrow securities are required to be valued at fair market value at the point at which they cease to be allocated to the tax-exempt bond issue. An arbitrage violation would not occur if the escrow securities are valued at present value at such time. Pursuant to current Reg. § 1.148-5(d)(3)(ii), however, the escrow securities arguably are required to be valued at fair market value unless, as a result of a transferred proceeds allocation under Reg. § 1.148-9(b) or the universal cap rule under Reg. § 1.148-6(b)(2) the escrow securities both (1) cease to be allocated to one issue of tax-exempt bonds, and (2) at the same time are allocated to a different issue of tax-exempt bonds. Under this reading of the current valuation regulations, the issuer in Example 1, who has no choice but to issue taxable indebtedness to defease the currently outstanding debt in order to effect remedial action, is unable to do so. Likewise, the Existing Regulations impede the taxable refunding described in Example 2.

The preamble to the Proposed Regulations notes the disincentives to the early retirement of tax-exempt bonds created by the current rules and acknowledges that such disincentives are inconsistent with general arbitrage policies. The preamble specifically states that the current regime “creates disincentives against retiring tax-exempt bonds . . . when the fair market value of the investment would cause investment yield to exceed the tax-exempt bond yield. Such disincentive is inconsistent with the general policies behind the arbitrage rules stated in Section 1.148-0.”

We applaud the approach reflected in the Proposed Regulations, but we believe the policy of removing disincentives to early retirement of tax-exempt bonds can best be achieved with certain clarifications and supplements. Additionally, given the age of the current valuation rules, and 20-plus years of experience with the current regime, we recommend a reordering and simplification of the valuation rules and certain specific changes.

2. Clarifications

We request that, when the Proposed Regulations are finalized, the regulations be clarified in the following manner.

Effective Date

As written, the Proposed Regulations can be applied only with respect to bonds sold on or after September 16, 2013. In the context of a taxable refunding, a valuation at fair market value adversely impacts the yield restriction and rebate position of the refunded bonds and not the refunding bonds, which are taxable in any event. It is unclear whether the phrase “bonds sold” in the effective date provision is referencing the refunded tax-exempt bonds or the refunding taxable bonds. If it is referencing the date of sale of the refunded tax-exempt bonds, it will be many years before the change in the regulations has any significant utility since in the most common fact pattern to which this rule will apply, first, tax-exempt bonds must be issued after September 16, 2013; second, after a period of time, the bonds must be refunded with tax-exempt refunding bonds; and finally, the taxable bonds would need to be issued to refund the tax-exempt refunding bonds.

As noted above, the preamble to the Proposed Regulations acknowledges that the fair market valuation rule in the Existing Regulations creates a disincentive to the issuance of taxable refunding bonds, which is inconsistent with the policies behind the arbitrage rules. The Proposed Regulations attempt to remedy this disincentive. In order to do so effectively, it should be clarified that the effective date is based on the date on which the refunding taxable bonds are sold. Alternatively, particularly if our suggestion in Section 3 (Extend Valuation Rule to Apply to Redemption with Equity Funds) is adopted, the new provision should be applicable with respect to deallocations under the transferred proceeds, universal cap or replacement proceeds rules occurring on or after September 16, 2013.

Application of Universal Cap Rule in the Context of Equity-Funded Escrows

As illustrated in Example 2 above, the policy of encouraging the early retirement of tax-exempt bonds would be best served if the escrow securities are permitted to be valued at present value when they cease to be allocated to tax-exempt bonds and are reallocated to taxable refunding bonds. Under the Proposed Regulations, such a result occurs if the transfer of the escrow securities from the tax-exempt bonds to the taxable bonds occurs as a result of either the transferred proceeds allocation rule under Reg. § 1.148-9(b)12 or the universal cap rule under Reg. § 1.148-6(b)(2).The escrow securities do in fact cease to be proceeds of the tax-exemptbonds as a result of the universal cap rule. While this deallocation enables the escrow securities to become proceeds of the taxable bonds, it does not cause such a reallocation to occur. The universal cap rule generally does not cause amounts to be proceeds of an issue because it is a rule that operates to limit the amount of proceeds that can be allocated to an issue. The Proposed Regulations simply require that the allocation from the tax-exempt issue to the taxable issue occur “as a result” of the universal cap rule, In our Example 2, the universal cap rule is one of the factors that enables the investments to become replacement proceeds of the taxable bonds. Moreover, permitting valuation of the investments at present value in this context is consistent with the tax policy goal of removing disincentives to the retirement of tax-exempt bonds prior to their stated maturity date.13 Accordingly, we propose that the following example be added to the revamped valuation regulations:

In 2002, City X issues tax-exempt bonds to finance eligible costs, In 2006, City X used non-borrowed funds (i.e., equity) to purchase escrow securities and create an escrow restricted to the yield on the tax-exempt bonds and defease the tax-exempt bonds to maturity. The yield on the tax-exempt bonds is 5.00% and the yield on the escrow securities is 4.95%. The early call option(s) on the tax-exempt bonds are retained by City X. In 2013, City X issues taxable bonds with a comparable maturity structure to the outstanding 2002 tax-exempt bonds and uses a portion of the proceeds to redeem the tax-exempt bonds on the same date. Only $100 of taxable bonds is needed to retire the tax-exempt bonds, but (he escrow securities would provide sufficient cash flow to support $115 of taxable bonds. City X issues $115 of taxable bonds, and $100 of the proceeds are used to retire the tax-exempt bonds and $15 of the proceeds are used for any lawful purpose of City X.14 At the time of issuance of the 2013 taxable bonds, the escrow securities have a fair market value that, if sold, would cause the yield on the escrow securities to exceed the yield on the 2002 tax-exempt bonds. Applying universal-cap principles, at the time the 2002 tax exempt bonds are redeemed, the escrow securities cease to be allocated as replacement proceeds of the tax-exempt bonds and, because they are used thereafter to secure the repayment of the taxable bonds, they become replacement proceeds of the taxable bonds. At the lime the escrow securities cease to be allocated to the tax-exempt bonds, the escrow securities are valued at present value.

Clarify Valuation Treatment of Purpose Investments

While the Existing Regulations are not clearly written on this point, we understand that the intended result of the Existing Regulations is that purpose investments15 are to be valued at present value at all times (the language of existing Reg. § 1.148-5(d)(2) describes a purpose investment as an example of an investment that is subject to mandatory valuation at present value). While we believe this approach is intended to be continued under the Proposed Regulations, the preamble and language of the Proposed Regulations could be interpreted as creating uncertainty (the preamble states “the fair market value method of valuation is generally required for any investment and the purpose investment example is removed from the language of Reg. § 1.148-5(d)(2)).16 This uncertainty can be avoided by specifically stating in Reg. § 1.148-5(d)(2) that it applies to purpose investments in all instances, or at a minimum clarifying the point in the preamble. With respect to nonpurpose investments, the clarification can be addressed by inserting the word “nonpurpose” before the word “investment” in the first sentence of the Reg. § 1.148-5(d)(3)(i) and clarifying the point in the preamble.

Clarify interaction Between Reg. § 1.148-2(d)(2) and Reg. 1.148-5(d)(3)

Current Reg. § 1.148-5(d)(2) is titled “mandatory valuation.” Current Reg. § 1.148-5(d)(3) is titled “mandatory valuation,” and current Reg. § 1.148-5(d)(3)(i) contains a lead-in stating “except as provided in paragraphs (d)(2) . . .,” and contains the words “must be valued.” The interplay of Reg. § 1.148-2(d)(2) and Reg. § 1.148-5(d)(3) under the Existing Regulations is unclear and subject to alternative interpretations.

The Proposed Regulations (i) include a new cross-reference to Reg. § 1.148-5(b)(3) and Reg.§ 1.148-5(d)(3) in revised Reg. § 1.148-5(d)(2), (ii) delete the reference to Reg. § 1.148-5(d)(2) in Reg. § 1.148-5(d)(3)(i) and (iii) the preamble to the Proposed Regulations interprets the Transferred Proceeds/Universal Cap Exception (as such term is defined in Section 4 (Summary of Existing Regulations) below) as the sole exception17 to application of the fair market valuation requirement of Reg. § 1.148-5(d)(3)(i). Nevertheless, the mandatory valuation title to Reg. § 1.148-5(d)(2) is retained. Additionally, the final sentence of Reg. § 1.148-5(d)(2) is removed in the Proposed Regulations. The preamble to the Proposed Regulations did not make mention of the inclusion of the new cross-reference and did not make mention of the removal of the cross-reference or the removal of the last sentence. Both the Existing Regulations and the Proposed Regulations create confusion. It is unclear whether one regulatory provision is intended to trump the other or they are intended to apply in a mandatory fashion but to different factual situations.

We recommend that IRS (1) clarify how the two “mandatory rules” interplay (if at all) or clarify the different circumstances to which each is to apply, and (2) state why the cross-reference to Reg. § 1.148-5(d)(2) and the final sentence of Reg. § 1.148-5(d)(2) is proposed to be removed. For example, if Reg. § 1.148-5(d)(2) is intended to apply to purpose investments and Reg. § 1.148-5(d)(3) is intended to nonpurpose investments, the point should be clarified/specified in language of the regulations and/or the preamble to the next version of the regulations.18

3. Additional Requests

We also request that the following provisions be added to the final valuation regulations.

Effective Date

If the fair market valuation rule, at least as applied to yield restricted investments, was inconsistent with the policies behind the arbitrage rules on September 16, 2013, the rule was also inconsistent with such policies from the date of its adoption. As an alternative to the effective date clarification described in Section 2 (Effective Date) above, the changes in the valuation rules should be completely retroactive at the election of the issuer.

Extend Valuation Rule to Apply to Redemption with Equity Funds

For the same policy reasons that IRS should not provide disincentives for the redemption of tax-exempt bonds with taxable bonds, it should not provide disincentives for the redemption of tax-exempt bonds with equity. The following text in bold and underscore is a specific change to Reg. § 1.148-5(d)(3)(ii) for this purpose:

Paragraph (d)(3)(i) of this section does not apply if the investment (A) is allocated from one issue to another as a result of the transferred proceeds allocation rule under § 1.148-9(b) or the universal cap rule under § 1.148-6(b)(2), provided that the issue from which the investment is allocated (that is, the first issue in an allocation from one issue to another) consists exclusively of tax-exempt bonds, or (B) ceases to be allocated to an issue in connection with the issuer using amounts that are not proceeds of an obligation to redeem tax-exempt bonds prior to maturity. In addition, paragraph (d)(3)(i) of this section does not apply to investments in a commingled fund (other than a bona fide debt service fund) unless it is an investment being initially deposited in or withdrawn from a commingled fund described in § 1.148-6(e)(5)(ii).

Extend Valuation Rule to Address Deallocations Other than by Operation of the Transferred Proceeds Rule and the Universal Cap Rule

Circumstances may arise whereby nonpurpose investments deallocate by means other than the transferred proceeds rule or the universal cap rule (e.g., amounts can be deallocated by no longer being treated as replacement proceeds). For example, assume the taxable bonds described in Example 2 above are issued on Day 1 and the tax-exempt bonds are defeased on Day 1 with taxable bond proceeds but redeemed on Day 30. The escrow securities would no longer be replacement proceeds of the tax-exempt bonds on Day 1 by operation of Reg. § 1.148-6(b)(1) because they are no longer used in a manner that causes those amounts to be replacement proceeds of the tax-exempt bonds, i.e., as a result of the defeasance on Day 1. Since they are not deallocated as a result of either the transferred proceeds rule or the universal cap rule, the fair market exception in the Proposed Regulations would not apply. The same policy considerations that justify an exception to the fair market value rule for deallocations as a result of transferred proceeds and universal cap also apply to deallocations as a result of the replacement proceeds rule. We recommend that the proposed valuation rule be modified to accommodate this circumstance by eliminating the requirement that the allocation from the tax-exempt bond issue to the taxable issue occur as a result of either the transferred proceeds allocation rule or the universal cap rule.

Alternatively, since securities pledged to the repayment of a bond issue will have been replaced by the proceeds of the taxable bond issue, such securities, by virtue of the general definition of replacement proceeds in Reg. § 1.148-1(c)(1),19 will become replacement proceeds of the taxable bonds. Proposed Reg. § 1.148-5(d)(3)(ii) could be modified to change “as a result of the transferred proceeds allocation rule under § 1.148-9(b) or the universal cap rule under § 1.148-6(b)(2)” to “as a result of the transferred proceeds allocation rule under § 1.148-9(b), the universal cap rule under § 1.148-6(b)(2), or the replacement proceeds rule under § 1.148-1(c)(1).”

Safe Harbor for Application of Anti-Abuse Authority

The opportunity to capture market gain is often an economic incentive for issuers to retire tax-exempt bonds early. Without such an incentive, many issuers will not have an economic reason to act to unburden the market via the early retirement of tax-exempt bonds. These issuers will only consider an early retirement of already defeased tax-exempt bonds if a liquidation of the escrow securities subsequent to tax-exempt bond redemption is permitted.20 Even if all of the suggestions regarding the scope of the present value rule contained in these comments are adopted, some bond counsel may be concerned that, if a subsequent liquidation of the escrow securities occurs too close in time to the redemption of the tax-exempt bonds, IRS will be able to assert its authority under Reg. § 1.148-10 to depart from the rules of Reg. § 1.148-5(d) and recompute the yield on the escrow securities based on fair market value methodology. Additionally, issuers and bond counsel may take different positions on this issue (i.e., allow different periods of time). The regulations should provide certainty and uniformity in practice. Uncertainty as to the facts and circumstances pursuant to which IRS may take such a position could be a substantial obstacle to unburdening the market via the early redemption of already defeased tax-exempt bonds. Accordingly, we propose that the following example be added to the final regulations [first paragraph is identical to the example set forth in Section 2 (Application of Universal Cap Rule in the Context of Equity-Funded Escrows) above, and is included only for ease of reference]:

(i) In 2002, City X issues tax-exempt bonds to finance eligible costs, In 2006, City X used non-borrowed funds (i.e., equity) to purchase escrow securities and create an escrow restricted to the yield on the tax-exempt bonds and defease the tax-exempt bonds to maturity. The yield on the tax-exempt bonds is 5.00% and the yield on the escrow securities is 4.95%. The early call option(s) on the tax-exempt bonds are retained by City X. In 2013, City X issues taxable bonds with a comparable maturity structure to the outstanding 2002 tax-exempt bonds and uses a portion of the proceeds to redeem the tax-exempt bonds on the same date. Only $100 of taxable bonds is needed to retire the tax-exempt bonds, but the escrow securities would provide sufficient cash flow to support $115 of taxable bonds. City X issues $115 of taxable bonds, and $100 of the proceeds are used to retire the tax-exempt bonds and $15 of the proceeds are used for any lawful purpose of City X. At the time of issuance of the 2013 taxable bonds, the escrow securities have a fair market value that, if sold, would cause the yield on the escrow securities to exceed the yield on the 2002 tax-exempt bonds. Applying universal cap principles, at the time the 2002 tax exempt bonds are redeemed, the escrow securities cease to be allocated as replacement proceeds of the tax-exempt bonds and, because they are used thereafter to secure the repayment of the taxable bonds, they become replacement proceeds of the taxable bonds. At the time the escrow securities cease to be allocated to the tax-exempt bonds, the escrow securities are valued at present value.

(ii) The result would be the same in each of the following circumstances:

a. Instead of issuing taxable bonds in an amount in excess of the amount required to redeem the tax-exempt bonds, the escrow securities are liquidated after a substantial period has passed after liquidation of the tax-exempt bonds. For this purpose, a substantial period is generally determined based on all facts and circumstances but, in all events a substantial period is deemed to have passed if the pricing and liquidation of the escrow securities occurs at least 90 days21 after the redemption of the tax-exempt bonds.

b. Instead of issuing taxable bonds with a comparable maturity structure to the outstanding 2002 tax-exempt bonds, City X issues taxable bonds with a 90-day term. Upon maturity of the taxable bonds, City X liquidates the escrow securities and uses a portion of the liquidation proceeds to repay the taxable bonds and uses the remaining liquidation proceeds for any lawful purpose of City X.

Furthermore, to the extent that an early redemption of tax-exempt bonds is necessary for valid business reasons wholly apart from arbitrage motivations, it does not seem appropriate to assert an arbitrage anti-abuse rule. Accordingly, we request that IRS adopt a safe harbor that provides that, if the redemption of the tax-exempt bonds is undertaken as a remedial action pursuant to Reg, § 1.141-12 as set forth in our Example 1 above, an issuer need not separate the pricing and liquidation of the escrow securities and the related redemption of tax-exempt bonds by any period of time. Moreover, we request that the preamble to the final regulations note that the examples proposed above are merely safe harbors and, to the extent that a non-arbitrage purpose exists for either of the transactions described above, it may not be necessary for the period of time between tax-exempt bond redemption and escrow liquidation to be as long as set forth in the above examples.

Exception to Fair Market Value Rule for Investments Acquired in Anticipation of Yield Restriction

Transactions occasionally occur wherein the bond issuer knows at the time a nonpurpose investment is purchased that it will be allocated as gross proceeds of a particular tax-exempt bond issue on a future date. The issuer may buy United States Treasury Securities — State and Local Government Series (“SLGS”) in such cases to assure that the yield restriction associated with the anticipated gross proceeds allocation will be met. In fact, the SLGS rules set forth in 31 CFR Part 344 specifically allow this.22 A future mark-to-market requirement applicable to the SLGS investment at the time it becomes gross proceeds of tax-exempt bonds would put the issuer in the untenable situation of not knowing whether yield on the investment from and after the valuation date will exceed the yield on the bonds and, accordingly, the issuer is unlikely to proceed with the transaction.

The following example illustrates the transaction. An issuer issues 20-year tax-exempt advance refunding bonds in 2010. All proceeds of this tax-exempt advance refunding bond issue are spent by 2013 when the advance refunded bonds are retired. The 2010 tax-exempt bonds are callable at par in 2020. In 2014, the issuer issues taxable advance refunding bonds to refund the 2010 tax-exempt bonds, which are not eligible for a tax-exempt advance refunding. The taxable bonds mature in 2018 (and the escrow established with the taxable bonds expires in 2020, the call date of the refunded 2010 tax-exempt bonds). Once the taxable bonds mature, the universal cap causes the “released proceeds” of the taxable bonds to become replacement proceeds of the 2010 tax-exempt refunded bonds. Although the 2014 escrow investments (e.g., SLGS) may at the time of purchase be properly restricted to the yield on the 2010 tax-exempt bonds, in anticipation of the 2018 reallocation, the yield based on fair market value of the investments in the escrow established with the taxable bonds in 2018 will not be known until 2018. The issuer would need to wait and take remedial action (presumably a yield reduction payment but, if such a payment is not available, an investment or escrow modification) on or after the reallocation date if the adjusted yield on the SLGS is greater than the yield on the 2010 tax-exempt bonds.

Under the Existing Regulations, the concern created by the above fact pattern is substantially mitigated by Reg. § l.148-5(d)(6)(i), which provides that “[t]he fair market Value of a United States Treasury obligation that is purchased directly from the United States Treasury is its purchase price.” While this rule may have been primarily created to ensure that SLGS are always deemed to be purchased at fair market value, the current regulation by its terms goes well beyond that limited application. In effect, it provides that the fair market value of SLGS is always par because SLGS are always purchased for par under the provisions of 31 CFR Part 344. The current rule, however, does not completely solve the problem highlighted above because open market securities are sometimes used for portfolios expected to be yield restricted in the future (particularly when SLGS are not available for purchase).

The Proposed Regulations limit the application of the “fair market value is par” rule to the time of acquisition. In other cases the Proposed Regulations would provide that the fair market value is the redemption value. We understand the desire to treat redeemed SLGS as redeemed at fair market value. However, using a hypothetical redemption value for SLGS (even if well defined) is usually inappropriate. Most SLGS are purchased for refunding or defeasance escrows.23 An issuer does not have unlimited freedom to redeem such SLGS and profit by an increase in value. Such SLGS generally can only be redeemed if other investments that continue to meet the escrow requirements are substituted. Moreover, the SLGS regulations for many years have prohibited the reinvestment amounts derived from an early SLGS redemption (whether in additional SLGS or in other investments) at a yield higher than the yield to maturity of the redeemed SLGS based on the redemption value.24 Thus the effective fair market value of SLGS redeemed prior to maturity is less than the redemption value; even if the Bureau of Fiscal Service (successor to the Bureau of Public Debt) is willing to pay 108% of par to the SLGS investor, few SLGS investors would find that there was any benefit to such a liquidation.

To solve the problem, without creating an opportunity for abuse, the mark-to-market requirement of Reg. § 1.148-5(d)(3) could be amplified to provide the following exceptions.

(iii) Exception to fair market value requirement for investments acquired in anticipation of yield restriction. Paragraph (d)(3)(i) of this section does not apply to a nonpurpose investment if at the time of purchase the yield on the nonpurpose investment is computed to be not materially higher than the yield on a bond issue to which the issuer anticipates the nonpurpose investment will be subsequently allocated.

(iv) Exception to fair market value requirement for amounts invested in SLGS. Paragraph (d)(3)(i) of this section does not apply to a nonpurpose investment if the nonpurpose investment is purchased directly from the United States Treasury.

4. Suggested Reordering and Simplification

Summary of Existing Regulations

Under the Existing Regulations, the valuation rules are set forth in Reg. §§ 1.148-5(b)(3), and 1.148-5(d)(1) through 1.148-5(d)(6). Although not clear in all instances, and in some cases inconsistent, the current rules addressing valuation can be summarized by reference to the following table.

Source of Funds

Allocated To/Away        Restricted             Unrestricted

from Tax-Exempt          Nonpurpose             Nonpurpose

Bonds                    Investments25         Investments

_____________________________________________________________________

Equity to                FMV                    FMV

Tax-Exempt

Taxable to               FMV                    FMV

Tax-Exempt

Tax-Exempt to            Present Value          Principal Amount,

Tax-Exempt                                       PV, or FMV

Tax-Exempt to            Unclear                FMV

Equity

Tax-Exempt to            Unclear                FMV

Taxable

Under current Reg. § 1.148-5(d)(2), any yield restricted investment must be valued at present value. Under Reg. § 1.148-5(d)(3)(i), and subject to the exception in the following sentence, an investment must be valued at fair market value on the date the investment is first allocated to an issue and on the first date an investment ceases to be allocated to an issue. The preamble to the Proposed Regulations interprets the Existing Regulations as requiring an investment to be marked-to-market when the investment shifts between proceeds of a tax-exempt and a taxable bond issue, in either direction. This approach is sometimes referred to as a two-directional or bi-directional approach. Under Reg. § 1.148-5(d)(3)(ii), the above general rule does not apply if the investment is allocated from one issue to another issue as a result of a transferred proceeds allocation under Reg. § 1.148-9(b) or the universal cap rule under Reg. § 1.148-6(b)(2) provided that both issues consist exclusively of tax-exempt bonds (the “Transferred Proceeds/Universal Cap Exception”).

Summary of Proposed Regulations

Under the Proposed Regulations, the Transferred Proceeds/Universal Cap Exception would be modified to provide that the exception applies if the issue away from which the investment is allocated consists exclusively of tax-exempt bonds (i.e., the first issue in an allocation from one issue to another). The modification to the Transferred Proceeds/Universal Cap Exception can be very helpful, particularly if the effective date is clarified as described above. The proposed rules addressing valuation can be summarized by reference to the following table.

Source of Funds

Allocated To/Away        Restricted             Unrestricted

from Tax-Exempt          Nonpurpose             Nonpurpose

Bonds                    Investments            Investments

_____________________________________________________________________

Equity to                FMV                    FMV

Tax-Exempt

Taxable to               FMV                    FMV

Tax-Exempt

Tax-Exempt to            Present Value          Principal Amount,

Tax-Exempt                                       PV, or FMV

Tax-Exempt to            FMV                    FMV

Equity

Tax-Exempt to            Present Value,26 FMV   Present Value

Taxable

Suggested Reordering and Simplification

We believe that the valuation regulations can be clarified and simplified in several respects. Before setting forth our proposed reordering and simplification changes, however, we reiterate the points made in Section 2 (Clarify Valuation Treatment of Purpose Investments) that purpose investments should always be valued at present value, and in Section 3 (“Extend Valuation Rule to Apply to Redemption with Equity Funds) that the valuation rules applied in connection equity redemptions of tax-exempt bonds should be the same as those applied in connection with taxable refundings of tax-exempt bonds.

We also would note that, generally, return on investments is attributable to the return of principal, investment earnings (i.e., interest)27 and gain (or loss) on sale attributable to market value appreciation (or depreciation). In the tax-exempt bond area, arbitrage is generally thought of as investment earnings (i.e., interest) in excess of the yield on the subject tax-exempt bonds. Also, pursuant to section 148(f)(4)(A)(i), “any gain or loss on the disposition of a nonpurpose investments shall be taken into account.” While this provision requires gain or loss on actual disposition of nonpurpose investments to be taken into account for purposes of calculating rebate, there is clearly more flexibility to determine whether deallocation of nonpurpose investments to a tax-exempt bond issues should be treated as a constructive disposition of the investment at fair market value. Absent some abuse, we do not believe that it should be necessary to value yield restricted investments at fair market value when they are deallocated from a bond issue.28 To treat an investment as yield restricted when it is first allocated to an issue subjects the investment to the arbitrage rules and often artificially forces the investment to be below market (e.g., if an issuer, in a 5% market environment, is required to yield restrict the investment to 4.25% percent, such investment’s value is artificially lowered through the use of lower yielding SLGS). To require a yield restricted investment to be subsequently valued at fair market value has the potential to create distorting economic results unrelated to any arbitrage return to the issuer and runs contrary to sound tax policy.

Moreover, for reasons beyond the acknowledged impediments such a rule creates with respect to the issuance of taxable refunding bonds, a mark-to-market requirement for yield restricted nonpurpose investments operates in a manner that is entirely contrary to the objectives of the arbitrage rules.29 If market gain on yield restricted nonpurpose investments can be used to facilitate the removal of tax-exempt interest from the market, the result should be encouraged by the regulations since doing so provides an appropriate incentive to “unburden” the tax-exempt bond market. We recommend that this issue be addressed by providing that yield restricted nonpurpose investments be valued at present value when deallocated from a tax-exempt bond issue. If IRS has concerns with such a provision/rule, we recommend that the concern be addressed in anti-abuse rules (for example, a provision could be included stating that if market gain is realized and tax-exempt bonds are taken off the market, it would be an abuse to subsequently refinance such bonds in the future in the tax-exempt market).

The suggested reordering and simplification changes can be summarized by reference to the following table:

Source of Funds

Allocated To/Away        Restricted             Unrestricted

from Tax-Exempt          Nonpurpose             Nonpurpose

Bonds                    Investments            Investments

_____________________________________________________________________

Equity to                FMV                    FMV

Tax-Exempt

Taxable to               FMV                    FMV

Tax-Exempt

Tax-Exempt to            Present Value          Principal Amount,

Tax-Exempt                                      PV, or FMV

Tax-Exempt to            Present Value          FMV

Equity

Tax-Exempt to            Present Value          FMV

Taxable

To accomplish the above result, Reg. §§ 1.148-5(b)(3), 1.148-5(d)(2), and 1.148-5(d)(3) can be replaced with the suggested provisions set forth below; and §§ 1.148-5(d)(4) through 1.148-5(d)(6) can be re-numbered as §§ 1.148-5(d)(7) through 1.148-5(d)(9).

Suggested Reg. §§ 1.148-5(d)(1) through 1.148-5(d)(6):

1.148-5(d)(1) In General. Insert existing Reg. § 1.148-5(d)(1), which sets forth the three valuation approaches (outstanding principal amount, present value, and fair market value).

1.148-5(d)(2) Purpose Investments. A purpose investment shall be valued at its present value at all times.

1.148-5(d)(3) Mandatory Valuation of Certain Investments at Fair Market Value. Except as provided in paragraphs (i), (ii) and (iii) below, a nonpurpose investment shall be valued at fair market value on the date that it is first allocated to a tax-exempt issue (either by purchase or deemed acquisition).

(i) A nonpurpose investment allocated from one tax-exempt issue to another tax-exempt issue shall be valued at its present value on the date of such allocation.

(ii) A nonpurpose investment shall be valued at present value on the date first allocated to a tax-exempt issue if at the time of original purchase the yield on the nonpurpose investment was computed to be not materially higher than the yield on the bond issue to which the issuer anticipated the nonpurpose investment would be subsequently allocated and to which the nonpurpose investment is in fact allocated.

(iii) A nonpurpose investment shall be valued at present value upon allocation to a tax-exempt issue if the nonpurpose investment was purchased directly from the United States Treasury.

1.148-5(d)(4) Nonpurpose Investments Held Beyond Temporary Period. For purposes of section 1.148-2, at the end of a temporary period provided under 1.148-2(e), a nonpurpose investment may be valued under any of the three valuation methods of paragraph (d)(1).

1.148-5(d)(5) Yield Restricted Nonpurpose Investments. A yield restricted investment shall be valued at its present value when it ceases to be allocated to a tax-exempt issue.

Example:

(i) In 2002, City X issues tax-exempt bonds to finance eligible costs. In 2006, City X used non-borrowed funds (i.e., equity) to purchase escrow securities and create an escrow restricted to the yield on the tax-exempt bonds and defease the tax-exempt bonds to maturity. The yield on the tax-exempt bonds is 5.00% and the yield on the escrow securities is 4.95%. The early call option(s) on the tax-exempt bonds are retained by City X. In 2013, City X issues taxable bonds and uses a portion of the proceeds to redeem the tax-exempt bonds on the same date. The amount of taxable bonds that may be issued and supported by cash flows from the escrow securities exceeds the amount required to redeem the tax-exempt bonds and the excess proceed derived from the taxable bonds are used by City X for lawful governmental purposes. At the time of issuance of the 2013 taxable bonds, the escrow securities have a fair market value that, if sold, would cause the yield on the escrow securities to exceed the yield on the 2002 tax-exempt bonds. At the time the escrow securities cease to be allocated to the tax-exempt bonds, the escrow securities are valued at present value.

(ii) The result would be the same if, instead of issuing taxable bonds in an amount in excess of the amount required to redeem the tax-exempt bonds, the escrow securities are liquidated after a substantial period has passed after liquidation of the tax-exempt bonds. For this purpose, a substantial period is generally determined based on all facts and circumstances but, in all events a substantial period is deemed to have passed if the pricing and liquidation of the escrow securities occurs at least [90] days after the redemption of the tax-exempt bonds.

1.148-5(d)(6) Unrestricted Nonpurpose Investments. An investment unrestricted as to yield shall be valued at its fair market value on the date it ceases to be allocated to a tax-exempt issue. This paragraph (d)(6) does not apply to investments in a commingled fund (other than a bona fide debt service fund) unless it is an investment being initially deposited in or withdrawn from a commingled fund described in section 1.148-6(e)(5)(iii).

D. Anti-Abuse Provisions

The Proposed Regulations modify Reg. § 1.148-10(e) by replacing the phrase “as necessary to clearly reflect the economic substance of the transaction” with the phrase “to prevent such financial advantage.” The revised anti-abuse provision in the Proposed Regulations would permit IRS to ignore its own published regulations and other official public guidance if IRS believed that a transaction was entered into for a “principal purpose of obtaining a material financial advantage based on the difference between tax-exempt and taxable interest rates in a manner that is inconsistent with the purposes of section 148.” The proposed change of standards separates potential arbitrage abuses from other tax law abuses. Read literally, this proposed provision appears to suggest that, even if a transaction were in compliance with published guidance, if the IRS thought that the transaction was entered into to achieve a financial advantage based on arbitrage, then IRS could ignore its own published guidance and impose whatever rule or standard it felt appropriate to prevent such financial advantage. The Existing Regulations limit the Commissioner’s ability to depart from the published regulations by authorizing him or her to do so only in order to “clearly reflect the economic substance of a transaction”. Reg. § 1.148-10(e) currently uses an economic substance standard that also applies in other areas of the tax law and has recently been codified as section 7701(o) of the Code. It does not provide that the Commissioner can create new rules if he or she does not like the application of the existing rules to a transaction; it does provide that the Commissioner can recast the form of the transaction to reflect the true economics of the transaction. Under the Existing Regulations, the recast transaction should still be subject to the provisions of the published regulations and not subject to whatever rule or standard that the Commissioner at that point thinks ought to apply.

The proposed deletion of the economic substance standard would change the current anti-abuse rule from a standard which provides that, if the economic substance of the transaction is different than the form of the transaction, then the form is recast to reflect economic substance if the form provides a financial advantage based on arbitrage; to a standard where, regardless of the economic substance of the transaction, if there is a financial advantage based on arbitrage, there is an abuse. We believe that this proposed extension of the Commissioner’s authority is overly broad. We are unsure why IRS would want to deviate from an economic substance doctrine that is applied across all areas of federal tax law. Perhaps, this change is grounded in the peculiar legislation found in the Technical and Miscellaneous Revenue Act of 1988.30 That legislation deleted and then re-inserted the word “necessary” in the provisions (now found in section 148(i) of the Code) providing the Commissioner with authority to promulgate arbitrage regulations. In the words of the Senate Finance Committee;

This amendment is intended to clarify that the Treasury’s regulatory authority is to be interpreted broadly, rather than in a literal, dictionary manner as was done by the Court of Appeals in the City of Tucson case [(City of Tucson v. Commissioner, 820 F.2d 1283 (D.C. Cir., 1987))]. That regulatory authority is intended to permit Treasury to eliminate any devices designed to promote the issuance of bonds either partially or wholly as investment conduits in violation of the provisions adopted by Congress to control such activities and to limit the issuance of tax-exempt bonds to amounts actually required to fund the activities for which their use specifically has been approved by Congress. Further, that regulatory authority is intended to permit Treasury to adopt rules (including allocation, accounting and replacement rules) necessary or appropriate to accomplish the purpose of the arbitrage restrictions, which is to eliminate significant arbitrage incentives to issue more bonds, issue bonds earlier, or to leave bonds outstanding longer.31

If IRS is determined to use a special standard for imposing anti-abuse rules not applicable to other areas of tax law (including other areas of tax-exempt bond law), then the standard adopted should be modeled on the 1988 legislative history of the provision authorizing such regulations. If such deviation from standard tax principles is to be followed, the standard should be to eliminate significant arbitrage incentives to issue more bonds, issue bonds earlier, or leave bonds outstanding longer. However, we believe that Congress never intended that arbitrage regulations provide that published guidance under arbitrage provisions should be ignored merely because IRS were to determine that there is a financial advantage based on the difference between tax-exempt and taxable rates. For example, it has been long understood that temporary-period arbitrage generally is not per se abusive; this change would allow IRS, at its whim, to make it so.

The proposed modification to Reg. § 1.148-10(e) also is a significant departure from prior anti-abuse authority asserted by the Commissioner. The preamble to the final 1992 arbitrage regulations32 states the reason for, and the role of, the anti abuse rules as follows:

1. General anti-abuse rule.

The existing regulations contain numerous narrow, specific anti-abuse rules. In lieu of many of these narrow rules, the proposed regulations provide a broad, general anti-abuse rule that treats bonds as taxable arbitrage bonds if the issuer uses an abusive device to obtain a material financial advantage based on arbitrage. This general anti-abuse rule replaces the general artifice or device rules contained in § 1.103-13(j) and § 1.148-9(g) and numerous specific anti-abuse rules. The application of this general abusive device rule is broader than the existing rules but is also intended to treat as arbitrage bonds all transactions and actions covered by these various existing anti-abuse rules.

* * * * *

P. Simplification and enforcement.

An important part of the simplification of the existing arbitrage regulations involves the elimination of narrow anti-abuse rules targeted to specific abusive transactions. In large measure, the proposed regulations replace these specific rules with more genera! rules on abusive devices and specific guidance on replacement proceeds.

The complexity of existing regulatory guidance on arbitrage restrictions, however, is in part attributable to statutory and regulatory responses to abuses. Permanent simplification in this area depends on the effectiveness of the proposed regulations, particularly the proposed general anti-abuse rules. Effective enforcement is an important component of this simplification effort. In furtherance of these goals, IRS is actively studying the enforcement procedures developed in the tax-exempt bond area. Related goals are building on increased enforcement in recent years and increasing voluntary compliance. Primary goals are the prompt examination of potentially abusive transactions and prompt published guidance on significant abusive transactions. In addition, this project may lead to legislative or other initiatives to reduce the difficulties currently encountered in examining tax-exempt bond transactions. [Emphasis added.]

Note that, although the 1992 final regulations introduced a broad anti-abuse approach instead of the more specific anti-abuse approaches taken in Reg. § 1.103-13(j) and Reg. § 1.148-9(g), the 1992 final regulations did not go so far as to say that IRS could ignore application of the regulations for transactions that it deemed “abusive.” The preamble to the 1992 final regulations addressed transactions that complied with the Existing Regulations but which IRS deemed to abusive by providing for the prompt publication of guidance to address “significant abusive transactions.” We agree that IRS has an interest in prohibiting abuse of the arbitrage rules, but not by injecting uncertainty into the application of previously published guidance. Bond counsel traditionally renders an unqualified opinion with respect to whether obligations qualify for exemption under section 103. This unqualified opinion standard requires a high level of certainty as to the ability to rely on published guidance from IRS and Treasury. We believe that the proposed modifications to Reg. § 1.148-10(e) would seriously lower the level of certainty with respect to reliance on published guidance,

The existing anti-abuse rules suggest that the Commissioner can ignore the published rules to the extent necessary to reflect the economic substance of the transaction. Based upon the lead-in to the change in the Proposed Regulations, we believe that Treasury and IRS intend to leave intact all but the heading and the first sentence of Reg. § 1.148-10(e). Given the nature of this provision, examples are very valuable in clarifying the meaning of the provision and should be retained as part of the provision.

For the reasons stated above, NABL suggests that the proposed amendment be withdrawn and that Reg. § 1.148-10(e) not be modified. In the alternative, we suggest that the language in Prop. Reg. § 1.148-10(e) be modified as follows:

(e) Authority of the Commissioner to prevent transactions that are inconsistent with the purpose of the arbitrage rules. If an issuer enters into a transaction for principal purpose of obtaining a material financial advantage based on the difference between tax-exempt and taxable interest rates in a manner that is inconsistent with the purposes of section 148, the Commissioner may exercise the Commissioner’s discretion to depart from the rules of §§ 1.148-1 through 1.148-11 as necessary to reflect the economics of the transaction to prevent such financial advantage. Any transaction recast in this manner will then be subject to §§ 1.148-1 through 1.148-11. For this purpose, the Commissioner may recompute yield on an issue or on investments, reallocate payments and receipts on investments, recompute the rebate amount on an issue, treat a hedge as either a qualified hedge or not a qualified hedge, or otherwise adjust any item whatsoever bearing upon the investments and expenditures of gross proceeds of an issue. For example, if the amount paid for a hedge is specifically based on the amount of arbitrage earned or expected to be earned on the hedged bonds, a principal purpose of entering into the contract is to obtain a material financial advantage based on the difference between tax-exempt and taxable interest rates in a manner that is inconsistent with the purposes of section 148.

FOOTNOTES

1 Notice of Proposed Rulemaking and Notice of Public Hearing, 78 Fed. Reg. 56,842 (Sept. 16, 2013).

2 On June 18, 1993, Treasury and IRS published comprehensive final regulations (T.D. 8476, 1993-2 C.B. 13) on the arbitrage investment restrictions and related provisions for tax-exempt bonds under sections 103, 148, 149 and 150 of the Internal Revenue Code of 1986, as amended (the “Code”). Since that time, those final regulations have been amended in certain-limited respects. The regulations issued in 1993 and the amendments thereto are collectively referred to herein as the “Existing Regulations.”

3 IRS Letter Ruling 200446006 (Jul. 15, 2004).

4 Notice of Proposed Rulemaking and Notice of Public Hearing Arbitrage Guidance for Tax-Exempt Bonds, 72 Fed. Reg. 54,606 (Sept. 26, 2007).

5 Disregarding any off-market aspect of the modified or existing hedge might be interpreted to include any noncompliance with the interest rate correlation test, but that seems an unlikely inference.

6 But that is also one of the reasons we suggested before that an interest rate correlation test is unnecessary.

7 I.R.B. 2008-15, 742.

8 Pub. L. No, 111-203, 124 Stat. 1376.

9 See Reg. § 1.148-4(f)(4)(i).

10 Reg, § 1.148-1(b).

11 We understand that numerous issuers have approached IRS in connection with potential private letter ruling requests and closing agreements in connection with seeking relief in circumstances similar to this Example 2. Presumably, the proposed changes in the valuation provisions in the Proposed Regulation are in response to issuers raising such circumstances with IRS.

12 In Example 2, the transfer does not occur as a result of the transferred proceeds allocation rule under Reg, § 1.148-9(b). This rule applies only to sale proceeds and investment proceeds of a bond issue. The escrow securities are neither sale proceeds nor investment proceeds of the tax-exempt bonds, but are instead replacement proceeds.

13 We acknowledge that this tax policy goal must be balanced against other potential consequences of this proposed change, such as possibly creating an incentive to defease callable bonds to maturity rather than currently redeem them, If IRS is concerned about creating an incentive, in the form of an updated valuation rule, for issuers to apply available funds to defease tax-exempt bonds to maturity while retaining their optional call right, IRS could create a rule (or even a safe harbor) within Reg. § 1.148-10 that provides that an issuer that sets aside its own funds for the retirement of tax-exempt bonds will not be treated as keeping bonds outstanding longer than necessary if the term of the escrow created with respect to such debt was necessary (i) to avoid a redemption premium with respect to the defeased bonds, or (ii) to avoid the investment of the escrow securities at a yield more than a basis point below the yield on the defeased bonds.

14 The economics of this transaction are similar to the economics of a sale of the escrow securities.

15 This result is sensible because purpose investments generally are not negotiable instruments for which there is a readily ascertainable market or value and should never be subject to a market-to-market requirement, even when transferring between taxable and lax-exempt bond issues. Additionally, purpose investments will regularly have a yield different from the yield on the conduit issuer’s tax-exempt bonds. A fair market valuation requirement would be particularly troubling to issuers of state revolving fund bonds, which make loans to governmental entities with proceeds of tax-exempt bonds on a subsidized basis. Such loans are often made on a taxable basis. At times, the loans are pledged to a tax-exempt state revolving fund bond issue well after such loans are originated. To require a purpose investment to be valued at fair market value when the bond issuer is intentionally providing a below-market interest rate on the investment would run entirely contrary to the purpose of the special yield rules on purpose investments.

16 Under the ambiguity in the Existing Regulations created by the cross-reference in Reg. § 1.148-5(d)(3)(i) to § 1.148-2(d)(2), such investments have been valued at present value, or par if they are plain par investments. Under the Proposed Regulations, the cross-reference in Reg. § 1.148-5(d)(3)(i) to § 1.148-5(d)(2) is removed, suggesting that perhaps Reg. § 1.148-5(d)(3) is intended to take precedence over Reg. § 1.148-5(d)(2) even for purpose investments. The purpose investment in the above state revolving fund example will necessarily have a fair market value below its present value or par value since the loan is a subsidized loan (it is designed to have an interest rate below the market interest rate on origination). A fair market valuation requirement could cause yields on the purpose investments to exceed the permitted spreads of 1/8% or 1.5%, which is an untenable (and presumably unintended) result.

17 The preamble states that the “Existing Regulations include only one exception to this mandatory fair market value rule.” The existing regulations state “[e]xcept as provided in (d)(2), (d)(3)(ii), and (d)(4) of this section. . . .” and thereby indicate that there are at least three exceptions. The Proposed Regulations state “[e]xcept as provided in (d)(3)(ii), and (d)(4) of this section. . . .” and thereby indicate that there are two exceptions. We recommend that IRS more clearly articulate the number and nature of the exceptions in the preamble for the next set of regulations.

18 See also the discussion above addressing purpose investments.

19 Reg, § 1.148-1(c)(1) provides in part that “amounts are replacement proceeds of an issue if the amounts have a sufficiently direct nexus to the issue or to the governmental purpose of the issue to conclude that the amounts would have been used for that governmental purpose if the proceeds of the issue were not used or to be used for that governmental purpose.” Since the defeasance securities were to be used for the governmental purpose of the taxable bonds had the taxable bonds not been issued, they will therefore have a sufficiently direct nexus to the taxable bonds to be characterized as replacement proceeds of the taxable bonds (even if they were not immediately deposited into a sinking fund for, or otherwise pledged to, the taxable bonds),

20 To further the policy of unburdening the market via the early redemption of tax-exempt bonds, some practitioners believe that the valuation rules should be modified to enable the issuer to simply liquidate the escrow securities, utilize proceeds from the sale of the escrow securities to call the tax-exempt bonds, and to enable the issuer to retain excess sale proceeds from the escrow securities. In order to do this, the valuation regulations would need to be modified to allow for the escrow securities to be valued at present value, not fair market value, even in the event of this actual disposition. While we see the policy reason that some are advocating for such a rule, we acknowledge that section 148(f)(4)(A)(i) (” In determining the aggregate amount earned on nonpurpose investments for purposes of paragraph (2) — (i) any gain or loss on the disposition of a nonpurpose investment shall be taken into account”) may preclude IRS from adopting such a rule in the context of an actual disposition of nonpurpose investments, although arguably such rule can be interpreted to apply solely to unrestricted nonpurpose investments for rebate purposes and not apply to yield restricted nonpurpose investments.

21 Because the value of securities fluctuates daily as interest rates change, there is risk every day that any appreciation in value of escrow securities will be diminished or eliminated. To the extent that IRS is concerned with blessing transactions that are motivated solely by arbitrage opportunities, even a relatively small required gap between tax-exempt bond redemption and escrow liquidation will be meaningful. In this context, we believe that a 90-day safe harbor is suitably conservative and the IRS should consider a 15-day safe harbor, by analogy to the single issue rule in Reg. § ].150-1(c)(1)(i). Nonetheless, if IRS is not comfortable providing a safe harbor of 15 days or 90 days, we ask that it provide a longer safe harbor in the interest of clarity, as opposed to no safe harbor at all.

22 31 CFR § 344.1 (see definition of eligible source of funds).

23 A small number of SLGS are purchased for unrestricted project funds, debt service reserve funds or bona fide debt service funds. Such SLGS are purchased for those accounts because (a) such amounts are permitted to be invested in SLGS, (b) SLGS are safe investments, (c) SLGS are easy to purchase without involving a broker, and (d) the yields on SLGS is relatively comparable to other investments. While the restrictions involved in escrowed securities may not apply to such SLGS, the restrictions on reinvestment of redemption proceeds does apply.

24 Before 2005, SLGS investors could profit from market value fluctuations. SLGS were at times redeemed at a profit and reinvested in higher yielding SLGS to meet the escrow requirements. However, the 2005 (current) SLGS regulations ended this practice.

25 Restricted nonpurpose investments are most commonly found in advance refunding escrows, sinking funds and other funds holding replacement proceeds. Unrestricted nonpurpose investments are most commonly found in project funds, debt service reserve funds and current refunding escrows.

26 Provided within the Transferred Proceeds/Universal Cap Exception,

27 Issuers do not typically invest gross proceeds in equity securities (e.g., stock).

28 We understand that the bi-directional mark-to-market requirement for yield restricted investments was added to the regulations to address possible abuses when investments are allocated (under transferred proceeds rules) from proceeds of a taxable bond issue to proceeds of a tax-exempt bond issue. A present value method of valuation could in such case allow a transferred investment to be valued for yield restriction purposes at a value higher than the total amount of principal and interest paid on taxable debt used to acquire the investment. Such potential for abuse does not exist in using the present value of an investment when investments are allocated away from tax-exempt bonds.

29 Application of the fair market valuation rule to yield restricted investments in the context of a constructive disposition arising from a deallocation of investments under the transferred proceeds, universal cap or replacement proceeds rules can allow issuers to take advantage of the spread between taxable and tax-exempt yields and penalize issuers who have book gains that are the result of market interest rate movements but that are not the result of the tax-exempt to taxable spread. To illustrate these points, assume advance refunding tax-exempt bonds are issued at an arbitrage yield of 3%. The refunding escrow is invested at 3% (in an assumed 3.50% taxable market) white a debt service reserve fund is invested at the 3.50% market rate. If rebate liability is computed at the end of the first computation period, the issuer would owe rebate equal to the excess earnings on the reserve fund, which is all of the arbitrage that has been earned. If, however, the fair market valuation rule were to be applied on that same date by reason of a deallocation, and assuming that the fair market values of the escrow and reserve fund securities are the same as on the date of original purchase, the escrow securities would be valued at a loss (since the 3% rate on the refunding escrow is below the 3.5% market rate). That constructive loss would offset the positive arbitrage on the reserve fund securities, allowing the issuer to retain some or all of the positive arbitrage on the reserve fund investments. If the taxable market had significantly rallied to a yield of 2% on the escrow securities, application of the fair market valuation rule in connection with any deallocations would treat the gain on the escrow securities as illicit arbitrage, notwithstanding the fact that the gain is totally attributable to the difference between the arbitrage yield of 3% and market yields of 2% and no portion is attributable to the spread between taxable and tax-exempt yields (i.e., 3.50% v. 3%).

30 Pub. L.No. 100-647, 102 Stat. 3342.

31 Senate Finance Committee Report Technical Corrections Bill of 1988, S.2238, August 3, 1988 at page 407, 408.

32 1992-2 C.B. 688, FI-36-92.




State Debt Management Group Seeks Withdrawal of Proposed Issue Price Definition.

David Lillard Jr. of the State Debt Management Network has commented on proposed regulations (REG-148659-07) on arbitrage investment restrictions applicable to tax-exempt bonds, suggesting that the proposed changes to the definition of “issue price” be withdrawn for further study, noting the negative impact the changes would have on the municipal market.

December 13, 2013

Internal Revenue Service

PO Box 7604

Ben Franklin Station

Washington, DC 20044

Re: Comment on Arbitrage Restrictions on Tax-Exempt Bonds Proposed Rulemaking (REG-148659-07)

To whom it may concern:

The State Debt Management Network (“SDMN”), an affiliate of the National Association of State Treasurers (“NAST”) appreciates the opportunity to provide comments on the proposed rulemaking by the Treasury of the United States (the “Treasury”) to amend certain provisions of its arbitrage regulations applicable to tax-exempt bonds (the “Arbitrage Regulations”) (REG 148659-07). SDMN welcomes the Treasury’s efforts to clarify the Arbitrage Regulations and to facilitate issuer compliance with the substantive requirements of the Internal Revenue Code, We believe that several of the proposed amendments will further these goals.

The proposed change to the definition of the term “issue price” for purposes of the Arbitrage Regulations, however, cannot be effectively implemented by issuers except by structuring the marketing of their bonds for this purpose. This proposed change would be likely to have significant and adverse unintended consequences for the municipal market. Accordingly, we urge the Treasury to withdraw this portion of its amendment proposals for further study. We would be happy to work with the Treasury in developing an alternative proposal to address the concerns that are identified in the Notice of Proposed Rulemaking in a manner that more fully reflects the actual working of the municipal underwriting process.

SDMN was founded in 1991, and is the leading non-partisan organization representing state level debt issuers throughout the United States. As officers of States and state level debt issuing agencies, SDMN’s membership is involved in bond issuances and recordkeeping for billions of dollars in state level debt issuances. They have a direct stake in their respective States’ financial well-being as well as in the health of the nation’s economy, SDMN seeks to provide educational conferences and webinars, publications, working groups, policy advocacy and support that enable state level issuers to pursue and administer sound financial policies and practices of benefit to the citizens of the nation with regard to debt issuances.

As representatives of state level issuers, SDMN members have a unique understanding of how policy changes can impact the issuance of municipal bonds at the state and local level. We strongly believe that the proposed changes to the definition of “issue price” are unnecessary in connection with many, if not all, municipal bond issues. Such changes, if implemented, would significantly increase the cost of capital for States and other municipal market issuers, disrupt competition in the market for their bonds, and impose substantial new burdens on these issuers. Issuers would not be able to assure compliance with the proposed requirements at the time that their bonds are issued and, in some instances, may not be able to assure compliance at all.

Our comments highlight several negative outcomes that would result from the proposal. In sum, the proposed changes to the rules for determining issue price would unnecessarily burden the debt issuance process with uncertainty and legal risk and increase the cost of borrowing for States, counties, cities, and municipal authorities, thereby increasing the costs of infrastructure and other end-uses to the States as well as the tax expenditure cost to the federal government as the total amount of tax exempt interest rises.

In regard to the proposed Arbitrage Regulations, SDMN offers the following comments, which have been approved by the SDMN Board of Directors:

The Current Reasonable Expectation Test Should Be Retained.

The proposed regulations will change the way bond issues are priced. While this disruption would be most clearly felt with respect to yield sensitive bond issues (such as advance refundings), the pricing of all issues may be expected to be impacted. SDMN believes the changes will almost certainly increase costs for issuers and will decrease certainty and transparency, while not necessarily reducing arbitrage. We further believe that the current reasonable expectation test has generally worked well for over 20 years and should be substantially retained. SDMN offers to work with the Treasury to develop appropriate refinements to the application of the current rule in order to further limit the possibility of inappropriate arbitrage. Any such refinement must be within the confines of the reasonable expectation test to assure issuers and their bondholders, underwriters and advisors that compliance may be determined with certainty upon the date of bond issuance.

We note that the proposed regulations do not appear to address competitive sales. Competitive sale procedures are dictated by state law to result in the lowest available cost of borrowing. The nature of the competitive sale process substantially limits the issuers’ ability to obtain information from its bond purchasers.

Issuers and bondholders cannot be at risk for the post-issuance actions of negotiated sale underwriters and competitive sale purchasers. We agree with the Honorable James McIntire, Washington State Treasurer [see, comment letter dated November 27, 2013] in his belief that the current rules, coupled with prudent IRS enforcement, are and will continue to be highly effective in achieving the interrelated goals of minimizing borrowing costs for issuers as well as minimizing arbitrage.

Issuer Monitoring of Secondary Market

Issuer monitoring of secondary market trading is impractical and many issuers do not have the capacity to monitor secondary market trading in their bonds. Even for issuers who might be able to develop the personnel resources necessary to monitor currently available secondary market trading information, such information does not currently constitute a reliable basis for a determination that may result in substantial legal risk. Moreover, secondary market activity, by definition, reflects changes in applicable interest rate levels subsequent to bond pricing. This fact makes such activity an inappropriate basis for determining the issuer’s arbitrage compliance. There may well be a difference between an issue price that is appropriately determined at the time a bond is sold by the issuer and the secondary market price obtained by the underwriter, or by another broker-dealer, at a later date, but this difference should not affect the “yield” on the bonds for purposes of the Arbitrage Regulations. Issuers cannot independently determine the degree to which such differences are attributable to changing market conditions and should not be required to as such changes in market condition do not affect their cost of funds.

Risk That Underwriters May Negotiate To Shift Risks of Determining Issue Price Back To the Issuer

The proposal may be expected to change the negotiations for bond issuances in a negative manner for issuers and the public. Specifically, both the proposed substitution of an in fact test for the reasonable expectations test and the proposed higher percentage of bonds of a maturity that must be sold prior to bond issuance to qualify for the safe harbor may be expected to reduce potential underwriters to those that are capable of placing the higher percentage of each maturity with the public by closing (or that are willing and able to hold the bonds as investments if the market does not permit them to do this), thereby reducing the competition for underwriting. Actual experience with bond issuance shows that it isn’t always possible for underwriters to sell even 10% of each maturity by closing as was reasonably expected at the time of pricing. This results from the fundamental fact that market clearing rates of interest constantly change. Fewer potential underwriters who can reasonably compete for an issuance will lessen issuers’ ability to negotiate competitive terms and ultimately raise borrowing costs for all tax exempt issuers. This may also limit issuers’ practical ability to utilize serial maturities in structuring the principal amortization of their debt.

Yield Reduction Payments Increase Issuer Costs

The proposal allowing yield reduction payments is intended to ensure that if the issue price of the bonds is greater than the price originally assumed as of the sale date for the issuance, there would be a mechanism to maintain compliance. However, reliance on these payments by issuers would raise costs and put the burden on issuers to reserve against and monitor potential yield reduction payments. This remedy is deficient as it can only be relied upon by issuers willing to bear the risk and uncertainty of not knowing the issue price and, hence the allowable yield, at closing. Moreover, the mechanism does not address the case where no sale is ever made to members of the public. Efforts to allocate risk between the issuer and underwriter would inevitably result in further lack of competition and increased cost to the issuer.

Impact of Excluding Underwriters from the Definition of “Public”

We share the concerns of the Honorable James McIntire, Washington State Treasurer, who pointed out in his IRS comment letter that the proposed rules may raise the all-in costs to issuers by limiting the ability to have issuances partially or fully underwritten by the underwriting group, limiting issuers’ ability to negotiate for lower rates and higher bond prices.

Costs to Federal Government

We remain concerned the proposal could lead to more tax exempt interest expense, translating to higher “costs” to the federal government for the exemption. We expect that the proposed change has the potential to increase yields, for example as issuers strive to meet the higher 25% threshold for the safe harbor and are forced to raise yields and reduce prices to meet the safe harbor. As a result, the proposed change would lead to more interest that is exempt from federal taxation, thereby increasing the tax expenditure cost to the federal government.

In summary, the Treasury’s proposed changes to the definition of issue price would he detrimental to States by increasing the cost of capital and imposing new burdensome requirements on issuers of municipal bonds. We do not believe these changes are necessary and believe that they will significantly alter market practice and will introduce uncertainty and risk to a well-established process for determining the yield of bonds for arbitrage compliance purposes. We wish to emphasize that we have grave doubts about the ability of issuers or the IRS to administer the proposed standard based upon currently available secondary market information. Moreover, even if sufficient secondary market information were available, reliance upon it would change the nature of the issue price determination by inappropriately reflecting market change subsequent to issuance, which would introduce unnecessary legal and financial risks that cannot be effectively addressed.

SDMN requests that these changes be withdrawn so that the other proposed amendments may be finalized and implemented while further study is made of any necessary changes to the existing issue price definition. We would welcome the opportunity to assist in this process.

As state debt issuers concerned about the financial strength and integrity of States and all governmental units within our States, we appreciate this opportunity to offer our views on this proposed rulemaking. Thank you for your consideration of our comments.

Sincerely,

David H. Lillard, Jr.

Tennessee State Treasurer and

Chair, State Debt Management

Network, an Affiliate of the

National Association of State

Treasurers

Washington, DC




State Housing Council Raises Concerns With Proposed Issue Price Definition.

Garth Rieman of the National Council of State Housing Agencies has raised concerns with changes to the definition of issue price under proposed regulations (REG-148659-07) on arbitrage investment restrictions applicable to tax-exempt bonds, urging the IRS to withdraw the proposed changes and work with municipal securities market stakeholders to develop an alternative approach.

December 16, 2013

Courier’s Desk

Internal Revenue Service

1111 Constitution Avenue, NW

Washington, DC

RE: REG-148659-07

To Whom It May Concern:

On behalf of the state housing finance agencies (HFAs) it represents, the National Council of State Housing Agencies (NCSHA) writes to express our strong concerns about the Internal Revenue Service’s September 16 proposed rule modifying the definition of “issue price” for the purpose of determining arbitrage restrictions applicable to the sale of tax-exempt bonds.

While we appreciate IRS’s desire to improve transparency in the municipal bond market, we believe that the proposed rule’s new definition of “issue price” will increase the cost of capital for HFAs and other municipal issuers, produce higher yields, impose burdensome monitoring requirements on public agencies, and reduce the amount of money HFAs and other municipal issuers can dedicate to their public obligations. Further, we do not believe that there is good reason to alter the long-standing and effective “reasonable expectation” standard currently used.

NCSHA strongly urges IRS to rescind this proposal.

HFAs and Housing Bonds: Filling a Critical Need

NCSHA represents the state housing finance agencies for all 50 states, the District of Columbia, Puerto Rico, New York City, and the U.S. Virgin Islands. HFAs are state-chartered, public mission-driven organizations dedicated to providing affordable housing help to those who need it.

The use of tax-exempt housing bonds is a critical tool in helping HFAs to meet their affordable housing mission. Using single-family Housing Bonds, more commonly known as Mortgage Revenue Bonds or MRBs, state HFAs have made 3 million families homeowners for the first time. In 2012 alone, HFAs utilized funding from MRB sales to extend affordable home loans to 36,783 low- and moderate-income consumers.

HFAs also utilize multifamily Housing Bonds to support the development and rehabilitation of affordable apartments. The funding from such bonds has supported the development of over one million affordable rental units, many of which assist residents with special needs, including the elderly, those in assisted living, persons with disabilities, rural poor, and those that were formerly homeless.

Do Not Jeopardize HFAs’ Ability to Fulfill Their Mission

The proposed rule, by requiring that HFAs and other municipal issuers use the actual sale price of the first 25 percent of bonds sold to determine the issue price of a maturity, is likely to increase HFAs’ borrowing costs. Many municipal issuers and underwriters, to ensure they comply with the proposed requirements, are likely to issue bonds at prices that ensure they will be able to sell 25 percent of their bonds right away. Such prices will almost certainly produce a higher yield than HFAs and other municipal issuers would generally have to pay, prompting them to spend more on interest payments. Consequently, HFAs and other municipal issuers will have to issue more debt to raise the capital they need.

In addition, the proposal would burden HFAs with monitoring and compliance requirements that may be unworkable, particularly when it comes to negotiated sales. In order to comply, issuers will have to rely on information from municipal bond sales provided through a number of platforms, such as the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access database. However, the data provided on such platforms can often be outdated and incomplete, making it difficult for HFAs to determine whether they truly represent the actual sale price of their bonds. These logistical concerns are particularly problematic when HFAs and other issuers issue advanced refunding bonds and need to quickly set up a refunding escrow.

In short, the new compliance and monitoring requirements will elevate the already substantial administrative burden placed on HFAs and other municipal issuers, diminishing the amount of money that can be dedicated to their affordable housing mission.

Consider an Alternative Approach

In conclusion, the proposed rule will make it substantially harder for HFAs and other public agencies to meet critical public needs, while doing little to address the agency’s concerns about the accuracy of issue prices. We strongly request that IRS not finalize the proposed rule, and instead work with all stakeholders in the municipal securities market to develop a mutually agreeable solution for increasing price transparency.

Thank you for your consideration. We would be happy to discuss these issues with you at your convenience.

Sincerely,

Garth Rieman

Director of Housing Advocacy

and Strategic Initiatives

National Council of State Housing

Agencies




EO Update - e-News for Charities and Nonprofits - January 17, 2014.

1.  Phone forum: Governance help for exempt organizations

Register now for this informative IRS presentation scheduled January 23, at 2 p.m. ET.

Topics include:

Register at:

http://ems.intellor.com/index.cgi?p=204871&t=71&do=register&s=&rID=417&edID=305

2.  Current Form 990 series forms/instructions & significant changes

Go here for list of current Form 990 series forms and instructions:

http://www.irs.gov/uac/Current-Form-990-Series-Forms-and-Instructions

See the Form 990 filing thresholds page to determine which form(s) an organization must file. See Tax Year 2013 Significant Changes or Tax Year 2012 Significant Changes, for an overview of changes made to these forms.

http://www.irs.gov/pub/irs-tege/2013_Form990_SignificantChanges.pdf

http://www.irs.gov/pub/irs-tege/2012_Form990_Significant%20Changes.pdf

For materials on how to complete the Form 990 and other forms for exempt organizations, go to Form 990 Resources and Tools for Exempt Organizations.

http://www.irs.gov/Charities-&-Non-Profits/Form-990-Resources-and-Tools-for-Exempt-Organizations

3.  EO’s free e-newsletter helps keep charities and nonprofits up to date

EO Update is a free electronic newsletter that helps charities, nonprofits and other tax-exempt organizations comply with their tax responsibilities.

Help spread the word by asking people to subscribe now:

http://www.irs.gov/Charities-&-Non-Profits/Subscribe-to-Exempt-Organization-Update

Each edition provides important information about:

EO Update is recommended reading for anyone interested in tax-exempt issues – especially tax practitioners, attorneys and leaders and staff of tax-exempt organizations. For more information about tax-exempt issues and exempt organization educational materials, go to our Charities and Nonprofits page.

http://www.irs.gov/Charities-&-Non-Profits

E-mail questions/comments about the publication to [email protected].

4.  IRS tax videos will help you file in 2014

Review these helpful and informative videos:

http://www.irs.gov/uac/Newsroom/Tax-Videos-from-IRS-Available-To-Help-You-File-in-2014

Copyright Notice

This is a work of the U.S. Government and is not subject to copyright protection in the United States. IRS Exempt Organizations encourages readers to reuse these articles in their own organization publications and websites and thereby help disseminate the information beyond the scope of EO Update’s subscribers.

If you have a technical or procedural question relating to Exempt Organizations, visit the Charities and Nonprofits homepage on the IRS.gov Web site.

If you have a specific question about exempt organizations, call EO Customer Account Services at 1-877-829-5500.




IRS Publishes Proposed Regs on Determining Basis in Interests in Tax-Exempt Trusts.

The IRS has published proposed regulations (REG-154890-03) that provide rules for determining a taxable beneficiary’s basis in a term interest in a charitable remainder trust (CRT) upon a sale or other disposition of all interests in the trust to the extent that basis consists of a share of adjusted uniform basis. Comments and hearing requests are due by April 17.

In October 2008 the IRS designated (Notice 2008-99) a CRT transaction, and other substantially similar transactions as transactions of interest under reg. section 1.6011-4(b)(6). In the identified transaction, a sale or other disposition of all interests in a CRT after the contribution of appreciated assets to, and their reinvestment by, the CRT results in the grantor or other non-charitable beneficiary — the taxable beneficiary — receiving the value of the taxable beneficiary’s trust interest while claiming to recognize little or no taxable gain. The taxable beneficiary contends that the entire interest in the CRT has been sold, and thus, section 1001(e)(1) does not apply to the transaction. As a result, the taxable beneficiary computes gain on the sale of its term interest using the portion of the uniform basis allocable to the term interest under reg. sections 1.1014-5 and 1.1015-1(b). The taxable beneficiary takes the position that this uniform basis is derived from the basis of the new assets acquired by the CRT rather than the grantor’s basis in the assets contributed to the CRT.

In response to Notice 2008-99, commentators agreed that a taxable beneficiary of a CRT shouldn’t benefit from a basis step-up attributable to tax-exempt gains and supported amending the uniform basis rules to prevent this benefit. The IRS and Treasury also believe that it is inappropriate for a taxable beneficiary to share in the uniform basis obtained through the reinvestment of income not subject to tax due to a trust’s tax-exempt status.

Accordingly, the proposed regs provide a special rule for determining the basis in some CRT term interests in transactions to which section 1001(e)(3) applies. Under the regs, the basis of a term interest of a taxable beneficiary is the portion of the adjusted uniform basis assignable to that interest reduced by the portion of the sum of the following amounts assignable to that interest: (1) the amount of undistributed net ordinary income described in section 664(b)(1) and (2) the amount of undistributed net capital gain described in section 664(b)(2). The regs don’t affect the CRT’s basis in its assets, but the IRS and Treasury may consider whether there should be any change in the treatment of the charitable remainderman participating in such a transaction.

The rules in the proposed regs apply only to charitable remainder annuity trusts and charitable remainder unitrusts as defined in section 664. Comments are requested on whether the rules also should apply to other types of tax-exempt trusts. The regs don’t affect the disclosure obligation provided in Notice 2008-99. The regs are proposed to apply to sales and other dispositions of interests in CRTs occurring after January 15, 2014, except for sales or dispositions occurring under a binding commitment entered into before January 16, 2014. However, the inapplicability of the regs to an excepted sale or disposition doesn’t preclude the IRS from applying all available legal arguments to contest the claimed tax treatment of such a transaction.

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed regulations that provide rules for determining a taxable beneficiary’s basis in a term interest in a charitable remainder trust upon a sale or other disposition of all interests in the trust to the extent that basis consists of a share of adjusted uniform basis. The regulations affect taxable beneficiaries of charitable remainder trusts.

DATES: Written or electronic comments and requests for a public hearing must be received by April 17, 2014.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-154890-03), room 5205, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C., 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-154890-03), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C., or sent electronically via the Federal eRulemaking Portal at www.regulations.gov (IRS REG-154890-03).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Allison R. Carmody at (202) 317-5279; concerning submissions of comments and requests for hearing, Oluwafunmilayo (Funmi) Taylor, at (202) 317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Statutory and Regulatory Rules

Charitable Remainder Trusts

A charitable remainder trust (CRT) is a trust that provides for the distribution of an annuity or a unitrust amount, at least annually, to one or more beneficiaries, at least one of which is not a charity, for life or for a limited term of years, with an irrevocable remainder interest held for the benefit of, or paid over to, charity. Thus, there is at least one current income beneficiary of a CRT, and a charitable remainder beneficiary. A CRT is not subject to income tax. See section 664(c).

Uniform Basis Rule

Property acquired by a trust from a decedent or as a gift generally has a uniform basis. This means that property has a single basis even though more than one person has an interest in that property. See §§ 1.1014-4(a)(1) and 1.1015-1(b). Generally, the uniform basis of assets transferred to a trust is determined under section 1015 for assets transferred by lifetime gift, or under section 1014 or 1022 for assets transferred from a decedent. Adjustments to uniform basis for items such as depreciation are made even though more than one person holds an interest in the property (adjusted uniform basis).

When a taxable trust sells assets, any gain is taxed currently to the trust, to one or more beneficiaries, or apportioned among the trust and its beneficiaries. If the trust reinvests the proceeds from the sale in new assets, the trust’s basis in the newly purchased assets is the cost of the new assets. See section 1012. Thus, the adjusted uniform basis of that taxable trust is attributable to basis obtained with proceeds from sales that were subject to income tax.

However, a CRT does not pay income tax on gain from the sale of appreciated assets. A CRT may sell appreciated assets and accumulate undistributed income and undistributed capital gains, and may reinvest the proceeds of the sales in new assets. The treatment of distributions from a CRT to its income beneficiary depends upon the amount of undistributed income and undistributed capital gains in the CRT. Sections 664(b)(1) and (2).

Basis in Term and Remainder Interests in a CRT

Section 1001(e) governs the determination of gain or loss from the sale or disposition of a term interest in property, such as a life or term interest in a CRT. In general, section 1001(e)(1) provides that the portion of the adjusted basis of a term interest in property that is determined pursuant to sections 1014, 1015, or 1041 is disregarded in determining gain or loss from the sale or other disposition of such term interest. Thus, the seller of such an interest generally must disregard that portion of the basis in the transferred interest in computing the gain or loss.

Section 1001(e)(3), however, provides that section 1001(e)(1) does not apply to a sale or other disposition that is part of a transaction in which the entire interest in property is transferred. Therefore, in the case of a sale or other disposition that is part of a transaction in which all interests in the property (or trust) are transferred as described in section 1001(e)(3), the capital gain or loss of each seller of an interest is the excess of the amount realized from the sale of that interest over the seller’s basis in that interest. Each seller’s basis is the seller’s portion of the adjusted uniform basis assignable to the interest so transferred. See § 1.1014-5(a)(1).

The basis of a term or remainder interest in a trust at the time of its sale or other disposition is determined under the rules provided in § 1.1014-5. See also §§ 1.1015-1(b) and 1.1015-2(a)(2), which refer to the rules of § 1.1014-5. Specifically, § 1.1014-5(a)(3) provides that, in determining the basis in a term or remainder interest in property at the time of the interest’s sale or disposition, adjusted uniform basis is allocated using the factors for valuing life estates and remainder interests. Thus, the portions of the adjusted uniform basis attributable to the interests of the life tenant and remaindermen are adjusted to reflect the change in the relative values of such interests due to the lapse of time.

Notice 2008-99

The IRS and the Treasury Department became aware of a type of transaction involving these provisions and, on October 31, 2008, the IRS and the Treasury Department published Notice 2008-99 (2008-47 IRB 1194) (“Notice”) to designate a transaction and substantially similar transactions as Transactions of Interest under § 1.6011-4(b)(6) of the Income Tax Regulations, and to ask for public comments on how the transactions might be addressed in published guidance. In this type of transaction, a sale or other disposition of all interests in a CRT subsequent to the contribution of appreciated assets to, and their reinvestment by, the CRT results in the grantor or other noncharitable beneficiary (the taxable beneficiary) receiving the value of the taxable beneficiary’s trust interest while claiming to recognize little or no taxable gain.

Specifically, upon contribution of assets to the CRT, the grantor claims an income tax deduction under section 170 of the Internal Revenue Code (Code) for the portion of the fair market value of the assets contributed to the CRT (which generally have a fair market value in excess of the grantor’s cost basis) that is attributable to the charitable remainder interest. When the CRT sells or liquidates the contributed assets, the taxable beneficiary does not recognize gain, and the CRT is exempt from tax on such gain under section 664(c). The CRT reinvests the proceeds in other assets, often a portfolio of marketable securities, with a basis equal to the portfolio’s cost. The taxable beneficiary and charity subsequently sell all of their respective interests in the CRT to a third party.

The taxable beneficiary takes the position that the entire interest in the CRT has been sold as described in section 1001(e)(3) and, therefore, section 1001(e)(1) does not apply to the transaction. As a result, the taxable beneficiary computes gain on the sale of the taxable beneficiary’s term interest by taking into account the portion of the uniform basis allocable to the term interest under §§ 1.1014-5 and 1.1015-1(b). The taxable beneficiary takes the position that this uniform basis is derived from the basis of the new assets acquired by the CRT rather than the grantor’s basis in the assets contributed to the CRT.

Explanation of Provisions

In response to the request for comments in the Notice, the IRS and the Treasury Department received three written comments. All three commenters agreed that a taxable beneficiary of a CRT should not benefit from a basis step-up attributable to tax-exempt gains, and each supported amending the uniform basis rules to foreclose this benefit. The IRS and the Treasury Department agree that it is inappropriate for a taxable beneficiary to share in the uniform basis obtained through the reinvestment of income not subject to tax due to a trust’s tax-exempt status.

Accordingly, these proposed regulations provide a special rule for determining the basis in certain CRT term interests in transactions to which section 1001(e)(3) applies. In these cases, the proposed regulations provide that the basis of a term interest of a taxable beneficiary is the portion of the adjusted uniform basis assignable to that interest reduced by the portion of the sum of the following amounts assignable to that interest: (1) the amount of undistributed net ordinary income described in section 664(b)(1); and (2) the amount of undistributed net capital gain described in section 664(b)(2). These proposed regulations do not affect the CRT’s basis in its assets, but rather are for the purpose of determining a taxable beneficiary’s gain arising from a transaction described in section 1001(e)(3). However, the IRS and the Treasury Department may consider whether there should be any change in the treatment of the charitable remainderman participating in such a transaction.

In addition to the comments supportive of a basis limitation described above and proposed to be adopted herein, the commenters addressed additional issues in response to the Notice. One commenter requested guidance specifying what valuation methods the IRS will accept as a reasonable method for determining the amount of a life-income recipient’s gain on the termination of certain types of CRTs. Another commenter suggested that the IRS and the Treasury Department could create a rule requiring a zero basis for all interests in CRTs in order to prevent an inappropriate result while still allowing for early termination of CRTs. The commenter also proposed that this rule be made applicable to all early terminations of CRTs. The IRS and the Treasury Department did not adopt a rule requiring a zero basis for all interests in CRTs because the IRS and the Treasury Department believe that the rule provided in the proposed regulations will prevent inappropriate results while treating parties to the transaction fairly. Additionally, the IRS and the Treasury Department believe that rules addressing early terminations other than those arising from a transaction described in section 1001(e)(3), and rules prescribing valuation methods, are beyond the scope of the issues intended to be addressed in these proposed regulations, and thus will not be considered as part of this guidance.

Finally, the rules in these proposed regulations are limited in application to charitable remainder annuity trusts and charitable remainder unitrusts as defined in section 664. The IRS and the Treasury Department request comments as to whether the rules also should apply to other types of tax-exempt trusts.

Effect on Other Documents

The issuance of these proposed regulations does not affect the disclosure obligation set forth in the Notice.

Proposed Effective/Applicability Date

These regulations are proposed to apply to sales and other dispositions of interests in CRTs occurring on or after January 16, 2014, except for sales or dispositions occurring pursuant to a binding commitment entered into before January 16, 2014. However, the inapplicability of these regulations to an excepted sale or disposition does not preclude the IRS from applying legal arguments available to the IRS before issuance of these regulations in order to contest the claimed tax treatment of such a transaction.

Availability of IRS Documents

The IRS notice cited in this preamble is published in the Internal Revenue Bulletin or Cumulative Bulletin and is available at the IRS website at http://www.irs.gov or the Superintendent of Documents, U.S. Government Printing Office, Washington, D.C., 20402.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply to these regulations because the regulations do not impose a collection of information on small entities. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Requests for Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and 8 copies) or electronic comments that are submitted timely to the IRS. The IRS and the Treasury Department also request comments on the administrability and clarity of the proposed rules, and how they can be made easier to understand. All comments will be available for public inspection and copying at www.regulations.gov or upon request. A public hearing will be scheduled if requested in writing by any person who timely submits written or electronic comments. If a public hearing is scheduled, notice of the date, time, and place of the public hearing will be published in the Federal Register.

Drafting Information

The principal author of these proposed regulations is Allison R. Carmody of the Office of Associate Chief Counsel (Passthroughs and Special Industries). Other personnel from the IRS and the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1 — INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

§ 1.1001-1 [Amended]

Par. 2. Section 1.1001-1, paragraph (f)(4), is amended by removing the language “paragraph (c)” and adding “paragraph (d)” in its place.

§ 1.1014-5 [Amended]

Par. 3. Section 1.1014-5 is amended by:

1. In paragraph (a)(1), first sentence, removing the language “paragraph (b)” and adding “paragraph (b) or (c)” in its place.

2. Re-designating paragraph (c) as newly-designated paragraph (d) and adding new paragraph (c).

3. In newly-designated paragraph (d), adding new Example 7 and Example 8.

The additions read as follows:

§ 1.1014-5 Gain or loss.

* * * * *

(c) Sale or other disposition of a term interest in a tax-exempt trust — (1) In general. In the case of any sale or other disposition by a taxable beneficiary of a term interest (as defined in § 1.1001-1(f)(2)) in a tax-exempt trust (as described in paragraph (c)(2) of this section) to which section 1001(e)(3) applies, the taxable beneficiary’s share of adjusted uniform basis, determined as of (and immediately before) the sale or disposition of that interest, is —

(i) That part of the adjusted uniform basis assignable to the term interest of the taxable beneficiary under the rules of paragraph (a) of this section reduced, but not below zero, by

(ii) An amount determined by applying the same actuarial share applied in paragraph (c)(1)(i) of this section to the sum of —

(A) The trust’s undistributed net ordinary income within the meaning of section 664(b)(1) and § 1.664-1(d)(1)(ii)(a)(1) for the current and prior taxable years of the trust, if any; and

(B) The trust’s undistributed net capital gains within the meaning of section 664(b)(2) and § 1.664-1(d)(1)(ii)(a)(2) for the current and prior taxable years of the trust, if any.

(2) Tax-exempt trust defined. For purposes of this section, the term tax-exempt trust means a charitable remainder annuity trust or a charitable remainder unitrust as defined in section 664.

(3) Taxable beneficiary defined. For purposes of this section, the term taxable beneficiary means any person other than an organization described in section 170(c) or exempt from taxation under section 501(a).

(4) Effective/applicability date. This paragraph (c) and paragraph (d), Example 7 and Example 8, of this section apply to sales and other dispositions of interests in tax-exempt trusts occurring on or after January 16, 2014, except for sales or dispositions occurring pursuant to a binding commitment entered into before January 16, 2014.

(d) * * *

Example 7. (a) Grantor creates a charitable remainder unitrust (CRUT) on Date 1 in which Grantor retains a unitrust interest and irrevocably transfers the remainder interest to Charity. Grantor is an individual taxpayer subject to income tax. CRUT meets the requirements of section 664 and is exempt from income tax.

(b) Grantor’s basis in the shares of X stock used to fund CRUT is $10x. On Date 2, CRUT sells the X stock for $100x. The $90x of gain is exempt from income tax under section 664(c)(1). On Date 3, CRUT uses the $100x proceeds from its sale of the X stock to purchase Y stock. On Date 4, CRUT sells the Y stock for $110x. The $10x of gain on the sale of the Y stock is exempt from income tax under section 664(c)(1). On Date 5, CRUT uses the $110x proceeds from its sale of Y stock to buy Z stock. On Date 5, CRUT’s basis in its assets is $110x and CRUT’s total undistributed net capital gains are $100x.

(c) Later, when the fair market value of CRUT’s assets is $150x and CRUT has no undistributed net ordinary income, Grantor and Charity sell all of their interests in CRUT to a third person. Grantor receives $100x for the retained unitrust interest, and Charity receives $50x for its interest. Because the entire interest in CRUT is transferred to the third person, section 1001(e)(3) prevents section 1001(e)(1) from applying to the transaction. Therefore, Grantor’s gain on the sale of the retained unitrust interest in CRUT is determined under section 1001(a), which provides that Grantor’s gain on the sale of that interest is the excess of the amount realized, $100x, over Grantor’s adjusted basis in the interest.

(d) Grantor’s adjusted basis in the unitrust interest in CRUT is that portion of CRUT’s adjusted uniform basis that is assignable to Grantor’s interest under § 1.1014-5, which is Grantor’s actuarial share of the adjusted uniform basis. In this case, CRUT’s adjusted uniform basis in its sole asset, the Z stock, is $110x. However, paragraph (c) of this section applies to the transaction. Therefore, Grantor’s actuarial share of CRUT’s adjusted uniform basis (determined by applying the factors set forth in the tables contained in § 20.2031-7 of this chapter) is reduced by an amount determined by applying the same factors to the sum of CRUT’s $0 of undistributed net ordinary income and its $100x of undistributed net capital gains.

(e) In determining Charity’s share of the adjusted uniform basis, Charity applies the factors set forth in the tables contained in § 20.2031-7 of this chapter to the full $110x of basis.

Example 8. (a) Grantor creates a charitable remainder annuity trust (CRAT) on Date 1 in which Grantor retains an annuity interest and irrevocably transfers the remainder interest to Charity. Grantor is an individual taxpayer subject to income tax. CRAT meets the requirements of section 664 and is exempt from income tax.

(b) Grantor funds CRAT with shares of X stock having a basis of $50x. On Date 2, CRAT sells the X stock for $150x. The $100x of gain is exempt from income tax under section 664(c)(1). On Date 3, CRAT distributes $10x to Grantor, and uses the remaining $140x of net proceeds from its sale of the X stock to purchase Y stock. Grantor treats the $10x distribution as capital gain, so that CRAT’s remaining undistributed net capital gains amount described in section 664(b)(2) and § 1.664-1(d) is $90x.

(c) On Date 4, when the fair market value of CRAT’s assets, which consist entirely of the Y stock, is still $140x, Grantor and Charity sell all of their interests in CRAT to a third person. Grantor receives $126x for the retained annuity interest, and Charity receives $14x for its remainder interest. Because the entire interest in CRAT is transferred to the third person, section 1001(e)(3) prevents section 1001(e)(1) from applying to the transaction. Therefore, Grantor’s gain on the sale of the retained annuity interest in CRAT is determined under section 1001(a), which provides that Grantor’s gain on the sale of that interest is the excess of the amount realized, $126x, over Grantor’s adjusted basis in that interest.

(d) Grantor’s adjusted basis in the annuity interest in CRAT is that portion of CRAT’s adjusted uniform basis that is assignable to Grantor’s interest under § 1.1014-5, which is Grantor’s actuarial share of the adjusted uniform basis. In this case, CRAT’s adjusted uniform basis in its sole asset, the Y stock, is $140x. However, paragraph (c) of this section applies to the transaction. Therefore, Grantor’s actuarial share of CRAT’s adjusted uniform basis (determined by applying the factors set forth in the tables contained in § 20.2031-7 of this chapter) is reduced by an amount determined by applying the same factors to the sum of CRAT’s $0 of undistributed net ordinary income and its $90x of undistributed net capital gains.

(e) In determining Charity’s share of the adjusted uniform basis, Charity applies the factors set forth in the tables contained in § 20.2031-7 of this chapter to determine its actuarial share of the full $140x of basis.

John Dalrymple

Deputy Commissioner for Services

and Enforcement.

[FR Doc. 2014-00807 Filed 01/16/2014 at 8:45 am; Publication Date: 01/17/2014]




S. 1913 Would Make Payments in Lieu of Taxes Program Permanent.

S. 1913, introduced by Sen. Mark Udall, D-Colo., would make permanent the payments in lieu of taxes program, which provides local governments with funds to offset the loss of a tax base when there is federal land within their jurisdictions.

113TH CONGRESS

2D SESSION

S.1913

To make permanent the Payments in Lieu of Taxes program.

IN THE SENATE OF THE UNITED STATES

JANUARY 13, 2014

Mr. UDALL of Colorado (for himself and Mr. BENNET) introduced

the following bill; which was read twice and referred to the

Committee on Energy and Natural Resources

A BILL

To make permanent the Payments in Lieu of Taxes program.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. PAYMENTS IN LIEU OF TAXES.

Section 6906 of title 31, United States Code, is amended by striking “of fiscal years 2008 through 2013” and inserting “fiscal year”.




IRS Issues Guidance on Current Refunding Issues of Tax-Exempt Bonds.

The IRS has issued guidance (Notice 2014-9) on the refunding of tax-exempt bonds issued before January 1, 2011, that qualify as recovery zone facility bonds under section 1400U-3.

In general, recovery zone facility bonds can be used to finance property located within designated recovery zones. For purposes of the statute, a recovery zone is any area (1) designated by the issuer as having significant poverty, unemployment, or general distress, or a significant rate of home foreclosures; (2) designated by the issuer as economically distressed by reason of the closure or realignment of a military installation under the Defense Base Closure and Realignment Act of 1990; and (3) for which a designation as an empowerment or renewal community is in effect as of February 17, 2009.

The statutory provisions for recovery zone facility bonds are silent regarding the permissibility of current refundings of these bonds after January 1, 2011. Under similar provisions for exempt facility bonds for disaster relief, the IRS and Treasury have previously provided guidance allowing current refundings within specified size limitations for purposes of bond issuance deadlines applicable to those bonds.

Accordingly, a current refunding issue that meets the requirements of Notice 2014-9 may be issued after January 1, 2011, for the issuance of the original qualified bonds and will be treated as an issue of qualified bonds. Also, for such a current refunding issue, the designation of the original qualified bonds by a specified state or local government official or state bond commission that meets the designation requirement of section 1400U-3(b)(1)(C) for recovery zone facility bonds is treated as meeting this requirement for the current refunding issue without further designation or further official state or local governmental action.

Taxpayers can rely on Notice 2014-9 until further guidance is issued.

http://www.irs.gov/pub/irs-drop/n-14-09.pdf




IRS Publishes Final Regs on Bond Premium Carryforwards.

The IRS has published final regulations (T.D. 9653) that provide guidance on the tax treatment of a debt instrument with a bond premium carryforward in the holder’s final accrual period.

Effective January 15, 2014, the final regs adopt, without substantive change, proposed regs (REG-140437-12) issued in January 2013. Corresponding temporary regs (T.D. 9609) are removed. The final regs provide guidance to holders of Treasury securities and other debt instruments acquired at a premium.

Before the temporary regs were issued, Treasury and the IRS received inquiries about a holder’s treatment of a taxable zero coupon debt instrument acquired at a premium and having a negative yield. In that situation, under the then-existing bond premium regs, a holder that elected to amortize the bond premium generally would have a capital loss on the sale, retirement, or other disposition of the debt instrument rather than an ordinary deduction under section 171(a)(1) for all or a portion of the bond premium.

If a zero coupon debt instrument is acquired at a premium, the bond premium allocable to an accrual period is carried forward to the next accrual period and to each succeeding accrual period. As a result, on the sale, retirement, or other disposition of the debt instrument, there generally will be a bond premium carryforward in the holder’s final accrual period. Under the prior bond premium regs, the holder would have a capital loss in an amount at least equal to the bond premium carryforward because there is no qualified stated interest to offset the bond premium carryforward and the holder’s basis in the bond has not been reduced. The acquisition of a zero coupon debt instrument at a premium and with a negative yield was not contemplated when the prior regs were adopted in 1997.

To address this situation, the temporary regs added a specific rule for the treatment of a bond premium carryforward determined as of the end of the holder’s final accrual period for any taxable debt instrument for which the holder has elected to amortize bond premium. The final regs adopt that rule and, thus, an electing holder deducts all or a portion of the bond premium under section 171(a)(1) when the instrument is sold, retired, or otherwise disposed of rather than recognizing a capital loss.

The final regs apply to a debt instrument acquired after January 3, 2013, but a taxpayer may rely on the regs for a debt instrument acquired before that date.

Bond Premium Carryforward

[4830-01-p]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

Treasury Decision 9653

RIN 1545-BL28

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations that provide guidance on the tax treatment of a debt instrument with a bond premium carryforward in the holder’s final accrual period. The regulations in this document provide guidance to holders of Treasury securities and other debt instruments acquired at a premium.

DATES: Effective Date: These regulations are effective on January 15, 2014.

Applicability Date: For the date of applicability, see § 1.171-2(a)(4)(i)(C)(2).

FOR FURTHER INFORMATION CONTACT: William E. Blanchard, (202) 317-3900 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On January 4, 2013, the IRS and the Treasury Department published temporary regulations (TD 9609) in the Federal Register (78 FR 666) relating to the federal income tax treatment of a debt instrument with a bond premium carryforward in the holder’s final accrual period, including a Treasury bill acquired at a premium. See § 1.171-2T. On the same day, the IRS and the Treasury Department published a notice of proposed rulemaking (REG-140437-12) cross-referencing the temporary regulations in the Federal Register (78 FR 687). No comments were received on the notice of proposed rulemaking. No public hearing was requested or held.

The proposed regulations are adopted without substantive change by this Treasury decision, and the corresponding temporary regulations are removed.

Explanation of provisions

Prior to the issuance of the temporary regulations, the IRS and the Treasury Department had received questions about an electing holder’s treatment of a taxable zero coupon debt instrument, including a Treasury bill, acquired at a premium and with a negative yield. In this situation, as explained in more detail below, under the bond premium regulations in effect prior to the issuance of the temporary regulations (the prior regulations), a holder that had elected to amortize bond premium under section 171 generally would have had a capital loss upon the sale, retirement, or other disposition of the debt instrument rather than an ordinary deduction under section 171(a)(1) for all or a portion of the bond premium. The acquisition of a zero coupon debt instrument at a premium and with a negative yield was not contemplated when the prior regulations were revised in 1997 (TD 8746).

Under section 171(c) and § 1.171-4, a holder can elect to amortize bond premium on taxable debt instruments. A holder acquires a debt instrument at a premium if the holder’s basis in the debt instrument immediately after its acquisition by the holder exceeds the sum of all amounts payable on the debt instrument after the acquisition date other than payments of qualified stated interest (as defined in § 1.1273-1(c)). The general effect of an election to amortize bond premium on a debt instrument that is a capital asset is to treat the bond premium as an offset to ordinary income rather than as a capital loss.

Under section 171(e) and § 1.171-2, an electing holder amortizes bond premium by offsetting the qualified stated interest allocable to an accrual period with the bond premium allocable to the period. As a result, the holder only includes the net amount of interest in income for the period. If the bond premium allocable to an accrual period exceeds the qualified stated interest allocable to the accrual period, the holder treats the excess as a bond premium deduction under section 171(a)(1) for the accrual period. However, the amount treated as a bond premium deduction is limited to the amount by which the holder’s total interest inclusions on the debt instrument in prior accrual periods exceed the total amount treated by the holder as a bond premium deduction on the debt instrument in prior accrual periods. If the bond premium allocable to an accrual period exceeds the sum of the qualified stated interest allocable to the accrual period and the amount treated as a deduction under section 171(a)(1), the excess is carried forward to the next accrual period and is treated as bond premium allocable to that period. See § 1.171-2(a)(4). Under § 1.1016-5(b), a holder’s basis in a taxable debt instrument is reduced by the amount of bond premium used to offset qualified stated interest on the debt instrument and the amount of bond premium allowed as a deduction under section 171(a)(1).

There is no stated interest payable, and therefore no qualified stated interest, on a zero coupon debt instrument, including a Treasury bill. As a result, under § 1.171-2, if a zero coupon debt instrument is acquired at a premium (that is, acquired for an amount greater than its stated principal amount), the bond premium allocable to an accrual period is carried forward to the next accrual period and to each succeeding accrual period. As a result, upon the sale, retirement, or other disposition of the debt instrument, there generally will be a bond premium carryforward in the holder’s final accrual period. In this situation, because there is no qualified stated interest to offset the bond premium carryforward and the holder’s basis in the debt instrument has not been reduced, under the prior regulations the holder would have had a capital loss in an amount at least equal to the bond premium carryforward.

To address the treatment of a bond premium carryforward in the situation described in the prior paragraph, the temporary regulations added a specific rule for the treatment of a bond premium carryforward determined as of the end of the holder’s final accrual period for any taxable debt instrument for which the holder had elected to amortize bond premium. These final regulations adopt the rule in the temporary and proposed regulations. Thus, in the situation described in the prior paragraph, under these final regulations an electing holder deducts all or a portion of the bond premium under section 171(a)(1) when the instrument is sold, retired, or otherwise disposed of rather than recognizing a capital loss.

As noted above, no comments were received on the temporary regulations. The final regulations in this document are substantively the same as the temporary regulations.

Applicability Date

Section 1.171-2(a)(4)(i)(C)(1) applies to a debt instrument (bond) acquired on or after January 4, 2013 (the effective/applicability date of the temporary regulations). A taxpayer, however, may rely on this section for a debt instrument (bond) acquired before that date.

Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the proposed regulations preceding these final regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business. No comments were received.

Drafting Information

The principal author of these regulations is William E. Blanchard, Office of Associate Chief Counsel (Financial Institutions and Products). However, other personnel from the IRS and the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 — INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by removing the entry for § 1.171-2T to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.171-2 is amended by adding new paragraph (a)(4)(i)(C) to read as follows:

§ 1.171-2 Amortization of bond premium.

(a) * * *

(4) * * *

(i) * * *

(C) Carryforward in holder’s final accrual period — (1) Bond premium deduction. If there is a bond premium carryforward determined under paragraph (a)(4)(i)(B) of this section as of the end of the holder’s accrual period in which the bond is sold, retired, or otherwise disposed of, the holder treats the amount of the carryforward as a bond premium deduction under section 171(a)(1) for the holder’s taxable year in which the sale, retirement, or other disposition occurs. For purposes of § 1.1016-5(b), the holder’s basis in the bond is reduced by the amount of bond premium allowed as a deduction under this paragraph (a)(4)(i)(C)(1).

(2) Effective/applicability date. Notwithstanding § 1.171-5(a)(1), paragraph (a)(4)(i)(C)(1) of this section applies to a bond acquired on or after January 4, 2013. A taxpayer, however, may rely on paragraph (a)(4)(i)(C)(1) of this section for a bond acquired before that date.

* * * * *

§ 1.171-2T [Removed]

Par. 3. Section 1.171-2T is removed.

Par. 4. Section 1.171-3 is amended by revising the fifth sentence in paragraph (b) to read as follows:

§ 1.171-3 Special rules for certain bonds.

* * * * *

(b) * * * However, the rules in § 1.171-2(a)(4)(i)(C) apply to any remaining deflation adjustment attributable to bond premium as of the end of the holder’s accrual period in which the bond is sold, retired, or otherwise disposed of. * * *

* * * * *

John Dalrymple

Deputy Commissioner for Services

and Enforcement.

Approved: January 7, 2014

Mark J. Mazur

Assistant Secretary of the

Treasury (Tax Policy).

[FR Doc. 2014-00613 Filed 01/14/2014 at 8:45 am; Publication Date: 01/15/2014]




Bond Premium Carryforward Final Regs Provide Welcome Relief for Taxpayers.

Taxpayers may deduct bond premium against ordinary income in the final accrual period under final regulations (T.D. 9653) released by Treasury on January 14.

Taxpayers may deduct bond premium against ordinary income in the final accrual period under final regulations (T.D. 9653 ) released by Treasury on January 14.

The final regs adopt the proposed (REG-140437-12 ) and temporary (T.D. 9609 ) regs, issued in January 2013, without substantive changes.

“I think this is welcome relief that fixes a mechanical problem under the bond premium rule,” said Stevie D. Conlon of Wolters Kluwer Financial Services Inc.

Under the final regulations, a taxpayer making a section 171 election to deduct bond premium against interest received on the bond may now deduct remaining premiums against ordinary income in the final accrual period. Before the final regs, any carryforward bond premium not deducted at maturity would release, so the bond’s basis was higher than its value, and the bondholder would have a capital loss.

“If you have a negative yield net of the bond premium, then you should be entitled to a corresponding ordinary loss,” Conlon said.

Under reg. section 1.171-2(a)(4), the amount of bond premium amortization was calculated every year. When the bond premium amortization exceeded the interest received on the bond, the bondholder did not receive the amortization amount. Rather, the difference between the amortization and the interest received was carried forward to the next year.

Under the new rules, taxpayers can deduct only up to the amount of interest payments on the bond; however, they may deduct the excess carryforward upon the bond’s maturity.

“Under reg. section 1.171-2(a)(4)(i)(A), bond premium in excess of qualified stated interest is deferred until later, so it’s not optimal for taxpayers, but it’s understandable,” Conlon said. “At least you are getting ordinary instead of capital loss under this rule. So I think it’s a very good finalization.”

Conlon said that after 2008, interest rates became incredibly low. That led to many short-term, high credit quality loans that paid hardly any interest, which made the issue more important to portfolio advisers in recent years. “We were seeing this mechanical issue arise regularly in our analysis of debt instruments for cost basis reporting purposes,” she said.

According to Conlon, the current interest rate environment is an aberration. “We can expect a rise in interest rates as the Federal Reserve moves away from quantitative easing,” she said. The regs are particularly important in the current, low-rate environment, she explained, but they will be less so once interest rates rise.

Treasury originally released the bond premium carryforward regs in response to questions regarding Treasury inflation-protected securities. According to their preamble, the temporary regs were a response to inquiries regarding a holder’s treatment of a taxable zero coupon debt instrument acquired at a premium and with a negative yield.

by William R. Davis




ABA Says Camp Business Accounting Proposal Would Have Unintended Consequences.

A proposal by House Ways and Means Committee Chair Dave Camp, R-Mich., to require personal service businesses earning more than $10 million to use the accrual method of accounting instead of the cash method would cause unintended harm and should be rejected, the American Bar Association said in a January 13 letter to the committee.

January 13, 2014

The Honorable Dave Camp

Chairman

Committee on Ways and Means

U.S. House of Representatives

Washington, D.C. 20515

The Honorable Sander M. Levin

Ranking Member

Committee on Ways and Means

U.S. House of Representatives

Washington, D.C. 20515

Re: Provisions in the Discussion Draft “Tax Reform Act of 2013” Requiring Law Firms and Other Personal Service Businesses to Pay Taxes Using the Accrual Method of Accounting

Gentlemen:

On behalf of the American Bar Association (“ABA”), which has almost 400,000 members, I write to express our concerns regarding provisions in Section 212 of the Committee’s discussion draft “Tax Reform Act of 2013” that would require all law firms and other personal service businesses with annual gross receipts over $10 million to use the accrual method of accounting (“accrual method”) rather than the traditional cash receipts and disbursement method of accounting (“cash method”).

Although we commend you for your efforts to craft legislation aimed at simplifying the tax laws — an objective that the ABA and its Section of Taxation have long supported — we are concerned that Section 212 would have the opposite effect and cause other negative unintended consequences. This far-reaching provision would create unnecessary complexity in the tax law by disallowing the use of the cash method; increase compliance costs and corresponding risk of manipulation; and cause substantial hardship to many law firms and other personal service businesses by requiring them to pay tax on income they have not yet received and may never receive. Therefore, we urge you and your Committee to remove this provision from the overall draft legislation.

Under current law, businesses are permitted to use the simple, straightforward cash method of accounting — in which income is not recognized until cash or other payment is actually received and expenses are not taken into account until they are actually paid — if they are individuals or pass-through entities (e.g., partnerships or subchapter S corporations), or their average annual gross receipts for a three year period are $5 million or less. In addition, all personal service businesses — including those engaged in the fields of law, accounting, engineering, architecture, health, actuarial science, performing arts, or consulting — whether organized as sole proprietorships, partnerships, limited liability companies, or S corporations, are exempt from the revenue cap and can use the cash method of accounting irrespective of their annual revenues, unless they have inventory.

Section 212 of the draft legislation would dramatically change current law by raising the gross receipts cap to $10 million while eliminating the existing exemption for personal service businesses, other partnerships and S corporations, and farmers. Therefore, if this proposal is enacted into law, all law firms and other personal service businesses with annual gross receipts over $10 million would be required to use the accrual method of accounting, in which income is recognized when the right to receive the income is present and expenses are recorded when they are fixed, determinable and economically performed, both aspects of which present complications.

Although Section 212 would allow certain small business taxpayers with annual gross receipts in the $5 million to $10 million range to switch to — and thereby enjoy the benefits of — the cash method of accounting (a concept that the ABA does not oppose), the proposal would significantly complicate tax compliance for a far greater number of small business taxpayers, including many law firms and other personal service businesses, by forcing them to use the accrual method.

Partnerships, S corporations, personal service corporations and other pass-through entities favor the cash method because it is simple and generally correlates with the manner in which these business owners operate their businesses — i.e, on a cash basis. Simplicity is important from a compliance perspective because it enables taxpayers to better understand the tax consequences of transactions in which they engage or plan to engage. In this regard, simplicity helps to mitigate compliance costs — which already are significant — and to improve compliance with the Code. The increased complexity associated with the accrual method will raise compliance costs for many law firms and other personal service businesses — as separate sets of records will be needed to reflect the accrual accounting — while greatly increasing the risk of noncompliance with the Code.

In addition to creating unnecessary complexity and compliance costs, Section 212 would lead to economic distortions that would adversely affect all personal service businesses that currently use the cash method of accounting and those who retain them, including many law firms and their clients, in several ways.

First, the proposal would place a new financial burden on millions of personal service businesses throughout the country — including many law firms — by requiring them to pay tax on income not yet received and which may never be received. As a result, the proposal would create significant economic distortions in terms of how many personal service businesses are organized and operate.

For example, most law firms are organized as partnerships owned by lawyers who have elected to join together in practice. In many firms, particularly larger firms, the partners change from year to year as older lawyers retire, younger lawyers are promoted, and other lawyers migrate to or from other firms. As an economic matter, firms that operate on the cash method are able to ensure that the partners who were present in the firm and performing legal services are taxed on the income actually received that year. However, if such firms were forced to switch to the accrual method, then partners will be taxed on income that their firms accrue on paper in the current year even though the partners may not be around when the clients pay their bills (if the bills are ever paid). For new partners and retiring partners alike, the economics will be changed dramatically.

The existing cash method of accounting produces a sound and fair result because it properly recognizes that the cash a business actually receives in return for the services it provides — not the business’ accounts receivable — is the proper reflection of its true income and its ability to pay taxes on that income. While accounts receivable clearly are important to determining the financial condition of a business and assessing its future prospects, they do not accurately reflect its current spendable income or its present ability to pay taxes on that income.

Second, for professional service providers that practice in regulated professions, such as lawyers, the proposal would impose greater financial hardships on their firms than may be felt by other types of small and medium sized businesses because many of these professionals are subject to special rules that significantly limit their ability to raise capital. For example, lawyers must comply with state court ethics rules that generally prohibit them from forming a law firm partnership with a nonlawyer or allowing a nonlawyer to own any interest in the law firm. As a result, many law firms must be capitalized solely by the individual lawyers who together own those firms and they are unable to raise equity capital from outside nonlawyer investors. Therefore, forcing these law firms to pay tax on income that has not yet been received and that may never be received could place a major strain on lawyers’ ability to properly capitalize and operate their firms.

Third, the proposal would discourage individual professional service providers from joining with other providers to create or expand a firm, even if it made economic sense and would benefit their clients, because it could trigger the accrual accounting requirement in the bill. For example, solo practitioner lawyers would be discouraged from entering into law firm partnerships — and many existing law firms would be discouraged from growing or expanding — because once a firm exceeds $10 million in annual gross receipts, it would be required to switch from cash to accrual accounting, thereby accelerating its tax payments. Sound tax policy should encourage — not discourage — the growth of small businesses, including those providing personal services such as law firms, especially in today’s difficult economic environment.

In sum, the mandatory accrual accounting provisions in Section 212 of the draft bill would create unnecessary complexity in the tax law, increased compliance costs, and significant new financial burdens and hardships for many law firms and other personal service businesses throughout the country by requiring them to pay tax on income not yet received and that may never be received. To avoid these harmful unintended consequences, the ABA urges you and the Committee to remove Section 212 from the draft bill or from any tax reform bill that may be approved by the Committee.

Thank you for considering the ABA’s views on this important issue. If you have any questions regarding our position, please contact ABA Governmental Affairs Director Thomas Susman at (202) 662-1765 or Associate Governmental Affairs Director Larson Frisby at (202) 662-1098.

Sincerely,

James R. Silkenat

President, American Bar Association

Chicago, IL

cc:

Members of the House Ways and Means Committee




Baucus Accounting Method Proposal Would Cause Problems, ABA Says.

A proposal by Senate Finance Committee Chair Max Baucus, D-Mont., to require personal service businesses earning more than $10 million to use the accrual method of accounting instead of the cash method would increase complexity and compliance burdens, the American Bar Association said in a January 13 letter to the committee.

January 13, 2014

The Honorable Max Baucus

Chairman

Committee on Finance

United States Senate

Washington, D.C. 20510

The Honorable Orrin G. Hatch

Ranking Member

Committee on Finance

United States Senate

Washington, D.C. 20510

Re: Provisions in the Chairman’s Staff Discussion Draft Bill Requiring Law Firms and Other Personal Service Businesses to Pay Taxes Using the Accrual Method of Accounting

Gentlemen:

On behalf of the American Bar Association (“ABA”), which has almost 400,000 members, I write to express our concerns regarding provisions in Section 51 of the Senate Finance Committee Chairman’s staff discussion draft bill to reform cost recovery and tax accounting rules that would require all solo practitioner lawyers, law firms and other personal service businesses with annual gross receipts over $10 million to use the accrual method of accounting (“accrual method”) rather than the traditional cash receipts and disbursement method of accounting (“cash method”).

Although we commend you for your efforts to craft legislation aimed at simplifying the tax laws — an objective that the ABA and its Section of Taxation have long supported — we are concerned that Section 51 would have the opposite effect and cause other negative unintended consequences. This far-reaching provision would create unnecessary complexity in the tax law by disallowing the use of the cash method; increase compliance costs and corresponding risk of manipulation; and cause substantial hardship to many lawyers, law firms and other personal service businesses by requiring them to pay tax on income they have not yet received and may never receive. Therefore, we urge you and your Committee to remove this provision from the overall draft legislation.

Under current law, businesses are permitted to use the simple, straightforward cash method of accounting — in which income is not recognized until cash or other payment is actually received and expenses are not taken into account until they are actually paid — if they are individuals or pass-through entities (e.g., partnerships or subchapter S corporations), or their average annual gross receipts for a three year period are $5 million or less. In addition, all personal service businesses — including those engaged in the fields of law, accounting, engineering, architecture, health, actuarial science, performing arts, or consulting — whether organized as sole proprietorships, partnerships, limited liability companies, or S corporations, are exempt from the revenue cap and can use the cash method of accounting irrespective of their annual revenues, unless they have inventory.

Section 51 of the draft legislation would dramatically change current law by raising the gross receipts cap to $10 million while eliminating the existing exemption for personal service businesses, other sole proprietorships, partnerships and S corporations, and farmers. Therefore, if this proposal is enacted into law, all solo practitioner lawyers, law firms and other personal service businesses with annual gross receipts over $10 million would be required to use the accrual method of accounting, in which income is recognized when the right to receive the income is present and expenses are recorded when they are fixed, determinable and economically performed, both aspects of which present complications.

Although Section 51 would allow certain small business taxpayers with annual gross receipts in the $5 million to $10 million range to switch to — and thereby enjoy the benefits of — the cash method of accounting (a concept that the ABA does not oppose), the proposal would significantly complicate tax compliance for a far greater number of small business taxpayers, including many solo practitioner lawyers, law firms and other personal service businesses, by forcing them to use the accrual method.

Sole proprietors, partnerships, S corporations, personal service corporations and other pass-through entities favor the cash method because it is simple and generally correlates with the manner in which these business owners operate their businesses — i.e, on a cash basis. Simplicity is important from a compliance perspective because it enables taxpayers to better understand the tax consequences of transactions in which they engage or plan to engage. In this regard, simplicity helps to mitigate compliance costs — which already are significant — and to improve compliance with the Code. The increased complexity associated with the accrual method will raise compliance costs for many solo practitioner lawyers, law firms and other personal service businesses — as separate sets of records will be needed to reflect the accrual accounting — while greatly increasing the risk of noncompliance with the Code.

In addition to creating unnecessary complexity and compliance costs, Section 51 would lead to economic distortions that would adversely affect all personal service businesses that currently use the cash method of accounting and those who retain them, including many lawyers, law firms and their clients, in several ways.

First, the proposal would place a new financial burden on millions of personal service businesses throughout the country — including many solo practitioner lawyers and law firms — by requiring them to pay tax on income not yet received and which may never be received. As a result, the proposal would create significant economic distortions in terms of how many personal service businesses are organized and operate.

For example, most law firms are organized as partnerships owned by lawyers who have elected to join together in practice. In many firms, particularly larger firms, the partners change from year to year as older lawyers retire, younger lawyers are promoted, and other lawyers migrate to or from other firms. As an economic matter, firms that operate on the cash method are able to ensure that the partners who were present in the firm and performing legal services are taxed on the income actually received that year. However, if such firms were forced to switch to the accrual method, then partners will be taxed on income that their firms accrue on paper in the current year even though the partners may not be around when the clients pay their bills (if the bills are ever paid). For new partners and retiring partners alike, the economics will be changed dramatically.

The existing cash method of accounting produces a sound and fair result because it properly recognizes that the cash a business actually receives in return for the services it provides — not the business’ accounts receivable — is the proper reflection of its true income and its ability to pay taxes on that income. While accounts receivable clearly are important to determining the financial condition of a business and assessing its future prospects, they do not accurately reflect its current spendable income or its present ability to pay taxes on that income.

Second, for professional service providers that practice in regulated professions, such as lawyers, the proposal would impose greater financial hardships on their firms than may be felt by other types of small and medium sized businesses because many of these professionals are subject to special rules that significantly limit their ability to raise capital. For example, lawyers must comply with state court ethics rules that generally prohibit them from forming a law firm partnership with a nonlawyer or allowing a nonlawyer to own any interest in the law firm. As a result, many law firms must be capitalized solely by the individual lawyers who together own those firms and they are unable to raise equity capital from outside nonlawyer investors. Therefore, forcing these law firms to pay tax on income that has not yet been received and that may never be received could place a major strain on lawyers’ ability to properly capitalize and operate their firms.

Third, the proposal would discourage individual professional service providers from joining with other providers to create or expand a firm, even if it made economic sense and would benefit their clients, because it could trigger the accrual accounting requirement in the bill. For example, solo practitioner lawyers would be discouraged from entering into law firm partnerships — and many existing law firms would be discouraged from growing or expanding — because once a firm exceeds $10 million in annual gross receipts, it would be required to switch from cash to accrual accounting, thereby accelerating its tax payments. Sound tax policy should encourage — not discourage — the growth of small businesses, including those providing personal services such as law firms, especially in today’s difficult economic environment.

In sum, the mandatory accrual accounting provisions in Section 51 of the staff discussion draft bill would create unnecessary complexity in the tax law, increased compliance costs, and significant new financial burdens and hardships for many solo practitioner lawyers, law firms and other personal service businesses throughout the country by requiring them to pay tax on income not yet received and that may never be received. To avoid these harmful unintended consequences, the ABA urges you and the Committee to remove Section 51 from the discussion draft bill or from any tax reform bill that may be approved by the Committee.

Thank you for considering the ABA’s views on this important issue. If you have any questions regarding our position, please contact ABA Governmental Affairs Director Thomas Susman at (202) 662-1765 or Associate Governmental Affairs Director Larson Frisby at (202) 662-1098.

Sincerely,

James R. Silkenat

President, American Bar Association

Chicago, IL

cc:

Members of the Senate Finance Committee




Federal Tax Proposals Would Cut Jobs, Growth and Infrastructure in States.

WASHINGTON—The National Governors Association (NGA) and The Council of State Governments (CSG) today released a study that found repealing federal tax provisions that most affect state and local budgets “would bring a net loss of approximately 417,000 jobs and $71 billion in real GDP” over the next 10 years.

The study, Macroeconomic Analysis of Federal Tax Proposals Affecting State and Local Budgets, analyzed two scenarios: one would place a 28 percent cap on the value of both state and local tax deductions and the earned interest exclusion for municipal bonds; the other would repeal both entirely. Although the magnitude of the effects of these scenarios varies significantly, the overall result is similar— higher tax burdens decrease consumption and savings rates, while lower levels of infrastructure spending decrease construction activity and the economic spillover associated with it.

“The study’s analysis of the potential effects on jobs, growth and investments in infrastructure shows how proposals to repeal or limit these tax provisions that benefit state and local investments run a real risk, if enacted, of creating unintended consequences,” said NGA Executive Director Dan Crippen.

Because both the cap and repeal scenarios would increase the interest rates that state and local governments pay on the municipal bonds they use to finance their investments in infrastructure, borrowing costs would increase by as much as $33 billion over the next decade, thereby decreasing investments in infrastructure.

Even more staggering, the study, prepared by Moody’s Analytics, found that “the tax consequences of the two proposals prove much more damaging to economic growth.” For example, “the tax proposals in the capped and repeal scenarios result in a 10 year tax increase of $187 billion and $1.1 trillion, respectively.”  In addition, the construction and manufacturing industries would see a significant decrease in demand under a full repeal scenario, resulting in 125,000 less jobs by 2023, according to the study.

“Limiting the tax deductibility of state and local taxes and changing the tax treatment of municipal bonds is a surefire strategy for killing jobs, curtailing growth and adding cost to infrastructure projects. The numbers don’t lie. These changes would be disastrous,” said CSG Executive Director David Adkins.

As part of the cap scenario, the study includes the administration’s proposal to offset some of the increased borrowing costs by providing limited direct subsidies to state and local borrowers through a new taxable America Fast Forward Bond (AFFB) program. The study, however, emphasizes the cap scenario is “filled with a number of unquantifiable factors, which would likely result in higher economic cost.”

It also warns that “arbitrarily reducing the value of the municipal bond market” could set a dangerous precedent, possibly causing permanent uncertainty about interest rates, opening “a door that cannot be closed” and raising borrowing costs for states and local governments “in perpetuity.” Additionally, recent subsidy payment reductions because of sequestration in the Build America Bond program, the proposed AFFB’s forerunner, will likely make AFFB less beneficial to issuers than the estimates included in this analysis.

The study complements recent studies of the National Association of Counties (NACO) and the Urban-Brookings Tax Policy Center in that it projects the 10-year macroeconomic effects of capping or repealing tax provisions that assist states and local governments. The NACO study, in particular, estimated that a 28 percent cap or full repeal of the interest exemption on municipal bonds would have cost states and local governments $173.4 billion and nearly $500 billion respectively, over the past 10 years.

The full report is available at:

http://www.nga.org/files/live/sites/NGA/files/pdf/2013/1311MoodysReport.pdf




IRS Releases Publication on General Rule for Pensions and Annuities.

The IRS has released Publication 939 (rev. Dec. 2013), General Rule for Pensions and Annuities, explaining how to determine the tax treatment of periodic payments received under a pension or annuity plan using the general rule.

http://www.irs.gov/pub/irs-pdf/p939.pdf




Treasury Comments on Coming Guidance on Treatment of Volunteer Emergency Responders Under ACA.

Final regulations on the Affordable Care Act employer shared responsibility provisions generally won’t require volunteer hours of volunteer firefighters and emergency personnel to be counted when determining full-time employees or equivalents, Treasury Assistant Secretary for Tax Policy Mark Mazur said in a January 10 blog post.

—————————————————–

Treasury Ensures Fair Treatment for Volunteer Firefighters and Emergency Responders Under the Affordable Care Act

By: Mark J. Mazur, Assistant Secretary for Tax Policy

1/10/2014

The Affordable Care Act requires that an employer with 50 or more full-time employees offer affordable and adequate health care coverage to its employees. For this purpose, full time means 30 hours or more per week on average, with the hours of employees working less than that aggregated into full-time equivalents. Employers that do not fulfill this obligation may be required to make a payment in lieu of meeting their responsibilities, which are described in what are called the employer shared responsibility provisions. An important question arises about how the hours of volunteer firefighters and other volunteer emergency responders should be taken into account in determining whether they are full-time employees and for counting toward the 50-employee threshold. Treasury is acting to ensure that emergency volunteer service is accorded appropriate treatment under the Affordable Care Act.

Treasury and the IRS issued proposed regulations on the employer shared responsibility provisions (Section 4980H of the Tax Code) in December 2012 and invited public comments. Numerous comments were received from individuals and local fire and Emergency Medical Service departments that rely on volunteers. The comments generally suggested that the employer responsibility rules should not count volunteer hours of nominally compensated volunteer firefighters and emergency medical personnel in determining full-time employees (or full-time equivalents). In addition, Treasury heard from numerous members of Congress who expressed these same concerns on behalf of the volunteer emergency responders in their states and districts.

Treasury and the IRS carefully reviewed these comments and spoke with representatives of volunteer firefighters and volunteer emergency personnel to gain a better understanding of their specific situations. Treasury and the IRS also reviewed various rules that apply to such volunteer personnel under other laws. These include the statutory provisions that apply to bona fide volunteers under Section 457(e)(11) of the Tax Code (relating to deferred compensation plans of state and local governments and tax-exempt organizations) and rules governing the treatment of volunteers for purposes of the Federal wage and hour laws. As a result of that review and analysis, the forthcoming final regulations relating to employer shared responsibility generally will not require volunteer hours of bona fide volunteer firefighters and volunteer emergency medical personnel at governmental or tax-exempt organizations to be counted when determining full-time employees (or full-time equivalents).

These final regulations, which we expect to issue shortly, are intended to provide timely guidance for the volunteer emergency responder community. We think this guidance strikes the appropriate balance in the treatment provided to traditional full-time emergency responder employees, bona fide volunteers, and to our Nation’s first responder units, many of which rely heavily on volunteers.

Mark J. Mazur is the Assistant Secretary for Tax Policy at the United States Department of the Treasury.




IRS Issues Proposed Regs for Determining Basis in Interests in Tax-Exempt Trusts.

The IRS has issued proposed regulations that provide rules for determining a taxable beneficiary’s basis in a term interest in a charitable remainder trust upon a sale or other disposition of all interests in the trust to the extent that basis consists of a share of adjusted uniform basis. (REG-154890-03)

http://www.ofr.gov/(X(1)S(2zp4glzpco5drgatg4rwdiyp))/OFRUpload/OFRData/2014-00807_PI.pdf




Year in Review: No Tax Reform . . . Yet.

Although top congressional taxwriters hoped that 2013 would be the year for tax reform, neither the Senate Finance nor House Ways and Means committees marked up tax reform legislation by the end of the year, and the outlook for reform in 2014 remains murky.

Would 2013 be the year for tax reform?

House Ways and Means Committee Chair Dave Camp, R-Mich., and Senate Finance Committee Chair Max Baucus, D-Mont., seemed to think so, as both vowed to mark up tax reform legislation in their committees by the end of the year. But by the fall of 2013, the prospects for tax reform weakened, thanks in part to a government shutdown that torpedoed two weeks of the congressional calendar.

As the calendar turns to 2014, the tax reform outlook couldn’t be foggier after the late-year announcement that President Obama has chosen Baucus to become the next U.S. ambassador to China. Even if Baucus is not immediately confirmed to the ambassadorship, both he and Camp face a ticking clock if they hope to leave tax reform as their legacy: Camp because his Ways and Means chairmanship expires at the end of the year, and Baucus because he had already announced his plan to retire from the Senate when his term expires at the end of the 113th Congress.

A Question of Revenue

With a divided Congress that has lately become better known for partisanship than for legislating, tax reform was always going to be a heavy lift in 2013. And one of the biggest partisan divides during the year was whether a tax code overhaul should raise revenue or be revenue neutral.

As the budget season started in early 2013, questions reemerged over whether Democrats and Republicans could find common ground on revenue increases. In his annual State of the Union address in February, Obama called on Congress to work on a tax reform package that would raise revenue. His budget , released in April, largely recycled tax proposals from previous budgets while calling for $1 trillion in new revenue, along with $100 billion from previously proposed corporate tax reforms.

The Democrat-controlled Senate passed a fiscal 2014 budget resolution later in the year that proposed raising $923 billion in new revenue through the reconciliation process, a budget procedure that shields legislation from procedural hurdles such as filibusters. Baucus, who was critical of using reconciliation for tax reform, voted against the budget, putting him at odds with his fellow Senate Democrats.

Meanwhile, Republicans in both chambers pushed for revenue-neutral tax reform, and the House-passed Republican budget included a revenue-neutral framework for tax reform and $4.6 trillion in spending cuts.

As Camp and Baucus continued their tax reform efforts throughout the year, Camp made no secret that his tax reform plan would be revenue neutral. But there was some question of whether Baucus’s plan would raise revenue, especially after Senate Finance Committee ranking minority member Orrin G. Hatch, R-Utah, told reporters in July that Baucus had agreed to keep his bill revenue neutral. Baucus later said he had made no such agreement, and a Hatch spokesperson said that “there was a misunderstanding between the two.”

Senate Majority Leader Harry Reid, D-Nev., later told reporters that Baucus should set a revenue target before the committee moved a tax reform bill and that the Senate-passed budget resolution was “a place to start.”

Bipartisan Efforts

Despite the revenue differences between the two parties, Camp and Baucus over the summer mounted a public campaign to gain momentum for their legislative tax reform effort. The two launched a website (http://www.taxreform.gov) and a Twitter account (@simplertaxes) asking the public for feedback on tax reform. They also hosted a series of bipartisan, bicameral luncheons on tax reform at Kelly’s Irish Times, a Washington bar that former Finance Committee Chair Bob Packwood frequented during his work on the Tax Reform Act of 1986. And as part of their Simpler Taxes for America tour, Camp and Baucus visited businesses in the Twin Cities area, the Philadelphia area, California, and Tennessee to promote their tax reform work.

The bipartisan effort continued on the individual committees as well. In February Camp and Ways and Means ranking minority member Sander M. Levin, D-Mich., announced the creation of 11 bipartisan working groups tasked with taking a closer look at various tax reform topics. The groups, each headed by a Republican and Democratic Ways and Means member, were not asked to propose specific policy changes. Instead, they served as a vehicle to help educate committee members and build relationships across the aisle.

In May the working groups made presentations to the full committee, and the Joint Committee on Taxation released a report (JCS-3-13 ) summarizing the groups’ findings. The working groups’ efforts bore some fruit in September, when the heads of the education working group, Reps. Diane Black, R-Tenn., and Danny Davis, D-Ill., introduced a bill to consolidate and simplify higher education tax credits. Camp publicly backed the measure, the Student and Family Tax Simplification Act (H.R. 3393 ).

In the Senate, Baucus and Hatch held a series of weekly meetings with Finance Committee members at which they released 10 tax reform option papers on topics including simplification, corporate investment, and small businesses. The papers, which did not take a position on revenue or endorse specific policies, instead provided an overview of the issues surrounding a particular topic and outlined policy suggestions from bills in both chambers, from testimony given at Finance hearings, and from other sources.

Baucus and Hatch also attempted to open up the tax reform process to non-taxwriters, sending a letter  in June to their Senate colleagues asking them to take part in what they characterized as a “blank slate” approach to tax reform that would assume the repeal of all tax expenditures. As part of the exercise, senators were to argue for whichever provisions they wanted to see returned to the code, justifying a particular tax break’s existence. To encourage participation and soothe senators’ fears of leaks, Baucus and Hatch promised that all submissions would be sealed until 2064. According to a Baucus spokesperson, more than 60 senators participated in the effort. A survey of offices by Tax Analysts found that only 25 of those participants made their letters public and that of those letters, most outlined only general principles for tax reform.

Markups Called Off

As Congress headed into its August recess, it seemed Baucus and Camp were readying their committees for fall markups. It was rumored that Camp, who briefly considered earlier in the year running for an open Senate seat, could be ready to move his bill in October.

The government shutdown that month, however, helped delay action on tax reform, as lawmakers devoted many of their working days to negotiating a solution to reopen the government. While some floated the idea of including tax reform instructions in legislation to resolve the impasse, the final bill had little impact on tax policy. It set up a budget conference that produced an agreement setting discretionary spending levels for two years, but that agreement did not include tax changes.

Baucus acknowledged in October that his committee would not mark up a tax reform bill and instead would release a set of tax reform discussion drafts. Similarly, Camp began to hint in November that time was running out to release a bill before finally acknowledging in December that his tax reform package was on hold.

Although neither Baucus nor Camp released full-fledged tax reform legislation in 2013, they both helped continue the tax policy conversation by releasing discussion drafts on several tax topics.

Camp, who had already released a discussion draft on international taxation in 2011, released two more in early 2013: one on the taxation of financial products  and one on the taxation of passthroughs and small businesses .

Baucus’s drafts, released in November and December, covered international taxation , tax administration , cost recovery and tax accounting , and energy taxation . Before his ambassadorship nomination was announced, Baucus said he wanted to release more discussion drafts in 2014.

Better Luck in 2014?

While the discussion drafts that Baucus and Camp have released could help lay the groundwork for tax reform in 2014, Baucus’s impending departure from the Senate raises the question whether all his work in 2013 was for naught. Sen. Ron Wyden, D-Ore., who is expected to take over the committee after Baucus’s confirmation as ambassador to China, could choose to pick up where Baucus left off on tax reform or begin reform efforts anew.

Wyden, who has introduced several comprehensive tax reform bills, offered little insight into his plans for the committee. “My views on this are pretty well known,” he told reporters December 19. “I think it’s pretty well understood that I think the tax code is a dysfunctional mess.”

In 2011 Wyden introduced the Bipartisan Tax Fairness and Simplification Act of 2011 (S. 727 ) with Sen. Daniel Coats, R-Ind. The measure would have cut the corporate rate to 24 percent, repealed several individual and corporate tax incentives along with the alternative minimum tax, and streamlined the individual income tax into three brackets at 15 percent, 25 percent, and 35 percent. The proposal did not include a territorial system for international taxation, but it would have eliminated controlled foreign corporations’ active income deferral and provided a repatriation tax holiday.

In the House, Budget Committee Chair and Ways and Means member Paul Ryan, R-Wis., predicted that the House taxwriting panel will take up tax reform again in early 2014. “Watch the Ways and Means Committee in the first quarter of next year,” he said on NBC’s Meet the Press December 15. “We’re going to be advancing tax reform legislation because we think that’s a key ingredient to getting people back to work, to increasing take-home pay, to grow this economy.”

Senate Budget Committee Chair Patty Murray, D-Wash., appearing on the same program, agreed that Congress should move on tax reform, but she again raised the revenue question. “I think where the divide comes is what you would do with any revenue that was generated from that,” she said. “But that doesn’t mean we couldn’t ever find a compromise with that. It would be an intense discussion.”

In his final press conference of 2013, Obama voiced his willingness to work on tax reform despite Baucus’s departure. “If Democrats and Republicans in the House and the Senate are serious about tax reform, then it’s not going to depend on one guy; it’s going to depend on all of us working together,” he said. “My office is ready, willing, and eager to engage both parties and [have] a conversation about how we can simplify the tax code, make it fairer, [and] make it work to create more jobs and do right by middle-class Americans.”

by Meg Shreve




Tax Credits Considered Critical to White House-Proposed 'Promise Zones.'

A set of tax provisions proposed by President Obama to encourage business investment in communities struggling economically is critical for job creation in those areas, Housing and Urban Development Secretary Shaun Donovan said January 9.

A set of tax provisions proposed by President Obama to encourage business investment in communities struggling economically is critical for job creation in those areas, Housing and Urban Development Secretary Shaun Donovan said January 9.

Earlier in the day, the White House announced  the designation of its first set of “promise zones” in five areas: southeastern Kentucky, Los Angeles, Philadelphia, San Antonio, and the Choctaw Nation of Oklahoma. Those zones are part of a program proposed in Obama’s fiscal 2014 budget plan to encourage economic growth in economically disadvantaged communities.

According to the Treasury Department’s green book explanation of the fiscal 2014 budget’s revenue proposals , the administration proposed two tax incentives for promise zones. The first is an employment credit for businesses employing promise zone residents, applicable to the first $15,000 of an eligible employee’s wages. The credit rate would be 20 percent for residents also working within the zone and 10 percent for residents working outside the zone. Under the second proposal, qualified property placed in service within the zone would be eligible for additional first-year depreciation of 100 percent of the adjusted basis of the property.

Under the administration’s proposal, a total of four sets of five promise zones are planned, with each set going into effect in 2015, 2016, 2017, and 2018. The zones and the available tax incentives would be in effect for 10 years.

“Yes, these promise zones will work without the tax credits. No, they won’t work to full capacity,” Donovan said in a conference call with reporters after Obama delivered a speech at the White House on the zones.

Although Congress has not considered the administration’s promise zone proposal, Senate Minority Leader Mitch McConnell, R-Ky., and Sen. Rand Paul, R-Ky., who both attended Obama’s speech, recently introduced the Economic Freedom Zones Act of 2013 (S. 1852 ), which also ties tax incentives to designated areas in need of economic growth.

McConnell on January 9 called on Senate Majority Leader Harry Reid, D-Nev., to allow a vote on an amendment incorporating his bill as part of the chamber’s consideration of an emergency unemployment compensation extension bill.

by Meg Shreve




IRS Updates Guidelines for Issuing Determination Letters, Rulings on Exempt Organizations.

The IRS has issued guidance (Rev. Proc. 2014-9, 2014-2 IRB 281) providing the procedures for issuing determination letters and rulings on the exempt status of organizations under sections 501 and 521.

The procedures also apply to the revocation or modification of determination letters or rulings. The revenue procedure, which is effective January 6, 2014, also provides guidance on the exhaustion of administrative remedies for purposes of declaratory judgment under section 7428. Rev. Proc. 2013-9 is superseded.

26 CFR 601.201: Rulings and determination letters.

TABLE OF CONTENTS

SECTION 1. WHAT IS THE PURPOSE OF THIS REVENUE PROCEDURE?

.01 Description of terms used in this revenue procedure

.02 Updated annually

SECTION 2. NATURE OF CHANGES AND RELATED REVENUE PROCEDURES

.01 Rev. Proc. 2013-9 is superseded

.02 Related revenue procedures

.03 What changes have been made to Rev. Proc. 2013-9?

SECTION 3. WHAT ARE THE PROCEDURES FOR REQUESTING RECOGNITION OF

EXEMPT STATUS?

.01 In general

.02 User fee

.03 Form 1023 application

.04 Form 1024 application

.05 Letter application

.06 Form 1028 application

.07 Form 8871 notice for political organizations

.08 Requirements for a substantially completed application

.09 Terrorist organizations not eligible to apply for

recognition of exemption

SECTION 4. WHAT ARE THE STANDARDS FOR ISSUING A DETERMINATION

LETTER OR RULING ON EXEMPT STATUS?

.01 Exempt status must be established in application and

supporting documents

.02 Determination letter or ruling based solely on

administrative record

.03 Exempt status may be recognized in advance of actual

operations

.04 No letter if exempt status issue in litigation or under

consideration within the Service

.05 Incomplete application

.06 Even if application is complete, additional information may

be required

.07 Expedited handling

.08 May decline to issue group exemption

SECTION 5. WHAT OFFICES ISSUE AN EXEMPT STATUS DETERMINATION

LETTER OR RULING?

.01 EO Determinations issues a determination letter in most cases

.02 Certain applications referred to EO Technical

.03 Technical advice may be requested in certain cases

.04 Technical advice must be requested in certain cases

SECTION 6. WITHDRAWAL OF AN APPLICATION

.01 Application may be withdrawn prior to issuance of a

determination letter or ruling

.02 § 7428 implications of withdrawal of application under

§ 501(c)(3)

SECTION 7. WHAT ARE THE PROCEDURES WHEN EXEMPT STATUS IS

DENIED?

.01 Proposed adverse determination letter or ruling

.02 Appeal of a proposed adverse determination letter issued by

EO Determinations

.03 Protest of a proposed adverse ruling issued by EO Technical

.04 Final adverse determination letter or ruling where no appeal

or protest is submitted

.05 How EO Determinations handles an appeal of a proposed

adverse determination letter

.06 Consideration by the Appeals Office

.07 If a protest of a proposed adverse ruling is submitted to EO

Technical

.08 An appeal or protest may be withdrawn

.09 Appeal or protest and conference rights not applicable in

certain situations

SECTION 8. DISCLOSURE OF APPLICATIONS AND DETERMINATION LETTERS

AND RULINGS

.01 Disclosure of applications, supporting documents, and

favorable determination letters and rulings

.02 Disclosure of adverse determination letters or rulings

.03 Disclosure to State officials when the Service refuses to

recognize exemption under § 501(c)(3)

.04 Disclosure to State officials of information about §

501(c)(3) applicants

SECTION 9. REVIEW OF DETERMINATION LETTERS BY EO TECHNICAL

.01 Determination letters may be reviewed by EO Technical to

assure uniformity

.02 Procedures for cases where EO Technical takes exception to a

determination letter

SECTION 10. DECLARATORY JUDGMENT PROVISIONS OF § 7428

.01 Actual controversy involving certain issues

.02 Exhaustion of administrative remedies

.03 Not earlier than 270 days after seeking determination

.04 Service must have reasonable time to act on an appeal or

protest

.05 Final determination to which § 7428 applies

SECTION 11. EFFECT OF DETERMINATION LETTER OR RULING RECOGNIZING

EXEMPTION

.01 Effective date of exemption

.02 Reliance on determination letter or ruling

SECTION 12. REVOCATION OR MODIFICATION OF DETERMINATION LETTER OR

RULING RECOGNIZING EXEMPTION

.01 Revocation or modification of a determination letter or

ruling may be retroactive

.02 Appeal and conference procedures in the case of revocation

or modification of exempt status letter

SECTION 13. EFFECT ON OTHER REVENUE PROCEDURES

SECTION 14. EFFECTIVE DATE

SECTION 15. PAPERWORK REDUCTION ACT

DRAFTING INFORMATION

SECTION 1. WHAT IS THE PURPOSE OF THIS REVENUE PROCEDURE?

This revenue procedure sets forth procedures for issuing determination letters and rulings on the exempt status of organizations under §§ 501 and 521 of the Internal Revenue Code other than those subject to Rev. Proc. 2014-6, last bulletin (relating to pension, profit-sharing, stock bonus, annuity, and employee stock ownership plans). Generally, the Service issues these determination letters and rulings in response to applications for recognition of exemption from Federal income tax. These procedures also apply to revocation or modification of determination letters or rulings. This revenue procedure also provides guidance on the exhaustion of administrative remedies for purposes of declaratory judgment under § 7428.

Description of terms used in this revenue procedure

.01 For purposes of this revenue procedure —

(1) The term “Service” means the Internal Revenue Service.

(2) The term “application” means the appropriate form or letter that an organization must file or submit to the Service for recognition of exemption from Federal income tax under the applicable section of the Internal Revenue Code. See section 3 for information on specific forms.

(3) The term “EO Determinations” means the office of the Service that is primarily responsible for processing initial applications for tax-exempt status. It includes the main EO Determinations office located in Cincinnati, Ohio, and other field offices that are under the direction and control of the Manager, EO Determinations. Applications are generally processed in the centralized EO Determinations office in Cincinnati, Ohio. However, some applications may be processed in other EO Determinations offices or referred to EO Technical.

(4) The term “EO Technical” means the office of the Service that is primarily responsible for issuing letter rulings to taxpayers on exempt organization matters, and for providing technical advice or technical assistance to other offices of the Service on exempt organization matters. The EO Technical office is located in Washington, DC. For purposes of this Revenue Procedure the term “EO Technical” includes EO Guidance. (EO Guidance is the office of the Service that is responsible for working with the Department of the Treasury and the Office of Chief Counsel to issue formal guidance items, and also reviews letter rulings, technical advice, and technical assistance, among other things.)

(5) The term “Appeals Office” means any office under the direction and control of the Chief, Appeals. The purpose of the Appeals Office is to resolve tax controversies, without litigation, on a fair and impartial basis. The Appeals Office is independent of EO Determinations and EO Technical.

(6) The term “determination letter” means a written statement issued by EO Determinations or an Appeals Office in response to an application for recognition of exemption from Federal income tax under §§ 501 and 521. This includes a written statement issued by EO Determinations or an Appeals Office on the basis of advice secured from EO Technical pursuant to the procedures prescribed herein and in Rev. Proc. 2014-5.

(7) The term “ruling” means a written statement issued by EO Technical in response to an application for recognition of exemption from Federal income tax under §§ 501 and 521.

(8) The term “Code” means the Internal Revenue Code.

Updated annually

.02 This revenue procedure is updated annually, but may be modified or amplified during the year.

SECTION 2. NATURE OF CHANGES AND RELATED REVENUE PROCEDURES

Rev. Proc. 2013-9 is superseded

.01 This revenue procedure is a general update of Rev. Proc. 2013-9, 2013-2 I.R.B. 255, which is hereby superseded.

Related revenue procedures

.02 This revenue procedure supplements Rev. Proc. 2014-10, this Bulletin, with respect to the effects of § 7428 on the classification of organizations under §§ 509(a) and 4942(j)(3). Rev. Proc. 80-27, 1980-1 C.B. 677, sets forth procedures under which exemption may be recognized on a group basis for subordinate organizations affiliated with and under the general supervision and control of a central organization. Rev. Proc. 72-5, 1972-1 C.B. 709, provides information for religious and apostolic organizations seeking recognition of exemption under § 501(d). General procedures for requests for a determination letter or ruling are provided in Rev. Proc. 2014-4. User fees for requests for a determination letter or ruling are set forth in Rev. Proc. 2014-8. Information regarding procedures for organizations described in § 501(c)(29) can be found in Rev. Proc. 2012-11, 2012-7 I.R.B. 368.

What changes have been made to Rev. Proc. 2013-9?

.03 Notable changes to Rev. Proc. 2013-9 that appear in this year’s update include —

(1) Dates, cross references, and names have been changed to reflect the appropriate annual Revenue Procedures.

SECTION 3. WHAT ARE THE PROCEDURES FOR REQUESTING RECOGNITION OF EXEMPT STATUS?

In general

.01 An organization seeking recognition of exempt status under § 501 or § 521 is required to submit the appropriate application. In the case of a numbered application form, the current version of the form must be submitted. A central organization that has previously received recognition of its own exemption can request a group exemption letter by submitting a letter application along with Form 8718, User Fee for Exempt Organization Determination Letter Request. See Rev. Proc. 80-27. Form 8718 is not a determination letter application. Attach this form to the determination letter application.

User fee

.02 An application must be submitted with the correct user fee, as set forth in Rev. Proc. 2014-8.

Form 1023 application

.03 An organization seeking recognition of exemption under § 501(c)(3) and § 501(e), (f), (k), (n), (q), or (r) must submit a completed Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. In the case of an organization that provides credit counseling services, see § 501(q). In the case of an organization that is a hospital and is seeking exemption under § 501(c)(3), see § 501(r).

Form 1024 application

.04 An organization seeking recognition of exemption under § 501(c)(2), (4), (5), (6), (7), (8), (9), (10), (12), (13), (15), (17), (19), or (25) must submit a completed Form 1024, Application for Recognition of Exemption Under Section 501(a), along with Form 8718. In the case of an organization that provides credit counseling services and seeks recognition of exemption under § 501(c)(4), see § 501(q).

Letter application

.05 An organization seeking recognition of exemption under § 501(c)(11), (14), (16), (18), (21), (22), (23), (26), (27), (28), or (29), or under § 501(d), must submit a letter application along with Form 8718.

Form 1028 application

.06 An organization seeking recognition of exemption under § 521 must submit a completed Form 1028, Application for Recognition of Exemption Under Section 521 of the Internal Revenue Code, along with Form 8718.

Form 8871 notice for political organizations

.07 A political party, a campaign committee for a candidate for federal, state or local office, and a political action committee are all political organizations subject to tax under § 527. To be tax-exempt, a political organization may be required to notify the Service that it is to be treated as a § 527 organization by electronically filing Form 8871, Political Organization Notice of Section 527 Status. For details, go to the IRS website at www.irs.gov/polorgs.

Requirements for a substantially completed application

.08 A substantially completed application, including a letter application, is one that:

(1) is signed by an authorized individual;

(2) includes an Employer Identification Number (EIN);

(3) for organizations other than those described in § 501(c)(3), includes a statement of receipts and expenditures and a balance sheet for the current year and the three preceding years (or the years the organization was in existence, if less than four years), and if the organization has not yet commenced operations or has not completed one accounting period, a proposed budget for two full accounting periods and a current statement of assets and liabilities; for organizations described in § 501(c)(3), see Form 1023 and Notice 1382;

(4) includes a detailed narrative statement of proposed activities, including each of the fundraising activities of a § 501(c)(3) organization, and a narrative description of anticipated receipts and contemplated expenditures;

(5) includes a copy of the organizing or enabling document that is signed by a principal officer or is accompanied by a written declaration signed by an authorized individual certifying that the document is a complete and accurate copy of the original or otherwise meets the requirements of a “conformed copy” as outlined in Rev. Proc. 68-14, 1968-1 C.B. 768;

(6) if the organizing or enabling document is in the form of articles of incorporation, includes evidence that it was filed with and approved by an appropriate state official (e.g., stamped “Filed” and dated by the Secretary of State); alternatively, a copy of the articles of incorporation may be submitted if accompanied by a written declaration signed by an authorized individual that the copy is a complete and accurate copy of the original copy that was filed with and approved by the state; if a copy is submitted, the written declaration must include the date the articles were filed with the state;

(7) if the organization has adopted by-laws or similar governing rules, includes a current copy; the by-laws need not be signed if submitted as an attachment to the application for recognition of exemption; otherwise, the by-laws must be verified as current by an authorized individual; and

(8) is accompanied by the correct user fee and Form 8718, when applicable.

Terrorist organizations not eligible to apply for recognition of exemption

.09 An organization that is identified or designated as a terrorist organization within the meaning of § 501(p)(2) is not eligible to apply for recognition of exemption.

SECTION 4. WHAT ARE THE STANDARDS FOR ISSUING A DETERMINATION LETTER OR RULING ON EXEMPT STATUS?

Exempt status must be established in application and supporting documents

.01 A favorable determination letter or ruling will be issued to an organization only if its application and supporting documents establish that it meets the particular requirements of the section under which exemption from Federal income tax is claimed.

Determination letter or ruling based solely on administrative record

.02 A determination letter or ruling on exempt status is issued based solely upon the facts and representations contained in the administrative record.

(1) The applicant is responsible for the accuracy of any factual representations contained in the application.

(2) Any oral representation of additional facts or modification of facts as represented or alleged in the application must be reduced to writing over the signature of an officer or director of the taxpayer under a penalties of perjury statement.

(3) The failure to disclose a material fact or misrepresentation of a material fact on the application may adversely affect the reliance that would otherwise be obtained through issuance by the Service of a favorable determination letter or ruling.

Exempt status may be recognized in advance of actual operations

.03 Exempt status may be recognized in advance of the organization’s operations if the proposed activities are described in sufficient detail to permit a conclusion that the organization will clearly meet the particular requirements for exemption pursuant to the section of the Code under which exemption is claimed.

(1) A mere restatement of exempt purposes or a statement that proposed activities will be in furtherance of such purposes will not satisfy this requirement.

(2) The organization must fully describe all of the activities in which it expects to engage, including the standards, criteria, procedures, or other means adopted or planned for carrying out the activities, the anticipated sources of receipts, and the nature of contemplated expenditures.

(3) Where the organization cannot demonstrate to the satisfaction of the Service that it qualifies for exemption pursuant to the section of the Code under which exemption is claimed, the Service will generally issue a proposed adverse determination letter or ruling. See also section 7 of this revenue procedure.

No letter if exempt status issue in litigation or under consideration within the Service

.04 A determination letter or ruling on exempt status ordinarily will not be issued if an issue involving the organization’s exempt status under § 501 or § 521 is pending in litigation, is under consideration within the Service, or if issuance of a determination letter or ruling is not in the interest of sound tax administration. If the Service declines to issue a determination or ruling to an organization seeking exempt status under § 501(c)(3), the organization may be able to pursue a declaratory judgment under § 7428, provided that it has exhausted its administrative remedies.

Incomplete application

.05 If an application does not contain all of the items set out in section 3.08 of this revenue procedure, the Service may return it to the applicant for completion.

(1) In lieu of returning an incomplete application, the Service may retain the application and request additional information needed for a substantially completed application.

(2) In the case of an application under § 501(c)(3) that is returned incomplete, the 270-day period referred to in § 7428(b)(2) will not be considered as starting until the date a substantially completed Form 1023 is refiled with or remailed to the Service. If the application is mailed to the Service and a postmark is not evident, the 270-day period will start to run on the date the Service actually receives the substantially completed Form 1023. The same rules apply for purposes of the notice requirement of § 508.

(3) Generally, the user fee will not be refunded if an incomplete application is filed. See Rev. Proc. 2014-8, section 10.

Even if application is complete, additional information may be required

.06 Even though an application is substantially complete, the Service may request additional information before issuing a determination letter or ruling.

(1) If the application involves an issue where contrary authorities exist, an applicant’s failure to disclose and distinguish contrary authorities may result in requests for additional information, which could delay final action on the application.

(2) In the case of an application under § 501(c)(3), the period of time beginning on the date the Service requests additional information until the date the information is submitted to the Service will not be counted for purposes of the 270-day period referred to in § 7428(b)(2).

Expedited handling

.07 Applications are normally processed in the order of receipt by the Service. However, expedited handling of an application may be approved where a request is made in writing and contains a compelling reason for processing the application ahead of others. Upon approval of a request for expedited handling, an application will be considered out of its normal order. This does not mean the application will be immediately approved or denied. Circumstances generally warranting expedited processing include:

(1) a grant to the applicant is pending and the failure to secure the grant may have an adverse impact on the organization’s ability to continue to operate;

(2) the purpose of the newly created organization is to provide disaster relief to victims of emergencies such as flood and hurricane; and

(3) there have been undue delays in issuing a determination letter or ruling caused by a Service error.

May decline to issue group exemption

.08 The Service may decline to issue a group exemption letter when appropriate in the interest of sound tax administration.

SECTION 5. WHAT OFFICES ISSUE AN EXEMPT STATUS DETERMINATION LETTER OR RULING?

EO Determinations issues a determination letter in most cases

.01 Under the general procedures outlined in Rev. Proc. 2014-4, EO Determinations is authorized to issue determination letters on applications for exempt status under §§ 501 and 521.

Certain applications referred to EO Technical

.02 EO Determinations will refer to EO Technical those applications that present issues which are not specifically covered by statute or regulations, or by a ruling, opinion, or court decision published in the Internal Revenue Bulletin. In addition, EO Determinations will refer those applications that have been specifically reserved by revenue procedure or by other official Service instructions for handling by EO Technical for purposes of establishing uniformity or centralized control of designated categories of cases. EO Technical will notify the applicant organization upon receipt of a referred application, and will consider each such application and issue a ruling directly to the organization.

Technical advice may be requested in certain cases

.03 If at any time during the course of consideration of an exemption application by EO Determinations the organization believes that its case involves an issue on which there is no published precedent, or there has been non-uniformity in the Service’s handling of similar cases, the organization may request that EO Determinations either refer the application to EO Technical or seek technical advice from EO Technical. See Rev. Proc. 2014-5, sections 4.04 and 4.05.

Technical advice must be requested in certain cases

.04 If EO Determinations proposes to recognize the exemption of an organization to which EO Technical had issued a previous contrary ruling or technical advice, EO Determinations must seek technical advice from EO Technical before issuing a determination letter. This does not apply where EO Technical issued an adverse ruling and the organization subsequently made changes to its purposes, activities, or operations to remove the basis for which exempt status was denied.

SECTION 6. WITHDRAWAL OF AN APPLICATION

Application may be withdrawn prior to issuance of a determination letter or ruling

.01 An application may only be withdrawn upon the written request of an authorized individual prior to the issuance of a determination letter or ruling. The issuance of a determination letter or ruling includes the issuance of a proposed adverse determination letter or ruling.

(1) When an application is withdrawn, the Service will retain the application and all supporting documents. The Service may consider the information submitted in connection with the withdrawn request in a subsequent examination of the organization.

(2) Generally, the user fee will not be refunded if an application is withdrawn. See Rev. Proc. 2014-8, section 10.

§ 7428 implications of withdrawal of application under § 501(c)(3)

.02 The Service will not consider the withdrawal of an application under § 501(c)(3) as either a failure to make a determination within the meaning of § 7428(a)(2) or as an exhaustion of administrative remedies within the meaning of § 7428(b)(2).

SECTION 7. WHAT ARE THE PROCEDURES WHEN EXEMPT STATUS IS DENIED?

Proposed adverse determination letter or ruling

.01 If EO Determinations or EO Technical reaches the conclusion that the organization does not satisfy the requirements for exempt status pursuant to the section of the Code under which exemption is claimed, the Service generally will issue a proposed adverse determination letter or ruling, which will:

(1) include a detailed discussion of the Service’s rationale for the denial of tax-exempt status; and

(2) advise the organization of its opportunity to appeal or protest the decision and request a conference.

Appeal of a proposed adverse determination letter issued by EO Determinations

.02 A proposed adverse determination letter issued by EO Determinations will advise the organization of its opportunity to appeal the determination by requesting Appeals Office consideration. To do this, the organization must submit a statement of the facts, law and arguments in support of its position within 30 days from the date of the adverse determination letter. The organization must also state whether it wishes an Appeals Office conference. Any determination letter issued on the basis of technical advice from EO Technical may not be appealed to the Appeals Office on issues that were the subject of the technical advice.

Protest of a proposed adverse ruling issued by EO Technical

.03 A proposed adverse ruling issued by EO Technical will advise the organization of its opportunity to file a protest statement within 30 days and to request a conference. If a conference is requested, the conference procedures outlined in Rev. Proc. 2014-4, section 12, are applicable.

Final adverse determination letter or ruling where no appeal or protest is submitted

.04 If an organization does not submit a timely appeal of a proposed adverse determination letter issued by EO Determinations, or a timely protest of a proposed adverse ruling issued by EO Technical, a final adverse determination letter or ruling will be issued to the organization. The final adverse letter or ruling will provide information about the filing of tax returns and the disclosure of the proposed and final adverse letters or rulings.

How EO Determinations handles an appeal of a proposed adverse determination letter

.05 If an organization submits a protest of the proposed adverse determination letter, EO Determinations will first review the protest, and, if it determines that the organization qualifies for tax-exempt status, issue a favorable exempt status determination letter. If EO Determinations maintains its adverse position after reviewing the protest, it will forward the protest and the exemption application case file to the Appeals Office.

Consideration by the Appeals Office

.06 The Appeals Office will consider the organization’s appeal. If the Appeals Office agrees with the proposed adverse determination, it will either issue a final adverse determination or, if a conference was requested, contact the organization to schedule a conference. At the end of the conference process, which may involve the submission of additional information, the Appeals Office will either issue a final adverse determination letter or a favorable determination letter. If the Appeals Office believes that an exemption or private foundation status issue is not covered by published precedent or that there is non-uniformity, the Appeals Office must request technical advice from EO Technical in accordance with Rev. Proc. 2014-5, sections 4.04 and 4.05.

If a protest of a proposed adverse ruling is submitted to EO Technical

.07 If an organization submits a protest of a proposed adverse exempt status ruling, EO Technical will review the protest statement. If the protest convinces EO Technical that the organization qualifies for tax-exempt status, a favorable ruling will be issued. If EO Technical maintains its adverse position after reviewing the protest, it will either issue a final adverse ruling or, if a conference was requested, contact the organization to schedule a conference. At the end of the conference process, which may involve the submission of additional information, EO Technical will either issue a final adverse ruling or a favorable exempt status ruling.

An appeal or protest may be withdrawn

.08 An organization may withdraw its appeal or protest before the Service issues a final adverse determination letter or ruling. Upon receipt of the withdrawal request, the Service will complete the processing of the case in the same manner as if no appeal or protest was received.

Appeal or protest and conference rights not applicable in certain situations

.09 The opportunity to appeal or protest a proposed adverse determination letter or ruling and the conference rights described above are not applicable to matters where delay would be prejudicial to the interests of the Service (such as in cases involving fraud, jeopardy, the imminence of the expiration of the statute of limitations, or where immediate action is necessary to protect the interests of the Government).

SECTION 8. DISCLOSURE OF APPLICATIONS AND DETERMINATION LETTERS AND RULINGS

Sections 6104 and 6110 provide rules for the disclosure of applications, including supporting documents, and determination letters and rulings.

Disclosure of applications, supporting documents, and favorable determination letters or rulings

.01 The applications, any supporting documents, and the favorable determination letter or ruling issued, are available for public inspection under § 6104(a)(1). However, there are certain limited disclosure exceptions for a trade secret, patent, process, style of work, or apparatus, if the Service determines that the disclosure of the information would adversely affect the organization.

(1) The Service is required to make the applications, supporting documents, and favorable determination letters or rulings available upon request. The public can request this information by submitting Form 4506-A, Request for Public Inspection or Copy of Exempt or Political Organization IRS Form. Organizations should ensure that applications and supporting documents do not include unnecessary personal identifying information (such as bank account numbers or social security numbers) that could result in identity theft or other adverse consequences if publicly disclosed.

(2) The exempt organization is required to make its exemption application, supporting documents, and determination letter or ruling available for public inspection without charge. For more information about the exempt organization’s disclosure obligations, see Publication 557, Tax-Exempt Status for Your Organization.

Disclosure of adverse determination letters or rulings

.02 The Service is required to make adverse determination letters and rulings available for public inspection under § 6110. Upon issuance of the final adverse determination letter or ruling to an organization, both the proposed adverse determination letter or ruling and the final adverse determination letter or ruling will be released pursuant to § 6110.

(1) These documents are made available to the public after the deletion of names, addresses, and any other information that might identify the taxpayer. See § 6110(c) for other specific disclosure exemptions.

(2) The final adverse determination letter or ruling will enclose Notice 437, Notice of Intention to Disclose, and redacted copies of the final and proposed adverse determination letters or rulings. Notice 437 provides instructions if the organization disagrees with the deletions proposed by the Service.

Disclosure to State officials when the Service refuses to recognize exemption under § 501(c)(3)

.03 The Service may notify the appropriate State officials of a refusal to recognize an organization as tax-exempt under § 501(c)(3). See § 6104(c). The notice to the State officials may include a copy of a proposed or final adverse determination letter or ruling the Service issued to the organization. In addition, upon request by the appropriate State official, the Service may make available for inspection and copying the exemption application and other information relating to the Service’s determination on exempt status.

Disclosure to State officials of information about § 501(c)(3) applicants

.04 The Service may disclose to State officials the name, address, and identification number of any organization that has applied for recognition of exemption under § 501(c)(3).

SECTION 9. REVIEW OF DETERMINATION LETTERS BY EO TECHNICAL

Determination letters may be reviewed by EO Technical to assure uniformity

.01 Determination letters issued by EO Determinations may be reviewed by EO Technical, or the Office of the Associate Chief Counsel (Passthroughs and Special Industries) (for cases under § 521), to assure uniform application of the statutes or regulations, or rulings, court opinions, or decisions published in the Internal Revenue Bulletin.

Procedures for cases where EO Technical takes exception to a determination letter

.02 If EO Technical takes exception to a determination letter issued by EO Determinations, the manager of EO Determinations will be advised. If EO Determinations notifies the organization of the exception taken, and the organization disagrees with the exception, the file will be returned to EO Technical. The referral to EO Technical will be treated as a request for technical advice, and the procedures in sections 14, 15, and 16 of Rev. Proc. 2014-5 will be followed.

SECTION 10. DECLARATORY JUDGMENT PROVISIONS OF § 7428

Actual controversy involving certain issues

.01 Generally, a declaratory judgment proceeding under § 7428 can be filed in the United States Tax Court, the United States Court of Federal Claims, or the district court of the United States for the District of Columbia with respect to an actual controversy involving a determination by the Service or a failure of the Service to make a determination with respect to the initial or continuing qualification or classification of an organization under § 501(c)(3) (charitable, educational, etc.); § 170(c)(2) (deductibility of contributions); § 509(a) (private foundation status); § 4942(j)(3) (operating foundation status); or § 521 (farmers cooperatives).

Exhaustion of administrative remedies

.02 Before filing a declaratory judgment action, an organization must exhaust its administrative remedies by taking, in a timely manner, all reasonable steps to secure a determination from the Service. These include:

(1) the filing of a substantially completed application Form 1023 under § 501(c)(3) pursuant to section 3.08 of this revenue procedure, or the request for a determination of foundation status pursuant to Rev. Proc. 2014-10, this Bulletin, or its successor;

(2) in appropriate cases, requesting relief pursuant to Treas. Reg. § 301.9100-1 of the Procedure and Administration Regulations regarding the extension of time for making an election or application for relief from tax;

(3) the timely submission of all additional information requested by the Service to perfect an exemption application or request for determination of private foundation status; and

(4) exhaustion of all administrative appeals available within the Service pursuant to section 7 of this revenue procedure.

Not earlier than 270 days after seeking determination

.03 An organization will in no event be deemed to have exhausted its administrative remedies prior to the earlier of:

(1) the completion of the steps in section 10.02, and the sending by the Service by certified or registered mail of a final determination letter or ruling; or

(2) the expiration of the 270-day period described in § 7428(b)(2) in a case where the Service has not issued a final determination letter or ruling, and the organization has taken, in a timely manner, all reasonable steps to secure a determination letter or ruling.

Service must have reasonable time to act on an appeal or protest

.04 The steps described in section 10.02 will not be considered completed until the Service has had a reasonable time to act upon an appeal or protest, as the case may be.

Final determination to which § 7428 applies

.05 A final determination to which § 7428 applies is a determination letter or ruling, sent by certified or registered mail, which holds that the organization is not described in § 501(c)(3) or § 170(c)(2), is a public charity described in a part of § 509 or § 170(b)(1)(A) other than the part under which the organization requested classification, is not a private foundation as defined in § 4942(j)(3), or is a private foundation and not a public charity described in a part of § 509 or § 170(b)(1)(A).

SECTION 11. EFFECT OF DETERMINATION LETTER OR RULING RECOGNIZING EXEMPTION

Effective date of exemption

.01 A determination letter or ruling recognizing exemption of an organization described in § 501(c), other than § 501(c)(29), is usually effective as of the date of formation of an organization if: (1) its purposes and activities prior to the date of the determination letter or ruling have been consistent with the requirements for exemption; (2) it has not failed to file required Form 990 series returns or notices for three consecutive years; and (3) it has filed an application for recognition of exemption within 27 months from the end of the month in which it was organized. Special rules may apply to an organization applying for exemption under § 501(c)(3), (9) or (17). See §§ 505 and 508, and Treas. Reg. §§ 1.508-1(a)(2), 1.508-1(b)(7) and 301.9100-2(a)(2)(iii) and (iv). In addition, special rules apply with respect to organizations described in § 501(c)(29). See Rev. Proc. 2012-11, 2012-7 IRB 368.

(1) If the Service requires the organization to alter its activities or make substantive amendments to its enabling instrument, the exemption will be effective as of the date specified in a determination letter or ruling.

(2) If the Service requires the organization to make a nonsubstantive amendment, exemption will ordinarily be recognized as of the date of formation. Examples of nonsubstantive amendments include correction of a clerical error in the enabling instrument or the addition of a dissolution clause where the activities of the organization prior to the determination letter or ruling are consistent with the requirements for exemption.

(3) An organization that otherwise meets the requirements for tax-exempt status and the issuance of a determination letter or ruling that does not meet the requirements for recognition from date of formation will generally be recognized from the postmark date of its application.

(4) Organizations that claim exempt status under § 501(c) generally must file annual Form,990 series returns or notices, even if they have not yet received their determination letter or ruling recognizing exemption. If an organization fails to file required Form 990 series returns or notices for three consecutive years, its exemption will be automatically revoked by operation of § 6033(j). Such an organization may apply for reinstatement of its exempt status, and such recognition may be granted retroactively, only in accordance with the procedure described in Notice 2011-44, 2011-25 IRB 883.

Reliance on determination letter or ruling

.02 A determination letter or ruling recognizing exemption may not be relied upon if there is a material change, inconsistent with exemption, in the character, the purpose, or the method of operation of the organization, or a change in the applicable law. Also, a determination letter or ruling may not be relied upon if it was based on any inaccurate material factual representations. See section 12.01.

SECTION 12. REVOCATION OR MODIFICATION OF DETERMINATION LETTER OR RULING RECOGNIZING EXEMPTION

A determination letter or ruling recognizing exemption may be revoked or modified: (1) by a notice to the taxpayer to whom the determination letter or ruling was issued; (2) by enactment of legislation or ratification of a tax treaty; (3) by a decision of the Supreme Court of the United States; (4) by the issuance of temporary or final regulations; (5) by the issuance of a revenue ruling, revenue procedure, or other statement published in the Internal Revenue Bulletin; or (6) automatically, pursuant to § 6033(j), for failure to file a required annual return or notice for three consecutive years.

Revocation or modification of a determination letter or ruling may be retroactive

.01 The revocation or modification of a determination letter or ruling recognizing exemption may be retroactive if there has been a change in the applicable law, the organization omitted or misstated a material fact, operated in a manner materially different from that originally represented, or, in the case of organizations to which § 503 applies, engaged in a prohibited transaction with the purpose of diverting corpus or income of the organization from its exempt purpose and such transaction involved a substantial part of the corpus or income of such organization. In certain cases an organization may seek relief from retroactive revocation or modification of a determination letter or ruling under § 7805(b). Requests for § 7805(b) relief are subject to the procedures set forth in Rev. Proc. 2014-4.

(1) Where there is a material change, inconsistent with exemption, in the character, the purpose, or the method of operation of an organization, revocation or modification will ordinarily take effect as of the date of such material change.

(2) In the case where a determination letter or ruling is issued in error or is no longer in accord with the Service’s position and § 7805(b) relief is granted (see sections 13 and 14 of Rev. Proc. 2014-4), ordinarily, the revocation or modification will be effective not earlier than the date when the Service modifies or revokes the original determination letter or ruling.

Appeal and conference procedures in the case of revocation or modification of exempt status letter

.02 In the case of a revocation or modification of a determination letter or ruling, the appeal and conference procedures are generally the same as set out in section 7 of this revenue procedure, including the right of the organization to request that EO Determinations or the Appeals Office seek technical advice from EO Technical. However, appeal and conference rights are not applicable to matters where delay would be prejudicial to the interests of the Service (such as in cases involving fraud, jeopardy, the imminence of the expiration of the statute of limitations, or where immediate action is necessary to protect the interests of the Government). Organizations revoked under § 6033(j) will not have an opportunity for Appeal consideration.

(1) If the case involves an exempt status issue on which EO Technical had issued a previous contrary ruling or technical advice, EO Determinations generally must seek technical advice from EO Technical.

(2) EO Determinations does not have to seek technical advice if the prior ruling or technical advice has been revoked by subsequent contrary published precedent or if the proposed revocation involves a subordinate unit of an organization that holds a group exemption letter issued by EO Technical, the EO Technical ruling or technical advice was issued under the Internal Revenue Code of 1939 or prior revenue acts.

SECTION 13. EFFECT ON OTHER REVENUE PROCEDURES

Rev. Proc. 2013-9 is superseded.

SECTION 14. EFFECTIVE DATE

This revenue procedure is effective January 6, 2014.

SECTION 15. PAPERWORK REDUCTION ACT

The collection of information for a letter application under section 3.05 of this revenue procedure has been reviewed and approved by the Office of Management and Budget (OMB) in accordance with the Paperwork Reduction Act (44 U.S.C. § 3507) under control number 1545-2080. All other collections of information under this revenue procedure have been approved under separate OMB control numbers.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid OMB control number.

The collection of this information is required if an organization wants to be recognized as tax-exempt by the Service. We need the information to determine whether the organization meets the legal requirements for tax-exempt status. In addition, this information will be used to help the Service delete certain information from the text of an adverse determination letter or ruling before it is made available for public inspection, as required by § 6110.

The time needed to complete and file a letter application will vary depending on individual circumstances. The estimated average time is 10 hours.

Books and records relating to the collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. The rules governing the confidentiality of letter applications are covered in § 6104.

DRAFTING INFORMATION

The principal author of this revenue procedure is Mr. Jonathan Carter of the Exempt Organizations, Tax Exempt and Government Entities Division. For further information regarding this revenue procedure, please contact the TE/GE Customer Service office at (877) 829-5500 (a toll-free call), or send an e-mail to [email protected] and include “Question about Rev. Proc. 2014-9” in the subject line.




IRS Updates Guidelines for Issuing Rulings and Determination Letters Affecting Some Foundations.

The IRS has updated (Rev. Proc. 2014-10, 2014-2 IRB 293) procedures for issuing rulings and determination letters on private foundation status under section 509(a), operating foundation status under section 4942(j)(3), and exempt operating foundation status under section 4940(d)(2), of organizations exempt from federal income tax under section 501(c)(3).

The updated procedures also apply to the issuance of determination letters on the foundation status under section 509(a)(3) of nonexempt charitable trusts. Rev. Proc. 2013-10 is superseded.

SECTION 1. PURPOSE AND SCOPE

The purpose of this revenue procedure is to set forth updated procedures of the Internal Revenue Service (the “Service”) with respect to issuing rulings and determination letters on private foundation status under § 509(a) of the Internal Revenue Code, operating foundation status under § 4942(j)(3), and exempt operating foundation status under § 4940(d)(2), of organizations exempt from Federal income tax under § 501(c)(3). This revenue procedure also applies to the issuance of determination letters on the foundation status under § 509(a)(3) of nonexempt charitable trusts described in § 4947(a)(1).

SECTION 2. WHAT CHANGES HAVE BEEN MADE TO REV. PROC. 2013-10?

.01 This revenue procedure is a general update of Rev. Proc. 2013-10, 2013-2 I.R.B. 267.

.02 Dates and cross references have been changed to reflect the appropriate annual Revenue Procedures.

SECTION 3. BACKGROUND

.01 All § 501(c)(3) organizations are classified as private foundations under § 509(a) unless they qualify as a public charity under § 509(a)(1) (which cross-references § 170(b)(1)(A)(i)-(vi)), (2), (3), or (4). See Treas. Reg. §§ 1.170A-9, 1.509(a)-1 through 1.509(a)-7. The Service determines an organization’s private foundation or public charity status when the organization files its Form 1023. This status will be included in the organization’s determination letter.

.02 In its Form 990, Return of Organization Exempt From Income Tax Under section 501(c), 527, or 4947(a)(1) of the Internal Revenue Code (except black lung benefit trust or private foundation), a public charity indicates the paragraph of § 509(a), and subparagraph of § 170(b)(1)(A), if applicable, under which it qualifies as a public charity. Because of changes in its activities or operations, this may differ from the public charity status listed in its original determination letter. Although an organization is not required to obtain a determination letter to qualify for the new public charity status, in order for Service records to recognize any change in public charity status, an organization must obtain a new determination of foundation status pursuant to this revenue procedure.

.03 If a public charity no longer qualifies as a public charity under § 509(a)(1)-(4), then it becomes a private foundation, and as such, it must file Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation. It is not necessary for the organization to obtain a determination letter on its new private foundation status (although it is permitted to do so pursuant to this revenue procedure). The organization indicates this change in foundation status by filing its Form 990-PF return and following any procedures specified in the form, instructions, or other published guidance. Thereafter, the organization may terminate its private foundation status, such as by giving notice and qualifying as a public charity again under § 509(a)(1)-(3) during a 60-month termination period in accordance with the procedures under § 507(b)(1)(B) and Treas. Reg. § 1.507-2(b).

.04 This revenue procedure applies to organizations that may have erroneously determined that the organization was a private foundation and wish to correct the error. For example, an organization may have erroneously classified an item or items in its calculation of public support, causing the organization to classify itself as a private foundation and to file Forms 990-PF. Pursuant to this revenue procedure, the organization can request to be classified as a public charity by showing that it continuously met the public support tests during the relevant periods. See section 7 below

.05 A private foundation may qualify as an operating foundation under § 4942(j)(3) without a determination letter from the Service, but the Service will not recognize such status in its records without a determination letter from the Service. An organization claiming to be an exempt operating foundation under § 4940(d)(2) must obtain a determination letter from the Service recognizing such status to be exempt from the § 4940 tax on net investment income.

SECTION 4. DETERMINATIONS OF FOUNDATION STATUS

.01 EO Determinations will issue determination letters on foundation status, including whether an organization is:

(1) a private foundation;

(2) a public charity described in §§ 509(a)(1) and 170(b)(1)(A) (other than clauses (v), (vii), and (viii));

(3) a public charity described in § 509(a)(2) or (4);

(4) a public charity described in § 509(a)(3), whether such organization is described in § 509(a)(3)(B)(i), (ii), or (iii) (“supporting organization type”), and whether or not a Type III supporting organization is functionally integrated;

(5) a private operating foundation described in § 4942(j)(3); or

(6) an exempt operating foundation described in § 4940(d)(2).

.02 EO Determinations will also issue determination letters on whether a nonexempt charitable trust described in § 4947(a)(1) is described in § 509(a)(3).

.03 EO Determinations will issue such determinations in response to applications for recognition of exempt status under § 501(c)(3), submitted by organizations pursuant to § 508(b). EO Determinations will also issue such determinations in response to separate requests for determination of foundation status submitted on Form 8940, Request for Miscellaneous Determination, pursuant to this revenue procedure or its successor revenue procedures.

SECTION 5. APPLICABILITY OF ANNUAL REVENUE PROCEDURES

.01 Rev. Proc. 2014-9 (updated annually) provides procedures of the Service in processing applications for recognition of exemption from Federal income tax under § 501(c)(3). Rev. Proc. 2014-4 (updated annually) governs requests for rulings and determination letters. Rev. Proc. 2014-8 (updated annually) prescribes user fees for applications, rulings, and other determinations. Except as specifically noted herein, those revenue procedures and their annual successors also apply to requests for determinations of foundation status.

.02 The provisions of Rev. Proc. 2014-9 and any successor revenue procedure regarding § 7428, protest, conference, and appeal rights also apply to all determinations of foundation status described in section 4.01 (except section 4.01(6) relating to exempt operating foundation status) and section 4.02, whether or not the request for determination is made in connection with an application for recognition of tax-exempt status.

.03 Where the issue of exemption under § 501(c)(3) is referred to EO Technical for decision under the procedures of Rev. Proc. 2014-9, the foundation status issue will be referred along with it.

SECTION 6. GENERALLY NO NEW DETERMINATION LETTER IF SAME STATUS IS SOUGHT

The Service generally will not issue a new determination letter to a taxpayer that seeks a determination of private foundation status that is identical to its current foundation status as determined by the Service. For example, an organization that is already recognized as described in §§ 509(a)(1) and 170(b)(1)(A)(ii) as a school generally will not receive a new determination letter that it is still described in §§ 509(a)(1) and 170(b)(1)(A)(ii) under the currently extant facts. However, the organization in such case could request a letter ruling, pursuant to Rev. Proc. 2014-4, that a given change of facts and circumstances will not adversely affect its status under §§ 509(a)(1) and 170(b)(1)(A)(ii).

SECTION 7. FORMAT OF REQUEST

.01 Organizations that are seeking to change their foundation status, including requests from public charities for private foundation status and requests from public charities to change from one public charity classification to another public charity classification, or seeking a determination or a change as to supporting organization type or functionally integrated status, or seeking operating foundation or exempt operating foundation status, or subordinate organizations included in a group exemption letter seeking a change in public charity status, must submit Form 8940, Request Miscellaneous Determination Under Section 507, 509(a), 4940, 4942, 4945, and 6033 of the Internal Revenue Code, along with all information, documentation, and other materials required by Form 8940 and the instructions thereto, as well as the appropriate user fee pursuant to Rev. Proc. 2014-8 or its successor revenue procedures.

.02 For complete information about filing requirements and the submission process, refer to Form 8940 and the Instructions for Form 8940.

SECTION 8. REQUESTS BY NONEXEMPT CHARITABLE TRUSTS

.01 A nonexempt charitable trust described in § 4947(a)(1) seeking a determination that it is described in § 509(a)(3) should submit a written request for a determination pursuant to Rev. Proc. 2014-4 or its successor revenue procedure.

.02 The request for determination must include the following information items, from the date that the organization became described in § 4947(a)(1) (but not before October 9, 1969) to the present:

(1) A subject line or other indicator on the first page of the request in bold, underlined, or all capitals font indicating “NONEXEMPT CHARITABLE TRUST REQUEST FOR DETERMINATION THAT IT IS DESCRIBED IN § 509(a)(3)”;

(2) The name, address, and Employer Identification Number of the beneficiary organizations, together with a statement whether each such beneficiary organization is described in § 509(a)(1) or (2);

(3) A list of all of the trustees that have served, together with a statement stating whether such trustees were disqualified persons within the meaning of § 4946(a) (other than as foundation managers);

(4) A copy of the original trust instrument and all subsequently adopted amendments to that instrument;

(5) Sufficient information to otherwise establish that the trust has met the requirements of § 509(a)(3) as provided for in Treas. Reg. § 1.509(a)-4 (other than § 1.509(a)-4(i)(4)); If the trust did not qualify under § 509(a)(3) in one or more prior years (after October 9, 1969) in which it was described in § 4947(a)(1), then it cannot be issued a § 509(a)(3) determination letter except in accordance with the procedures for termination of private foundation status under § 507(b)(1)(B); and

(6) Such other information as is required for a determination under Rev. Proc. 2014-4 or any successor revenue procedure.

SECTION 9. DETERMINATIONS OPEN TO PUBLIC INSPECTION

Determinations and rulings as to foundation status are open to public inspection pursuant to § 6104(a).

Section 10. Not Applicable to Private Foundation Terminations Under § 507 or Changes of Status Pursuant to Examination

These procedures do not apply to a private foundation seeking to terminate its status under § 507. These procedures also do not apply to the examination of an organization which results in changes to its foundation status.

SECTION 11. EFFECT ON OTHER REVENUE PROCEDURES

Rev. Proc. 2013-10 is superseded.

SECTION 12. EFFECTIVE DATE

This revenue procedure is effective January 6, 2014.

SECTION 13. PAPERWORK REDUCTION ACT

The collections of information contained in this revenue procedure have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. § 3507) under control number 1545-1520.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid OMB control number.

The collections of information in this revenue procedure are in sections 7.02 and 8.02. This information is required to evaluate and process the request for a letter ruling or determination letter. The collections of information are required to obtain a letter ruling or determination letter. The likely respondents are tax-exempt organizations.

DRAFTING INFORMATION

The principal author of this revenue procedure is Mr. Dave Rifkin of the Exempt Organizations, Tax Exempt and Government Entities Division. For further information about this revenue procedure, contact Customer Account Services at 877-829-5500. Dave Rifkin can be reached by e-mail at [email protected]. Please include “Question about Rev. Proc. 2014-10” in the subject line.

26 CFR 601.201: Rulings and determination letters. (Also: Part I, sections 25, 103, 143, 1.25-4T, 1.103-1, 6A.103A-2)




Taxpayer Advocate Calls on IRS to Stop Erroneous Revocations.

The IRS needs to take steps to stop the erroneous revocation of some organizations’ tax-exempt status for failure to file required information returns, the Taxpayer Advocate Service said in a report released January 9.

In her annual report  to Congress, National Taxpayer Advocate Nina Olson addressed a Pension Protection Act provision that mandates the automatic revocation of exemption of any organization that does not file information returns or e-Postcards for three straight years. She said that since the policy took effect in 2010, about 9,000 of the roughly 550,000 automatic revocations have been made in error. Organizations that automatically lose their exempt status because of IRS mistakes may suffer by losing grants and donations, she said.

Olson said the errors were partly due to the IRS systems failing to recognize subordinate organizations as part of a group return when the subordinates and parent had different accounting periods. Another reason is a programming change that caused IRS computers to calculate the three-year nonfiling period as beginning when an organization received its employer identification number, not when it received its IRS determination letter.

“By computing the three-year nonfiling period with reference to the EIN date,” the IRS exempt organizations function “is perpetuating erroneous revocations,” Olson said.

Olson also faulted the IRS for including in the nonfiling period the periods in which filers of e-Postcards, which are submitted by smaller organizations, were waiting for their exemption applications to be processed. She said this is unfair because the code requires filing of the postcard but it cannot be done without IRS input.

“It is impossible to submit an e-Postcard in that period without assistance from the IRS,” Olson said.

Olson made several recommendations. She said that when the IRS is about to treat an organization’s exemption as automatically revoked, it should inform the organization and give it 30 days to correct the problem. The IRS also should clearly communicate the availability of administrative review “for organizations raising concerns [that] the IRS is proceeding in error,” she said.

Also, when notifying organizations that they have failed to file, the IRS should explain that it calculates the nonfiling period by using the EIN and that they can contact the agency if that method could lead to erroneous revocation, according to Olson. The nonfiling period should not include the time during which an organization could not submit an e-Postcard without contacting the IRS, she said.

When asked to comment, the IRS did not address the erroneous revocations section of the report specifically. But it said it would review closely the report’s overall contents and recommendations. It added that it is making progress on a number of issues addressed in the report, adding that it must balance limited resources to meet its dual mission of providing taxpayer service and enforcing the tax laws.

Eve Rose Borenstein of the Borenstein and McVeigh Law Office LLC told Tax Analysts the TAS report “hits the nail on the head” in describing the problems with the IRS’s approach, in particular the agency’s “filing clock” administrative assumptions, such as the EIN reliance. “That assumption has exposed many organizations to erroneous revocation and attendant ‘reinstatement’ procedures, which typically surface once an organization files an initial exemption application,” she said. She agreed there needs to be a mechanism for administrative review.

The problem of erroneous revocations is not new. In May 2012 Lois Lerner, then director of exempt organizations in the IRS Tax-Exempt and Government Entities Division, said the IRS was more than willing to look at an organization that may have had its exemption revoked by mistake. Such organizations should approach the IRS, she said, adding that the agency had made corrections after the organizations had explained why the revocations were unwarranted.

by Fred Stokeld




EO Update: e-news for Charities & Nonprofits January 3, 2014.

1.  New options for automatically revoked organizations to apply for reinstatement

Organizations that have had their tax-exempt status automatically revoked for not filing required 990 series returns may apply for reinstatement. Revenue Procedure 2014-11 provides four options for applying for reinstatement and explains how the new procedures apply to pending and recently approved applications.

http://www.irs.gov/pub/irs-drop/rp-14-11.pdf

Revenue Procedure 2014-11 modifies and supersedes the procedures described in Notice 2011-44.

http://www.irs.gov/irb/2011-25_IRB/ar10.html

Also see: Automatic Revocation – How to have your tax-exempt status retroactively reinstated

http://www.irs.gov/portal/site/irspup/menuitem.143f806b5568dcd501db6ba54251a0a0/?vgnextoid=e18ce2d3a7543410VgnVCM1000003b4d0a0aRCRD&vgnextchannel=7c8246d964264310VgnVCM1000004e0d010a____

2.  IRS issues proposed correction and disclosure procedures for failures to meet new requirements for charitable hospitals; invites public comments

Notice 2014-3 contains a proposed revenue procedure that provides correction and disclosure procedures under which certain failures to meet the requirements of § 501(r) of the Internal Revenue Code will be excused for purposes of § 501(r)(1) and 501(r)(2)(B). This notice invites comments regarding the procedures set forth in the proposed revenue procedure, including what additional examples, if any, would be helpful and whether hospitals should be required to make additional disclosures.

http://www.irs.gov/pub/irs-drop/n-14-03.pdf

3.  IRS confirms charitable hospitals may continue to rely on proposed regulations pending further guidance

Notice 2014-2 confirms that hospital organizations can rely on proposed regulations under section 501(r) of the Internal Revenue Code published on June 26, 2012, and April 5, 2013, pending the publication of final regulations or other applicable guidance.

http://www.irs.gov/pub/irs-drop/n-14-02.pdf

4.  Read current guidance on user fees for employee plans and exempt organizations

Review Revenue Procedure 2014-8 on page 242.

http://www.irs.gov/pub/irs-irbs/irb14-01.pdf




EO Update: e-News for Charities & Nonprofits January 10, 2014.

1.  Phone forum: Good governance makes sense for exempt organizations

Register now for this informative IRS presentation scheduled January 23, at 2 p.m. ET.

http://ems.intellor.com/index.cgi?p=204871&t=71&do=register&s=&rID=417&edID=305

Topics include:

2.  Review revenue procedures for 2014

Rev. Proc. 2014-4

This revenue procedure is a general update of Rev. Proc. 2013-4, 2013-1 I.R.B. 126, which contains the Service’s general procedures for Employee Plans and Exempt Organizations letter ruling requests.

http://www.irs.gov/irb/2014-1_IRB/ar08.html

Rev. Proc. 2014–5

This revenue procedure is a general update of Rev. Proc. 2013-5, 2013-1 I.R.B. 170, which contains the general procedures for technical advice requests for matters within the jurisdiction of the Commissioner, Tax Exempt and Government Entities Division.

http://www.irs.gov/irb/2014-1_IRB/ar09.html

Rev. Proc 2014-9

This document sets forth procedures for issuing determination letters and rulings on the exempt status of organizations under sections 501 and 521 of the Code. The procedures also apply to the revocation and modification of determination letters or rulings, and provide guidance on the exhaustion of administrative remedies for purposes of declaratory judgment under section 7428 of the Code. Rev. Proc. 2013-9 superseded.

http://www.irs.gov/irb/2014-2_IRB/ar17.html#d0e2710

Rev. Proc. 2014-10

This document sets forth procedures for issuing determination letters and rulings on private foundation status under section 509(a) of the Code, operating foundation status under section 4942(j)(3), and exempt operating foundation status under section 4940(d)(2), of organizations exempt from federal income tax under section 501(c)(3). It supersedes Rev. Proc. 2013-10.

http://www.irs.gov/irb/2014-2_IRB/ar18.html

3.  Interactive Form 1023 update

The IRS’s Exempt Organizations (EO) office has updated its alternate version of Form 1023, Application for Recognition of Exemption. The application, which incorporates changes suggested by the public, became available at the end of December and includes information about the current user fee.

View the application at:

http://www.stayexempt.irs.gov/StartingOut/InteractiveForm1023Application.aspx

The Interactive Form 1023 (i1023) features pop-up information boxes for most lines of the form. These boxes contain explanations and links to related information on IRS.gov and StayExempt.irs.gov, EO’s educational website. Once completed, applicants will print and mail the form and its attachments, just like the standard Form 1023.

Please send your comments about this form to [email protected].

Anticipated i1023 benefits:

The i1023 is based on recommendations by the IRS’s external Advisory Committee on Tax-Exempt and Government Entities (ACT).




Outlook 2014: Movement on Tax Reform Possible in 2014, But Little Chance of Enactment.

WASHINGTON — Municipal bond market participants, on guard against proposals to limit or eliminate the tax exemption, doubt 2014 will bring comprehensive tax reform.

Movement will be slowed not only by political gridlock, they say, but also by changes in leadership in the House and Senate tax-writing committees. President Obama intends to nominate Senate Finance Committee Chairman Max Baucus, D-Mont. to become ambassador to China. And House Ways and Means Committee chairman Dave Camp, R-Mich., in his last year of his term as chair in 2014, is unlikely to receive a waiver from term limits to continue to hold the job. Rep. Paul Ryan, R-Wis., chairman of the House Budget Committee, has already said he would like to take over leadership of the tax committee.

The timeline of Baucus’ confirmation to the ambassador post is unclear. Baucus had previously announced that he was not going to seek re-election in 2014, and the impending ambassadorship means he’ll likely leave the Senate before the end of the year.

Baucus released a few tax-reform discussion drafts in the past several weeks that focus on non-muni specific areas of the tax code. He may release a discussion draft about infrastructure tax reform in January, which could include bond-related provisions.

Whenever he leaves, most sources think Sen. Ron Wyden, D-Ore., is most likely to replace him as chairman of the Senate Finance Committee. It is unclear whether Wyden would take the same approach to tax reform as Baucus.

The likely early change in leadership may be a setback to tax reform in the Senate in the short run.

“It has the potential to slow the process,” said Michael Decker, Securities Industry and Financial Markets Association managing director and co-head of municipal securities.

Since Baucus has been a leading supporter of tax reform among Democrats, “his early departure does not bode well for a bipartisan effort next year,” said Matt Fabian, a managing director at Municipal Market Advisors.

But Chuck Samuels, an attorney at Mintz Levin, said he thinks that Wyden’s ascendency to the chairman position is “probably a boost for tax reform,” because Wyden is more aggressive than Baucus.

Micah Green, a partner at Patton Boggs and the former president and co-chief executive officer of SIFMA, thinks the change in Senate leadership could make it more difficult to move tax reform in 2014 but noted that “Ron Wyden happens to be a tax reformer.”

However, Wyden has scared the muni market by introducing bills that would change the exemption for interest on municipal bonds to a traditional tax credit.

Susan Collet, senior vice president of government relations for the Bond Dealers of America, said that “it will remain to be seen where as chairman he will come out on certain issues.”

Decker said Wyden has previously supported direct-pay bonds, and that it is unclear if Wyden is committed to tax-credit bonds or if what he really wants are more direct-pay bonds. Wyden is well aware of Republican opposition to direct-pay bonds and has indicated that he hasn’t tried to resurrect Build America Bonds because the legislation would not go anywhere.

Direct-pay bonds, while not a viable substitute for tax-exempt bonds, would be a good supplement to them, Decker said. But there is a consensus in the market that tax credit bonds are not really “a viable financing tool” because “there are a lot of inefficiencies associated with tax-credit financing,” he said.

Bill Daly, director of governmental affairs for the National Association of Bond Lawyers, said Wyden “clearly is interested in [tax reform] and it will clearly move forward,” although it is uncertain what form tax reform efforts will take and how far forward reform will move.

With Camp in his last year as Ways and Means Committee chairman in 2014, he is going to be interested in proceeding with tax-reform efforts and may even introduce a bill, Capitol Hill-watchers said. Ryan said on Meet the Press that Ways and Means Committee members are interested in advancing tax reform legislation in the first quarter of 2014.

But while market participants think they’ll be some movement on tax reform in 2014, the chances that reform will actually be enacted are slim.

Hurdles Ahead

Decker said there will be hurdles with moving bills through the House and Senate, reconciling versions of the bills and getting presidential approval. A big disagreement between the two chambers is whether tax reform should be revenue neutral or revenue raising.

The fact that 2014 is a midterm election year also makes enacting tax-reform legislation in the next 12 months more challenging, according to market participants.

“Politicians will talk endlessly about the need for tax reform, but actually approving it means assigning winners and losers while working together with sworn partisan enemies,” Fabian told The Bond Buyer. “That is not something easily done ahead of yet another contentious election cycle.”

Municipal bond market participants should continue to urge members of Congress to preserve the tax-exemption for munis, market participants agree.

Samuels said the budget agreement that maintains the sequester for direct-pay bonds through 2021 and extends it through 2023 should be “a rallying symbol for people to keep the advocacy up.”

Decker said it would be hard for Camp to achieve his objective of lowering the top rate to 25% while keeping tax reform revenue and distributionally neutral without cutting back on tax preferences, including the exemption for municipal bond interest.

“I think this just has to be a factor,” he said. “The math doesn’t work otherwise.”

Frank Shafroth, director of the Center for State and Local Government Leadership at George Mason University, said that two potential wild cards for tax reform in 2014 are the budget resolution for fiscal 2015, which may include instructions for tax reform, and the need for another debt ceiling increase, which may spur discussion of taxes. .

Most market participants think President Obama will continue to include a 28% cap on the value of the tax-exemption for munis in his fiscal 2015 budget, which is supposed to be released in February. They also expect the president to once again propose America Fast Forward bonds, direct-pay bonds that could be used to finance a range of projects, including those eligible for private-activity bond financing.

“The administration has expressed a strong commitment” to those proposals, Decker said.

Shafroth said Obama might include in his budget something different “that will raise greater complications and maybe more restrictions” than the 28% cap. The president has recently put an emphasis on addressing income inequality, and there’s been a perception that munis only benefit the wealthy, he said.

In addition to monitoring how any tax-reform proposals would affect munis, the National Governors Association is watching to see if there would be any change to the deduction of state and local taxes. “We’re watching both of those issues very closely,” NGA deputy director of policy David Quam said, noting that doing away with this deduction would essentially raise the cost of state and local taxes.

Collet said thinks that, separate from tax reform, there could be forthcoming bills or proposals about a new Build America Bond program that would be immune from sequestration.

Democrats generally want to do some kind of economic stimulus, and bonds tend to be in those types of proposals. However, it may be a challenge to figure out how to pay for stimulus programs, and there might need to be a significant bargain between Democrats and Republicans in order for a stimulus bill to pass, Collet said.

The Debt Ceiling

Congress will also have to address the debt ceiling again in 2014. Legislation passed in October suspended the debt ceiling through Feb. 7. The Treasury is once again expected to engage in extraordinary measures so that the U.S. can continue to pay its obligations in the short-term.

Treasury Secretary Jack Lew told Congress in Dec. 19 letter that by using extraordinary measures, the department could extend the nation’s borrowing authority until late February or early March.

Daly said that it’s a “reasonably good bet” that the window for state and local government series securities (SLGS) will close on or before Feb. 7. Issuers buy SLGS from the Treasury for their advance refunding escrows to avoid violating yield restriction requirements. The maturities of SLGS can be tailored to match the maturities of the refunding bonds so the investment does not exceed the bond yield.

Daly added that it unclear what Republicans in Congress will ask for in exchange for passing a debt limit increase.

Fabian said that the Republicans were “burned with the government shutdown,” so to the extent that the debt ceiling has to be addressed, “I think it will be less confrontational ahead of the midterms.”

Utah State Treasurer and incoming National Association of State Treasurers President Richard Ellis said that if a debt ceiling fight occurs around primary season or around the time of the general election, there could be problems for incumbents in Congress.

“I think midterm elections will be something interesting to watch,” he said. He suspects that there will be “not quite as much grandstanding” among members of Congress.

Marketplace Fairness Act

Another issue that experts will be paying attention to in 2014 is internet sales tax legislation.

In May, the Senate passed the Marketplace Fairness Act, which would allow states to compel out-of-state online retailers to collect sales taxes. In September, House Judiciary Committee Chairman Rep. Bob Goodlatte, R-Va., released principles on what he would like to see in online sales tax legislation.

“The House is primed to take that up,” Quam said.

A few weeks ago, the Supreme Court declined to hear challenges from Amazon and Overstock to New York’s internet sales tax law. By doing so, the court essentially said that the issue of taxing online purchases is up to Congress to handle, Shafroth said.

Shafroth also said that Goodlatte will feel pressure from voters in his district to move forward with legislation.

“The issue is, does the Congressman want to serve his constituents,” Shafroth said.

BY NAOMI JAGODA

DEC 27, 2013 11:56am ET




Tax Break’s Escape Might Lessen Pressure to Sell: Bloomberg Muni Credit.

For the $3.7 trillion municipal bond market, Washington’s political divide may be a good thing.

The coming year’s congressional elections weaken chances of a far-reaching tax-code overhaul that would roll back the break for buyers of state and local-government debt, said analysts including Morgan Stanley Wealth Management’s John Dillon and Matt Posner, who follows federal policy for Municipal Market Advisors. That may aid a market hit by losses this year as investors pulled out money amid speculation about rising interest rates and mounting distress in governments such as Puerto Rico’s.

“The likelihood of any changes to the treatment of the municipal bond tax exemption in 2014 are dim,” said Posner, whose firm is based in Concord, Massachusetts. “This Congress is unable to get much done at all.”

A change to the century-old tax break to state and local government debt would weaken the value of the securities, which sell for higher prices than other bonds because investors don’t have to pay federal taxes on the income. The subsidy also pushes down costs for states and cities, which borrow to pay for roads, schools and other public works.

Little Emerges

The possibility that the tax exemption could be eliminated or curtailed has persisted in Washington since 2010, when the leaders of President Barack Obama’s deficit-cutting commission proposed eliminating it as part of a broad package of changes. The following year, Obama sought to curb its value to the wealthiest taxpayers to raise revenue, a proposal that the administration has continued to endorse.

None of the proposals has advanced in Congress. The enmity between the Republican-led House and the Democrat-run Senate made 2013 its least productive first year of any session in three decades, based on the number of laws passed, according to GovTrack, which follows legislation.

Yet the risk that Congress could roll back the exemption unnerved investors. Posner, the bond analyst, said it’s one reason that the gap between short- and long-term interest rates in the tax-exempt market is wider than for bonds that don’t carry the tax break. That reflects the risk of holding debt that will mature years from now. He said it may also be one reason why investors have been pulling money from municipal bond mutual funds, which lost $26 billion from March through September, according to Federal Reserve data.

“Just the uncertainty has to make for some selling pressure,” Posner said.

Fresh Love

Spurred by such selling, muni performance is set to trail stocks, commodities, Treasuries and corporate bonds this year, according to data compiled by Bloomberg and Bank of America Merrill Lynch. Munis have declined 0.9 percent, after adjusting for the volatility in trading, the numbers show.

The diminished chance that Congress may succeed in rewriting the tax code may help municipal bonds. David Litvack, head of tax-exempt bond research at U.S. Trust, a New York-based unit of Bank of America Corp., said the advantages of municipal bonds may become more apparent as investors file their taxes for 2013, when the top tax bracket rose.

“We don’t see much incentive in an election year for politicians to compromise,” Litvack said. “Barring an unexpected sweep by the Democrats in the House of Representatives so that they would get a majority, we don’t see the same thing happening for the next two years as well.”

Danger Diminished

There are other obstacles. Senate Finance Committee Chairman Max Baucus, who has led efforts to change the tax code, is becoming ambassador to China. His counterpart in the House, Ways and Means Committee Chairman Dave Camp of Michigan must step down in 2014 because of Republicans’ six-year term limit for committee leaders. The budget agreement signed by Obama, which fixes spending targets through fiscal 2015, has also removed pressure to deal with spending.

John Dillon, head of muni strategy at Morgan Stanley Wealth Management in Purchase, New York, said the market’s dominant concern is the threat of rising interest rates, which would reduce the value of outstanding bonds. Still, he said, the diminished risk to the tax exemption should help demand.

“It don’t think the threat goes away, but it’s mitigated for 2014,” he said.

In trading yesterday, the interest rate on AAA 10-year local securities was 2.93 percent, little changed from Dec. 27, according to Bloomberg data. The ratio of the yield of munis to U.S. Treasuries of comparable maturity, a measure of relative value, was about 98.6 percent, near the lowest since June. It compares with a five-year average of 102 percent. The smaller the number, the more expensive munis are compared with federal securities.

To contact the reporter on this story: William Selway in Washington at [email protected]

To contact the editor responsible for this story: Stephen Merelman at [email protected]

By William Selway  Dec 30, 2013 9:01 PM PT




IRS: Proposed Revenue Procedure Addresses Requirements for Tax-Exempt Hospitals.

The IRS has issued a proposed revenue procedure (Notice 2014-3) that provides correction and disclosure procedures under which some failures by charitable hospital organizations to meet the requirements of section 501(r) will be excused.

Under section 501(r), a section 501(r)(2) hospital organization will not be treated as an exempt organization described in section 501(c)(3) unless it meets the requirements described in section 501(r)(3) through 501(r)(6). Proposed regs (REG-130266-11) published in June 2012 addressed the requirements of section 501(r)(4), (r)(5), and (r)(6). Proposed regs (REG-106499-12) published in April 2013 addressed the consequences for failing to meet any of the section 501(r) requirements.

To provide an incentive for hospital organizations to take steps not only to avoid failures but to remedy and disclose them when they occur, the 2013 proposed regs specify that a hospital organization’s failure to meet one or more of the requirements described in section 501(r) and proposed reg. section 1.501(r)-3 through 1.501(r)-6 that is neither willful nor egregious will be excused if the hospital organization corrects the failure and makes disclosure in accordance with the rules set forth in additional guidance to be issued by Treasury and the IRS.

If adopted, Notice 2014-3 will provide that guidance. A hospital organization will be able to rely on the revenue procedure to correct and disclose any failure to meet a requirement of section 501(r) that is not willful or egregious, provided that the hospital organization has begun correcting the failure in accordance with the terms of the guidance and that it has disclosed the failure before the hospital organization is first contacted by the IRS concerning an examination of the organization. If the annual return for the tax year in which the failure is discovered is not yet due (with extensions), the hospital organization need only to have begun correcting the failure in accordance with the revenue procedure before the hospital organization is first contacted by the IRS concerning an examination.

Under the proposed revenue procedure, a failure that is willful includes a failure due to gross negligence, reckless disregard, or willful neglect. A hospital organization’s correction and disclosure of a failure does not create a presumption that the failure was not willful or egregious. However, the fact that correction and disclosure in accordance with the revenue procedure were made will be considered a factor and may indicate that an error or omission may not have been willful or egregious.

http://www.irs.gov/pub/irs-drop/n-14-03.pdf




IRS: Tax-Exempt Hospitals May Rely on Proposed Regulations.

The IRS has issued a notice (Notice 2014-2) confirming that tax-exempt hospital organizations can rely on proposed regulations (REG-130266-11, REG-106499-12) under section 501(r) pending the publication of final regulations or other applicable guidance.

In June 2012 the IRS published proposed regs that provide guidance on the new section 501(r) requirements for charitable hospital organizations regarding financial assistance and emergency medical care policies, charges for specified care provided to individuals eligible for financial assistance, and billing and collections. In April 2013 the IRS published proposed regs that provide guidance to charitable hospital organizations on the community health needs assessment (CHNA) requirements and related excise tax and reporting obligations. The regs also clarify the consequences for failing to meet those and other requirements for charitable hospital organizations.

Although the statutory requirements of section 501(r) are already in effect, hospital organizations won’t be required to comply with the 2012 and 2013 proposed regs until they are published as final or temporary regs. Because the preamble to the 2013 proposed regs did not expressly mention whether taxpayers could rely on sections other than proposed reg. section 1.501(r)-3 pending the publication of final or temporary regs, some commentators have asked whether they can rely currently on the other sections of the 2013 proposed regs. Treasury and the IRS confirm that tax-exempt organizations may rely on all the provisions of both the 2012 and 2013 proposed regs pending the publication of final or temporary regs or other applicable guidance. Also, organizations may rely on reg. section 1.501(r)-3 of the 2013 proposed regs for any CHNA conducted or implementation strategy adopted on or before the date that is six months after final or temporary regs are published.

http://www.irs.gov/pub/irs-drop/n-14-02.pdf




IRS: Reinstatement Procedures for Revocations under Section 6033(j).

Revenue Procedure 2014-11 provides procedures for reinstating the tax-exempt status of organizations that have had their tax-exempt status automatically revoked under section 6033(j) of the Internal Revenue Code for failure to file required annual returns or notices for three consecutive years.

http://www.irs.gov/pub/irs-drop/rp-14-11.pdf




Market Groups Agree: Proposed Issue Price Rules Unworkable.

Municipal market groups often at odds with one another are for once in agreement, with each telling the Internal Revenue Service that its proposed issue price rules are unworkable and would hurt issuers as well as the market.

Groups representing lawyers, dealers, municipal advisors and issuers asked the IRS in comments on its proposals to keep the reasonable expectations standard in the existing issue price rules. Several of the groups have asked the IRS to withdraw its proposed rules.

The National Association of Bond Lawyers told the IRS in the summary of its 23-page letter, “The proposed definition of ‘issue price’ is not required or appropriate to address the policy objectives and state concerns of Treasury and the IRS.”  The group also warned the proposal “is not administrable by issuers under existing law and market practices” and would “impose substantial additional expense on issuers and alter long-standing practices in the municipal market.”

The Securities Industry and Financial Markets Association, in its 19-page letter, said it wants to be a constructive contributor to updating the issue price rules but, “the proposed regulations, while well intentioned, represent an approach to defining and documenting issue price which is unworkable based on limitations on the ability of issuers, underwriters and others to monitor sales of bonds during the order period.”

While issuers are often at odds with dealers, the State Debt Management Network, an affiliate of the National Association of State Treasurers, told the IRS that it has “grave doubts about the ability of issuers or the IRS to administer the proposed standard based on currently available secondary market information.”

The proposed rules were published in September, and comments about them were to be sent to the IRS by Monday. A public hearing about the proposed rules is scheduled for Feb. 5.

The IRS and Treasury Department proposed the issue price rules to address their concerns that the current rules do not result in a true issue price of bonds and may contribute to “flipping,” when the prices of munis trade up on the day of issuance, with dealers and institutional investors buying them at the lowest prices and retail investors at the highest prices.

Issue price is extremely important because it is used to help determine the yield on bonds and whether the issuer is complying with arbitrage rebate or yield restriction requirements, as well as the amount of federal subsidy payments issuers receive for direct-pay bonds such as Build America Bonds. Issue price also plays a role in complying with other muni tax rules such as the 2% limit on issuance costs for private activity bonds and the size of debt service reserve funds.

Under the current rules, the issue price for each maturity of bonds publicly offered is the first price at which a substantial amount of the bonds is reasonably expected to be sold to the public, with substantial defined as 10%. The issue price is usually determined based on reasonable expectations when the bonds are priced, before the closing of a bond deal.

However, the proposed rules would eliminate the reasonable expectations standard and instead base the determination of issue price on actual sales of the bonds. The proposed rules include a safe harbor under which the issue price would be the price at which the first 25% of the bonds is actually sold to the public. Under the proposed rules, “the public” would be any person other than an underwriter, a term that would be defined as “any person that purchases bonds from the issuer for the purpose of effecting the original distribution of the bonds, or otherwise participates directly or indirectly in the original distribution.”

The IRS is concerned about the reasonable expectations test, believing it can be manipulated. When it proposed the issue price rules, the agency said that trade reporting data on the Municipal Securities Rulemaking Board’s EMMA system, “has shown, in certain instances, actual sales to the public at prices that differed significantly from the issue price used by the issuer. These price differences have raised questions about the ability of the reasonable expectations standard to produce a representative issue price. The reported trade data has also called into question whether sales to underwriters and security dealers have been included as sales to the public in determining issue price in certain instances.”

But market participants are particularly concerned with the proposed move away from the reasonable expectations standard and creation of a safe harbor of 25% of actual sales.

Groups said that there is no good way to track the prices of bonds to determine when 25% of each maturity is sold to the public. The Municipal Securities Rulemaking Board’s EMMA system “lacks sufficiently specific details of trades to provide a solution to the problem,” the Bond Dealers of America said in its 12-page letter. The proposed rules also “fail to distinguish changes in bond prices that result from changes in interest rates and other external factors,” BDA said.

The Government Finance Officers Association and other groups noted that some maturities may not meet the 25% actual sale test for days, weeks or months after the bond sale, and that the rules don’t address what an issuer should do if the 25% threshold is not met.

Market groups said that the proposed rules would result in higher borrowing costs for issuers. To satisfy the safe harbor, issuers will need to ensure that 25% of each maturity is sold to the public. But to achieve that goal, bonds probably would be sold at lower prices, meaning higher interest rates for the issuer.

The National Association of Independent Public Finance Advisors and other groups were particularly concerned that the proposed rules would make it hard for issuers to sell bonds on a competitive rather than negotiated basis.

Generally, underwriters of competitive sales take on the risks of unsold bonds, knowing that they might not be able to find buyers at the offering price immediately after the sale. There is no preliminary order period and limited marketing, NAIPFA said.

In addition, the proposed rules may lead issuers to have negotiated sales in order to assure the bonds are underwritten at the final stated price. But issuers have historically achieved “significant financial benefits” from using the competitive sale method, NAIPFA said.

NABL President Allen Robertson told The Bond Buyer that “any revised definition of issue price would need [issue price] to be determined as of the sale date.”

If the IRS proposed the issue price to be determined after the sale date, issuers could violate state law, policy of authorizing resolutions and could also unintentionally violate other provisions of federal tax law, he said. Also bond counsel has to be able to confirm whether they can give an unqualified approving opinion on the sale date. If it can’t do so because issue price can’t be determined until after the issue date, the bonds would not be issued and the bond purchase agreement would “crater” between pricing and closing, NABL warned.

The SDMN said the proposal could lead to higher costs to the federal government for the tax-exemption for municipal bonds. Since the proposed rules may lead to higher yields to meet the 25% threshold, there would be more interest exempt from federal income taxes.

While the IRS proposed the rules in order to discourage flipping, they could actually lead to more bond flipping, GFOA said.

“If the standard requires 25% of each maturity to be sold to the public, an issuer will have to accept lower prices on the bonds in order to sell enough bonds to meet that threshold, leading to artificially inflated rates at greater taxpayer expense, which would actually encourage flipping,” the issuer group told the IRS.

NABL said that concerns the IRS has about the offering and distribution process for municipal securities — such as an underwriter making a public offering of only 10% of a maturity to establish a lower issue price and then selling the remaining 90% at a higher price — would be better addressed by working with municipal securities regulators than by changing tax policy.

Groups also contend the proposed rules’ definition of an underwriter is unreasonable. “It uses extremely broad terms and requires that issuers determine the intent of bond purchasers,” BDA said. “Even with the ability to cure bond yield-related problems through yield reduction payments, it will be impossible for an issuer and its bond counsel to determine the parties that the IRS might view as an underwriter with the sort of certainty necessary to conclude that a bond issue is tax-exempt.”

The proposal allowing for yield-reduction payments if the issue price of the bonds is greater than the price originally assumed at the issuance date is problematic, SDMN said. Reliance on these payments would increase issuer costs. In addition, issuers relying on yield reduction payments would have to be willing to bear risk and the uncertainty of not knowing the issue price and allowable yield at closing.

BY NAOMI JAGODA

DEC 17, 2013 2:07pm ET




BDA Submits Comment Letter: IRS Proposed Regulations Affecting Issue Price.

The BDA believes that the Proposed Rules are unworkable, will result in higher interest costs for issuers of tax-exempt bonds, and should be substantially revised and reproposed. We offered workable solutions for the IRS to consider should they decide to revisit and repropose these rules.

Today the BDA submitted a comment letter to the IRS regarding proposed regulations affecting issue price.

Highlights of the letter include discussion of the following:

The rules must take into account the reality that municipal securities are bought and sold within the context of a fluid marketplace with capital at risk;

The IRS must identify its policy goals and weigh the costs of any solution to issuers of municipal bonds;

The Proposed Rules do not offer a workable means of determining issue price if the “safe harbor” is not satisfied; and

The proposed safe harbor rule for determining issue price will lead to unnecessarily higher interest rates as market participants are compelled to use the safe harbor to establish the issue price in each transaction.

You can find the final letter here:

http://origin.library.constantcontact.com/download/get/file/1105697510106-326/Final.BDA.Issue.Price.12.16.13.pdf

Referenced enclosure here:

http://origin.library.constantcontact.com/download/get/file/1105697510106-327/08.05.10.letter.IssuePrice.pdf




IRS Issues Interim Guidance on Supporting Organizations.

The IRS has issued interim guidance (Notice 2014-4) for Type III supporting organizations seeking to qualify as functionally integrated by supporting a governmental supported organization.

The guidance also provides interim guidance to some grantors to determine whether a potential grantee is a Type I, Type II, or functionally integrated Type III supporting organization for purposes of the excise taxes imposed under sections 4942, 4945, and 4966. Notice 2006-109 is modified. Comments are due by March 7.

T.D. 9605, published in December 2012, established the requirements to qualify as a functionally integrated Type III supporting organization but reserved on reg. section 1.509(a)-4(i)(4)(iv) to provide future guidance on the specific requirements for qualifying as functionally integrated by supporting a governmental supported organization. Notice 2006-109, issued in December 2006, provided interim guidance on the rules for grants to supporting organizations that maintain donor-advised funds and provided procedures under which the grantors, acting in good faith, could rely on written representations or reasoned written opinions of counsel in determining whether a grantee is a Type I, Type II, or functionally integrated Type III supporting organization for purposes of imposing excise taxes.

Notice 2014-4 provides a transitional rule for qualifying as functionally integrated by supporting a governmental supported organization. Until the earlier of the date final regs are published under reg. section 1.509(a)-4(i)(4)(iv) or the first day of the organization’s third tax year beginning after December 31, 2013, a Type III supporting organization will be treated as meeting the requirements of reg. section 1.509(a)-4(i)(4), and hence will be treated as functionally integrated, if it (1) supports at least one supported organization that is a governmental entity to which the supporting organization is responsive within the meaning of reg. section 1.509(a)-4(i)(3), and (2) engages in activities for or on behalf of the governmental supported organization that perform the functions of, or carry out the purposes of, that governmental supported organization and that, but for the involvement of the supporting organization, would normally be engaged in by the governmental supported organization itself. The transitional rule is not intended to signal what future proposed regulations will require regarding qualifying as functionally integrated by supporting a governmental entity. No Type III supporting organization will qualify as functionally integrated by satisfying this transitional rule once final regulations under reg. section 1.509(a)-4(i)(4)(iv) are published, the IRS stated.

Until further guidance addresses the reliance standards of Notice 2006-109, private foundations and sponsoring organizations that maintain donor-advised funds may continue to rely on the grantor reliance standards of Notice 2006-109, as modified by Rev. Proc. 2011-33 and Notice 2014-4. For grants made after December 28, 2012, a Type III supporting organization must meet the requirements described in current reg. section 1.509(a)-4(i)(4) or Notice 2014-4 to be considered functionally integrated for purposes of a representation or opinion of counsel on which a grantor may rely. The notice is effective December 23, 2013, except as described in the notice.

Interim Guidance Regarding Supporting Organizations

Part III — Administrative, Procedural, and Miscellaneous

SECTION 1. PURPOSE

This notice provides interim guidance for Type III supporting organizations seeking to qualify as functionally integrated by supporting a governmental supported organization. It also modifies section 3 of Notice 2006-109, 2006-2 C.B. 1121, by providing interim guidance to certain grantors in determining whether a potential grantee is a Type I, Type II, or functionally integrated Type III supporting organization for purposes of the excise taxes imposed under §§ 4942, 4945, and 4966 of the Internal Revenue Code (Code).

SECTION 2. BACKGROUND

.01 Qualifying as a Functionally Integrated Type III Supporting Organization

An organization described in § 501(c)(3) of the Code is classified as either a private foundation or a public charity. To be classified as a public charity, an organization must be described in § 509(a)(1), (2), (3), or (4). Organizations described in § 509(a)(3) are known as “supporting organizations” because their non-private foundation status is based on their provision of support to one or more organizations described in § 509(a)(1) or (2), which in this context are referred to as “supported organizations.” Supporting organizations that are “operated in connection with” their supported organization(s) are called “Type III supporting organizations.” The Pension Protection Act of 2006, Public Law 109-280 (120 Stat. 780) (PPA), divided Type III supporting organizations into two categories — those that are “functionally integrated” and those that are not.

On December 28, 2012, the Department of the Treasury (the Treasury Department) and the Internal Revenue Service (IRS) published a Treasury Decision in the Federal Register (TD 9605, 2013-11 I.R.B. 587 [77 FR 76382]) containing final and temporary regulations (the “2012 regulations”) that, among other things, set forth the requirements to qualify as a functionally integrated Type III supporting organization. To qualify as functionally integrated, the 2012 regulations provide that a Type III supporting organization must meet one of three tests. It must:

(1) Engage in activities substantially all of which directly further the exempt purposes of one or more of the supported organizations to which the supporting organization is responsive1 by performing the functions of, or carrying out the purposes of, such supported organization(s) and that, but for the involvement of the supporting organization, would normally be engaged in by the supported organization(s);

(2) Be the parent of each of its supported organizations; or

(3) Support a governmental supported organization and otherwise meet the requirements described in § 1.509(a)-4(i)(4)(iv).

The 2012 regulations reserved § 1.509(a)-4(i)(4)(iv) to provide future guidance on the specific requirements relating to qualifying as functionally integrated by supporting a governmental supported organization.

The 2012 regulations also contained transition relief under which a Type III supporting organization in existence on December 28, 2012, that met and continued to meet the requirements of the “but for” test under former § 1.509(a)-4(i)(3)(ii), as in effect prior to December 28, 2012, would be treated as functionally integrated until the first day of its second taxable year beginning after December 28, 2012. See § 1.509(a)-4(i)(11)(ii)(A). A Type III supporting organization met the “but for” test under former § 1.509(a)-4(i)(3)(ii) if the activities it engaged in for or on behalf of its supported organization(s) performed the functions of, or carried out the purposes of, such supported organization(s), and, but for the involvement of the supporting organization, would normally be engaged in by the supported organization(s).

.02 Reliance for Grantors

On December 18, 2006, the Treasury Department and the IRS issued Notice 2006-109 to provide interim guidance on the PPA rules regarding grants to supporting organizations by private foundations and sponsoring organizations that maintain donor advised funds. Section 3.01 of Notice 2006-109 provides procedures under which these grantors, acting in good faith, may rely on written representations and/or reasoned written opinions of counsel in determining whether a grantee is a Type I, Type II, or functionally integrated Type III supporting organization for purposes of §§ 4942, 4945 and 4966. Section 3.02 of Notice 2006-109 states that, solely for purposes of a representation or opinion of counsel on which a grantor may rely, an organization will be considered a functionally integrated Type III supporting organization if it would meet the “but for” test set forth in former 1.509(a)-4(i)(3)(ii), as in effect at the time that notice was published. Notice 2006-109 states that the reliance criteria in section 3.01 are in effect “until further guidance is issued” and that the “functionally integrated” definition in section 3.02 is in effect until the issuance of regulations defining the term.

In 2011, the Treasury Department and the IRS issued Rev. Proc. 2011-33, 2011-1 C.B. 887, which provides general rules for reliance by grantors and contributors to organizations described in §§ 509(a)(1), (2), and (3) for purposes of §§ 4942, 4945, and 4966. Rev. Proc. 2011-33 modified Notice 2006-109 by specifying that grantors may rely on any Type I, Type II, Type III, or Type III functionally integrated supporting organization classifications that are listed in the IRS Business Master File (“BMF”) extract and former Publication 78, Cumulative List of Organizations Described in § 170(c) of the Internal Revenue Code (now part of Exempt Organizations Select Check) and providing that a grantor or contributor may rely on information about an organization from the BMF extract that is obtained from a third party, so long as certain specified requirements are met.

SECTION 3. INTERIM GUIDANCE FOR TYPE III SUPPORTING ORGANIZATIONS

.01 Transitional Rule for Qualifying as Functionally Integrated by Supporting a Governmental Supported Organization

Until the earlier of the date final regulations are published under § 1.509(a)-4(i)(4)(iv) or the first day of the organization’s third taxable year beginning after December 31, 2013, a Type III supporting organization will be treated as meeting the requirements of § 1.509(a)-4(i)(4), and hence will be treated as functionally integrated, if it:

(1) Supports at least one supported organization that is a governmental entity to which the supporting organization is responsive within the meaning of § 1.509(a)-4(i)(3); and

(2) Engages in activities for or on behalf of the governmental supported organization described in paragraph (1) that perform the functions of, or carry out the purposes of, that governmental supported organization and that, but for the involvement of the supporting organization, would normally be engaged in by the governmental supported organization itself.

This transitional rule is not intended to signal what future proposed regulations will require with respect to qualifying as functionally integrated by supporting a governmental entity. No Type III supporting organization will qualify as functionally integrated by reason of satisfying this transitional rule once final regulations under § 1.509(a)-4(i)(4)(iv) are published.

.02 Reliance on Notice 2006-109 for Grantors

Until further guidance is issued addressing the reliance standards of Notice 2006-109, private foundations and sponsoring organizations that maintain donor-advised funds may continue to rely on the grantor reliance standards of section 3 of Notice 2006-109, as modified by Rev. Proc. 2011-33 and this notice. For grants made after December 28, 2012, a Type III supporting organization must meet the requirements described in current § 1.509(a)-4(i)(4) or section 3.01 of this notice to be considered functionally integrated for purposes of a representation or opinion of counsel on which a grantor may rely. Accordingly, in order to determine that a Type III supporting organization is functionally integrated based on a written representation, a grantor must collect and review a written representation and documents that demonstrate the grantee meets the requirements described in current § 1.509(a)-4(i)(4) or section 3.01 of this notice.

SECTION 4. EFFECTIVE DATE

This notice is effective December 23, 2013. However, a supporting organization may rely on the transitional rule described in Section 3.01 of this notice beginning on December 28, 2012, and until the earlier of the date final regulations are published under § 1.509(a)-4(i)(4)(iv) or the first day of the organization’s third taxable year beginning after December 31, 2013. Grantors to a supporting organization may rely on the interim guidance provided in section 3.02 of this notice for grants made after December 28, 2012 and before the date further guidance is issued addressing the reliance standards of Notice 2006-109.

SECTION 5. REQUEST FOR COMMENTS

The IRS and the Department of Treasury request comments regarding this notice. Comments should refer to Notice 2014-4 and be submitted by March 7, 2014, to:

CC:PA:LPD:PR (Notice 2014-4)

Room 5203

Internal Revenue Service

P.O. Box 7604

Ben Franklin Station

Washington, DC 20044

Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4:00 p.m. to:

CC:PA:LPD:PR (Notice 2014-4)

Courier’s Desk

Internal Revenue Service

1111 Constitution Ave., N.W.

Washington, DC 20224

Alternatively, taxpayers may submit comments electronically to notice:

[email protected]

Please include “Notice 2014-4” in the subject line of any electronic communications.

All comments will be available for public inspection and copying.

SECTION 6. PAPERWORK REDUCTION ACT

The collection of information contained in this notice has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545-2050.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid OMB control number.

The collection of information is in section 3 of Notice 2006-109, as modified by section 3.02 of this notice. Collecting the required information may provide private foundations and sponsoring organizations of donor advised funds with relief from excise taxes imposed by §§ 4942, 4945, and 4966 of the Code.

The estimated total annual reporting and/or recordkeeping burden is 612,294 hours.

The estimated annual burden per respondent/recordkeeper varies from 7 hours, 53 minutes to 9 hours, 48 minutes, depending on individual circumstances, with an estimated average of 8 1/2 hours. The estimated total number of respondents and/or recordkeepers is 65,000.

The estimated frequency of collection of such information is occasional.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. § 6103.

SECTION 7. EFFECT ON OTHER DOCUMENTS

This notice modifies Notice 2006-109.

SECTION 8. DRAFTING INFORMATION

The principal author of this notice is Mike Repass of the Exempt Organizations, Tax Exempt and Government Entities Division. For further information regarding this notice, contact Mike Repass at (202) 317-8536 (not a toll-free call).

FOOTNOTE

1 Treas. Reg. § 1.509(a)-4(i)(3) requires a Type III supported organization to demonstrate “responsiveness” to a supported organization by having one of three specified relationships with its supported organization(s) that results in the officers, directors, or trustees of the supported organization(s) having a “significant voice” in the operations of the supporting organization.

Citations: Notice 2014-4; 2014-2 IRB 1




IRS to Delay Opening of 2014 Filing Season Until January 31.

The IRS has announced (IR-2013-100) plans to open the 2014 tax return filing season 10 days later than originally scheduled to give the IRS enough time to program and test its tax processing systems.

The IRS had to change the original opening date from January 21 to January 31 because of delays in the IRS’s annual process for updating its systems as a result of the 16-day federal government closure in October. The IRS said that many software companies are expected to begin accepting tax returns in January and will hold those returns until the IRS systems open on January 31. Taxpayers will receive their tax refunds faster by using e-file or Free File with the direct deposit option, the IRS added.

The Internal Revenue Service today announced plans to open the 2014 filing season on Jan. 31 and encouraged taxpayers to use e-file or Free File as the fastest way to receive refunds.

The new opening date for individuals to file their 2013 tax returns will allow the IRS adequate time to program and test its tax processing systems. The annual process for updating IRS systems saw significant delays in October following the 16-day federal government closure.

“Our teams have been working hard throughout the fall to prepare for the upcoming tax season,” IRS Acting Commissioner Danny Werfel said. “The late January opening gives us enough time to get things right with our programming, testing and systems validation. It’s a complex process, and our bottom-line goal is to provide a smooth filing and refund process for the nation’s taxpayers.”

The government closure meant the IRS had to change the original opening date from Jan. 21 to Jan. 31, 2014. The 2014 date is one day later than the 2013 filing season opening, which started on Jan. 30, 2013 following January tax law changes made by Congress on Jan. 1 under the American Taxpayer Relief Act (ATRA). The extensive set of ATRA tax changes affected many 2012 tax returns, which led to the late January opening.

The IRS noted that several options are available to help taxpayers prepare for the 2014 tax season and get their refunds as easily as possible. New year-end tax planning information has been added to IRS.gov this week.

In addition, many software companies are expected to begin accepting tax returns in January and hold those returns until the IRS systems open on Jan. 31. More details will be available in January.

The IRS cautioned that it will not process any tax returns before Jan. 31, so there is no advantage to filing on paper before the opening date. Taxpayers will receive their tax refunds much faster by using e-file or Free File with the direct deposit option.

The April 15 tax deadline is set by statute and will remain in place. However, the IRS reminds taxpayers that anyone can request an automatic six-month extension to file their tax return. The request is easily done with Form 4868, which can be filed electronically or on paper.

IRS systems, applications and databases must be updated annually to reflect tax law updates, business process changes and programming updates in time for the start of the filing season.

The October closure came during the peak period for preparing IRS systems for the 2014 filing season. Programming, testing and deployment of more than 50 IRS systems is needed to handle processing of nearly 150 million tax returns. Updating these core systems is a complex, year-round process with the majority of the work beginning in the fall of each year.

About 90 percent of IRS operations were closed during the shutdown, with some major work streams closed entirely during this period, putting the IRS nearly three weeks behind its tight timetable for being ready to start the 2014 filing season. There are additional training, programming and testing demands on IRS systems this year in order to provide additional refund fraud and identity theft detection and prevention.




IRS: Current Edition of the FSLG Newsletter.

A publication of the Federal, State, & Local Governments office of the Tax Exempt and Government Entities Operating Division, this newsletter is issued semiannually and provides information about current developments and upcoming events of interest to government entities.

Topics include:

http://www.irs.gov/pub/irs-tege/p4090_0114.pdf




IRS: Applicable Federal Rates.

Revenue Ruling 2014-01 provides various prescribed rates for federal income tax purposes including the applicable federal interest rates, the adjusted applicable federal interest rates, the adjusted federal long-term rate, the adjusted federal long-term tax-exempt rate. These rates are determined as prescribed by § 1274.

http://www.irs.gov/pub/irs-drop/rr-14-01.pdf




Tax Court Holds That Some of Attorney's Expenses Not Deductible.

The Tax Court held that an attorney wasn’t entitled to deduct business expenses paid in prior years, but said that it was a matter of genuine dispute whether the expenses are included in net operating losses applicable to the years at issue and he wasn’t entitled to deduct a court-ordered fine and payment of an opposing attorney’s fees.

Citations: Naren Chaganti v. Commissioner; T.C. Memo. 2013-285; No. 7344-12

NAREN CHAGANTI,

Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

UNITED STATES TAX COURT

Filed December 17, 2013

Naren Chaganti, pro se.1

Karen O. Myrick, for respondent.

MEMORANDUM OPINION

PARIS, Judge: On March 4, 2013, petitioner filed a motion for partial summary judgment pursuant to Rule 121,2 requesting the Court find in his favor in [*2] regard to the following issues, believed to be questions of law about which there exist no genuine issues of material fact:

(1) whether petitioner was entitled to deduct business expenses paid in previous years for tax years 2006 and 2007 when those expenses were actually reimbursed; and

(2) whether petitioner was entitled to deduct court-ordered payments made in tax years 2006 and 2007.

On March 12, 2013, respondent filed a cross-motion for partial summary judgment on the same issues. Also on March 12, 2013, both petitioner and respondent filed objections to each other’s respective motions for partial summary judgment. On the basis of the following, the Court will grant respondent’s motion for partial summary judgment in part and will deny it in part. The Court will deny petitioner’s motion for partial summary judgment in full.

BACKGROUND

Some of the facts have been stipulated and are so found. The stipulation of facts, supplemental stipulation of facts, and exhibits received in evidence are [*3] incorporated herein by this reference. Petitioner resided in Missouri at the time this petition was filed.

Petitioner is a licensed attorney who has been providing legal services to clients since 1998. Among these clients is petitioner’s brother’s business, which is based in St. Louis, Missouri. For all relevant years at issue, petitioner was a cash basis taxpayer.

In providing legal services to his brother’s business, petitioner incurred and paid significant expenses for travel, meals, and incidentals.3 Petitioner and his brother also had an arrangement by which petitioner’s brother’s business would pay petitioner a per diem expense reimbursement of $147 per day for each day petitioner was in St. Louis performing services for the business. Petitioner was not immediately reimbursed for these expenses but rather was reimbursed periodically as the business could afford to do so. From tax year 2001 to 2005 petitioner paid significant expenses related to legal services provided to his brother’s business. It is unclear whether petitioner reported or deducted these expenses on his Federal income tax returns for the tax years in which he paid [*4] them.4 In tax years 2006 and 2007 petitioner received $40,000 and $22,200, respectively, from his brother’s business as reimbursement for expenses accumulated from tax years 2001 through 2005.

In 2004 petitioner also began performing legal services on behalf of a plaintiff litigating in the U.S. District Court for the Eastern District of Missouri (District Court). On November 14, 2005, petitioner was ordered to pay a $262 fine for opposing counsel attorney’s fees and court reporter charges as a result of petitioner’s role in his client’s failure to appear at a deposition. After failing to pay the fine as ordered, petitioner was held in contempt by the District Court at a hearing on December 29, 2005, and ordered to pay the $262 on or before January 2, 2006. The District Court stated that after that date it would impose a daily fine of $100 until the sanction was paid. Despite being held in contempt, petitioner did not pay the $262 sanction until January 26, 2006. During the remainder of the litigation, petitioner engaged in behavior that the District Court deemed unnecessarily protracting and contentious.

The District Court ruled against petitioner’s client and for the defendant on a motion for summary judgment in March 2006. Petitioner, as plaintiff’s counsel, [*5] filed a motion to reconsider, vacate, and set aside the judgment, which was denied on April 12, 2006. Petitioner appealed the ruling to the U.S. Court of Appeals for the Eighth Circuit, which affirmed the District Court’s decision on April 26, 2007.

Following the entry of judgment, the defendant in the case filed a motion for attorney’s fees and bill of costs. The defendant’s motion requested that petitioner, as opposed to the plaintiff himself, pay the excess attorney’s fees incurred as a result of petitioner’s “bad faith, unreasonable, and vexatious multiplication of the proceedings”. On August 22, 2007, the District Court granted this motion in part, allowing the award of excess attorney’s fees of $18,125 which it specifically attributed to petitioner’s misconduct. The District Court ordered petitioner to pay that amount to opposing counsel and also ordered petitioner to pay to the Clerk of the Court a $2,300 fee for late payment of the original $262 fine.5 Petitioner paid these amounts on December 28, 2007.

Petitioner did not timely file Federal income tax returns for tax years 2006 and 2007. After respondent prepared substitutes for returns on March 22, 2010, and June 15, 2009, respectively, petitioner eventually filed delinquent returns for [*6] tax years 2006 and 2007 on May 26, 2010. On these returns petitioner listed business expenses of $40,000 and $22,200 for tax years 2006 and 2007, respectively, described as “prior years’ travel and per diem expenses.” For tax year 2007 petitioner also listed as a business expense $20,425 in court-ordered payments. This amount was attributable to the $2,300 fee for late payment of petitioner’s $262 deposition fine, plus the $18,125 petitioner was ordered to pay for opposing counsel attorney’s fees.

On January 6, 2012, respondent mailed to petitioner a notice of deficiency for tax years 2006 and 2007. The notice determined a deficiency in Federal income tax for tax year 2006 of $9,332, as well as an addition to tax for failure to timely file under section 6651(a)(1) of $2,102 and an accuracy-related penalty under section 6662(a) of $1,866. It also determined a deficiency in Federal income tax for tax year 2007 of $21,936, as well as an addition to tax for failure to timely file under section 6651(a)(1) of $5,192 and an accuracy-related penalty under section 6662(a) of $4,387. The determination, in part, was due to respondent’s finding that petitioner was not entitled to deduct prior years’ business expense per diem payments and court-ordered payments as business expenses for tax years 2006 and 2007. On March 19, 2012, petitioner timely filed a petition in this Court for review of respondent’s determination.

[*7] DISCUSSION

Summary judgment serves to “expedite litigation and avoid unnecessary and expensive trials.” Fla. Peach Corp. v. Commissioner, 90 T.C. 678, 681 (1988). The Court may grant summary judgment only if there are no genuine disputes of material fact. Naftel v. Commissioner, 85 T.C. 527, 529 (1985). The moving party must prove that no genuine disputes of material fact exist and that he is entitled to judgment as a matter of law. FPL Grp., Inc. & Subs. v. Commissioner, 115 T.C. 554, 559 (2000); Bond v. Commissioner, 100 T.C. 32, 36 (1993). In deciding whether to grant summary judgment, the Court considers the facts, and any inferences drawn from the facts, in the light most favorable to the nonmoving party. Naftel v. Commissioner, 85 T.C. at 529.

Both petitioner and respondent have filed motions for partial summary judgment. Because neither party contends that there are any genuine disputes of material fact with respect to the above-stated issues, the Court must evaluate which party is entitled to summary judgment on those issues as a matter of law.

Prior year per diem payments

Section 461(a) requires a taxpayer to deduct expenses in the year required under his method of accounting. A cash basis taxpayer generally must deduct his expenses in the year that payment of those expenses takes place. Tippin v. Commissioner, [*8] 104 T.C. 518, 531 (1995); Reynolds v. Commissioner, T.C. Memo. 2000-20, aff’d, 296 F.3d 607 (7th Cir. 2002); sec. 1.461-1(a), Income Tax Regs. Petitioner admits that he incurred and paid the expenses relating to his brother’s business during tax years 2001 through 2005. Petitioner argues only that he complied with section 461(a) by deducting the per diem expenses in the year the reimbursements were paid to him. Petitioner’s argument reflects a semantic misunderstanding. The law is clear that, for a cash basis taxpayer, the deduction generally must be taken in the year the expense is actually paid by the taxpayer. See Reynolds v. Commissioner, T.C. Memo. 2000-20. Petitioner has failed to point out any exception in the Code that would exclude him from the general rule. Accordingly, petitioner was not entitled to deductions for tax years 2006 and 2007 for reimbursements related to business expenses paid in prior years.6

Section 6214 empowers the Court to consider net operating loss (NOL) carryforwards and carrybacks in determining the correct amount of tax for the years at issue. See Harris v. Commissioner, 99 T.C. 121, 124-125 (1992); Calumet Indus., Inc. v. Commissioner, 95 T.C. 257, 274-275 (1990); Lone Manor Farms, Inc. v. Commissioner, 61 T.C. 436, 440 (1974), aff’d without published opinion, [*9] 510 F.2d 970 (3d Cir. 1975). Petitioner has not yet shown whether he included the above-discussed expenses in determining his NOLs for tax years 2003, 2004, and 2005. The inclusion of these expenses in petitioner’s NOLs for those years and the veracity of the expenses themselves are questions of material fact that must be addressed in determining the applicability of petitioner’s NOLs to the years at issue. Accordingly, the Court will not make any decisions as to those issues at this time.

Court-ordered payments

The court-ordered payments petitioner made during tax years 2006 and 2007 consisted of three separate fines. The first was the $262 petitioner was ordered to pay in reimbursement of deposition fees and opposing counsel attorney’s fees for failure to present a client at a deposition. The second was the $2,300 imposed on petitioner as a fee for failure to timely pay the $262 fine once held in contempt. The last was the $18,125 petitioner was ordered to pay pursuant to 28 U.S.C. sec. 1927 (2006), as opposing counsel attorney’s fees attributable to petitioner’s unreasonable protraction of the litigation.

Section 162 provides for the deduction of all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Section 162(f), however, disallows a deduction for fines or penalties [*10] paid to a government or a governmental agency for the violation of any law. Disallowance under section 162(f) is not limited to criminal fines and penalties. Huff v. Commissioner, 80 T.C. 804, 821 (1983). It is clear that the $2,300 fine imposed on petitioner for failure to pay that sanction was for the violation of his duties as an officer of the court in being held in contempt and failing to timely pay the $262 sanction. This amount was paid to the Clerk of the Court for the District Court, a governmental agency responsible for collecting such fines and penalties. Accordingly, petitioner is not entitled to deduct the $2,300 sanction as an ordinary and necessary business expense for tax year 2007.

The remaining two sanctions, while court ordered, were not paid to a government or governmental agency but rather to opposing counsel.7 Section 162 sets forth dual requirements that, to be deductible, an expense must be both ordinary and necessary. An ordinary expense is one that is common and acceptable in the taxpayer’s particular business. Welch v. Helvering, 290 U.S. 111, 113-114 (1933). A necessary expense is an expense that is appropriate and [*11] helpful in carrying on the taxpayer’s trade or business. Heineman v. Commissioner, 82 T.C. 538, 543 (1984).

Petitioner was ordered to pay a $262 sanction for reimbursement of deposition fees and opposing counsel attorney’s fees for failure to present a client at a deposition. It is clear that it may be ordinary and necessary to a taxpayer’s practice of law to hold depositions and that such expenses may be deductible under section 162. Petitioner argues that it was ordinary and necessary to his practice to keep his client from appearing at the scheduled deposition because, due to some unforeseen circumstance, he felt it was in his client’s best interest. Petitioner has yet to present evidence in support of this assertion.

Unlike the sanction imposed under 28 U.S.C. sec. 1927, discussed below, it is unknown at this time under which statute petitioner was ordered to pay the $262 sanction to opposing counsel. It is similarly unknown what criteria were required to impose this sanction and whether such an imposition in and of itself would indicate that the expense was not ordinary or necessary to the practice of law. Taken in a light most favorable to each nonmoving party in these cross-motions for summary judgment, a genuine dispute of material fact exists. Accordingly, neither petitioner nor respondent is entitled to summary judgment at this time with regard to the deductibility of the $262 sanction.

[*12] Petitioner was ordered to pay the remaining $18,125 fine as a result of what was found to be his willful and unreasonable protraction of the litigation. The District Court found petitioner liable under 28 U.S.C. sec. 1927, which states that “[a]ny attorney or other person admitted to conduct cases in any court of the United States * * * who so multiplies the proceedings in any case unreasonably and vexatiously may be required by the court to satisfy personally the excess costs, expenses, and attorney’s fees reasonably incurred because of such conduct.” The District Court then engaged in a lengthy itemized analysis to separate the amount of opposing counsel attorney’s fees that could be directly attributed to petitioner’s improper conduct from those which would be reasonably typical to the practice of law.8

The Court finds that the mere fact that petitioner was ordered to pay opposing counsel attorney’s fees under 28 U.S.C. sec. 1927, demonstrates that those amounts were not ordinary and necessary to the practice of law. The District Court’s further analysis in removing the amounts attributable to typical legal expenses confirms that the remaining $18,125 that petitioner was ordered to pay was not common to the practice of law, nor was it appropriate or helpful to his [*13] business. Accordingly, petitioner is not entitled to deduct the $18,125 fine levied against him under 28 U.S.C. sec. 1927, as an ordinary and necessary business expense for tax year 2007.

To reflect the foregoing,

An appropriate order will be issued.

FOOTNOTES

1 Mr. Chaganti filed an entry of appearance with the Court to represent himself. Though his name is represented as Narendra Chaganti on his tax returns and the notice of deficiency, Mr. Chaganti apparently uses the name “Naren” to practice law.

2 Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the years in issue, and Rule references are to the Tax Court Rules of practice and procedure.

3 In all the tax years at issue petitioner reported his home address as being in Town & Country, Mo. (a suburb of St. Louis, Mo.) and his business address as being in Los Angeles, Cal. Petitioner has not at this time made any showing as to why he was entitled to deduct travel expenses related to legal services provided to his brother’s business in St. Louis.

4 It is also unclear whether petitioner included these expenses in determining the net operating losses of $18,048, $19,510, and $29,104 he reported on his Federal income tax returns for tax years 2003, 2004, and 2005, respectively.

5 This late fee was based on the $100 daily fine multiplied by the 23 days that passed between the court-ordered deadline of January 2, 2006, and January 26, 2006, the actual date that payment was received.

6 It should be noted that this determination reflects the Court’s findings with respect to the timing of the deductions only and not the veracity of the expenses themselves.

7 The Court refrains at this time from engaging in an analysis of whether such payments could be considered constructively paid to a government or governmental agency for the purposes of sec. 162(f). With respect to the $18,125 sanction issued under 28 U.S.C. sec. 1927 (2006), the analysis below renders this question moot. With respect to the $262 sanction which, for reasons discussed below, presents a genuine dispute of material fact, this question will be decided at a later time.

8 The District Court found that of the $42,675 in opposing counsel attorney’s fees, $18,125 was attributable to petitioner’s improper conduct.




Court Holds Nonprofit Company Did Not Have Authority to Establish Church Plan.

A U.S. district court refused to dismiss an individual’s complaint against her employer, a nonprofit healthcare company, seeking a declaration that its pension plans are not church plans exempt from ERISA, finding that 29 U.S.C. § 1002(33)(A) requires that a church plan be established by a church and the company is not a church.

Citations: Starla Rollins v. Dignity Health et al.; No. 3:13-cv-01450

STARLA ROLLINS,

Plaintiff,

v.

DIGNITY HEALTH, ET AL.,

Defendants.

IN THE UNITED STATES DISTRICT COURT

FOR THE NORTHERN DISTRICT OF CALIFORNIA

ORDER DENYING DEFENDANTS’ MOTION TO DISMISS

Defendants’ motion to dismiss came before the Court on November 4, 2013. Having considered the parties’ arguments and the papers submitted, the Court now DENIES Defendants’ motion for the reasons set forth below.

BACKGROUND

Defendant Dignity Health (“Dignity”)1 is a non-profit healthcare provider with facilities in sixteen states. Compl. ¶ 1. From 1986 to 2012, Plaintiff Starla Rollins (“Rollins”) was employed as a billing coordinator at a Dignity-operated hospital. Id. ¶ 18. Based on her employment, Rollins will be eligible for pension benefits from Dignity’s benefits plan (the “Plan”) when she reaches retirement age. Id.

Rollins alleges that Dignity’s Plan violates the Employee Retirement Income Security Act (“ERISA”), 29 U.S.C. §§ 1001 et seq. Dignity contends that its Plan need not comply with ERISA because it is a “church plan,” which the statute explicitly exempts from its requirements. Rollins maintains that the Plan does not qualify as a church plan as defined by ERISA and in the alternative, if the Plan is exempt, such an exemption violates the Establishment Clause of the First Amendment and is therefore void. Id. ¶¶ 162-164.

On behalf of herself and others similarly situated, Rollins seeks declaratory relief that Dignity’s Plan is not a church plan exempt from ERISA, as well as injunctive relief requiring Dignity to conform the Plan to ERISA’s requirements. She also requests that Dignity make Plan participants whole for any losses they suffered as a result of its ERISA non-compliance and that Dignity pay any other statutory penalties and fees. Dignity moves to dismiss, contending that the Plan is a church plan, exempt from ERISA as a matter of law, and therefore, that Rollins’s allegations regarding ERISA violations fail to state a claim for relief.

LEGAL STANDARD

Dismissal is appropriate under Federal Rule of Civil Procedure 12(b)(6) when a complaint’s allegations fail “to state a claim upon which relief can be granted.” Fed. R. Civ. P. 12(b)(6). In ruling on a motion to dismiss, a court must “accept all material allegations of fact as true and construe the complaint in a light most favorable to the non-moving party.” Vasquez v. Los Angeles County, 487 F.3d 1246, 1249 (9th Cir. 2007). To survive a motion to dismiss, a plaintiff must plead “enough facts to state a claim to relief that is plausible on its face.” Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 570 (2007). “A claim has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.” Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009).

DISCUSSION

Enacted in 1974, ERISA was designed to ensure that employees actually receive the benefits they are promised by establishing, among other requirements, minimum funding standards and disclosure obligations for employee benefits plans. Pub. L. No. 94-406, 88 Stat. 829 (1974), codified at 29 U.S.C. §§ 1001 et seq. ERISA explicitly exempted “church plans” from its requirements and explained “the term ‘church plan’ means [ ] a plan established and maintained for its employees by a church or by a convention or association of churches.” 29 U.S.C. § 1002(33)(A) (1976). The statute permitted a church plan to also cover employees of church agencies, but the permission was to sunset in 1982. Id.

In 1980, ERISA was amended to eliminate the 1982 deadline and to include other clarifications. The relevant statutory section, 29 U.S.C. § 1002(33), now reads as follows:

(A) The term “church plan” means a plan established and maintained (to the extent required in clause (ii) of subparagraph (B)) for its employees (or their beneficiaries) by a church or by a convention or association of churches which is exempt from tax under section 501 of title 26.

(B) The term “church plan” does not include a plan —

(i) which is established and maintained primarily for the benefit of employees (or their beneficiaries) of such church or convention or association of churches who are employed in connection with one or more unrelated trades or businesses (within the meaning of section 513 of title 26), or

(ii) if less than substantially all of the individuals included in the plan are individuals described in subparagraph (A) or in clause (ii) of subparagraph (C) (or their beneficiaries).

(C) For purposes of this paragraph —

(i) A plan established and maintained for its employees (or their beneficiaries) by a church or by a convention or association of churches includes a plan maintained by an organization, whether a civil law corporation or otherwise, the principal purpose or function of which is the administration or funding of a plan or program for the provision of retirement benefits or welfare benefits, or both, for the employees of a church or a convention or association of churches, if such organization is controlled by or associated with a church or a convention or association of churches.

(ii) The term employee of a church or a convention or association of churches includes —

(I) a duly ordained, commissioned, or licensed minister of a church in the exercise of his ministry, regardless of the source of his compensation;

(II) an employee of an organization, whether a civil law corporation or otherwise, which is exempt from tax under section 501 of Title 26 and which is controlled by or associated with a church or a convention or association of churches; . . .

29 U.S.C. § 1002(33).

According to Rollins, despite the language in section C (i), which permits church-associated organizations to maintain church plans, section A still demands that only a church may establish a church plan. Although Rollins also disputes whether Dignity is a church-associated organization under section C (i), the Court first addresses, and finds dispositive, her argument that Dignity is not a church, and as such cannot establish a church plan, and therefore that Dignity’s Plan is not a “church plan” under the statute.

Dignity does not contend that it is a church or that its Plan was started by a church. Rather, relying primarily on section C, it argues that the ERISA statute allows a plan to qualify as a church plan regardless of what entity established the plan, so long as the plan is maintained by a tax-exempt non-profit entity “controlled by or associated with a church or a convention or association of churches.” 29 U.S.C. § 1002(33)(C)(i). Because it is a tax-exempt entity associated with the Roman Catholic Church, and its Plan is maintained by a subcommittee associated with the Roman Catholic Church, Dignity argues that, as a matter of law, its Plan qualifies as a church plan.2

Thus, the primary question before the Court is whether the ERISA statute requires a church plan to have been established by a church, or whether the statute merely requires that a church plan be maintained by a tax-exempt organization controlled by or associated with a church.

At the outset, the Court notes that although Dignity argues that “three decades of agency interpretations” — specifically a series of Internal Revenue Service (“IRS”) private letter rulings (“PLRs”) — support its position that to qualify as a church plan, a plan need only be maintained by a tax-exempt entity associated with a church, the Court declines to defer to the IRS’s interpretation of the ERISA statute here. The IRS’s private letter rulings apply only to the persons or entities who request them and are not entitled to judicial deference.3 The Court instead conducts its own independent analysis of the statute. 26 C.F.R. § 301.6110-7; 26 U.S.C. § 6110 (“a written determination may not be used or cited as precedent”); see also Bankers Life & Cas. Co. v. United States, 142 F.3d 973, 978 (7th Cir. 1998) (“Neither the courts nor the IRS may rely on letter rulings as precedent.”).

When interpreting a federal statute, a court’s goal is to “ascertain[ ] the intent of Congress” and “giv[e] effect to its legislative will.” In re Ariz. Appetito’s Stores, Inc., 893 F.2d 216, 219 (9th Cir. 1990). “The preeminent canon of statutory interpretation requires us to presume that the legislature says in a statute what it means and means in a statute what it says there.” BedRoc Ltd., LLC v. United States, 541 U.S. 176, 183 (2004) (internal quotation marks omitted). In construing the provisions of a statute, a court should thus “first look to the language of the statute to determine whether it has a plain meaning.” Satterfield v. Simon & Schuster, Inc., 569 F.3d 946, 951 (9th Cir. 2009). To the extent a statute is not “plain,” a court may look to the traditional canons of statutory interpretation and to the statute’s legislative history. Nw. Forest Res. Council v. Glickman, 82 F.3d 825, 830-31 (9th Cir. 1996).

The Court’s inquiry into whether a plan qualifies as a church plan begins with the text of section A, which, again, states:

The term “church plan” means a plan established and maintained (to the extent required in clause (ii) of subparagraph (B)) for its employees (or their beneficiaries) by a church or by a convention or association of churches which is exempt from tax under section 501 of Title 26.

29 U.S.C. § 1002(33)(A) (emphasis added). A straightforward reading of this section is that a church plan “means,” and therefore by definition, must be “a plan established . . . by a church or convention or association of churches.”

Complicating the inquiry, however, is section C, which states:

(i) A plan established and maintained for its employees (or their beneficiaries) by a church or by a convention or association of churches includes a plan maintained by an organization, whether a civil law corporation or otherwise, the principal purpose or function of which is the administration or funding of a plan or program for the provision of retirement benefits or welfare benefits, or both, for the employees of a church or a convention or association of churches, if such organization is controlled by or associated with a church or a convention or association of churches.

(ii) The term employee of a church or a convention or association of churches includes —

(I) a duly ordained, commissioned, or licensed minister of a church in the exercise of his ministry, regardless of the source of his compensation;

(II) an employee of an organization, whether a civil law corporation or otherwise, which is exempt from tax under section 501 of Title 26 and which is controlled by or associated with a church or a convention or association of churches; . . .

29 U.S.C. § 1002(33)(C) (emphasis added). Dignity contends that section C (i) includes within the category of plans “established and maintained . . . by a church” — “a plan maintained by a [church-associated] organization;” therefore, any plan that is maintained by a church-associated organization is a church plan, regardless of whether the plan was established by a church or convention or association of churches. Mot. at 17-18. Although Dignity’s proposed reading of the statute is not unreasonable on its face, it violates long-held principles of statutory construction and therefore cannot be the meaning of the statute.

To begin, Dignity’s reading violates a “cardinal principle of statutory construction . . . to give effect, if possible, to every clause and word of a statute rather than to emasculate an entire section.” Bennett v. Spear, 520 U.S. 154, 173 (1997) (internal citations and quotation marks omitted). If, as Dignity argues, all that is required for a plan to qualify as a church plan is that it meet section C’s requirement that it be maintained by a church-associated organization, then there would be no purpose for section A, which defines a church plan as one established and maintained by a church. In 1980, Congress amended the church plan exemption portion of the statute to add the language in section C relied upon by Dignity. At the same time, Congress chose to retain the language in section A, that the “[t]he term ‘church plan’ means a plan established and maintained by a church.” To completely ignore the language of section A — language that Congress actively retained — violates the principle to give effect to every clause and word and the related principle “not to interpret a provision in a manner that renders other provisions of the same statute inconsistent, meaningless or superfluous.” In re HP Inkjet Printer Litig., 716 F.3d 1173, 1184 (9th Cir. 2013).

Dignity’s reading not only renders section A meaningless, but also disregards the limiting language of section C (i), that to maintain a church plan, an organization must not only be associated with the church, but it must have as its “principal purpose or function . . . the administration or funding of a [benefits] plan or program . . . for the employees of a church.” Dignity is a healthcare organization; its mission is the provision of healthcare, not the administration of a benefits plan. While its Retirement Plans Sub-Committee’s purpose is plan administration, the statute does not say that the organization may have a subcommittee who deals with plan administration. Rather, the statute dictates that organization itself must have benefits plan administration as its “principal purpose,” which Dignity plainly does not.

Furthermore, Dignity’s suggested interpretation would reflect a perfect example of an exception swallowing the rule. While the amended section C (i) does permit church plans to include plans maintained by some church-associated organizations, for such a specific exception to govern what a church plan is, would completely vitiate the original rule embodied in section A, defining a church plan as a plan established and maintained by a church. The Court cannot agree with the notion that Congress could have intended the narrow permission in section C (i) to — by implication — entirely consume the rule it clearly stated in section A.

The canon expressio unius est exclusio alterius also militates against Dignity’s interpretation of the statute. The canon instructs that “where Congress includes particular language in one section of a statute but omits it in another section of the same Act, it is generally presumed that Congress acts intentionally and purposely in the disparate inclusion or exclusion.” Russello v. United States, 464 U.S. 16, 23 (1983) (citation omitted). Based on this canon, we must presume that Congress acted intentionally in using the words “establish and maintain” in section A as something only a church can do, as opposed to the use of only the word “maintain” in section C (i) to refer to the capabilities of church-associated organizations. To assert that any church-associated organization can establish its own church plan fails to appreciate the distinction drawn by Congress through its purposeful word choice.

Moreover, the use of the word “maintain by an organization” in section C (i) mirrors the word “maintain” in the preceding clause, “a plan established and maintained by a church.” This repetition of the word “maintain” without the word “establish” suggests that only the category of “who may maintain a church plan” is being expanded upon in section C (i), not the category of “who may establish a church plan.”

At oral argument, Dignity also relied on section C (ii), which allows employees of church-associated organizations to be covered by a church plan, to support its position. Dignity argued that because it is associated with a church and its employees can be covered by a church plan, that its Plan is a church plan. That an established church plan may include employees of a church-associated organization, however, does not mean that an associated organization may establish a church plan. Section C (ii) merely explains which employees a church plan may cover — once a valid church plan is established. It does nothing more.

The Court holds that notwithstanding section C, which permits a valid church plan to be maintained by some church-affiliated organizations, section A still requires that a church establish a church plan. Because the statute states that a church plan may only be established “by a church or by a convention or association of churches,” only a church or a convention or association of churches may establish a church plan. 29 U.S.C. 1002(33)(A). Dignity’s effort to expand the scope of the church plan exemption to any organization maintained by a church-associated organization stretches the statutory text beyond its logical ends.

The Court acknowledges that the position it takes here runs contrary to several cases outside this circuit that have considered the church plan exemption and have held that it applies to plans established by church-affiliated entities. Although those cases are not binding authority, the Court has nevertheless examined each contrary case and is not convinced by the reasoning the cases employed.

Initially, the Court notes that the contrary cases themselves differ in their interpretations of the statutory text. Several cases to have explored the issue appear to have read section C (i)’s language on who may maintain a church plan to abrogate the limitations clearly set out in section A on who can establish a church plan. See, e.g., Thorkelson v. Publ’g House of Evangelical Lutheran Church in Am., 764 F. Supp. 2d 1119, 1126-27 (D. Minn. 2011); Lown v. Cont’l Cas. Co., 238 F.3d 543, 547 (4th Cir. 2001). Yet others overlooked the express limitation on section C (i) that an organization maintaining a church plan must have as its “principal purpose or function . . . the administration or funding of a [benefits plan]” and cannot simply be a church-affiliated healthcare organization, or publishing house. See, e.g, Chronister v. Baptist Health, 442 F.3d 648, 652 (8th Cir. 2006); Lown, 238 F. 3d at 547. And still others read into the statute’s broad definition of employees who may be covered by a church plan, a completely different idea that church-affiliated organizations may start their own church plans. See e.g., Rinehart v. Life Ins. Co. of N. Am., No. C08-5486 RBL, 2009 WL 995715, at *3 (W.D. Wash. Apr. 14, 2009).

As explained in detail above, the Court is not persuaded by these flawed approaches. Rather, it adheres to the principle that Congress “says in a statute what it means and means in a statute what it says there.” BedRoc Ltd., LLC, 541 U.S. at 183 (internal quotation marks omitted). If Congress intended to alter the types of entities that can establish a church plan, such amendment would have been made to section A, which again, clearly states that a church plan is one “established and maintained . . . by a church or by a convention of association of churches.” The Court is not compelled by the legal gymnastics required to infer from section C’s grant of permission to church associations to maintain a church plan, or its broad view of which employees may be covered by a church plan — that a church plan may be established by any entity other than a church or a convention or association of churches as set forth in section A.

Although the text is conclusive, the Court notes that legislative history also strongly supports its reading. The history explains that the purpose behind section C was only to permit churches to delegate the administration of their benefits plans to specialized church pension boards without losing their church plan status; it was not to broaden the scope of organizations who could start a church plan.

Prior to the amendment, because the statute read that a church plan was one “maintained by a church or by a convention or association of churches,” churches whose plans were managed by pension boards were concerned about their status. To ensure they could maintain the exemption, leaders of several large church organizations wrote to and testified before Congress about their concerns.4

In response to the churches’ concerns, Sen. Herman E. Talmadge of Georgia introduced legislation as far back as 1978, with language substantially identical to the language currently in section C (i), to ensure that “a plan funded or administered through a pension board . . . [would] be considered a church plan” so long as the pension board’s “principal purpose or function” was the administration of the church plan, and the pension board was “controlled by or associated with a church.” 124 Cong. Rec. S8089 (daily ed. June 7, 1978) (statement of Sen. Herman Talmadge). In 1980, H.R. 3904 and S. 1076 were introduced in their respective houses and both sought to make broad changes to ERISA. Sen. Talmadge’s church plan concerns were reflected in S. 1090 that year, and eventually came to be a part of S. 1076. H.R. 3904 did not initially include any changes to the church plan exemption, but after H.R. 3904 and S. 1076 both passed their respective houses, the Senate proposed, and the House accepted amendments to H.R. 3904, including Sen. Talmadge’s proposed changes to the church plan exemption. Request To Concur In Senate Amendment With Amendments To H.R. 3904, Multi-Employer Pension Plan Amendments Act Of 1980, August 1, 1980.

When seeking to add the language about the church plan exemption reflected in section C into S. 1076, Sen. Talmadge explained to the Senate Finance Committee that the purpose of his proposal was to expand the church plan definition to include “church plans which rather than being maintained directly by a church are instead maintained by a pension board maintained by a church.” Senate Committee on Finance, Executive Session Minutes, June 12, 1980, at 40. In turn, a Press Release documenting the Senate Finance Committee’s favorable report on the legislation that same day stated that the Committee had “agreed that the current definition of church plan would be continued. . . . The definition would be clarified to include plans maintained by a pension board maintained by a church.” Press Release, United States Senate Committee on Finance (June 12, 1980).

Likewise, once the provision was incorporated into H.R. 3904, the Senate Labor and Human Resources Committee noted on August 15, 1980, that pursuant to the amended bill, the definition of a church plan “would be continued” and only “clarified to include plans maintained by a pension board maintained by a church.” Senate Labor and Human Resources Committee Report on H.R. 3904, August 15, 1980. The same position was echoed in the House by Representative Ullman in his comments on August 25, 1980, just weeks before the bill’s passage. 126 Cong. Rec. H23049 (daily ed. Aug. 25, 1980). The legislative history thus demonstrates that section C (i) was only intended to permit church pension boards to administer church plans; it was never contemplated to be so broad as to permit any church-affiliated agency to start its own plan and qualify for ERISA exemption as a church plan.

In sum, both the text and the history confirm that a church plan must still be established by a church. Because Dignity is not a church or an association of churches, and does not argue that it is, the Court concludes that Dignity does not have the statutory authority to establish its own church plan, and is not exempt from ERISA as a matter of law. Defendants’ motion to dismiss on this ground is thereby DENIED.

Consequently, the Court refrains from ruling on Rollins’s constitutional claim which is premised on a finding that Dignity’s plan is exempt from ERISA. For the same reason, the Court also declines to consider Dignity’s argument that its exemption from ERISA eliminates the Court’s subject matter jurisdiction over this suit. In its reply brief, Dignity also argued that the Court lacks subject matter jurisdiction “because courts may not entangle themselves in a church’s affairs.” Defs.’ Reply at 11. As Dignity failed to raise the argument prior to its reply brief, the Court declines to consider this argument. See United States ex rel. Giles v. Sardie, 191 F. Supp. 2d 1117, 1127 (C.D. Cal. 2000) (“It is improper for a moving party to introduce new facts or different legal arguments in the reply brief than those presented in the moving papers.”); see also Nevada v. Watkins, 914 F.2d 1545, 1560 (9th Cir. 1990) (“[Parties] cannot raise a new issue for the first time in their reply briefs.” (citation omitted)).

CONCLUSION

For the foregoing reasons, Defendants’ motion to dismiss is DENIED.

IT IS SO ORDERED.

DATED: December 12, 2013

Thelton E. Henderson, Judge

United States District Court

FOOTNOTES

1 The Defendants’ jointly moved to dismiss. Defendants in this case are Dignity Health, Herbert J. Vallier, a former Dignity Health official, and members of Dignity Health’s Retirement Plans Sub-Committee. For convenience, the Court refers to the Defendants’ collectively as “Dignity.”

2 To support Dignity’s position that both Dignity and its Plan subcommittee are “associated with” the Roman Catholic Church, Dignity submits volumes of documents as an appendix to its motion and as exhibits to two declarations submitted in connection with its papers. “When ruling on a Rule 12(b)(6) motion to dismiss, if a district court considers evidence outside the pleadings, it must normally convert the 12(b)(6) motion into a Rule 56 motion for summary judgment, and it must give the nonmoving party an opportunity to respond. A court may, however, consider certain materials — [including] matters of judicial notice — without converting the motion to dismiss into a motion for summary judgment.” United States v. Ritchie, 342 F.3d 903, 908 (9th Cir. 2003) (citation omitted). However, a court may take judicial notice of documents only for their existence, not the truth of the contents therein. In re Am. Apparel, Inc. S’holder Litig., 855 F. Supp. 2d 1043, 1064 (C.D. Cal. 2012). As Dignity cites to these documents for the truth of the matters asserted within, the Court finds the documents inappropriate for judicial notice and declines to review them here on a motion to dismiss.

3 Even if entitled to any deference, at best informal, non-precedential decisions, such as the IRS’s PLRs, are entitled to only Skidmore deference, see Barrios v. Holder, 581 F.3d 849, 859 (9th Cir. 2009), such that the weight the Court must give to the letters depends on “the thoroughness evident in [their] consideration, the validity of [their] reasoning, [their] consistency with earlier and later pronouncements, and all those factors which give [them] power to persuade, if lacking power to control.” Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944). The PLRs that Dignity relies on recite Dignity’s predecessor organization’s structure and repeat portions of the statute. I.R.S. P.L.R. 9409042 (Dec. 8, 1993), 9525061 (Mar. 28, 1995), I.R.S. P.L.R. 9717039 (Jan. 31, 1997), I.R.S. P.L.R. 200023057 (Mar. 20, 2000). The letters do not analyze the statute closely or evaluate how its language applies to Dignity. Because the IRS’s letters are conclusory, even under the Skidmore framework, they are not entitled to deference. See Shin v. Holder, 607 F.3d 1213, 1219 (9th Cir. 2010) (denying deference to Board of Immigration Appeals where its ruling was conclusory and “lack[ed] any meaningful analysis”).

4 See, e.g., Letter from Gary S. Nash, Secretary, Church Alliance for Clarification of ERISA, to Hon. Harrison A Williams, Jr., Chairman, Senate Committee on Human Resources (August 11, 1978); Hearing on the ERISA Improvements Act of 1978 Before the S. Comm. on Labor and Human Resources (1978) (statements of Dr. Charles C. Coswert, Executive Secretary, Board of Annuities and Relief of the Presbyterian Church of the United States and Gary S. Nash, General Counsel, Annuity Board of the Southern Baptist Convention, Church Alliance for Clarification of ERISA, available as a part of the Appendix to ERISA Improvements Act of 1978, Hearings before S. Committee on Labor and Human Resources, 96th Cong. 1317-1394 (1978).




District Court Rebukes IRS Church Plan Rulings.

David Cay Johnston reports on the first court case in an expanding effort to exempt pension plans from ERISA on religious grounds; the decision implicitly criticizes the IRS Office of Chief Counsel.

The IRS Office of Chief Counsel came in for sharp criticism from a federal judge in the first significant decision in five lawsuits by workers who complain that the IRS is helping employers quietly strip away their pension rights.

Hundreds of thousands of workers at hospitals and other nonprofit organizations have been moved into so-called church pension plans, which are exempt from ERISA. IRS private letter rulings enabled each of these moves.

Most of the nonprofits that were granted IRS approval to operate as church plans exempt from ERISA were seriously under funded, the trustees having failed to set aside enough money to pay the old-age benefits workers had earned. The federal government guarantees the pensions of workers in ERISA plans, although when a plan fails, workers typically get less than they had been promised. Workers moved into church plans, however, lose the federal guarantee.

The five cases don’t involve plans run by churches, but those operated by groups that claim a religious affiliation of some kind even though they may have for-profit partners, operate commercial businesses, and engage in activities that violate the doctrine of the affiliated religion. If the workers lose the five cases, there will be a swift expansion of church plans.

In some cases the plans always operated outside ERISA. In most cases, however, workers in ERISA plans were absorbed into church plans following approval from the IRS chief counsel.

Workers generally were not told about the valuable government guarantee they lost, although current IRS policy requires notifying workers. Many of these plans asked for, and got, refunds of insurance premiums paid to the Pension Benefit Guaranty Corporation when they operated subject to ERISA.

Rollins v. Dignity Health

The action in the first case came after a motion to dismiss by lawyers for Dignity Health, which covers 60,000 workers in Arizona, California, and Nevada. Dignity sought to dismiss a putative class action lawsuit brought by Starla Rollins, a longtime billing office employee .

District Judge Thelton E. Henderson denied the motion . His ruling amounts to a public thrashing of IRS chief counsel.

The chief counsel’s private letter rulings are shocking because ERISA makes pension administrators fiduciaries, a necessity because the administrators are typically employees of the sponsoring nonprofit or company and have divided loyalties. Section 404(a)(1) requires plan administrators to act “solely in the interest of the participants and beneficiaries and for the exclusive purpose of providing benefits to participants and beneficiaries and defraying reasonable expenses.”

Taking away a guaranteed income in old age cannot possibly meet the “solely and exclusively” test, indicating IRS chief counsel turned a blind eye to this standard in these private letter rulings.

The complaint  filed by Bruce F. Rinaldi and Karen L. Handorf of Cohen Milstein Sellers & Toll PLLC and by Lynn Sarko of Keller Rohrback LLP argues that “Dignity plainly is not a church or a convention or association of churches” and that the pension was “not established by a church or a convention or association of churches,” as the law requires of church plans. “Dignity is not owned by the Catholic Church” and “does not receive funding from the Catholic Church or other religious organizations,” according to the plaintiffs.

The plaintiffs argue that Dignity:

is long since removed from the days when nuns once ran the hospitals, spread the gospel, and faithfully stewarded retirement assets for their employees. Dignity deliberately chooses to distance itself from, or even abrogate, many religious convictions of the Catholic Church, when it is in its economic interest to do so, such as when it hires employees, performs or authorizes medical procedures forbidden by the Catholic Church, and encourages divergent and contrary spiritual support to its clients.

Only two of nine Dignity directors are nuns. The executive ranks are composed entirely of lay people. CEO Lloyd H. Dean was paid more than $6 million in 2011, including more than $1 million to his retirement plan. A dozen other employees made between $1.1 million and $2.9 million. Last year Dignity paid more than $2.7 million just to persuade four executives to go away, its Form 990 shows.

In 2012 Dignity bought U.S. HealthWorks, a for-profit operator with 2,700 employees, which has “no claimed ties to religion.” “Dignity’s current growth model specifically targets the acquisition of additional healthcare facilities that have no claimed ties to religion,” according to the complaint. “These facilities do not purport, and have never purported, to adhere to the moral and doctrinal teachings of the Catholic Church.”

That point is significant because if Dignity prevails, it would open the door to organizations claiming religious affiliation to get exempted from ERISA and then take over for-profit enterprises and operate for-profit affiliates, just as Dignity does. That could strip multitudes of their government-guaranteed pensions.

The plaintiffs say that allowing Dignity a church plan exemption “violates the establishment clause [of the First Amendment] because it harms Dignity employees, puts Dignity competitors at economic disadvantage and relieves Dignity of no genuine religious burden created by ERISA.”

Dignity operates ERISA-governed health and welfare benefit plans, dependent life insurance plans, and short-term disability plans, filing the necessary Forms 5500 each year with the IRS and the Labor Department. So Dignity runs ERISA plans, fully complying with the law, when it chooses, but claims a church plan exemption for its pension plan. How could the IRS chief counsel fail to have noticed this discrepancy?

Significantly, Dignity’s lawyers do not assert that it is owned and operated by the Catholic Church. Instead, they write about how a “healing ministry is a central component” of the church’s mission and note that Dignity “operates 24 Catholic and 15 non-Catholic hospitals.”

Catholic hospitals follow church doctrine. But in court papers, Dignity said its non-Catholic hospitals provide contraceptive and sterilization services. This argument presents a real problem for Dignity. If artificial contraception and sterilization violate church teaching, how can Dignity countenance their being provided at any facility under its embrace? And since it does, how can its pension qualify as a church plan?

Lawyers for Dignity disagree with the First Amendment claim, arguing that no unfair advantage can arise from its pension being exempt from ERISA because no law requires employers to provide retirement benefits. Point made — for this case. But the argument has a broader policy implication that cuts against Dignity.

Dignity’s argument, if adopted, would put pressure on competing employers subject to ERISA to jettison their pension plans. Exempt employers can promise workers benefits without setting aside money each year to pay them, while an employer subject to ERISA must fund its plan. Competitors subject to ERISA could try to persuade workers that they are better off because their pension is guaranteed and the competition’s plan may be a fraud. But that argument is both esoteric and unlikely to get past in-house counsel’s warnings about libel litigation.

The other option would be not to offer a pension, which goes against the express intent of the 1974 pension law. The policy question Dignity’s lawyers present is whether the tax aspects of pension law should discourage those plans when Congress expressly said its intent was to promote pensions and their sound funding.

Letter Rulings

In its motion to dismiss, Dignity relied heavily on four IRS private letter rulings. A predecessor, Catholic Hospitals Healthcare West, obtained the first (LTR 9409042 ). The IRS concluded the pension was a church plan from the get-go, a ruling whose validity the plaintiffs challenge.

The bigger problem is with three subsequent rulings — in 1995 (LTR 9525061 ), 1997 (LTR 9717039 ), and 2000 (LTR 200023057 ). They were sought because of “mergers with hospitals that maintained ERISA-governed pension plans.” The IRS enabled the stripping of a valuable government guarantee from workers, and the organization that did the stripping, Dignity, admits it.

The loss of a pension guarantee cannot possibly benefit workers, but it could be a boon to pension plan trustees who violated their duty of loyalty. A private letter ruling means escape from civil litigation and any risk of indictment for fraud. That the IRS chief counsel issued the first private letter ruling may be problematic and even, as the plaintiff claims, improper.

But the three later private letter rulings are clearly at odds with the legal standards both in the original 1974 pension protection law and the 1980 addendum. If the Dignity mergers had been with other church-run hospitals, the issues would be murky, but the hospitals and other operations Dignity took over were not church-run. Some of them are commercial for-profit enterprises.

Motion Denied

Henderson paid no heed to the private letter rulings, saying he need not even read them. Private letter rulings “apply only to the persons or entities who request them and are not entitled to judicial deference,” he said. He conducted his own analysis, coming to conclusions that evinced little to no support for the arguments made by Dignity.

The judge focused on the requirement that to be exempt, a pension plan must be “established and maintained . . . by a church” or by a church-associated organization created to administer a church pension plan. Then he turned to section A of the 1980 law, which contains the established language, writing that it is inextricably intertwined with section C:

Although Dignity’s proposed reading of the statute is not unreasonable on its face, it violates long-held principles of statutory construction and therefore cannot be the meaning of the statute.

To began, Dignity’s reading violates a “cardinal principle of statutory construction. . . . To give effect, if possible, to every clause and word of a statute rather than to emasculate an entire section.”

If, as Dignity argues, all that is required for a plan to qualify as a church plan is that it meet section C’s requirement that it be maintained by a church-associated organization, then there would be no purpose for section A, which defines a church plan as one established and maintained by a church. . . .

Dignity’s reading not only renders section A meaningless, but also disregards the limiting language of section C (i), that to maintain a church plan, an organization must not only be associated with the church, but it must have as its “principal purpose or function . . . the administration or funding of a [benefits] plan or program . . . for the employees of a church.” Dignity is a healthcare organization; its mission is the provision of healthcare, not the administration of a benefits plan.

That’s exactly how the law should be read. It is a withering indictment of chief counsel for issuing private letter rulings that cannot possibly be in the interests of workers in ERISA plans.

Dignity said it was unswayed. A statement distributed by Dignity’s director of strategic communications, Tricia Griffin, said the firm “values the contributions our employees make to our mission, and we remain committed to ensuring our retirees and beneficiaries receive the benefits they have earned. We are disappointed in the recent decision by Judge Henderson, but will continue to defend the case.”

Dignity said it was relevant that it provided $1.6 billion in a combination of charity care, community benefits, and services for which the bills went unpaid.

Dignity’s charity care is so insignificant that Deloitte LLP did not even mention it in its 49-page audit of Dignity. However, more than eight pages were devoted to the troubled pension plan, which was badly funded in 2011 and became even worse in 2012.

Dignity said it owes its workers $3.7 billion in benefits, but at the end of last year it had only $2.4 billion set aside to pay them. In 2011 funding was better, with three-quarters of the necessary funds invested.

The 9 percentage point drop in the pension plan funding ratio occurred even though Dignity cut pension benefit accruals, according to the Deloitte audit. So much for Dignity’s written statement asserting that it “values” its employees.

The record shows Dignity to be an amalgam of nonprofit and commercial activity not owned by, and arguably not even established by, the Catholic Church. Its financial disclosures show it is run with hardly more regard for charity than any of several for-profit corporations that describe themselves as socially responsible.

A pending request by Dignity for a fifth IRS private letter ruling provides chief counsel with a golden opportunity to set this matter right. Citing Henderson, or just relying on his insights without credit, chief counsel can reject Dignity’s private letter ruling. It can renounce its past private letter rulings for not complying with the 1980 law, for ignoring the “solely and exclusively” requirement, and for favoring feckless trustees and the entities that employed them without regard for the interests of the workers whose pension rights were taken away.

Multitudes of workers toiling away in the expectation that their pensions will be there when their hair turns gray can only hope that IRS chief counsel recognizes that to err is human, to correct divine.

David Cay Johnston

David Cay Johnston received the Pulitzer Prize for his coverage of tax policy while at The New York Times. He now teaches at Syracuse University College of Law and is the author of three books about taxes — Free Lunch, Perfectly Legal, and The Fine Print.




NY Authorizes Veterans' School Tax Exemptions.

ALBANY, N.Y. — New York’s school districts can authorize partial property tax exemptions for military veterans under a new state law.

The measure signed this week by Gov. Andrew Cuomo was effective immediately.

Legislative sponsors say veterans already qualify for partial tax exemptions on municipal property taxes but have had to pay back the school tax portion.

The new law leaves the decision up to school boards whether to adopt resolutions to provide the exemptions.

They include 15 percent reductions in assessed value for veterans who served during a time of war, another 10 percent for those who were in combat zones, and an additional reduction for service-connected disabilities.

Sponsors say the fiscal implications remain to be determined.




IRS Issues Interim Guidance on Supporting Organizations.

The IRS has issued interim guidance for Type III supporting organizations seeking to qualify as functionally integrated by supporting a governmental supported organization.

http://services.taxanalysts.com/taxbase/eps_pdf2013.nsf/DocNoLookup/29584/$FILE/2013-29584-1.pdf




FASB Agrees to Amend Guidance for Nonprofit Expense Reporting.

The Financial Accounting Standards Board on December 18 tentatively decided to adjust some existing guidance on the reporting of expenses among nonprofit entities so that donors and other parties can better understand how those organizations are allocating their resources.

The Financial Accounting Standards Board on December 18 tentatively decided to adjust some existing guidance on the reporting of expenses among nonprofit entities so that donors and other parties can better understand how those organizations are allocating their resources.

At a meeting in Norwalk, Conn., Don Kim, a postgraduate technical assistant at FASB, said U.S. generally accepted accounting principles don’t require all nonprofit organizations to disclose information about expenses according to both their functional and natural classifications, adding that only voluntary health and welfare entities are required to provide information about natural expenses in their statement of functional expenses.

Kim said members of the board’s Not-for-Profit Advisory Committee agreed with the staff that requiring the natural classification of expenses wouldn’t subject most nonprofit organizations to significant costs regarding financial statement preparation and auditing.

FASB members tentatively supported the staff recommendation to modify U.S. GAAP and require all nonprofit entities to disclose information about their natural expenses — a disclosure that existing guidance only encouraged most nonprofits to provide in their financial statements. The board also agreed to retain the current requirement under FASB Statement No. 117, “Financial Statements of Not-for-Profit Organizations,” to provide information about functional expenses.

FASB member Marc Siegel said the reporting of expenses by nature could give financial statement users a better understanding of how nonprofit entities are spending their money. He also noted that nonprofits are already required to provide similar information on Form 990, “Return of Organization Exempt From Income Tax.”

The board decided that it would not modify the existing guidance that permits a nonprofit entity to present expenses by nature or function in its statement of activities after the staff couldn’t identify sufficient reasoning to mandate more prescriptive presentation requirements.

The staff recommended that nonprofit entities be required to provide information about expenses by function and nature in a matrix format because that disclosure would provide incremental benefits to the users of financial statements. The staff said the information could be provided either as a basic financial statement or as a schedule in a footnote disclosure.

According to Kim, the Not-for-Profit Advisory Committee generally agreed that the matrix format adds understandability, clarity, and transparency to the reporting of expenses, which are useful for donors and the governing boards of nonprofit organizations when they are assessing how a nonprofit allocates its resources.

FASB members agreed that an analysis of a nonprofit entity’s reporting of expenses should be presented in a single location in its financial statements, but they decided against requiring the analysis to be presented in a matrix format, thinking that would be overly prescriptive. The board also agreed to grant nonprofit entities some flexibility by permitting them to provide the analysis of expenses either on the statement of activities or in the financial statement footnotes.

FASB member Lawrence Smith said that because nonprofit entities do not maintain the same level of regular communication that public companies can provide to users, they should be allowed more flexibility for presenting the analysis in whatever way they think is most appropriate. He added that most users of nonprofit financial statements are more inclined to review the entire document.

The board tentatively decided that under the newly proposed guidelines, nonprofit entities should be reporting information about all of their natural expenses and not only about those that are classified as operating expenses. The board also agreed not to provide relief to any types of nonprofit entities from the tentative decisions made on the content and presentation of expenses.

FASB’s latest decisions were made as part of its project on reexamining the standards for nonprofit financial statement presentation. The board decided in October to modify the existing requirements that dictate how some nonprofit organizations present their operating cash flows.

by Thomas Jaworski




IRS EO Update-e-News for Charities and Nonprofits - December 16, 2013.

Inside This Issue:

1.  IRS to employers:  Hire veteran by December 31 and save on taxes

If you plan to hire soon, consider hiring veterans. If you do, you may be able to claim the federal Work Opportunity Tax Credit worth thousands of dollars.

You must act soon. The WOTC is available to employers who hire qualified veterans before the new year.

Read about the six key facts about the WOTC in this tax tip:

http://www.irs.gov/uac/Newsroom/IRS-to-Employers-Hire-Veterans-by-Dec-31-and-Save-on-Taxes

2.  2014 standard mileage rates for business, medical, and moving announced

The IRS recently issued the 2014 optional standard mileage rates used to calculate the deductible costs of operating an automobile for business, charitable, medical or moving purposes.

Beginning on Jan. 1, 2014, the standard mileage rates for the use of a car (also vans, pickups or panel trucks) will be:

For more information, read news release:

http://www.irs.gov/2014-Standard-Mileage-Rates-for-Business,-Medical-and-Moving-Announced

3.  Register for the phone forum:  ABCs of charitable contributions for 501(c)(3) organizations

This phone forum on December 19 at 2 p.m. ET will help charity leaders, tax practitioners and others understand the rules involving charitable donations.

Register now:

http://ems.intellor.com/index.cgi?p=204857&t=71&do=register&s=&rID=417&edID=305

Presentation topics include:

For more information on EO phone forums, go to the IRS Exempt Organizations Phone Forums page:

http://www.irs.gov/Charities-&-Non-Profits/Phone-Forums-Exempt-Organizations

4.  Copies of scanned EO returns available

Electronic copies of certain scanned Exempt Organization returns are available for purchase from the IRS. Tax year 2013 returns will be available when filed beginning in January 2014. The IRS is also updating the pricing for scanned returns.

http://www.irs.gov/Charities-&-Non-Profits/Copies-of-Scanned-EO-Returns-Available

5.  Don’t fall for charity scams following disasters

The IRS warns consumers not to fall for bogus charity scams. They often occur in the wake of major disasters like the recent tornadoes in the Midwest or the typhoon in the Philippines. Thieves play on the goodwill of people who want to help disaster victims. They pose as a real charity in order to steal money or get private information to commit identity theft.

The scams use different tactics. Offering charity relief, criminals often:

For more information, read tax tip:

http://www.irs.gov/uac/Newsroom/Dont-Fall-for-Charity-Scams-Following-Disasters




IRS Provides Tax Tips on End-of-Year Giving.

The IRS has reminded (IR-2013-98) individuals and businesses making charitable contributions of some tax law changes in recent years, including a provision that is set to expire at the end of 2013 allowing for special donations by some IRA owners, rules on donating clothing and household items, and guidelines for monetary donations.

IRS Offers Tips for Year-End Giving

December 16, 2013

WASHINGTON — Individuals and businesses making contributions to charity should keep in mind several important tax law provisions that have taken effect in recent years. Some of these changes include the following:

Special Tax-Free Charitable Distributions for Certain IRA Owners

This provision, currently scheduled to expire at the end of 2013, offers older owners of individual retirement arrangements (IRAs) a different way to give to charity. An IRA owner, age 70 1/2 or over, can directly transfer tax-free up to $100,000 per year to an eligible charity. This option, first available in 2006, can be used for distributions from IRAs, regardless of whether the owners itemize their deductions. Distributions from employer-sponsored retirement plans, including SIMPLE IRAs and simplified employee pension (SEP) plans, are not eligible.

To qualify, the funds must be transferred directly by the IRA trustee to the eligible charity. Distributed amounts may be excluded from the IRA owner’s income — resulting in lower taxable income for the IRA owner. However, if the IRA owner excludes the distribution from income, no deduction, such as a charitable contribution deduction on Schedule A, may be taken for the distributed amount.

Not all charities are eligible. For example, donor-advised funds and supporting organizations are not eligible recipients.

Amounts transferred to a charity from an IRA are counted in determining whether the owner has met the IRA’s required minimum distribution. Where individuals have made nondeductible contributions to their traditional IRAs, a special rule treats amounts distributed to charities as coming first from taxable funds, instead of proportionately from taxable and nontaxable funds, as would be the case with regular distributions. See Publication 590, Individual Retirement Arrangements (IRAs), for more information on qualified charitable distributions.

Rules for Charitable Contributions of Clothing and Household Items

To be tax-deductible, clothing and household items donated to charity generally must be in good used condition or better. A clothing or household item for which a taxpayer claims a deduction of over $500 does not have to meet this standard if the taxpayer includes a qualified appraisal of the item with the return.

Donors must get a written acknowledgement from the charity for all gifts worth $250 or more that includes, among other things, a description of the items contributed. Household items include furniture, furnishings, electronics, appliances and linens.

Guidelines for Monetary Donations

To deduct any charitable donation of money, regardless of amount, a taxpayer must have a bank record or a written communication from the charity showing the name of the charity and the date and amount of the contribution. Bank records include canceled checks, bank or credit union statements, and credit card statements. Bank or credit union statements should show the name of the charity, the date, and the amount paid. Credit card statements should show the name of the charity, the date, and the transaction posting date.

Donations of money include those made in cash or by check, electronic funds transfer, credit card and payroll deduction. For payroll deductions, the taxpayer should retain a pay stub, a Form W-2 wage statement or other document furnished by the employer showing the total amount withheld for charity, along with the pledge card showing the name of the charity.

These requirements for the deduction of monetary donations do not change the long-standing requirement that a taxpayer obtain an acknowledgment from a charity for each deductible donation (either money or property) of $250 or more. However, one statement containing all of the required information may meet both requirements.

Reminders

To help taxpayers plan their holiday-season and year-end giving, the IRS offers the following additional reminders:

Contributions are deductible in the year made. Thus, donations charged to a credit card before the end of 2013 count for 2013. This is true even if the credit card bill isn’t paid until 2014. Also, checks count for 2013 as long as they are mailed in 2013.

Check that the organization is eligible. Only donations to eligible organizations are tax-deductible. Exempt Organization Select Check, a searchable online database available on IRS.gov, lists most organizations that are eligible to receive deductible contributions. In addition, churches, synagogues, temples, mosques and government agencies are eligible to receive deductible donations, even if they are not listed in the database.

For individuals, only taxpayers who itemize their deductions on Form 1040 Schedule A can claim deductions for charitable contributions. This deduction is not available to individuals who choose the standard deduction, including anyone who files a short form (Form 1040A or 1040EZ). A taxpayer will have a tax savings only if the total itemized deductions (mortgage interest, charitable contributions, state and local taxes, etc.) exceed the standard deduction. Use the 2013 Form 1040 Schedule A to determine whether itemizing is better than claiming the standard deduction.

For all donations of property, including clothing and household items, get from the charity, if possible, a receipt that includes the name of the charity, date of the contribution, and a reasonably-detailed description of the donated property. If a donation is left at a charity’s unattended drop site, keep a written record of the donation that includes this information, as well as the fair market value of the property at the time of the donation and the method used to determine that value. Additional rules apply for a contribution of $250 or more.

The deduction for a car, boat or airplane donated to charity is usually limited to the gross proceeds from its sale. This rule applies if the claimed value is more than $500. Form 1098-C or a similar statement, must be provided to the donor by the organization and attached to the donor’s tax return.

If the amount of a taxpayer’s deduction for all noncash contributions is over $500, a properly-completed Form 8283 must be submitted with the tax return.

And, as always it’s important to keep good records and receipts.




Cuomo Vetoes Volunteer Firefighter Benefits Bills.

ALBANY, N.Y. — Gov. Andrew Cuomo vetoed legislation that would have guaranteed job leaves for volunteer firefighters and ambulance workers during emergencies and another bill that would have extended coverage for their injuries in the line of duty outside the areas they regularly serve.

Authorizing leave when New York or the federal government declares a state of emergency would force staffing shortages and a financial burden on private and public employers, Cuomo said. Extending the injury coverage, similar to workers’ compensation, would impose “an undue burden” on municipalities before they have the opportunity to opt out of its provisions, he said.

“I laud the sponsor’s goal of better facilitating the efforts of volunteers to help with disasters,” Cuomo said in a veto message. “However, this bill provides no standard by which an employer could reject an employee’s request for leave even if the employee’s services were needed.”

The bills would have amended New York’s labor and municipal benefit laws. The vetoes were announced Thursday.

Noting that federal law requires employers provide leave to National Guard and military reservists, sponsors urged similar protection for emergency responders, including for long-term call-ups to local emergencies and disasters. Under existing law, they can be forced to use vacation or sick time, forfeit pay or even lose their jobs for not going to work.




Budget Agreement Would Hurt BABs.

WASHINGTON — Municipal bond market participants said the two-year budget agreement announced Tuesday evening by House and Senate Budget Committee leaders would extend by two years the cuts to the federal subsidy payments issuers receive for Build America Bonds and other direct-pay bond programs.

The deal, called the Bipartisan Budget Act of 2013, was negotiated ahead of the budget conference committee’s Dec. 13 deadline by House Budget Committee chairman Paul Ryan, R-Wis. and Senate Budget Committee chairman Patty Murray, D-Wash.

The agreement is a step toward avoiding another federal government shutdown in January. If it’s passed by Congress, the agreement would allow the House and Senate Appropriations Committees to work on spending bills at agreed-upon levels before the current continuing resolution expires on Jan. 15.

The House is expected to take up the budget act first, and the Senate will follow. Ryan said that the intention is to bring the agreement to the House floor by the end of the week.

Muni market observers said they expect the deal to be approved by Congress.

The budget act would provide $63 billion in sequester relief for discretionary programs in fiscal 2014 and 2015, divided evenly between defense discretionary and non-defense discretionary programs, according to a news release from budget committee leaders.

But the sequester for mandatory programs, which includes the subsidy payments for BABs and other direct-pay bonds, remains the same for fiscal 2014 through 2021. And the agreement extends sequestration for mandatory programs by two years, requiring President Obama to sequester the same percentage of mandatory budgetary resources in 2022 and 2023 as will be sequestered in 2021. Doing so would reduce spending by $28 billion.

In total, the budget agreement would provide mandatory savings and non-tax revenue of about $85 billion. The deal would reduce the deficit by between $20 billion and $23 billion, the congressional leaders said.

The BAB program was created under the American Recovery and Reinvestment Act and allowed state and local governments to issue taxable bonds in 2009 and 2010 and receive subsidies from the federal government equal to 35% of interest costs.

State and local governments issued BABs with the assurance that the federal government would give them the full subsidy. But BABs have already taken a hit from sequestration and the budget agreement would cause subsidy payments to be less than 35% of interest costs for a longer period of time.

“It was bad enough when [the federal government] reneged on the deal the first time, and now they’re doing it again.” said Bill Daly, director of governmental affairs for the National Association of Bond Lawyers.

Susan Collet, senior vice president of government relations for the Bond Dealers of America, said that the budget agreement is “a very disappointing way to treat a program that was designed to help state and local governments meet their financing needs.”

Michael Decker, Securities Industry and Financial Markets Association managing director and co-head of municipal securities said, “We commend congressional budget negotiators for reaching a compromise on difficult fiscal issues. The budget agreement will help minimize uncertainty for state and local governments and market participants. However, we believe it would have been appropriate for negotiators to have exempted direct-pay bond subsidy payments from automatic reductions under the sequester.”

John Godfrey, senior government relations representative for the American Public Power Association, said the reduction rate for the subsidy payments in 2022 and 2023 would be less than the 7.2% rate for fiscal 2014 because the amount of money cut from Medicare will be higher. Additionally, fewer BAB subsidy payments will face cuts in 2022 and 2023 because at least some of the bonds will have been redeemed by then, he said.

Godfrey said that it’s “crazy” that the federal government is “still renegotiating the terms of the financing of the BABs issued.” The muni market is learning just as it feared that the federal government wouldn’t make good on its promise to pay the full subsidy.

“All this makes it clear that Build America Bonds could not be a substitute for municipal bonds,” he said.

The higher spending on domestic discretionary programs under the budget agreement presumably will increase grants to states, Daly said. However, Godfrey said that he doesn’t think the sequester relief will be of much help to state and local governments because discretionary spending on state and local aid has been declining substantially.

The budget agreement does not include tax reform, but Collet noted that the deal doesn’t prevent future budget deals from making changes to the tax exemption for munis.

BY NAOMI JAGODA

DEC 11, 2013 2:50pm ET




IRS Update: Effect of Sequestration on Certain State & Local Government Filers of Form 8038-CP.

Pursuant to the requirements of the Balanced Budget and Emergency Deficit Control Act of 1985, as amended, refund payments to certain state and local government filers claiming refundable credits under section 6431 of the Internal Revenue Code applicable to certain qualified bonds are subject to sequestration. This means that refund payments processed on or after October 1, 2013 and on or before September 30, 2014 will be reduced by the fiscal year 2014 sequestration rate of 7.2 percent, irrespective of when the amounts claimed by an issuer on any Form 8038-CP was filed with the IRS. The sequestration reduction rate will be applied unless and until a law is enacted that cancels or otherwise impacts the sequester, at which time the sequestration reduction rate is subject to change.

These reductions apply to Build America Bonds, Qualified School Construction Bonds, Qualified Zone Academy Bonds, New Clean Renewable Energy Bonds, and Qualified Energy Conservation Bonds for which the issuer elected to receive a direct credit subsidy pursuant to section 6431.  Issuers should complete Form 8038-CP in the manner provided by the Form 8038-CP Instructions, and affected issuers will be notified through correspondence that a portion of their requested payment was subject to the sequester reduction.  Issuers should use this correspondence to identify the portion(s) of amounts requested that were subject to the sequester reduction.

Issuers with any questions about the status of refunds claimed on Form 8038-CP, including any sequester reduction, should contact IRS Customer Account Services at 1-877-829-5500.

Click here to see the FY2013 notice:




Interest Rates Remain the Same for the First Quarter of 2014.

WASHINGTON – The Internal Revenue Service today announced that interest rates will remain the same for the calendar quarter beginning Jan. 1, 2014.  The rates will be:

Under the Internal Revenue Code, the rate of interest is determined on a quarterly basis.  For taxpayers other than corporations, the overpayment and underpayment rate is the federal short-term rate plus 3 percentage points.

Generally, in the case of a corporation, the underpayment rate is the federal short-term rate plus 3 percentage points and the overpayment rate is the federal short-term rate plus 2 percentage points. The rate for large corporate underpayments is the federal short-term rate plus 5 percentage points. The rate on the portion of a corporate overpayment of tax exceeding $10,000 for a taxable period is the federal short-term rate plus one-half (0.5) of a percentage point.




Law Firm Explains Proposed Rules for Social Welfare Groups.

Under proposed regulations (REG-134417-13), section 501(c)(4) groups would be barred from participating in various not explicitly partisan activities, additional information disclosures would likely be required, and other types of exempt groups would likely be affected, according to a December 3 memo from Trister, Ross, Schadler & Gold PLLC.

December 3, 2013

TO:

Clients

FROM:

Trister, Ross, Schadler & Gold, PLLC

RE:

IRS Notice of Proposed Rulemaking on Political Activities of

501(c)(4) Social Welfare Organizations and Potentially Other

Groups

OVERVIEW

Last week, the Internal Revenue Service released a Notice of Proposed Rulemaking (NPRM) to substantially revise the treatment of political activities by Internal Revenue Code (IRC) section 501(c)(4) “social welfare organizations.” 78 Fed. Reg. 71535 (Nov. 29, 2013). Contrary to some reports, no new rules are in effect yet, and there is no set timetable for final regulations.

Although this rulemaking is directed to 501(c)(4)s, the NPRM asks whether similar rules should apply to charities (501(c)(3)s), labor organizations (501(c)(5)s) and trade associations (501(c)(6)s). And, the NPRM asks how a redefinition of “political” activity for these groups should affect the treatment of political activity for section 527 “political organizations” themselves (in IRS terminology, “exempt function” activity). Because many 501(c) groups (except (501(c)(3)s) sponsor and rely for much of their political spending on separate segregated funds that are regulated by section 527, any IRS changes on this subject could have broad impact.

The proposed 501(c)(4) regulations seek to more clearly define the activities and expenditures that will be treated as “political,” as distinct from “social welfare,” for 501(c)(4) groups — and the new rules would substantially expand the former at the expense of the latter. Relatedly, the IRS asks for comments on whether and how its longstanding and unquantified “primary purpose” standard for 501(c)(4) “social welfare” activity should be revised to specify how much, if any, political activity (as redefined) a social welfare organization may conduct.

The NPRM requests comments from the public by February 27, 2014, regarding the proposed regulations and the other issues raised by the IRS in its accompanying explanation. Although the NPRM suggests no timetable for adopting final rules, nothing is likely to be issued or effective until sometime after the November 4, 2014 general election.

The following Q&A explains the IRS proposal and the potential consequences if it were adopted as proposed.

Q. What prompted this rulemaking?

A. The IRS doesn’t say; it refers generally to “recent[ ] increased attention [to] potential political campaign intervention” by 501(c)(4) groups. It seems likely that the controversy over the IRS’s handling of applications for 501(c)(4) tax qualification by “tea party” groups, which prompted media scrutiny of the subjective nature of IRS judgments about what is “political activity,” triggered this formal effort to revise the rules for the first time in 54 years.

Q. What are the current IRS rules that apply to 501(c)(4) political activity?

A. Current IRS regulations that date from 1959 provide that a 501(c)(4) organization is operated “exclusively for the promotion of social welfare” (as the IRC says) if it is “primarily” engaged in activities that promote the common good and general welfare of the people of the community. The regulations (though not the IRC) provide that participation in political campaigns does not qualify as an activity that promotes social welfare. Therefore, if an organization’s primary purpose or activity is partisan political activity, the organization does not qualify as a 501(c)(4) group. Generally, partisan political activities of 501(c)(4) (and other 501(c)) groups are those that support or oppose a candidate for elected public office or a political party, and the IRS has used a flexible “facts and circumstances” approach rather than specific guidelines to determine what they are.

In addition to the primary-purpose restriction, 501(c)(4) organizations that have net investment income (interest, dividends, capital gains, rents and royalties) may be subject to a 35% federal tax on the lesser of their investment income or the expenditures for their political activities under IRC section 527(f)(1) & (2), unless they conduct these activities through a “separate segregated fund” that is organized under IRC section 527(f)(3). So, a 501(c)(4) group’s programmatic choices can entail substantial and costly consequences depending on the IRS’s classification of activities as “political.”

Q. What is the main difference between the current “facts and circumstances” test and the proposed standard for defining political activity?

A. The NPRM introduces a new term — “direct or indirect candidate-related political activity” — to define the activities and expenditures that would be treated as political, meaning that, specifically, they would not be “social welfare” activities, and, in the aggregate, they could not comprise the “primary purpose” of a 501(c)(4) organization.

This new category is much broader than what the “facts and circumstances” test covers. That test tries to identify partisan political activity — conduct that is designed to achieve particular election outcomes or to favor particular political parties. In contrast, the proposed standard includes inherently partisan spending on such activities as express advocacy and political contributions, but it also covers any near-election references of any kind to any candidate (including incumbents) in any media, even if purely legislative, as well as nonpartisan voter registration, GOTV efforts and voter guides, and advocacy about appointed executive branch and judicial officeholders. The NPRM’s stated overriding goal is “greater certainty” and “reduc[ing] the need for detailed factual analysis” in defining what is “political.”

Q. What activities that plainly are partisan would be included in the revised “political” category?

A. The following activities that are self-evidently partisan in nature would be included:

1. Express advocacy and its functional equivalent. Communications regarding the nomination or election of either a clearly identified candidate for elective office or the candidates of a particular political party that either:

Contain so-called magic words that expressly advocate for or against that result, such as “vote,” “oppose,” “support,” “elect,” “defeat,” or “reject”, or

Are susceptible to no reasonable interpretation other than as a call for or against that result (what is often called “the “functional equivalent” of express advocacy)

This covers all forms of communication, including “oral” messages, regardless of how many recipients are intended or reached. And, this includes, but is not limited to, “independent expenditures” that are reported to the Federal Election Commission (FEC).

2. Contributions and solicitations of contributions. Either a contribution of money or anything of value to, or the solicitation of contributions on behalf of, either:

Any person, if the contribution is recognized by federal, state, or local campaign finance law as a reportable contribution to a candidate for elective office; or

Any section 527 organization (so, this includes a 501(c)(4) group’s own PAC)

3. Republication of candidate or 527 group materials. Distribution of any written, electronic or other material that is prepared by or on behalf of a candidate or a section 527 organization.

4. FEC-reported membership communications. Express-advocacy communications about federal candidates by a 501(c)(4) that are reportable to the FEC on Form 7.

5. Recall elections. Express advocacy or its functional equivalent with respect to whether or not an incumbent officeholder should be subjected to a recall, a procedure that exists in numerous states and localities but not at the federal level. The IRS has not previously definitively addressed whether or not contributions or expenditures in recall elections qualify as political activity in the same manner as regular elections.

Q. What activities that are not necessarily partisan would be included in the revised “political” category?

A. The new “political” standard would cover many activities that either are not partisan or are not necessarily partisan, and it would not matter that, in fact, the activity as undertaken is indisputably nonpartisan and permissible for even a 501(c)(3) organization to undertake. These activities include:

1. Contributions to another section 501(c) organization that itself engages in any “candidate-related political activity.” The current standard for “political” activity by 501(c)(4)s only reaches contributions if they are earmarked for political purposes or if the 501(c)(4) does not take reasonable steps to ensure that the recipient does not use the funds for 527 exempt function activities. The new standard effectively would reverse that by covering all contributions to another 501(c) group of any kind (including 501(c)(3), (4), (5) or (6)) that engages in any “political activity” (as redefined), regardless of whether the contribution is either restricted or used for non-political activity. The proposal does not explain what time period applies to evaluate the recipient’s status as a group that does not engage in “political” activity.

And, in order for a such a contribution to avoid treatment as “political” spending, the contributor 501(c)(4) must obtain a written representation from the recipient stating that the recipient does not engage in candidate-related political activity (and, the contributor must neither know nor have reason to know that this representation is inaccurate or unreliable), and there must be a written restriction prohibiting use the contribution for political activity.

This would create a tremendous deterrent against contributions by 501(c)(4) groups to other tax-exempt groups, as well as a tremendous deterrent against engaging in “political” activity as redefined.

2. Advocating the appointment or confirmation of government executives and judges. This provision covers both express advocacy and its functional equivalent regarding whether or not a clearly-identified individual should be appointed, nominated or confirmed to a federal, state or local executive branch or judicial position. The proposal incorrectly asserts that under current law this activity is treated as “political” activity. Rather, following review of the issue in the aftermath of the 1988 Robert Bork Supreme Court nomination, the IRS has stated that activities to influence a legislature’s consideration of an appointment comprise lobbying and do not constitute participation or intervention in a political campaign within the meaning of IRC section 501(c)(3).

3. “Electioneering communications.” Any “public communication” within 30 days of a primary election or 60 days of a general election that refers (without express advocacy or its functional equivalent) in any manner to one or more clearly-identified federal, state or local candidates (including an incumbent officeholder) in that election, or, in the case of a general election, refers to one or more political parties in that election is treated as candidate-related. “Public communications” include messages via broadcast, cable, satellite, website, newspaper, magazine, other periodical, any form of paid advertising, or that otherwise are intended to or do reach more than 500 persons. So, this category is far broader than what the FEC defines as “electioneering communications,” which are confined to references to federal candidates in broadcast media. The coverage of “electioneering communications” is also broader than many state law provisions that regulate these types of communications; and, in fact, most states do not regulate them.

4. Voter registration and “get-out-the-vote” drives. These activities are covered regardless of whether the activity is nonpartisan and can, at least currently, be conducted by a 501(c)(3) organization.

5. Voter guides. These are included if they either refer to or attach anything that refers to any clearly identified candidate or, in a general election, any political party, also regardless of whether they are nonpartisan. It is unclear what would be considered a voter guide, and the rule could include voting records frequently circulated even by 501(c)(3) public charities.

6. Candidate appearances. Candidate appearances may take many forms, only some of which are partisan. Nonpartisan candidate debates and other events, even within 30 days of a primary election or 60 days of a general election, in which one or more candidates participate, may currently be sponsored by public charities and 501(c)(4)s and not be treated as partisan political activity. And, under current IRS standards, there are many circumstances in which incumbent officeholders who are also candidates in an upcoming election meet, speak and appear in their official capacities, and the event is treated as nonpartisan.

Q. Does the IRS suggest how 501(c)(4) “primary purpose” should be calculated?

A. No. The NPRM asks whether and how to quantify how much of an organization’s activity must promote social welfare for the organization to qualify under section 501(c)(4). The NPRM suggests that the IRS might conclude that — like 501(c)(3)s – 501(c)(4)s can’t engage in any political activity. The IRS also asks for comment about how it should “measure” political activity for applicants for 501(c)(4) status. And, although the IRS proposes no specific rule to define “primary purpose,” it is possible that the final rules may do so without the IRS first proposing anything specific on the subject.

Q. Would the amount of a group’s political activity be determined only by its spending?

A. No. Activities conducted by a 501(c)(4) organization that would be considered in evaluating its “political” activity include those that are either paid for by the organization, conducted by an officer, director, or employee acting in that capacity, or conducted by a volunteer acting under the organization’s direction or supervision. So, the IRS does not propose simply an “expenditure” test for calculating “primary purpose”; non-spending would be counted, but the NPRM doesn’t suggest how it would be quantified or affect the determination of primary purpose.

Q. Would these rules require additional disclosures by 501(c)(4) groups?

A. Indirectly, most likely yes. The new standard for political activity would cause many groups to forgo certain activity completely or substantially in order to maintain their “social welfare” purpose, in order to avoid the 35% 527(f) tax, or both. Many groups likely would shift “political” activity as redefined to a self-financed, sponsored 527 “separate segregated fund” (SSF) that, under current law, must itemize most of its spending and receipts in periodic public reports.

An issue that is raised by the NPRM, but not addressed, is whether the option of shifting political activities from a 501(c)(4) to a 527 as suggested above will be impossible in some circumstances. IRS rules currently bar SSFs from spending more than an “insubstantial” amount on anything except “exempt function” activity under section 527. So, if what is “political” for a 501(c)(4) is broader and does not align with what is 527 “exempt function” activity, a 501(c)(4) group could find itself facing unpalatable choices outside of its power to resolve. For example, the 501(c)(4) would be precluded from undertaking an activity because it would jeopardize its exempt status by conducting excessive political activity, and the 527 SSF would also be precluded from engaging in the activity because it does not constitute an “exempt function” activity.

Q. How would these rules affect a 501(c)(4) group’s website?

A. Websites would be fully covered. For example, the IRS explains that “content previously posted by an organization on its website that clearly identifies a candidate and remains on the website during the specified pre-election period would be treated as candidate-related political activity.” So, an organization may have to choose between counting some or all of the website costs as “political” or scrubbing its website during those periods of all references to “candidates,” regardless of the fact that they only pertain to incumbents’ official conduct and regardless of their importance and immediacy to the group’s legislative and advocacy programs and needs. The NPRM also asks for comments on: whether and under what circumstances material posted by a third party on an organization’s website should be attributed to the organization, and whether establishing and maintaining a link to another website that contains candidate-related political activity, where the linking organization has no control over the content, should be attributed to the 501(c)(4) as its own activity.

Q. Would the 501(c)(4) definition of political activity be the same for 501(c)(3) organizations, which are prohibited from engaging in any direct or indirect participation or intervention in political campaigns?

A. Not necessarily. While the IRS requests comments on whether there should also be new rules for 501(c)(3) organizations’ political activities, the NPRM asks whether 501(c)(4) “political” activities should overlap but differ from those for 501(c)(3) groups. The IRS says a “more nuanced” approach may be necessary for 501(c)(3)s because they are prohibited from undertaking any political activities.

Q. Would the same definition be used for labor organizations and trade associations to determine their activities that are political and do not constitute their primary purpose?

A. Possibly. Although the IRC and the IRS regulations do not specify that labor organizations or trade associations must have a particular “exclusive” or “primary” purpose, the IRS does apply a primary-purpose standard to them. And, like 501(c)(4)s, they are subject to the 527(f) tax on their political activities. The NPRM explicitly asks for comments about whether they should be subject to the same “political” activity standards as 501(c)(4)s. The NPRM asserts that any such revised rules for those groups would be adopted only after another rulemaking (which could be initiated at any time). So, how the IRS redefines political activities for 501(c)(4)s effectively could determine how they are redefined for unions and trade associations as well.




IRS Releases Publication on Tax-Exempt Status for Organizations.

The IRS has released Publication 557 (rev. Oct. 2013), Tax-Exempt Status for Your Organization, which explains the rules and procedures for organizations to obtain recognition of exemption from federal income tax under section 501(a) and discusses the procedures to obtain an appropriate ruling or determination letter recognizing the exemption.

http://www.irs.gov/pub/irs-pdf/p557.pdf




Firm Suggests Ways for Public Hospitals to Relinquish Exemption.

T.J. Sullivan of Drinker Biddle & Reath LLP, in comments on proposed regulations (REG-106499-12) that provide guidance to charitable hospital organizations on the community health needs assessment requirements and related excise tax and reporting obligations, has suggested ways that a governmental entity could voluntarily terminate its section 501(c)(3) status.

October 17, 2013

Internal Revenue Service

Office of Chief Counsel

CC:PA:LPD:PR (REG-106499-12)

Room 5203

PO Box 7604

Ben Franklin Station

Washington, DC 20044

RE: Public Hospital Relinquishment of Exemption Under Section 501(c)(3)

Dear Sir or Madam:

I am writing on behalf of East Alabama Healthcare Authority (EAHA) and similarly situated public hospitals, all of the income of each of which is excluded from federal income tax under Section 115 of the Internal Revenue Code of 1986, as amended (the “Code”) and which have, voluntarily at some point in the past, sought and received recognition of exemption as a hospital described in Section 501(c)(3) of the Code. EAHA appreciates this opportunity to comment on the proposed regulations implementing new Code Section 501(r). EAHA believes some of the requirements imposed by Code Section 501(r) on all Section 501(c)(3) hospitals may be unnecessarily burdensome if applied to public hospitals and requests that the Internal Revenue Service (“IRS”) adopt an administrative mechanism to allow EAHA and similarly situated public hospitals to voluntarily relinquish their Section 501(c)(3) recognition if they so choose.

Although already effectively exempt from federal and state income taxation as a governmental entity, or instrumentality thereof, under the intergovernmental immunity doctrine, many local governmental hospital organizations like EAHA previously obtained determinations from the IRS that they were tax-exempt organizations described in Section 501(c)(3) of the Code. A common reason for voluntarily seeking Section 501(c)(3) recognition (in addition to the entity’s exclusion from gross income through intergovernmental immunity as a governmental entity) was to allow the organization’s employees to participate in Section 403(b) qualified retirement plans. Many such organizations, including EAHA, also have been determined to be exempt from the Form 990 filing obligation which, prior to enactment of Section 501(r), was the only real disadvantage to Section 501(c)(3) status for such organizations. Enactment of Section 501(r), however, has placed a substantial burden on these governmental hospital organizations that, like EAHA, have obtained Section 501(c)(3) determinations. Since they have a solid alternate exemption to rely on, such governmental hospital organizations likely will reconsider whether the additional Section 501(c)(3) recognition is necessary or even advisable. Unfortunately, it appears that there presently is no effective process for a public hospital to voluntarily relinquish Section 501(c)(3) status after it has been recognized.

In addition to requesting that such a process be adopted in the final Section 501(r) regulations, if not beforehand, the remainder of this comment letter is intended to offer possible suggestions for a process under which a governmental entity, or an affiliate or instrumentality thereof, could voluntarily terminate its Section 501(c)(3) recognition as seemingly contemplated by Rev. Proc. 2013-4, Section 7.04(14).

In Rev. Proc. 2012-4, the IRS added the following as Section 7.04(14):

In exempt organization matters, the Exempt Organizations Determinations office issues determination letters involving: Government entity voluntary termination of § 501(c)(3) recognition (must include documentation of tax-exempt status other than under § 501(a)).

This exact same language appeared again in Rev. Proc. 2013-4, Section 7.04(14). However, the IRS apparently has never fully implemented a procedure to permit governmental entities with Section 501(c)(3) recognition to voluntarily terminate their Section 501(c)(3) recognition. Without a specific procedure in place, it appears that a governmental hospital organization with a Section 501(c)(3) determination may be treated like all other Section 501(c)(3) recognized entities in that it may not voluntarily relinquish its Section 501(c)(3) status absent some organizational or operational change in character sufficient to remove it from the description of Section 501(c)(3). See, e.g., Gen. Couns. Mem. 37165 (June 14, 1977).

We would like to propose three alternative procedures under which the IRS could allow a governmental entity to pursue the course of action apparently contemplated in Section 7.04(14) of Rev. Proc. 2013-4. Initially, we would suggest a clarification that Section 7.04(14) applies not only to governmental entities but also to affiliates and instrumentalities of governmental entities. Certain affiliates and instrumentalities of governmental entities are exempt organizations through both the intergovernmental immunity doctrine and Section 501(c)(3) recognition by virtue of their relationship with a governmental entity. Therefore, it makes sense to permit such public hospital organizations to voluntarily terminate their Section 501(c)(3) recognition as well.

The first alternative proposed procedure is for the IRS to amend Part II of Form 8940, Request for Miscellaneous Determination Under Section 507, 509(a), 4940, 4942, 4945, and 6033 of the Internal Revenue Code. This amendment would provide the option for such organizations to request a determination letter in accordance with Rev. Proc. 2013-4, Section 7.04(14) by checking the applicable box on the revised Form 8940. This is the most efficient procedure in our opinion for both the taxpayer and the IRS and the most likely to produce a timely result.

A second alternative proposed procedure is for the IRS to permit such organizations to submit a determination letter request pursuant to the current procedures provided in Rev. Proc. 2013-4, but as amended as described below. This procedure would allow the Exempt Organizations Determinations office to issue determination letters to taxpayers submitting properly formatted and documented requests with the applicable user fee provided in the Rev. Proc. In connection with this proposal, we would propose an amendment to the current language of the Rev. Proc. requiring the governmental entity to include documentation of tax-exempt status other than under Section 501(a). Instead, we propose requiring the requesting taxpayer to certify (under penalties of perjury) that all of its income is excluded under Section 115 within its determination letter request.

Since governmental entities are effectively exempt from federal income taxation under the intergovernmental immunity doctrine, many do not have written documentation from the IRS to establish their tax-exempt status or gross income exclusion other than under Section 501(a). Instead, these entities have made their own determination of their tax-exempt status. If their determination is found by the IRS to be incorrect, the entity is deemed taxable. Requiring a taxpayer requesting a determination letter under Section 7.04(14) of Rev. Proc. 2013-4 to certify its tax-exempt status other than under Section 501(a) provides the IRS with assurance that entity assets will remain devoted to tax-exempt or governmental purposes. If an entity’s certification is erroneous, the entity would be treated as any other taxable entity that misclassified itself as tax-exempt. Requiring more determinative evidence of alternate tax-exempt status other than under Section 501(a) seems unnecessary for an entity requesting voluntary termination of its Section 501(c)(3) recognition when such evidence is not required absent previously obtaining a Section 501(c)(3) determination, and likely would be costly and fraught with delay.

The third alternative proposed procedure is to permit such organizations to submit a determination letter request pursuant to the procedure provided in Rev. Proc. 2013-4. This would allow the Exempt Organizations Determinations office to issue determination letters to taxpayers submitting properly formatted and documented requests with the applicable user fee provided in the Rev. Proc. As the current language of the Rev. Proc. requires the governmental entity to include documentation of tax-exempt status other than under Section 501(a), we would propose that the IRS incorporate an expedited process for obtaining a private letter ruling to fulfill this requirement. The private letter ruling could be processed by the Chief Counsel’s office, but requested by the taxpayer submitting one overall determination letter request that also contains an expedited private letter ruling request.

This comment letter proposes three alternative suggestions for a governmental entity, or an affiliate or instrumentality thereof, that operates a public hospital to voluntarily terminate its Section 501(c)(3) recognition. The administrative burden of each of these options for the taxpayer and the IRS varies. We prefer, and therefore recommend, the first alternative. However, all three would provide a viable method to allow a governmental entity, or an affiliate or instrumentality thereof, to voluntarily terminate its Section 501(c)(3) recognition.

We appreciate your consideration and would be happy to answer any questions.

Very truly yours,

T.J. Sullivan

Drinker Biddle & Reath LLP

Washington, DC




Fitch 2014 Outlook: Nonprofit Continuing Care Retirement Communities.

Read the report at:

https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=726239




IRS Tells Arizona City Its BABs Don't Qualify for Subsidy Payments.

WASHINGTON — The Internal Revenue Service has told Avondale, Ariz. that it believes $29.8 million of Build America Bonds it issued in 2009 do not qualify for subsidy payments because of tax law violations.

Avondale, which disclosed the IRS’ Nov. 12 proposed adverse determination letter in an event notice posted on the Municipal Securities Rulemaking Board’s EMMA system this week, said the subsidy payments for the BABs are estimated to be between $675,000 and $54,000 per year for 25 years. It said the loss of the subsidy payments, if retroactive, could total about $10.83 million from issuance through maturity.

The IRS claims the bonds don’t qualify for the subsidy payment because the BABs are private-activity bonds and because of alleged issue price problems, according to the event notice.

But Avondale is disputing the IRS’ proposed determination. “The city does not agree with the positions taken by the service in the notice and plans to exercise appeal rights,”  the city said in its event notice.

The BAB program was created under the American Recovery and Reinvestment Act and allowed state and local governments to issue taxable bonds in 2009 and 2010 and receive subsidy payments from the Treasury Department equal to 35% of the interest costs.

The BABs were issued to finance street improvements, sewer improvements and a multi-purpose recreation center, according to their official statement. Kevin Artz, Avondale’s finance and budget director, said that under a lease agreement, a private company operates the recreational center and shares some of the profits with the city.

Under federal tax law, BABs cannot be private activity bonds. Bonds are private activity bonds if more than 10% of a project is used by private parties and more than 10% of the debt service is paid for or secured by private parties.

Artz also said the IRS thinks the BABs were issued with more than a de minimis amount of premium, generally defined as 0.25% of the stated redemption price at maturity multiplied by the number of complete years from the bond’s issue date to its maturity date.

The IRS’ letter does not affect the ad valorem tax levy required on taxable property in Avondale to pay debt service on the bonds, the city said in its event notice.

Greenberg Traurig LLP served as bond counsel for the deal and Robert W. Baird & Co. served as underwriter, according to the official statement. Stone & Youngberg, now a division of Stifel Nicolaus & Co., served as financial advisor.

At least two other issuers have settled tax disputes over BABs with the IRS.

In 2012, Half Moon Bay, Calif. agreed to reduce its subsidy payments to 29% for $10.2 million of BABs it issued in 2009 after the IRS claimed the bonds violated the tax law because they were not used for capital expenditures.

A few months ago, the Nebraska Public Power District agreed to pay $350,000 to settle IRS charges that some of the bonds were sold at a price greater than the de minimis amount of premium.

BY NAOMI JAGODA

DEC 4, 2013 4:11pm ET




State Treasurer Cites Potential Adverse Effects of Proposed Regs on Arbitrage Restrictions.

Washington State Treasurer James McIntire has expressed concern with proposed regs (REG-148659-07) modifying the rules for determining the issue price of tax-exempt bonds for arbitrage purposes, warning that the regs would impose burdensome and potentially unworkable market monitoring obligations on municipal issuers.

November 27, 2013

Internal Revenue Service

P.O. Box 7604

Ben Franklin Station

Washington DC 20044

November 26, 2013

Re: Comments on REG-148659-07

To whom it may concern:

I am writing on behalf of the State of Washington to comment on the Internal Revenue Service’s proposed regulations released on September 13, 2013, (REG-148659-07) specifically the proposed provisions modifying the long-standing rules for determining issue price (the “Proposed Issue Price Rules”).

Based on our experience as a large and frequent issuer of municipal bonds, we strongly believe the Proposed Issue Price Rules, if enacted as drafted, would increase the cost of capital for the State of Washington, result in higher arbitrage yields, increase the amount of interest income exempt from Federal tax and increase the potential for profitable “flipping” of tax-exempt bonds in the secondary market. Further, the Proposed Issue Price Rules would impose burdensome and potentially unworkable market monitoring obligations on municipal issuers. It is critical to the continued effective functioning of the municipal bond market that any revised issue price rules retain a “reasonable expectations” provision and maintain the definition of “substantial amount” or “safe harbor amount” at or close to 10%.

Eliminating the “reasonable expectations” provision and changing the 10% “substantial amount” definition to a 25% “safe harbor” provision creates strong incentives for underwriters and issuers to price bonds at interest rates that ensure that 25% of each maturity of a bond issue will be sold to end investors at the list price immediately on the date of sale. Qualifying for the 25% safe harbor in this way eliminates (a) the costs and time commitment required for issuers, underwriters and/or legal counsel to monitor and interpret secondary market trading information over multi-week time periods; (b) the need to perform onerous and potentially complex yield adjustment calculations; (c) the risk of being required to make “yield reduction payments;” and (d) an underwriter’s risk that it could be accused of abusive “flipping” of bonds post sale. But pricing bonds to be able to qualify for the 25% safe harbor will undoubtedly result in higher interest rates.

In negotiated sales, the State of Washington negotiates with underwriters to achieve the lowest possible all-in cost for a bond issue, given market conditions at the time of sale. Frequently, this process results in certain maturities being fully or partially underwritten by the underwriting group rather than being sold immediately to end investors on the day of sale. The practical requirement to immediately sell 25% of each maturity to end investors will greatly diminish our ability to negotiate for higher prices or interest rates that are lower than the rates required to sell 25% of each maturity. This will generally lead to higher all-in interest costs on negotiated bond sales and higher arbitrage yields. It also generates more interest-income exempt from Federal tax. Moreover, this will create more opportunities for end investors or underwriters to “flip” bonds at lower interest rates and higher prices in the days and weeks after a bond sale.

The Proposed Issue Price Rules could even more severely disrupt the functioning of the competitive new issue market by introducing significant uncertainty and administrative burden. This will have a material negative impact on our state’s cost of capital as Washington issues nearly all of its debt through competitive sales. In competitive bond sales, there are very limited opportunities for dealers to “pre-market” upcoming issues to investors. Underwriters bid for entire bond issues at prices they expect but have no assurance will enable them to sell most of the bonds to the public and other dealers. The practical requirement to ensure that 25% of each maturity will be sold quickly to the public at list price will motivate underwriters to bid lower prices and higher yields.

In addition to the significant adverse impact the Proposed Issue Price Rules would have on borrowing costs of issuers like ourselves, there are significant impediments to their accurate application in any case. Market information dissemination platforms provided by the MSRB (EMMA), Bloomberg and Thompson-Reuters (TM3) provide reasonably good information on secondary market trading, but the information is not 100% accurate. Further, the information provided can be difficult to interpret given that no dealer or investor names are disclosed, trade amounts greater than $5 million par amount are not disclosed until one week following the trade date and trade details can be revised long after the trade information is originally submitted. Further, trade tracking can be complicated by intra-entity trades and distribution affiliation agreements that exist among some dealer firms.

In conclusion, we are strongly in agreement with the wide range of market participants who believe that the Proposed Issue Price Rules will penalize issuers who negotiate the best deals with underwriters, result in higher arbitrage yields for tax purposes and increased amounts of interest income exempt from Federal tax. We firmly believe that the current rules, coupled with prudent IRS enforcement, are and will continue to be highly effective in achieving the interrelated goals of minimizing borrowing costs for issuers, minimizing arbitrage yields and minimizing the amount of interest income exempt from Federal tax.

Sincerely,

James L. McIntire

State Treasurer

State of Washington

Olympia, WA




IRS Releases Federal and State Reference Guide Publication.

The IRS has released Publication 963 (rev. Nov. 2013), Federal-State Reference Guide, which provides state and local government employers a complete reference source for Social Security and Medicare coverage guidance and FICA tax withholding issues.

http://www.irs.gov/pub/irs-pdf/p963.pdf




Insurance Industry Unhappy About New Identified Mixed Straddle Regs.

The insurance industry does not support new proposed (REG-112815-12) and temporary (reg. section 1.1092(b)-6T; T.D. 9627) regulations on identified mixed straddles (IMSs) because they limit insurers’ ability to use capital loss carryforwards, speakers said at a December 4 IRS hearing on the regs.

The insurance industry does not support new proposed (REG-112815-12 ) and temporary (reg. section 1.1092(b)-6T; T.D. 9627 ) regulations on identified mixed straddles (IMSs) because they limit insurers’ ability to use capital loss carryforwards, speakers said at a December 4 IRS hearing on the regs.

Peter J. Bautz of the American Council of Life Insurers and Jeffrey Maddrey of PricewaterhouseCoopers LLP commented on the new regulations’ adverse effect on the insurance industry, particularly the asymmetrical tax treatment for bond holders.

Maddrey said he believes the existing regulations, which have been in place since 1985, allow insurance companies to use expiring loss carryforwards. “We continue to believe these transactions are entirely appropriate under current law, especially considering the context of the way insurance companies operate their business,” he said.

A mixed straddle exists when one leg of the straddle is marked to market while the other leg is not. Insurers use an IMS when they have expiring loss carryforwards; the IMS preserves an insurer’s ownership in the bond but allows it to recognize gain to offset the expiring losses. The proposed and temporary regulations eliminate a taxpayer’s ability to recognize gain on an IMS, freezing the gains when the taxpayer enters the mixed straddle and recognizing the gains only when the position is ultimately disposed.

Bautz conceded that there are other ways for insurers to recognize gains, such as by selling appreciated bonds and buying similar ones from the market. However, he said, those alternatives significantly increase transaction costs.

The commentators noted that asymmetrical bond treatment affects the insurance industry in particular because the industry’s investment portfolios are generally all bonds. Asymmetry exists in bond taxation because gain is generally ordinary while losses are capital. The industry uses the identified straddle rules to trigger gain that offsets expiring bad debt capital losses. According to Maddrey, taxpayers trigger gain when interest rates are declining, thus increasing the value of the bonds. He argued that “buy and hold” investors need a way to trigger gain when they have expiring capital losses and that the existing regulations provide just that.

Maddrey also said that while other types of investors have the luxury of a diversified portfolio with various liquid assets, insurance companies generally purchase bonds with the intention of holding them to maturity. That means that other investors are able to trigger gain more easily to offset expiring losses.

Treasury initially released the proposed and temporary regs on August 2 and made them immediately effective. However, commentators raised concerns regarding an immediate effective date, and Treasury later delayed the applicability until final regulations are released. The final regs are expected to be released by the end of June 2014.

by William R. Davis




IRS: 2014 Standard Mileage Rates.

Notice 2013-80 provides the optional 2014 standard mileage rates for taxpayers to use in computing the deductible costs of operating an automobile for business, charitable, medical, or moving expense purposes.  This notice also provides the amount taxpayers must use in calculating reductions to basis for depreciation taken under the business standard mileage rate, and the maximum standard automobile cost that may be used in computing the allowance under a fixed and variable rate (FAVR) plan.

Notice 2013-80 is available at:

http://www.irs.gov/pub/irs-drop/n-13-80.pdf




IRS Releases Publication on Charitable Contributions.

The IRS has released Publication 526 (rev. 2013), Charitable Contributions, which explains how to claim a deduction for charitable contributions and discusses organizations that are eligible to receive deductible charitable contributions.

http://www.irs.gov/pub/irs-pdf/p526.pdf




Contracts and Grants between Nonprofits and Government.

This brief summarizes the results of the 2013 National Survey of Nonprofit-Government Contracts and Grants. Expanding on the 2010 study of human service nonprofits, we examine most types of nonprofits with expenses of $100,000 or more. This report documents the size and scope of government financing, administration of contracts and grants, and nonprofit perceptions of problems and improvements in these processes and reports on the financial status of nonprofits at the end of the Great Recession. Nearly 56,000 nonprofits have government contracts and grant, and we estimate that governments paid $137 billion to nonprofits in 2012.

Read the full report at:

http://www.urban.org/UploadedPDF/412968-Contracts-and-Grants-between-Nonprofits-and-Government.pdf

Sarah L. Pettijohn, Elizabeth T. Boris




Capping Charitable Deduction Will Reduce Giving, AEI Predicts.

Although recent tax increases may stimulate charitable giving in the short term, enacting a proposed limit on the charitable deduction would significantly reduce donations and result in “serious — maybe catastrophic” harm to many nonprofits, the American Enterprise Institute predicted in a December report.

http://www.aei.org/papers/economics/fiscal-policy/taxes/the-great-recession-tax-policy-and-the-future-of-charity-in-america/




EOs Should Pay Attention to Tax Reform, Panel Says.

Although prospects of passing a tax reform package anytime soon are slim, tax-exempt organizations should be alert to what tax reform could mean to them, panelists at a program on legislation and exempt organizations said December 4.

Although prospects of passing a tax reform package anytime soon are slim, tax-exempt organizations should be alert to what tax reform could mean to them, panelists at a program on legislation and exempt organizations said December 4.

Alexander L. Reid of Morgan, Lewis & Bockius LLP, moderating a program sponsored by the District of Columbia Bar Taxation Section’s Exempt Organizations Committee, said that based on his recent conversation with a House Ways and Means Committee tax counsel, the exempt organizations portion of the tax reform bill being drafted by committee Chair Dave Camp, R-Mich., is significant and far-reaching. Topics that have been the subject of committee hearings in recent years — colleges and universities, political and lobbying activities, and commercial activities, among others — are areas that members have found interesting, Reid said, adding, “Anything that there has been a hearing on is on the table.”

Reid also said that although committee members want to preserve the deduction for charitable contributions, “they also want to envision the [charitable] sector as it is today and maybe as it will be in the next five to 10 years.”

Alan Lee, Ways and Means Democratic tax counsel, who spoke on his own behalf, said there are rumors that Camp is not committed to maintaining the charitable deduction in its current form, although that does not mean he wants to repeal it or cap it at 28 percent, as has been proposed before.

Camp, who had originally intended to introduce and have his committee mark up a tax reform bill by the end of 2013, told reporters December 4 that that won’t be possible. (Related coverage .)

Lee said that while a bill next year is possible, it would be difficult to act on tax reform when there are so many budget issues to deal with. “Getting tax reform through the House, I think, is a very difficult prospect,” Lee said. “Once members start realizing this is not just a rate reduction exercise and that this actually has real impacts because these are real policies, you’re going to have a lot of members in the Republican caucus taking a step back and wanting to really take a closer look at the bill.”

Alexander Brosseau, Democratic tax policy analyst for the Senate Budget Committee, said that for a tax reform bill to succeed, it would have to have bipartisan support. “Certainly, coming out of the House, it has to, so long as the Senate is controlled by Democrats and the White House [is] the same,” he said.

by Fred Stokeld




TE/GE Memo Revises Procedures for Verifying Membership Requirements of Veterans' Organizations.

The IRS has issued a memorandum (TEGE-04-1113-21) revising examination guidelines for section 501(c)(19) tax-exempt veterans’ organizations to eliminate an agent’s discretion to request military service discharge certificates at the start of exams for purposes of determining whether the organization meets statutory membership requirements.

November 26, 2013

Affected IRM: IRM 4.76.26

Expiration Date: Nov 26, 2014

MEMORANDUM FOR

ALL EO EXAMINATIONS MANAGERS,

ALL EO EXAMINATIONS REVENUE AGENTS

FROM:

Nanette M. Downing

Director, EO Examinations

SUBJECT:

Verification of Statutory Membership Requirements

of Veterans’ Organizations

This memorandum revises examination guidelines for tax-exempt veterans’ organizations described in section 501(c)(19) of the Internal Revenue Code (IRC) by eliminating an agent’s discretion to request DD Forms 214 at the outset of examinations for the purpose of determining whether the organization meets statutory membership requirements.

IRC sections 501(c)(19) and 170(c)(3) provide statutory membership requirements for certain tax-exempt veterans’ organizations. Compliance with these requirements has a direct effect on the qualification for tax-exempt status and the deductibility of contributions.

In order to confirm whether a veterans’ organization meets statutory membership requirements, IRM 4.76.26.12(1) provides that examining agents may request, among other documents, DD Forms 214, Certificate of Release or Discharge from Active Duty, of veterans’ organizations. DD Form 214 is a military service discharge certificate issued to veterans, providing proof of military service. However, DD Form 214 also contains private information, such as medical information.

Effective immediately, if an agent needs to determine the composition of membership of a veterans’ organization, the agent shall initially request and collect from the organization four sets of documents, as follows:

1. Membership list(s) that contain the names of the members, the military service dates, and the status of each individual member. This status information is to indicate whether the member is active duty, veteran, cadet, or spouse. The organization may provide list(s) from its affiliated parent organization.

2. A document that shows the dues structure and classes of memberships.

3. The documentary information used by the organization to create the membership list(s) noted above. Organizations should be informed that to satisfy this request they may provide membership applications, membership cards, or other similar documents, other than DD Form 214.

4. Documents showing the organization’s policies and procedures on how it decides an individual is eligible for membership, including documents which show the means by which it enforces its membership requirements.

If an agent possesses information that contradicts documentary information provided or if the organization fails to satisfy a reasonable request, agents may then request DD Forms 214 or other discharge documents from the organization in order to ascertain compliance with the federal tax laws cited herein. DD Forms 214 must include the name, department, component and branch of service, and record of service dates. All other personal information may be redacted.

The contents of this memorandum will be incorporated in IRM 4.76.26.

Please submit your questions to Mandatory Review via *TEGE EO Review Staff.




NABL Seeks Guidance on Political Subdivision Question.

Allen Robertson of the National Association of Bond Lawyers has submitted to Treasury a memorandum requesting guidance on whether an issuer with a limited number of property owners, electors, or taxpayers is a political subdivision for purposes of section 103.

November 21, 2013

Vicky Tsilas

Associate Tax Legislative Counsel

Office of the Tax Legislative Counsel

Department of the Treasury

1500 Pennsylvania Avenue, NW Room 3044

Washington DC 20220

James Polfer

Branch V Chief, Financial Institutions and Products

Internal Revenue Service

1111 Constitution Ave NW

Washington, DC 20224-0001

Dear Ms. Tsilas and Mr. Polfer:

The National Association of Bond Lawyers (“NABL”) respectfully submits the attached memorandum requesting guidance on whether an issuer with a limited number of property owners, electors or taxpayers is a political subdivision for purposes of section 103 of the Internal Revenue Code. This guidance is necessary as a result of Technical Advice Memorandum 201334038 (the “TAM”), which NABL believes is contrary to established legal authority. The TAM has had an immediate chilling effect on the issuance of tax-exempt bonds by such issuers throughout the country and has raised questions in the market about outstanding bonds of such issuers, which may result in a loss in value of those bonds for current holders. This memorandum was prepared by an ad hoc taskforce comprised of those individuals listed on Exhibit A, and was approved by the NABL Board of Directors.

NABL exists to promote the integrity of the municipal market by advancing the understanding of and compliance with the law affecting public finance. We respectfully provide this submission in furtherance of that mission.

If NABL can provide further assistance, please do not hesitate to contact Bill Daly in our Washington, D.C. office at (202) 503-3300.

Sincerely,

Allen K. Robertson

National Association of Bond

Lawyers

Washington, DC

* * * * *

MEMORANDUM

GUIDANCE ON “POLITICAL SUBDIVISION”

Technical Advice Memorandum 201334038, dated August 23, 2013 (the “TAM”), has raised concerns in the bond community regarding the issuance of tax-advantaged obligations by certain issuers having a limited number of property owners, electors or taxpayers (“Districts”). The National Association of Bond Lawyers (“NABL”) is concerned that the Internal Revenue Service’s position in the TAM is contrary to established legal authority regarding the requirements for a District to qualify as a political subdivision and that this change has had an immediate chilling effect on the issuance of tax-exempt bonds by Districts throughout the country.

Under the traditional legal analysis that has been applied by the courts, the IRS, and practitioners for many years, the determination of whether an entity is properly considered a political subdivision for federal income tax purposes is based on whether it has been delegated the right to exercise substantial sovereign powers.1 These sovereign powers include the power to tax, the power of eminent domain and the police power. A qualified issuer need not have all three powers but it must have more than an insubstantial amount of at least one of the sovereign powers.

The TAM raises serious concerns with respect to certain issuers. The TAM calls into question whether Districts with a limited number of property owners, electors or taxpayers may ever qualify as a “division of a state or local government” by asserting that “an entity that is organized and operated in a manner intended to perpetuate private control, and to avoid indefinitely responsibility to a public electorate, cannot be a political subdivision of a State,” effectively requiring that the governing board of a District either be elected by a broad-based electorate or be appointed by a state or local government that is itself elected by a broad-based electorate.

Position in TAM Not Supported by Existing Authority.

The TAM cites Revenue Ruling 83-1312 for the proposition that an essential factor to be considered in determining whether a District is a political subdivision is whether the District is controlled by a state or local government.

The entities considered in Revenue Ruling 83-131 were North Carolina electric and telephone membership corporations that provided utility services, and the ruling addressed the applicability of an exception to the excise tax imposed on the sale or use of diesel fuel under then section 4041 of the Code. Former section 4041(g)(2) of the Code provided an exception from the diesel fuel excise tax “with respect to the sale of any liquid for the exclusive use of any State, any political subdivision of a State, or the District of Columbia, or with respect to the use by any of the foregoing of any liquid as a fuel.” The ruling stated that “the term political subdivision has been defined consistently for all federal tax purposes as denoting either a division of a state or local government that is a municipal corporation or a division of a state or local government that has been delegated the right to exercise sovereign power.” The ruling stated that the corporations at issue did not have the power to tax or police power, and that their power of eminent domain was significantly limited, and therefore “the corporations do not have sufficient sovereign power to qualify as political subdivisions.”

Revenue Ruling 83-131 proceeded to state that “[a]lthough the corporations are not political subdivisions, they still would come within the scope of the exemption in question if sales to them could be considered to be made for the exclusive use of a state or local government.” The ruling then provides that “[i]in determining whether a sale to, or use by, an organization is for the exclusive use of a state or local government, it must be established that the organization either (a) is controlled, directly or indirectly, by an agency of a state or local government, or (b) is performing a traditional governmental function on a nonprofit basis.” Thus, the language in Revenue Ruling 83-131 which is the sole authority cited in the TAM for the proposition that control by a state or local government is an essential element for qualification as a political subdivision was not from the part of the ruling dealing with political subdivision status, but rather was from the part of the ruling that analyzed whether, even though the corporations were not political subdivisions, sales to such corporations might nonetheless be considered made “for the exclusive use of a state or local government.” In determining that the corporations at issue were not political subdivisions, Revenue Ruling 83-131 relied exclusively on the traditional analysis described above regarding whether the corporations had been delegated authority to exercise more than an insubstantial amount of one or more of the sovereign powers.3

Not only does the lone authority cited in the TAM not support the position asserted in the TAM as described above, we are aware of no other authority supporting the proposition that a District having a limited number of property owners, electors or taxpayers cannot qualify as a political subdivision. In fact, such a proposition is contrary to other precedents in which Districts were respected notwithstanding the fact that all or substantially all of the property in the District is owned by a single landowner (or related landowners). In Commissioner v. Birch Ranch & Oil Co., 192 F.2d 924 (9th Cir. 1951), the court held that the taxpayer was entitled to deduct payments made to a District, stating:

Since the district met the requirements of California law, its status as a district entity, not to be confused with the owners of the ranch, or the taxpayer-corporation, cannot be questioned regardless of the fact that the district served but a single ranch, (plus one 240 acre parcel). The western states have long considered that the reclamation, even of a single parcel of land in a single ownership, may justify the exercise of sovereign powers. Here the power afforded is that of taxation.

Id. at 928. Similarly, in Rutland v. Tomlinson, 63-1 U.S.T.C. ¶ 9173 (DC. Fla. 1963), the court upheld the taxpayer’s deductions for taxes paid to a District in which the taxpayer owned approximately 95 percent of the land comprising the District. See also Rev. Rul. 76-45, 1976-1 C.B. 54 (holding that taxes imposed by a District formed and controlled by a single taxpayer are deductible to the extent allocable to maintenance or interest charges).

It also should be noted that in Announcement 2011-78, 2011-51 I.R.B. 874, in an advance notice of proposed rulemaking relating to governmental employee benefit plans under section 414 of the Code, the IRS proposed a definition of political subdivision that included a requirement that the governing officers of the entity be either appointed by State officials or publicly elected. The Announcement acknowledged that the term “political subdivision” is also used for other purposes of the Code, and provided that the proposed definition would not apply for any other purposes of the Code, with a specific reference to section 103 of the Code, thus recognizing that the proposed definition in the Announcement would be contrary to existing authority under section 103 and should not be applied for purposes of section 103.

IRS Concern over Private Entities

It appears that the principal concern of the IRS underlying the analysis set forth in the TAM is the possibility that a non-governmental entity could assert political subdivision status solely by reason of being delegated a limited right to exercise sovereign power. The IRS states in the TAM that “the mere delegation of sovereign power is not sufficient to create a political subdivision. If it were sufficient, then a clearly private entity with powers of eminent domain, including some railroads and utilities, could issue bonds without any political oversight.”

While we appreciate the IRS’s concern regarding private entities asserting the ability to issue tax-exempt bonds, a number of factors make the typical District clearly distinguishable from such private entities. Districts typically are formed under specific state statutes containing detailed requirements regarding how a District must be formed, the powers a District may exercise, the activities a District may undertake, how a District’s governing body is elected or appointed, and disposition of the District’s assets upon dissolution. Moreover, under applicable governing statutes, formation and operation of a District may also involve state or local government approval of a service or business plan, intergovernmental agreements relating to the provision of facilities and services, approval of property platting, permitting and/or licensing, oversight of finances and operations through required periodic reporting, a contribution of funds to the financing by a state or local governmental unit, and judicial validation of the entity’s creation and/or issuance of its debt. In addition, state law often provides that Districts are considered political subdivisions and/or governmental entities for state law purposes, resulting in the District being subject to numerous state law requirements generally applicable to governmental entities, such as open meeting and public records laws, requirements to adopt a budget and conduct an audit, governing body members being subject to conflict of interest and disclosure laws, and governing body members or employees being treated as governmental/public officials or employees.

Thus, under State law, the typical District is subject to substantial controls over its formation and operation, and is subject to numerous requirements generally applicable to governmental entities, all intended to ensure that such Districts are used solely in furtherance of the public purposes that were intended by the State legislature to be furthered when the legislation authorizing the formation of such Districts was enacted. All of these factors are evidence of the public control and public accountability that typically apply to Districts, as governmental entities, and that exist regardless of the number of property owners, electors or taxpayers that may exist in the District.

Request for a Safe Harbor.

NABL is concerned that the reasoning of the TAM has led to confusion among issuers and their counsel as to the appropriate standard to be applied in determining whether a District qualifies as a political subdivision eligible to issue tax-advantaged bonds. As a result, transactions that would have otherwise gone forward have been put on hold pending clarification as to whether the holding of the TAM represents a change of what was thought to be well-established law, and bonds that were previously issued are trading at reduced prices as a result of the uncertainty, causing losses in value to current holders.

The Internal Revenue Service and Treasury have often issued guidance to establish “safe harbors” for issuers of tax-exempt obligations. Generally, if an issuer is within the confines of a safe harbor, it is able to market its obligations to investors, invest its bond proceeds or undertake an action related to its bond-financed property with the comfort that the Internal Revenue Service will not challenge a particular issue of law. Given the concerns raised by the TAM, NABL believes that a safe harbor that, if satisfied, would result in a District being recognized as a political subdivision for purposes of the issuance of tax-advantaged obligations is appropriate. The requirements of the safe harbor are intended to reflect the requirements of existing authority, while also addressing the IRS’s concerns over private entities potentially claiming political subdivisions status.

NABL respectfully suggests the following safe harbor:

An issuer will be a political subdivision for purposes of section 103 of the Code if:

1. The issuer is treated as a political subdivision, political body or municipal corporation under applicable State law,

2. The issuer has been delegated more than an insubstantial amount of the power of eminent domain, the power to tax or the police power; and

3. Upon the dissolution of the issuer, the assets of the issuer are distributed to, or at the direction of, a State or an entity that is treated as a political subdivision, political body or municipal corporation under applicable State law.

For purposes of the foregoing, an entity is generally treated as a political subdivision, political body or municipal corporation under applicable State law if, e.g., it is subject to legal requirements such as open meeting and public records laws, it is required to adopt a budget and conduct an audit, it is required to obtain State or local government approval of a business or service plan, it is subject to judicial validation procedures, its governing body members are subject to public conflict of interest and disclosure laws, or its governing body members or employees are treated as governmental officials or employees.

* * * * *

Exhibit A

NABL Ad Hoc Taskforce Members

Michael L. Larsen

Parker Poe Adams & Bernstein LLP

200 Meeting St Ste 301

Charleston, SC 29401

Telephone: (843) 727-6311

Email: [email protected]

Richard J. Moore

Orrick, Herrington & Sutcliffe LLP

405 Howard St

San Francisco, CA 30303

Telephone: (415) 773-5759

Email: [email protected]

Clifford M. Gerber

Sidley Austin LLP

555 California St Ste 2000

San Francisco, CA 94104

Telephone: (415) 772-1246

Email: [email protected]

Mitchell J. Bragin

Kutak Rock LLP

1101 Connecticut Ave NW Ste 1000

Washington, DC 20036

Telephone: (202) 828-2450

Email: [email protected]

David A. Caprera

Kutak Rock LLP

1801 California St Ste 3100

Denver, CO 80202

Telephone: (303) 297-2400

Email: [email protected]

Matthias M. Edrich

Kutak Rock LLP

1801 California St Ste 3100

Denver, CO 80202

Telephone: (303) 297-7887

Email: [email protected]

Robert J. Eidnier

Squire Sanders (US) LLP

127 Public Sq Ste 4900 Key Tower

Cleveland, OH 44114

Telephone: (216) 479-8676

Email: [email protected]

Kimberly C. Betterton

Ballard Spahr LLP

300 E Lombard St FL 19

Baltimore, Maryland 21202

Telephone: (410) 528-0551

Email: [email protected]

Scott R. Lilienthal

Hogan Lovells US LLP

555 13th St NW

Washington, DC 20004

Telephone: (202) 637-5849

Email [email protected]

Carol L. Lew

Stradling Yocca Carlson & Rauth

660 Newport Center Dr Ste 1600

Newport Beach, CA 92660

Telephone: (949) 725-4237

Email [email protected]

Vanessa Albert Lowry

Greenberg Traurig LLP

2001 Market St Ste 2700

Philadelphia, PA 19103

Telephone: (215) 988-7911

Email: [email protected]

Alexandra M. MacLennan

Squire Sanders (US) LLP

One Tampa City Center

201 North Franklin Street, Suite 2100

Tampa, Florida 33602

Telephone: (813) 202-1353

Email: [email protected]

November 21, 2013

FOOTNOTES

1 See Comm’r v. Shamberg’s Estate, 144 F.2d 998 (2d Cir. 1944), cert. denied, 323 U.S. 792 (1945), dealing with bonds issued by the Port Authority of New York; Texas Learning Technology Group v. Comm’r, 96 T.C. 686 (1991); Rev. Proc. 84-37, 1984-1 C.B. 513; Rev. Rul. 77-164, 1977-1 C.B. 20. See also Ellen P. Aprill, “Municipal Bonds and Accountability to the General Electorate” Tax Notes (November 4, 2013), pp. 547-553.

2 1983-2 C.B. 184.

3 Although not specifically relied upon in the ruling, a distinction between Revenue Ruling 83-131 and a prior ruling (Revenue Ruling 57-193, 1957-1 C.B. 364) which had held that North Carolina electric and telephone membership corporations qualified as political subdivisions, was the fact that the applicable State statute had been amended such that assets of the corporation would no longer be distributed to the State upon dissolution.




IRS LTR: Installment Method Not Required for Additional Payment.

The IRS ruled that a taxpayer could recognize gain on additional compensation paid to the taxpayer for property seized under eminent domain using a method of accounting other than the installment method.

Index Number: 1374.00-00, 453.10-02

Release Date: 11/29/2013

Date: August 28, 2013

Refer Reply To: CC:ITA:B04 – PLR-113874-13

Dear * * *:

This letter responds to your request for rulings under § 453 of the Internal Revenue Code and § 1.337(d)-7 of the Income Tax Regulations concerning the $z payment that Taxpayer received as just compensation for property seized by State.

FACTS

During Month 1, State seized property that Taxpayer owned under State eminent domain law and paid Taxpayer $x. Pursuant to that law, Taxpayer treated the $x payment as partial compensation while pursuing a claim against State for just compensation for the seized property. Taxpayer deferred recognition of the gain on the $x payment under § 1033. On Date 1, Taxpayer converted from a C Corporation to a REIT. In Year 1, after vigorous litigation extending over several years, Taxpayer was awarded a final judgment of $y, of which $z was additional just compensation for the seizure and the remainder was interest and costs. If Taxpayer receives the rulings it has requested, Taxpayer intends to include the gain on the $z payment on its Year 1 federal income tax return.

LAW

Section 453(a) provides, in general, that income from an installment sale is taken into account under the installment method. Under § 453(b) (1) an installment sale means a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs.

RULINGS

Ruling 1: Based strictly on the facts taken together that Taxpayer’s property was seized by State, Taxpayer vigorously litigated the amount of the just compensation in State courts over several years, and the $z payment was pursuant to an adverse final judgment of the State court, we rule that Taxpayer may properly recognize the gain on the $z payment on its Year 1 federal income tax return, using a method of accounting other than the installment method under § 453.

Ruling 2: Based strictly on Ruling 1, we rule that if Taxpayer reports the $z payment on its Year 1 federal income tax return, the payment will not be subject to tax under § 1.337(d)-7 of the Income Tax Regulations. Section 1374(d)(7)(C).

Except as expressly provided in rulings 1 and 2, we do not express or imply an opinion concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

The taxpayer must attach a copy of this letter to any income tax return to which it is relevant. Alternatively, a taxpayer filing its returns electronically may satisfy this requirement by attaching a statement to the return that provides the date and control number of the letter ruling.

The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.

In accordance with the Power of Attorney on file with this office, we will send a copy of this letter to your authorized representative.

Sincerely,

Michael J. Montemurro

Chief, Branch 4

Office of Associate Chief Counsel

(Income Tax & Accounting)

Citations: LTR 201348007




Impact of Clergy Rental Exclusion Holding Could Be Big, Practitioners Say.

A U.S. district court decision striking down the rental allowance exclusion for ministers could have a major impact on churches and clergy if it is upheld, practitioners and representatives of religious denominations said November 25.

A U.S. district court decision striking down the rental allowance exclusion for ministers could have a major impact on churches and clergy if it is upheld, practitioners and representatives of religious denominations said November 25.

In a November 22 holding  on a suit brought by the Freedom From Religion Foundation Inc. (FFRF) against the IRS, the U.S. District Court for the Western District of Wisconsin said that section 107(2), which provides for the exclusion, violates the establishment clause of the First Amendment because it benefits only religious people even though the benefit is not needed to ease a special burden on the exercise of religion. Although the exclusion benefits many ministers who may feel its loss if it is taken away, it violates the First Amendment principle that a person’s religion should not affect one’s legal rights, duties, or benefits, Judge Barbara B. Crabb wrote.

The FFRF rejoiced at the news. “This decision agrees with us that Congress may not reward ministers for fighting a ‘godless and anti-religious’ movement by letting them pay less income tax. The rest of us should not pay more because clergy pay less,” FFRF co-presidents Annie Laurie Gaylor and Dan Barker said in a statement .

FFRF’s attorney, Richard L. Bolton, said the holding is not hostile to religion and should not be considered controversial: “The Court has simply recognized the reality that a tax free housing allowance available only to ministers is a significant benefit from the government unconstitutionally provided on the basis of religion.”

Michael E. Batts of Batts Morrison Wales & Lee, who has served as chair of the Commission on Accountability and Policy for Religious Organizations, told Tax Analysts the decision, if upheld, would have a massive impact on houses of worship and clergy across the United States. It would affect the ability of churches and other religious organizations to compensate clergy, he said, adding that churches might have to devote more of their budgets to clergy compensation at the expense of other areas.

In a statement , Russell D. Moore, president of the Ethics and Religious Liberty Commission of the Southern Baptist Convention, said the holding ultimately could harm clergy serving small congregations. “The clergy housing allowance isn’t a government establishment of religion, but just the reverse,” he said. “The allowance is neutral to all religions. Without it, clergy in small congregations of all sorts would be penalized and harmed.”

Crabb stayed enforcement of her decision pending an appeal.

The court’s decision did not implicate the section 107(1) exclusion for clergy living in parsonages provided by churches.

by Fred Stokeld




Court Holds Ministers' Housing Allowance Exemption Is Unconstitutional.

A U.S. district court held that section 107(2), which excludes the rental allowance paid to a minister from gross income, is an unconstitutional violation of the establishment clause and enjoined its enforcement, finding that it provides a benefit to religious persons that it does not give to others.

The Freedom From Religion Foundation (FFRF) and its co-presidents filed a suit in U.S. district court challenging the availability of federal income tax exemptions for “ministers of the gospel” under section 107, arguing that the exemptions violate the Constitution’s establishment and equal protection clauses.

U.S. District Judge Barbara B. Crabb rejected the government’s argument that FFRF and its co-presidents lacked standing to challenge the law, finding that the injury is clear from the face of the statute and that the co-presidents weren’t required to first claim the exemption and have it rejected before filing suit. Crabb said she found it difficult to take seriously the government’s argument that FFRF’s co-presidents may qualify as ministers of the gospel. The court concluded that the statute denied FFRF’s co-presidents an exemption, that they suffered an injury, and that the injury was traceable to those in the government who implement the tax code.

Crabb then addressed the merits of the case and found that based on the Supreme Court’s decision in Texas Monthly Inc. v. Bullock, 489 U.S. 1 (1989), the exemption in section 107(2) violates the establishment clause. In that decision, the Supreme Court held that a state sales tax exemption provided only to publishers of religious writings was unconstitutional. Crabb acknowledged that the withdrawal of the exemption would greatly affect ministers and their churches, but she said that only underscores the preferential treatment that she found to have violated the First Amendment. Crabb concluded her opinion by saying the government isn’t powerless to provide exemptions to benefit religion and that Congress can rewrite the provision so that it complies with the principles established by the Supreme Court.

FREEDOM FROM RELIGION FOUNDATION, INC.,

ANNIE LAURIE GAYLOR AND DAN BARKER,

Plaintiffs,

v.

JACOB LEW AND DANIEL WERFEL,

Defendants.1

IN THE UNITED STATES DISTRICT COURT

FOR THE WESTERN DISTRICT OF WISCONSIN

OPINION AND ORDER

Plaintiff Freedom from Religion Foundation, Inc. and its two co-presidents, plaintiffs Annie Laurie Gaylor and Dan Barker, brought this lawsuit under the Administrative Procedure Act, 5 U.S.C. § 702, contending that certain federal income tax exemptions received by “ministers of the gospel” under 26 U.S.C. § 107 violate the establishment clause of the First Amendment and the equal protection component of the Fifth Amendment. Defendants Timothy Geithner and Douglas Schulman (now succeeded by Jacob Lew and Daniel Werfel) have filed a motion for summary judgment, dkt. #40, which is ready for review.

In their complaint, plaintiffs challenged both § 107(1) and § 107(2), but in response to defendants’ motion for summary judgment, plaintiffs narrowed their claim to § 107(2), which excludes from gross income a minister’s “rental allowance paid to him as part of his compensation.” (Section 107(1) excludes “the rental value of a home furnished to [the minister] as part of his compensation.”) Because plaintiffs have not opposed defendants’ argument that plaintiffs lack standing to challenge § 107(1), I will grant defendants’ motion as to that aspect of plaintiffs’ claim.

With respect to plaintiffs’ challenge to § 107(2), I adhere to my conclusion in the order denying defendants’ motion to dismiss, dkt. #30, that plaintiffs have standing to sue because it is clear from the face of the statute that plaintiffs are excluded from an exemption granted to others. With respect to the merits, I conclude that § 107(2) violates the establishment clause under the holding in Texas Monthly, Inc. v. Bullock, 489 U.S. 1 (1989), because the exemption provides a benefit to religious persons and no one else, even though doing so is not necessary to alleviate a special burden on religious exercise. This conclusion makes it unnecessary to consider plaintiffs’ equal protection argument.

Although plaintiffs did not file their own motion for summary judgment, “[d]istrict courts have the authority to enter summary judgment sua sponte as long as the losing party was on notice that it had to come forward with all its evidence.” Ellis v. DHL Exp. Inc. (USA), 633 F.3d 522, 529 (7th Cir. 2011). In this case, the parties have fully briefed the relevant issues, which are primarily legal rather than factual. Further, plaintiffs asked the court to enter judgment in their favor in their brief in opposition to defendants’ motion for summary judgment. Dkt. #52 at 66. Although defendants objected to this request in their reply brief, dkt. #53 at 3, it was on the same grounds that defendants believe that they are entitled to summary judgment. Defendants do not suggest that they would have raised any other arguments or presented any additional facts if plaintiffs had filed their own motion. Under these circumstances, I conclude that it is appropriate to deny defendants’ motion for summary judgment and grant summary judgment in plaintiffs’ favor with respect to § 107(2).

In concluding that § 107(2) violates the Constitution, I acknowledge the benefit that the exemption provides to many ministers (and the churches that employ them) and the loss that may be felt if the exemption is withdrawn. Clergy Housing Allowance Clarification Act of 2002, 148 Cong. Rec. H1299-01 (Apr. 16, 2002) (statement of Congressman Jim Ramstad) (in 2002, estimating that § 107 would relieve ministers of $2.3 billion in taxes over next five years). However, the significance of the benefit simply underscores the problem with the law, which is that it violates the well-established principle under the First Amendment that “[a]bsent the most unusual circumstances, one’s religion ought not affect one’s legal rights or duties or benefits.” Board of Education of Kiryas Joel Village School District v. Grumet, 512 U.S. 687, 715 (1994) (O’Connor, J., concurring in part and concurring in the judgment). Some might view a rule against preferential treatment as exhibiting hostility toward religion, but equality should never be mistaken for hostility.

It is important to remember that the establishment clause protects the religious and nonreligious alike. Linnemeir v. Board of Trustees of Purdue University, 260 F.3d 757, 765 (7th Cir. 2001) (“The Supreme Court has consistently described the Establishment Clause as forbidding not only state action motivated by a desire to advance religion, but also action intended to ‘disapprove,’ ‘inhibit,’ or evince ‘hostility’ toward religion.”). If a statute imposed a tax solely against ministers (or granted an exemption to everyone except ministers) without a secular reason for doing so, that law would violate the Constitution just as § 107(2) does. Stated another way, if the government were free to grant discriminatory tax exemptions in favor of religion, then it would be free to impose discriminatory taxes against religion as well. Under the First Amendment, everyone is free to worship or not worship, believe or not believe, without government interference or discrimination, regardless what the prevailing view on religion is at any particular time, thus “preserving religious liberty to the fullest extent possible in a pluralistic society.” McCreary County, Kentucky v. American Civil Liberties Union of Kentucky, 545 U.S. 844, 882 (2005) (O’Connor, J., concurring).

OPINION

A. Standing

As they did in their motion to dismiss, defendants argue that plaintiffs do not have standing to challenge § 107(2). To obtain standing, plaintiffs must show that they suffered an injury in fact that is fairly traceable to defendants’ conduct and capable of being redressed by a favorable decision from the court. Lujan v. Defenders of Wildlife, 504 U.S. 555, 560-61 (1992).

Plaintiffs Gaylor’s and Barker’s alleged injury is the unequal treatment they receive under § 107(2):

In the case of a minister of the gospel, gross income does not include —

* * *

(2) the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home and to the extent such allowance does not exceed the fair rental value of the home, including furnishings and appurtenances such as a garage, plus the cost of utilities.

In particular, plaintiffs argue that “ministers of the gospel” receive a tax exemption under § 107(2) that Gaylor and Barker do not, even though a portion of the salary Gaylor and Barker receive from Freedom from Religion Foundation is designated as a housing allowance. Plts.’ PFOF ¶ 2, dkt. #50; Dfts.’ Resp. to Plts.’ PFOF ¶ 2, dkt. #55. In addition, plaintiffs argue that an order enjoining § 107(2) would redress their injury because it would eliminate the unequal treatment. The parties agree that Gaylor and Barker are both members of the foundation and that the purpose of the foundation is related to the claims in this case, so if the individual plaintiffs have standing, then the foundation does as well. Sierra Club v. Franklin County Power of Illinois, LLC, 546 F.3d 918, 924 (7th Cir. 2008).

Defendants do not deny that a person who is denied a tax exemption that others receive has suffered an injury in fact. Texas Monthly, Inc. v. Bullock, 489 U.S. 1, 7-8 (1989) (general interest magazine had standing to challenge state tax exemption received by religious publications); Arkansas Writers’ Project, Inc. v. Ragland, 481 U.S. 221, 224-25 (1987) (same). See also Arizona Christian School Tuition Organization v. Winn, ___ U.S. ___, 131 S. Ct. 1436, 1439 (2011) (“[P]laintiffs may demonstrate standing on the ground that they have incurred a cost or been denied a benefit on account of their religion. Those costs and benefits can result from alleged discrimination in the tax code, such as when the availability of a tax exemption is conditioned on religious affiliation.”). In addition, defendants do not deny that a discriminatory tax exemption may be redressed by eliminating the exemption for everyone. Heckler v. Mathews, 465 U.S. 728, 740, (1984) (“We have often recognized that the victims of a discriminatory government program may be remedied by an end to preferential treatment for others.”). However, defendants argue that the lawsuit is premature because plaintiffs have never tried to claim the exemption. Until the Internal Revenue Service denies a claim, defendants say, plaintiffs have not suffered an injury.

As an initial matter, it is not clear whether plaintiffs would have standing to challenge § 107(2) in the context of a proceeding to claim the exemption. In several cases, courts have rejected establishment clause challenges to tax exemptions brought by parties who filed claims for the exemption that were denied. In each of those cases, the court held that the party could not receive the exemption if the court declared it to be unconstitutional, so a favorable decision could not redress their injury. Templeton v. Commissioner of Internal Revenue, 719 F.2d 1408, 1412 (7th Cir. 1983); Ward v. Commissioner of Internal Revnue, 608 F.2d 599, 601 (5th Cir. 1979); Kirk v. Commissioner of Internal Revenue, 425 F.2d 492, 495 (D.C. Cir. 1970). Thus, if accepted, defendants’ view could insulate § 107 from challenge by anyone.

In any event, I considered and rejected defendants’ argument in the context of denying their motion to dismiss. Dkt. #30. In particular, I concluded that plaintiffs’ alleged injury is clear from the face of the statute and that there is no plausible argument that the individual plaintiffs could qualify for an exemption as “ministers of the gospel,” so it would serve no legitimate purpose to require plaintiffs to claim the exemption and wait for the inevitable denial of the claim. Finlator v. Powers, 902 F.2d 1158, 1162 (4th Cir. 1990) (concluding that nonexempt taxpayers had standing to challenge exemption without first claiming exemption because plaintiffs’ “injury is created by the very fact that the [law] imposes additional [tax] burdens on the appellants not placed on” those entitled to exemption). See also California Medical Association v. Federal Electric Commission, 453 U.S. 182, 192 (1981) (concluding that plaintiffs had standing, noting that they “expressly challenge the statute on its face, and there is no suggestion that the statute is susceptible to an interpretation that would remove the need for resolving the constitutional questions raised”); Harp Advertising Illinois, Inc. v. Village of Chicago Ridge, Illinois, 9 F.3d 1290, 1291-92 (7th Cir. 1993) (“Challenges to statutes as written, without inquiring into their application, are appropriate when details of implementation are inconsequential.”).

The Supreme Court has not addressed this question explicitly, but in Walz v. Tax Commission of City of New York, 397 U.S. 664, 666-67 (1970), the plaintiff was an owner of real estate in New York City who objected to the issuance of “property tax exemptions to religious organizations.” Although there was no indication in the opinion that the owner requested an exemption for himself before bringing his lawsuit, the Court reached the merits of his claim under the establishment clause. In Winn, 131 S. Ct. at 1449, the Court acknowledged that it had omitted a discussion of standing from the decision in Walz but suggested that the plaintiff could have relied on the alleged discriminatory treatment among different property owners to demonstrate standing to sue.

In their motion for summary judgment, defendants do not ask the court to reconsider the conclusion that plaintiffs have standing to challenge § 107(2) if it is clear from the face of the statute that they are not entitled to the exemption. Instead, defendants expand an argument that was relegated to a footnote in their motion to dismiss, dkt. #23 at 10 n.3, which is that it is not clear from the face of the statute and the implementing regulations that plaintiffs are ineligible for the exemption under § 107(2). Rather, defendants say that it is “conceivable” that atheists such as Gaylor and Barker could qualify as “ministers of the gospel” under § 107, so they should be required to claim the exemption before challenging the statute.

Although defendants devote a substantial amount of their briefs to this argument, it is difficult to take it seriously. Under no remotely plausible interpretation of § 107 could plaintiffs Gaylor and Barker qualify as “ministers of the gospel.” However, for the sake of completeness, I will address the primary arguments that defendants raise in their briefs on this issue.

Much of defendants’ argument rests on Kaufman v. McCaughtry, 419 F.3d 678, 682 (7th Cir. 2005), in which the court concluded that atheism could qualify as a religion under the free exercise clause in the context of a claim brought by an atheist prisoner who wanted to start an atheist study group. (The court went on to reject the prisoner’s claim because he could not show that the absence of an atheist study group imposed a substantial burden on his religious exercise, id. at 683, without explaining how an atheist could make that showing in a different case.) However, the issue in this case is not the scope of the free exercise clause of the First Amendment as interpreted in the context of one case decided in 2005, but the proper interpretation of the phrase “ministers of the gospel” in a statute enacted in 1954, so cases such as Kaufman provide little guidance.

Alternatively, defendants says that the IRS regulations promulgated under § 107 do not discriminate against “nontheistic beliefs” and that the IRS does not evaluate the “content” of a claimant’s professed religion, but these arguments are red herrings as well. As I noted in the order denying defendants’ motion to dismiss, the IRS has interpreted § 107 liberally to include members of non-Christian faiths. E.g., Salkov v. Commissioner of Internal Revenue, 46 T.C. 190, 194 (1966) (approving tax exemption for Jewish cantor after rejecting interpretation of term “gospel” as being limited to books of New Testament and instead construing term to mean “glad tidings or a message, teaching, doctrine, or course of action having certain efficacy or validity”). However, even if I assume that IRS would continue to stretch the plain meaning of § 107, there is a difference between non-theistic faiths such as Buddhism and having no faith at all. Torcaso v. Watkins, 367 U.S. 488, 495 (1961) (distinguishing “those religions based on a belief in the existence of God,” “those religions founded on different beliefs” and “non-believers”). Defendants point to no regulations or decisions suggesting that a person who did not subscribe to any faith could qualify for an exemption under § 107(2).

Regardless whether the IRS might recognize atheism as a religion, this does not answer the question whether it would recognize an atheist “minister,” which is the only question that matters. Defendants cite no evidence that atheists have “ministers” as that term is used in § 107, which is sufficient reason to reject an argument that an atheist could qualify for an exemption under that statute.

Even if I assume that there are atheists ministers, neither plaintiff Gaylor nor plaintiff Barker could qualify as one. Under the federal regulations, the key question is whether the claimant is seeking an exemption for “services performed by a minister [that] are performed in the exercise of his ministry.” 26 C.F.R. § 1.1402(c)-5(b)(2). The tax court has struggled to come up with a consistent framework to answer that question, applying different tests in cases such as Good v. Commissioner of Internal Revenue, 104 T.C.M. (CCH) 595 (T.C. 2012), Mosley v. Commissioner of Internal Revenue, 68 T.C.M. (CCH) 708 (T.C. 1994), and Lawrence v. Commissioner of Internal Revenue, 50 T.C. 494 (1968), but both sides in this case cite Knight v. Commissioner of Internal Revenue, 92 T.C. 199, 205 (1989), as identifying all the relevant factors. In Knight, the court considered whether the claimant: (1) performs sacerdotal functions under the tenets and practices of the particular religious body constituting his church or church denomination; (2) conducts worship services; (3) performs services in the control, conduct, and maintenance of a religious organization that operates under the authority of a church or church denomination; (4) is ordained, commissioned, or licensed; and (5) is considered to be a spiritual leader by his religious body.

Plaintiffs do not come close to meeting any of these factors. Defendants cite no persuasive evidence that either Gaylor or Barker is ordained, that they perform “sacerdotal” functions or conduct “worship” services, that anyone in the foundation considers Gaylor and Barker to be “spiritual” leaders or that the foundation is under the authority of a “church.”

Again, even assuming that atheism is a religion, the Freedom from Religion Foundation is not an “atheist” organization in the sense that the purpose of the group is to “practice” atheism like the prisoner in Kaufman. Rather, the foundation is open to non-atheists, Barker Decl. ¶ 19, dkt. #48, and the purpose of the foundation, according to its bylaws, is to advocate and educate. Gaylor Decl., dkt. #47 exh. 1 at 1 (purpose of foundation is to promote “the constitutional principle of separation of church and state and to educate the public on matters related to non-theistic beliefs”). Defendants do not identify a single “religious” belief espoused by the foundation. In fact, defendants admit that the foundation is not a church or a religious organization operating under the authority of a church, that plaintiffs Gaylor’s and Barker’s roles as co-presidents of the foundation do not constitute an ordination, commissioning or licensing as ministers and that the foundation does not engage in worship. Dfts.’ Resp. to Plts.’ PFOF ¶¶ 14, 22, 29, dkt. #55.

Although some of Gaylor’s and Barker’s work may relate to religious issues, this is in the context of political and legal advocacy, similar to organizations such as the American Center for Law and Justice or the Anti-Defamation League. Tanenbaum v. Commissioner of Internal Revenue, 58 T.C. 1, 8 (1972) (denying exemption for employee of American Jewish Committee because he “was not hired to perform ‘sacerdotal functions’ or to conduct ‘religious worship’; rather, his job is to encourage and promote understanding of the history, ideals, and problems of Jews by other religious groups”). See also Flowers v. United States, No. CA 4-79-376-E, 1981 WL 1928, *6 (N.D. Tex. Nov. 25, 1981) (upholding denial of exemption because housing allowance was for educational rather than sacerdotal functions); Colbert v. Commissioner, 61 T.C. 449 (1974) (taxpayer did not qualify for exemption because his “primary emphasis . . . was in warning and awakening people to the dangers of communism and in educating them as to the principles of communism” rather than “religious instruction in the principles laid down by Christ”). In other words, even if I were to assume that the foundation is an “atheist organization,” that is not enough to qualify plaintiffs as ministers because they do not engage in the activities that a minister performs. Kirk, 425 F.2d at 495 (affirming denial of claim under § 107 by church employee in part because “all the services performed by petitioner in this case were of secular nature”).

Defendants argue that plaintiff Barker engages in a number of activities that could be classified as “sacerdotal,” such as performing “de-baptisms,” lecturing, performing marriages, counseling, promoting free thought and writing “free thought” songs. (The regulations do not define the term “sacerdotal” except to say that it “depends on the tenets and practices of the particular religious body constituting [a claimant’s] church or church denomination.” 26 C.F.R. § 1.1402(c)-5(b)(2)(i).) Defendants’ argument is a nonstarter because it does not apply to Gaylor, only to Barker; defendants admit that Gaylor is not a minister. Dfts.’ Resp. to Plts.’ PFOF ¶ 14, dkt. #55. “Where at least one plaintiff has standing, jurisdiction is secure and the court will adjudicate the case whether the additional plaintiffs have standing or not.” Ezell vs. City of Chicago, 651 F.3d 684, 696 (7th Cir. 2011).

In any event, none of this evidence provides any support for a view that Barker could qualify as a minister of the gospel. As an initial matter, defendants do not deny that Barker engaged in some of the activities (such as writing songs and books) before working for the foundation, Dfts.’ Rep. to Plts.’ Resp. to Dfts.’ PFOF ¶ 6, dkt. #54, and that any marriages he officiates are done on his own time, not as an employee of the foundation. Barker Decl. ¶ 24, dkt. #48. See also Tanenbaum, 58 T.C. at 8 (refusing to consider “[a]ny other functions [the claimant] may perform . . . by virtue of his own personal desires but are not cause for remuneration by the” employer). The counseling Barker performs relates to issues such as “how to deal with religious relatives,” “how to start an FFRF chapter” and “how to teach children about morality without religion.” Dfts.’ PFOF ¶ 6(a), dkt. #41 (emphasis added). The “debaptismal certificate” can be downloaded by anyone off the internet and will be signed by Barker for five dollars. Dkt. #42-15. Each certificate includes the saying “With soap, baptism is a good thing.” Id. Barker describes the certificates as “a tongue-in-cheek way to bring attention to opting out of religion.” Barker Decl. ¶ 25, dkt. #48. I do not see how any of this conduct could relate “to the tenets and practices” of a particular religious body and defendants do not even attempt to develop an argument on this point.

In their reply brief, defendants argue that it “does not matter whether Ms. Gaylor or Mr. Barker would or would not be eligible for the exclusion provided in § 107 if they claimed it. What matters is that an atheist may lawfully make a claim for the exclusion.” Dkt. #53 at 6. This argument is puzzling because it rests on a premise that a plaintiff’s own experience is irrelevant to the question of standing. That is obviously incorrect. A plaintiff’s standing to sue is determined not by asking whether some hypothetical third party is being injured, but by whether the plaintiff is being injured. Kowalski v. Tesmer, 543 U.S. 125, 129 (2004) (“We have adhered to the rule that a party generally must assert his own legal rights and interests, and cannot rest his claim to relief on the legal rights or interests of third parties.”) (internal quotations omitted). Defendants seem to concede now that plaintiffs have been injured because they cannot qualify for the exemption. Defendants do not explain why that injury “does not matter” so long as it would be possible for some atheist to qualify under some set of circumstances, but they seem to be confusing standing with the merits. To the extent defendants are arguing that § 107(2) is constitutional if it would allow an exemption for an “atheist minister” in the abstract, that argument has nothing to do with standing.

Defendants make a related argument in their reply brief that plaintiffs’ alleged injury would not be fairly traceable to any “religious discrimination” by defendants if § 107 were interpreted as encompassing an “atheist minister.” Dfts.’ Br., dkt. #53, at 12. Again, this argument rests on a misunderstanding of standing requirements. The question is whether the plaintiff’s injury is fairly traceable to the defendant’s conduct, Massachusetts v. EPA, 549 U.S. 497, 536 (2007), not whether the plaintiff will be able to prove that the injury was caused by a violation of a particular right, which is another question on the merits. Arreola v. Godinez, 546 F.3d 788, 794-95 (7th Cir. 2008) (“Although the two concepts unfortunately are blurred at times, standing and entitlement to relief are not the same thing.”).

Accordingly, I conclude that plaintiffs have standing to bring a facial challenge to § 107(2) because the statute denies them an exemption that others receive, the injury is fairly traceable to the conduct of defendants as those responsible for implementing the tax code and plaintiff’s injury is redressable by a declaration that § 107(2) is unconstitutional and an order enjoining its enforcement.

Finally, defendants raise other arguments about whether the case is ripe for adjudication and whether the Administrative Procedure Act waives the government’s sovereign immunity under the facts of this case, but both of these arguments are contingent on a finding that § 107(2) does not harm plaintiffs. Because I have rejected that argument, I need not address defendants’ other arguments separately.

B. Merits

1. Standard of review

The First Amendment to the United States Constitution states that “Congress shall make no law respecting an establishment of religion. . . .” U.S. Const., Amend. I. The first question in every case brought under the establishment clause is the proper standard of review.

The test applied most commonly by courts was articulated first in Lemon v. Kurtzman, 403 U.S. 602 (1971). Under Lemon, government action violates the establishment clause if (1) it has no secular purpose; (2) its primary effect advances or inhibits religion; or (3) it fosters an excessive entanglement with religion. Although individual justices have criticized the test, e.g., Santa Fe Independent School District v. Doe, 530 U.S. 290, 319 (2000) (Rehnquist, C.J., dissenting); Tangipahoa Parish Board of Education v. Freiler, 530 U.S. 1251 (2000) (Scalia, J., dissenting from denial of certiorari), the Supreme Court as a whole continues to apply it. E.g., McCreary County, Kentucky v. American Civil Liberties Union of Kentucky, 545 U.S. 844, 859-67 (2005). Further, it is the test the Court of Appeals for the Seventh Circuit has employed in recent cases brought under the establishment clause. E.g., Doe ex rel. Doe v. Elmbrook School District, 687 F.3d 840, 849 (7th Cir. 2012); Sherman ex rel. Sherman v. Koch, 623 F.3d 501, 507 (7th Cir. 2010); Milwaukee Deputy Sheriffs’ Association v. Clarke, 588 F.3d 523, 527 (7th Cir. 2009); Vision Church v. Village of Long Grove, 468 F.3d 975, 991-92 (7th Cir. 2006).

In Lynch v. Donnelly, 465 U.S. 668, 691 (1984), Justice O’Connor offered what she later described as a “refinement” of the first two parts of the Lemon test, under which the court asks “whether the government’s purpose is to endorse religion and whether the statute actually conveys a message of endorsement,” Wallace v. Jaffree, 472 U.S. 38, 69 (1985) (O’Connor, J., concurring), viewed from the perspective of a “reasonable observer.” Elk Grove Unified School District v. Newdow, 542 U.S. 1, 34 (2004) (O’Connor, J., concurring in the judgment). The Supreme Court has applied Justice O’Connor’s test in several subsequent cases, e.g., McCreary County, 545 U.S. at 866; Zelman v. Simmons-Harris, 536 U.S. 639, 654-55 (2002); County of Allegheny v. American Civil Liberties Union Greater Pittsburgh Chapter, 492 U.S. 573, 620 (1989), as has the Court of Appeals for the Seventh Circuit. Clarke, 588 F.3d at 529; Linnemeir v. Board of Trustees of Purdue University, 260 F.3d 757, 764 (7th Cir. 2001); Freedom from Religion Foundation, Inc. v. City of Marshfield, Wisconsin, 203 F.3d 487, 493 (7th Cir. 2000). See also Salazar v. Buono, 559 U.S. 700, 721 (2010) (assuming that “reasonable observer” test applied).

Although the Supreme Court has articulated other tests as well over the years, e.g., Lee v. Weisman, 505 U.S. 577 (1992); Marsh v. Chambers, 463 U.S. 783, 787 (1983), the parties rely on the modified version of the Lemon test, so I will do the same.

2. Texas Monthly, Inc. v. Bullock

Consideration of the question whether § 107(2) violates the establishment clause must begin with Texas Monthly, Inc. v. Bullock, 489 U.S. 1 (1989), the only case in which the Supreme Court has addressed the constitutionality of a tax exemption granted solely to religious persons. In Texas Monthly, the statute at issue exempted from the state sales tax “[p]eriodicals that are published or distributed by a religious faith and that consist wholly of writings promulgating the teaching of the faith and books that consist wholly of writings sacred to a religious faith.”

The justices in the plurality opinion (Justices Brennan, Marshall and Stevens) and those concurring in the judgment (Justices Blackmun and O’Connor) agreed that the statute violated the establishment clause. The plurality applied the familiar test under Lemon, 403 U.S. at 612, as well as the endorsement test. In concluding that the statute did not have a secular purpose or effect and conveyed a message of religious endorsement, the plurality emphasized that the exemption provided a benefit to religious publications only, without a corresponding showing that the exemption was necessary to alleviate a significant burden on free exercise:

Every tax exemption constitutes a subsidy that affects nonqualifying taxpayers, forcing them to become indirect and vicarious “donors.” Insofar as that subsidy is conferred upon a wide array of nonsectarian groups as well as religious organizations in pursuit of some legitimate secular end, the fact that religious groups benefit incidentally does not deprive the subsidy of the secular purpose and primary effect mandated by the Establishment Clause. However, when government directs a subsidy exclusively to religious organizations that is not required by the Free Exercise Clause and that either burdens nonbeneficiaries markedly or cannot reasonably be seen as removing a significant state-imposed deterrent to the free exercise of religion, as Texas has done, it provides unjustifiable awards of assistance to religious organizations and cannot but convey a message of endorsement to slighted members of the community.

Id. 14-15 (internal quotations, citations and alterations omitted). In addition, the plurality stated that the statute seemed “to produce greater state entanglement with religion than the denial of an exemption” because the statute required the government to “evaluat[e] the relative merits of differing religious claims” in order to determine whether a publication qualified for the exemption. Id. at 20.

In the concurring opinion, Justices Blackmun and O’Connor concluded that “a tax exemption limited to the sale of religious literature by religious organizations violates the Establishment Clause” because it results in “preferential support for the communication of religious messages.” Id. at 28. They added that “[a] statutory preference for the dissemination of religious ideas offends our most basic understanding of what the Establishment Clause is all about and hence is constitutionally intolerable.” Id.

Because no single opinion garnered at least five votes in Texas Monthly, “the holding of the Court may be viewed as that position taken by those Members who concurred in the judgments on the narrowest grounds.” Marks v. United States, 430 U.S. 188, 193 (1977) (internal quotation marks omitted). Although the rule in Marks likely would make Justice Blackmun’s opinion controlling, the differences between the plurality and concurring opinions in Texas Monthly are minimal for the purpose of this case. Under either opinion, a tax exemption provided only to religious persons violates the establishment clause, at least when the exemption results in preferential treatment for religious messages. Haller v. Commissioner of the Dept. of Revenue, 728 A.2d 351, 354-55 (Pa. 1999) (“[A] majority of the Court in Texas Monthly clearly recognized that tax exemptions that include religious organizations must have an overarching secular purpose that equally benefits similarly situated nonreligious organizations.”).

Because a primary function of a “minister of the gospel” is to disseminate a religious message, a tax exemption provided only to ministers results in preferential treatment for religious messages over secular ones. Accordingly, I conclude that Texas Monthly controls the outcome of this case. Although this case involves an income tax exemption instead of a sales tax exemption, neither the plurality nor the concurrence placed any importance on the type of tax involved and defendants do not provide any grounds for distinguishing the two types. Even Justice Scalia in his dissent in Texas Monthly stated that § 107 is a “tax exemptio[n] of the type the Court invalidates today.” Texas Monthly, 489 U.S. at 33 (Scalia, J., dissenting).

3. Accommodation of religion

Tellingly, defendants make little effort to distinguish Texas Monthly. They make a fleeting reference to the plurality’s statement that preferential treatment for religious groups may be permissible if it “remov[es] a significant state-imposed deterrent to the free exercise of religion,” Texas Monthly, 489 U.S. at 14, but they do not explain how that statement might apply to this case. Of course, “[a]ny [government action] pertaining to religion can be viewed as an ‘accommodation’ of free exercise rights,” Corporation of Presiding Bishop of Church of Jesus Christ of Latter-day Saints v. Amos, 483 U.S. 327, 347 (1987) (O’Connor, J., concurring in the judgment), but the “principle that government may accommodate the free exercise of religion does not supersede the fundamental limitations imposed by the Establishment Clause.” Lee, 505 U.S. at 587.

Although it is undoubtedly true that taxes impose a burden on ministers, the same is true for all taxpayers. Defendants do not identify any reason why a requirement on ministers to pay taxes on a housing allowance is more burdensome for them than for the many millions of others who must pay taxes on income used for housing expenses. In any event, the Supreme Court has rejected the view that the mere payment of a generally applicable tax may qualify as a substantial burden on free exercise. Jimmy Swaggart Ministries v. Board of Equalization of California, 493 U.S. 378, 391 (1990) (“[T]o the extent that imposition of a generally applicable tax merely decreases the amount of money appellant has to spend on its religious activities, any such burden is not constitutionally significant.”).

Defendants cite several cases in which courts have found that 26 U.S.C. § 1402(e) and (g), which give exemptions to certain religious persons from paying taxes related to Social Security, are permissible accommodations of religion. E.g., Droz v. Commissioner of Internal Revenue, 48 F.3d 1120, 1121 (9th Cir. 1995); Hatcher v. Commissioner of Internal Revenue, 688 F.2d 82, 84 (10th Cir. 1979). See also Templeton, 719 F.2d at 1413-14 (rejecting equal protection challenge to same provisions). However, the exemptions in § 1402 are limited to those who have a religious objection to receiving public insurance and belong to a religion that will provide the assistance that others ordinarily would receive under Social Security. Thus, § 1402 is distinguishable from § 107 because § 1402 limits the exemption to those whose religious exercise would be substantially burdened. In addition, there is no preferential treatment to religious persons because the exemption is limited to those who will receive from their religious sect (rather than the government) the benefits the tax is designed to provide. Droz, 48 F.3d at 1121 (§ 1402(g) is a permissible accommodation because it is “an exemption narrowly drawn to maintain a fiscally sound Social Security system and to ensure that all persons are provided for, either by the Social Security system or by their church”); Hatcher, 688 F.2d at 84 (“That the principal purpose of the legislation is not to advance or inhibit religion is evident in the mandate that those who receive the exemption forego the benefit of the program. To further assure that one claiming the exemption does not become a public charge Congress required that the exemption only be given to persons belonging to organizations that make provision for dependent members.”).

Along the same lines, the cases in which the Supreme Court has upheld religious accommodations are in contexts that otherwise would result in severe restrictions on free exercise. Board of Education of Kiryas Joel Village School District v. Grumet, 512 U.S. 687, 705 (1994) (“The Constitution allows the State to accommodate religious needs by alleviating special burdens.”) (emphasis added). For example, in Amos, 483 U.S. at 335, the Court upheld a religious exemption in an antidiscrimination law that otherwise would have required religious groups to violate their own religious beliefs, such as by requiring Catholic churches to ordain women as priests. And in Cutter v. Wilkinson, 544 U.S. 709 (2005), the Court concluded that a law requiring administrators to provide religious accommodations to persons housed in state institutions was justified by the reality of institutionalization, which is “severely disabling to private religious exercise.” Id. at 720-21. Thus, in both situations, the accommodations are best described not as singling out religious persons for more favorable treatment, but as an attempt to prevent inequality caused by government-imposed burdens. School District of Abington Township v. Schempp, 374 U.S. 203, 299 (1963) (Brennan, J., concurring) (“[H]ostility, not neutrality, would characterize the refusal to provide chaplains and places of worship for prisoners and soldiers cut off by the State from all civilian opportunities for public communion.”).

As noted above, in this case, the burden of taxes is borne equally by everyone who pays them, regardless of religious affiliation, so concerns about free exercise do not justify a special exemption. In 1984, the Treasury Secretary himself recognized this point in a memorandum in which he recommended the repeal of § 107 because “[t]here is no evidence that the financial circumstances of ministers justify special tax treatment. The average minister’s compensation is low compared to other professionals, but not compared to taxpayers in general.” U.S. Dept. of Treasury, Tax Reform for Fairness, Simplicity, and Economic Growth: The Department Report to the President, vol. II 49 (1984). In fact, the Secretary argued that § 107 “provides a disproportionately greater benefit to relatively affluent ministers, due to the higher marginal tax rates applicable to their incomes.” Id. (The Treasury Department withdrew the recommendation after many members of the clergy objected to it. Gabriel O. Aitsebaomo, Challenges to Federal Income Tax Exemption of the Clergy and Government Support of Sectarian Schools through Tax Credits Device and the Unresolved Questions after Arizona v. Winn, 28 Akron Tax J. 1, 15 (2013).) Under these circumstances, I see no basis for concluding that § 107(2) may be justified as an accommodation of religion.

4. Walz v. Tax Commission of City of New York

Instead of Texas Monthly, defendants rely on Walz, 397 U.S. 664, in which the Supreme Court rejected a challenge under the establishment clause to a statute that gave a tax exemption to property used for “religious, educational or charitable purposes.” Id. at 666-67. The obvious distinction between Walz and this case is that the statute in Walz was not a tax exemption benefiting religious persons only, but a wide variety of nonprofit endeavors. See also Schempp, 374 U.S. at 301-02 (1963) (Brennan, J., concurring) (no establishment clause violation when “certain tax deductions or exemptions . . . incidentally benefit churches and religious institutions, along with many secular charities and nonprofit organizations” because, in that situation “religious institutions simply share benefits which government makes generally available to educational, charitable, and eleemosynary groups”).

Defendants argue that the broader scope of the statute in Walz “was not dispositive for the majority,” Dfts.’ Br., dkt. #44, at 42, but that view is contradicted by the opinion itself as well as later decisions applying it. In concluding that the purpose of the exemption was not to advance religion, the Court observed that the state “has not singled out one particular church or religious group or even churches as such; rather, it has granted exemption to all houses of religious worship within a broad class of property owned by nonprofit, quasi-public corporations which include hospitals, libraries, playgrounds, scientific, professional, historical, and patriotic groups.” Walz, 397 U.S. at 673. It went on to say that the statute applies to groups that have “beneficial and stabilizing influences in community life” as opposed to “private profit institutions.” Id. See also id. at 687, 689 (Brennan, J., concurring) (“These organizations are exempted because they, among a range of other private, nonprofit organizations contribute to the well-being of the community in a variety of nonreligious ways, and thereby bear burdens that would otherwise either have to be met by general taxation, or be left undone, to the detriment of the community. . . . Government may properly include religious institutions among the variety of private, nonprofit groups that receive tax exemptions, for each group contributes to the diversity of association, viewpoint, and enterprise essential to a vigorous, pluralistic society.”); id. at 697 n.1 (Harlan, J., concurring) (tax exemption does not violate establishment clause “because New York has created a general class so broad that it would be difficult to conclude that religious organizations cannot properly be included in it”).

In Texas Monthly, 489 U.S. at 11, the plurality stated that “[t]he breadth of New York’s property tax exemption was essential to our holding [in Walz ] that it was not aimed at establishing, sponsoring, or supporting religion, but rather possessed the legitimate secular purpose and effect of contributing to the community’s moral and intellectual diversity and encouraging private groups to undertake projects that advanced the community’s well-being and that would otherwise have to be funded by tax revenues or left undone.” Further, the plurality reviewed other cases in which the Court had upheld benefits to religious organizations and concluded that they too involved a broader array of groups. “[W]ere those benefits confined to religious organizations, they could not have appeared other than as state sponsorship of religion; if that were so, we would not have hesitated to strike them down for lacking a secular purpose and effect.” Texas Monthly, 489 U.S. at 10-11 (plurality opinion) (citing Widmar v. Vincent, 454 U.S. 263 (1981); Mueller v. Allen, 463 U.S. 388 (1983); and Walz, 397 U.S. 664). See also Grumet, 512 U.S. at 704 (“We have frequently relied explicitly on the general availability of any benefit provided religious groups or individuals in turning aside Establishment Clause challenges,” including in Walz.).

To support their argument that the holding in Walz was not limited to exemptions that include nonreligious groups, defendants cite the statement by the Court that it was “unnecessary to justify the tax exemption on the social welfare services or ‘good works’ that some churches perform for parishioners and others-family counselling, aid to the elderly and the infirm, and to children.” Walz, 397 U.S. at 674. However, defendants are taking the statement out of context. The Court went on to explain that it did not want the government to have to evaluate whether a religious body’s good works were “good enough” to qualify because that could “produc[e] a kind of continuing day-to-day relationship which the policy of neutrality seeks to minimize.” Id. Thus, the Court’s observation is best read as an attempt to avoid a justification for an exemption that would lead to greater entanglement between church and state. The Court did not suggest that the government was free to provide tax exemptions to religious entities without including other groups.

Defendants also rely on Walz for the proposition that a “tax exemption does not implicate the same constitutional concerns as a direct subsidy,” Dfts.’ Br., dkt. #44, at 43, quoting the Court’s statement that “[t]he grant of a tax exemption is not sponsorship since the government does not transfer part of its revenue to churches but simply abstains from demanding that the church support the state.” Walz, 397 U.S. at 675. Taken to its logical conclusion, an argument relying on a distinction between exemptions and subsidies would permit the government to eliminate all taxes for religious organizations, an extreme position that defendants do not advance. However, in the absence of a categorical approach, it is not clear how exemptions could be treated differently from subsidies and defendants do not provide any suggestions.

In any event, to the extent that Walz suggested a different analysis for exemptions, that view is inconsistent with both the plurality and concurring opinions in Texas Monthly, neither of which made a distinction between the two types of support. It was rejected explicitly by the plurality, which stated that “[e]very tax exemption constitutes a subsidy that affects nonqualifying taxpayers, forcing them to become ‘indirect and vicarious ‘donors.'” Texas Monthly, 489 U.S. at 14 (quoting Bob Jones University v. United States, 461 U.S. 574, 591 (1983)). The Court has resisted the distinction in other opinions as well. Ragland, 481 U.S. at 236 (“Our opinions have long recognized — in First Amendment contexts as elsewhere — the reality that tax exemptions, credits, and deductions are a form of subsidy that is administered through the tax system.”) (internal citations omitted); Regan v. Taxation With Representation of Washington, 461 U.S. 540, 544 (1983) (“Both tax exemptions and tax-deductibility are a form of subsidy that is administered through the tax system.”). See also Walz, 397 U.S. at 701 (Douglas, J., dissenting) (“[O]ne of the best ways to ‘establish’ one or more religions is to subsidize them, which a tax exemption does.”); Adler, The Internal Revenue Code, The Constitution, and the Courts: The Use of Tax Expenditure Analysis in Judicial Decision Making, 28 Wake Forest L. Rev. 855, 862 n.30 (1993) (“[T]he large body of literature about tax expenditures accepts the basic concept that special exemptions from tax function as subsidies.”), quoted with approval in Rosenberger v. Rector & Visitors of University of Virginia, 515 U.S. 819, 861 (1995) (Thomas, J., concurring).

Defendants cite Winn, 131 S. Ct. at 1439, as an example of a recent case in which the Court distinguished between exemptions and subsidies. However, Winn was a case about determining a plaintiff’s injury for the purpose of taxpayer standing, a doctrine the Court has taken great effort to cabin. Id. at 1445 (emphasizing “the general rule against taxpayer standing”). The Court did not rely on Walz for the distinction it made between exemptions and subsidies in the standing context and defendants do not explain how the distinction in Winn applies to a case about the substantive scope of the establishment clause. In sum, I conclude that defendants cannot rely on Walz or Winn to preserve § 107(2).

5. Other cases

In addition to Texas Monthly, there are other cases in which the Supreme Court has held that it violates the establishment clause to single out religious beliefs for preferential treatment without providing a similar benefit to secular individuals or groups. For example, in Community for Public Education v. Nyquist, 413 U.S. 756, 793 (1973), the Court concluded that tax exemptions for parents of children in sectarian schools violated the establishment clause, reasoning that “[s]pecial tax benefits . . . cannot be squared with the principle of neutrality established by the decisions of this Court.” And in Estate of Thornton v. Caldor, Inc., 472 U.S. 703 (1985), in an opinion by Chief Justice Burger (the author of Walz), the Court held that it violated the establishment clause to give employees an “unqualified” right not to work on the Sabbath because it meant “that Sabbath religious concerns automatically control over all secular interests at the workplace” and “the statute takes no account of the convenience or interests of the employer or those of other employees who do not observe a Sabbath.” Id. at 709. See also Grumet, 512 U.S. at 708-09 (“[A] statute [may] not tailor its benefits to apply only to one religious group.”).

In addition to these Supreme Court cases, there are several cases in which other courts have concluded that tax exemptions violated the establishment clause when they benefited religious groups only. E.g., Finlator, 902 F.2d at 1162 (striking down sales tax exemption for Bibles); Haller, 728 A.2d at 355 (striking down sales tax exemption for “religious publications”); Appeal of Springmoor, Inc., 498 S.E.2d 177 (N.C. 1998) (striking down property tax exemption for nursing homes “owned, operated and managed by a religious or Masonic organization”); Thayer v. South Carolina Tax Commission, 413 S.E.2d 810, 813 (S.C. 1992) (striking down sales tax exemption for “religious publications”). See also American Civil Liberties Union Foundation of Louisiana v. Crawford, CIV.A. 00-1614, 2002 WL 461649 (E.D. La. Mar. 21, 2002) (granting preliminary injunction against tax exemption provided to places of accommodation “operated by religious organizations for religious purposes”). Defendants cite no cases to the contrary, with the exception of cases involving § 1402, which are distinguishable for the reasons explained above.

6. Purpose and effect of § 107(2)

In an attempt to show that neither the purpose nor the effect of § 107(2) is to advance or endorse religion, defendants argue that the provision actually eliminates discrimination among different religions and between religious and nonreligious persons. In support of this view, defendants say that the impetus for both § 107(1) and § 107(2) can be traced to the “convenience of the employer” doctrine, under which employees would not be taxed under certain circumstances on the value of housing provided by their employer. Commissioner of Internal Revenue v. Kowalski, 434 U.S. 77, 85-86 (1977). The Treasury Department began applying the doctrine in 1919, shortly after the federal government began collecting income tax, using the rationale that housing should not be viewed as compensation if it is provided by the employer to enable an employee to do his job properly. Id. at 84-90. Examples of employees who received the exemption included seamen and hospital workers who were required to be on call 24 hours a day. Id. at 84, 86. In 1954, Congress codified the exemption in 26 U.S.C. § 119, which allows an employee to exclude from his gross income “the value of any . . . lodging furnished to him, . . . but only if . . . the employee is required to accept such lodging on the business premises of his employer as a condition of his employment.”

According to defendants, in 1921 the Treasury Department refused to apply the convenience of the employer doctrine to ministers who lived in church-provided housing. (Plaintiffs dispute that view, but I need not resolve that dispute for the purpose of this opinion.) Defendants say that, in response, Congress passed § 213(b)(11) of the Revenue Act of 1921, which allowed ministers of the gospel to exclude from their gross income the rental value of housing they received as part of their compensation. (That exemption later became § 107(1).) Finally, defendants say that the purpose of § 107(2) when it was enacted in 1954 was to eliminate discrimination against ministers who could not claim the already existing exemption for ministers who lived in parsonages. In particular, defendants say that § 107(2) was needed to help “less-established and less wealthy religions [that] were not able to provide housing for their spiritual leaders.” Dfts.’ Br., dkt. #44, at 33. Defendants cite a committee report from the House of Representatives in support of their view:

Under present law, the rental value of a home furnished a minister of the gospel as a part of his salary is not included in his gross income. This is unfair to those ministers who are not furnished a parsonage, but who receive larger salaries (which are taxable) to compensate them for expenses they incur in supplying their own home.

Your committee has removed the discrimination in existing law by providing that the present exclusion is to apply to rental allowances paid to ministers to the extent used by them to rent or provide a home.

H.R. Rep. No. 1337, at 15, available in U.S. Code Congressional and Administrative News, 83rd Congress, Second Session, at 4040 (1954).

Plaintiffs challenge defendants’ view that the purpose of § 107(2) was to eliminate religious discrimination by quoting a statement from Representative Peter Mack, the sponsor of the 1954 law,:

Certainly, in these times when we are being threatened by a godless and anti-religious world movement we should correct this discrimination against certain ministers of the gospel who are carrying on such a courageous fight against this. Certainly this is not too much to do for these people who are caring for our spiritual welfare.

Hearings Before the H. Comm. on Ways & Means, 83rd Cong. 1, at 1574-75 (June 9, 1953) (statement of Peter F. Mack, Jr.), dkt. #51-9. Plaintiffs argue that Mack’s statement shows that § 107(2) “was deliberately intended to send a message of support for religion during the Cold War.” Plts.’ Br., dkt. #52, at 52.

The difference between plaintiffs’ and defendants’ view of the purpose of § 107(2) is more semantic than substantive. Under either view, the point of the law was to assist a subset of religious groups, which, as I will explain below, is not a secular purpose under the establishment clause.

Because the validity of § 107(1) is not before the court, I must assume for the purpose of this case that Congress did not violate the establishment clause by granting a tax exemption on the rental value of a home provided to a minister as part of his compensation. However, by defendants’ own assertion, the purpose of § 107(1) was to eliminate discrimination between secular and religious employees by giving ministers a similar exemption to the one now codified in 26 U.S.C. § 119 for housing provided to an employee for the convenience of the employer. Assuming this is correct, it does little to help justify the later enactment of § 107(2), which expanded the exemption to include not just the value of any housing provided but also the portion of the minister’s salary designated for housing expenses. Defendants say that § 107(2) was needed to eliminate discrimination against certain religious sects, particularly those that were “less wealthy and less established,” but there are multiple problems with that argument.

To begin with, defendants are wrong to suggest that § 107(2) was needed to eliminate religious discrimination. Section 107(1) is not discriminatory in the sense that it singles out certain religions for more favorable treatment; rather, it gives a benefit to ministers who meet certain housing criteria, just as § 119 gives a benefit to employees who meet certain housing criteria. Although not all ministers can qualify for the exemption, the same is true for secular employees under § 119. In other words, § 107(1) no more “discriminates” against ministers who purchase their own housing than § 119 “discriminates” against secular employees who purchase their own housing. Because the distinction made in both statutes relates to the type of housing the employee has rather than religious affiliation, there is no religious discrimination. Under defendants’ view, if one religious person received a tax exemption, then Congress would be compelled to give every religious person the same exemption, even if the exemption had nothing to do with religion.

Further, to the extent that § 107(1) discriminates among religions, § 107(2) does not eliminate that discrimination but merely shifts it. In particular, § 107(2) discriminates against those religions that do not have ministers. Erwin Chemerinsky, The Parsonage Exemption Violates the Establishment Clause and Should Be Declared Unconstitutional, 24 Whittier L. Rev. 707, 723 (2003) (“[S]ection 107(2) itself discriminates among religions: It offers a huge financial benefit to those religions and churches that have clergy as compared to those which do not. Moreover, it discriminates among clergy based on the specific tasks they are performing.”); Thomas E. O’Neill, A Constitutional Challenge to Section 107 of the Internal Revenue Code, 57 Notre Dame L. Rev. 853, 865-66 (1982) (“Section 107(2) may unconstitutionally prefer certain religions over others. For example, a congregational religion with no permanent or specifically designated ministers would not receive section 107(2)’s financial benefits as would a centralized religion with a designated ministry.”). In addition, § 107(2) creates an imbalance even with respect to those ministers who benefit from § 107(1) because ministers who get an exemption under § 107(2) can use their housing allowance to purchase a home that will appreciate in value and still can deduct interest they pay on their mortgage and property taxes, resulting in a greater benefit than that received under § 107(1). Chemerinsky, 24 Whittier L. Rev. at 712; 26 U.S.C. § 265(a)(6) (“No deduction shall be denied under this section for interest on a mortgage on, or real property taxes on, the home of the taxpayer by reason of the receipt of an amount as . . . (B) a parsonage allowance excludable from gross income under section 107”).

In any event, even if I assume that the exemption in § 107(2) applies equally to all religions, that would not solve the problem because the provision applies to religious persons only. Congress did not incorporate an exemption for secular employees into § 107(2) or expand § 119 to accomplish a similar result. Kowalski, 434 U.S. at 84-96 (rejecting interpretation of § 119 that would extend it to cash allowances). A desire to assist disadvantaged churches and ministers is not a secular purpose and it does not produce a secular effect when similarly disadvantaged secular organizations and employees are excluded from the benefit. Nyquist, 413 U.S. at 788-89 (law motivated by desire to help “low-income parents” send children to sectarian schools “can only be regarded as one ‘advancing’ religion”). The establishment clause requires neutrality not just among the various religious sects but between religious and secular groups as well. McCreary County, 545 U.S. at 875-76 (“[T]he government may not favor one religion over another, or religion over irreligion, religious choice being the prerogative of individuals under the Free Exercise Clause.”); Nyquist, 413 U.S. at 771 (“[I]t is now firmly established that a law may be one ‘respecting an establishment of religion’ even though its consequence is not to promote a ‘state religion,’ and even though it does not aid one religion more than another but merely benefits all religions alike.”) (internal citation omitted); Gillette v. United States, 401 U.S. 437, 450 (1971) (“[T]he Establishment Clause prohibits government from abandoning secular purposes . . . to favor the adherents of any sect or religious organization.”). Under defendants’ view, there would be no limit to the amount of support the government could provide to religious groups over secular ones.

Alternatively, defendants cite provisions in the tax code granting housing allowance exemptions for nonreligious reasons as evidence that § 107(2) does not advance religion. First, under 26 U.S.C. § 134, members of the military may exclude from their gross income any “qualified military benefit,” which includes a housing allowance. 37 U.S.C. § 403. Second, under 26 U.S.C. § 911, United States citizens who live abroad may deduct a portion of their housing expenses from their gross income. Finally, under 26 U.S.C. § 912, certain federal employees who live abroad may exclude from their gross income “foreign area allowances,” which may include housing expenses.

In Texas Monthly, 489 U.S. at 14, the plurality acknowledged that a tax exemption benefiting sectarian groups could survive a challenge under the establishment clause if the exemption was “conferred upon a wide array of nonsectarian groups as well.” However, the Court rejected the argument that it was enough to point to a small number of secular groups that could receive a similar exemption for a different reason:

The fact that Texas grants other sales tax exemptions (e.g., for sales of food, agricultural items, and property used in the manufacture of articles for ultimate sale) for different purposes does not rescue the exemption for religious periodicals from invalidation. What is crucial is that any subsidy afforded religious organizations be warranted by some overarching secular purpose that justifies like benefits for nonreligious groups.

Texas Monthly, 489 U.S. at 15 n.4.

In this case, defendants have not identified an “overarching secular purpose” that justifies both § 107(2) and the other exemptions they cite. Defendants suggest vaguely that all of the recipients have “unique housing needs,” Dfts.’ Br., dkt. #44, at 39, but they never identify how the needs of ministers who do not live in employer housing are different from those of any other taxpayer. In their reply brief, defendants say that § 107 is like the other statutes in that all of them involve “[p]eople whose housing is dictated by their work,” Dfts.’ Br., dkt. #53, at 20, but that argument is disingenuous because it applies only to § 107(1), which is not at issue in this case. Section 107(2) does not include any limitations on the type or location of housing that a minister purchases or rents, so it cannot be described as being related to the convenience of the employer doctrine.

Each of the other statutes defendants cite involving exemptions for secular employees was motivated by a purpose specific to the particular group involved. For example, the purpose of § 911 is to protect American business people living overseas from double taxation, Brewster v. Commissioner of Internal Revenue, 473 F.2d 160, 163 (D.C. Cir. 1972), and the purpose of § 912 is to insure that “federal civilian employees should be adequately reimbursed for additional expenses necessarily incurred because of their overseas services.” Anderson v. United States, 16 Cl. Ct. 530, 534 (1989). Thus, both of these statutes are less about giving a particular group preferential treatment and more about attempting to avoid penalizing particular taxpayers for engaging in work that provides a benefit to the United States.

Although I did not uncover a discussion of the purpose of § 134 in the case law, it seems obvious that it would be a mistake to rely on any benefit members of the military receive as providing an “overarching secular purpose” for giving a similar benefit to ministers or anyone else. Because members of the military are unique in the level of service they give to the government and the sacrifices they make, it is not surprising that they receive certain benefits not available to the general public. A housing allowance is only one of many “qualified military benefits” that may be excluded from gross income.

Defendants say that § 912 (relating to federal civilian employees living overseas) is similar to § 107 in that its original scope was limited to employees who lived in housing provided by the government, but Congress expanded the exemption to cover housing allowances as well. Anderson, 16 Cl. Ct. at 534-35. This argument is a nonstarter because it does not change the fact that, unlike § 107(2), the purpose of both exemptions in § 912 is to alleviate special burdens experienced by certain taxpayers as a result of their living situation. In any event, any superficial similarity between § 107 and § 912 is irrelevant because a decision by the federal government to expand the scope of an exemption to more of its own employees as it did in § 912 does not implicate the establishment clause as does an exemption that singles out religious persons for more favorable treatment.

In sum, defendants cite no evidence that the concerns that motivated § 134, § 911 and § 912 have anything to do with § 107(2). Accordingly, I agree with plaintiffs that § 107(2) does not have a secular purpose or effect and that a reasonable observer would view § 107(2) as an endorsement of religion.

7. Applicability of § 107(2) to atheists

As discussed above, defendants argued in the context of addressing plaintiffs’ standing to sue that it is “conceivable” that an atheist could qualify as a “minister of the gospel” under § 107. Dfts.’ Br., dkt. #44, at 10. In the context of discussing the merits in their reply brief, defendants make a similar statement that an atheist could “make a claim” that he or she is a minister of the gospel under § 107. Dfts.’ Br., dkt. #53, at 27. In support of an argument that construing § 107(2) to include atheists would defeat plaintiffs’ claim, defendants cite a passage in Justice Blackmun’s concurring opinion in Texas Monthly that the tax exemption at issue in that case “might survive Establishment Clause scrutiny” if it included “atheistic literature distributed by an atheistic organization.” Texas Monthly, 489 U.S. at 49 (Blackmun, J., concurring in the judgment). However, defendants never go so far as to argue that the phrase “minister of the gospel” § 107 could be interpreted reasonably as applying to an atheist. In fact, they decline expressly to take a position on that issue. Dfts.’ Br., dkt. #44, at 10 (“The United States is not taking the position that any particular person would, in fact, qualify to claim the exclusion under § 107(2).”).

I am not aware of any decision in which a majority of the Supreme Court considered whether a claim under the establishment clause would be defeated if the particular benefit at issue were granted to atheists, but still excluded secular groups. At least in the context of this case, there is a plausible argument that the claim would survive. Under Lemon, the question is whether the government has “advanced religion.” Thus, if atheism were included under the umbrella of “religion,” § 107(2) still would advance religion over secular interests, even if the provision applied to atheists, because secular taxpayers still would be excluded from the benefit. Further, regardless whether § 107(2) could be read to include an “atheist minister,” the statute still discriminates against religions that do not employ ministers, as noted above.

Regardless, to the extent defendants mean to argue that § 107(2) is constitutional because of an abstract possibility that an atheist could qualify as a minister of the gospel, I disagree. Defendants are correct that courts must construe statutes to “avoid constitutional difficulties,” Clark v. Martinez, 543 U.S. 371, 381-382 (2005), but that canon applies only if the statute is “readily susceptible to such a construction.” Reno v. American Civil Liberties Union, 521 U.S. 844, 884 (1997). A court may not “rewrite a . . . law to conform it to constitutional requirements.” Id. at 884-885.

In this case, no reasonable construction of § 107 would include atheists. In the concurring opinion in Texas Monthly that defendants cite, Justice Blackmun rejected as “facially implausible” an argument that atheistic literature could be included as part of “[p]eriodicals that are published or distributed by a religious faith and that consist wholly of writings promulgating the teaching of the faith and books that consist wholly of writings sacred to a religious faith.” Texas Monthly, 489 U.S. at 29 (Blackmun, J., concurring in the judgment). Defendants do not explain why they believe interpreting § 107 to include atheists is any more plausible. Hearings Before the H. Comm. on Ways & Means, 83rd Cong. at 1574-75 (sponsor of § 107(2) stating that purpose of law was to help ministers who are “fight[ing] against” a “godless and anti-religious world movement”).

The only authority defendants cite is Kaufman, 419 F.3d at 682, in which the court concluded that atheism could qualify as a religion under the free exercise clause for the purpose of that case. However, the question under § 107 is not whether atheism is a religion but whether an atheist can be a “minister of the gospel,” a very different question. In Kaufman, the court cited Reed v. Great Lakes Cos., 330 F.3d 931, 934 (7th Cir. 2003), for the proposition that religion under the free exercise could be defined simply as “taking a position on divinity,” Kaufman, 419 F.3d at 682, but, as discussed above, qualifying as a “minister of the gospel” is much more complicated. Defendants cite no evidence that an “atheist minister” exists (a term that many might view as an oxymoron), let alone an atheist that satisfies the IRS’s criteria for a “minister of the gospel,” by performing “sacerdotal” functions, conducting “worship” services or acting as a “spiritual” leader under the authority of a “church.”

8. Entanglement

With respect to the question whether § 107(2) fosters excessive entanglement between church and state, I see little distinction between this case and Texas Monthly, in which the plurality concluded that the Texas statute “appear[ed], on its face, to produce greater state entanglement with religion than the denial of an exemption” because granting the exemption required the government to “evaluat[e] the relative merits of differing religious claims” and created “[t]he prospect of inconsistent treatment and government embroilment in controversies over religious doctrine.” Texas Monthly, 489 U.S. at 20 (plurality opinion). Defendants argue that “it is constitutionally permissible for a government to determine whether a person’s belief is ‘religious’ and sincerely held,” Dfts.’ Br., dkt. #53, at 25, but, as discussed above, § 107 and its implementing regulations go well beyond a determination whether a belief is “religious,” involving a complex and inherently ambiguous multifactor test. Compare Kaufman, 419 F.3d at 682 (concluding in four paragraphs that atheism could qualify as a religion under free exercise clause) with Foundation of Human Understanding v. United States, 88 Fed. Cl. 203 (Fed. Cl. 2009) (32-page decision devoted entirely to question whether organization qualified as “church” under tax code). See also Justin Butterfield, Hiram Sasser and Reed Smith, The Parsonage Exemption Deserves Broad Protection, 16 Tex. Rev. L. & Pol. 251, 264 (2012) (arguing in favor of the constitutionality of § 107, but acknowledging that “there is an entanglement problem” with the implementing regulations).

More persuasive is defendants’ reliance on Hosanna-Tabor Evangelical Lutheran Church & School v. EEOC, ___ U.S. ___, 132 S. Ct. 694, 699 (2012), in which the Supreme Court concluded that a “minister” could not sue a church for employment discrimination under Title VII. Although the Court did not consider expressly whether a “ministerial” exception to Title VII created excessive entanglement, the Court applied the exception to the facts of the case without expressing any reservations.

Hosanna-Tabor is not on all fours with this case because, like Amos, it involved countervailing concerns that a contrary rule would lead to interference with “a religious group’s right to shape its own faith and mission through its appointments.” Hosanna-Tabor, 132 S. Ct. at 706. In any event, because I have concluded that § 107(2) does not have a secular purpose or effect, I need not decide whether the provision fosters excessive entanglement between church and state. Doe, 687 F.3d at 851 n. 15 (“Since we conclude that the District acted unconstitutionally on other grounds, we need not . . . consider the District’s actions under Lemon’s entanglement prong.”).

C. Conclusion

Although I conclude that § 107(2) violates the establishment clause and must be enjoined, this does not mean that the government is powerless to enact tax exemptions that benefit religion. “[P]olicies providing incidental benefits to religion do not contravene the Establishment Clause.” Capitol Square Review & Advisory Board v. Pinette, 515 U.S. 753, 768 (1995) (plurality opinion). In particular, because “[t]he nonsectarian aims of government and the interests of religious groups often overlap,” the government is not “required [to] refrain from implementing reasonable measures to advance legitimate secular goals merely because they would thereby relieve religious groups of costs they would otherwise incur.” Texas Monthly, 489 U.S. at 10 (plurality opinion). Thus, if Congress believes that there are important secular reasons for granting the exemption in § 107(2), it is free to rewrite the provision in accordance with the principles laid down in Texas Monthly and Walz so that it includes ministers as part of a larger group of beneficiaries. Haller, 728 A.2d at 356 (noting that Texas amended statute at issue in Texas Monthly to grant sales tax exemption to broader range of groups). As it stands now, however, § 107(2) is unconstitutional.

ORDER

IT IS ORDERED that

1. The motion for summary judgment filed by defendants Timothy Geithner and Douglas Schulman (now succeeded by Jacob Lew and Daniel Werfel), dkt. #40, is GRANTED with respect to plaintiffs’ Freedom from Religion Foundation, Inc.’s, Annie Laurie Gaylor’s and Dan Barker’s challenge to 26 U.S.C. § 107(1). Plaintiff’s complaint is DISMISSED as to that claim for lack of standing.

2. Defendants’ motion for summary judgment is DENIED as to plaintiffs’ challenge to 26 U.S.C. § 107(2). On the court’s own motion, summary judgment is GRANTED to plaintiffs as to that claim.

3. It is DECLARED that 26 U.S.C. § 107(2) violates the establishment clause of the First Amendment to the United States Constitution.

4. Defendants are ENJOINED from enforcing § 107(2). The injunction shall take effect at the conclusion of any appeals filed by defendants or the expiration of defendants’ deadline for filing an appeal, whichever is later.

5. The clerk of court is directed to enter judgment in favor of plaintiffs and close this case.

ENTERED this 21st day of November, 2013.

By the Court:

Barbara B. Crabb

District Judge

FOOTNOTE

1 Initially, plaintiffs sued Timothy Geithner and Douglas Schulman in their official capacities as Secretary of the Treasury Department and Commissioner of the Internal Revenue Service. Pursuant to Fed. R. Civ. P. 25(d), I have substituted the new Secretary, Jacob Lew, and the Acting Commissioner, Daniel Werfel.

Citations: Freedom From Religion Foundation Inc. et al. v. Jacob Lew et al.; No. 3:11-cv-00626




Treasury, IRS Will Issue Proposed Guidance for Tax-Exempt Social Welfare Organizations.

WASHINGTON — The U.S. Department of the Treasury and the Internal Revenue Service today will issue initial guidance regarding qualification requirements for tax-exemption as a social welfare organization under section 501(c)(4) of the Internal Revenue Code. This proposed guidance defines the term “candidate-related political activity,” and would amend current regulations by indicating that the promotion of social welfare does not include this type of activity. The proposed guidance also seeks initial comments on other aspects of the qualification requirements, including what proportion of a 501(c)(4) organization’s activities must promote social welfare.

The proposed guidance is expected to be posted on the Federal Register later today.

There are a number of steps in the regulatory process that must be taken before any final guidance can be issued. Given the significant public interest in these and related issues, Treasury and the IRS expect to receive a large number of comments. Treasury and the IRS are committed to carefully and comprehensively considering all of the comments received before issuing additional proposed guidance or final rules.

“This is part of ongoing efforts within the IRS that are improving our work in the tax-exempt area,” said IRS Acting Commissioner Danny Werfel. “Once final, this proposed guidance will continue moving us forward and provide clarity for this important segment of exempt organizations.”

“This proposed guidance is a first critical step toward creating clear-cut definitions of political activity by tax-exempt social welfare organizations,” said Treasury Assistant Secretary for Tax Policy Mark J. Mazur. “We are committed to getting this right before issuing final guidance that may affect a broad group of organizations. It will take time to work through the regulatory process and carefully consider all public feedback as we strive to ensure that the standards for tax-exemption are clear and can be applied consistently.”

Organizations may apply for tax-exempt status under section 501(c)(4) of the tax code if they operate to promote social welfare. The IRS currently applies a “facts and circumstances” test to determine whether an organization is engaged in political campaign activities that do not promote social welfare. Today’s proposed guidance would reduce the need to conduct fact-intensive inquiries by replacing this test with more definitive rules.

In defining the new term, “candidate-related political activity,” Treasury and the IRS drew upon existing definitions of political activity under federal and state campaign finance laws, other IRS provisions, as well as suggestions made in unsolicited public comments.

Under the proposed guidelines, candidate-related political activity includes:

1. Communications

Communications that expressly advocate for a clearly identified political candidate or candidates of a political party.

Communications that are made within 60 days of a general election (or within 30 days of a primary election) and clearly identify a candidate or political party.

Communications expenditures that must be reported to the Federal Election Commission.

2. Grants and Contributions

Any contribution that is recognized under campaign finance law as a reportable contribution.

Grants to section 527 political organizations and other tax-exempt organizations that conduct candidate-related political activities (note that a grantor can rely on a written certification from a grantee stating that it does not engage in, and will not use grant funds for, candidate-related political activity).

3. Activities Closely Related to Elections or Candidates

Voter registration drives and “get-out-the-vote” drives.

Distribution of any material prepared by or on behalf of a candidate or by a section 527 political organization.

Preparation or distribution of voter guides that refer to candidates (or, in a general election, to political parties).

Holding an event within 60 days of a general election (or within 30 days of a primary election) at which a candidate appears as part of the program.

These proposed rules reduce the need to conduct fact-intensive inquiries, including inquiries into whether activities or communications are neutral and unbiased.

Treasury and the IRS are planning to issue additional guidance that will address other issues relating to the standards for tax exemption under section 501(c)(4). In particular, there has been considerable public focus regarding the proportion of a section 501(c)(4) organization’s activities that must promote social welfare. Due to the importance of this aspect of the regulation, the proposed guidance requests initial comments on this issue.

The proposed guidance also seeks comments regarding whether standards similar to those proposed today should be adopted to define the political activities that do not further the tax-exempt purposes of other tax-exempt organizations and to promote consistent definitions across the tax-exempt sector.




Proposed Regs Define Candidate-Related Political Activities for Social Welfare Groups.

The IRS has issued proposed regulations (REG-134417-13) that provide guidance on political activities related to candidates that don’t promote social welfare for purposes of tax-exempt status under section 501(c)(4). Comments and public hearing requests are due by February 27.

Organizations may apply for tax-exempt status under section 501(c)(4) if they operate to promote social welfare, which under the current rules doesn’t include participation or intervention in political campaigns on behalf of, or in opposition to, any candidate for public office. The preamble to the proposed regs highlights the history of the “political campaign intervention” standard and the facts and circumstances analysis the IRS has applied over the years to determine whether an organization is engaged in that activity.

Treasury and the IRS have determined that more definitive rules on political activities related to candidates — rather than the current, fact-intensive analysis — would be helpful in applying the rules on qualification for tax-exempt status under section 501(c)(4). Accordingly, the proposed regs amend the current rules to provide that the promotion of social welfare does not include “candidate-related political activity,” as defined under the regs.

Under the proposed regs, candidate-related political activity includes communications that expressly advocate for a clearly identified political candidate; communications made within 60 days of a general election, or within 30 days of a primary election, that clearly identify a candidate or political party; and communications expenditures that must be reported to the Federal Election Commission. Candidate-related political activity also includes any contribution that is recognized under campaign finance law as a reportable contribution and grants to section 527 political organizations and other tax-exempt organizations that conduct candidate-related political activities. The regs provide that a grantor may rely on a written certification from a grantee stating that it does not engage in, and will not use grant funds for, candidate-related political activity.

Other candidate-related political activities identified in the proposed regs include voter registration drives and “get out the vote” drives; distribution of material prepared by or on behalf of a candidate or by a section 527 political organization; preparation or distribution of voter guides that refer to candidates or political parties; and events held within 60 days of a general election, or within 30 days of a primary election, at which a candidate appears as part of the program. The regs are proposed to apply on the date that final regs are published in the Federal Register.

Treasury and the IRS have received requests for guidance on the meaning of “primarily” as used in the current rules under section 501(c)(4). Before deciding how to proceed, Treasury and the IRS have requested comments on what portion of an organization’s activities must promote social welfare for an organization to qualify under section 501(c)(4) and whether more limits should be imposed on any or all activities that do not further social welfare. Comments are also requested on how to measure the activities of organizations seeking to qualify as section 501(c)(4) social welfare organizations for these purposes.

The proposed regs don’t address the definition of political campaign intervention under section 501(c)(3), the definition of exempt function activity under section 527, or the application of section 527(f). Comments are requested on whether standards similar to those in the proposed regs should be adopted to define the political activities that do not further the tax-exempt purposes of other tax-exempt organizations and to promote consistent definitions across the tax-exempt sector.

Guidance for Tax-Exempt Social Welfare Organizations on

Candidate-Related Political Activities

[4830-01-p]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-134417-13]

RIN 1545-BL81

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed regulations that provide guidance to tax-exempt social welfare organizations on political activities related to candidates that will not be considered to promote social welfare. These regulations will affect tax-exempt social welfare organizations and organizations seeking such status. This document requests comments from the public regarding these proposed regulations. This document also requests comments from the public regarding the standard under current regulations that considers a tax-exempt social welfare organization to be operated exclusively for the promotion of social welfare if it is “primarily” engaged in activities that promote the common good and general welfare of the people of the community, including how this standard should be measured and whether this standard should be changed.

DATES: Written or electronic comments and requests for a public hearing must be received by February 27, 2014.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-134417-13), Room 5205, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-134417-13), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC, or sent electronically via the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG-134417-13).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Amy F. Giuliano at (202) 317-5800; concerning submission of comments and requests for a public hearing, Oluwafunmilayo Taylor at (202) 317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of information should be received by January 27, 2014.

Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the proper performance of the functions of the IRS, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information;

How the quality, utility, and clarity of the information to be collected may be enhanced; and

How the burden of complying with the proposed collection of information may be minimized, including through forms of information technology.

The collection of information in these proposed regulations is in § 1.501(c)(4)-1(a)(2)(iii)(D), which provides a special rule for contributions by an organization described in section 501(c)(4) of the Internal Revenue Code (Code) to an organization described in section 501(c). Generally, a contribution by a section 501(c)(4) organization to a section 501(c) organization that engages in candidate-related political activity will be considered candidate-related political activity by the section 501(c)(4) organization. The special rule in § 1.501(c)(4)-1(a)(2)(iii)(D) provides that a contribution to a section 501(c) organization will not be treated as a contribution to an organization engaged in candidate-related political activity if the contributor organization obtains a written representation from an authorized officer of the recipient organization stating that the recipient organization does not engage in any such activity and the contribution is subject to a written restriction that it not be used for candidate-related political activity. This special provision would not apply if the contributor organization knows or has reason to know that the representation is inaccurate or unreliable. The expected recordkeepers are section 501(c)(4) organizations that choose to contribute to, and to seek a written representation from, a section 501(c) organization.

Estimated number of recordkeepers: 2,000.

Estimated average annual burden hours per recordkeeper: 2 hours.

Estimated total annual recordkeeping burden: 4,000 hours.

A particular section 501(c)(4) organization may require more or less time, depending on the number of contributions for which a representation is sought.

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and return information are confidential, as required by section 6103.

Background

Section 501(c)(4) of the Code provides a Federal income tax exemption, in part, for “[c]ivic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare.” This exemption dates back to the enactment of the federal income tax in 1913. See Tariff Act of 1913, 38 Stat. 114 (1913). The statutory provision was largely unchanged until 1996, when section 501(c)(4) was amended to prohibit inurement of an organization’s net earnings to private shareholders or individuals.

Prior to 1924, the accompanying Treasury regulations did not elaborate on the meaning of “promotion of social welfare.” See Regulations 33 (Rev.), art. 67 (1918). Treasury regulations promulgated in 1924 explained that civic leagues qualifying for exemption under section 231(8) of the Revenue Act of 1924, the predecessor to section 501(c)(4) of the 1986 Code, are “those not organized for profit but operated exclusively for purposes beneficial to the community as a whole,” and generally include “organizations engaged in promoting the welfare of mankind, other than organizations comprehended within [section 231(6) of the Revenue Act of 1924, the predecessor to section 501(c)(3) of the 1986 Code].” See Regulations 65, art. 519 (1924). The regulations remained substantially the same until 1959.

The current regulations under section 501(c)(4) were proposed and finalized in 1959. They provide that “[a]n organization is operated exclusively for the promotion of social welfare if it is primarily engaged in promoting in some way the common good and general welfare of the people of the community.” Treas. Reg. § 1.501(c)(4)-1(a)(2)(i). An organization “embraced” within section 501(c)(4) is one that is “operated primarily for the purpose of bringing about civic betterments and social improvements.” Id. The regulations further provide that “[t]he promotion of social welfare does not include direct or indirect participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office.” Treas. Reg. § 1.501(c)(4)-1(a)(2)(ii). This language is similar to language that appears in section 501(c)(3) requiring section 501(c)(3) organizations not to “participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office” (“political campaign intervention”). However, unlike the absolute prohibition that applies to charitable organizations described in section 501(c)(3), an organization that primarily engages in activities that promote social welfare will be considered under the current regulations to be operating exclusively for the promotion of social welfare, and may qualify for tax-exempt status under section 501(c)(4), even though it engages in some political campaign intervention.

The section 501(c)(4) regulations have not been amended since 1959, although Congress took steps in the intervening years to address further the relationship of political campaign activities to tax-exempt status. In particular, section 527, which governs the tax treatment of political organizations, was enacted in 1975 and provides generally that amounts received as contributions and other funds raised for political purposes (section 527 exempt function income) are not subject to tax. Section 527(e)(1) defines a “political organization” as “a party, committee, association, fund, or other organization (whether or not incorporated) organized and operated primarily for the purpose of directly or indirectly accepting contributions or making expenditures, or both, for an exempt function.” Section 527(f) also imposes a tax on exempt organizations described in section 501(c), including section 501(c)(4) social welfare organizations, that make an expenditure furthering a section 527 exempt function. The tax is imposed on the lesser of the organization’s net investment income or section 527 exempt function expenditures. Section 527(e)(2) defines “exempt function” as “the function of influencing or attempting to influence the selection, nomination, election, or appointment of any individual to any federal, state, or local public office or office in a political organization, or the election of Presidential or Vice-Presidential electors” (referred to in this document as “section 527 exempt function”).1

Unlike the section 501(c)(3) standard of political campaign intervention, and the similar standard currently applied under section 501(c)(4), both of which focus solely on candidates for elective public office, a section 527 exempt function encompasses activities related to a broader range of officials, including those who are appointed or nominated, such as executive branch officials and certain judges. Thus, while there is currently significant overlap in the activities that constitute political campaign intervention under sections 501(c)(3) and 501(c)(4) and those that further a section 527 exempt function, the concepts are not synonymous.

Over the years, the IRS has stated that whether an organization is engaged in political campaign intervention depends upon all of the facts and circumstances of each case. See Rev. Rul. 78-248 (1978-1 CB 154) (illustrating application of the facts and circumstances analysis to voter education activities conducted by section 501(c)(3) organizations); Rev. Rul. 80-282 (1980-2 CB 178) (amplifying Rev. Rul. 78-248 regarding the timing and distribution of voter education materials); Rev. Rul. 86-95 (1986-2 CB 73) (holding a public forum for the purpose of educating and informing the voters, which provides fair and impartial treatment of candidates, and which does not promote or advance one candidate over another, does not constitute political campaign intervention under section 501(c)(3)). More recently, the IRS released Rev. Rul. 2007-41 (2007-1 CB 1421), providing 21 examples illustrating facts and circumstances to be considered in determining whether a section 501(c)(3) organization’s activities (including voter education, voter registration, and get-out-the-vote drives; individual activity by organization leaders; candidate appearances; business activities; and Web sites) result in political campaign intervention. The IRS generally applies the same facts and circumstances analysis under section 501(c)(4). See Rev. Rul. 81-95 (1981-1 CB 332) (citing revenue rulings under section 501(c)(3) for examples of what constitutes participation or intervention in political campaigns for purposes of section 501(c)(4)).

Similarly, Rev. Rul. 2004-6 (2004-1 CB 328) provides six examples illustrating facts and circumstances to be considered in determining whether a section 501(c) organization (such as a section 501(c)(4) social welfare organization) that engages in public policy advocacy has expended funds for a section 527 exempt function. The analysis reflected in these revenue rulings for determining whether an organization has engaged in political campaign intervention, or has expended funds for a section 527 exempt function, is fact-intensive.

Recently, increased attention has been focused on potential political campaign intervention by section 501(c)(4) organizations. A recent IRS report relating to IRS review of applications for tax-exempt status states that “[o]ne of the significant challenges with the 501(c)(4) [application] review process has been the lack of a clear and concise definition of ‘political campaign intervention.'” Internal Revenue Service, “Charting a Path Forward at the IRS: Initial Assessment and Plan of Action” at 20 (June 24, 2013). In addition, “[t]he distinction between campaign intervention and social welfare activity, and the measurement of the organization’s social welfare activities relative to its total activities, have created considerable confusion for both the public and the IRS in making appropriate section 501(c)(4) determinations.” Id. at 28. The Treasury Department and the IRS recognize that both the public and the IRS would benefit from clearer definitions of these concepts.

Explanation of Provisions

1. Overview

The Treasury Department and the IRS recognize that more definitive rules with respect to political activities related to candidates — rather than the existing, fact-intensive analysis — would be helpful in applying the rules regarding qualification for tax-exempt status under section 501(c)(4). Although more definitive rules might fail to capture (or might sweep in) activities that would (or would not) be captured under the IRS’ traditional facts and circumstances approach, adopting rules with sharper distinctions in this area would provide greater certainty and reduce the need for detailed factual analysis in determining whether an organization is described in section 501(c)(4). Accordingly, the Treasury Department and the IRS propose to amend Treas. Reg. § 1.501(c)(4)-1(a)(2) to identify specific political activities that would be considered candidate-related political activities that do not promote social welfare.

To distinguish the proposed rules under section 501(c)(4) from the section 501(c)(3) standard and the similar standard currently applied under section 501(c)(4), the proposed regulations would amend Treas. Reg. § 1.501(c)(4)-1(a)(2)(ii) to delete the current reference to “direct or indirect participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office,” which is similar to language in the section 501(c)(3) statute and regulations. Instead the proposed regulations would revise Treas. Reg. § 1.501(c)(4)-1(a)(2)(ii) to state that “[t]he promotion of social welfare does not include direct or indirect candidate-related political activity.” As explained in more detail in section 2 of this preamble, the proposed rules draw upon existing definitions of political campaign activity, both in the Code and in federal election law, to define candidate-related political activity that would not be considered to promote social welfare. The proposed rules draw in particular from certain statutory provisions of section 527, which specifically deals with political organizations and taxes section 501(c) organizations, including section 501(c)(4) organizations, on certain types of political campaign activities. Recognizing that it may be beneficial to have a more uniform set of rules relating to political campaign activity for tax-exempt organizations, the Treasury Department and the IRS request comments in subparagraphs a through c of this section of the preamble regarding whether the same or a similar approach should be adopted in addressing political campaign activities of other section 501(c) organizations, as well as whether the regulations under section 527 should be revised to adopt the same or a similar approach in defining section 527 exempt function activity.

a. Interaction with section 501(c)(3)

These proposed regulations do not address the definition of political campaign intervention under section 501(c)(3). The Treasury Department and the IRS recognize that, because such intervention is absolutely prohibited under section 501(c)(3), a more nuanced consideration of the totality of facts and circumstances may be appropriate in that context. The Treasury Department and the IRS request comments on the advisability of adopting an approach to defining political campaign intervention under section 501(c)(3) similar to the approach set forth in these regulations, either in lieu of the facts and circumstances approach reflected in Rev. Rul. 2007-41 or in addition to that approach (for example, by creating a clearly defined presumption or safe harbor). The Treasury Department and the IRS also request comments on whether any modifications or exceptions would be needed in the section 501(c)(3) context and, if so, how to ensure that any such modifications or exceptions are clearly defined and administrable. Any such change would be introduced in the form of proposed regulations to allow an additional opportunity for public comment.

b. Interaction with section 527

As noted in the “Background” section of this preamble, a section 501(c)(4) organization is subject to tax under section 527(f) if it makes expenditures for a section 527 exempt function. Consistent with section 527, the proposed regulations provide that “candidate-related political activity” for purposes of section 501(c)(4) includes activities relating to selection, nomination, election, or appointment of individuals to serve as public officials, officers in a political organization, or Presidential or Vice Presidential electors. These proposed regulations do not, however, address the definition of “exempt function” activity under section 527 or the application of section 527(f). The Treasury Department and the IRS request comments on the advisability of adopting rules that are the same as or similar to these proposed regulations for purposes of defining section 527 exempt function activity in lieu of the facts and circumstances approach reflected in Rev. Rul. 2004-6. Any such change would be introduced in the form of proposed regulations to allow an additional opportunity for public comment.

c. Interaction with sections 501(c)(5) and 501(c)(6)

The proposed regulations define candidate-related political activity for social welfare organizations described in section 501(c)(4). The Treasury Department and the IRS are considering whether to amend the current regulations under sections 501(c)(5) and 501(c)(6) to provide that exempt purposes under those regulations (which include “the betterment of the conditions of those engaged in [labor, agricultural, or horticultural] pursuits” in the case of a section 501(c)(5) organization and promoting a “common business interest” in the case of a section 501(c)(6) organization) do not include candidate-related political activity as defined in these proposed regulations. The Treasury Department and the IRS request comments on the advisability of adopting this approach in defining activities that do not further exempt purposes under sections 501(c)(5) and 501(c)(6). Any such change would be introduced in the form of proposed regulations to allow an additional opportunity for public comment.

d. Additional guidance on the meaning of “operated exclusively for the promotion of social welfare”

The Treasury Department and the IRS have received requests for guidance on the meaning of “primarily” as used in the current regulations under section 501(c)(4). The current regulations provide, in part, that an organization is operated exclusively for the promotion of social welfare within the meaning of section 501(c)(4) if it is “primarily engaged” in promoting in some way the common good and general welfare of the people of the community. Treas. Reg. § 1.501(c)(4)-1(a)(2)(i). As part of the same 1959 Treasury decision promulgating the current section 501(c)(4) regulations, regulations under section 501(c)(3) were adopted containing similar language: “[a]n organization will be regarded as ‘operated exclusively’ for one or more exempt purposes only if it engages primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3).” Treas. Reg. § 1.501(c)(3)-1(c)(1). Unlike the section 501(c)(4) regulations, however, the section 501(c)(3) regulations also provide that “[a]n organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.” Id.

Some have questioned the use of the “primarily” standard in the section 501(c)(4) regulations and suggested that this standard should be changed. The Treasury Department and the IRS are considering whether the current section 501(c)(4) regulations should be modified in this regard and, if the “primarily” standard is retained, whether the standard should be defined with more precision or revised to mirror the standard under the section 501(c)(3) regulations. Given the potential impact on organizations currently recognized as described in section 501(c)(4) of any change in the “primarily” standard, the Treasury Department and the IRS wish to receive comments from a broad range of organizations before deciding how to proceed. Accordingly, the Treasury Department and the IRS invite comments from the public on what proportion of an organization’s activities must promote social welfare for an organization to qualify under section 501(c)(4) and whether additional limits should be imposed on any or all activities that do not further social welfare. The Treasury Department and the IRS also request comments on how to measure the activities of organizations seeking to qualify as section 501(c)(4) social welfare organizations for these purposes.

2. Definition of Candidate-Related Political Activity

These proposed regulations provide guidance on which activities will be considered candidate-related political activity for purposes of the regulations under section 501(c)(4). These proposed regulations would replace the language in the existing final regulation under section 501(c)(4) — “participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office” — with a new term — “candidate-related political activity” — to differentiate the proposed section 501(c)(4) rule from the standard employed under section 501(c)(3) (and currently employed under section 501(c)(4)). The proposed rule is intended to help organizations and the IRS more readily identify activities that constitute candidate-related political activity and, therefore, do not promote social welfare within the meaning of section 501(c)(4). These proposed regulations do not otherwise define the promotion of social welfare under section 501(c)(4). The Treasury Department and the IRS note that the fact that an activity is not candidate-related political activity under these proposed regulations does not mean that the activity promotes social welfare. Whether such an activity promotes social welfare is an independent determination.

In defining candidate-related political activity for purposes of section 501(c)(4), these proposed regulations draw key concepts from the federal election campaign laws, with appropriate modifications reflecting the purpose of these regulations to define which organizations may receive the benefits of section 501(c)(4) tax-exempt status and to promote tax compliance (as opposed to campaign finance regulation). In addition, the concepts drawn from the federal election campaign laws have been modified to reflect that section 501(c)(4) organizations may be involved in activities related to local or state elections (in addition to federal elections), as well as the broader scope of the proposed definition of candidate (which is not limited to candidates for federal elective office).

The proposed regulations provide that candidate-related political activity includes activities that the IRS has traditionally considered to be political campaign activity per se, such as contributions to candidates and communications that expressly advocate for the election or defeat of a candidate. The proposed regulations also would treat as candidate-related political activity certain activities that, because they occur close in time to an election or are election-related, have a greater potential to affect the outcome of an election. Currently, such activities are subject to a facts and circumstances analysis before a determination can be made as to whether the activity furthers social welfare within the meaning of section 501(c)(4). Under the approach in these proposed regulations, such activities instead would be subject to a more definitive rule. In addition, consistent with the goal of providing greater clarity, the proposed regulations would identify certain specific activities as candidate-related political activity. The Treasury Department and the IRS acknowledge that the approach taken in these proposed regulations, while clearer, may be both more restrictive and more permissive than the current approach, but believe the proposed approach is justified by the need to provide greater certainty to section 501(c)(4) organizations regarding their activities and reduce the need for fact-intensive determinations.

The Treasury Department and the IRS note that a particular activity may fit within one or more categories of candidate-related political activity described in subsections b through e of this section 2 of the preamble; the categories are not mutually exclusive. For example, the category of express advocacy communications may overlap with the category of certain communications close in time to an election.

a. Definition of “candidate”

These proposed regulations provide that, consistent with the scope of section 527, “candidate” means an individual who identifies himself or is proposed by another for selection, nomination, election, or appointment to any public office or office in a political organization, or to be a Presidential or Vice-Presidential elector, whether or not the individual is ultimately selected, nominated, elected, or appointed. In addition, the proposed regulations clarify that for these purposes the term “candidate” also includes any officeholder who is the subject of a recall election. The Treasury Department and the IRS note that defining “candidate-related political activity” in these proposed regulations to include activities related to candidates for a broader range of offices (such as activities relating to the appointment or confirmation of executive branch officials and judicial nominees) is a change from the historical application in the section 501(c)(4) context of the section 501(c)(3) standard of political campaign intervention, which focuses on candidates for elective public office only. See Treas. Reg. § 1.501(c)(3)-1(c)(3)(iii). These proposed regulations instead would apply a definition that reflects the broader scope of section 527 and that is already applied to a section 501(c)(4) organization engaged in section 527 exempt function activity through section 527(f).

b. Express advocacy communications

These proposed regulations provide that candidate-related political activity includes communications that expressly advocate for or against a candidate. These proposed regulations draw from Federal Election Commission rules in defining “expressly advocate,” but expand the concept to include communications expressing a view on the selection, nomination, or appointment of individuals, or on the election or defeat of one or more candidates or of candidates of a political party. These proposed regulations make clear that all communications — including written, printed, electronic (including Internet), video, and oral communications — that express a view, whether for or against, on a clearly identified candidate (or on candidates of a political party) would constitute candidate-related political activity. A candidate can be “clearly identified” in a communication by name, photograph, or reference (such as “the incumbent” or a reference to a particular issue or characteristic distinguishing the candidate from others). The proposed regulations also provide that candidate-related political activity includes any express advocacy communication the expenditures for which an organization reports to the Federal Election Commission under the Federal Election Campaign Act as an independent expenditure.

c. Public communications close in time to an election

Under current guidance, the timing of a communication about a candidate that is made shortly before an election is a factor tending to indicate a greater risk of political campaign intervention or section 527 exempt function activity. In the interest of greater clarity, these proposed regulations would move away from the facts and circumstances approach that the IRS has traditionally applied in analyzing certain activities conducted close in time to an election. These proposed regulations draw from provisions of federal election campaign laws that treat certain communications that are close in time to an election and that refer to a clearly identified candidate as electioneering communications, but make certain modifications. The proposed regulations expand the types of candidates and communications that are covered to reflect the types of activities an organization might conduct related to local and state, as well as federal, contests, including any election or ballot measure to recall an individual who holds state or local elective public office. In addition, the expansion of the types of communications covered in the proposed regulations reflects the fact that an organization’s tax exempt status is determined based on all of its activities, even low cost and volunteer activities, not just its large expenditures.

Under the proposed definition, any public communication that is made within 60 days before a general election or 30 days before a primary election and that clearly identifies a candidate for public office (or, in the case of a general election, refers to a political party represented in that election) would be considered candidate-related political activity. These timeframes are the same as those appearing in the Federal Election Campaign Act definition of electioneering communications. The definition of “election,” including what would be treated as a primary or a general election, is consistent with section 527(j) and the federal election campaign laws.

A communication is “public” if it is made using certain mass media (specifically, by broadcast, in a newspaper, or on the Internet), constitutes paid advertising, or reaches or is intended to reach at least 500 people (including mass mailings or telephone banks). The Treasury Department and the IRS intend that content previously posted by an organization on its Web site that clearly identifies a candidate and remains on the Web site during the specified pre-election period would be treated as candidate-related political activity.

The proposed regulations also provide that candidate-related political activity includes any communication the expenditures for which an organization reports to the Federal Election Commission under the Federal Election Campaign Act, including electioneering communications.

The approach taken in the proposed definition of candidate-related political activity would avoid the need to consider potential mitigating or aggravating circumstances in particular cases (such as whether an issue-oriented communication is “neutral” or “biased” with respect to a candidate). Thus, this definition would apply without regard to whether a public communication is intended to influence the election or some other, non-electoral action (such as a vote on pending legislation) and without regard to whether such communication was part of a series of similar communications. Moreover, a public communication made outside the 60-day or 30-day period would not be candidate-related political activity if it does not fall within the ambit of express advocacy communications or another specific provision of the definition. The Treasury Department and the IRS request comments on whether the length of the period should be longer (or shorter) and whether there are particular communications that (regardless of timing) should be excluded from the definition because they can be presumed to neither influence nor constitute an attempt to influence the outcome of an election. Any comments should specifically address how the proposed exclusion is consistent with the goal of providing clear rules that avoid fact-intensive determinations.

The Treasury Department and the IRS also note that this rule regarding public communications close in time to an election would not apply to public communications identifying a candidate for a state or federal appointive office that are made within a specified number of days before a scheduled appointment, confirmation hearing or vote, or other selection event. The Treasury Department and the IRS request comments on whether a similar rule should apply with respect to communications within a specified period of time before such a scheduled appointment, confirmation hearing or vote, or other selection event.

d. Contributions to a candidate, political organization, or any section 501(c) entity engaged in candidate-related political activity

The proposed definition of candidate-related political activity would include contributions of money or anything of value to or the solicitation of contributions on behalf of (1) any person if such contribution is recognized under applicable federal, state, or local campaign finance law as a reportable contribution; (2) any political party, political committee, or other section 527 organization; or (3) any organization described in section 501(c) that engages in candidate-related political activity within the meaning of this proposed rule. This definition of contribution is similar to the definition of contribution that applies for purposes of section 527. The Treasury Department and the IRS intend that the term “anything of value” would include both in-kind donations and other support (for example, volunteer hours and free or discounted rentals of facilities or mailing lists). The Treasury Department and the IRS request comments on whether other transfers, such as indirect contributions described in section 276 to political parties or political candidates, should be treated as candidate-related political activity.

The Treasury Department and the IRS recognize that a section 501(c)(4) organization making a contribution may not know whether a recipient section 501(c) organization engages in candidate-related political activity. The proposed regulations provide that, for purposes of this definition, a recipient organization would not be treated as a section 501(c) organization engaged in candidate-related political activity if the contributor organization obtains a written representation from an authorized officer of the recipient organization stating that the recipient organization does not engage in any such activity and the contribution is subject to a written restriction that it not be used for candidate-related political activity. This special provision would apply only if the contributor organization does not know or have reason to know that the representation is inaccurate or unreliable.

e. Election-related activities

The proposed definition of candidate-related political activity would include certain specified election-related activities, including the conduct of voter registration and get-out-the-vote drives, distribution of material prepared by or on behalf of a candidate or section 527 organization, and preparation or distribution of a voter guide and accompanying material that refers to a candidate or a political party. In addition, an organization that hosts an event on its premises or conducts an event off-site within 30 days of a primary election or 60 days of a general election at which one or more candidates in such election appear as part of the program (whether or not such appearance was previously scheduled) would be engaged in candidate-related political activity under the proposed definition.

The Treasury Department and the IRS acknowledge that under the facts and circumstances analysis currently used for section 501(c)(4) organizations as well as for section 501(c)(3) organizations, these election-related activities may not be considered political campaign intervention if conducted in a non-partisan and unbiased manner. However, these determinations are highly fact-intensive. The Treasury Department and the IRS request comments on whether any particular activities conducted by section 501(c)(4) organizations should be excepted from the definition of candidate-related political activity as voter education activity and, if so, a description of how the proposed exception will both ensure that excepted activities are conducted in a non-partisan and unbiased manner and avoid a fact-intensive analysis.

f. Attribution to a section 501(c)(4) organization of certain activities and communications

These proposed regulations provide that activities conducted by an organization include, but are not limited to, (1) activities paid for by the organization or conducted by the organization’s officers, directors, or employees acting in that capacity, or by volunteers acting under the organization’s direction or supervision; (2) communications made (whether or not such communications were previously scheduled) as part of the program at an official function of the organization or in an official publication of the organization; and (3) other communications (such as television advertisements) the creation or distribution of which is paid for by the organization. These proposed regulations also provide that an organization’s Web site is an official publication of the organization, so that material posted by the organization on its Web site may constitute candidate-related political activity. The proposed regulations do not specifically address material posted by third parties on an organization’s Web site. The Treasury Department and the IRS request comments on whether, and under what circumstances, material posted by a third party on an interactive part of the organization’s Web site should be attributed to the organization for purposes of this rule. In addition, the Treasury Department and the IRS have stated in guidance under section 501(c)(3) regarding political campaign intervention that when a charitable organization chooses to establish a link to another Web site, the organization is responsible for the consequences of establishing and maintaining that link, even if it does not have control over the content of the linked site. See Rev. Rul. 2007-41. The Treasury Department and the IRS request comments on whether the consequences of establishing and maintaining a link to another Web site should be the same or different for purposes of the proposed definition of candidate-related political activity.

Proposed Effective/Applicability Date

These regulations are proposed to be effective the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register. For proposed date of applicability, see § 1.501(c)(4)-1(c).

Statement of Availability for IRS Documents

For copies of recently issued Revenue Procedures, Revenue Rulings, Notices, and other guidance published in the Internal Revenue Bulletin or Cumulative Bulletin, please visit the IRS Web site at http://www.irs.gov or the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that this rule will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that only a minimal burden would be imposed by the rule, if adopted. Under the proposal, if a section 501(c)(4) organization chooses to contribute to a section 501(c) organization and wants assurance that the contribution will not be treated as candidate-related political activity, it may seek a written representation that the recipient does not engage in candidate-related political activity within the meaning of these regulations. Therefore, a regulatory flexibility analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Requests for Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The Treasury Department and the IRS generally request comments on all aspects of the proposed rules. In particular, the Treasury Department and the IRS request comments on whether there are other specific activities that should be included in, or excepted from, the definition of candidate-related political activity for purposes of section 501(c)(4). Such comments should address how the proposed addition or exception is consistent with the goals of providing more definitive rules and reducing the need for fact-intensive analysis of the activity. All comments submitted by the public will be made available for public inspection and copying at www.regulations.gov or upon request.

A public hearing will be scheduled if requested in writing by any person who timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register.

Drafting Information

The principal author of these regulations is Amy F. Giuliano, Office of Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1 — INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.501(c)(4)-1 is proposed to be amended by revising the first sentence of paragraph (a)(2)(ii) and adding paragraphs (a)(2)(iii) and (c) to read as follows:

§ 1.501(c)(4)-1 Civic organizations and local associations of employees.

(a) * * *

(2) * * *

(ii) * * * The promotion of social welfare does not include direct or indirect candidate-related political activity, as defined in paragraph (a)(2)(iii) of this section. * * *

(iii) Definition of candidate-related political activity — (A) In general. For purposes of this section, candidate-related political activity means:

(1) Any communication (as defined in paragraph (a)(2)(iii)(B)(3) of this section) expressing a view on, whether for or against, the selection, nomination, election, or appointment of one or more clearly identified candidates or of candidates of a political party that —

(i) Contains words that expressly advocate, such as “vote,” “oppose,” “support,” “elect,” “defeat,” or “reject;” or

(ii) Is susceptible of no reasonable interpretation other than a call for or against the selection, nomination, election, or appointment of one or more candidates or of candidates of a political party;

(2) Any public communication (defined in paragraph (a)(2)(iii)(B)(5) of this section) within 30 days of a primary election or 60 days of a general election that refers to one or more clearly identified candidates in that election or, in the case of a general election, refers to one or more political parties represented in that election;

(3) Any communication the expenditures for which are reported to the Federal Election Commission, including independent expenditures and electioneering communications;

(4) A contribution (including a gift, grant, subscription, loan, advance, or deposit) of money or anything of value to or the solicitation of contributions on behalf of —

(i) Any person, if the transfer is recognized under applicable federal, state, or local campaign finance law as a reportable contribution to a candidate for elective office;

(ii) Any section 527 organization; or

(iii) Any organization described in section 501(c) that engages in candidate-related political activity within the meaning of this paragraph (a)(2)(iii) (see special rule in paragraph (a)(2)(iii)(D) of this section);

(5) Conduct of a voter registration drive or “get-out-the-vote” drive;

(6) Distribution of any material prepared by or on behalf of a candidate or by a section 527 organization including, without limitation, written materials, and audio and video recordings;

(7) Preparation or distribution of a voter guide that refers to one or more clearly identified candidates or, in the case of a general election, to one or more political parties (including material accompanying the voter guide); or

(8) Hosting or conducting an event within 30 days of a primary election or 60 days of a general election at which one or more candidates in such election appear as part of the program.

(B) Related definitions. The following terms are defined for purposes of this paragraph (a)(2)(iii) only:

(1) “Candidate” means an individual who publicly offers himself, or is proposed by another, for selection, nomination, election, or appointment to any federal, state, or local public office or office in a political organization, or to be a Presidential or Vice-Presidential elector, whether or not such individual is ultimately selected, nominated, elected, or appointed. Any officeholder who is the subject of a recall election shall be treated as a candidate in the recall election.

(2) “Clearly identified” means the name of the candidate involved appears, a photograph or drawing of the candidate appears, or the identity of the candidate is apparent by reference, such as by use of the candidate’s recorded voice or of terms such as “the Mayor,” “your Congressman,” “the incumbent,” “the Democratic nominee,” or “the Republican candidate for County Supervisor.” In addition, a candidate may be “clearly identified” by reference to an issue or characteristic used to distinguish the candidate from other candidates.

(3) “Communication” means any communication by whatever means, including written, printed, electronic (including Internet), video, or oral communications.

(4) “Election” means a general, special, primary, or runoff election for federal, state, or local office; a convention or caucus of a political party that has authority to nominate a candidate for federal, state or local office; a primary election held for the selection of delegates to a national nominating convention of a political party; or a primary election held for the expression of a preference for the nomination of individuals for election to the office of President. A special election or a runoff election is treated as a primary election if held to nominate a candidate. A convention or caucus of a political party that has authority to nominate a candidate is also treated as a primary election. A special election or a runoff election is treated as a general election if held to elect a candidate. Any election or ballot measure to recall an individual who holds state or local elective public office is also treated as a general election.

(5) “Public communication” means any communication (as defined in paragraph (a)(2)(iii)(B)(3) of this section) —

(i) By broadcast, cable, or satellite;

(ii) On an Internet Web site;

(iii) In a newspaper, magazine, or other periodical;

(iv) In the form of paid advertising; or

(v) That otherwise reaches, or is intended to reach, more than 500 persons.

(6) “Section 527 organization” means an organization described in section 527(e)(1) (including a separate segregated fund described in section 527(f)(3)), whether or not the organization has filed notice under section 527(i).

(C) Attribution. For purposes of this section, activities conducted by an organization include activities paid for by the organization or conducted by an officer, director, or employee acting in that capacity or by volunteers acting under the organization’s direction or supervision. Communications made by an organization include communications the creation or distribution of which is paid for by the organization or that are made in an official publication of the organization (including statements or material posted by the organization on its Web site), as part of the program at an official function of the organization, by an officer or director acting in that capacity, or by an employee, volunteer, or other representative authorized to communicate on behalf of the organization and acting in that capacity.

(D) Special rule regarding contributions to section 501(c) organizations. For purposes of paragraph (a)(2)(iii)(A)(4) of this section, a contribution to an organization described in section 501(c) will not be treated as a contribution to an organization engaged in candidate-related political activity if —

(1) The contributor organization obtains a written representation from an authorized officer of the recipient organization stating that the recipient organization does not engage in such activity (and the contributor organization does not know or have reason to know that the representation is inaccurate or unreliable); and

(2) The contribution is subject to a written restriction that it not be used for candidate-related political activity within the meaning of this paragraph (a)(2)(iii).

(c) Effective/applicability date. Paragraphs (a)(2)(ii) and (iii) of this section apply on and after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

John Dalrymple

Deputy Commissioner for Services

and Enforcement.

FOOTNOTE

1 In 2000 and 2002, section 527 was amended to require political organizations (with some exceptions) to file a notice with the IRS when first organized and to periodically disclose publicly certain information regarding their expenditures and contributions. See sections 527(i) and 527(j).

Citations: REG-134417-13




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IRS LTR: Lease Arrangement in Bond-Financed Project Doesn't Give Rise to Security Interest.

The IRS ruled that a lease arrangement under which bonds are issued by an authority that acquires, constructs, and maintains facilities on behalf of a state which then leases the buildings does not give rise to a security interest in the facilities within the meaning of reg. section 1.141-4(d)(4).

Citations: LTR 201346002

Index Number: 141.00-00, 141.01-00, 141.01-02

Release Date: 11/15/2013

Date: August 14, 2013

Refer Reply To: CC:FIP:B5 – PLR-113154-13

Dear * * *

This letter is in response to your request for a ruling that the lease arrangement described herein will not cause the Bonds to meet the private security or payment test under section 141(b)(2) of the Internal Revenue Code.

FACTS AND REPRESENTATIONS

You make the following factual representations. Authority was created by the Act as a body corporate, separate from the State. Authority acquires, constructs, and maintains facilities on behalf of the State and is the primary issuer of debt to finance the acquisition and construction of buildings for various State purposes. Typically, Authority holds legal title to the buildings and the State leases the building pursuant to long term operating leases. Authority uses the lease payments from the State to pay debt service on the lease revenue bonds issued for acquisition or construction of buildings.

Authority issued the Bonds to finance construction and/or renovation of various buildings, including the Facility. Authority holds legal title to the Facility and the State leases the Facility pursuant to a multi-year operating lease (the “Lease”). The debt service on the Bonds is payable from, and secured by, the State’s payments on the Lease (the “Lease Payments”) along with the rentals with respect to various other facilities financed with proceeds of Authority’s bonds issued under the same indenture (the “Parity Bonds”). The State is obligated to pay all costs of operating and maintaining the Facility. The only payments from nongovernmental persons with respect to the Facility are payments that do not exceed direct operating costs of the Facility attributable to use by such persons.

The Bondholders do not have a mortgage on or other security agreement creating a security interest in the Facility under State law. The remedies available to the Bondholders upon nonpayment of debt service are obtaining a money judgment against the State for unpaid Lease Payments or other rentals and filing suit to compel Authority or the State to perform in accordance with the terms of the leases, Act, or related indenture by means of an action in the nature of mandamus.

Pursuant to the Lease, the State may cease Lease Payments only if the Facility becomes untenantable for reasons other than those caused by the State. In the indenture for the Bonds, Authority has covenanted not to sell, lease, mortgage, or otherwise dispose of the Facility, other than the Lease, so long as the Parity Bonds are outstanding, with the following exceptions. Authority can do so (1) in a manner it determines is in the best interest of the bondholders if the Lease is terminated, (2) if the rental for the part of the Facility retained is not less than the rental just prior to such action, (3) at the end of the Lease term, or (4) if Authority has sufficient funds to pay the remaining Lease Payments when due.

The State intends to enter into management contracts with nongovernmental persons for performance of certain substantial services at the Facility (the “Management Contracts”). Authority represents that the terms of the Management Contracts will cause the Bonds to satisfy the private business use test of section 141(b)(1).

LAW

Section 103(a) provides generally that gross income does not include interest on any state or local bond. Section 103(b)(1) provides that this exclusion does not apply to any private activity bond unless it is a qualified bond under section 141. Under section 141(a), a bond is a private activity bond if either the private business use test under section 141(b)(1) and the private security or payment test under section 141(b)(2) are satisfied, or the private loan financing test under section 141(c) is satisfied.

Section 141(b)(2) provides, in part, that the private security or payment test is satisfied if the payment of the principal of, or the interest on, more than 10 percent of the proceeds of such issue is (under the terms of such issue or any underlying arrangement) directly or indirectly (A) secured by any interest in property used or to be used for a private business use, or payments in respect of such property, or (B) to be derived from payments (whether or not to the issuer) in respect of property, or borrowed money, used or to be used for a private business use.

Section 1.141-4(a)(1) of the Income Tax Regulations provides that the private security or payment test relates to the nature of the security for, and the source of, the payment of debt service on an issue. The private payment portion of the test takes into account the payment of the debt service on the issue that is directly or indirectly to be derived from payments (whether or not to the issuer or any related party) in respect of property, or borrowed money, used or to be used for a private business use. The private security portion of the test takes into account the payment of the debt service on the issue that is directly or indirectly secured by any interest in property used or to be used for a private business use or payments in respect of property used or to be used for a private business use.

Section 1.141-4(a)(3) provides that the security for, and payment of debt service on, an issue is determined from both the terms of the bond documents and on the basis of any underlying arrangement. An underlying arrangement may result from separate agreements between the parties or may be determined on the basis of all of the facts and circumstances surrounding the issuance of the bonds. For example, if the payment of debt service on an issue is secured by both a pledge of the full faith and credit of a state or local governmental unit and any interest in property used or to be used in private business use, the issue meets the private security or payment test.

Section 1.141-4(c)(2)(i)(A) provides that both direct and indirect payments made by any nongovernmental person that is treated as using proceeds of the issue are taken into account as private payments to the extent allocable to the proceeds used by that person. Payments are taken into account as private payments only to the extent that they are made for the period of time that proceeds are used for a private business use. Payments for a use of proceeds include payments (whether or not to the issuer) in respect of property financed (directly or indirectly) with those proceeds, even if not made by a private business user. Payments are not made in respect of financed property if those payments are directly allocable to other property being directly used by the person making the payment and those payments represent fair market value compensation for that other use.

Section 1.141-4(c)(2)(i)(C) provides that payments by a person for a use of proceeds do not include the portion of any payment that is properly allocable to the payment of ordinary and necessary expenses (as defined under section 162) directly attributable to the operation and maintenance of the financed property used by that person. For this purpose, general overhead and administrative expenses are not directly attributable to those operations and maintenance.

Section 1.141-4(d)(4) provides that property used or to be used for a private business use and payments in respect of that property are treated as private security if any interest in that property or payments secures the payment of debt service on the bonds. For this purpose, the phrase “any interest in” is to be interpreted broadly and includes, for example, any right, claim, title, or legal share in property or payments.

Section 1.141-4(d)(5) provides that the payments taken into account as private security are payments in respect of property used or to be used for a private business use. Except as otherwise provided in this paragraph (d)(5) and paragraph (d)(6) of this section, the rules in paragraphs (c)(2)(i)(A) and (B) and (c)(2)(ii) of this section apply to determine the amount of payments treated as payments in respect of property used or to be used for a private business use. Thus, payments made by members of the general public for use of a facility used for a private business use (for example, a facility that is subject of a management contract that results in private business use) are taken into account as private security to the extent that they are made for the period of time that property is used by a private business user.

ANALYSIS

Authority represents that the terms of the Management Contract will cause the Bonds to satisfy the private business use test. Because the private use test is met, the Bonds will be private activity bonds if the private security or payment test is also met. Specifically, you ask whether the Lease and covenants related to the Facility will give rise to private security when Authority enters into the Management Contracts. Whether or not a particular arrangement rises to a security interest for purposes of section 1.141-4(d)(4) depends on the facts and circumstances associated with the arrangement.

The Lease Payments and the State’s rental payments on other facilities financed by the Parity Bonds are security for the Bonds. These payments are not private payments as they are made by a governmental person. Accordingly, neither are they private security.

Authority represents that the Bondholders do not have a mortgage or other security agreement creating a security interest in the Facility under State law. However, because section 1.141-1(d)(4) provides that the phrase “any interest in property” is to be interpreted broadly, Authority is concerned that in its documents relating to the Facility and the Bonds, it has given the Bondholders rights in the Facility that might be within the meaning of that provision.

The Bondholders’ remedies for nonpayment of debt service include obtaining a money judgment against the State or filing suit to compel performance under the Lease, Act, or indenture. Authority has covenanted that generally it will not sell, lease, mortgage, or otherwise dispose of the Facility other than the Lease, as long as the Parity Bonds are outstanding. These restrictions do not apply after the Lease is terminated or if the rentals or Authority’s other monies are sufficient to cover the amounts of the Lease Payments. However, only Authority can initiate these actions, such as leasing or selling the Facility for the benefit of the Bondholders after the Lease is terminated. The Bondholders cannot compel Authority to so act.

We conclude that the terms of the Lease and the covenants contained in the indenture merely provide some assurance to Bondholders that Authority will continue to make the Facility available to the State and that the State will continue to use the Facility and make Lease Payments until the Lease is ended or other monies are available to pay debt service on the Bonds. Until such time, neither the Bondholders nor any other parties (other than the State or Authority) will be granted rights in the Facility. Accordingly, the terms do not give rise to a security interest in the Facility within the meaning of section 1.141-4(d)(4).

CONCLUSION

Based solely on the facts described herein and representations made by Authority, we conclude that the Lease and related covenants will not cause the private security or payment test of section 141(b)(2) to be met.

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any transaction or item discussed or referenced in this letter. Specifically, we express no opinion as to whether the interest paid on the Bonds is excludable from gross income.

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.

In accordance with a Power of Attorney on file with this office, a copy of this letter is being sent to Authority’s authorized representative.

The ruling contained in this letter is based upon information and representations submitted by Authority and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the materials submitted in support of the request for a ruling, it is subject to verification upon examination.

Sincerely,

Associate Chief Counsel

(Financial Institutions & Products)

By: Johanna Som de Cerff

Senior Technician Reviewer

Branch 5




NABL Says IRS Ruling Having Chilling Effect on Bonds.

The new position on political subdivisions that the Internal Revenue Service has taken in a bond-related tax dispute with a community development district in Florida has had a “chilling effect” on the issuance of such bonds and has hurt existing bond issues, bond lawyers are warning.

The National Association of Bond Lawyers made the warning in a letter sent to Treasury Department and IRS officials on Nov. 21. Accompanying the letter was a four-page memorandum explaining NABL’s opposition to the ruling and urging the agency and the Treasury Department to adopt new guidance containing a “safe harbor” for tax-exempt bond issuers.

The controversy is rooted in a 12-page technical advice memorandum dated May 9 that the IRS chief counsel’s office sent the Village Center Community Development District. The TAM, which wasn’t received by the CDD until June and wasn’t widely released until Aug. 23, concluded the district’s bonds were taxable because its board is, and will always be, controlled by private parties rather than publicly elected officials.

The CDD, a commercial development of about 167 acres of land in Lady Lake, Lake County, Fla. that provides security, fire, recreational golf and other services to residents of nearby districts, issued $472 million of bonds.

In its TAM, the IRS chief counsel stated: “We believe that an entity that is organized and operated in a manner intended to perpetuate private control, and to avoid indefinitely responsibility to a public electorate, cannot be a political subdivision of a state.”

But NABL said in its letter that the TAM “is contrary to established legal authority.”

“The TAM has had an immediate chilling effect on the issuance of tax-exempt bonds by such issuers throughout the country and has raised questions in the market about outstanding bonds of such issuers, which may result in a loss in value of those bonds for current holders,” NABL said in the letter, which was signed by its president Allen Robertson.

NABL said that under the traditional legal analysis applied by the IRS, the courts and practitioners for many years, an entity is considered a political subdivision, with the right to issue tax-exempt bonds, if it is delegated the right to exercise substantial sovereign powers. These include the power to tax, the power of eminent domain and police power.

“A qualified issuer need not have all three powers but it must have more than an insubstantial amount of at least one of the sovereign powers,” NABL said.

The TAM, which focuses on the Village Center CDD’s responsibility to an electorate, calls into question whether districts with a limited number of property owners electors, or taxpayers may ever qualify as a political subdivision, the bond lawyers said.

The IRS supports its position in the TAM in part with IRS Revenue Ruling 83-131.

But NABL says the revenue ruling doesn’t provide any support. The entities that were the subject of the revenue ruling were North Carolina electric and telephone membership corporations that provided utility services, NABL says. The revenue ruling notes that “the term political subdivision has been defined consistently for all federal tax purposes as denoting either a division of a state or local government that is a municipal corporation or …that has been delegated the right to exercise sovereign power,” The IRS concludes in the revenue ruling that the corporations do not qualify as political subdivisions in part because they do not have sufficient sovereign power.

NABL says the IRS appears to be concerned that private entities that exercise sovereign power, like railroads and utilities, could issue tax-exempt bonds without any political oversight. But CDDs are not private entities because they are created by and subject to the rules of governments, the bond lawyers said.

NABL asks the tax regulators to create a safe harbor under which an issuer will be a political subdivision if it meets three conditions. The first is that it is treated as a political subdivision under applicable state law. The second is that it has been delegated more than an insubstantial amount of the power of eminent domain, the power to tax or police power. The third is that, upon dissolution of the issuer, its assets are either distributed to, or directed by, a state or other political subdivision.

The memorandum and guidance was developed by an ad hoc task force made up of 12 NABL members. It was approved by the NABL board.

BY            LYNN HUME




Updated 2013-2014 Priority Guidance Plan – Tax-Exempt Bonds.

The IRS and Treasury have released the first quarter update to the 2013-2014 priority guidance plan, noting the addition of five guidance projects.

The original 2013-2014 plan, released August 9, 2013, included 324 guidance projects identified as priorities for the July 2013-June 2014 plan year.

TAX-EXEMPT BONDS

1. Guidance on reallocations of New Clean Renewable Energy Bonds under § 54C.

2. Guidance on the definition of political subdivision under § 103 for purposes of the tax-exempt, tax credit, and direct pay bond provisions.

3. Guidance under § 141 relating to private activity bonds.

4. Guidance under § 142 to provide temporary relief after a declared disaster.

5. Notice amplifying the Oklahoma storm relief provided by Notice 2013-39 and Notice 2013-40 for purposes of §§ 42 and 142.

PUBLISHED 07/29/13 in IRB 2013-31 as NOT. 2013-47 (RELEASED 07/10/13).

6. Final regulations on public approval requirements for private activity bonds under § 147(f). Proposed regulations were published on September 9, 2008.

7. Regulations on arbitrage investment restrictions under § 148.

PUBLISHED 09/16/13 in FR as REG-148659-07 (NPRM).

8. Regulations on rebate overpayment under § 148.

PUBLISHED 09/16/13 in FR as REG-148812-11 (NPRM).

9. Regulations on bond reissuance under § 150. Notice 2008-41 was published on April 14, 2008 and was supplemented by Notice 2008-88 and Notice 2010-7.




Seminars From the 2013 Forums Available at IRS Nationwide Tax Forums Online.

The IRS reminds tax professionals that they can earn continuing professional education credits online through seminars filmed at the 2013 IRS Nationwide Tax Forums. The 14 self-study seminars are now available on the IRS Nationwide Tax Forums Online (NTFO) site. Self-study seminars provide information to students using interactive videos, PowerPoint slides and transcripts.

The 2013 NTFO seminars cover many topics of interest to tax professionals including the following subjects:

http://www.irstaxforumsonline.com/




IRS LTR: Nonprofit's Income Is Exempt as Exercise of Essential Government Function.

The IRS ruled that the income of a corporation formed by a state political subdivision to operate and maintain public terminals and warehouses is derived from the exercise of an essential governmental function and is excludable from gross income under section 115(1).

Citations: LTR 201346006

Index Number: 115.00-00

Release Date: 11/15/2013

Date: August 2, 2013

Refer Reply To: CC:TEGE:EOEG:EO – PLR-117177-13

Dear * * *:

This letter responds to a letter from your authorized representative dated April 4, 2013, requesting a ruling that Company’s income is excludable from gross income under Internal Revenue Code (“IRC”) § 115. Company represents the facts as follows.

FACTS

Company was formed on Date 1, by Authority, a political subdivision of State, to operate Facilities as they then existed and have subsequently been expanded. Its articles provide that it is “to operate, maintain, develop and improve the public terminal and warehouse facilities of the ports of the [State]” and “to foster the development of the foreign commerce of the United States and the ports of the [State].” The members of Company’s board of directors are selected by the Board of Authority, with the executive director of the Authority serving as a permanent member. Authority’s Board has the authority to remove and replace any member of Company’s board of directors. Company’s board of directors appoints all officers of Company.

Upon dissolution of Company all of its net assts shall be distributed to Authority. Company’s articles further provide that no part of its net earning shall inure to the benefit of, or be distributable to its directors, officers, or other private persons.

Authority and Company are parties to a service agreement that provides that Company will manage, operate and conduct the business of the Facilities in accordance with the policies established by Authority’s Board and the Statute. Pursuant to the agreement Authority has delegated to Company the authority to establish rates, charges, regulations, tariffs, practices and requirements concerning the use of the Facilities. However, Authority retains the right to review and revise all such rates and charges. Under the agreement all gross revenues collected by Company, less its expenses must be paid to Authority.

On Date 2, the Internal Revenue Service (“Service”) issued Company a letter ruling concluding that Company’s income is excludable from gross income under IRC § 115. Company’s activities serve the good of the general public by having central management for state-owned facilities. On Date 3, the Service issued Company a subsequent letter ruling concluding that certain changes in Company’s operations would not affect the ruling contained in the Date 2 letter.

Company plans to convert from a nonprofit, non-stock corporation to a limited liability company pursuant to the laws of State. Company will be treated as a corporation for federal tax purposes following the conversion. Authority will hold the sole membership in Company. The purpose of the conversion is to streamline, modernize and make more efficient the operations of both entities and to give more oversight and control of Company’s activities to Authority.

After the conversion, Authority will continue to receive all net revenues attributable to Company’s operations. Additionally, any liquidation proceeds upon a termination of Company would be distributed exclusively to Authority.

Company has two wholly-owned subsidiaries, Subsidiary 1 and Subsidiary 2. Subsidiary 1 owns X, which enables certain cargo to be transported to, from and between the public terminal and warehouse facilities of the ports of State. Subsidiary 2 has acted as manager of Subsidiary 1 and the operator of X. Both subsidiaries are limited liability companies and are disregarded entities for federal tax purposes. In connection with the proposed conversion, Subsidiary 2 will merge into Subsidiary 1 and Subsidiary 1 will take over the duties of Subsidiary 2 to manage and operate X.

LAW AND ANALYSIS

IRC § 115(1) provides that gross income does not include income derived from any public utility or the exercise of any essential governmental function and accruing to a state or any political subdivision thereof.

Rev. Rul. 77-261, 1977-2 C.B. 45, holds that income generated by an investment fund that is established by a state to hold revenues in excess of the amounts needed to meet current expenses is excludable from gross income under IRC § 115(1), because such investment constitutes an essential governmental function. The ruling explains that the statutory exclusion is intended to extend not to the income of a state or municipality resulting from its own participation in activities, but rather to the income of an entity engaged in the operation of a public utility or the performance of some governmental function that accrues to either a state or political subdivision of a state. The ruling points out that it may be assumed that Congress did not desire in any way to restrict a state’s participation in enterprises that might be useful in carrying out projects that are desirable from the standpoint of a state government and that are within the ambit of a sovereign to conduct.

Rev. Rul. 90-74, 1990-2 C.B. 34, holds that the income of an organization formed, funded, and operated by political subdivisions to pool various risks (e.g., casualty, public liability, workers’ compensation, and employees’ health) is excludable from gross income under IRC § 115(1) because the organization is performing an essential governmental function. In Rev. Rul. 90-74, private interests neither materially participate in the organization nor benefit more than incidentally from the organization.

Company operates, maintains, develops and improves the public terminal and warehouse facilities of the ports of State. That function constitutes the performance of an essential governmental function within the meaning of IRC § 115(1). See Rev. Rul. 77-261 and Rev. Rul. 90-74.

In addition, all the net revenue of Company accrues to Authority. No private interests participate in or benefit from the operation of Company, other than incidentally or as providers of goods or services. Company dedicates its assets and income exclusively for the benefit of Authority. See Rev. Rul. 90-74.

All of Company’s assets that remain upon dissolution of Company (after providing for all outstanding obligations) will be distributed to Authority, which is a political subdivision of the State. See Rev. Rul. 90-74.

Based on the information and representations submitted on behalf of Company, we conclude that:

The income of Company will derive from the exercise of an essential governmental function and will accrue to a state or a political subdivision thereof. Company’s income will be excludable from gross income under IRC § 115(1) upon Company’s conversion under State law to a single-member limited liability company that is treated as a corporation for federal income tax purposes.

No opinion is expressed concerning the Federal tax consequences under any IRC provision other than the one specifically cited above.

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter.

This ruling is directed only to the taxpayer requesting it. IRC § 6110(k)(3) provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant. Alternatively, taxpayers filing their returns electronically may satisfy this requirement by attaching a statement to their return that provides the date and control number of the letter ruling.

The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.

Sincerely,

Kenneth M. Griffin

Chief, EO Branch

(Tax Exempt & Government Entities)




Final Exempt Hospital Regs May Result in Extensive Reporting Changes.

Substantial changes to Form 990 Schedule H, “Hospitals,” are possible once the section 501(r) charitable hospital regulations are finalized, an IRS official said November 22.

Substantial changes to Form 990 Schedule H, “Hospitals,” are possible once the section 501(r) charitable hospital regulations are finalized, an IRS official said November 22.

Stephen Clarke, tax law specialist (rulings and agreements), IRS Tax-Exempt and Government Entities Division, outlined changes made to Form 990, “Return of Organization Exempt From Income Tax,” for tax year 2013, including the creation of a new part V, section C of Schedule H, which provides for narrative responses to check-box questions in part V, section B, on such things as community health needs assessments and discounted care.

Speaking during a breakout session at the Western Conference on Tax-Exempt Organizations in Los Angeles organized by Loyola Law School, Clarke said the Schedule H changes for tax year 2013 are similar in scope to those made for 2012.

“Once the 501(r) regulations are finalized, we’ll make more extensive changes to reflect those regulations,” he told Tax Analysts.

Because the guidance has been proposed and is not final, the IRS has held off on making some changes until those regulations are finalized, he said.

The hospital schedule isn’t the only one that will likely see regulation-driven changes, Clarke said. Schedule A, which section 501(c)(3) organizations use to indicate they are public charities and not private foundations, clarifies the requirements for functionally integrated and nonfunctionally integrated Type III supporting organizations, including transition rules for how those organizations meet the integral part test for the 2013 tax year, he said.

Temporary and proposed regs (REG-155929-06; 2013-11 IRB 650 ) released last year that interpreted the 2006 Pension Protection Act’s Type III supporting organization provisions provide guidance on how these organizations meet the integral part test for tax year 2014 and later years, he said.

“So you can expect to see on our 2014 Schedule A some significant revisions which we’re working hard on to reflect the implementing regs for the 2006 Pension Protection Act,” he said.

According to a February TE/GE memo  regarding determination letters to Type III supporting organizations and general requirements, organizations seeking classification as a Type III supporting organization must satisfy the integral part test for either a functionally or nonfunctionally integrated supporting organization. There are three ways to satisfy the test, including being the parent of each supported organization, the memo says.

All forms, schedules, and instructions for Forms 990, and a list of changes to them, for the 2013 tax year should be posted online by early next year, Clarke said. Some are available online now, he said.

Donor-Advised Funds

Practitioners shouldn’t expect new regulations on donor-advised funds anytime soon, Ruth Madrigal, attorney-adviser, Treasury Office of Tax Legislative Counsel, said during an afternoon session November 21. The project isn’t one that can be simply fitted in between section 501(r) hospital regulations and supporting organization regulations or other large projects, she said.

“This is going to be a big project,” she said. “It’s a complicated project.”

“We are finally to a point where I can think about beginning to sit down and talk about donor-advised fund guidance with the IRS,” she added. “But it’s still going to be a ways off.”

Madrigal reminded conference attendees that donor-advised funds were only defined in the code in 2006. Speaking on her own behalf, she said there are good things about donor-advised funds generally. However, she said a few large sponsoring organizations with a lot at risk might be more compliant than a lot of little organizations, which in many cases are run by the donors themselves.

“I worry about small private foundations that have very low balances and don’t want to spend the little that they have on administrative expenses, which is what lawyers and accountants are,” she said.

by David van den Berg




Camp Says His Reform Bill Will Not Change Estate and Gift Taxes.

House Ways and Means Committee Chair Dave Camp, R-Mich., told reporters November 20 that he is not planning to make changes to estate and gift tax law in the comprehensive tax reform bill he is drafting.

Asked why not, Camp said, “I don’t think that policy needs the reform that the rest of the code does, and we are doing international [reform], which ’86 didn’t do,” referring to the Tax Reform Act of 1986.

Later, Camp added that he believes that the section of the code dealing with estate and gift taxes was settled at the beginning of the year. “It’s not necessary to revisit it,” he said.

Congress made major estate and gift tax provisions permanent as part of the American Taxpayer Relief Act of 2012 (P.L. 112-240) enacted January 2.

That act set the top rate on taxable estates over $1 million at 40 percent and maintained the inflation-indexed $5.12 million exemption amount and portability provisions that were enacted in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.

Camp’s decision not to touch estate tax law may anger some Republicans, many of whom would like to see the estate tax repealed. Several House Republicans have introduced bills that would repeal or otherwise alter the estate tax. Ways and Means member Kevin Brady, R-Texas, introduced a bill (H.R. 2429) this year to repeal the estate tax and modify the gift tax. The bill has 170 cosponsors.

by Lindsey McPherson




Updated 2013-2014 Priority Guidance Plan Adds 5 Projects – Exempt Organizations.

The IRS and Treasury have released the first quarter update to the 2013-2014 priority guidance plan, noting the addition of five guidance projects.

The original 2013-2014 plan, released August 9, 2013, included 324 guidance projects identified as priorities for the July 2013-June 2014 plan year.

EXEMPT ORGANIZATIONS

1. Revenue Procedures updating grantor and contributor reliance criteria under §§ 170 and 509.

2. Revenue Procedure to update Revenue Procedure 2011-33 for EO Select Check.

3. Guidance under § 501(c)(4) relating to measurement of an organization’s primary activity and whether it is operated primarily for the promotion of social welfare, including guidance relating to political campaign intervention.

4. Final regulations under §§ 501(r) and 6033 on additional requirements for charitable hospitals as added by § 9007 of the ACA. Proposed regulations were published on June 26, 2012 and April 5, 2013.

5. Additional guidance on § 509(a)(3) supporting organizations (SOs).

6. Guidance under § 4941 regarding a private foundation’s investment in a partnership in which disqualified persons are also partners.

7. Final regulations under § 4944 on program-related investments. Proposed regulations were published on April 19, 2012.

8. Guidance regarding the new excise taxes on donor advised funds and fund management as added by § 1231 of the Pension Protection Act of 2006.

9. Regulations under §§ 6011 and 6071 regarding the return and filing requirements for the § 4959 excise tax for community health needs assessments failures by charitable hospitals as added by § 9007 of the ACA.

PUBLISHED 08/15/13 in FR as TD 9629 (FINAL and TEMP).

10. Guidance under § 6033 on returns of exempt organizations.

11. Final regulations under § 6104(c). Proposed regulations were published on March 15, 2011.

12. Final regulations under § 7611 relating to church tax inquiries and examinations. Proposed regulations were published on August 5, 2009.




Partnership's Deduction for Qualified Conservation Contribution Is Disallowed.

Citations: 61 York Acquisition LLC et al. v. Commissioner; T.C. Memo. 2013-266; No. 22910-12

The Tax Court disallowed a partnership’s claimed charitable contribution deduction for its contribution of an easement to an organization, finding that the contribution failed to meet the exclusivity requirement since the restriction didn’t preserve the entire exterior of the structure.

61 YORK ACQUISITION, LLC,

SIB PARTNERSHIP, LTD., TAX MATTERS PARTNER,

Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

UNITED STATES TAX COURT

Filed November 19, 2013

Kevin M. Flynn and Henry S. Lovejoy, for petitioner.

Michael Dean Wilder and Michael A. Sienkiewicz, for respondent.

MEMORANDUM OPINION

LARO, Judge: In 2006, 61 York Acquisition, LLC (partnership) contributed a historic preservation facade easement in a certified historic structure. In respect thereof, the partnership claimed a charitable contribution deduction of $10,730,000 on its 2006 partnership tax return. Respondent disallowed the [*2] deduction in full. Respondent further determined that the partnership was liable for a 40% accuracy-related penalty under section 6662(h)1 or, alternatively, for a 20% accuracy-related penalty under section 6662(a) and (b)(1), (2), or (3).

This case is presently before the Court on respondent’s motion for partial summary judgment. At issue is whether the partnership’s contribution is a “qualified conservation contribution” under section 170(h)(1) entitling the partnership to a charitable contribution deduction. We hold that it is not. Consequently, we will grant respondent’s motion.

BACKGROUND

The following facts are not in dispute.

The partnership owns the entire interest in 332 Property, LLC, a Delaware limited liability company, which is treated as a disregarded entity for Federal income tax purposes. 332 Property, LLC, owns a partial interest in a property at 330-332 South Michigan Avenue in Chicago, Illinois (property). The property is in the Historic Michigan Boulevard District and is a Chicago landmark designation. On December 27, 2006, the National Park Service classified the property as a “certified historic structure” for charitable contribution purposes.

[*3] Ownership of the property is divided into two parts: the “Office Property”, which consists of the first 14 floors of the property, and the “Residential Property”, which consists of residential condominium units on the top 6 floors of the property.

On January 3, 2000, the respective owners of the office property and the residential property entered into an “Amended and Restated Declaration of Covenants, Conditions, Restrictions and Easements” (amended declaration) which set forth the ownership rights and responsibilities of the respective owners.

Section 20.16 of the amended declaration provides that the owner of the office property owns the “Facade” and “reserves the right, in its sole and exclusive discretion, to [ ] grant an easement in or dedicate the Facade to or for the benefit of any private, city, county, state or federal historic preservation agency or trust.” Section 1.1 of the amended declaration defines “Facade” as follows:

[t]he exterior wall of the Building facing Michigan Avenue and Van Buren Street from the street level up to the Roof * * * but excluding (i) the glass in the windows, window frames, window systems, joints and seals located in the Building; (ii) the Roof and the Roof structure, membrane, flashings and seals over the cornice; (iii) the window frames, flashings, systems, machinery and equipment and joints and seals located in the Condominium; (iv) the Garage entrance and exit doors and entrance and exit door systems and joints and seals; and (v) the structural support for the exterior wall of the Building. [Emphasis added.]

[*4] Section 5.1(I) of the amended declaration provides that the owner of the office property is responsible for “Maintenance of the Facade and maintenance of other portions of the facade of the Building”. Finally, section 14.1 of the amended declaration provides that an owner who wishes to make an addition, improvement, or alteration that “materially alters the Facade of the Building” must obtain prior written consent of the other owner.

In 2004 the partnership, as the owner of 332 Property, LLC, acquired the office property but did not acquire the residential property. On December 18, 2006, the partnership granted a “Conservation Deed of Easement” (easement) in the property to the National Architectural Trust, Inc. (NAT). The easement terms require the grantor to obtain prior written consent from the NAT before making any change to the “Protected Facades”, which include “the existing facades on the front, sides and rear of the Building and the measured height of the Building.”

In its 2006 return, the partnership claimed a charitable contribution deduction of $10,730,000 with respect to the easement contribution. Attached to the 2006 return was Form 8283, Noncash Charitable Contributions, which included a declaration by an appraiser valuing the easement at $10,730,000.

On June 25, 2012, respondent issued the partnership a notice of final partnership administrative adjustment (FPAA) disallowing the charitable [*5] contribution deduction because the partnership did not establish that the requirements of section 170 (or the regulations thereunder) had been met nor establish that the value of the easement was $10,730,000. Respondent also determined, with respect to the noncash charitable contribution, that the partnership was liable for an accuracy-related penalty under section 6662(h) for a gross valuation misstatement or, in the alternative, that the partnership was liable for an accuracy-related penalty under section 6662(a) and (b)(1), (2) or (3) for negligence or disregard of rules or regulations, a substantial understatement of income tax, or a substantial valuation misstatement, respectively. SIB Partnership, Ltd., the tax matters partner, petitioned the Court in response to the FPAA. At the time of the filing of this petition, the partnership’s principal place of business was in New York.

DISCUSSION

I. Standard of Review

The Court may grant summary judgment upon all or any part of the legal issues in controversy where the record establishes that there is no genuine dispute as to any material fact and a decision may be rendered as a matter of law. Rule 121(a) and (b). The moving party bears the burden of proving that there is no genuine dispute as to any material fact, and factual inferences are drawn most [*6] favorably to the party opposing summary judgment. Fielder v. Commissioner, T.C. Memo. 2012-284, at *13; see also United States v. Diebold, Inc., 369 U.S. 654, 655 (1962); Dahlstrom v. Commissioner, 85 T.C. 812, 821 (1985). In responding to a motion for summary judgment, a nonmoving party such as petitioner must do more than merely allege or deny facts. Rule 121(d). The nonmoving party must “set forth specific facts showing that there is a genuine dispute for trial.” Id. See generally Celotex Corp. v. Catrett, 477 U.S. 317, 324 (1986).

Respondent contends that there is no genuine dispute of material fact as to whether the easement at issue is a qualified conservation contribution under section 170(h). While petitioner’s response attempts to place before the Court a factual dispute as to whether the terms of the easement and amended declaration collectively impose enforceable restrictions on the entire exterior of the property, petitioner has not submitted any affidavits, declarations, answers to interrogatories, deposition testimony, or any other acceptable evidence to show that there is a genuine dispute for trial. See Rule 121(d). On the basis of the record at hand, we conclude that this case is ripe for partial summary judgment.

[*7] II. Qualified Conservation Contribution Under Section 170(h)

Section 170(a)(1) generally allows a deduction for any charitable contribution made during the taxable year. In this context, a charitable contribution includes a gift of property to a charitable organization, made with charitable intent and without the receipt or expectation of receipt of adequate consideration. See Hernandez v. Commissioner, 490 U.S. 680, 690 (1989); United States v. Am. Bar Endowment, 477 U.S. 105, 116-118 (1986); see also sec. 1.170A-1(h)(1) and (2), Income Tax Regs. While section 170(f)(3) generally does not allow an individual to deduct a charitable contribution for a gift of property consisting of less than his or her entire interest in that property, an exception applies in the case of a “qualified conservation contribution”. See sec. 170(f)(3)(B)(iii). A contribution of real property is a qualified conservation contribution if (1) the real property is a “qualified real property interest”, (2) the contributee is a “qualified organization”, and (3) the contribution is “exclusively for conservation purposes”. Sec. 170(h)(1); see also sec. 1.170A-14(a), Income Tax Regs.

The parties do not dispute that the easement is a “qualified real property interest” under section 170(h)(2), nor do they dispute that the NAT is a “qualified organization” under section 170(h)(3). The parties’ sole point of disagreement is [*8] whether the contribution is “exclusively for conservation purposes” under section 170(h)(4).

A contribution is made exclusively for conservation purposes if it meets the tests of section 170(h)(4) and (5).2 Section 170(h)(4)(A) provides that a contribution is for a conservation purpose if it preserves a historically important land area or a certified historic structure. Section 170(h)(4)(B) provides that a contribution that consists of a restriction with respect to the exterior of a certified historic structure shall not be considered to be exclusively for conservation purposes unless the interest: (1) includes a restriction which preserves the entire exterior of the building (including the front, sides, rear, and height of the building); and (2) prohibits any change in the exterior of the building which is inconsistent with the historical character of the exterior.

To determine whether the conservation easement complies with the requirements for the conservation easement deduction under Federal tax law, we must look to State law to determine the effect of the easement. State law determines the nature of the property rights, and Federal law determines the appropriate tax treatment of those rights. Carpenter v. Commissioner, T.C. Memo. [*9] 2012-1, 103 T.C.M. (CCH) 1001, 1004 (2012); Estate of Lay v. Commissioner, T.C. Memo. 2011-208, 102 T.C.M. (CCH) 202, 208 (2011). Specifically, we must look to State law to determine whether the partnership granted the NAT a restrictive easement as to the entire exterior of the property.

Respondent argues that the partnership cannot grant a valid easement restricting the entire exterior of the building when the partnership does not own the entire exterior. Petitioner argues that, under Illinois law, ownership of the entire exterior is not required to grant an easement which imposes enforceable restrictions on the entire exterior of the building. Under Illinois State law, a person can grant only a right which he himself possesses. Munroe v. Brower Realty & Mgmt. Co., 565 N.E.2d 32, 36 (Ill. App. Ct. 1990); see also Fyffe v. Fyffe, 11 N.E.2d 857, 862 (Ill. App. Ct. 1937). We hold that the partnership did not assign a restrictive easement in the entire exterior of the property, as required by the plain meaning of section 170(h)(4)(B)(1), because the partnership only had rights to the Facade, as defined by the amended declaration.3

[*10] Petitioner argues that the partnership has an assignable right in the entire exterior because the partnership has an obligation under section 5.1(I) of the amended declaration to maintain the entire facade of the building. In essence, petitioner invites the Court to find a right in an obligation, but does not cite any Illinois caselaw in support of its proposition. We decline this invitation.

Petitioner next argues that section 14.1 of the amended declaration, which disallows certain alterations to the property without the prior written consent of the other property owner, gives the partnership an assignable right to the entire exterior of the property. However, the altering owner must obtain prior written consent from the other owner only if the alteration will materially alter the Facade of the property. The partnership does not have the right to restrict alterations to the two sides of the building not covered by the definition of Facade, nor the numerous excluded portions of the other two sides.4 The partnership cannot contribute a right it does not possess.5 Therefore, we hold that the partnership’s [*11] contribution is not a “qualified conservation contribution” under section 170(h)(1) because it is not a restriction that preserves the entire exterior of a certified historic structure.

In reaching our holdings, we have considered all arguments made, and, to the extent not mentioned above, we conclude they are moot, irrelevant, or without merit.

To reflect the foregoing,

An appropriate order will be issued.

FOOTNOTES

1 Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the year at issue, and Rule references are to the Tax Court Rules of Practice and Procedure.

2 Sec. 170(h)(5)(A) generally provides that a contribution of a qualified real property interest may be exclusively for conservation purposes only if it is protected in perpetuity.

3 Because we hold that the partnership did not have a right to the entire exterior of the property, we need not decide whether, under Illinois State law, an ownership right is required to grant a restrictive easement in the entire exterior of a building.

4 Because we hold that the partnership does not possess a right in the entire exterior of the property, we need not decide whether an alteration that is inconsistent with the historic character of the exterior is necessarily a materially alteration.

5 Because we hold that the partnership does not possess the right to restrict alterations to the entire exterior of the building, we need not decide whether this right “runs with the land”.




IRS Issues Draft Form 1099-OID With New Fields.

The IRS on November 15 posted to its website a draft 2014 Form 1099-OID, “Original Issue Discount,” that eliminates two former fields and adds two new fields for taxpayers to report market discount and acquisition premiums.

The IRS on November 15 posted to its website a draft 2014 Form 1099-OID, “Original Issue Discount,”  that eliminates two former fields and adds two new fields for taxpayers to report market discount and acquisition premiums.

The two fields eliminated from the form are “Foreign tax paid” and “Foreign country or U.S. possession.”

The addition of the acquisition premium box represents a “paradigm shift,” according to Stevie D. Conlon of Wolters Kluwer Financial Services Inc. “Completion of the form went from standardized data based on the issued price of the instrument for the entire issue of the debt to a calculation of acquisition premium for each tranche offering,” she said.

Acquisition premium is the excess of a debt instrument’s adjusted basis immediately after purchase over the debt instrument’s adjusted issue price at that time. The amount will have to be calculated for each series in a debt offering. Before the new reporting requirements, a taxpayer did not have to calculate the unique purchase price for each purchaser for each series in the offering.

The new reporting requirements will require more work to complete the forms, Conlon said. However, she said the new draft form dovetails with the new cost basis reporting requirements. Treasury in April issued final regulations (T.D. 9616 ) on broker reporting of basis for debt instruments and options. The final regs implement the rules in phases; basis reporting for less complex debt instruments begins January 1, 2014, while reporting for more complex debt instruments, including those without fixed yield and maturity dates, won’t begin until January 1, 2016.

Opponents of the new reporting requirements are expected to argue that they don’t have systems in place to calculate the acquisition premiums. However, Conlon said the requirements represent good tax policy because they will provide more accurate data for investors.

by William R. Davis




Moody's: Report Analyzes Impact of Elimination of Federal Deductions for State, Local Taxes.

The National Governors Association and the Council of State Governments have released a report prepared by Moody’s Analytics on how tax proposals in the president’s 2014 budget proposal that would limit or eliminate deductions for state and local taxes and municipal bond interest would affect state and local budgets.

http://www.nga.org/files/live/sites/NGA/files/pdf/2013/1311MoodysReport.pdf




Couple's Overvaluation of Easement Donation Results in Gross Valuation Misstatement Penalties.

Citations: George Gorra et ux. v. Commissioner; T.C. Memo. 2013-254; No. 15336-10

The Tax Court, sustaining gross valuation misstatement penalties, held that a couple was entitled to a noncash charitable contribution deduction for a façade easement donation but found that they overvalued the easement and determined that the value was much less than the amount the couple claimed on their returns.

GEORGE GORRA AND LEILA GORRA,

Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

UNITED STATES TAX COURT

Filed November 12, 2013

Frank Agostino, Reuben Muller, and Jairo Cano, for petitioners.*

Marc L. Caine and Marissa J. Savit, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

KERRIGAN, Judge: This case involves a noncash charitable contribution deduction. Respondent determined the following tax deficiencies and penalties:1

[*2]

Penalties

_____________________________

Year           Deficiency          Sec. 6662(a)          Sec. 6662(h)

______________________________________________________________________

2006             $79,252             $15,853                 $26,743

2007              25,719               5,344                  10,688

Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. We round all monetary amounts to the nearest dollar.

After concessions we must consider (1) whether petitioners are entitled to a charitable contribution deduction under section 170 for the donation of a facade easement and (2) whether petitioners are liable for a gross valuation misstatement penalty pursuant to section 6662(h) or, in the alternative, for an accuracy-related penalty pursuant to section 6662(a).

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. Petitioners resided in New York when they filed the petition. [*3] Petitioner husband graduated from the University of Pennsylvania Wharton School of Business where he received a bachelor of science degree in economics. Petitioner husband attended the New York University Stern School of Business graduate program for one year. For approximately 30 years petitioner husband has been involved with commercial real estate transactions in Manhattan. Petitioner husband has also maintained an interest in architecture from the Victorian period for many years. Petitioner wife practiced as a tax attorney with Mobil Oil from 1978 to 1981. Thereafter, petitioner wife left her position as a tax attorney and worked full time raising petitioners’ children.

The Property

On May 17, 1993, petitioners purchased a townhouse at Block 1520, Lot 9 in the borough of Manhattan with a street address on East 91st Street, New York, New York (property). The property is in the Carnegie Hill Historic District of New York City. The property is a single-family residence with four stories; it is 15 feet wide and approximately 3,300 square feet.2 The lot is approximately 1,500 square feet. Petitioners owned the property at all relevant times. On December 18, 2006, and at all times relevant, there was no mortgage on the property.

[*4] In March 2006 a real estate agency listed the property for sale at $5,800,000. Petitioners reduced the price to $5,575,000 on June 23, 2006. On September 19, 2006, petitioners further reduced the price to $5,295,000. The property was taken off the market in March 2007.

On or about January 11, 2007, the National Park Service certified that the property contributes to the significance of the Carnegie Hill Historic District and is a “certified historic structure” for a charitable contribution for conservation purposes in accordance with the Tax Treatment Extension Act of 1980, Pub. L. No. 96-541, sec. 6(b), 94 Stat. at 3207. The property is not classified as “sound, first-class condition”.

The Easement

On December 18, 2006, petitioners executed a conservation deed of easement (deed) with the Trust for Architectural Easements (Trust), which was known at the time as the National Architectural Trust (NAT).3 Among other things, the deed grants the Trust the right to enter and inspect petitioners’ property, including granting access through the interior of the building. On December 20, 2006, petitioners also made a $45,000 cash contribution to the [*5] Trust.4 On December 26, 2006, a representative of the Trust executed the deed on behalf of the Trust.

At all times relevant the Trust was a nonprofit organization exempt from taxation pursuant to section 501(c)(3). For the purposes of this case the Trust is a “qualified organization” within the meaning of section 170(h)(3).

The primary mission of the Trust is to encourage participation in the voluntary historic preservation program funded by the Federal Government with the Federal Tax Incentive Program. The Trust also engages in additional preservation activities that relate to historic architecture. The Trust monitors the properties where it holds easements by sending employees to visit the properties. The Trust employs three people to monitor 550 properties. Trust employees inspect visually the properties. During these annual inspections Trust employees also photograph the properties. The Trust uploads the resulting pictures and notes onto a server and compares the pictures to images from previous years to determine whether there are changes to the property.

If Trust employees find a violation through their inspection process, the deed gives the Trust the right to institute legal proceedings to procure an [*6] injunction against violations of the deed. The deed also gives the Trust the right to enter the property to correct any violations and then place a lien on the property for the cost of such repairs.

Before 2006 Springfield Management Services (SMS) performed services for the Trust. SMS did not perform services for the Trust while the Trust held an easement for the property.

The Deed

The terms of the deed, in pertinent part, include the following:

* * * * * * *

E. Grantor [petitioners] desires to grant to the Grantee [the NAT], and the Grantee desires to accept an Open Space and Architectural Facade Conservation Deed of Easement (the Easement) on the Property, exclusively for conservation purposes.

F. It is the intent of the parties that the facades of the improvements located on the Property (the “Building”), including the existing facades on the front, sides and rear of the Building and the measured height of the Building (collectively the “Protected Facades”), are protected by this Easement so that any change to the Protected Facades shall require prior express written approval by the Grantee, which may be withheld or conditioned in its sole discretion, and shall be consistent with the historical character of the Building exterior, as required under applicable federal, state and local laws. * * *

II

The Grantor does hereby grant and convey to the Grantee, TO HAVE AND TO HOLD, an Easement in gross, in perpetuity, in, on, and to [*7] the Property, the Building and the Protected Facades, being an Open Space and Architectural Facade Conservation Deed of Easement on the Property * * *.

A. Without the express written consent of the Grantee, * * * Grantor will not undertake * * * with respect to those parts of the Protected Facades:

1. any alteration, construction or remodeling of existing exterior improvements on the Protected Facades, or the placement thereon * * * [or]

2. any exterior extension of existing improvements on the Property, or the erection of any new or additional exterior improvements on the property or in the open space above or surrounding the existing improvements.

* * * * * * *

III

A. The Grantee * * * shall have * * * the following rights:

1. at reasonable times and upon reasonable notice, the right to enter upon and inspect the Protected Facades and any improvements thereon. * * *

2. in the event of a violation of the Easement and Grantor’s failure to cure, * * * such violation within fifty (50) business days following Grantor’s receipt of Grantee’s written notice of such violation:

(a) the right to institute legal proceeding to enjoin such violation by temporary, and/or permanent injunction, to require the restoration of the Property or the improvements thereon, including the Protected Facades, and open space, to their prior condition; to be reimbursed by Grantor for all related [*8] reasonable costs and attorney’s fees; and to avail itself of all other legal and equitable remedies.

* * * * * * *

IV

A. This Easement is binding not only upon Grantor but also upon its successors, heirs and assigns and all other successors in interest to the Grantor, and shall continue as a servitude running in perpetuity with the land. This Easement shall survive any termination of Grantor’s or the Grantee’s existence. The Rights of the Grantee under this instrument shall run for the benefit of and may be exercised by its successors and assigns, or by its designees duly authorized in a deed of Easement.

B. Grantee covenants and agrees that it will not transfer, assign or otherwise convey its rights under this Easement except to another “qualified organization” described in Section 170(h)(3) of the Internal Revenue Code of 1986 and controlling Treasury regulations, and Grantee further agrees that it will not transfer this Easement unless the transferee first agrees to continue to carry out the conservation purposes for which this Easement was created, provided, however, that nothing herein contained shall be construed to limit the Grantee’s right to give its consent (e.g., to changes in a Protected Facades [sic]) or to abandon some or all of its rights hereunder.

C. In the event this Easement is ever extinguished through a judicial decree, Grantor agrees on behalf of itself, its heirs, successors and assigns, that Grantee, or its successors and assigns, will be entitled to receive upon the subsequent sale, exchange or involuntary conversion of the Property, a portion of the proceeds from such sale, exchange or conversion equal to the same proportion that the value of the initial Easement donation bore to the entire value of the property at the time of donation as estimated by a state licensed appraiser, unless controlling state law provides that the Grantor [petitioners] is entitled to the full proceeds in such situations, without regard to the [*9] Easement. Grantee agrees to use any proceeds so realized in a manner consistent with the conservation purposes of the original contribution.

New York City Landmarks Preservation Commission

The New York City Landmarks Preservation Commission (LPC) is the New York City agency responsible for identifying and designating the city’s landmarks and buildings in the city’s historic districts. The LPC regulates changes to designated buildings. The LPC consists of 11 Commissioners and approximately 50 full-time staff members, including architects, architectural historians, and restoration specialists. The LPC is responsible for the preservation of 26,000 structures and had a staff of four employees responsible for inspection during relevant times.

New York City Landmarks Law

New York City adopted its Landmarks Preservation Law (Landmarks Law) in 1965 in response to concerns about the destruction of buildings with significant historical, architectural, and cultural value. Penn Cent. Transp. Co. v. City of New York, 438 U.S. 104, 108-109 (1978); see N.Y. City Admin. Code sec. 25-303. The Landmarks Law was enacted in order to safeguard New York City’s historic, aesthetic, and cultural heritage; help stabilize and improve property values in historic districts; encourage civic pride in the beauty and accomplishments of the [*10] past; protect and enhance the city’s attractions for tourists; strengthen the city’s economy; and promote the use of landmarks for the education, pleasure, and welfare of the people of New York City.

Petitioners’ property is subject to the Landmarks Law, which requires property owners to keep designated properties in good repair and to obtain an LPC permit before starting work if the work will affect a landmark’s exterior or if the work requires a Department of Buildings permit. Violations of the Landmarks Law occur either when work is performed on a landmark without a permit or when work does not comply with a permit. The Landmarks Law provides, in pertinent part:

In making * * * [a] determination with respect to * * * [an] application for a permit to construct, reconstruct, alter or demolish an improvement in an historic district, the commission shall consider (a) the effect of the proposed work in creating, changing, destroying or affecting the exterior architectural features of the improvement upon which such work is to be done, and (b) the relationship between the results of such work and the exterior architectural features of other, neighboring improvements in such district.

N.Y. City Admin. Code sec. 25-307(b)(1). The Landmarks Law further provides: “[The commission is not authorized] to regulate or limit the height and bulk of buildings, [or] to regulate and determine the area of yards, courts and other open [*11] spaces”. N.Y. City Admin. Code sec. 25-304(a). The Landmark Law defines “exterior architecture feature” as:

[t]he architectural style, design, general arrangement and components of all of the outer surfaces of an improvement, as distinguished from the interior surfaces enclosed by said exterior surfaces, including, but not limited to, the kind, color and texture of the building material and the type and style of all windows, doors, lights, signs and other fixtures appurtenant to such improvement.

N.Y. City Admin. Code sec. 25-302(g).

The task of administering the law was given to the LPC. Penn Cent. Transp. Co., 438 U.S. at 110; see N.Y.C. Charter ch. 74, sec. 3020. The LPC is responsible for identifying and designating New York City’s landmarks and the buildings in the city’s historic districts, including the Carnegie Hill District. The LPC also regulates changes to designated buildings, including petitioners’ property. Since July 1998 when the Landmark Protection Bill became effective, the LPC has had the power to seek civil fines for violations of its regulations and to seek criminal penalties (fines and imprisonment) and injunctive relief. N.Y. City Admin. Code secs. 25-317 and 25-317.1.

The LPC does not monitor yearly each of the structures in its jurisdiction. The LPC does not photograph each structure and does not compare the annual photograph of the previous year. In order to track violations, the LPC uses [*12] referrals from sources other than its staff. The LPC receives approximately 800 to 1,000 reports of violations each year. In 2006 and 2007 the LPC retained four employees who were responsible for the enforcement and preservation of approximately 26,000 structures in New York City.

Haims Appraisal

On December 18, 2006, petitioners obtained an appraisal of their property for tax purposes from Jerome Haims Realty, Inc. The NAT provided petitioners with Eric Haims’ name, along with the name of one other appraiser, and advised that Mr. Haims is a preapproved appraiser of conservation easements. Petitioners paid Jerome Haims Realty, Inc., $3,000 for Mr. Haims’ appraisal services.

Mr. Haims, who is a qualified appraiser as defined in section 1.170A13(c)(5), Income Tax Regs., appraised the easement that petitioners donated to the NAT. Mr. Haims prepared an appraisal report that included a description of petitioners’ property and estimated the fair market value of the easement donated to the NAT. The appraisal valued the donated property as of December 11, 2006.

The appraisal described petitioners’ property as 3,300 square feet of gross living area (as per New York City records), and 15 feet of frontage on the north side of East 91st Street by 100 feet 8 1/2 inches of depth, containing 1,515 square feet of lot area. The appraisal stated that although the property was listed for sale [*13] on the market at an asking price of $5,295,000, on the basis of Mr. Haims’ analysis the property’s market value5 was actually $5,500,000.

The Haims appraisal used the sales comparison approach and determined the market value of the property before the donation of the easement. The appraisal established the diminution of the value of the easement reflected as a percentage of the “before” market value of the property. Mr. Haims conducted a market study using paired sales data of residential properties in New York. The appraisal stated that on the basis of the data and analysis presented, the value of the historic preservation easement was equal to 11% of the property’s market value, or $605,000.

Recording the Deed

After signing the easement deed on December 18, 2006, petitioners entrusted the Trust to record it. On December 26, 2006, the vice president of the Trust executed the deed on behalf of the Trust. On December 28, 2006, the Trust delivered the deed to the New York City Department of Finance, Office of the Register (city register). The Trust also paid the city register $122 for recording fees and taxes.

[*14] The cover sheet for the recording forms that were presented to the city register, however, contained an error: The property’s street number was incorrectly listed on the cover sheet. Because the address on the cover sheet did not match the address on the deed, the city register requested that the Trust resubmit the deed with the discrepancy resolved. The Trust resubmitted the deed in January 2007 to correct the discrepancy. The deed was recorded by the city register on January 18, 2007.

Inspection of the Property by the Trust

On October 18, 2007, the Trust sent petitioners a letter informing them that the inspector noted no alteration had been made to their property and the inspection was done on May 11, 2007. The letter reminded petitioners that “the exterior of the Property may not be altered legally without the prior approval of the Trust”.

On November 22, 2007, petitioners notified the Trust in writing that they wanted to replace the rear windows. The Trust approved the changes on December 24, 2007.

On March 2, 2008, petitioners received a letter from the Trust informing them that their property would be inspected in spring 2008. On August 7, 2008, the Trust sent petitioners a letter informing them that the inspector noticed that no [*15] alterations had been made since the last inspection and the property appeared to be in good repair.

On February 13, 2009, the Trust sent petitioners a letter stating that the property would be visited during spring 2009. On May 20, 2009, the Trust inspected the property. On November 17, 2009, the Trust sent petitioners a letter which stated that the window replacement at the rear facade was consistent with the approved plan and that the Trust had no objection.

The November 17, 2009, letter also noted that petitioners had installed a retractable awning. The Trust reminded petitioners that making alterations without its written consent was a violation of the easement and that if there were any unauthorized alterations inconsistent with the historic character of the property, petitioners would be required to restore the property to its prior condition. The Trust, however, determined that the awning was consistent with the historical character of the property.

Tax Returns

A certified public accountant prepared petitioners’ 2006 and 2007 Federal income tax returns. Petitioners timely filed both tax returns.

Petitioners filed a Form 8283, Noncash Charitable Contributions, with their 2006 Federal income tax return and reported a noncash charitable contribution of [*16] $605,000 for the donation of the facade easement to the NAT. Petitioners then deducted $238,778 of their 2006 reported noncash charitable contribution. For 2007 petitioners deducted a noncash charitable contribution carryforward of $68,456.

Notice of Deficiency

On April 8, 2010, respondent issued the notice of deficiency to petitioners for tax years 2006 and 2007, disallowing the noncash charitable contribution deductions petitioners claimed on their 2006 and 2007 income tax returns. The notice of deficiency also determined that petitioners were liable for the gross valuation misstatement penalty under section 6662(h) or, in the alternative, the accuracy-related penalty under section 6662(a). In response, petitioners filed a petition.

OPINION

Generally, the Commissioner’s determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving, by a preponderance of the evidence, that those determinations are incorrect. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933). Tax deductions are a matter of legislative grace, and a taxpayer has the burden of proving his or her [*17] entitlement to a deduction. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

Section 7491(a)(1) provides an exception that shifts the burden of proof to the Commissioner as to any factual issue relevant to a taxpayer’s liability for tax if (1) the taxpayer introduces credible evidence with respect to the issue, sec. 7491(a)(1); and (2) the taxpayer satisfies certain other conditions, including substantiation of any item and cooperation with the Government’s requests for witnesses and information, sec. 7491(a)(2); see also Rule 142(a)(2). Petitioners and respondent stipulated that petitioners met the specifications of section 7491(a)(2)(B) with respect to “cooperat[ing] with reasonable requests by the Secretary for witnesses, information, documents, meetings, and interviews”.

Petitioners contend that because they also introduced credible evidence establishing both compliance with the technical provisions of section 170 and the value of the easement, the burden should shift to respondent under section 7491(a)(1). Credible evidence is evidence that the Court would find sufficient upon which to base a decision on the issue in favor of the taxpayer if no contrary evidence were submitted. Rendall v. Commissioner, T.C. Memo. 2006-174, aff’d, 535 F.3d 1221 (10th Cir. 2008); see Higbee v. Commissioner, 116 T.C. 438, 442443 (2001). Petitioners did not produce evidence that meets the definition of [*18] “credible evidence” as used in section 7491(a)(1). We find that petitioners have not shown that they meet the specifications of section 7491(a) to shift the burden of proof to respondent as to the remaining relevant factual issues. The burden of proof remains with petitioners.

I. Noncash Charitable Contributions

A deduction is allowed for any charitable contribution for which payment is made within the taxable year if the contribution is verified under regulations prescribed by the Secretary. Sec. 170(a)(1). Generally, a charitable contribution deduction is not allowed for a charitable gift of property consisting of less than the donor’s entire interest in that property. Sec. 170(f)(3)(A). Section 170(f)(3)(B)(iii), however, provides an exception for a “qualified conservation contribution”. Section 170(h)(1) defines a qualified conservation contribution as follows:

SEC. 170(h). Qualified Conservation Contribution. —

(1) In general.– For purposes of subsection (f)(3)(B)(iii), the term “qualified conservation contribution” means a contribution —

(A) of a qualified real property interest,

(B) to a qualified organization,

(C) exclusively for conservation purposes.

[*19] All three requirements must be met for a donation to be a qualified conservation contribution. Simmons v. Commissioner, T.C. Memo. 2009-208, slip op. at 9, aff’d, 646 F.3d 6 (D.C. Cir. 2011). The legislative history underlying section 170(h) indicates the policy behind the qualified conservation contribution exception and its restrictions:

The committee believes that the preservation of our country’s natural resources and cultural heritage is important, and the committee recognizes that conservation easements now play an important role in preservation efforts. The committee also recognizes that it is not in the country’s best interest to restrict or prohibit the development of all land areas and existing structures. Therefore, the committee believes that provisions allowing deductions for conservation easements should be directed at the preservation of unique or otherwise significant land areas or structures. * * *

S. Rept. No. 96-1007, at 9 (1980), 1980-2 C.B. 599, 603.

Section 170(f)(11) further provides that no charitable contribution deduction shall be allowed under section 170(a) for any contribution of property for which a deduction of more than $5,000 is claimed unless the taxpayer obtains a qualified appraisal of the property. Sec. 170(f)(11)(A), (C). For contributions of property for which a deduction of more than $500,000 is claimed, the taxpayer must also attach the qualified appraisal of the property to his or her Federal tax return. Sec. 170(f)(11)(D).

[*20] The parties agree that the Trust was at all relevant times an organization exempt from Federal taxation under section 501(c)(3) and a qualified organization under section 170(h)(1)(B), as defined by section 170(h)(3). The parties do not dispute that petitioners properly attached an appraisal (qualified or not) to their Federal income tax return as specified by section 170(f)(11)(D).

Therefore, we must determine (1) whether petitioners’ easement contribution was a qualified real property interest, as defined by section 170(h)(2); (2) whether petitioners’ easement contribution was made exclusively for conservation purposes, as defined by section 170(h)(4) and (5); and (3) whether the Haims appraisal was a qualified appraisal under section 170(f)(11)(C). We must also determine the value of the easement contribution.

A. Qualified Real Property Interest

For purposes of section 170(h)(2)(C) the term “qualified real property interest” includes “a restriction (granted in perpetuity) on the use which may be made of the real property.” A restriction granted in perpetuity on the use of the property must be based on legally enforceable restrictions that will prevent uses of the retained interest in the property that are inconsistent with the conservation purposes of the contribution. See sec. 1.170A-14(g)(1), Income Tax Regs. [*21] We addressed the issue of what constitutes a “qualified real property interest” in Belk v. Commissioner, 140 T.C. 1, 7 (2013). In Belk the taxpayers donated a conservation easement; in the conservation easement agreement they agreed not to develop land on a golf course. The conservation easement agreement, however, permitted the taxpayers to remove portions of the golf course from the conservation easement and replace them with property currently not subject to the conservation easement. We found that the use restriction was not granted in perpetuity because the conservation easement agreement permitted the taxpayers to change what property was subject to the conservation easement. Id. at 10. We noted that the taxpayers did not agree never to develop the golf course. Id. at 10-11. We thus held that the taxpayers failed to donate an interest in real property which was subject to a use restriction granted in perpetuity. Id. at 11. We stated: “To conclude otherwise would permit petitioners a deduction for agreeing not to develop the golf course when the golf course can be developed by substituting the property subject to the conservation easement.” Id.

Unlike the conservation easement agreement in Belk petitioners’ deed clearly defines the property donated under the easement and restricts the easement to that property. The deed includes an exhibit with the legal description of the land and the boundaries of petitioners’ property, which is also a matter of public [*22] record. The deed provides that “the facades of the improvements located on the Property (the ‘Building’), including the existing facades on the front, sides and rear of the Building and the measured height of the Building (collectively the ‘Protected Facades’), are protected by this Easement.” To prevent any ambiguity and clearly define the easement rights, the deed provides that “[w]ritten descriptions and photographs of the Protected Facades * * * shall control.” The boundaries of the property are clear, and the easement clearly relates to the front, sides, rear, and measured height of the building; no substitution is allowed.

In addition, the deed grants “an Easement in gross, in perpetuity, in, on, and to the Property”. It further states: “This Easement is binding not only upon Grantor, but also upon its successors, heirs and assigns and all other successors in interest to the Grantor, and shall continue as a servitude running in perpetuity with the land.” The deed mandates specifically that the Trust will not transfer, assign, or otherwise convey its rights under the easement unless it is to a qualified organization under section 170(h)(3) and the transferee agrees to continue to carry out the conservation purposes for which the easement was created.

Accordingly, we hold that petitioners’ easement contribution was a qualified real property interest.

[*23] B. Exclusively for Conservation Purposes

1. Valid Conservation Purpose

Section 170(h)(4)(A)(iv) provides, in pertinent part, that a valid conservation purpose is the preservation of a historically important land area or a certified historic structure.

Section 170(h)(4)(C) defines the phrase “certified historic structure” as (i) any building, structure, or land, which is listed in the National Register, or (ii) any building that is located in a registered historic district (as defined in section 47(c)(3)(B)) and is certified by the Secretary of the Interior to the Secretary of the Treasury as being of historic significance to the district. For this purpose, a structure means any structure, whether or not it is depreciable; accordingly, easements on private residences may qualify. Sec. 1.170A-14(d)(5)(iii), Income Tax Regs.

The enactment of the Pension Protection Act of 2006 (PPA), Pub. L. No. 109-280, 120 Stat. 780, created additional requirements under section 170(h)(4)(B) for any contribution of property in a registered historic district. PPA sec. 1213(a)(1), 120 Stat. at 1075. Section 170(h)(4)(B) provides:

(B) Special rules with respect to buildings in registered historic districts. — In the case of any contribution of a qualified real property interest which is a restriction with respect to the exterior of a building [*24] described in subparagraph (C)(ii), such contribution shall not be considered to be exclusively for conservation purposes unless —

(i) such interest —

(I) includes a restriction which preserves the entire exterior of the building (including the front, sides, rear, and height of the building), and

(II) prohibits any change in the exterior of the building which is inconsistent with the historical character of such exterior, * * *

With respect to section 170(h)(4)(B) the General Explanation of Tax Legislation Enacted in the 109th Congress prepared by the Staff of the Joint Committee on Taxation states as follows:

A charitable deduction is allowable with respect to buildings (as is the case under present law) but the qualified real property interest that relates to the exterior of the building must preserve the entire exterior of the building including the space above the building, the sides, the rear, and the front of the building. In addition, such qualified real property interest must provide that no portion of the exterior of the building may be changed in a manner inconsistent with the historical character of such exterior.

Staff of J. Comm. on Taxation, General Explanation of Tax Legislation Enacted in the 109th Congress 590 (J. Comm. Print 2007).6

[*25] If restrictions to preserve a building or land area within a registered historic district permit future development on the site, a deduction will be allowed only if the terms of the restrictions require that such development conform with appropriate local, State, or Federal standards for construction or rehabilitation within the district. Sec. 1.170A-14(d)(5)(i), Income Tax Regs. In general, a facade easement is a restriction the purpose of which is to preserve certain architectural, historic, and cultural features of the facade, or front, of a building. The terms of a facade easement might permit the property owner to make alterations to the facade of the structure if the property owner obtains consent from the qualified organization that holds the easement. This Court has held that a facade easement may constitute a qualifying conservation contribution. See Hilborn v. Commissioner, 85 T.C. 677 (1985).

Respondent contends that the conservation purpose requirement of section 170(h)(4) is not met because the easement does not preserve the property beyond what is already required under local law. By virtue of the property’s location in Carnegie Hill Historic District, petitioners’ property is subject to the Landmarks Law. Petitioners are thus required to keep the property in good repair and to [*26] obtain an LPC permit before starting work if the work will affect the property’s exterior or if the work requires a Department of Buildings permit.

Petitioners contend that their easement meets the conservation requirement and that the examination of local preservation law is part of the valuation process. See Hilborn v. Commissioner, 85 T.C. at 689. Petitioners argue that their easement is different from easements in prior cases before the Court because their easement is more than a facade easement; it is a full envelope easement. They contend that their easement is more restrictive than existing local laws and reduces development potential. Petitioners provide examples of properties for which the LPC approved a rear addition.

Petitioners’ property is a certified historic structure within the meaning of section 170(h)(4)(A)(iv) because it is in a registered historic district and was certified as such by the Secretary of the Interior through the National Park Service in response to petitioners’ request on January 11, 2007.

The easement at issue preserves petitioners’ property as a certified historic structure. We find that the easement was more restrictive than the Landmarks Law.

The Landmarks Law mandates that petitioners obtain approval from the LPC before making changes to their property, while the deed imposes certain [*27] clearly defined restrictions and gives the Trust unlimited discretionary authority to approve or deny changes to petitioners’ property. The LPC passively monitors changes to historic buildings, while the Trust actively monitors changes to historic buildings. The LPC relies heavily on complaints as part of its monitoring. The Trust performed annual inspections and kept records including photographs. When the LPC reviews a building, it looks at it from the perspective of the streetscape.

Approval from the LPC to make improvements to a property is based on a comparison of the surrounding historical properties. That means petitioners may be given authority from the LPC to make improvements to their property as long as their building remains consistent with the exterior architectural features of neighboring improvements.

The properties directly across the street from petitioners’ building are five or more stories high while petitioners’ property is only four stories above ground. If petitioners applied for a permit to build an additional story, there is a chance the LPC would allow petitioners to do so as long as the addition was consistent with the exterior architectural features of neighboring buildings. The deed, however, requires that improvements to the property involving the existing front, sides, rear, and height of the building need written approval from the Trust. There is a risk [*28] that the Trust will deny an improvement. At trial an employee of the Trust testified that the approval process of the Trust was different from that of the LPC and that the Trust did not approve all projects that met the qualifications of the LPC.

The Landmarks Law states specifically that the LPC is not authorized to regulate or limit the height and bulk of buildings or to regulate and determine the area of yards, courts, or other open spaces. N.Y. City Admin. Code sec. 25304(a). The Trust, with its unlimited discretion, may deny petitioners’ request to make any changes to their home for any reason, while the LPC must follow specific guidelines in its decisionmaking. The Trust has the ultimate say in granting petitioners the right to make changes to their property. Petitioners, however, have the option of appealing a denied permit request with the LPC and changing the LPC’s decision.

John Weiss, deputy counsel to the LPC, testified that in order for the LPC to review a change application for a covered property, both the property owner and the easement holder must sign the change application. If the easement holder refused to sign the change application, then the LPC would not approve it. Here, the easement holder was the Trust. Therefore, the LPC would require the Trust’s approval before reviewing a change application for petitioners’ property.

[*29] Mr. Weiss also testified the LPC must obtain either the consent of the property owner or a court order to enter the premises of a covered property. The Trust, however, has the right to enter petitioners’ property without a court order. The Trust’s monitoring visits require an appointment because the Trust needs access to the property’s backyard. The Trust thus places a larger burden on petitioners’ property rights than the Landmarks Law.

The Court on several occasions has considered whether a conservation deed of easement was more or less restrictive than local law in order to determine whether a contribution was for conservation purposes.

In 1982 East, LLC v. Commissioner, T.C. Memo. 2011-84, the taxpayer contributed a conservation easement deed for a townhouse in a historic district in New York City to the NAT. The deed of easement prohibited the taxpayer from altering the townhouse’s facade without the written consent of the donee organization. In particular the deed prohibited the taxpayer from erecting “‘any new or additional exterior improvements on the [subject] property or in the open space above or surrounding the * * * townhouse’ without the express written consent of NAT.” Id., slip op. at 8. We observed that the LPC would need to approve any alteration made to the taxpayer’s property. We further observed that in making its determination to approve an alteration, the LPC would consider [*30] whether an alteration would “‘change, destroy or affect any exterior architectural feature’ of the subject property and, in the case of an improvement, ‘whether such construction would affect or not be in harmony with the external appearance of other, neighboring improvements’.” Id. at 26 (quoting N.Y. City Admin. Code sec. 25-306(a)(1)).

We found in 1982 East, LLC that the LPC’s determination would consider the external appearance of the townhouse’s facade and the ability of the taxpayer to alter the aesthetics of the subject property by building above it. Id. Consequently we found that the deed of easement in 1982 East, LLC was not more restrictive than the Landmarks Law, holding: “[I]t is local law and the rules of the LPC that preserve the subject property and not the rights which NAT possessed under the deed of easement.” Id.

The deed in the instant case is more restrictive than the deed of easement in 1982 East, LLC. For instance petitioners’ deed mentions specifically the rear of the building, while the deed of easement in 1982 East, LLC did not. This distinction constitutes a major difference in the rights already granted to the LPC under the Landmarks Law. Although both petitioners’ deed and the LPC restrict improvements relating to the exterior of the building, it is unclear whether the LPC would limit changes to the rear of a property. Under the deed petitioners are [*31] expressly restricted from making alterations to the rear of the building without approval. The LPC, however, is less restrictive: It focuses on how change to a property would affect the neighborhood.7 This is a significant difference. We conclude that petitioners’ easement is more restrictive than local law.

In Simmons v. Commissioner, T.C. Memo. 2009-208, the taxpayers granted facade easements via conservation easement deeds for two historic properties in Washington, D.C., to L’Enfant, a historical preservation commission similar to the Trust. The conservation easement deeds provided in effect that the taxpayers “could not make any material changes to the respective facades in any way without L’Enfant’s consent.” Id., slip op. at 4. The Court found that the deeds were more restrictive than local law and allowed the taxpayers section 170 deductions, stating:

Even if we were to accept respondent’s contention that the easements did not impose any restrictions on * * * [the taxpayer] over and above those imposed by the District of Columbia, the easements still added an additional level of approval before any changes could be made to the properties. * * * [The taxpayer] is required to obtain L’Enfant’s [*32] consent to make any changes to the facades, even if those changes are allowable under District of Columbia preservation laws.

Id. at 26. We thus concluded that the approval process alone was enough to differentiate rights granted under the deeds from those already in place under local law.

In Scheidelman v. Commissioner, T.C. Memo. 2013-18, the taxpayer contributed an architectural conservation facade easement for a townhouse in New York City to the NAT. The Court concluded that the taxpayer’s argument that the LPC did not enforce restrictions as effectively as the NAT was “speculation * * * not supported by anything but anecdotes, and * * * contrary to evidence specifically related to the * * * property.” Id. at *19. We concluded that the easement did not materially diminish the value of the taxpayer’s property.

Unlike the deed in Scheidelman, which provided a conservation easement only for the facade, petitioners’ deed concerns the front, side, rear, and measured height of property, as required by section 170(h)(4)(B) following the enactment of the PPA in 2006. We note that the taxpayer in Scheidelman completed her donation in 2004 and therefore the special requirements of section 170(h)(4)(B) did not apply. We also find petitioners’ arguments regarding the Trust’s ability to enforce restrictions more effectively than the LPC to be convincing.

[*33] In Dunlap v. Commissioner, T.C. Memo. 2012-126, taxpayers granted a facade easement on their loft building in New York City to the NAT. The taxpayers’ property had a special “sound, first-class condition” designation with the LPC which caused it to be subject to a higher standard of preservation than most other historic structures in New York City. The Court found that because the building had the sound, first-class condition designation, the facade easement was not more stringent than the LPC regulations and enforcement. The NAT had failed to provide any easement monitoring of the property, donated in 2003, until 2006. The Court also noted that the NAT appeared to be more concerned with making money for SMS (a for-profit entity which employed many of the people who were held out to third parties as working for the NAT and which was owned by the same two people who founded the NAT) than monitoring and enforcing the terms of the facade easements it held, until 2006 when its obligations to SMS ended. We concluded that the value of the easement was zero.

Unlike the easement in Dunlap, petitioners’ property does not have a sound, first-class condition designation. Approximately 150 buildings of the 29,000 structures in New York City that the LPC monitors have this designation. A property with this designation is subject to a higher standard of preservation. We also find that the Trust monitored and enforced the terms of the easement it held [*34] on petitioners’ property, whereas it is unclear whether the LPC ever inspected the property. We note that the taxpayers in Dunlap completed their donation before the enactment of section 170(h)(4)(B) and their donation concerned only the facade of their loft building. We further note that although prior cases criticized the Trust for its affiliation with SMS, we are not convinced that the Trust engaged in the same practices at the time of petitioners’ donation.

Finally, in Herman v. Commissioner, T.C. Memo. 2009-205, the taxpayer donated the unused development air rights via a conservation easement deed in a historic property in New York, New York, to the NAT. We found that an easement restricting only air rights and the maximum height of the building was not restrictive enough to preserve the certified historic structure of the building.

Although the deed in Herman was not restrictive enough to preserve the certified historic structure of the building, we note that petitioners’ deed is much more restrictive than the deed in Herman. Unlike the deed in Herman, petitioners’ deed restricts them from making changes not only to the height of the building but also to the building’s front, side, and rear, as well as the building’s surrounding property.

We further note that although the deed allows the Trust to consent to changes to petitioners’ property, the deed requires any rehabilitative work or new [*35] construction on the facades to comply with the requirements of all applicable Federal, State, and local Government laws and regulations. Section 1.170A-14(d)(5), Income Tax Regs., specifically allows a donation to satisfy the conservation purposes test even if future development is allowed, as long as that future development is subject to local, State, and Federal laws and regulations. See Simmons v. Commissioner, slip op. at 11. Therefore, the deed complies with section 170(h)(4)(B). We conclude that petitioners’ easement has a conservation purpose.

2. Exclusively for Conservation Purposes

a. Conservation Purpose in Perpetuity

Like section 170(h)(2)(C), section 170(h)(5) specifies that the conservation purpose must be protected in perpetuity. Section 170(h)(5)(A) provides that “[a] contribution shall not be treated as exclusively for conservation purposes unless the conservation purpose is protected in perpetuity.” Although subsections (h)(2)(C) and (h)(5) both require perpetuity, they are separate and distinct requirements. Section 170(h)(2)(C) specifies that the interest in real property donated by taxpayers must be subject to a use restriction in perpetuity, whereas section 170(h)(5) specifies that the conservation purpose of the conservation [*36] easement must be protected in perpetuity. Belk v. Commissioner, 140 T.C. at 12; sec. 1.170A-14(a), Income Tax Regs.

We discussed section 170(h)(5) perpetuity in 1982 East, LLC, quoting the legislative history:

“[I]t is * * * intended that contributions of perpetual easements * * * qualify for * * * [a section 170] deduction only in situations where the conservation purposes of protecting or preserving the property will in practice be carried out. Thus, it is intended that a contribution of a conservation easement * * * qualify for a deduction only if the holding of the easement * * * is related to the purpose or function constituting the donee’s purpose for exemption (organizations such as * * * historic trusts * * * ) and the donee is able to enforce its rights as holder of the easement * * * and protect the conservation purposes which the contribution is intended to advance.” * * *

1982 East, LLC v. Commissioner, slip op. at 17-18 (quoting H.R. Conf. Rept. No. 95-263, at 30-31 (1977), 1977-1 C.B. 519, 523).

We further discussed the legislative intent behind this perpetuity requirement, quoting the Senate report:

“[For the contribution to be protected in perpetuity] [t]he contribution must involve legally enforceable restrictions on the interest in the property retained by the donor that would prevent uses of the retained interest inconsistent with the conservation purposes. * * * By requiring that the conservation purpose be protected in perpetuity, the committee intends that the perpetual restrictions must be enforceable by the donee organization (and successors in interest) against all other parties in interest (including successors in interest).” * * *

[*37] Id. at 18-19 (quoting S. Rept. No. 96-1007, at 13-14 (1980), 1980-2 C.B. 599, 605-606).

In 1982 East, LLC v. Commissioner, slip op. at 21, we found that the property at issue was not protected in perpetuity because the NAT was not guaranteed a proportionate share of proceeds in the event of a casualty or condemnation before the mortgage held by First Republic Bank was satisfied. In that case First Republic Bank retained a prior claim to all condemnation and insurance proceeds in preference to the donee until that mortgage was satisfied and discharged. Thus, at any point before the mortgage was repaid, the possibility existed for First Republic Bank to deprive the NAT of value that should have otherwise been dedicated to the conservation purpose. Id. at 23. The Court ultimately found that the contribution of donated property failed to comply with the perpetuity requirements of section 1.170A-14(g)(6)(ii), Income Tax Regs.

In Simmons we held that the easement was a valid conservation easement. We stated: “Although the grants do allow L’Enfant to consent to changes to the properties, the grants require any rehabilitative work or new constructions on the facades to comply with the requirements of all applicable Federal, State, and local government laws and regulations.” Simmons v. Commissioner, slip op. at 11.

[*38] Respondent argues that there are facts to indicate that the Trust was willing to terminate the easement upon petitioners’ request after the easement donation. A lawyer on behalf of petitioners reached out to the Trust about removing the easement. Respondent further argues that petitioners’ easement is comparable to those in other cases in which the Court found that easements were not granted in perpetuity.

Petitioners argue that the easement was granted in perpetuity because it is binding on petitioners’ successors and heirs, it continues as a servitude running in perpetuity with the land, and it survives the termination of the Trust’s existence. Petitioners further argue that the Trust enforces the easement in perpetuity by (1) annually monitoring the property to ensure the property is in compliance with the easement, (2) reviewing any requests for alterations, and (3) tracking changes in ownership of the property to communicate easement obligations to new owners. At trial an employee of the Trust testified that petitioners were told the easement would not be removed.

The terms of the deed grant the easement in perpetuity under section 170(h)(5). The deed grants “an Easement in gross, in perpetuity, in, on, and to the Property”. The deed further states: “This Easement is binding * * * and shall [*39] continue as a servitude running in perpetuity with the land.” This language shows petitioners’ intent to satisfy section 170(h)(5).

We find that the Trust was not willing to terminate the easement. Under the terms of the deed the easement is granted in perpetuity and may not be terminated at any time. The Trust has no intention of releasing the deed. Petitioners requested to have the easement terminated because they were having a difficult time selling their property, and the Trust denied this request.

Moreover, the facts in the case at hand are distinguishable from those in 1982 East, LLC because petitioners do not have a mortgage on the property, and upon sale, exchange, or involuntary conversion the Trust is entitled to its proportionate share of future proceeds, absent controlling State law that provides otherwise.

In Carpenter v. Commissioner, T.C. Memo. 2013-172, we concluded that a conservation easement will not qualify as a qualified conservation contribution if the deed allows mutual agreement to extinguish the easement and extinguishment by judicial proceedings is mandatory. Section 1.170A-14(g)(6), Income Tax Regs., provides that a conservation easement can be extinguished if “the restrictions are extinguished by judicial proceeding and all of the donee’s proceeds * * * from a subsequent sale or exchange of the property are used by the donee [*40] organization in a manner consistent with the conservation purposes of the original contribution.”

The deed in this case allows the easement to be extinguished by judicial decree and requires the donees to use proceeds in a manner consistent with the conservation purposes of the original contribution. The deed does not include other language regarding extinguishment. The deeds in Carpenter included the following language:

If circumstances arise in the future such that render the purpose of this Conservation Easement impossible to accomplish, this Conversation Easement can be terminated or extinguished, whether in whole or in part, by judicial proceedings, or by mutual written agreement of both parties, provided no other parties will be impacted and no laws or regulations are violated by such termination.

Carpenter v. Commissioner, at *4. The deed in the instant case does not include the mutual agreement language and meets the requirements of section 1.170A-14(g)(6), Income Tax Regs.

b. Recording the Deed

Respondent contends that the deed was not recorded under applicable New York law until 2007 and therefore its conservation purpose was not protected in perpetuity under section 170(h)(5)(A) for 2006.

[*41] N.Y. Real. Prop. sec. 317 (McKinney 2006) stated: “Every instrument, entitled to be recorded, must be recorded by the recording officer in the order and as of the time of its delivery to him therefor, and is considered recorded from the time of such delivery.”

The deed was delivered for recording on December 28, 2006, and the required fee was paid. The deed delivered on December 28, 2006, is identical to the deed as recorded; the only error was on the cover sheet to the recording forms, which incorrectly listed the property’s address. The Department of Finance provided a receipt for the delivery of the deed. Therefore, the deed was deemed recorded on December 28, 2006. See Manhattan Co. v. Laimbeer, 15 N.E. 712 (N.Y. 1888) (“In the matter of deeds and mortgages it is constantly spoken of that such papers are recorded when left at the clerk’s office for such purpose[.]”).

Furthermore, section 1.170A-14(g)(3), Income Tax Regs., provides: “A deduction shall not be disallowed under section 170(f)(3)(B)(iii) and this section merely because the interest which passes to, or is vested in, the donee organization may be defeated by the performance of some act or the happening of some event, if on the date of the gift it appears that the possibility that such act or event will [*42] occur is so remote as to be negligible.”8 We find the possibility that the deed would not be recorded because of a clerical error in the cover sheet to be remote. But cf. Solutto v. Commissioner, T.C. Memo. 1993-614 (finding that the possibility of the donee organization, to which the taxpayers granted facade easements of their units in a condominium building, losing the easement was not so remote as to be negligible because the organization did not obtain subordination agreements to protect it from foreclosure, even though the organization had lost up to 45% of its accepted easements to foreclosure, the easement restrictions were unenforceable until several years after the purported donation, and the easement did not stand in priority to a particular security interest), aff’d without published opinion, 67 F.3d 314 (11th Cir. 1995).

Accordingly, we find that the easement was contributed exclusively for conservation purposes.

[*43] C. Qualified Appraisal

To be a qualified appraisal under section 170(f)(11)(E), an appraisal of property (1) must be treated as a qualified appraisal under regulations or other guidance prescribed by the Secretary and (2) must be conducted by a qualified appraiser in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed by the Secretary.

1. Definition of Qualified Appraisal

Section 1.170A-13(c)(3), Income Tax Regs., defines a qualified appraisal as a document that, among other things: (1) relates to an appraisal that is made not earlier than 60 days before the date of contribution of the appraised property and not later than the due date (including extensions) of the return on which a deduction is first claimed under section 170; (2) is prepared, signed, and dated by a qualified appraiser; (3) includes (a) a description of the property appraised, (b) the fair market value of such property on the date of contribution and the specific basis for the valuation, (c) a statement that such appraisal was prepared for income tax purposes, (d) the qualifications of the qualified appraiser, and (e) the signature and taxpayer identification number of such appraiser; and (4) does not involve an appraisal fee that violates certain prescribed rules. The parties stipulated that Mr. [*44] Haims, who performed the appraisal for petitioners, is a “qualified appraiser” as the term is defined in section 1.170A-13(c)(5), Income Tax Regs.

The regulation imposes substantive requirements on the content of an appraisal report. Scheidelman v. Commissioner, 682 F.3d 189, 198 (2d Cir. 2012), vacating and remanding T.C. Memo. 2010-151. A qualified appraisal provides the IRS with sufficient information to evaluate the claimed deduction and deal more effectively with the prevalent use of overvaluation. Hewitt v. Commissioner, 109 T.C. 258, 265 (1997), aff’d without published opinion, 166 F.3d 332 (4th Cir. 1998).9

The parties agree that the Haims report meets the reporting requirements of certain subdivisions in section 1.170A-13(c)(3)(ii), Income Tax Regs.; however, respondent claims that the Haims report fails to meet the reporting requirements of section 1.170A-13(c)(3)(ii)(C), (I), (J), and (K), Income Tax Regs.

Pursuant to section 1.170A-13(c)(3)(ii)(C), Income Tax Regs., an appraisal report must include the date or expected date of the contribution. The Haims [*45] appraisal reports the date or expected date of contribution as December 11, 2006. Therefore, petitioners’ filings gave respondent sufficient information to determine that the expected date of contribution was in December 2006.

Pursuant to section 1.170A-13(c)(3)(ii)(I), Income Tax Regs., an appraisal report should include the appraised fair market value of the donated property on the date or expected dated of contribution. Fair market value is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” Sec. 1.170-1(c)(2), Income Tax Regs.

The Haims appraisal report used the phrase “market value”, which it defined as follows: “The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably and for self interest, and assuming that neither is under undue duress”.

Although we have previously observed that the phrase “market value” is not necessarily synonymous with “fair market value” depending on how the term is defined and used, see Crimi v. Commissioner, T.C. Memo. 2013-51, at *15 (“The [*46] * * * appraisal used a standard of market value as opposed to fair market value[.]”), there is no discernible difference between market value as used by the Haims appraisal and the definition of fair market value in the regulation. We have noted that three elements are necessary for a definition to mirror fair market value: (1) the parties are reasonably aware of all facts relevant to the valued property, (2) the parties cannot be under any compulsion to buy or sell, and (3) the parties must be considered hypothetical rather than actual persons. Bank One Corp v. Commissioner, 120 T.C. 174, 308-310 (2003), aff’d in part, vacated in part and remanded sub nom. J.P. Morgan Chase & Co. v. Commissioner, 458 F.3d 564 (7th Cir. 2006). The definition of market value as used in the Haims appraisal is consistent with these criteria and meets the requirements of section 1.170A13(c)(3)(ii)(I), Income Tax Regs. See also Irby v. Commissioner, 139 T.C. 371 (2012); Crimi v. Commissioner, T.C. Memo. 2013-51.

Pursuant to section 1.170A-13(c)(3)(ii)(J), Income Tax Regs., an appraisal must include the method of valuation used to determine the fair market value. The Haims appraisal uses the “before and after” method. The Haims appraisal explained and identified the method used, including how a paired sales analysis was used and a percentage reduction was applied to the before value. The Haims [*47] appraisal meets the requirements of section 1.170A-13(c)(3)(ii)(J), Income Tax Regs. See Scheidelman v. Commissioner, 682 F.3d at 196.

Pursuant to section 1.170A-13(c)(3)(ii)(K), Income Tax Regs., an appraisal must report the specific basis for valuation. The Haims appraisal explains that it used an “an empirically driven market study using paired sales data residential properties in New York”. The Haims appraisal also provides detail on how the properties were selected.

Mr. Haims’ approach was very similar to the approach taken in Simmons. The Simmons appraisals, which were qualified appraisals, adequately described the parcels of land owned by the taxpayer and the structures built thereon, contained lengthy discussions of historic preservation easements in general, and identified the method of valuations used and the basis for the valuation reached. The Simmons appraisals also contained statistics gathered by L’Enfant that the appraiser took into account in preparing the appraisals. Thus, respondent “may deem * * * [Mr. Haims’] ‘reasoned analysis’ unconvincing, but it is incontestably there.” Scheidelman v. Commissioner, 682 F.3d at 198. The Haims appraisal meets the requirements of section 1.170A-13(c)(3)(ii)(K), Income Tax Regs.

[*48] 2. Generally Accepted Appraisal Standards

Section 170(f)(11)(E) as amended by the PPA specifies that the qualified appraisal must be conducted by a qualified appraiser in accordance with generally accepted appraisal standards. The Department of the Treasury provided guidance in the form of Notice 2006-96, 2006-2 C.B. 902. According to that Notice an appraisal will meet the specifications of section 170(f)(11)(E) if, for example, “the appraisal is consistent with the substance and principles of the Uniform Standards of Professional Appraisal Practice (‘USPAP’)”. Id. sec. 3.02(2), 2006-2 C.B. at 902.

Respondent contends that there were serious defects in the Haims appraisal and that it was inconsistent with USPAP. Respondent contends that Mr. Haims used Department of Finance records when he should have used Department of Building Records. In addition, respondent contends that the after-value analysis Mr. Haims used is not consistent with USPAP. Petitioners contend that Mr. Haims did use Department of Building records.

Appraising is not an exact science and has a subjective nature. The Haims appraisal meets the specifications of section 170(f)(11)(E).

[*49] Accordingly, we find that the Haims appraisal was a qualified appraisal for purposes of section 170(f)(11). Petitioners are entitled to a charitable contribution deduction under section 170(a)(1).

D. Valuation

No established market exists for determining the fair market value of an easement. Simmons v. Commissioner, slip op. at 18; see also Hilborn v. Commissioner, 85 T.C. at 688. We have used the “before and after” approach on numerous occasions to determine the fair market values of restrictive easements with respect to which charitable contribution deductions are claimed. See, e.g., Hilborn v. Commissioner, 85 T.C. at 689; Simmons v. Commissioner, T.C. Memo. 2009-208; Griffin v. Commissioner, T.C. Memo. 1989-130, aff’d, 911 F.2d 1124 (5th Cir. 1990).

Under this approach the fair market value of the restriction is equal to the difference (if any) between the fair market value of the encumbered property before the restriction is granted and its fair market value after the restriction is granted. Sec. 1.170A-14(h)(3)(i), Income Tax Regs. Where the grant of a conservation restriction has no material effect on the value of the property, or serves to enhance, rather than reduce, the value of the property, no deduction is allowed. Sec. 1.170A-14(h)(3)(ii), Income Tax Regs.

[*50] The “before” value of the property generally reflects the highest and best use of the property in its condition just before the donation of the easement. Hilborn v. Commissioner, 85 T.C. at 689. The highest and best use of the property in its “before” condition takes into account the manner by which the property likely would have been developed absent the easement. Simmons v. Commissioner, slip op. at 19. The evaluation of that likelihood also takes into account the effect of existing zoning or historic preservation laws that already restrict the property’s development regardless of the existence of the restrictive easement. Id.

Both petitioners and respondent submitted expert reports regarding the value of petitioners’ easement. Respondent’s expert was Richard Marchitelli, executive managing director of Cushman & Wakefield. Mr. Marchitelli has appraised facade easements in New York City, including townhouses. He is a member of the Appraisal Institute. Petitioners’ expert was Gary Miller, president of Nico Valuation Services, Ltd. He is a member of the Appraisal Institute. Mr. Miller has valued more than $1 billion of real estate.

Both experts agree that the “before” value of petitioners’ townhouse was $5,200,000. They have different reasoning for reaching the fair market value, and they differ on the “after” value of the property. Respondent’s expert believes that [*51] the “after” value of the property was $5,300,000 and that the easement had no influence on the fair market value of the property. Petitioners’ expert believes that the “after” value is $4,735,000, resulting in an easement value of $465,000.

1. Marchitelli Report and Testimony

The Marchitelli report used the “before and after” method to determine the value of the easement. The report compares sales of townhouses in the Upper East Side of Manhattan that were not encumbered by easements to sales of townhouses in the Upper East Side that were encumbered by easements. The findings in the report indicate that wider, larger townhouses tend to sell for a higher price per square foot than smaller, narrower townhouses.

The report discussed seven sales involving Upper East Side landmark townhouses encumbered by facade easements. The sales took place between June 2005 and September 2007, but all the easements were donated before the PPA was enacted in 2006. The report includes copies of the deeds for the seven properties. The deeds for these easements state: “The term ‘facade’ as herein consists of all exterior surfaces of the improvements on the Property, including all walls, roofs, and chimneys”. Several of these deeds include language which limits the deed to exteriors that are visible on the opposite side of the street. Mr. Marchitelli testified that there are different types of easements and not all easements cover [*52] side walls or rear walls. He believes that the data does not support a different value for different types of easements.

The seven sales without easements had prices ranging from $1,380 to $2,949 per square foot. Only one townhouse was smaller than petitioners’ property. The average price of townhouses without easements was $2,159 per square foot.

The seven townhouses with easements had prices ranging from $1,616 to $2,692 per square foot. The townhouses in five of these seven sales were larger than petitioners’ townhouse. The average price of those with easements was $2,195 per square foot. Mr. Marchitelli testified that wider townhouses are more desirable. None of these townhouses was in the same district as petitioners’ property. Four of these townhouses were sold after the date of petitioners’ easement. Mr. Marchitelli testified that there were no comparable properties at the time in the same district as petitioners’ townhouse. He further testified that he determines the size of a townhouse using the tax maps rather than the square footage of the living area of the townhouse because he believes the square footage of the living area overstates the size of the home.

[*53] 2. Miller Report and Testimony

The Miller report uses the sales comparison approach to the “before and after” method by looking at the sales of similar property in surrounding neighborhoods. The size used for comparisons ranged from 3,072 to 3,721 square feet. To determine the value of the facade easement, the report analyzed the market to determine whether the encumbrance of properties by conservation easements has any resultant effect on value. The report describes petitioners’ easement as an “envelope easement” that preserved the existing front, rear, top, and any exposed sides of the building from unauthorized alterations. The report notes that petitioners’ townhouse is small for the market.

The Miller report addresses floor area ratio (FAR), which is the total floor area in a zoning lot divided by the lot area of that zoning lot. Properties in New York, New York, are subject to zoning restrictions based on FAR. If two or more buildings are in the same zoning lot, the FAR is the sum of their floor areas divided by the lot area. The Miller report concludes that petitioners could be allowed to develop an additional 2,744 square feet on the basis of the unused development right in place. The report explains that it is likely that petitioners’ unused development right would be used in the form of a 15-foot extension on the rear and one or two additional levels above the fourth story. Mr. Miller testified [*54] that he would not expect a purchaser to build a four-story rear addition, which would be an 83% increase in bulk. The report contends that this expansion would be subject to strict guidelines.

In order to value the easement, the report looked at nine paired sales — four with respect to a property referred to as easement No. 1 and five with respect to another property referred to as easement No. 2. Sales of properties with easements were compared to sales of comparable properties that did not have easements. Adjustments were made, and the remaining difference in price shows the impact of the easement. The deeds for both of the properties with easements described each of the easements as a “Scenic, Open, Space and Architectural Facade Conservation Easement on the Property exclusively for conservation purposes”. A ratio was used to compare the price the easement property should have sold for according to sales of comparable unencumbered properties and the actual sale price of the encumbered property. The sale price per square foot was the primary unit of comparison. The two properties with easements that were used in the paired sales analysis were much larger than petitioners’ townhouse. These properties have square footage of 12,401 and 7,006. The ratios reflecting a discount ranged from -8% to -35% for the first property, which was 12,401 square feet. The range of ratios for the property with 7,006 square feet was -2% to -15%.

[*55] The Miller report concluded that petitioners’ easement demonstrates a diminution in value of 9% of its encumbered value. This would reduce the value of the property to $1,435 per square foot from $1,575 per square foot. During his testimony Mr. Miller stated that “there’s no scientific way to break down the parts” referring to the 9% diminution in value. He believes that his report explains how he reached the diminution in value of 9%. He testified that keeping a residence in “good repair” is more expensive if you have an easement because you are required by the easement to keep it maintained and preserved.

3. Analysis

Respondent contends that petitioners’ easement has no value. Respondent compares it to the easements in Dunlap v. Commissioner, T.C. Memo. 2012-126, and Scheidelman v. Commissioner, T.C. Memo. 2013-18. As discussed above, in Dunlap the taxpayers donated a facade easement regarding a property in New York, New York, to the NAT that restricted the ability to alter, construct or remodel the facade without the NAT’s express written consent. The donation took place in 2003. We concluded that the value of the facade easement was zero because the it did not result in increased restrictions on that property above those required and enforced by the LPC on the date of the donation. In Scheidelman we held that the taxpayers’ facade easement was valued at zero because, among other [*56] things, the property was already restricted by the LPC. The facade easement was donated in 2004. Respondent argues that petitioners’ easement also mirrors the existing restrictions already in local law.

Mr. Marchitelli had several concerns with the Miller report. He believes that people buy a house to live in, and he testified that townhouses historically have not been renovated to increase their size. He believes that the Miller report overemphasized the value of development rights and that the market does not attach significance to the development rights.

Mr. Marchitelli raised the issue that the Miller report does not compare the easement properties discussed in the report with petitioners’ townhouse. He believes that comparisons are being made to two separate properties with easements and that the report does not compare these properties to petitioners’ townhouse. He believes that this analysis makes the report “convoluted”.

Petitioners contend that it is appropriate to make adjustments to comparable sale figures when using the compared sales approach. See Friedberg v. Commissioner, T.C. Memo. 2011-238, slip op. at 23. They further contend that if a buyer in the Carnegie Hill neighborhood had the choice of buying two identical properties at the same price but for the easement, the buyer would choose the property without the easement.

[*57] Mr. Miller testified that he did not compare petitioners’ property to the comparison sale properties because petitioners’ property was substantially lower in value. Mr. Miller criticized the Marchitelli report for not making adjustments for the condition of property, such as an elevator and servant’s quarters.

Ordinarily, any encumbrance on real property, however slight, would tend to have some negative effect on the property’s fair market value. Evans v. Commissioner, T.C. Memo. 2010-207, slip op. at 15. We do not find respondent’s expert report credible insofar as it maintained that an easement would have absolutely no effect on the fair market value of a valuable piece of real estate. Simmons v. Commissioner, slip op. at 26. In White House Hotel Ltd. P’ship v. Commissioner, 615 F.3d 321, 327 (5th Cir. 2010), vacating and remanding 131 T.C. 112 (2008), the Court of Appeals for the Fifth Circuit noted: “[R]ather extraordinarily, * * * [the Commissioner’s expert] assigned the easement a value of zero”.

The paired sales analysis involves a comparison of the fair market value of a property with and without an easement. The fair market value of the property with the easement is divided by the fair market value of the property without the easement to derive a diminution percentage attributable to the conservation [*58] easement involved. Strasburg v. Commissioner, T.C. Memo. 2000-94, slip op. at 12 n.8. We have approved this method, which we refer to as the “percentage diminution approach”. See, e.g., Butler v. Commissioner, T.C. Memo. 2012-72, slip op. at 75.

Since both respondent and petitioners’ experts agree that the “before” value is $5,200,000, we will use that as the “before” value. We conclude that neither petitioners nor respondent was persuasive about the value of the easement.

We do not agree with respondent that the easement had no value. To determine the value of the easement, we should consider whether the easement is more restrictive than the restrictions provided by local law. See Hilborn v. Commissioner, 85 T.C. 677. As discussed above, petitioners’ easement is more restrictive than local law. Respondent’s reliance on Dunlap and Scheidelman is misplaced. Moreover, we have previously allowed charitable contribution deductions even if the property was subject to local conservation law before the granting of the easement. Simmons v. Commissioner, slip op. 25 (noting that local preservation laws do not necessarily prevent charitable contributions); see Griffin v. Commissioner, T.C. Memo. 1989-130; Nicoladis v. Commissioner, T.C. Memo. 1988-163.

[*59] Petitioners also did not meet their burden of proving that the value of the easement is $465,000. We do not rely on easement sale No. 1 in the Miller report because the property with the easement is 12,401 square feet. We realize that appraisers have to rely on sales that are available at the time of the appraisal and that adjustments can be made; however, the property used for easement sale No. 1 is substantially larger than petitioners’ property, and a reasonable comparison cannot be made. The property used for easement No. 1 is 26.5 feet wide, and petitioners’ townhouse is only 15 feet wide. The testimony of both Mr. Miller and Mr. Marchitelli indicates that a wider townhouse has more value than a narrow townhouse. Twenty adjustments were made in this comparison. When numerous adjustments have to be made, there is a likelihood that the outcome is less reliable than in a comparison where fewer adjustments have to be made.

The easement sale No. 2 property is still larger than petitioners’ property, but unlike the easement sale No. 1 property, it is not substantially larger. The property used for easement No. 2 is 7,006 square feet and 20 feet wide. This is still larger and wider than petitioners’ property, but it provides a more reasonable comparison than easement sale No. 1. Mr. Miller made adjustments to the four comparable sales, and the diminution in value ranged from 2% to 13%.

[*60] The 9% diminution in value used by Mr. Miller is too high. We agree with petitioners that there is value for an envelope easement. There is a reasonable chance that the property may not be able to be developed or modified, especially in the rear of the property. Even though all the paired sales in the Miller report are based on wider properties than petitioners’ townhouse, we conclude a more reasonable diminution would be 2%.

The property in the comparable sale analysis for easement sale No. 2 with the 2% diminution in value is the property closer is in size to petitioners’ property. This comparable property is 4,500 square feet and 20 feet wide. The price per square foot is $1,956. According to the Miller report the “before” value of petitioners’ property is $1,561 per square foot. Mr. Miller made adjustments in using this sale, including adjustments for size, physical characteristics, and condition. Both the comparable property and the easement No. 2 property are five feet wider than petitioners’ property.

We note that the easement No. 2 property in the Miller report does not explicitly include the rear of the property. The easement No. 2 property, however, is larger and wider than petitioners property, and those differences balance out the easement No. 2 property does not include the rear of the property. We are not required to accept the Miller valuation in its entirety. See Symington v. Commissioner, [*61] 87 T.C. 892, 902 (1986); Buffalo Tool & Die Mfg. Co. v. Commissioner, 74 T.C. 441, 452 (1980).

We have considered the expert reports and testimony and conclude that there should be only a 2% reduction in value. This decrease stems from heightened financial burdens of an eased facade, enforcement actions of the Trust, and the scope of the easement. See Simmons v. Commissioner, slip op. at 25. The value of petitioners’ easement is $104,000.

II. Penalties

Respondent contends that petitioners are liable for penalties under section 6662(h) or, in the alternative, under section 6662(a).

A. Section 6662(h)

PPA sec. 1219(a), 120 Stat. at 1083, made several changes to section 6662(h). Section 6662(h) provides a 40% penalty for gross valuation misstatements. Gross valuation misstatements occurs when the value of any property reported on an income tax return is 200% or more of the amount determined to be the correct amount, among other things. See sec. 6662(h)(2). Before the enactment of the PPA the threshold for gross valuation misstatement was 400% or more of the amount determined to be the correct amount. PPA sec. [*62] 1219(a), 120 Stat. at 1083. The PPA also eliminated the reasonable cause exception for gross valuation misstatements. Id.

Petitioners valued the easement at $605,000. The amounts they reported on their 2006 and 2007 Federal income tax returns reflected this value. We conclude that the easement has a value of $104,000. Thus, petitioners’ valuation of $605,000 is greater than 200% of the amount determined to be the correct value. Petitioners are liable for a gross valuation misstatement. Therefore, a 40% penalty is imposed on the portion of the underpayment attributable to the gross valuation misstatement. The reasonable cause exception does not apply in the case of gross valuation misstatements with respect to charitable donations. See sec. 6664(c)(3).

A penalty pursuant to section 6662(h) applies to any portion of an underpayment for the year to which a deduction is carried that is attributable to a gross valuation misstatement for the year in which the carryover of the deduction arises. See sec. 1.6662-5(c), Income Tax Regs. Petitioners therefore are liable for this penalty for both tax years 2006 and 2007.

Petitioners contend that the section 6662(h) penalty should not be assessed because it is an excessive fine under the Eighth Amendment to the United States Constitution. The Eighth Amendment provides: “Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments [*63] inflicted.” U.S. Const. amend. VIII. The touchstone of the inquiry is the “principle of proportionality: The amount of the forfeiture must bear some relationship to the gravity of the offense that it is designed to punish.” United States v. Bajakajian, 524 U.S. 321, 334 (1998).

The purpose of civil tax penalties is to encourage voluntary compliance. Cf. United States v. Boyle, 469 U.S. 241, 245 (1985) (“Congress’ purpose in the prescribed civil penalty [section 6651(a)(1)] was to ensure timely filing of tax returns to the end that tax liability will be ascertained and paid promptly.”). Indeed, the Commissioner’s policy statement explains that “[p]enalties are used to enhance voluntary compliance[.] * * * Penalties provide the Service with an important tool * * * because they enhance voluntary compliance by taxpayers.” Internal Revenue Manual pt. 1.2.20.1.1 (June 29, 2004).

In Helvering v. Mitchell, 303 U.S. 391 (1938), the Supreme Court analyzed whether a civil fraud penalty under the Revenue Act of 1928 was punishment or purely remedial in character. The Court found the penalty to be remedial, stating: “The remedial character of sanctions imposing additions to a tax has been made clear by this Court in passing upon similar legislation. They are provided primarily as a safeguard for the protection of the revenue and to reimburse the [*64] government for the heavy expense of investigation and the loss resulting from the taxpayer’s fraud.” Id. at 401.

In Little v. Commissioner, 106 F.3d 1445 (9th Cir. 1997), aff’g T.C. Memo. 1993-281, the Court of Appeals for the Ninth Circuit held that the IRS’ imposition of negligence and substantial understatement penalties under section 6662 did not violate the Excessive Fines Clause because they are remedial and do not constitute “punishment”. The Court of Appeals held that the penalties at issue are “purely revenue raising because they serve only to deter noncompliance with the tax laws by imposing a financial risk on those who fail to do so”, and that the taxpayer failed to establish that the penalties in question were penal sanctions unrelated to the Government’s interest in raising revenue. Id. at 1454-1455.

We have similarly found contentions that civil tax penalties violate the Excessive Fines Clause to be without merit. See, e.g., Acker v. Commissioner, 26 T.C. 107, 114 (1956); Ryan v. Commissioner, T.C. Memo. 1998-62; Louis v. Commissioner, T.C. Memo. 1996-257, aff’d, 170 F.3d 1232 (9th Cir. 1999).

Section 6662(h) does not violate the Excessive Fines Clause. As the Court of Appeals for the Fourth Circuit stated: “Even assuming arguendo that the Excessive Fines Clause is implicated in this case, there is no basis for concluding that the * * * [civil tax penalty] is excessive. If the * * * [civil tax penalty] is [*65] always calculated as * * * [a percentage] of the tax deficiency regardless of the means by which the income is accrued, the sanction could not be excessive as to one person, but not excessive as to another.” Thomas v. Commissioner, 62 F.3d 97, 103 (4th Cir. 1995), aff’g T.C. Memo. 1994-128. Section 6662(h) is calculated as a percentage of an underpayment, so it bears a relationship to the gravity of the offense that it is designed to remedy.

Moreover, perceived overvaluation of noncash charitable contributions prompted Congress to amend the tax laws several times. Consistent with this perception the PPA lowered the threshold for imposing penalties related to deductions for charitable contribution property. Such congressional actions demonstrate the remedial nature of the penalty and Congress’ intent to regulate the difficult realm of valuing charitable contribution property.

B. Section 6662(a)

Respondent argues in the alternative that petitioners are liable for a section 6662(a) and (b)(1) and (2) accuracy-related penalty due to negligence or disregard of rules or regulations or a substantial understatement of income tax. This issue does not need to be addressed since petitioners are liable for a section 6662(h) penalty.

[*66] Any contentions we have not addressed are irrelevant, moot, or meritless. To reflect the foregoing,

Decision will be entered under Rule 155.

FOOTNOTES

* Brief amicus curiae was filed by Miriam L. Fisher and Theodore J. Wu as attorneys for Trust for Architectural Easements.

1 Respondent concedes the portion of the penalty under sec. 6662(a) for tax year 2006 that relates to petitioners’ cash contribution. The amount of the penalty under sec. 6662(a) that is still in issue for 2006 is $13,372.

2 The tax record shows square footage of 3,300. Respondent’s expert contends the square footage is 3,240.

3 We refer to the organization as “the NAT” when discussing the organization before its name change and as “the Trust” when discussing the organization after its name change.

4 For tax year 2006 respondent allowed a cash charitable contribution deduction of $44,300 for petitioners’ payment to the NAT. There is no indication in the record that the remaining $700 is still in issue.

5 As discussed below, although Mr. Haims used the term “market value” in his appraisal, he determined the property’s fair market value.

6 Taxpayers who make a donation in excess of $10,000 also must pay a $500 fee to the Internal Revenue Service (IRS). Sec. 170(f)(13). This provision, however, did not go into effect until after petitioners made their contribution. See Pension Protection Act of 2006 (PPA), Pub. L. No. 109-280, sec. 1213(e)(3), 120 Stat. at 1076 (noting that the provision applies to contributions made 180 days after August 17, 2006, the date of the PPA’s enactment).

7 The LPC further requires approval for “any significant modification of the existing bulk or envelope of a building”. N.Y. City Admin. Code sec. 25302(x)(1)(c). This language is likewise less restrictive than the language in petitioners’ deed, which prohibits any alterations (significant or not) to the rear of the building without approval.

8 Sec. 1.170A-14(g)(3), Income Tax Regs., cross-references sec. 1.170A1(e), Income Tax Regs., which likewise provides: “If as of the date of a gift a transfer for charitable purposes is dependent upon the performance of some act or the happening of a precedent event in order that it might become effective, no deduction is allowable unless the possibility that the charitable transfer will not become effective is so remote as to be negligible.”

9 Sec. 170(h)(4)(B)(iii) provides further restrictions for any contribution made the year after the enactment of the PPA. See PPA sec. 1213(a)(1), 120 Stat. at 1075-1076. Because petitioners made their contribution in 2006, the year in which the PPA was enacted, sec. 170(h)(4)(B)(iii) does not apply in this case. However, the parties stipulated that the Haims appraisal included a description of the building, its address, block, and lot, and photographs.




CRS Provides Overview of Payment in Lieu of Taxes Program.

Payment in lieu of taxes (PILT) issues currently under debate include whether to continue mandatory spending for PILT, which expired in fiscal 2013, and the PILT eligibility of Indian, urban, and National Wildlife Refuge System lands, the Congressional Research Service said in a November 7 report that provided an overview of the PILT program.

PILT (Payments in Lieu of Taxes): Somewhat Simplified

M. Lynne Corn

Specialist in Natural Resources Policy

November 7, 2013

Congressional Research Service

7-5700

www.crs.gov

RL31392

Summary

Under federal law, local governments are compensated through various programs for reductions to their property tax bases due to the presence of most federally owned land. These lands cannot be taxed, but may create demand for services such as fire protection, police cooperation, or simply longer roads to skirt the federal property. Some of these programs are run by specific agencies and apply only to that agency’s land. The most widely applicable program, administered by the Department of the Interior (DOI), applies to many types of federally owned land, and is called “Payments in Lieu of Taxes,”or PILT. The authorized level of PILT payments is calculated under a complex formula. No precise dollar figure can be given in advance for each year’s PILT authorization level. This report addresses only the PILT program administered by DOI. There is no PILT-like program generally applicable to military lands, but a small fraction of military lands are eligible for the DOI PILT program. Furthermore, PILT does not apply to Indian-owned lands, virtually none of which are subject to local taxes.

This report explains PILT payments, with an analysis of the five major factors affecting the calculation of a payment to a given county. It also describes the effects of certain legislative changes in PILT in 2009 and 2012. Before 2008, annual appropriations were necessary to fund PILT, but a provision in P.L. 110-343 for mandatory spending ensured that, beginning with FY2008 and continuing through the payment to be made in 2012, all counties would receive 100% of the authorized payment. Then on July 6, 2012, the President signed P.L. 112-141, containing a provision extending mandatory spending to FY2013. The Budget Control Act (P.L. 112-25) provided for a sequestration of 5.1% of PILT payments for FY2013.

Since the creation of PILT in 1976, various changes in the law have been proposed. One proposal has been to include additional lands under the PILT program, particularly Indian lands, which are not now eligible for PILT. Most categories of Indian-owned lands cannot be taxed by local governments, though they generally enjoy county services. In some counties, this means a very substantial portion of the land is not taxable. The remaining tax burden (for roads, schools, fire and police protection, etc.) therefore falls more heavily on other property owners. To help compensate for this burden, some counties have proposed that Indian lands (variously defined) be included among those eligible for PILT payments. Examples of other lands mentioned for inclusion are those of the National Aeronautics and Space Administration, and the Departments of Defense and Homeland Security. Another proposal from some counties would revisit the compensation formula to emphasize a payment rate more similar to property tax rates (which vary widely among counties), a feature that would be a major change in counties with high property values. Finally, for lands in the National Wildlife Refuge System (NWRS), some have argued that all lands of the system should be eligible for PILT, rather than limiting the PILT payments to lands reserved from the public domain and excluding PILT payments for acquired lands. The exclusion of NWRS-acquired lands affects primarily counties in eastern states.

With PILT’s mandatory spending having expired in FY2013, the program will be subject to the annual appropriations process for the payment to be made in 2014. Over the next few years, the larger debate for Congress might then be summarized as three decisions: (1) whether to approve future extensions of mandatory spending (either temporary or permanent); (2) whether to make the diametrically opposed choice of reducing the program through appropriations or by changing the PILT formula; and (3) whether to add or subtract any lands to the list of those now eligible for PILT payments. Background on all three issues is discussed here.

Contents

Introduction

Changes to PILT in the 110th and 112th Congresses

How PILT Works: Five Steps to Calculate Payment

Step 1. How Many Acres of Eligible Lands Are There?

Step 2. What Is the Population in the County?

Step 3. Are There Prior-Year Payments from Other Federal Agencies?

Step 4. Does the State Have Pass-Through Laws?

Step 5. What Is This Year’s Consumer Price Index?

Putting It All Together: Calculating a County’s Payment

National Totals

From Authorization to Appropriation

Current Issues

Inclusion of Indian Lands

Inclusion of Urban Lands and Tax Equivalency

National Wildlife Refuge System Lands

County Uncertainty and Fiscal Effects on Counties

Congressional Interest

Figures

Figure 1. Total PILT Payments, FY1993-FY2013: Appropriations in

Current and Inflation-Adjusted 2012 Dollars

Figure 2. Total PILT Payments, FY1993-FY2013 Authorized Amount and

Appropriation

Figure 3. Ceiling Payments Based on County Population Level, FY2013

Figure 4. PILT Payment Level as a Function of Specific Prior

Payments (FY2013)

Figure 5. Steps in Calculating PILT for Eligible Federal Lands

Tables

Table 1.   Authorized PILT Payments to Selected Urban Counties, FY2013

Table 2.   NWRS Acres Eligible for PILT in Selected States, FY2012

Table A-1. Total PILT Payments, FY1993-FY2013: Appropriations in

Current and Inflation-Adjusted 2012 Dollars

Table A-2. Total PILT Payments, FY1993-FY2013: Authorized Amount and

Appropriation

Table A-3. Prior-Year Payment Laws That Are Offset Under Next PILT

Payment

Appendixes

Appendix. PILT Data Tables

Contacts

Author Contact Information.

Introduction

Generally, federal lands may not be taxed by state or local governments unless the governments are authorized to do so by Congress. Because local governments are often financed by property or sales taxes, this inability to tax the property values or products derived from the federal lands may affect local tax bases, sometimes significantly. If the federal government controls a significant share of the property, then the revenue-raising capacity of the county may be compromised because federal lands are not subject to state and local taxes. Instead of authorizing taxation, Congress has usually chosen to create various payment programs designed to compensate for lost tax revenue. These programs take various forms. Many pertain to the lands of a particular agency (e.g., the National Forest System or the National Wildlife Refuge System).1 The most wide-ranging payment program is called “Payments in Lieu of Taxes” or PILT.2 It is administered by the Department of the Interior and affects most acreage under federal ownership. Exceptions include most military lands and lands under the Department of Energy (DOE lands have their own smaller payment program).3 In FY2013, the PILT program covered 606.4 million acres, or about 94% of all federal land.

The Payments in Lieu of Taxes Act of 1976 (P.L. 94-565, as amended, 31 U.S.C. §§ 6901-6907) was passed at a time when U.S. policy was shifting from one of disposal of federal lands to one of retention. The policy meant that the retained lands would no longer be expected to enter the local tax base at some later date. Because of that shift, Congress agreed with recommendations of a federal commission that if these federal lands were never to become part of the local tax base, some compensation should be offered to local governments to make up for the presence of non-taxable land within their jurisdictions.4 Moreover, there was a long-standing concern that some federal lands produced large revenues for local governments, while other federal lands produced little or none. Many Members, especially those from western states with a high percentage of federal lands, felt that the imbalance needed to be addressed. The resulting law authorizes federal PILT payments to local governments that may be used for any governmental purpose.

Many of the issues addressed when PILT was created have continued. One issue is the appropriate payment level, complicated by later erosion of the purchasing power of the payments due to inflation. For many years, counties held that payments were effectively declining because of inflation. When PILT was amended in 1994, the authorized payment level went up (adjusted annually for inflation), but continued to be subject to annual appropriations. Figure 1 shows a major increase in the actual and inflation-adjusted dollars appropriated for PILT from FY1993 to FY2013.5 But the 1994 amendments, designed to overcome years of erosion due to inflation, caused the authorized payment level to increase still faster. (See Figure 2.)

Figure 1. Total PILT Payments, FY1993-FY2013: Appropriations

in Current and Inflation-Adjusted 2012 Dollars

($ in millions)

Source: Current dollars from annual Payments in Lieu of Taxes: National Summary. Inflation adjustment is based on chain-type price index. Adjustment for 2013 is based on the index for the first two quarters of the year.

Note: For the same data in tabular format, see Table A-1.

Critics of PILT cite examples of what they view as its idiosyncrasies. First, while there is no distinction between acquired and public domain lands6 for other categories of eligible lands, acquired lands of the Fish and Wildlife Service (FWS) are not eligible for PILT — which works to the detriment of many counties in the East and Midwest, where nearly all FWS lands were acquired. Second, while payments under the Secure Rural Schools (SRS) program7 require an offset in the following year’s PILT payment for certain lands under the jurisdiction of the Forest Service, if the eligible lands are under the jurisdiction of the Bureau of Land Management (BLM), no reduction in the next year’s PILT payment occurs.8 Third, while payments under the Bankhead-Jones Farm Tenant Act (7 U.S.C. § 1012) require a reduction in the following year’s

PILT payment if the lands are under BLM, no such reduction occurs if Bankhead-Jones payments are for lands under the Forest Service. Fourth, some of the “units of general local government” (counties)9 that receive large payments have other substantial sources of revenue, while some of the counties receiving little are relatively poor. Fifth, a few counties which receive very large payments from other federal revenue-sharing programs (because of valuable timber, mining, recreation, and other land uses) are also authorized to receive a minimum payment ($0.35 per acre)10 from PILT, thus somewhat cancelling out the goal of evening payments across counties. Sixth, in some counties the PILT payment greatly exceeds the amount that the county would receive if the land were taxed at fair market value, while in others it is much less. Given such issues, and the complexity of federal land management policies, consensus on substantive change in the PILT law has been elusive, particularly when Congress has a stated goal of reducing federal expenditures.

Figure 2. Total PILT Payments, FY1993-FY2013

Authorized Amount and Appropriation

($ in millions)

Source: Annual Payments in Lieu of Taxes: National Summary.

Note: For the same data in tabular format, see Table A-2.

Changes to PILT in the 110th and 112th Congresses

The Continuing Appropriations Act, 2009 (P.L. 110-329), provided the FY2008 level ($228.9 million) through March 6, 2009; if this had been the full-year appropriation, it would have constituted roughly 61% of the figure estimated for full payment of the FY2009 authorized level. However, Section 601(c) of Title VI of P.L. 110-343 (the Emergency Economic Stabilization Act of 2008) provided for mandatory spending of the full authorized level for five years — FY2008-FY2012. For FY2008, an additional payment was made to raise the FY2008 level to the full authorized amount, and for FY2009-FY2012, the payments were at 100% of the authorized amount.

Then, on July 6, 2012, the President signed P.L. 112-141, in which Section 100111 extends mandatory spending for PILT to FY2013, without making any other changes to the law. Under the Budget Control Act (P.L. 112-25), PILT is categorized as a non-exempt, non-defense mandatory spending program. As such, it was subject to a 5.1% sequestration of the payments scheduled for FY2013 or $21.5 million from an authorized payment of $421.7 million.11

How PILT Works: Five Steps to Calculate Payment

Calculating a particular county’s PILT payment first requires answering several questions:

1. How many acres of eligible lands are in the county?

2. What is the population of the county?

3. What were the previous year’s payments, if any, for all of the eligible lands under the other payment programs of federal agencies?12

4. Does the state have any laws requiring the payments from other federal agencies to be passed through to other local government entities, such as school districts, rather than staying with the county government?

5. What was the increase in the Consumer Price Index during the year?

Each of these questions will be discussed below. Finally, their use in the computation of each county’s payment is described.

Step 1. How Many Acres of Eligible Lands Are There?

Nine categories of federal lands are identified in the law as eligible for PILT payments:13

1. lands in the National Park System;

2. lands in the National Forest System;

3. lands administered by the Bureau of Land Management;

4. lands in the National Wildlife Refuge System that are withdrawn from the public domain;

5. lands dedicated to the use of federal water resources development projects;14

6. dredge disposal areas under the jurisdiction of the U.S. Army Corps of Engineers;

7. lands located in the vicinity of Purgatory River Canyon and Piñon Canyon, Colorado, that were acquired after December 31, 1981, to expand the Fort Carson military reservation;

8. lands on which are located semi-active or inactive Army installations used for mobilization and for reserve component training; and

9. certain lands acquired by DOI or the Department of Agriculture under the Southern Nevada Public Land Management Act (P.L. 105-263).

______________________________________________________________________

Section 6904/6905 Payments

Two sections of the PILT law (31 U.S.C. § 6904 and § 6905) provide special payments for limited categories of land, for limited periods. These are described in the FY2013 Payments in Lieu of Taxes: National Summary (p. 13) as follows:

Section 6904 of the Act authorizes payments for lands or interests therein, which were acquired after December 31, 1970, as additions to the National Park System or National Forest Wilderness Areas. To receive a PILT payment, these lands must have been subject to local real property taxes within the five year period preceding acquisition by the Federal government. Payments under this section are made in addition to payments under Section 6902. They are based on one percent of the fair market value of the lands at the time of acquisition, but may not exceed the amount of real property taxes assessed and levied on the property during the last full fiscal year before the fiscal year in which [they were] acquired. Section 6904 payments for each acquisition are to be made annually for five years following acquisition, unless otherwise mandated by law. . . .

Section 6905 of the Act authorizes payments for any lands or interests in land owned by the Government in the Redwood National Park or acquired in the Lake Tahoe Basin under the Act of December 23, 1980 (P.L. 96-586, 94 Stat. 3383). Section 6905 payments continue until the total amount paid equals 5 percent of the fair market value of the lands at the time of acquisition. However, the payment for each year cannot exceed the actual property taxes assessed and levied on the property during the last full fiscal year before the fiscal year in which the property was acquired by the Federal government.

In the FY2013 payments, the Section 6904/6905 payments totaled $602,330 or 0.14% of the total program. California counties received the largest amount ($107,044, before sequestration). Sixteen states and territories had no counties receiving payments under these two sections in FY2013. These states and territories were Connecticut, Delaware, Illinois, Iowa, Kansas, Mississippi, New Jersey, North Dakota, Oklahoma, Rhode Island, South Dakota, Utah, Vermont, and Guam, Puerto Rico, and the Virgin Islands.

The payments under Section 6904 cease five years after acquired land is incorporated into a national park unit or a National Forest Wilderness Area. As a result, counties experience a sudden drop in their PILT payment after five years.

_____________________________________________________

In addition, if any lands in the above categories were exempt from real estate taxes at the time they were acquired by the United States, those lands are not eligible for PILT, except in three circumstances:

1. land received by the state or county from a private party for donation to the federal government within eight years of the original donation;

2. lands acquired by the state or county in exchange for land that was eligible for PILT; or

3. lands in Utah acquired by the United States if the lands were eligible for a payment in lieu of taxes program from the state of Utah.

Only the nine categories of lands (plus the three exceptions) on this list are eligible for PILT payments; other federal lands — such as military bases, post offices, federal office buildings, and the like — are not eligible for PILT. The exclusion of lands in the National Wildlife Refuge System that are acquired is an interesting anomaly, and may reflect nothing more than the House and Senate committee jurisdictions at the time P.L. 94-565 was enacted.15

Step 2. What Is the Population in the County?

The law restricts the payment a county may receive based on population. Under the schedule provided in 31 U.S.C. § 6903, counties are paid at a rate that varies with the population; counties with low populations are paid at a high rate per person, and populous counties are paid less per person. For example, for FY2013, a county with a population of 1,000 people will not receive a PILT payment over $171,110 ($171.11 per person); a jurisdiction with a population of 30,000 will not receive a payment over $2.6 million (30,000 x $85.58 per person). And no county is credited with a population over 50,000. Consequently, in FY2013, at the authorized payment level of $68.45 per person, no county may receive a PILT payment over $3.4 million (50,000 x $68.45/person) regardless of population. Figure 3 shows the relationship between the population of a county and the maximum PILT payment.

Step 3. Are There Prior-Year Payments from Other Federal Agencies?

Federal land varies greatly in revenue production. Some lands have a large volume of timber sales, some have recreation concessions such as ski resorts, and some generate no revenue at all. Some federal lands have payment programs for state or local governments, and these may vary markedly from year to year. To even out the payments among counties and prevent grossly disparate payments, Congress provided that the previous year’s payments on eligible federal lands from specific payment programs to counties would be subtracted from the PILT payment of the following year. So for a hypothetical county with three categories of eligible federal land, one paying the county $1,000, the second $2,000, and the third $3,000, then $6,000 would be subtracted from the following year’s PILT payment. Most counties are paid under this offset provision, which is called the standard rate. In Figure 4, the standard rate is shown by the sloping portion of the line, indicating that as the sum of the payment rates from other agencies increases, the PILT payment rate declines on a dollar-for-dollar basis.

Figure 3. Ceiling Payments Based on County Population Level,

FY2013

Source: Calculations based on Payments in Lieu of Taxes: National Summary FY2013, p. 15.

Figure 4. PILT Payment Level as a Function of Specific Prior

Payments (FY2013)

At the same time, Congress wanted to ensure that each county got some PILT payment, however small, even if the eligible lands produced a substantial county payment from other agencies. If the county had payments from three federal payment programs of $1,000, $2,000, and $1 million, for instance, subtracting $1.003 million from a small PILT payment would produce a negative number — meaning no PILT payment to the county at all. In that case, a minimum rate applies, which does not deduct the other agencies’ payments. In Figure 4, the flat portion to the right shows that, after the other agencies’ payments reach a certain level ($2.54 per acre in FY2013), the rate of the PILT payment remains fixed (at $0.35 per acre in FY2013).

The payments made in prior years that count against future PILT payments are specified in law (16 U.S.C. § 6903(a)(1)). Any other payment programs beyond those specified would not affect later PILT payments. These specified payments are shown in Table A-3. Eligible lands under some agencies (e.g., National Park Service and Army Corps of Engineers) have no payment programs that affect later PILT payments.

Step 4. Does the State Have Pass-Through Laws?

Counties may receive payments above the calculated amount described above, depending on state law. Specifically, states may require that the payments from federal land agencies pass through the county government to some other entity (typically a local school district), rather than accrue to the county government itself. When counties in a “pass-through” state are paid under the formula which deducts their prior year payments from other agencies (e.g., from the Refuge Revenue Sharing Fund (RRSF; 16 U.S.C. § 715s) of FWS, or the Forest Service (FS) Payments to States (16 U.S.C. § 500)),16 the amount paid to the other entity is not deducted from the county’s PILT payments in the following year. According to DOI:

Only the amount of Federal land payments actually received by units of government in the prior fiscal year is deducted. If a unit receives a Federal land payment, but is required by State law to pass all or part of it to financially and politically independent school districts, or any other single or special purpose district, payments are considered to have not been received by the unit of local government and are not deducted from the Section 6902 payment.17

For example, if a state requires all counties to pass along some or all of their RRSF payments from FWS to the local school boards, the amount passed along is not deducted from the counties’ PILT payments for the following year (31 U.S.C. § 6907). Or if two counties of equal population in two states each received $2,000 under the FS Payments to States, and State #1 pays that amount directly to the local school board, but State #2 does not, then under this provision, the PILT payment to the county in State #1 will not be reduced in the following year, but that of the county in State #2 will drop by $2,000. State #1 will have increased the total revenue coming to the state and to each county by taking advantage of this feature.18

Consequently, the feature of PILT that was apparently intended to even out payments among counties (at least of equal population size) may not have that result if the state takes advantage of this pass-through feature.19 Under 31 U.S.C. § 6903(b)(2), each governor gives the Secretary of the Interior an annual statement of the amounts actually paid to each county government under the relevant federal payment laws. DOI checks each governor’s report against the records of the payment programs of federal agencies.

In addition, there is a pass-through option for the PILT payment itself. A state may require that the PILT payment itself go to a smaller unit of government, contained within the county (typically a school district) (16 U.S.C. § 6907). If so, one check is sent by the federal government to the state for distribution by the state to these smaller units of government. The distribution must occur within 30 days. As of FY2013, Wisconsin is the only state to have selected this feature of PILT.

Step 5. What Is This Year’s Consumer Price Index?

A provision in the 1994 amendments to PILT adjusted the authorization levels for inflation. The standard and minimum rates, as well as the payment ceilings, are adjusted each year. Under 31 U.S.C. § 6903(d), “the Secretary of the Interior shall adjust each dollar amount specified in subsections (b) and (c) to reflect changes in the Consumer Price Index published by the Bureau of Labor Statistics of the Department of Labor, for the 12 months ending the preceding June 30.” This is an unusual degree of inflation adjustment; no other federal land agency’s payment program has this feature. But as will be shown below, increases in the authorization do not necessarily lead to a commensurate increase in the funds received by the counties.

Putting It All Together:

Calculating a County’s Payment

Knowing the answers to these questions, one can then make two comparisons to calculate the authorized payment level for a county. (Figure 5 shows a flow chart of the steps in these comparisons.) All charts and comparisons in this report are based on FY2013 payment levels.

Alternative A. Which is less: the county’s eligible acreage times $2.54 per acre or the county’s ceiling payment based on its population? Pick the lesser of these two numbers. From it, subtract the previous year’s total payments for these eligible lands under specific payment or revenue-sharing programs of the federal agencies that control the eligible land.20 The amount to be deducted is based on an annual report from the governor of each state to DOI. This option is called the standard provision.

Alternative B. Which is less: the county’s eligible acreage times $0.35 per acre or the county’s ceiling payment? Pick the lesser of these two. This option is called the minimum provision, and is used in the counties that received relatively large payments (over $2.19 per acre for FY2013) from other federal agencies in the previous year.

Figure 5. Steps in Calculating PILT for Eligible Federal

Lands

(FY2013 payment levels)

Note: The payments (marked *) are the specific payments for federal lands. The amount subtracted is reduced in states with pass-through laws. Also, mandatory spending continues through FY2013; under current law, the PILT program returns to annual appropriations in FY2014.

Source: Prepared by CRS, based on PILT statute (31 U.S.C §§ 6901-6907).

The county is authorized to receive whichever of the above calculations — (A) or (B) — is greater. This calculation must be made for all counties individually to determine the national authorization level. From the program’s inception through FY2007, the authorized payments were subject to annual appropriations, and if appropriations were insufficient for full funding, each county received a pro rata share of the appropriation. After passage of P.L. 110-343 and P.L. 112-141, each county received the full authorized amount for FY2008-FY2012; as a result of sequestration (P.L. 112-25), each county received 94.8% of the authorized amount for FY2013.

The combination of specific payments and PILT in the standard option means that reductions (or increases) in those other payments in the previous year could be exactly offset by increases (or reductions) in PILT payments. However, provided that the county’s population is not so low as to affect the outcome, PILT payments cannot fall below $0.35 per acre for FY2013 (see Alternative B, above), so the full offset occurs only when the other federal payments in the previous year total less than $2.19 per acre (i.e., the maximum payment of $2.54 per acre minus the $0.35 per acre minimum payment from PILT).21

The standard option, with its offset between agency-specific payments and PILT payments, still does not guarantee a constant level of federal payments to counties, because of the time lag in determining PILT payments. Federal payments for a given fiscal year are generally based on the receipts of the prior year. PILT payments of the following fiscal year are offset by these payments.

To illustrate, consider a county whose only eligible federal lands are under the jurisdiction of FWS. If the federal receipts on the FWS lands dropped in FY2013 (compared to FY2012), authorized payments in FY2014 from the FWS Refuge Revenue Sharing Fund would fall. Authorized PILT payments will therefore increase to offset the drop — in FY2014. (This example assumes that the PILT payment is calculated under the standard option.) The counties will be authorized to receive at least $2.54 per acre from RRSF and PILT payments combined,22 but the two payments would not come in the same year. Consequently, if RRSF payments are falling from year to year, the combined payments in the given year would be less than $2.54 per acre, but if RRSF payments are rising, the authorized combined payment in the given year would be more than $2.54 per acre.

National Totals

Information from all 2,130 counties with eligible land is needed on a national scale before an aggregate figure for the nation can be calculated precisely, and consequently no precise dollar figure can be given in advance for each year’s PILT authorization level.23 However, because the amount for full authorization for FY2013 has been calculated, and because major changes in the factors stated above are not likely to decrease the payments at the national level, the full authorization level for FY2014 seems likely to be similar to, or slightly larger than, the amount for the full authorization in FY2013 ($421.7 million), even though individual counties’ payments may vary.

From Authorization to Appropriation

Until about 1994, the full amount authorized under the law’s formula had generally been appropriated, with a few exceptions such as sequestration under the Gramm-Rudman-Hollings Act (Title II of P.L. 99-177). But the buying power of the payments fell due to inflation. In response, Congress amended the law in 1994 (P.L. 103-397) to adjust for inflation.

The amendment focused on increasing the total payments, building in inflation protection, and making certain additional categories of land eligible.24 After the amendments passed, the increasing discrepancy between appropriations and the rapidly rising authorization levels led to even greater levels of frustration among local governments, and prompted intense interest among some Members in increasing appropriations. Eventually, the result was the passage of P.L. 110-343 and P.L. 112-141. (See Figure 2, above.)

Current Issues

While the enactment of six years of mandatory spending put the issue of full funding to rest for a time, county governments now strongly support continuing mandatory spending for PILT. This question was the biggest issue facing the program in the 112th Congress and remains so in the 113th Congress. At the same time, with the congressional debate over spending levels in general, there may be proposals to modify or even eliminate PILT in later years as a means of reducing federal deficits. Several more specific issues are also being debated in Congress or within county governments. Among them are the inclusion of Indian or other categories of lands; tax equivalency, especially for eligible urban lands; and payments affecting the National Wildlife Refuge System.

Inclusion of Indian Lands

While the inclusion of other lands (e.g., military lands generally or those of specific agencies such as the National Aeronautics and Space Administration) under the PILT program has been mentioned from time to time, some counties with many acres of non-taxable Indian lands within their boundaries have long supported adding Indian lands to the list of lands eligible for PILT. The primary arguments made are that these lands receive benefits from the county, such as road networks, but Indian residents do not pay for them with property taxes; on the other hand, the federal government does not actually own these lands.

The complexity of the PILT formula makes it very difficult to calculate the consequences of such a move, either for authorization levels or appropriation levels. Additionally, Congress would have to decide what sorts of “Indian lands” would be eligible for such payments and a variety of other complex issues.25 If some categories of Indian lands were to be added to those lands already eligible, Congress might wish to limit payments to counties with more than some minimum percentage of Indian lands within their borders. Regardless, even a very restrictive definition of “Indian lands” seems likely to add many millions of acres to those already eligible. Even if the criteria for eligibility were determined, it would still be difficult to determine the effect on authorization levels. To paint an extreme example, if all of the eligible Indian lands were in counties whose PILT payments were already capped due to the population ceiling, inclusion of Indian lands would have no effect on PILT authorization levels.

As long as mandatory spending is in place, appropriations would go up to fund the newly eligible lands. If mandatory spending expires and annual appropriations are less than the authorized level, each county would receive a pro rata share of the authorized full payment level. Individual counties whose eligible acres had jumped markedly with the inclusion of Indian lands might receive substantially more than in the past. Other counties (particularly those with few or no eligible Indian acres) would receive a smaller fraction of the authorized amount as limited dollars would be distributed among more lands.

Inclusion of Urban Lands and Tax Equivalency

Some observers have wondered whether urban federal lands are included in the PILT program. The response is that urban lands are not excluded from PILT under the current law. For example, in FY2013, the counties in which Sacramento, Chicago, and Cleveland are found, as well as the District of Columbia, all received PILT payments (see Table 1),though the property tax on similar, but nonfederal, lands would likely have been substantially greater.

Table 1. Authorized PILT Payments to Selected Urban Counties, FY2013

______________________________________________________________________________

County              Eligible Acres               FY2013 Authorized Payment ($)

______________________________________________________________________________

Sacramento

County (CA)             9,621                             24,437

Cook County

(IL)                      139                                353

Cuyahoga

County (OH)             2,592                              6,584

Arlington County

(VA)                       27                                  0a

District of

Columbia               6,959                              17,843

______________________________________________________________________________

Source: U.S. Dept. of the Interior, Payments in Lieu of Taxes: National

Summary, FY2013.

FOOTNOTE TO TABLE 1

a Under the PILT formula, Arlington County’s 27 eligible acres

(all under the National Park Service) would generate a payment of $69.

However, under the law, no payment is made for amounts under $100.

END OF FOOTNOTE TO TABLE 1

Eastern counties, which tend to be small, rarely have both large populations and large eligible acreage in the same county. On the other hand, western counties tend to be very large and may have many eligible acres, and some, like Sacramento, may have large populations as well. Furthermore, as the cases of Arlington County and the District of Columbia illustrate, PILT payments are by no means acting as an equivalent to property tax payments, because if the 6,959 acres in the District of Columbia or the 27 acres in Arlington County were owned by taxable entities, those acres would result in much more than $17,339, or $0, respectively, in property taxes.

Because the formula in PILT does not reflect property taxes, counties such as these might support a revised formula that would approach property tax payments.

National Wildlife Refuge System Lands

As noted above, lands in the National Wildlife Refuge System (NWRS) that were withdrawn from the public domain are eligible for PILT, and those that were acquired are not. In addition, the National Wildlife Refuge Fund (NWRF, also called the Refuge Revenue-Sharing Fund, or RRSF) relies on annual appropriations for full funding. For FY2013, payments for NWRF were approximately 23% of the authorized level. For refuge lands eligible for PILT, some or perhaps all of the NWRF payment will be made up for in the following year’s PILT payment, but for acquired lands, this will not occur because they are not eligible for PILT. Congress may consider making all refuge lands eligible for PILT, and/or providing mandatory spending for NWRF, as it has for PILT. Eastern counties could be the largest beneficiaries of such a change, although some western states may also have many NWRS acres that are not currently eligible for PILT. (See Table 2 for selected state examples.) Adding the 9.7 million acres of NWRS lands under the primary jurisdiction of FWS, but currently ineligible for PILT would increase PILT lands by about 1.6%.

Table 2. NWRS Acres Eligible for PILT in Selected States, FY2012

____________________________________________________________________________

NWRS Acres Reserved from                      Percent Eligible

State           Public Domain              Total NWRS Acres   for PILT

_____________________________________________________________________________

Alabama                      0                    71,386           0.0

Arizona              1,553,465                 1,743,674          89.0

Iowa                       334                   119,056           0.3

Maine                        0                    69,416           0.0

Montana                433,135                 1,496,823          28.9

Ohio                        77                     9,234           0.8

Oregon                 268,360                   591,534          45.4

______________________________________________________________________________

Source: Compiled from Annual Report of Lands Under Control of the U.S.

Fish and Wildlife Service As of September 30, 2012 (the most recent year

available).

County Uncertainty and Fiscal Effects on Counties26

The PILT program, as a mandatory spending program, has provided a relatively certain flow of funds to recipient jurisdictions. Some observers and policy makers are concerned that returning PILT to discretionary spending or eliminating the program completely would destabilize the fiscal structure of some jurisdictions receiving PILT payments. Nationally, however, the relative size of the PILT payments would seem to mitigate the impact and PILT reductions would not seem to have a measurable fiscal impact on most county budgets that receive PILT transfers. Locally, the impacts may be greater, perhaps substantially.

The reliance on property taxes is important for most counties. Nationwide, in FY2011, local property taxes (which includes counties, cities, and special districts) comprised roughly 47.4% of own-source revenue or just over $429 billion.27 However, in FY2013, the PILT program is very much smaller: the authorized $422 million in PILT payments is roughly 0.09% of property tax revenue nationally.28 For counties that receive a significantly larger PILT payment, however, the impact would be greater. First, for the 14 counties that received over $3 million in 2013, the government services provided by the county could be adversely affected in the near term, though restructuring the property tax could likely compensate for the reduced federal payment. Second, smaller payments would also be important in low-property value, low-population counties with relatively greater shares of federally owned land.

Congressional Interest

Congressional interest, after the 1994 revisions to PILT, has focused on the three areas cited above: (1) whether to approve mandatory spending (either temporary or permanent); (2) whether to make the diametrically opposed choice of reducing the program through appropriations or through changing the PILT formula; and (3) whether to add or subtract any lands to the list of those now eligible for PILT payments. PILT payments for FY2013 totaled $399.8 million in mandatory spending;29 in contrast, the annual appropriation for the Department of the Interior for FY2013 was $10.7 billion, or about 27 times the PILT program. However, for a relatively small fraction of the federal or even departmental budget, PILT garners considerable attention for local reasons: (1) according to the FY2013 Payments in Lieu of Taxes: National Summary, 2,130 counties were eligible for PILT payments; (2) the average payment per county (many of which are sparsely populated) was $187,900; (3) while some counties received no payment (because they have very few federal lands and PILT makes no payments under $100), many received over $1 million and 14 received over $3 million.30 The resulting impact on budgets of local governments helps generate interest despite the comparatively small size of the PILT program. With the termination of mandatory spending, counties with large federal land holdings face significant fiscal uncertainty.

Appendix. PILT Data Tables

The first two tables below show the data presented in Figure 1 and Figure 2. The third shows the agency payments that offset payments under PILT in the following year.

Table A-1. Total PILT Payments, FY1993-FY2013:

Appropriations in Current and Inflation-Adjusted 2012 Dollars

($ in millions)

_____________________________________________________________________

Inflation-Adjusted

Year                  Appropriation            Appropriation

_____________________________________________________________________

1993                      103.2                       149.8

1994                      104.1                       148.0

1995                      101.1                       140.8

1996                      112.8                       154.3

1997                      113.1                       152.1

1998                      118.8                       158.0

1999                      124.6                       163.4

2000                      134.0                       171.8

2001                      199.2                       249.7

2002                      209.4                       258.5

2003                      218.6                       264.6

2004                      224.7                       264.7

2005                      226.8                       258.9

2006                      232.5                       257.5

2007                      232.5                       250.8

2008                      367.2                       388.5

2009                      381.6                       400.7

2010                      358.1                       371.5

2011                      375.2                       381.8

2012                      393.0                       393.0

2013                      400.2                       395.5

______________________________________________________________________

Source: Current dollars from annual Payments in Lieu of Taxes:

National Summary. Inflation adjustment is based on chain-type price

index. Adjustment for 2013 is based on the index for the first two

quarters of the year.

Notes: For the same data in a bar chart, see Figure 1.

Table A-2. Total PILT Payments, FY1993-FY2013:

Authorized Amount and Appropriation

($ in millions)

______________________________________________________________________

Year                     Authorized                  Appropriated

__________________________________________________

1993                        103.2                        103.2

1994                        104.4                        104.1

1995                        130.5                        101.1

1996                        165.1                        112.8

1997                        212.0                        113.1

1998                        260.5                        118.8

1999                        303.7                        124.6

2000                        317.6                        134.0

2001                        338.6                        199.2

2002                        350.8                        209.4

2003                        324.1                        218.6

2004                        331.3                        224.7

2005                        332.0                        226.8

2006                        344.4                        232.5

2007                        358.3                        232.5

2008                        367.2                        367.2

2009                        381.6                        381.6

2010                        358.1                        358.1

2011                        375.2                        375.2

2012                        393.0                        393.0

2013                        421.7                        400.2

____________________________________________________________________

Source: Annual Payments in Lieu of Taxes: National Summary.

Notes: For the same data in a bar chart, see Figure 2.

Table A-3. Prior-Year Payment Laws That Are Offset Under Next PILT

Payment

_____________________________________________________________________________

______________________________________________________________________

Sources: 31 U.S.C. § 6903(a)(1), Payments in Lieu of Taxes: National Summary FY2013, p. 14. The latter document has typographical errors which are corrected here, as noted. Because the various payment laws are identified in some documents by title, in others by a U.S. Code citation, or still others by the Statutes at Large, or date, or Public Law, all of these are cited here, where they exist.

FOOTNOTES TO TABLE A-3

a Payments in Lieu of Taxes: National Summary FY2013 erroneously states payment rate is 75% of appraised value. The error first appeared in the FY2000 Summary, and has not been corrected.

b When payments are made for lands under the jurisdiction of the Forest Service for the Secure Rural Schools (SRS) program, the payments result in a reduction (offset) in the following year’s PILT payment. However, if the lands are under BLM jurisdiction, no offset is made in the following year’s PILT payment. All BLM lands eligible for SRS payments are in Oregon.

c Acquired lands in the National Wildlife Refuge System are not eligible for PILT payments. See text.

END OF FOOTNOTES TO TABLE A-3

Author Contact Information

M. Lynne Corn

Specialist in Natural Resources Policy

[email protected], 7-7267

FOOTNOTES

1 For more information on some of these agency-specific payment programs, see CRS Report RL30335, Federal Land Management Agencies’ Mandatory Spending Authorities, by M. Lynne Corn and Carol Hardy Vincent; and CRS Report R41303, Reauthorizing the Secure Rural Schools and Community Self-Determination Act of 2000, by Katie Hoover. The program under the Department of Energy is described in U.S. General Accounting Office [now Government Accountability Office], Energy Management: Payments in Lieu of Taxes for DOE Property May Need to Be Reassessed, GAO/RCED-94-204 (Washington, DC: July 1994).

2 U.S. Department of the Interior, Office of Budget, Payments in Lieu of Taxes: National Summary Fiscal Year 2013, Washington, DC, 2012. A similar document is issued every year; each contains tables for payments and acreage by state and county. To query data from the most recent fiscal year, see http://www.doi.gov/pilt/.

3 A program, commonly referred to as Impact Aid, supports local schools based on the presence of children of federal employees, including military dependents. It provides some support to local governments, however, and to some extent it compensates for lost property tax revenue when military families live on federally owned land. For more information, see CRS Report RL33960, The Elementary and Secondary Education Act, as Amended by the No Child Left Behind Act: A Primer, by Rebecca R. Skinner.

4 Public Land Law Review Commission, One Third of the Nation’s Land: A Report to the President and to the Congress, Washington, DC, June 1970, pp. 235-241.

5 Inflation adjustments in this report use the implicit price deflator for the Gross Domestic Product. See http://www.bea.gov//national/nipaweb/DownSS2.asp, Table 1.1.9. Data for FY2013 used the implicit price deflator for the first two quarters of the year.

6 Acquired lands are those which the United States obtained from a state or individual. Public domain lands are generally those which the United States obtained from a sovereign nation.

7 See CRS Report R41303, Reauthorizing the Secure Rural Schools and Community Self-Determination Act of 2000, by Katie Hoover.

8 All of the BLM lands eligible for SRS payments are in Oregon.

9 Unit of general local government is defined in the law (31 U.S.C. § 6901(2)) as “a county (or parish), township, borough, or city where the city is independent of any other unit of general local government, that (i) is within the class or classes of such political subdivisions in a State that the Secretary of the Interior, in his discretion, determines to be the principal provider or providers of governmental services within the State; and (ii) is a unit of general government as determined by the Secretary of the Interior on the basis of the same principles as were used on January 1, 1983, by the Secretary of Commerce for general statistical purposes” plus the District of Columbia, Puerto Rico, Guam, and the Virgin Islands. For simplicity, the word county will be used in the rest of this report to refer to a unit of general local government, and must be understood here to be equivalent to the above definition. This shorthand is often used by DOI.

10 This and subsequent references to payment rates and ceilings are based on FY2013 figures unless otherwise noted.

11 OMB Report to the Congress on the Joint Committee Sequestration for Fiscal Year 2013, p. 36 gave a slightly smaller initial estimate, based on a lower projected authorized level. Available at http://www.whitehouse.gov/sites/default/files/omb/assets/legislative_reports/fy13ombjcsequestrationreport.pdf. The figures here are the final figures, and are taken from the Payments in Lieu of Taxes: National Summary Fiscal Year 2013, p. 9.

12 Regardless of how many agencies have jurisdiction over eligible lands in a county, all of the payments specified in 31 U.S.C. § 6903(a)(1) are added together and deducted from the following year’s single PILT payment. Any other federal lands payments the county may get that are not specified in that provision are not deducted. The formula in 31 U.S.C. § 6903 sets a cap on the total PILT payment for all of the eligible land in the county.

13 See 31 U.S.C. § 6901. The law refers to these nine categories of lands as “entitlement lands,” and the term is used throughout the act. However, because entitlement is a word which is used in a very different, and potentially confusing, context in the congressional budget process, these lands will be called eligible lands in this report.

14 These lands are under the jurisdiction of the Bureau of Reclamation, for the most part.

15 At the time, jurisdiction over the National Wildlife Refuge System (NWRS) generally was in one committee, while jurisdiction over public domain lands was within the jurisdiction of different committees. This was true in both the House and Senate. The committees considering PILT had no jurisdiction over the acquired lands within the NWRS.

16 Under 16 U.S.C. § 500, these payments are made to the states or territories, and must be used for schools or roads in the counties where the national forests are located. Each state has its own rules on the mechanics of that transfer, on the proportion to be used for roads and the proportion for schools. Some states direct that the education portion be given directly to school boards. For more information see CRS Report R40225, Federal Land Management Agencies: Background on Land and Resources Management, coordinated by Ross W. Gorte.

17 U.S. Dept. of the Interior, Payments in Lieu of Taxes: National Summary, Fiscal Year 2013, p. 11.

18 Note that even though a county as a whole may benefit from this provision, the county government itself will not, because it forgoes the revenues given directly to its school system.

19 However, the Supreme Court has held that states cannot direct counties to spend their PILT payments (i.e., payments under the DOI-managed program described in this report) for particular purposes, once they have actually received their PILT payment. Lawrence County v. Lead-Deadwood School District, 469 U.S. 256 (1985).

20 Payments under the Secure Rural Schools program for Forest Service lands (but not Bureau of Land Management lands) are included among those prior year payments to be deducted. See CRS Report R41303, Reauthorizing the Secure Rural Schools and Community Self-Determination Act of 2000, by Katie Hoover.

21 To illustrate more concretely, imagine each county as a large bucket, whose sides are marked off in “$/acre.” PILT, in effect, checks the payment already in the bucket from other agencies, then adds at least enough money to the bucket to bring it to the $2.54/acre mark. Moreover, if the bucket is already above the $2.19/acre mark, PILT adds 35¢/acre, regardless of the amount in the bucket already. The money bucket could reach levels of $15/acre or more, with the last 35¢ added by PILT. The county population ceilings might then be thought of as holes in the sides of some of the buckets that prevent the buckets from filling beyond a certain level for that bucket (i.e., county).

22 An exception would occur if the county’s population is so small that the county is affected by the PILT ceiling on payments due to population.

23 DOI does not include estimated full payment levels in its annual budget justification to Congress, and confines itself to the Administration’s request for the year. However, DOI’s annual report of current year PILT payments to counties includes this information.

24 Other important issues in 1994 were the question of the equity of the payments and the balance struck in the payment formula (a) between heavily and sparsely populated communities, (b) between those with federal lands generating large revenues and those with lands generating little or no revenue, and (c) between the amounts paid under PILT and the amounts that would be paid if the lands were simply taxed at fair market value. But these issues were not addressed in the 1994 amendments and have scarcely been mentioned in the debate since then.

25 The many classifications of “Indian lands” include trust lands, restricted lands, and fee (private) lands, both on and off reservations. Trust lands are lands held by the federal government in trust for an Indian tribe or individual. Restricted lands are lands held by an Indian tribe or individual but subject to federal restrictions on alienation (e.g., sale) or encumbrance (e.g., mortgaging). Most, but by no means all, Indian trust and restricted lands are on Indian reservations. Trust and restricted lands, whether on or off reservations, are not subject to state or local land taxes. On-reservation Indian fee lands may or may not be subject to state and local land taxes, depending on the federal statute under which the land was fee-patented. Off-reservation Indian fee lands are generally subject to state and local land taxes. (Indian reservations may also include non-Indian fee lands, which are subject to state and local taxation.) Alaskan Native corporation lands (none of which are trust lands) are affected by the Alaska Native Claims Settlement Act’s limits on state taxation. Congress would have to decide which of these many classifications of Indian lands would be subject to PILT benefits. Further, Congress might choose to distinguish between Indian lands which have never been taxed by a county or state versus those Indian lands that were once taxable but which were acquired into non-taxable status after some specified date.

26 This section prepared by Steven Maguire, Section Research Manager, Government Finance and Taxation Section (7-7841, [email protected]).

27 Own-source revenue is all revenue that is not a transfer from the state or federal government. Data are from the Barnett, Jeffery L., and Phillip M. Vidal, “State and Local Government Finance Summary: 2011,” Appendix Table A-1, Governments Division Briefs, U.S. Census Bureau, July 2013. The report is available at the following: http://www2.census.gov/govs/local/summary_report.pdf.

28 It is important to note that 30% of all counties in the country have no lands eligible for PILT and thus the two figures are not entirely comparable. Specifically, it is not clear what fraction of the own-source revenue is produced in the 70% of counties with lands eligible for PILT payments. For more on the number of counties by state, see U.S. Census Bureau, “2012 Census of Governments: Organization Component Estimates.”

29 A total of $421.7 million was authorized under the PILT formula; from this figure, $21.5 million was deducted for sequestration, and $0.4 million was deducted for administrative expenses.

30 Payments in Lieu of Taxes: National Summary, FY2013. The 14 counties were in eight states: AK (1), AZ (3), CA (3), CO (1), NV (2), NM (1), UT (1), and WY (2).




EO Update: e-news for Charities and Nonprofits.

1.  Looking for the 2012 Forms 990?

Organizations requiring 2012 forms and instructions can find them on the Prior Year Forms & Pubs list or the webpage Current Form 990 Series – Forms and Instructions. As new 2013 forms roll out, they will replace 2012 forms on the Current Forms & Pubs list. Form 990-series returns for calendar year filers with an extension are due Nov. 15.

http://www.irs.gov/uac/Current-Form-990-Series-Forms-and-Instructions

2.  Revenue procedure provides details about inflation-adjusted items for 2014

Revenue Procedure 2013-35, which sets forth inflation-adjusted items for 2014, will be published in Internal Revenue Bulletin 2013-47 on Nov. 18. Items in the revenue procedure that apply to exempt organizations include:

Insubstantial benefit limitations for contributions associated with charitable fund-raising campaigns

– Low cost article. For taxable years beginning in 2014, for purposes of defining the term “unrelated trade or business” for certain exempt organizations under § 513(h)(2), “low cost articles” are articles costing $10.40 or less.

Reporting exception for certain exempt organizations with nondeductible lobbying expenditures

– For taxable years beginning in 2014, the annual per person, family, or entity dues limitation to qualify for the reporting exception under § 6033(e)(3) (and section 5.05 of Rev. Proc. 98-19, 1998-1 C.B. 547), regarding certain exempt organizations with nondeductible lobbying expenditures, is $110 or less.

http://www.irs.gov/pub/irs-drop/rp-13-35.pdf

3.  2014 PTIN renewal period underway for tax professionals

The IRS reminds the nation’s almost 690,000 federal tax return preparers to renew their Preparer Tax Identification Numbers (PTINs) for 2014. All current PTINs will expire on Dec. 31, 2013. See news release:

http://www.irs.gov/uac/Newsroom/2014-PTIN-Renewal-Period-Underway-for-Tax-Professionals

4.  Register for upcoming EO workshop

Register for this workshop for small and medium-sized 501(c)(3) organizations:

December 10 – New York, NY

Hosted by Baruch College

http://www.irs.gov/Charities-%26-Non-Profits/Upcoming-Workshops-for-Small-and-Medium-Sized-501(c)(3)-Organizations

5.  IRS warns of pervasive telephone scam

The IRS recently warned consumers about a sophisticated phone scam targeting taxpayers, including recent immigrants, throughout the country. See news release:

http://www.irs.gov/uac/Newsroom/IRS-Warns-of-Pervasive-Telephone-Scam




Do We Need a New Legal Definition of Charity?

Do we need a new legal definition of charity? In answering this critical question, the history of the federal tax definition of charity and the origins of the law of charity must be considered alongside the current federal and state laws surrounding the tax treatment of charity. The law of charities, based on centuries of historical precedent, is not only relevant in terms of current regulations, but also flexible enough to accommodate the changing needs of society.

Read the full report at:

http://www.urban.org/UploadedPDF/412946-Do-We-Need-a-New-Legal-Definition-of-Charity.pdf

Marion R. Fremont-Smith




Fire Chiefs Group Expresses Concern About Effect of ACA on Volunteer Fire Departments.

William Metcalf of the International Association of Fire Chiefs has urged the IRS to do all it can to avert the disastrous effect of any requirement that would force service agencies providing volunteer fire and emergency services protection to buy health insurance for volunteers under the Affordable Care Act.

[Editor’s Note: The document appearing at this citation is one of many substantially similar letters received but not published by Tax Analysts.]

September 27, 2013

The Honorable Daniel Werfel

Acting Commissioner of Internal Revenue

Internal Revenue Service

1111 Constitution Avenue, NW

Washington, DC 20004

Re: Information Reporting by Applicable Large Employers on Health Insurance Coverage Offered Under Employer-Sponsored Plans. Docket Number: REG-136630-12

Dear Acting Commissioner Werfel:

On behalf of the nearly 10,000 fire and emergency services chiefs of the International Association of Fire Chiefs (IAFC), I am submitting the following comments in reference to Docket Number: REG-136630-12. The IAFC is concerned that the Shared Responsibility Provision presents a serious threat to fire departments relying upon volunteer emergency responders.

While this proposed rule eases reporting requirements for employers, I continue to be concerned about the impact that the Shared Responsibility Provision will have on volunteer fire departments across the United States. As you know, the Internal Revenue Service (IRS) has classified nominally compensated volunteer firefighters as common-law employees of their fire departments. Unfortunately, the IRS’ interim final rule on the Shared Responsibility Provision makes no clear mention of nominally compensated volunteer firefighters and emergency medical personnel; as a result, many fire departments may be unintentionally forced to comply with the Shared Responsibility Provision — an action which will pose a threat to public safety.

Recent data from the National Fire Protection Association show that approximately 27,595 fire departments, or 92% of all fire departments in the United States, have volunteer firefighters and/or volunteer emergency medical personnel. In many rural and suburban areas, volunteers may work multiple 12- or 24-hour shifts per week, and provide the only fire and emergency medical response. These fire departments, which are often funded by private donations and local taxes, do not have the capacity to offer insurance to their volunteers. If the IRS defines nominally compensated volunteers as “employees” for the purposes of the Shared Responsibility Provision, fire departments may be forced to choose between eliminating volunteer emergency responders or significantly reducing training hours and the number of firefighters and emergency medical personnel who respond to life-threatening emergencies.

As you determine the final regulations for implementing the Shared Responsibility Provision, I urge you to clearly exempt nominally compensated volunteer firefighters and emergency medical personnel from being considered “employees.” Without this clear, common-sense guidance, volunteer fire departments may be forced to take measures which could seriously harm public safety in communities across the nation.

If nominally compensated volunteers are considered employees, I encourage you to count only hours spent on-duty, in training, or responding to emergency incidents. In many volunteer fire departments, volunteers are not assigned to a shift and are permitted to remain at home or work, and only respond to emergencies when alerted. In these cases, volunteers are free to control their own activities when not responding to emergencies and are not required to remain in any geographic location. Hours of service should not be counted when a volunteer merely has their pager or cell phone and are not responding to an emergency.

Both Congress and the Administration have taken strong steps to support fire departments and incentivize increased staffing levels; the IRS should not force the fire service to take a step back by incentivizing reduced training and eliminating firefighters and emergency medical personnel.

Sincerely,

Chief William R. Metcalf,

EFO, MIFireE

International Association of Fire

Chiefs

President and Chairman of the Board

Fairfax, VA




Municipal Bonds and Accountability to the General Electorate.

Ellen P. Aprill argues that any major change to the criteria for what constitutes a political subdivision, such as the requirement of direct or indirect accountability to the general electorate that appears in a recent technical advice memorandum, should provide taxpayers an opportunity to comment.

Ellen P. Aprill is the John E. Anderson Professor of Tax Law at Loyola Law School.

A recent IRS technical advice memorandum denied tax-exempt status to the bonds of a development district because the district was not “inherently accountable, directly or indirectly, to a general electorate.” Aprill argues that this is an unprecedented change that the IRS should introduce only in a format that includes notice-and-comment procedure.

On May 9 the IRS issued TAM-127670-12 , which concludes that bonds of a development district do not qualify as bonds of a political subdivision under reg. section 1.103-1(b). According to that technical advice memorandum (District TAM), “A governmental unit is inherently accountable, directly or indirectly, to a general electorate. In effect, section 103 relies, in large part, on the democratic process to ensure that subsidized bond financing is used for projects which the general electorate considers appropriate State or local government purposes.” Later, the District TAM observes that entities that “avoid indefinitely responsibility to a public electorate, either directly or through another elected State or local government body” are not political subdivisions.

As Scott Lilienthal, president of the National Association of Bond Lawyers, noted, the District TAM “could create some widespread problems” because “special districts are a pretty widely used method of financing in various states.”1 Kristin Franceschi, former president of the National Association of Bond Lawyers, wrote the IRS before the issuance of the technical advice memorandum to say that “a departure (from the current status of dirt bonds) could have an immediate and disruptive effect in some quarters of the tax-exempt bond market.”2 The concerns that the District TAM raises, however, are legal as well as practical. That a bond of a political subdivision must have “inherent accountability, directly or indirectly, to a general electorate” has no basis in precedential tax authorities or in general local government law, including Supreme Court cases.

Reg. section 1.103-1(b) says, “The term ‘political subdivision’ . . . denotes any division of any State or local governmental unit which is a municipal corporation or which has been delegated the right to exercise part of the sovereign power of the unit. As thus defined, a political subdivision of any State or local governmental unit may or may not . . . include special assessment districts so created, such as road, water, sewer, gas, light, reclamation, drainage, irrigation, levee, school, harbor, port improvement, and similar districts and divisions of any such unit.” Rev. Rul. 77-164 elucidates, “Three generally acknowledged sovereign powers of states are the power to tax, the power of eminent domain, and the police power.3 . . . It is not necessary that all three of these powers be delegated. However, possession of only an insubstantial amount of any or all sovereign powers is not sufficient.”

The District TAM cites Rev. Rul. 83-131 for requiring an issuing entity of bonds to be “motivated by a wholly public purpose.” That revenue ruling, which involved excise taxes and not tax-exempt bonds, concludes that the issuing entities, electric membership corporations, are not so motivated. However, that observation is an aside. More significant is the IRS statement that the electric membership corporations “are not divisions of a state or local government unit but are financially autonomous and not controlled by a state or local government.”

Rev. Rul. 83-131 revokes Rev. Rul. 57-193, which had determined that electric membership corporations were political subdivisions. In reaching that conclusion, Rev. Rul. 57-193 had relied on an applicable North Carolina law that clearly provided they were. Following Rev. Rul. 57-193, however, North Carolina amended its statute. Under the new statutory structure, when electric membership corporations dissolve, they distribute their remaining assets — after satisfaction of debt — to their members. The previous law had provided that those assets went to the state. The new provisions plainly say that electric membership corporations are not political subdivisions.

Nowhere does Rev. Rul. 83-131 reference accountability to a public electorate. It applies a two-prong analysis that concludes that the electric membership corporations are not divisions of a state or local government and that they do not have sufficient sovereign power. Based on those two factors, it concludes that the corporations are not political subdivisions.

Rev. Rul. 83-131 acknowledges that the electric membership corporations could fall under an exception and that the exemptions for state and local governments might still apply to them “if sales to them could be considered to be made for the exclusive use of a state or local government.” In making that determination, the revenue ruling provided that “it must be established that the organization is either (a) controlled, directly or indirectly, by an agency of a state or local government, or (b) is performing a traditional governmental function on a nonprofit basis.” The revenue ruling does not discuss or imply that public purpose entails accountability to a public electorate.

The private letter rulings and technical advice memoranda that cite Rev. Rul. 83-131 emphasize different aspects of it, but none makes accountability to a general electorate an element of their analyses, and many misstate the revenue ruling’s analysis. Generally, those private letter rulings transform the “division of a state or local government” prong of Rev. Rul. 83-131’s political subdivision analysis to require that the issuing entities are “motivated by a wholly public purpose.”

The earliest TAMs that cite Rev. Rul. 83-131, TAMs 9103003, 91303004, 9103005, and 9107002 (involving sections 115, 3121(b)(7), and 3306(b)(7), but not section 103), point to the issuing entity in Rev. Rul. 83-131 not qualifying as a political subdivision because it, upon dissolution, distributed its assets to its members and had only a limited power of eminent domain.4

LTRs 9833002  and 9834002 , which both involve credits and refunds for fuel excise taxes, emphasize the exceptions offered in Rev. Rul. 83-131. They explicitly describe the revenue ruling as providing a two-prong test with the first prong asking whether the taxpayer is a municipal corporation or a division of state government that has been delegated sovereign powers. Those letter rulings characterize the second prong as saying that “the exemption for state and local governments would include the taxpayer if the taxpayer is either directly or indirectly controlled by an agency of the state or local government or if the taxpayer is performing a traditional government function” (emphasis added). They apply the exceptions described in Rev. Rul. 83-131 as the second prong. Moreover, nothing in those letter rulings about the revenue ruling’s two-prong test speaks of accountability to the general electorate to satisfy the control requirement, as the District TAM requires.

LTR 200017018 , which involves section 103 and an authority created under state law by local governments to develop ports, changes the nature of Rev. Rul. 83-131’s two-prong test. It states, citing the revenue ruling, “in determining whether an entity is a division of a state or local governmental unit, important considerations are the extent the entity is (1) controlled by the state or local government unit, and (2) motivated by a wholly public purpose.” As noted above, while both of those factors are mentioned in Rev. Rul. 83-131, they do not constitute the two prongs of the test established by it. In Rev. Rul. 83-131, wholly public purpose is not an independent test. Evaluating whether an entity performs traditional functions of state or local government is an alternative test to determine whether the entity is under the control of state or local government. In restating the two-prong test of Rev. Rul. 83-131, the letter ruling misstates it.

Still, the indicia to which LTR 200017018 looks in determining governmental control are revealing. It considers whether “(1) the Authority is governed by a board of directors appointed by its member governmental units A, B, and C; (2) the Authority’s net revenues inure to the benefit of the State and its municipalities; and (3) the Authority’s assets will be distributed to its member governmental units upon dissolution.” The letter ruling goes into no detail about how the directors are appointed; we do not know how distant those with power to appoint are from the general electorate. Moreover, the nature of the authority’s board is but one of three factors the letter ruling takes into account in determining governmental control. After listing those three factors, it concludes without explanation that “The Authority will be motivated by a wholly public purpose.”

LTR 200151015 , which involves whether a district is a political subdivision for purposes of section 170, repeats the erroneous, reformulated two-prong test — control by state or local government and wholly public motivation — of Rev. Rul. 83-131 as established in LTR 200017018. LTR 200151015 appears to find that the district is under governmental control because “the District is controlled by the Governor, the Country Executive and the Mayor (or their designees) who have the power to appoint the X members of its board of directors.” While the facts indicate indirect — perhaps very indirect — control by the general electorate, nothing in the letter ruling makes that control a requirement. The letter ruling concludes that an entity providing for the development of cultural arts facilities serves a public purpose because the state legislature has so determined and because those establishments encourage economic development and tourism, and thus reduce unemployment.

LTR 200204032 , which involves whether an agency formed to operate four hydroelectric generating facilities qualifies as a political subdivision under section 103, concludes that the agency is a division of the state under the transformed two-prong test of Rev. Rul. 83-131. “The Agency was created pursuant to State legislation, and the legislature may intervene to prevent a fundamental departure of the Agency from its public purposes. . . . Also, all of the Agency’s directors and alternate directors are subject to control by the Municipal Utilities. A majority of the directors are appointees of the Municipal Utilities, and only the directors appointed by the Municipal Utilities may remove a director for cause. Directors and alternate directors appointed by the Electric Association [cooperative electric companies exempt under section 501(c)(12)], are not entitled to vote on the removal of a director or alternate director.” The letter ruling explains that the municipal utilities are “each home rule municipalities and political subdivisions of the State,” but it discusses not at all the extent to which the municipalities are subject to accountability to the general electorate.5 Without any citation to authority, the letter ruling concludes that “owning hydroelectric generating facilities that provide electricity at a cost effective rate to citizens of the State . . . is a wholly public purpose.” Importantly, as in other letter rulings citing Rev. Rul. 83-131, the wholly public purpose factor goes to the nature of the entity’s endeavor and not to the nature of control exercised by government.

LTR 200238001  involves whether the district established to provide fire protection is a political subdivision for purposes of tax-exempt interest and exemption from FUTA. It also relies on the reformulated Rev. Rul. 83-131 test, which looks to control and public purpose of the entity. LTR 200238001 finds that the district is a political subdivision because it “is formed pursuant to State law and has a substantial power, the right to levy a tax on property within its boundaries. . . . The District also performs a governmental function by providing fire protection and emergency services. Finally, at least five members of the Board of Trustees are subject to the control of either the County Judge/Executive, an elected official of the County, or the control of the property owners of the District” (emphasis added). That is, even under the mistakenly reformulated version of the Rev. Rul. 83-131’s two-prong test, control by property owners is deemed adequate for governmental control. The letter ruling states that the district “performs a government function by providing fire protection and emergency services.” Again, public purpose is a distinct inquiry, different from the nature of government control.

LTR 200305005 , which involves whether an entity created to manage a medical university and related medical facilities was a political subdivision for purposes of sections 103 and 170, uses the revised version of the Rev. Rul. 83-131 test. As in other letter rulings, the discussion of public purpose is brief and conclusory: “The Entity’s general purpose of management, regulation, and operation of the Medical University of State and related medical facilities, is a wholly public purpose.” What appears to be the analysis of control is more detailed:

The Entity was created pursuant to State legislation, and the Entity directly reports to the State governor and the State legislature. All actions of the Entity are subject to review by the State legislature. The State can thus prevent changes in the organization or operation of the Entity that would threaten the public purposes for which the Entity was created. All of the Entity’s funds inure to the benefit of the State and may be used only for public purposes. The State legislature appropriates funds to Entity for its operating and maintenance expenses. The Entity is required to submit an annual audit and an annual budget to the State. Control and supervision of the Entity is vested in a board of directors that consists of the board of trustees of the Medical University of State, which is an integral part of State.

The nature of the entity’s board is only one element of the multi-factor analysis, and that analysis does not speak to any role of the general electorate.

Similarly, TAM 200646017 , which involves whether a nonprofit corporation organized to operate a public school and that issued debt on behalf of the state was a division of the state within the meaning of reg. section 1.103-1(b), considers multiple factors in deciding that the entity satisfied the transformed requirements of Rev. Rul. 83-131 of control and wholly public purpose:

In accordance with the State Constitution, education is a public purpose of the State. Public schools perform the education function for the State. The Academy was created pursuant to State Law B which expressly permits and fosters the creation and operation of public school academies. Under State Law B, public school academies such as the Academy are public schools, and the powers granted by State Law B to academies constitute the performance of essential public purposes and governmental functions. Private inurement is not allowed in the organization or operation of the Academy. In addition, the operations of the Academy are subject to the control and supervision of the University Board, which is a part of the State, as well as by the State Board of Education. The State is the principal source of operating expenses for the Academy through the provision of State Funds. Accordingly, we conclude that the Academy is a division of the State.

This memorandum again illustrates that control of the board is but one factor in the wholly public purpose analysis, and nowhere does the memorandum require accountability to the general electorate. Although the memorandum does not explicitly say, it seems that the academy was organized in accordance with section 501(c)(3), which requires prohibition of inurement; that is, the inurement prohibition is a tax-exemption issue, not an issue relating to qualification of the academy as a division of the state.

The most recent letter ruling to cite Rev. Rul. 83-131, LTR 201050017,  which addresses whether an association created to administer compensation in connection with state medical services was a division of the state that was not required to file tax returns or pay federal income tax. It revises the holding of Rev. Rul. 83-131 even more than earlier letter rulings. It cites Rev. Rul. 83-131 for determining that an entity is a division of a state which depends on factors including the entity’s “public purpose and attributes, whether its assets or income will inure to private interests and the degree of its control by State.” Yet the letter ruling, despite adding prohibition of inurement as a new factor found nowhere in Rev. Rul. 83-131, looks to several factors to support its conclusion, much like others that cited Rev. Rul. 83-131:

Here, Association was established by State’s legislature for a public purpose, and the Plan which it administers was funded by State with an initial appropriation of Y million. Funds held by the Association on behalf of the Plan are funds of State under State law. Association has been granted sovereign immunity under State law. Association’s board of directors is appointed by State’s chief financial officer. Moreover, Association is operated in accordance with a plan of operations that was approved by the Department. Cumulatively, the foregoing factors indicate that Association is a division of State.

That letter ruling evidences no concern about the distance of the board from the general electorate. The state CFO appoints the board, but the letter ruling does not tell us how the state’s CFO is chosen. In particular, the letter ruling does not say whether the position is elected or appointed. The distance of the board from the general electorate is simply not a consideration in the letter ruling; it is irrelevant.

In sum, while several letter rulings reinterpret Rev. Rul. 83-131 to establish a two-prong test requiring an issuing entity to be controlled by the government and have public purpose, they analyze the nature of the entity’s board as an aspect of government control and not as relevant to public purpose. The letter rulings evaluate public purpose according to the entity’s activities and accord deference to the decisions of the state or local government establishing the entity. They do not discuss accountability to the general electorate. They permit government control to be shown in several ways, including through funding and financial reporting. The interpretation of Rev. Rul. 83-131 in the District TAM is unprecedented.

Rev. Rul. 77-164, quoted above, says that determining whether a municipal corporation has been delegated sufficient sovereign powers to be treated as a political subdivision requires consideration of “all of the facts and circumstances, including the public purposes of the entity and its control by a government.” Those factors closely echo the restatement of Rev. Rul. 83-131 found in many of the letter rulings that cite it. Nowhere, however, does Rev. Rul. 77-164 require a municipal corporation to engage in direct or indirect democracy so that it will be considered a political subdivision.

Quoting Rev. Rul. 77-164’s public purpose and government control criteria has become common. A Lexis search produces 185 letter rulings and TAMs citing it. Of the 15 letter rulings and memoranda issued since 2000, LTR 201114010  is particularly illuminating because it accepts a utility department created by a state “legislature pursuant to State statute as an independent department of City free from political influence from the Mayor of City or the City-County Council” as a political subdivision. The utility department was managed by a board, members of which were appointed annually by trustees “with no oversight by City.” Although initial trustees were appointed by the city mayor, the city-county council, and the county circuit judge, subsequent trustees are appointed by remaining trustees on expiration of a trustee’s term (or if the trustee dies, resigns, becomes a nonresident of the city, or is removed for cause). Thus, neither the department’s board nor the trustees that appointed the board answered to the electorate. In the letter ruling the district established under a municipal code plan to establish an authority to run an additional utility system. Under the agreement, the department board will serve as the board of directors of the authority. The letter ruling concludes that the authority is a political subdivision, because, among other factors, it will be controlled by the department, which the letter ruling already concluded is a political subdivision. The utter insulation of both authority and department from the electorate did not affect the conclusion of the letter ruling or even merit comment.

I have found only one letter ruling in the bond area that refers to control by the electorate as a consideration in determining whether an issuer is a political subdivision. LTR 9725038  says that determination requires consideration of factors that show the issuing entity “will be a government rather than a private entity.” Those factors include the entity’s “public purpose and attributes, whether its assets or income will inure to private interests, the degree of its control by a state or local government or government official, and the degree of its control by an electorate.” The letter ruling cites no authority for this list of factors. Moreover, “degree of control by an electorate” is only a factor, not a requirement, and the ruling does not specify that electorate refers to a public electorate. While the public in fact elected the governing board of the water district in LTR 9725038, any project to be paid for by assessment had to be approved by “property owners potentially affected by the [water district] project.” That is, even the lone ruling discussing control by an electorate noted as a positive factor a special role for a vote by property owners.

Also illuminating is Announcement 2011-78, 2011-51 IRB 874 , an advanced notice of proposed rulemaking under section 414(d) defining the term “governmental plan.” The announcement explains NLRB v. Natural Gas Utility District of Hawkins County, Tennessee, 402 U.S. 600 (1971), as the case that courts have used to help determine “whether an entity is an agency or instrumentality of a State or a political subdivision of a State for purposes of ERISA. The two-prong test in Hawkins County analyzes whether the entity has been ‘(1) created directly by the state, so as to constitute departments or administrative arms of the government, or (2) administered by individuals who are responsible to public officials or to the general electorate.’ Hawkins County, 402 U.S. at 604-05.” I note that responsibility to public officials, and not necessarily publicly elected officials, is an alternative to responsibility to the general electorate, in that Supreme Court test. The announcement further explains:

In addition to this two-prong test, the Supreme Court also analyzed other factors, including: whether the utility had broad powers to accomplish its public purpose; whether the utility’s property and revenue were exempt from state and local taxes (as well as whether its bonds were tax-exempt); whether the utility had the power of eminent domain; whether the utility was required to maintain public records; whether the utility’s commissioners were appointed by an elected county judge; and whether the commissioners could be removed by the State of Tennessee pursuant to State procedures for removal of public officials. Many of these factors are similar to the factors used in determining whether an entity is an agency or instrumentality of a State or a political subdivision of a State under these proposed regulations.

Announcement 2011-78 merits attention for its difference from the way the section 103 regulations analyze political subdivisions. The section 414(d) regulations as proposed in the announcement would define a political subdivision of a state as:

1. a regional, territorial, or local authority, such as a county or municipality (including a municipal corporation), that is created or recognized by state statute to exercise sovereign powers (which generally refer to the power of taxation, the power of eminent domain, and the police power); and

2. an authority whose governing officers either are appointed by state officials or publicly elected.

The second requirement has no parallel in section 103, and the announcement is careful to specify that the proposed regulations it contains are not applicable for any purpose of the code other than section 414(d), including section 103.6 Moreover, that new requirement would be effective only when promulgated in the precedential form of final regulations, after comment. In the section 414(d) context, a new set of requirements as those proposed in the announcement are not to be applied retroactively in a non-precedential document, such as a TAM.

Two groups have criticized the announcement’s restrictive definition of political subdivision. Kerry Korpi of the American Federation of State, County and Municipal Employees wrote that “existing policies [under reg. section 1.103-1(b)] provide sufficient guidance in determining whether an entity is a governmental subdivision or instrumentality, and that these definitions should be incorporated into the proposed regulations regarding the definition of governmental plan” (Mar. 12, 2012) . The State Bar of Texas made a long list of suggestions . They include:

Expanding the list of examples of local authorities to include local entities that are commonly created pursuant to State statutes or created pursuant to other local government laws, ordinances or other official action, such as local hospital districts created to provide medical care for indigent persons residing in a city or county, mental health and mental retardation authorities created to provide mental health services and mental retardation services for indigent persons residing in a city or county, local housing authorities created to provide affordable housing for local needy residents, airport authorities, transit authorities created to provide affordable mass transit for needy residents of a city or county, or city, county or local river or water authorities, school districts and special districts (or any entity similar to those described above created for legitimate governmental purposes).

Whether as a result of those comments or for other reasons, the regulations suggested in that announcement have gone no further than an advanced notice of proposed rulemaking. There has been no notice of proposed rulemaking published in the Federal Register.

The Supreme Court, in a series of nontax cases, has recognized the validity of political subdivisions that permitted only landowners to vote for their governing boards. In Sayler Land Company v. Tulare Lake Basin Water, 410 U.S. 719 (1973), litigants alleged that that kind of limitation on voting in a water storage district violated the equal protection clause of the Fourteenth Amendment. In the case, four landowners owned almost 85 percent of the land in the district. 410 U.S. at 735 (Douglas, J., dissenting). The Court rejected the challenge. It concluded that the “water storage district, by reason of its special limited purpose and of the disproportionate effect of its activities on landowners as a group” did not require election by the general electorate. 410 U.S. at 1229. See also Associate Enterprises Inc. v. Toltec Watershed Improvement District, 410 U.S. 743 (1973) (relying on Sayler and reaching the same conclusion). Similarly, in Ball v. James, 451 U.S. 355 (1981), the Court, relying on Sayler, upheld a voting scheme established by state law for electing directors of a water reclamation district that limited voting eligibility to landowners and apportioned voting power according to the amount of land each voter owns. The case explicitly discusses the ability of those districts to issue tax-exempt bonds. 451 U.S. at 360-361. In his concurrence, Justice Powell wrote:

Our cases have recognized the necessity of permitting experimentation with political structures to meet the often novel problems confronting local communities. . . . As this case illustrates, it may be difficult to decide when experimentation and political compromise have resulted in an impermissible delegation of those governmental powers that generally affect all of the people to a body with a selective electorate. But state legislatures, responsive to the interests of all the people, normally are better qualified to make this judgment. 451 U.S. at 373.

Scholars analyzing those Supreme Court cases have made similar observations. In 1993, professor Richard Briffault of Columbia Law School observed that “there are nearly 30,000 special districts in the United States, and the special district is our most rapidly growing form of local government.”7 States retain considerable control over the organization and structure of local governments because “local government organization does not abide by the ‘plain vanilla’ model.”8

Professor Thomas W. Merrill of Columbia Law School, in considering the factors that argue for and against limiting local voting to property owners, argues that that form of voting is preferable when it is important to ensure “that voters are sufficiently informed and motivated to render a decision that accords with the preference of the members of the community and when the voting community will largely internalize both the benefits and costs of the proposals.”9 Merrill is an example of a scholar who concludes that voting by property owners is not only constitutional but also preferable in some situations. According to his criteria, community development districts would seem to be a place where that limitation on voting would work.

Whether an entity qualifies as a political subdivision for purposes of section 103 is, of course, a question for federal and not state government. Still, this delicate area of state-federal relations calls for comity and deference to state decisions. At the very least, a major change to the criteria of what constitutes a political subdivision, such as the unprecedented requirement of direct or indirect accountability to the general electorate that appears in the District TAM, should be offered in a format that gives notice to the tens of thousands of local governments and political subdivisions that provide services to U.S. taxpayers. Giving those local governments and political subdivisions an opportunity to offer comment to the IRS on the enormous disruption that that kind of change in legal standard would produce is critical to our tax system. The recent announcement in Treasury’s 2013-2014 Priority Guidance Plan, released August 9, that it will provide guidance on the definition of political subdivision under section 103 is a good first step. An unprecedented and radical change should not be formulated in non-precedential guidance with retroactive effect, such as a technical advice memorandum. That approach undermines the respect accorded the IRS and its procedures.

FOOTNOTES

1 Michael C. Bender et al., “Billionaire Morse’s Florida Dirt Bonds Not Tax-Exempt,” Bloomberg.com (June 6, 2013), available at http://www.bloomberg.com/news/2013-06-05/florida-billionaire-s-development-bonds-not-tax-exempt-irs-says.html.

2 “IRS Rules Florida Development Bonds Should be Taxable,” CNBC, June 6, 2013, available at http://www.cnbc.com/id/100796689. For additional coverage of the District TAM, see, e.g., Jennifer DePaul, “Fla. Village Center CDD Lawyer Blasts Ruling, Asks IRS to Reconsider,” The Bond Buyer, July 18, 2013, available at http://www.bondbuyer.com/issues/122_138/fla-village-center-cdd-lawyer-blasts-ruling-asks-irs-to-reconsider-1053857-1.html. Jennifer DePaul, “IRS Send Updated Notice of Proposed Issue to Fla. Village CDD,” The Bond Buyer, Aug. 16, 2013, available at http://www.bondbuyer.com/issues/122_159/irs-sends-updated-notice-of-proposed-issue-to-fla-village-cdd-1054761-1.html; Jason Garcia, “As IRS Cracks Down on the Villages, Disney World Watches,” OrlandoSentinel.com, July 13, 2103, available at http://articles.orlandosentinel.com/2013-07-13/business/os-disney-the-villages-tax-free-bonds-20130713_1_villages-walt-disney-world-disney-springs.

3 Rev. Rul. 77-164 citing Estate of Alexander J. Shamberg, 3 T.C. 131 (1944), acq., 1945 C.B. 6, aff’d 144 F.2d 998 (2d Cir. 1944), 1945 C.B. 335, cert. denied, 323 U.S. 792 (1944).

4 Indeed, LTR 923006 recognized rural water districts as political subdivisions for purposes of sections 3121(b)(7) and 3306(c)(7), even though earlier TAMs had concluded the districts did not so qualify, because the state had amended the applicable dissolution provision to require that, upon dissolution, a district’s assets would be distributed to another water district or to a local political subdivision.

5 According to Osborne M. Reynolds Jr., Local Government Law 86, 111 (2009), home rule municipalities are granted the right under a state statute or constitution to govern their own affairs even in the case of a conflict with state law. Those rights would seem to include whether to have the general electorate or property owners vote on particular issues.

6 See Lynn Hume, “Lawyer: IRS Position on Village Center CDD is Turnaround,” The Bond Buyer, Oct. 18, 2013, available at http://www.bondbuyer.com/issues/122_202/lawyer-irs-position-on-village-center-cdd-is-turnaround-1056626-1.html, describing the argument by the development district’s lawyer that the District TAM is inconsistent with reassurances given by an IRS representative during discussion of the announcement at an ABA tax section meeting.

7 Briffault, “Who Rules at Home? One Person/One Vote and Local Governments,” 69 U. Chi. L. Rev. 339, 361 (1993).

8 Id. at 341.

9 Merrill, “Reassessing the State and Local Toolkit: Direct Voting by Property Owners,” 77 U. Chi. L. Rev. 275, 275 (2010).

Copyright 2013 Ellen P. Aprill.

All rights reserved.




Will Historic Boardwalk Guidance Restrict Last-Minute Investor Involvement?

Last-minute investor involvement in section 47 historic rehabilitation tax credit deals is “something that I think we need to take into account” in a coming safe harbor revenue procedure, Curtis Wilson, IRS associate chief counsel (passthroughs and special industries), said November 6.

Investors who come in at the last minute to limit their downside risk in such deals are anxiously awaiting the guidance, which the IRS plans to issue in response to the Third Circuit’s decision in Historic Boardwalk Hall LLC v. Commissioner, No. 11-1832 (3d Cir. 2012).

Speaking at the American Institute of Certified Public Accountants’ Fall Tax Division meeting in National Harbor, Md., William P. O’Shea of Deloitte Tax LLP said he has heard rumors that the government is considering restricting availability of the credit when the tax equity investor is brought in right before the project is placed in service. That restriction is not a good idea, he said.

O’Shea added that he believed that at the American Bar Association Section of Taxation meeting in San Francisco, Craig Gerson, attorney-adviser, Treasury Office of Tax Legislative Counsel, indicated that the coming section 47 safe harbor would focus on upside rather than downside.

“There’s recognition that an entirely legitimate deal might not have a lot of downside risk, because the credits themselves are going to give you a cushion in terms of a return of your investment,” said Wilson, who spoke on his own behalf. “It’s probably true that in terms of the balance of things, you need some downside risk, but upside risk is probably more of our focus this time.”

Management Fee Waivers

Wilson said the IRS is working on guidance on management fee waivers. He noted that while some waivers are hardwired to occur at partnership formation, others occur at the election of the partner before earning the fee.

“Most [partners] do it annually, but I understand there are some that do it quarterly. Rumor has it that there are some that even do it monthly. That’s creating perhaps some concerns that these waivers aren’t necessarily appropriate,” Wilson said.

Noel Brock, a professor at West Virginia University, asked whether the IRS’s guidance will alter the tax treatment of the fee waiver based on when the waiver occurs.

Wilson said the IRS is considering the timing — “basically, how genuine is it” that the partner is exposed to not earning the fee. “We’re relatively early on this one. We’ve given some thought to some approaches, but we’ve been focusing on some other things,” he said.

Publicly Traded Partnership Qualifying Income

O’Shea said he thought the IRS has been issuing more generous private letter rulings than it has in the past on what constitutes qualifying income under section 7704 for publicly traded partnerships.

“That depends on the perspective,” Wilson said. “We’ve given some rulings in the past and tried to be consistent. Every time you do something in a little bit different fact situation, it starts looking similar to something else.”

Wilson added that the IRS has several pending section 7704 letter rulings. “And you don’t always see them because [taxpayers] withdraw, but we’ve turned down a number, too,” he said.

O’Shea questioned whether the IRS might consider making public the type of circumstances that have been denied rulings. “Maybe that’s a situation where we need to do a little guidance that puts some parameters around what we think is good and what’s bad,” Wilson said.

He also announced that his office’s phone number will change from 202-622-3000 to 202-317-3100 in the coming weeks.

by Amy S. Elliott




IRS Forcing All Applicants for Same-Day EINs to Apply Online.

Although taxpayers and their representatives will still be able to request a new employer identification number by faxing or mailing a Form SS-4, “Application for Employer Identification Number,” those wishing to receive same-day EINs will be required to use the online EIN assistant, an IRS official said November 5.

Speaking at the American Institute of Certified Public Accountants National Tax Conference in National Harbor, Md., David Alito, deputy commissioner (operations), IRS Wage and Investment Division, said IRS phone assistors will be available to help only those with previously assigned EINs. “We want to be able to ensure that we have the service available for taxpayers with questions that need the phone service for existing EINs,” he said.

Many practitioners expressed concern over the change both because the EIN assistant limits issuance to one EIN per responsible party per day (although that limitation also applies to requests submitted by phone, fax, or mail) and because the website is reportedly down a lot. “If this is the only way we can get them, this needs to be changed,” one practitioner said in a written audience question.

The limit of one EIN per day is necessary “because we started having a run on EINs,” Alito said, adding, “We had robotic systems pinging our system trying to get multiple EINs, and we were in danger of running out. It’s a finite set of numbers.”

If practitioners access the website when it happens to be down, they should try again the next day, Alito said.

Another practitioner, speaking from the audience, said that while the EIN assistant is good for a nonprofessional, for professionals it takes “about six times as long, going through screen after screen after screen.”

Alito also pointed out that individual taxpayers who order their tax return or account transcripts online must wait seven to 10 days to receive them by mail. He said that in January the IRS plans to launch a new application that will allow taxpayers to request, view, and print transcripts in the same online session. “This hopefully will save both time and effort for the taxpayers as well as us,” he said.

by Amy S. Elliott




Lawmakers React to Incomplete Disclosure of Charitable Asset Diversions.

Recent reports that some charities are understating the extent of their losses from the unauthorized diversion of their assets have attracted the attention of Congress.

Several members of the congressional taxwriting committees have reacted in recent days to an October 27 article in The Washington Post reporting that, based on the newspaper’s analysis of filings between 2008 and 2012, more than 1,000 nonprofits reported on their IRS information returns a significant diversion of charitable assets due to embezzlement, fraud, theft, and other improper uses of funds. The article also said some charities reporting the diversions on their Form 990, “Return of Organization Exempt From Income Tax,” routinely left out details about the losses, with about half the filers not disclosing the total amounts lost.

House Ways and Means Committee Chair Dave Camp, R-Mich., said in a statement provided to Tax Analysts, “It is vital that nonprofits account for, and accurately report, how their funds are used, even when the worst happens and funds are misused. Misrepresenting the loss of charitable donations due to mismanagement, fraud or embezzlement diminishes the trust we put in nonprofit organizations.”

Senate Finance Committee member Chuck Grassley, R-Iowa, said the public should know when charitable dollars are diverted to non-charitable activities. “Without this kind of disclosure, law enforcement and charitable donors might never learn of diversion,” he said in a statement.

Grassley on November 1 also sent a letter  to the American Legacy Foundation, which, according to the Post, lost $3.4 million through embezzlement by a former employee but told the IRS simply that the amount of the loss was more than $250,000. The foundation told the Post it did not report the total amount lost because a Justice Department investigation was underway at the time, an explanation Grassley found troubling. He posed 30 questions about the foundation’s actions and asked for a response by November 15.

Inadequate Enforcement?

The Post quoted charity specialists as saying there is no established penalty for organizations that fail to disclose the full extent of the improper diversion of their assets.

But charity specialists contacted by Tax Analysts following the Post article’s publication said penalties are available but for various reasons are not enforced. Jack Siegel of Charity Governance Consulting LLC, who also spoke with the Post, said that if the code is parsed, penalties for making false statements can be found. However, he added that penalties for perjury are limited because failure to fully disclose is not necessarily perjury.

“There’s only so far these folks can go,” Siegel said of the IRS.

Siegel said that with any rule that requires a written disclosure of facts, there will be discretion in how much one will be required to disclose. “I think charities take advantage of that fact, and as a practical matter there’s only so much the IRS can do,” he said.

Another limitation, Siegel said, is that the exempt organizations function in the IRS Tax-Exempt and Government Entities Division is not really a revenue-producing operation. Rather, it is tasked with ensuring that organizations comply with the tax laws. “And so there is, from an enforcement standpoint, [a question of] how many resources do you want to put into going after people,” Siegel said.

Gary Snyder, publisher of the newsletter Nonprofit Imperative, who also was quoted in the Post, said the IRS does not have enough staff to enforce the disclosure requirement. Another problem, he said, is that the IRS has assured organizations that the section of the information return that asks about their governance practices will be used only for data collection and not enforcement.

“The IRS just does not care or does not have the resources to care,” Snyder said, adding that the IRS audits less than 1 percent of all exempt organization returns.

Snyder said Congress has done little about the problem and that state attorneys general lack the resources to address it.

Elaine Waterhouse Wilson of the West Virginia University College of Law agreed that many state attorney general offices are poorly equipped to address incomplete reporting of diversions. Although some states — Illinois, Massachusetts, New York, and Pennsylvania, for example — are active in charity oversight, for many others it isn’t a priority, she said.

“From a resource allocation point of view, they just don’t have the wherewithal to go after that, unless they saw the underreporting as kind of part and parcel — almost like a conspiracy with the embezzler,” Wilson said. She added that some states have no one dedicated to charity oversight and that other states do not believe in regulating charities.

A possible solution, Wilson said, would be for information returns to ask more straightforward, unambiguous questions about the misuse of charitable assets that would not allow for vague or misleading answers.

In a November 1 follow-up story published on washingtonpost.com that discussed congressional and state reaction to the original article, the Post reported that officials from several state charity regulators said they would act on the newspaper’s findings.

‘Embarrassment’

Snyder attributed the tendency of some charities to downplay the extent of diversions to embarrassment. “We have a situation where nobody wants to deal with the problem at hand . . . because they’re embarrassed,” he said. “It’s a huge problem that nobody wants to deal with, including those that are sending in their IRS forms.”

Siegel said charities that fail to tell the whole story are worried about how their donors will react and, in some cases, how grant-makers and government agencies that fund them will respond. He added that charities are sometimes reluctant to give too much detail because they fear the possibility of defamation, particularly if there has not been a final criminal adjudication.

According to Snyder, the problem needs more attention from the press. “Unless it becomes a public issue where the media have gotten involved, nothing happens,” he said.

Siegel said the press and public should pay more attention to charities’ information returns. “To the extent donors take the time and look at a [Form] 990 . . . it puts a donor on notice, and certainly they have the right to call up and say, ‘Before I write my check out, tell me what happened,'” he said.

The IRS did not respond to a request from Tax Analysts for comment.

by Fred Stokeld




Tax Reform: The Truth About Municipal Bonds.

The Committee for a Responsible Federal Budget (CRFB), a bipartisan, non-profit organization committed to educating the public about issues that have significant fiscal policy impact, is made up of some of the nation’s leading budget experts (including past Chairmen and Directors of the Budget Committees, the Congressional Budget Office, the Office of Management and Budget, the Government Accountability Office, and the Federal Reserve Board). The CRFB is posting a series of articles in its blog series, “The Tax Break-Down”, which analyze and review tax breaks under discussion as a part of tax reform.

Near and dear to the hearts of state and local governments in Georgia and across the country is the tax-exempt status of interest on municipal bonds. By way of background, interest earned from state and local government bonds has been tax-free since the income tax started in 1913. The interest that people earn from holding these bonds, unlike other interest, does not count as income; rather, the federal government forgoes income tax revenue to indirectly subsidize the cost of borrowing for local governments. Because these municipal bonds offer tax-free returns, investors are willing to accept a lower level of interest, depending on their individual tax rates.

Proponents of the municipal bond tax exemption argue that the exclusion provides important support for state and local governments to invest in infrastructure, education, health care, and other productive public investments. They also point out that infrastructure investment in the United States is centered around the tax-exemption, with a $3.7 trillion bond market. Changes to the exclusion – especially for existing bonds – could cause severe disruptions in this large market and thus the broader economy. Reduction could also hurt the ability of state and local government to borrow, as evidenced by S&P’s warning that reducing the tax benefits around municipal bond interest would have “negative credit implications for state and local governments and other tax-exempt issuers.”

Opponents of the exclusion argue that the tax code should not be the vehicle for supporting local governments and local projects, especially those that have a private purpose. To the extent these projects are worthy, opponents argue that a tax exemption is an expensive and poorly targeted way to encourage investment, with disproportionate benefits for the wealthy, who purchase such bonds as a means of reducing their tax burden.

The debate over whether municipal bonds should be “on the table” during these tax reform discussions is a heated one, with serious ramifications for state and local governments. It is important that stakeholders understand the issues! For a detailed look at who issues municipal bonds and why, and what options are on the tax reform agenda that might impact municipal bonds in the future, review the informative charts, maps and diagrams presented by CRFB in the full blog post here: http://crfb.org/blogs/tax-break-down-municipal-bonds

King & Spalding LLP

USA

October 31 2013




IRS Releases Publication on Gaming Tax Issues for Indian Tribal Governments.

The IRS has released Publication 3908 (rev. Oct. 2013), Gaming Tax Law and Bank Secrecy Act Issues for Indian Tribal Governments, which discusses federal tax law regarding operations for gaming activities described in the Indian Gaming Regulatory Act, including recordkeeping, employment tax, tax on wagers, and forms to file.

http://www.irs.gov/pub/irs-pdf/p3908.pdf




IRS LTR: High School Athletic Organization Loses Exemption.

The IRS revoked the tax-exempt status of an organization established to host high school sporting events, finding that a substantial amount of the organization’s assets inured to the private benefit of its founder.

Person to Contact: * * *

Release Date: 10/25/13

UIL: 501.03-19

Date: July 20, 2013

Tax Period(s) Ended: * * *

LEGEND:

A = * * *

B = * * *

C = * * *

D = * * *

Dear * * *

This is a final adverse determination regarding your exempt status under section 501(c)(3) of the Internal Revenue Code (the “Code”). It is determined that you do not qualify as exempt from Federal income tax under section 501(c)(3) of the Code effective January 1, 2008.

The revocation of your exempt status was made for the following reason(s):

A substantial amount of your organization’s assets inured to the private benefit of your founder. Because a substantial amount of your charitable assets were used for private purposes, the organization is not operated exclusively for exempt purposes described in section 501(c)(3) of the Code.

Contributions to your organization are not deductible under section 170 of the Code.

You are required to file Federal income tax returns on Forms 1120 for the tax periods stated in the heading of this letter and for all tax years thereafter. File your return with the appropriate Internal Revenue Service Center per the instructions of the return. For further instructions, forms, and information please visit www.irs.gov.

If you were a private foundation as of the effective date of revocation, you are considered to be taxable private foundation until you terminate your private foundation status under section 507 of the Code. In addition to your income tax return, you must also continue to file Form 990-PF by the 15th Day of the fifth month after the end of your annual accounting period.

You have waived your right to contest this determination under declaratory judgment provisions of section 7428 of the Internal Revenue Code.

You also have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate assistance is not a substitute for established IRS procedures, such as the formal appeals process. The Taxpayer Advocate cannot reverse a legally correct tax determination, or extend the time fixed by law that you have to file a petition in a United States Court. The Taxpayer Advocate can however, see that a tax matters that may not have been resolved through normal channels get prompt and proper handling. If you want Taxpayer Advocate assistance, please contact the Taxpayer Advocate for the IRS office that issued this letter. You may call toll-free, 1-877-777-4778, for the Taxpayer Advocate or visit www.irs.gov/advocate for more information.

If you have any questions, please contact the person whose name and telephone number are shown in the heading of this letter.

Sincerely Yours,

[signature omitted]

Appeals Team Manager

Enclosure:

Publication 892

* * * * *

Person to Contact/ID Number: * * *

Contact Numbers:

Telephone: * * *

Fax: * * *

Date: April 12, 2012

Taxpayer Identification Number: * * *

Form: * * *

Tax Year(s) Ended: * * *

LEGEND:

ORG = * * *

ADDRESS = * * *

Dear * * *

We have enclosed a copy of our report of examination explaining why we believe revocation of your exempt status under section 501(c)(3) of the Internal Revenue Code (Code) is necessary.

If you accept our findings, take no further action. We will issue a final revocation letter.

If you do not agree with our proposed revocation, you must submit to us a written request for Appeals Office consideration within 30 days from the date of this letter to protest our decision. Your protest should include a statement of the facts, the applicable law, and arguments in support of your position.

An Appeals officer will review your case. The Appeals office is independent of the Director, EO Examinations. The Appeals Office resolves most disputes informally and promptly. The enclosed Publication 3498, The Examination Process, and Publication 892, Exempt Organizations Appeal Procedures for Unagreed Issues, explain how to appeal an Internal Revenue Service (IRS) decision. Publication 3498 also includes information on your rights as a taxpayer and the IRS collection process.

You may also request that we refer this matter for technical advice as explained in Publication 892. If we issue a determination letter to you based on technical advice, no further administrative appeal is available to you within the IRS regarding the issue that was the subject of the technical advice.

If we do not hear from you within 30 days from the date of this letter, we will process your case based on the recommendations shown in the report of examination. If you do not protest this proposed determination within 30 days from the date of this letter, the IRS will consider it to be a failure to exhaust your available administrative remedies. Section 7428(b)(2) of the Code provides, in part: “A declaratory judgment or decree under this section shall not be issued in any proceeding unless the Tax Court, the Claims Court, or the District Court of the United States for the District of Columbia determines that the organization involved has exhausted its administrative remedies within the Internal Revenue Service.” We will then issue a final revocation letter. We will also notify the appropriate state officials of the revocation in accordance with section 6104(c) of the Code.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate assistance is not a substitute for established IRS procedures, such as the formal appeals process. The Taxpayer Advocate cannot reverse a legally correct tax determination, or extend the time fixed by law that you have to file a petition in a United States court. The Taxpayer Advocate can, however, see that a tax matter that may not have been resolved through normal channels gets prompt and proper handling. You may call toll-free 1-877-777-4778 and ask for Taxpayer Advocate Assistance. If you prefer, you may contact your local Taxpayer Advocate at:

* * *

If you have any questions, please call the contact person at the telephone number shown in the heading of this letter. If you write, please provide a telephone number and the most convenient time to call if we need to contact you.

Thank you for your cooperation.

Sincerely,

Nanette M. Downing

Director, EO Examinations

Enclosures:

Publication 892

Publication 3498

Report of Examination

* * * * *

LEGEND:

ORG = Organization name

EIN = ein

XX = Date

City = city

State = state

BM-1 & BM-2 = 1st & 2nd BM

CO-1 through Co-5 =- 1st through 5th COMPANIES

ISSUE

Whether ORG, operates exclusively for exempt purposes.

FACTS

ORG, (ORG) was incorporated in the state of State as a Non-profit (Non-Stock) — Domestic Corporation on July 22, 19XX. ORG was recognized as tax-exempt by the Service as an organization described in Code section 501(c)(3) in a determination letter dated February 14, 20XX. ORG was also determined to be a publicly supported organization during its advanced ruling period.

The following activities are listed on the Form 1023, Application for Recognition of Exemption under Internal Revenue Code Section 501(c)(3), Part II, #1, Activities and Operational Information:

The organization is formed to host high school sporting events around the country. Formed at the request of participating school principals, athletic directors, and coaches, participation in these events and open to high schools of any size, type, strength, or geographic location. Currently contests in football, boys and girl’s soccer, boys and girl’s basketball, girl’s field hockey, and girl’s volleyball are occurring. All events are known and sanctioned by the local and state high school organizing bodies of each team that participates and the National Federation of High School Associations. The contests take place in several cities across the country. Additional sports and cities will be added as resources allow as to make these athletic and scholarship opportunities available to more students.”

The purpose of the events is the purpose of the organization. It is to provide high school athletic programs of all sizes and competition levels with an opportunity to further develop and demonstrate the educational aspects of sports through the competition of interstate interscholastic athletic competitions; exposure to world-class competition facilities; experience in team travel and travel participations; the responsibility of representing their organization through sportsmanship and citizenship; and the opportunity to provide exposure to themselves, their team, their school, and their community; and to accomplish these objectives while providing continuing education scholarships to participating student-athletics.

All of the organizations’ time is spent either: 1) marketing to and preparing participating teams to travel; 2) organizing and producing the event and 3) securing funding to cover the event cost and the scholarships given to each participating team. This work is preformed primarily by the Executive Director with great leadership and volunteer assistance from the Board of Directors. Actual Events employ the use of Event Volunteers.

ORG hosts high school sporting event competitions at the professional sports facilities located in CO-1 in City, State, for high schools located in 46 of 50 states of the United States of America. The 5-day events are for both male and female sports activities; the sports hosted are: Baseball, Basketball, Lacrosse, Softball, Football, Filed Hockey, Track and Field, Volleyball, Wrestling, and Cheerleading. During the 5 day stay, the teams participate in around 1 to 3 games, depending on the sport. The teams stay at CO-1 and are able to take in all the entertainment it offers, while not participating in the ORG sporting events. If the sporting event were not hosted by a charitable organization, none of the 46 State Athletic Association would allow their high school sports teams to participate in the experience.

CO-2 (CO-2), a for-profit corporation, conducts business from the same location as ORG and shares two of three common board members: husband and wife, BM-1 and BM-2. CO-2 performs the marketing for ORG. An interested team submits a ORG application, along with a minimum deposit, to CO-2. CO-2 then invoices the team for the remaining amount due and deposits the check into its checking account.

At this point, ORG invoices CO-2 for a tournament entry fee of $$ to $$, tournament related costs, and the amounts that were being charged by CO-1 for meals, hotels, park passes, special events, and the facility where the tournament takes place, plus an additional 3 percent to pay ORG employee salaries.

A participating team typically holds fundraising events to cover expenses and submits partial payments to CO-2 until the invoice is paid in full. CO-2 records the expenses of the airfare and land transportation on its books and records; no part of these expenses are recorded on ORG’S books and records. CO-2 pays ORG for tournament costs on an allocated basis per payment received and uses the remaining moneys not sent to ORG for travel expenses recorded on CO-2 books and records; CO-2 keeps any residual dollars submitted by each team.

The following descriptions of both organizations’ activities were submitted by ORG:

Marketing

CO-2 Enterprises markets to High Schools via Email and Faxes. Primary marketing is from hosting State Dinners which are organized by our Steering Committee Coaches. We found over the years that majority of our new Schools were being referred by other teams that had participated. By hosting these dinners we are creating a relationship with these coaches that is ensuring a more memorable experience.”

Team Booking

A Coach will either request information over the phone, website or at one of our dinners. CO-2 will then make a travel proposal for the school which includes meals, hotels, park, passes, special events, and the tournament they will be participating in. There are many other inclusions but those are the primary ones. The packages are bundled and is [sic] not an Ala Carte option for them. Once a team decides they are going to attend they complete a Team Application which is a ORG * * * Document and submit it typically with a team deposit. At that time a team is invoiced from CO-2 and a [sic] invoice is made from ORG * * * to CO-2 for booking the team into the tournament.

Receivables

Majority of teams are fundraising to participate in this event so they are set up on payment plans. Teams will typically make 4 to 5 payments throughout the process. Payments will be sent into CO-2 on behalf of the schools for a tentative number of participants. As invoices adjust in CO-2 they will be adjusted in ORG * * * as well.

Payments

As payments are required to suppliers CO-2 will pay its bills to ORG * * *. All event items are paid through ORG * * *. Facility rental, officials, hotels, park passes, etc. CO-2 pays for travel related items such as buses and airlines.

Expenses

Primarily all expenses are recorded in CO-2 Enterprises except for a few salaries in ORG * * *. ORG * * * charges a tournament entry fee of $$* * * – $$* * *, plus * * *% to cover the salaries.

Travel Experience

From the time the team gets on the plane back home until the time they are on their way back we handle all the details for them. When a team arrives at the airport we will meet them at baggage claim and load them on buses to the hotel. When a team arrives at a hotel we have a check in area that is special just for our participants. Coaches won’t even need to go to the front desk and check in their team. We are creating a “College Like” road trip feel for the team and the coach where all the coach needs to worry about is Coaching. During their stay they will typically play 1 to 3 games a day and also attend some type of attraction. Attractions range from CO-1, CO-3, CO-4, CO-5, and so on.

Scholarship Awards

At the end of the school year ORG * * * sends out notifications to all our participating coaches for that school year. Each coach is responsible to nominate one graduating senior to be awarded a $$* * * to $$* * * Book Scholarship.

Ultimately it is up to the coach who is awarded this but we do have a list of criteria that we would like them to follow. The entire experience is much more then [sic] who the best athlete is. It is more about who is a team leader, involvement in the community, overcoming adversity, improving grades and so on and so on. Once the school has their Book Scholarship winner that same student athlete is then eligible to enter our Essay Competition. The topic is different each year and is chosen by our Steering Committee Coaches. These same coaches are also the ones that will read all the essays and determine the winner. Each of our sports will receive a Essay Scholarship winner. Volleyball, Field Hockey, Football, Boys and Girls Basketball, Wrestling, Baseball, Softball and Boys and Girls Lacrosse. Scholarship amounts are determined on the size of the tournaments participation. Scholarships typically range from $$* * * to $$* * * per sport. The payments are made out to the College that the winner will be attending and can be used for any college related expenses.”

CO-2, a for-profit entity, receives benefits from making the travel arrangements for all travel related to a ORG event. ORG stated that approximately * * * percent of CO-2’s business is derived from ORG events.

Since CO-2 deposits all receipts associated with an athletic competition hosted by ORG on its books and records and pays ORG the cost plus * * * percent for tournament related costs (mostly payments to CO-1), the income innures to CO-2, the for-profit entity operated by the officers of ORG.

The total amount of scholarships given by ORG. are small compared to the revenues reported. ORG reported on its Form 990 for 20XX scholarships in the amount $$* * * and gross receipts of $$* * *. For the 20XX, ORG reported scholarships in the amount of $$* * * and gross receipts of $$* * *.

ORG stated that in order for a high school team to be allowed to participate in an amateur sporting event, that event must be hosted by a non-profit organization pursuant to the guidelines of the State Athletic Associations.. In the past, CO-2 asked Rotary Clubs to “host the amateur sporting activities;” though “hosted” by the Rotary Club, all financial transactions were reported on CO-2’s books and records. An officer of CO-2 researched other organizations that conduct music competition events in a similar manner and decided to establish an exempt organization to host the sporting events, making the whole process much easer for CO-2 to manage. The organizations on which ORG stated that it modeled its operations were * * * and * * *

LAW

Organizations that are exempt from federal income tax under Internal Revenue Code section 501(c)(3) are described as follows:

Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.

An organization is not organized or operated exclusively for one or more [exempt] purposes . . . unless it serves a public rather than a private interest. Thus, to meet the requirements of this subdivision, it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests. Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii).

Prohibited private interests include those of unrelated third parties as well as insiders. Christian Stewardship Assistance, Inc. v. Commissioner, 70 T.C. 1037 (1978); American Campaign Academy v. Commissioner, 92 T.C. 1053 (1989). Private benefits include an “advantage; profit; privilege; gain; [or] interest.” Retired Teachers Legal Fund v. Commissioner, 78 T.C. 280, 286 (1982).

An organization formed to educate people in Hawaii in the theory and practice of “est” was determined by the Tax Court to be a part of a “franchise system which is operated for private benefit;, therefore, the Tax Court determined that it should not be recognized as exempt under section 501(c)(3) of the Code. est of Hawaii v. Commissioner, 71 T.C. 1067, 1080 (1979). Although the organization was not formally controlled by the same individuals who controlled the for-profit entity that owned the license to the “est” body of knowledge, publications, and methods, the for-profit entity exerted considerable control over the applicant’s activities by setting pricing, the number and frequency of different kinds of seminars and training, and providing the trainers and management personnel who are responsible to it in addition to setting price for the training. The court stated that the fact that the organization’s rights were dependent upon its tax-exempt status showed the likelihood that the for-profit entities were trading on that status. The question for the court was not whether the payments made to the for-profit were excessive, but whether the for-profit entity benefited substantially from the operation of the organization. The court determined that there was a substantial private benefit because the organization “was simply the instrument to subsidize the for-profit corporations and not vice versa and had no life independent of those corporations.”

The Tax Court in Wayne Baseball, Inc., v. Commissioner, T.C. Memo 199-304, held that an adult amateur baseball league could not be described in section 501(c)(3) because a substantial part of the league’s activities furthered the social and recreational interests of its members. The Tax Court determined that the sponsoring of an adult amateur baseball team furthered the team members’ social and recreational interests to a more than insubstantial extent; accordingly, the Tax Court determined that the organization did not operate exclusively as a section 501(c)(3) organization. Id.

GOVERNMENT POSITION

It appears that ORG is organized and operated primarily to benefit CO-2, a for-profit organization, rather than to achieve a tax exempt purpose such that it is similar to the organization described in est of Hawaii, 71 T.C. 1067. In addition, ORG operates to promote the social and recreational interests of the team members who participate in its events with such activities as visits to CO-1 as part of the event packages, making it similar to the organization in Wayne Baseball, T.C. Memo. 19XX-304.

CO-2 receives a benefit from being the only for-profit organization used to book travel arrangements for ORG events. ORG has not established that “it is not organized or operated for the benefit of private interests, such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.” Treas. Reg. § 1.501(c)(3)-1(d)(1)(ii). Rather, ORG was created to meet each State Athletic Association’s requirement that an event must be hosted by a charitable organization in order for a high school team in that state to participate in a sporting event and to provide a stream of business opportunity for CO-2. Like the organization in est of Hawaii, 71 T.C. 1067, the organization appears to have been established for the benefit of CO-2, a for-profit entity, in order to provide the main stream of revenue for it and appears to have no life independent of CO-2.

TAXPAYER’S POSITION

We believe that the facts reflect that the organization is fulfilling its exempt purpose as originally requested on Form 1023, Application for Recognition of Exemption. Internal Revenue Services in a determination letter to the taxpayer in response to form 1023 approved their application for recognition of exemption.

In reviewing your letter dated April 12, 20XX in which you propose revocation of the taxpayer’s exemption, it appears that the primary issue which leads you to your determination that the taxpayer’s exempt status should be revoked is that ORG (ORG) utilizes the services of an entity known as CO-2 We stipulate that the facts reflect the owners and officers of CO-2 are also officers and directors of ORG. We further stipulate that a substantial portion of CO-2’s revenues arise from services preformed for ORG. However, we believe that the facts reflect that there is no private enurement to CO-2 from these activities. In fact, CO-2 has in recent years reflected operating loses and, other than reasonable salaries paid to employees and the officers of CO-2 for their services, no amounts have enured to their benefit.

In addition, we provided you with evidence to show that this type of relationship between a for-profit entity and a not-for-profit entity in this industry (that being provision of travel services and the hosting of youth sports events) is very typical.

Further, you make a reference in your report to various cases supporting the government’s position that ORG is essentially no more that a glorified travel agent, we have reviewed these cases and do not believe they are on point.

We believe that the IRS has not appropriately considered all of the evidence provided; importantly, but not limited to, the mischaracterization of ORG as an organization formed to promote the social and recreational interest of team members. Rather, we believe it is apparent from all of the evidence available to the field agent that ORG is fulfilling its exempt purpose as reflected on Form 1023 and as approved by the IRS determination letter.

We respectfully request that this information be reviewed by an appeals officer along with testimony that we provided.

ORG has entered into contracts to provide events for various youth groups through December 20XX. As an alternative to appealing the revocation, if the IRS would agree to allow ORG to cease operation and liquidate as of December 31, 20XX, we would agree to that.

CONCLUSION

ORG is not operated exclusively for one or more exempt purposes, and it provides private benefit to shareholders or individuals associated with CO-2, a for-profit entity.. Accordingly, the exempt status of ORG is revoked as of January 1, 20XX.

Citations: LTR 201343028




IRS LTR: Proposed Bequest to Camp Would Constitute an "Unusual Grant."

The IRS ruled that a proposed bequest to an organization that operates a camp for seriously ill children constitutes an unusual grant within the meaning of reg. section 1.170A-9(f)(6)(ii) because the size of the grant is not only unusual and unexpected but would also adversely affect the group’s publicly supported status.

LEGEND:

C = Name of Founder

D = State

E = Date

G = Name of Foundation

T = Trust

f = $ Amount of Unusual Grant

Dear * * *:

We have considered your March 22, 2012 request for recognition of an unusual grant under Treasury Regulations section 1.170A-9(f)(6)(ii) and related provisions.

Based on the information provided, we have concluded that the proposed grant constitutes an unusual grant under section 1.170A-9(f)(6)(ii) and related provisions of the regulations. The basis for our conclusion is set forth below.

FACTS

You were incorporated in the State of D on E. You were recognized as exempt from federal income tax under section 501(c)(3) of the Internal Revenue Code (“the Code”). You operate a camp for seriously ill children. We have further determined that you are not a private foundation within the meaning of section 509(a) of the Code because you are an organization of the type described in section 509(a)(1) and 170(b)(1)(A)(vi) of the Code.

The camp is funded by donations. You have received funding from individuals, businesses, corporations, foundations, civic groups and other organizations. Your public support has continued to grow. You anticipate that this trend will continue. You have a representative governing body made up of individuals with previous experience with organizations similar to yours.

You are requesting recognition of a proposed grant of $f from T as an unusual grant under sections 1.170A-9(f)(6)(ii) and related provisions of the regulations. The grant is in the form of a charitable bequest to you upon the passing of C. No restrictions were placed on the bequest.

The proceeds from this grant are to be used to pay off tax exempt bonds issued by you to fund the construction of your facilities for which C had provided a personal guarantee. Any remaining funds will be used to partially fund your operations for up to one (1) year and/or to establish an endowment in the name of C.

C was your founder. A review of your previously filed Form 990 filings indicates that you previously received contributions from C during Fiscal year ended 20* * * and 20* * *. You have also received contributions from G in previous years.

C was not an employee, board member, or person in position to exercise control over you. You met the facts and circumstances test in each of the years from 20* * * – 20* * *. Subject to the treatment of the bequest as an unusual grant your public support percentage would be * * *%

LAW

Treasury Regulations sections 1.170A-9(f)(6)(ii) and 1.509(a)-3(c)(4) set forth the criteria for an unusual grant:

Treasury Regulations section 1.170A-9(f)(6)(ii) states that, for purposes of applying the 2-percent limitation described in paragraph (f)(6)(i) of this section to determine whether the 33 1/3 percent support test or the 10 percent support limitation in paragraph (f)(3)(i) of this section is satisfied, one or more contributions may be excluded from both the numerator and the denominator of the applicable support fraction if such contributions meet the requirements of paragraph (f)(6)(iii) of this section. The exclusion is generally intended to apply to substantial contributions or bequests from disinterested parties which:

are attracted by reason of the publicly supported nature of the organization;

are unusual or unexpected with respect to the amount thereof; and

would, by reason of their size, adversely affect the status of the organization as normally being publicly supported.

Treasury Regulations section 1.509(a)-3(c)(4) states that all pertinent facts and circumstances will be taken into consideration to determine whether a particular contribution may be excluded. No single factor will necessarily be determinative. Such factors may include:

Whether the contribution was made by a person who:

a. created the organization

b. previously contributed a substantial part of its support or endowment

c. stood in a position of authority with respect to the organization, such as a foundation manager within the meaning of section 4946(b)

d. directly or indirectly exercised control over the organization, or

e. was in a relationship described in Internal Revenue Code section 4946(a)(1)(C) through 4946(a)(1)(G) with someone listed in bullets a, b, c, or d above.

A contribution made by a person described in a. – e. is ordinarily given less favorable consideration than a contribution made by others not described above.

Whether the contribution was a bequest or an inter vivos transfer. A bequest will ordinarily be given more favorable consideration than an inter vivos transfer.

Whether the contribution was in the form of cash, readily marketable securities, or assets which further the exempt purposes of the organization, such as a gift of a painting to a museum.

Whether (except in the case of a new organization) prior to the receipt of the particular contribution, the organization (a) has carried on an actual program of public solicitation and exempt activities and (b) has been able to attract a significant amount of public support.

Whether the organization may reasonably be expected to attract a significant amount of public support after the particular contribution. Continued reliance on unusual grants to fund an organization’s current operating expenses (as opposed to providing new endowment funds) may be evidence that the organization cannot reasonably be expected to attract future public support.

Whether, prior to the year in which the particular contribution was received, the organization met the one-third support test described in section 1.509(a)-3(a)(2) without the benefit of any exclusions of unusual grants pursuant to section 1.509-3(c)(3);

Whether the organization has a representative governing body as described in Treasury Regulations section 1.509(a)-3(d)(3)(i); and

Whether material restrictions or conditions within the meaning of Treasury Regulations section 1.507-2(a)(7) have been imposed by the transferor upon the transferee in connection with such transfer.

Treasury Regulations section 1.509(a)-3(c)(6), Example 5 read in conjunction with Example 4 provides an example of a bequest received by an organization from an individual not in control of the governing body, in cash, with no restrictions as to its use, which contribution could be excluded as an unusual grant for the purpose of determining the one-third support test.

APPLICATION OF LAW

The proposed bequest constitutes an unusual grant within the meaning of Section 1.170A-9(f)(6)(ii) and related provisions of the regulations for exclusion as an unusual grant. It is unusual and unexpected with respect to the amount and you received it due to your publicly supported nature. Additionally it would by reason of its size adversely affect your publicly supported status.

After reviewing the factors detailed in section 1.509(a)-3(c)(4) of the regulations we have determined that the proposed contribution constitutes an unusual grant. Although made by the founder, the proposed contribution is in the form of a bequest, was made in cash and has no restrictions as to its use. The founder had no authority with respect to you as an officer or board member. Further, you have carried on a program of exempt activities and have attracted public support since inception of your organization. You have met the public support tests yearly under facts and circumstances and will meet the one-third public support test if the proposed bequest is treated as an unusual grant. You are similar to the organization in Treasury Regulations section 1.509(a)-3(c)(6), Example 5.

We’ll make our determination letter available for public inspection under Internal Revenue Code section 6110 after deleting certain identifying information. Please read the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that show our proposed deletions. If you disagree with our proposed deletions, you should follow the instructions in Notice 437. If you agree with our deletions, you don’t need to take any further action.

If you have any questions, please contact the person listed in the heading of this letter.

Sincerely,

Kenneth Corbin

Acting Director,

Exempt Organizations

Citations: LTR 201342011




AICPA Comments on EO Information Return.

Jeffrey Porter of the American Institute of Certified Public Accountants has submitted comments on Form 990, “Return of Organization Exempt from Income Tax,” and instructions, suggesting changes to the 2014 form and instructions.

October 25, 2013

Mr. Ken Corbin

Acting Director, Exempt Organizations

Internal Revenue Service

1111 Constitution Avenue, N.W.

Washington, D.C. 20224

RE: Comments on Form 990, Return of Organization Exempt from Income Tax, and Instructions

Dear Mr. Corbin:

The American Institute of CPAs (AICPA) is pleased to provide comments on Form 990, Return of Organization Exempt from Income Tax, and instructions. Our matrix includes comments and recommendations for the 2014 forms and instructions, while indicating the importance and urgency of each recommendation.

The comments were developed by the AICPA Exempt Organizations Taxation Technical Resource Panel (TRP) and approved by the AICPA Tax Executive Committee. The Exempt Organizations TRP is comprised of practitioners who serve tax-exempt organizations and are experienced with both the nuances of the form and the challenges that arise for taxpayers in trying to complete it.

The AICPA is the world’s largest member association representing the accounting profession, with more than 394,000 members in 128 countries and a 125-year heritage of serving the public interest. Our members advise clients on federal, state and international tax matters and prepare income and other tax returns for millions of Americans. Our members provide services to individuals, not-for-profit organizations, small and medium-sized businesses, as well as America’s largest businesses.

We appreciate your consideration of our comments, and look forward to working with you in the future on this matter. We are available to meet with you to discuss and explain our comments further. If you have any questions, please contact Jeanne Schuster, Chair, AICPA Exempt Organizations Taxation Technical Resource Panel, at (617) 585-0373, or [email protected]; or Amy Wang, AICPA Technical Manager, at (202) 434-9264, or [email protected].

Sincerely,

Jeffrey A. Porter, CPA

Chair, Tax Executive Committee

American Institute of CPAs

Washington, DC

* * * * *

General Instructions

Section of the Form

Instructions, Foreign Filings & Public Disclosure

Importance/Urgency

Low

Comment

If a foreign form (Form 926, 5471, etc.) is attached to Form 990 instead of Form 990-T, the instructions do not address whether it is open to public disclosure. Currently, GuideStar does not appear to publish these forms when they are filed with a Form 990. The instructions make it clear that if the foreign forms are filed with Form 990-T, they are then removed for public disclosure purposes.

Recommendation

Please clarify that foreign forms are removed from the public disclosure copy of the Form 990.

Section of the Form

Instructions, Section E, When to File

Importance/Urgency

Low

Comment

It is understood that an organization that has an application for exemption pending must file Forms 990-EZ, 990-PF, or 990 while its application for exemption is in pending status. Currently, it is unclear whether and when an organization that has an application for exemption pending must file a Form 990-N. In addition, if the organization is not yet in the IRS system and cannot file a Form 990-N, the instructions do not address whether or not the organization must file a paper extension until it can get into the IRS system and file a Form 990-N.

Recommendation

Clarify in the instructions whether an organization must file an extension for a Form 990-N. Because the extension period might expire before exemption is granted, allow organizations whose exemption is pending and if granted on a retroactive basis to qualify to file a Form 990-N. An exemption pending box can be added to the form. In the alternative, provide guidance regarding the Form 990-N extension process.

Section of the Form

Instructions, Section H, Failure to File

Importance/Urgency

Low

Comment

If Forms 990, 990-EZ, 990-PF, or 990-N has been filed late, but within a three-year period, the instructions do not address whether this occurrence counts as a filing within three consecutive years for purposes of the automatic revocation provisions.

Recommendation

Clarify in the instructions that one return filed within three consecutive years qualifies as a filed return, even if late, except if the late return is for the third year and no return was filed for the previous two years.

Section of the Form

Instructions, Who Must File, Subcategory, Form 990-N

Importance/Urgency

Low

Comment

Small organizations need to maintain proper donor records in order to know when they have reached the filing threshold for a Form 990-EZ or full Form 990.

Recommendation

The instructions should note that all small organizations should keep track of their charitable contributions by donor. Once the filing thresholds have been reached for filing a Form 990-EZ, the organizations will have the appropriate documentation in order to file the Form 990-EZ and related Schedule A.

Heading, Part I and II

Section of the Form

Part I, Line 16a, Glossary

Importance/Urgency

Medium

Comment

This line requires organizations to report any “professional fundraising” paid to officers, directors, trustees, key employees or disqualified persons from Lines 5 and 6 of Part IX. These amounts are then excluded from Part I, Line 15.

Recommendation

The Internal Revenue Service (IRS) should clarify the definition of professional fundraisers as it relates to IRS appointed officers who are really employees (CEO, CFO, etc.). The definition for professional fundraising should include details for such individuals since employees are excluded from this definition.

Part III

Section of the Form

Part III, Line 4e

Importance/Urgency

Low

Comment

Currently, taxpayers have to manually calculate the total grants and program revenue for Lines 4a-4d to make sure the total amounts match with Parts VIII and IX of the return.

Recommendation

In addition to having the total program service expenses on line 4e, please add the total grants and program service revenue.

Part IV

Section of the Form

Part IV, Line 25a and Schedule L, Part I Header

Importance/Urgency

High

Comment

The excess benefit rules apply to section 501(c)(29) organizations. The updated form and instructions need to include these organizations.

Recommendation

Add section 501(c)(29) to the list of affected organizations on the face of the form at Part IV, Line 25a. The section 501(c)(29) organizations were appropriately added to the instructions.

Section of the Form

Part IV, Questions 12a and 12b

Importance/Urgency

High

Comment

The language in the instructions continues to confuse taxpayers and paid preparers. The source of the confusion comes from the definition in the Glossary for generally accepted accounting principles (GAAP). The definition as stated in the Glossary appears narrower than intended. There are audited financial statements with formal opinion letters for financial statements that are not prepared according to U.S. GAAP (e.g., cash-basis accounting, International Finance Accounting Standards (IFRS), hybrid accounting, etc.). Exempt organization taxpayers would like to answer “yes” to this question because an answer of “no” confuses their stakeholders.

Recommendation

One option is to remove the reference to GAAP from both the instructions to Line 12 and the Glossary (but keep audited financial statements). A second option is to re-write the definition of GAAP in the Glossary to allow for other methods of accounting, including but not limited to cash-basis, modified cash-basis and IFRS.

Section of the Form

Part IV, Line 29

Importance/Urgency

High

Comment

The question posed is whether the organization received more than $25,000 in non-cash contributions. If the answer is “yes,” Schedule M needs completion. The instructions also provide that contributions of services or use of facilities are not included. Line 33 of Schedule M asks to include a description in Part II if the organization did not report an amount in Column (c) for a type of property for which Column (a) is checked. The instructions ask for an explanation of why the organization did not report revenue for the item. Since in many instances, it is likely that organizations will not take into account contributions where no revenue has been recorded, the answer to Line 29 may be “no” and result in Line 33 of Schedule M having no response.

Recommendation

To make certain that Line 33 of Schedule M contains a response where relevant, Line 29 presentation on the form, as well as the instructions, need revising to make clear that the $25,000 threshold is regardless of whether amounts were included in the financial statements or in financial statement revenue. The question can include a parenthetical to allow the form to read: “Did the organization receive more than $25,000 in non-cash contributions (whether or not included in revenue)?”

Part V

Section of the Form

Part V, Line 2a

Importance/Urgency

Medium

Comment

Please clarify whether the number of employees paid by a related exempt organization must be indicated at this line if the related organization files the W-2s and W-3s while the employee works for the filing organization. If the employee is included on the filing organization, the instructions should indicate whether he/she is also included on the related organization because it was the related organization that issued the W-2. If the answer is yes, double reporting will presumably occur as both organizations will include the employee on this line of the Form 990.

Recommendation

Clarify whether or not to report an employee more than once. In addition, clarify whether the number on this line has any correlation to the salary expense reported on Part IX. For example:

Organization P is the parent and common paymaster for Organizations S and T. Therefore, all payroll related activities run through Organization P. Employee X is an employee of Organization P. However, he/she spends 20% of his/her time with Organization S, 30% of his time with Organization T and the remaining 50% with Organization P. While Organization P pays for all of Employee X’s salary and related payroll expenses, Organizations S and T reimburse P for the amount of time Employee X spends at their organization. Therefore, Organizations S, T, and P each report 20%, 30% and 50% respectively of Employee X’s salary on their Part IX.

Please clarify whether the procedure should be: 1) Organizations S, T, and P report Employee X on their Part V, Line 2a because Employee X works for all three organizations, or 2) Only Organization P report Employee X on Part V, Line 2a because Organization P is the one the issued the W-2 to Employee X.

Section of the Form

Part V, Line 2a

Importance/Urgency

Low

Comment

The face of the form indicates an organization should report the number of employees on its Form W-3 for the year. However, the instruction for this line indicates this number is the organization’s number of employees.

Recommendation

Please change the language on either the core form or the instructions in order for the two questions to ask for the same number.

Part VI

Section of the Form

Part VI, Line 15

Importance/Urgency

Medium

Comment

The last paragraph of the instructions for Line 15 indicates that if the filing organization did not compensate its CEO, executive director, other officers, or key employees, it should answer “no” to Lines 15a and 15b. However, the instructions do not address what the answer is if the filing organization itself did not compensate those employees but a related organization or common paymaster did. Some organizations take this question literally and answer “no” because they themselves do not compensate the employees despite having these types of individuals’ compensation reported in Part VII, Column (D).

Recommendation

Clarify that an organization should only answer “no” if no compensation was paid to these individuals whether by the filing or related organization.

Section of the Form

Part VI, Line 15

Importance/Urgency

Medium

Comment

The instructions to Line 15 state that an organization should answer “yes” if the organization used a process for determining compensation of those individuals listed in Part VII. What if the filing organization relied on its parent or related organization to determine the compensation and the filing organization itself does not have a process? The instructions do not clearly explain whether the filing organization must have its own process or whether it can rely on a related organization’s process.

Recommendation

Clarify whether filing organizations must have their own processes to determine compensation or whether they can rely on a related organization’s process to determine the filing organization’s compensation and still check “yes.” Also, include an additional subpart below Line 15 to have a box checked if: “Process was performed by a related organization.”

Section of the Form

Part VI, Line 1a

Importance/Urgency

Low

Comment

The form indicates a disclosure is required if the organization delegates broad authority to an executive committee. However, “broad authority” is not defined. Almost all organizations delegate some powers to the executive committee.

Recommendation

Please provide examples of decisions that qualify and do not qualify under “broad authority.” For example, it is our opinion that the authority to approve compensation of executives is not considered broad authority, but hiring/firing executives is considered broad authority.

Part VII

Section of the Form

Part VII, Section B

Importance/Urgency

High

Comment

The instructions add disclosures for organizations using management companies such as contract CFO services. However, the instructions lack specificity as to what is disclosed regarding compensation. It is common for individuals to work for a company that provides contract CFO services to organizations. Those individuals are assigned to perform work for multiple organizations throughout the year. Their compensation from the management company may not be allocated to the individual clients easily. Also, those individuals may not want to disclose how much they are compensated by their employer, especially if it is not solely related to services provided to the reporting exempt organizations.

Recommendation

Expand the instructions to specify that the compensation is for the calendar year ending with, or within, the calendar year to match other similar disclosures on the Form 990. The instructions should permit the disclosure of an allocated amount rather than the full amount paid by the management company to the individual and also, allow for a reasonable estimate if actual amounts are not available.

Section of the Form

Part VII, Section B

Importance/Urgency

Medium

Comment

Suppose a parent organization pays a vendor on behalf of a related subsidiary organization, and the subsidiary reimburses the parent for the expenses. Instructions are needed to explain which organization (parent or subsidiary) should report the expense if the vendor is paid greater than $100,000.

Recommendation

When one organization is paying expenses on behalf of another organization, please clarify which organization should report the payment on Part VII, Section B.

Part VIII, IX, X and XI

Section of the Form

Part VIII, Line 8b (and Schedule G, Part II, Direct vs. Indirect Expenses)

Importance/Urgency

Medium

Comment

There is confusion surrounding what is classified as a “direct expense” versus “indirect expense” for special events. Postage, invitation costs, and securing sponsorships all occur before the day of the event but directly relate to the event. However, many taxpayers work under the logic that “direct expenses” really mean “day of event” and “indirect expenses” really mean “pre-day of event.” In addition, for most taxpayers, there is significant administrative burden in separating out the expenses of an event into those two categories.

Recommendation

Please specify the appropriate indirect expenses to list in Part IX of Form 990.

Section of the Form

Part XI, Line 6, Instructions

Importance/Urgency

High

Comment

The instructions are incorrect. This line is for donated services and use of facilities. However, the instructions indicate it is the sum of Lines 3, 4, and 5.

Recommendation

Two recommendations:

1) The instructions should explain that this line is an item that requires an entry and it is not the sum of the lines above. For better transparency, require detail of the income and expenses for donated services and use of faculties on Schedule O, or

2) The second option is to separate Line 6 into Line 6a) Revenue from donated services and use of facilities, and Line 6b) expenses from donated services and use of faculties. Separating revenue and expenses can provide greater transparency. Sometimes, these amounts will equal, and in that case, the number nets to zero.

Schedule B

Section of the Form

Schedule B, Page 1, Special Rules

Importance/Urgency

Medium

Comment

Per Treas. Reg. 1.6033-2(a)(2)(iii)(a), an organization described in section 501(c)(3) which meets the 33 1/3% of support test of the regulations under section 170(b)(1)(A)(vi) (without regard to whether such organization otherwise qualifies as an organization described in section 170(b)(1)(A)) is required to provide the name and address of a person who contributed, bequeathed, or devised $5,000 or more during the year only if this amount exceeds 2% of the total contributions, bequests and devises received by the organization during the year.

Recommendation

Please clarify if an organization that meets the section 509(a)(1) test and the section 170(b)(1)(A)(vi) test but is not granted exempt status under section 170(b)(1)(A)(vi), such as a school or hospital, the organization is still able to use the special rule for Schedule B.

Schedule C

Section of the Form

Schedule C, Part II, Page 1, Instructions, Column 2

Importance/Urgency

High

Comment

The instructions state: “for which the election was valid and in effect for its tax year beginning in the year 2011.” This language is only correct for fiscal year organizations. For calendar year organizations, the tax year will begin January 1, 2013 and an election made in that year is valid and effective for 2013.

Recommendation

Please correct the instructions to use the appropriate date in future forms.

Schedule D

Section of the Form

Schedule D, Part I, Other Funds

Importance/Urgency

Medium

Comment

Some taxpayers are not including scholarship funds in Column (b) as “funds or other accounts.”

Recommendation

Please add an example or clarification to the instructions regarding whether scholarship funds meet the definition of “funds or other accounts.” Also, add language to clarify that Part I should report “funds or other accounts,” which are part of the endowments (reported in Part V).

Section of the Form

Schedule D, Part V, Endowments, Lines 1 and 4

Importance/Urgency

Low

Comment

Consider changing the instructions to only reflect endowments for the filing organization rather than those endowments held by a related organization. It is duplicate reporting by the parent organization when the related organization holds the endowments. Additionally, it can cause confusion to the tax preparer if an endowment is reported in Part V of Schedule D but no investment assets appear on the filing organization’s balance sheet.

Recommendation

Change instructions to only require Line 1 reporting of endowment funds when held by the organization. Change Line 4 to say, “Describe in Part XIII the intended uses of the organization’s endowment fund. Also, if `yes’ to Lines 3(a)(i) or 3(a)(ii), name the organization(s) in Part XIII.”

Schedule F

Section of the Form

Schedule F, Part I

Importance/Urgency

Medium

Comment

Due to the amount of ownership in a program related investment (PRI), activities of the PRI can consolidate on the exempt organization’s financial statements. In this case, the assets, liabilities, and equity of the PRI are reported on the exempt organization’s return.

Recommendation

Please clarify whether the amount reported on Schedule F, Part I, Line 3(f) is the total assets of the PRI or total equity balance of the PRI. The instructions indicate the ending book value is reported. It is not clear if this value is the net equity balance or total asset balance.

Section of the Form

Schedule F, Part IV, Question 1

Importance/Urgency

Medium

Comment

Schedule F, Part IV, Question 1 states: “Was the organization a U.S. transferor of property to a foreign corporation during the tax year? If ‘Yes,’ the organization may need to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation (see Instructions for Form 926).” Based on conversations with the IRS, the answer to this question is “Yes” if the organization made grants to foreign organizations that are corporations. We believe that this question is answered “Yes” when the organization has made grants to foreign corporations.

Recommendation

The IRS should make it clear in the instructions that the “transfer of property” to a U.S. corporation for these purposes does not include grants. Grants are already disclosed on Schedule F, Part II, and a grant is not the type of transfer that triggers a Form 926 filing. Therefore, this question is redundant for grants. Responding “Yes” for grants will also make it difficult for the IRS to determine whether the organization may have a Form 926 filing requirement.

Schedule G

Section of the Form

Schedule G, Part II, Direct vs. Indirect Expenses (and Part VIII, Line 8b)

Importance/Urgency

Low

Comment

There is confusion surrounding what is classified as a “direct expense” versus “indirect expense” for special events. Postage, invitation costs, and securing sponsorships all occur before the day of the event but directly relate to the event. However, many taxpayers work under the logic that “direct expenses” really mean “day of event” and “indirect expenses” really mean “pre-day of event.” In addition, for most taxpayers, there is significant administrative burden in separating out the expenses of an event into those two categories.

Recommendation

Please specify the appropriate indirect expenses to list in Part IX of Form 990.

Schedule I

Section of the Form

Schedule I, Parts II and III

Importance/Urgency

Medium

Comment

Taxpayers continue to have confusion about what qualifies as cash vs. non-cash. The instructions provide examples of tangible non-cash items such as equipment and supplies. However, there are many other types of grants being made where the recipient receives a financial benefit but never has access to cash. For example, gift cards are generally considered cash equivalents. However, organizations may receive the benefits from gift cards but never have access to cash.

Recommendation

Please add the following as examples of non-cash contributions for Schedule I purposes: 1) Financial aid and scholarships that are applied against a student’s tuition account 2) Gift cards to individuals for necessities such as groceries, household items, etc. 3) Payments to a third party vendor on behalf of an individual (e.g. paying the utility company for a family in need).

Schedule J

Section of the Form

Schedule J, Part I, Line 4a

Importance/Urgency

High

Comment

The question asks whether a person listed in Part VII, Section A, Line 1a with respect to the filing or related organization has received a severance or change-of-control payment. The instructions provide that “a severance payment is a payment made if the right to the payment is contingent solely upon the person’s severance from service in specified circumstances, such as upon an involuntary separation from service.” The utilization of the phrase “such as upon involuntary separation” is reasonably interpreted as illustrative, and not exclusive. The language that is used causes uncertainty as to whether voluntary separations are also within the purview of the instructions.

Recommendation

In order to eliminate any uncertainty as to the types of separation payments disclosed, please clarify whether separation pay includes voluntary separation payments.

Section of the Form

Schedule J, Part VII, Listing of Trustees and Officers on Part VII and on Schedule J

Importance/Urgency

High

Comment

Neither the form nor the instructions forbid listing the same person on more than one line.

Recommendation

To avoid confusion to the reader with the use of multiple lines for one individual, the form and instructions should state that all compensation to one individual should be listed only once and not broken into multiple individual listings.

Section of the Form

Schedule J, Header Above Line 5

Importance/Urgency

Medium

Comment

The header and instructions indicate that the following questions only apply to organizations exempt under section 501(c)(3) and (4). Instructions are needed to explain if section 501(c)(29) organizations are added to this list.

Recommendation

Consider adding section 501(c)(29) organizations to the list of organizations required to complete this part of Schedule J.

Schedule K

Section of the Form

Schedule K, Part III, Line 7, Instructions

Importance/Urgency

High

Comment

The new question on the 2013 Schedule K asks about the private security or payment test of section 141(b)(2) but provides no additional definitions.

Recommendation

Please add a definition for “private security test” and “private payment test” to the Schedule K instructions and glossary.

Schedule L

Section of the Form

Schedule L, Part I, Header

Importance/Urgency

High

Comment

Section 501(c)(29) organizations are also subject to excess benefit transaction rules. This information is missing from the header.

Recommendation

Modify the header to include section 501(c)(29) organizations.

Section of the Form

Schedule L, Part IV

Importance/Urgency

High

Comment

For purposes of Part IV, the list of interested persons includes an entity other than a section 501(c)(3) organization, a section 501(c) organization of the same subsection as the filing organization, or an entity more than 35% controlled by one or more current directors. Consider the following example: Organization A (501(c)(3)) owns 100% of Corporation B. The officers of B consist entirely of directors from A. B has business transactions with A in excess of $100,000. As the instructions are currently written, the transactions are reported on Part IV, and all directors of B are treated as not independent with respect to A. Since A owns/controls B, A can do what it wants with B (e.g., liquidate, merge, etc.). It does not make sense that those board members are deemed to lack independence with respect to A.

Recommendation

Add the following to the list of exceptions: Business transactions with an organization controlled by the filing organization.

Schedule M

Section of the Form

Schedule M, Column C

Importance/Urgency

Low

Comment

A “total” line is needed to sum up the amounts in Column C in order for the Schedule M contribution detail to easily agree back to Part VIII, Line 1g of the Form 990.

Recommendation

Please add a “total” line to sum up the amounts in Column C.

Schedule N

Section of the Form

Schedule N, Part II

Importance/Urgency

Medium

Comment

The instructions need greater clarification regarding what types of transactions are excluded. It is logical that a sale of investment assets for fair market value consideration in order to pay down debt is not the kind of transaction that would require a Schedule N disclosure. However, the instructions appear to require this disclosure.

Recommendation

Add to the examples of situations that are not reporting requirements: “Sale of investment assets such as securities for full fair market value consideration for any purpose.”

Schedule R

Section of the Form

Schedule R, Instructions

Importance/Urgency

Medium

Comment

The definition of control of a nonprofit (as defined in the Glossary to the Form 990) includes the following statement: “Also, a (parent) organization controls a (subsidiary) nonprofit organization if a majority of the subsidiary’s directors or trustees are trustees, directors, officers, employees, or agents of the parent.” This definition of control includes situations where there is coincidental overlap (i.e., there is no right or ability of one organization to appoint or remove board members of the other). While the organizations may be related, there lacks a sense of an element of control in these situations.

Recommendation

At conferences and in conversations with the IRS, IRS personnel have indicated that there is coincidental overlap when each organization is the controlled and controlling entity. With coincidental overlap, there is no control. This presentation on the Form 990 may confuse readers from understanding the true nature of the organizations’ relationship. The IRS should modify the instructions to state that in cases where there is coincidental overlap of board members, each organization should report the other entity as “related” using Schedule R. However, neither organization is a controlled or controlling entity.

Section of the Form

Schedule R, Definitions

Importance/Urgency

High

Comment

It is a challenge to determine “brother/sister” organizations in large organizations with complex structures and multiple layers of organizations. Additional examples of the extent/reach of Schedule R reporting are helpful. The following examples and questions illustrate the issue. Example: A and B (brother/sister organizations) are commonly controlled by C (the parent). D is a supporting organization of A. B owns 100% of E, a for-profit C corporation. Should D report on B’s Schedule R? Should E report on A’s Schedule R? Should E report on D’s Schedule R? A and B have separate boards, but all board member are appointed by C. No board members of B are on D’s board. None of the officers of E are part of A or D’s boards. However, C directly or indirectly controls all of the organizations. This issue becomes more pronounced when dealing with a Catholic hospital system or state university system. It is quite burdensome to locate every controlled for-profit subsidiary and/or partnership. Reasonable efforts should apply.

Recommendation

Please provide an example in the instructions with similar facts as this AICPA provided comment. Please also allow for reasonable efforts.

Section of the Form

Part IV

Importance/Urgency

Medium

Comment

The definition of control for trusts is ownership of more than 50% of the beneficial interest in the trust. More clarity is required with regards to split interest trusts. It appears that many split interest trusts will need reporting (if the beneficial interest is more than 50%) even though the filing organization has no actual control over the assets or distributions of income.

Recommendation

Exclude the reporting requirement for trusts for which there is an outside unrelated trustee and a trust document that gives the beneficiary no control.

Section of the Form

Part V, Line 2

Importance/Urgency

High

Comment

It is extremely burdensome for organizations to gather this information and ensure consistency amongst related organizations. Not all members of related groups utilize the same tax preparers.

Recommendation

Eliminate the detailed reporting on Line 2 or limit the request to just a few specific transactions such as: controlled group interest, annuities, royalties, and rent.




State AG Office Expresses Support for Required E-Filing of EO Information Returns.

 

Connecticut Assistant Attorney General Karen Gano has expressed support for President Obama’s fiscal 2014 budget proposal to phase in the required electronic filing of Form 990, stressing that its adoption is needed for the effective oversight of charities.

M. Ruth M. Madrigal

Advisor, Office of Tax Policy

Department of the Treasury

1500 Pennsylvania Ave., NW, Room 3120

Washington, DC 20220

Re: Budget Initiative for E-Filing of IRS Form 990s and Machine-Readable Data

Dear Attorney Madrigal:

We met last February at the Columbia Law School Charities Policy conference on “Future of State Charities Regulation.” In your remarks at the conference, you acknowledged the need for universal e-filing of IRS Forms 990 to enable accessibility of machine-readable data concerning tax-exempt organizations. After your remarks, we spoke briefly about the possibility and feasibility of initiating mandatory e-filing of 990s. I was delighted to see recently that President Obama’s FY 2014 budget proposes to phase in required electronic filing of the Form 990 and have the IRS release the data in a computable format in a timely manner. The proposal, coming soon after The Aspen Institute’s report on “Liberating Nonprofit Sector Data for Impact,” supports the findings and challenges addressed in that report.

Connecticut is leading the multistate project that, in effect, constitutes the corresponding liberation of the wealth of additional valuable data about nonprofit organizations — in addition to data collected on the Forms 990 — that is collected by the states through state charities registrations. Forty states require nonprofits and their professional fundraisers to register with the state under disparate state-specific and mostly paper-based systems. Most of that data is not available in electronic and searchable format. Even when it is, it can be accessed only through state-specific websites. Missouri Assistant Attorney General Bob Carlson and I are chairing a pilot project with twelve states to develop and launch a single, unified electronic state charities registration website that will make all states’ charities registration data universally available and computable.

We anticipate that the unified state charities registration system will be interfaced with the IRS’s electronic 990 filing system for maximum efficiency, in a manner similar to Hawaii’s current electronic state registration system. Our plan is to launch the website in 2014-2015 and we anticipate that all forty registration states will enable registration on the unified website within five to ten years of launch. All state attorneys general, and also seventeen secretaries of state or heads of other state charities registration agencies, have a direct interest in unified electronic state charities registration and required e-filing of IRS Forms 990 as part of their oversight responsibilities for protecting charitable assets and charitable solicitations in their respective states.

I have discussed President Obama’s budget proposal to phase in mandatory e-filing of Forms 990, and your comments from our conversation in February about the importance of such an initiative, with our Deputy Attorney General, Nora Dannehy. She agrees that the budget proposal for e-filing of 990s is a critical and necessary step for effective oversight and policy ability of the states to effectively carry out our charities oversight responsibilities. In addition, the correspondence of required e-filing for 990s with the initiation of unified electronic state charities registration will render significant efficiencies and cost savings for nonprofits in complying with state and federal regulatory requirements.

If our Office can provide additional information or facilitate the efforts to initiate required e-filing of 990s, please contact us.

Yours truly,

Karen Gano

Assistant Attorney General

State of Connecticut

Hartford, CT




IRS Releases Tax Statistics on Municipal Bonds.

The IRS has released tax statistics collected from information returns filed by state and local governments that issue tax-exempt bonds to finance essential operations, facilities, infrastructure, and services for their constituents.

SOI Data on Municipal Bonds

State and local governments across the United States and its territories issue tax-exempt bonds to finance essential operations, facilities, infrastructure, and services for their constituents. SOI conducts annual studies on tax-exempt governmental bonds and tax-exempt private activity bonds derived from Forms 8038-G and Forms 8038 filed by bond issuers. The American Recovery and Reinvestment Act of 2009 (ARRA), expanded bond finance options to include: tax-exempt bonds, direct payment bonds, and tax credit bonds.

Tax-Exempt Bond Proceeds, Issue Years 2005-2009

Highlights of the Data

Over 25,000 tax-exempt bonds generated nearly $446.2 billion in total proceeds during 2009, as reported on Forms 8038-G and Forms 8038 filed with the IRS.

More than $340.7 billion in governmental bond proceeds funded public projects such as schools, transportation infrastructure, and utilities in 2009.

An additional $105.6 billion in tax-exempt private activity bond proceeds financed projects such as residential rental facilities, single family housing, and facilities of Internal Revenue Code section 501(c)(3) organizations like hospitals and private universities.

Over 81.8 percent of total tax-exempt bond proceeds for 2009 were used to finance long-term development projects.

Nonrefunding bond issues (also referred to as “new money issues”) are bonds issued to finance new capital projects.

New money proceeds increased by 3.1 percent from $259.3 billion in 2008 to $267.7 billion in 2009.

Direct payment bonds, through the Build America Bonds (BABs) and the Recovery Zone Economic Development Bond (RZEDs) Programs, created nearly $65.3 billion in total proceeds for 2009.

In 2009, State and local governments issued $3.7 billion in tax credit bonds, largely through the Qualified School Construction Bond (QSCBs) and Qualified Zone Academy Bond (QZABs) Programs.

Products

Many products based on the annual studies are made available to the public:

Total Tax-Exempt Bonds, Direct Payment Bonds, and

Tax Credit Bonds, 2009

[Money amounts are in millions of dollars]

____________________________________________________________________

Percentage

Type of bond                Number       Amount         of total

amount

(1)          (2)            (3)

_____________________________________________________________________

Total                         26,384        515,283          100.0

Tax-exempt bonds             25,095        446,233           86.6

Direct Payment bonds1           911         65,326           12.7

Tax credit bonds2               378          3,724            0.7

______________________________________________________________________

NOTE: Detail may not add to totals because of rounding.

FOOTNOTES TO TABLE

2 Bonds reported on the Form 8038-G, Information

Return for Tax-Exempt Governmental Obligations, with a

specific reference to “Build America Bond” or “Recovery Zone Economic

Development Bond” in either their issue name or other description.

3 Includes data from governmental and private activity

bond returns (Forms 8038-G and 8038) that specifically reference

“qualified school construction” bonds, “clean renewable energy”

bonds, “qualified zone academy” bonds, or “Midwestern tax credit”




Must Contingent Fee Lawyers Capitalize Litigation Costs?

Gregg D. Polsky and R. Kader Crawford contend that the INDOPCO regulations promulgated in 2004 now control whether litigation costs must be capitalized.

Lawyers who represent personal injury claimants are typically compensated on a contingent fee basis. And it is becoming increasingly common for plaintiffs’ lawyers involved in other types of litigation, such as patent enforcement, to also use contingent fee arrangements. During the pendency of the litigation, contingent fee lawyers often pay the litigation costs necessary to prosecute the claim. For instance, contingent fee lawyers usually pay court fees, expert witness and consultant fees, deposition and court reporters’ fees, travel costs, and copying costs.1

Surprisingly, the tax treatment of those payments remains stubbornly controversial.2 The issue is whether contingent fee lawyers can immediately deduct litigation costs in the year in which they are incurred or instead must capitalize them. If the costs are capitalized, cost recovery would be accomplished upon conclusion of the case, either through a basis offset against the lawyer’s amount realized or as a bad debt or loss deduction.

The IRS has consistently maintained that all litigation costs paid by contingent fee lawyers are capitalized, regardless of the technical particularities of the contingent fee agreement.3 The IRS has thus far prevailed in all of the reported cases on the issue with one notable exception. In that case, the Ninth Circuit concluded that a relatively unusual type of contingent fee agreement — a gross fee contract — allowed the lawyer to immediately deduct costs.4 After that decision, the IRS stated that it will continue to assert that litigation costs must be capitalized in gross fee contract situations except in the Ninth Circuit.5

Despite the IRS’s well-known position on litigation costs and its near universal success in the courts, a prominent commentator on litigation-related tax issues recently wrote that he believed that “the vast majority of plaintiffs’ law firms (either unwittingly or aggressively) probably do deduct client costs as they pay them, rather than waiting until the case settles.”6 In addition to the controversy over what current law requires, there is controversy over what the law ought to be. Recent legislative proposals would allow all contingent fee litigators to immediately deduct their costs.7 As might be expected, lobbyists for trial lawyers strongly support those proposals,8 while lobbyists aligned with common personal injury defendants have announced their opposition.9

In this article, we contend that the INDOPCO regulations promulgated in 2004 now control whether litigation costs must be capitalized. The INDOPCO regulations establish that while lawyers who use conventional contingent fee arrangements must capitalize their costs, lawyers who use gross fee contracts can immediately deduct their costs.

We also argue that while litigation costs incurred under gross fee contracts are immediately deductible under current doctrine, as a policy matter these costs should be capitalized. Thus, we conclude that (1) Treasury or the IRS should issue prospective-only guidance, as contemplated by the INDOPCO regulations, to require litigation costs incurred under gross fee contracts to be capitalized; and (2) legislative proposals that would allow immediate deductions for litigation costs should be rejected.

A. Litigation Costs Generally

Most commonly, litigation costs paid by contingent fee lawyers are structured as advances or zero-interest loans from the lawyer to the client.10 The client is technically responsible for the costs, but the lawyer agrees to front the costs until the case is resolved. When the case is resolved, the client repays the loan out of the proceeds of the litigation, with the remaining proceeds divided between the lawyer and the client as provided by the contingent fee contract. If the proceeds of the litigation are insufficient to repay the advances, or if there are no proceeds at all, the client may be personally responsible for the shortfall. Alternatively, the lawyer might agree to not seek repayment of any shortfall, in which case the arrangement is effectively a nonrecourse loan with the cause of action serving as collateral.

As explained below, tax motivations have led some plaintiffs’ lawyers to depart from this typical arrangement and begin to use a gross fee contract. Under a gross fee contract, the lawyer still pays the litigation costs during the prosecution of the claim.11 However, when the case is resolved, there is no priority allocation of the proceeds to reimburse the lawyer for costs. Instead, the proceeds are simply divided according to the contingent fee percentage. Thus, in a gross fee contract, the proceeds are allocated in the same manner whether the litigation costs were $100 or $100,000. Because the lawyer is no longer entitled to a priority allocation for his costs, the contingent fee percentage is presumably adjusted upward to compensate him for taking on the additional risk.12

In summary, there are three types of advance structures: recourse advances, nonrecourse advances, and gross fee arrangements. To illustrate how each works, consider the following scenarios under a 40 percent contingent fee contract for recourse/nonrecourse advances and a 50 percent contingent fee contract for a gross fee arrangement: (a) $2 million settlement, $200,000 of costs; (b) $500,000 settlement, $200,000 of costs; and (c) $100,000 settlement, $200,000 of costs. Table 1 illustrates the consequences to the parties under each of the arrangements.

Table 1

__________________________________________________________________________

Lawyer’s

Reimbursement                             Right to

Type of                Of Costs to     Lawyer’s Share of         Reimbursement

Arrangement            Lawyer          Recovery                  From Client

______________________________________________________________________________

Scenario A: $2 Million Settlement, $200,000 Costs

______________________________________________________________________________

40%/recourse           $200,000        40% of $1.8 million =     N/A

$720,000

 

40%/nonrecourse        Same as above   Same as above             Same as above

50%/gross fee          N/A             50% of $2 million =       N/A

$1 million

_____________________________________________________________________________

Scenario B: $500,000 Settlement, $200,000 Costs

_____________________________________________________________________________

40%/recourse           $200,000        40% of $300,000 =         N/A

$120,000

40%/nonrecourse        Same as above   Same as above             Same as above

50%/gross fee          N/A             50% of $500,000 =         N/A

$250,000

_____________________________________________________________________________

Scenario C: $100,000 Settlement, $200,000 Costs

______________________________________________________________________________

40%/recourse           $100,000        $0                        $100,000

40%/nonrecourse        $100,000        $0                        $0

50%/gross fee          N/A             50% of $100,000 =         N/A

$50,000

______________________________________________________________________

[table continued]

______________________________________________________________________________

Type of                       Lawyer’s Total               Client’s

Arrangement                   Recovery                     Recovery

_____________________________________________________________________________

Scenario A: $2 Million Settlement, $200,000 Costs

______________________________________________________________________________

40%/recourse                  $920,000                     $1.08 million

40%/nonrecourse               Same as above                Same as above

50%/gross fee                 $1 million                   $1 million

______________________________________________________________________________

Scenario B: $500,000 Settlement, $200,000 Costs

_____________________________________________________________________________

40%/recourse                  $320,000                     $180,000

40%/nonrecourse               Same as above                Same as above

50%/gross fee                 $250,000                     $250,000

_____________________________________________________________________________

Scenario C: $100,000 Settlement, $200,000 Costs

_____________________________________________________________________________

40%/recourse                  $200,000                     -$100,000

40%/nonrecourse               $100,000                     $0

50%/gross fee                 $50,000                      $50,000

B. Historical Cases

Tax cases involving recourse and nonrecourse advances (as opposed to gross fee situations) have universally found that the lawyers must capitalize the advances.13 Those cases conclude that advances are loans for tax purposes.14 It is axiomatic that when money is loaned, the lender capitalizes the loan amount and then eventually recovers the amount as a basis offset against principal repayments or as bad debt deductions. Lenders cannot deduct the cost of their loans any more than car manufacturers can deduct the cost of their cars. And when attorneys loan money to their clients, they are acting as lenders.

While that conclusion seems obvious for recourse advances, when the lawyer has the legal right to repayment regardless of the success of the underlying case, the analysis is somewhat more complicated for nonrecourse advances. Courts have sometimes struggled in those cases because of the traditional tax definition of a loan as an “unconditional obligation to repay.”15 In the nonrecourse advance situation, the repayment obligation is conditional on the cause of action yielding a recovery at least as large as the total amount advanced, because the plaintiff is not liable for any shortfall. But traditional nonrecourse loans have similarly contingent repayment obligations,16 yet it is clear that nonrecourse loans are still treated as loans for tax purposes.17 If a sale of collateral would not result in sufficient proceeds to cover the outstanding debt, a nonrecourse borrower has the option to relinquish the collateral to the lender and be absolved of any liability for the shortfall.18 That the collateral’s value must exceed the outstanding debt in order for repayment of a nonrecourse loan to be ensured does not change the fact that nonrecourse debt is clearly debt for tax purposes.19 Thus, in determining whether an obligation meets the federal tax definition of debt as an unconditional obligation to repay, the contingencies resulting from the nonrecourse features of a debt must be ignored.

Nonrecourse advances are simply nonrecourse loans. The collateral is the cause of action, and the attorney’s recourse is limited to the proceeds eventually generated by the cause of action. If the proceeds are insufficient (or if there are no proceeds at all), the attorney bears the shortfall, just as a nonrecourse lender bears the shortfall when the collateral’s value drops below the amount of the debt. And because it is clear that nonrecourse loans remain debt for tax purposes, the attorney must capitalize advances regardless of whether the client is personally liable for any shortfall.

While courts have consistently reached this conclusion, their analysis is often muddled because they believe that they have to circumvent the “unconditional” issue. Some courts have noted state bar rules that precluded attorneys from advancing costs without requiring clients to be personally liable.20 Others contended that regardless of the legal technicalities, the attorney had a sufficiently high expectation of repayment, emphasizing that the attorney would invest time, effort, and money into a contingent fee case only if he had a high degree of confidence that the case would yield a payout in excess of litigation costs.21 Under the nonrecourse loan theory espoused above, those facts are immaterial; if the advance arrangement is characterized as a nonrecourse loan, the proceeds loaned are always capitalized regardless of state bar rules or the likelihood of repayment.22

Thus, while the courts’ reasoning was muddled, their conclusions — that nonrecourse advances had to be capitalized — were consistent. In response to this state of affairs, one law firm, the Boccardo Law Firm, began to use gross fee contracts in some of its cases.23 Under those contracts, the firm would receive 33.3 percent of any pretrial settlement or 40 percent of any post-trial recovery regardless of the amount of litigation costs that it incurred. The IRS took the position that despite the absence of an obligation to repay the costs incurred by the law firm, the costs still had to be capitalized. In a 1993 case, the Tax Court agreed with the IRS, concluding that the gross fee contracts were substantively very similar to nonrecourse advances because of the strong likelihood that the law firm would recoup its costs out of the eventual recovery.24

However, two years later, the Ninth Circuit reversed the Tax Court’s decision, determining that the absence of a repayment right in favor of the law firm precluded characterization of the gross fee contract as a loan.25 As a result, the Ninth Circuit held that the law firm’s immediate deduction of costs was proper. In 1997 the IRS issued a field service advisory, which announced that the IRS disagreed with the Ninth Circuit’s reasoning and would continue to assert that litigation costs incurred under a gross fee contract had to be capitalized, except in the Ninth Circuit where it was bound by the Boccardo decision.26

C. Recent Developments

After the 1997 field service advisory, the state of the tax law appeared to be clear: Advances had to be capitalized under the case law, whether they were made on a recourse or nonrecourse basis. The tax consequences of gross fee contracts, however, remained uncertain. The Ninth Circuit, in the only appellate decision on point, allowed litigation costs to be immediately deductible under these contracts, but the IRS and the Tax Court disagreed. Adding to the confusion, a prominent commentator recently said that he believed that plaintiffs’ lawyers are routinely deducting their costs, regardless of whether they are using gross fee contracts or more traditional advance arrangements.27

Given this state of affairs and the large amount of tax dollars at stake, it is not surprising that lobbyists and legislators have been active on these issues. The American Association for Justice (AAJ) (formerly the American Trial Lawyers Association) has pushed for legislation that would allow contingent fee lawyers to immediately deduct their costs regardless of the type of fee arrangement.28 In 2009 Sen. Arlen Specter, along with several cosponsors, introduced a bill that would accomplish this result, but the bill never made it out of committee.29

On the other hand, the American Medical Association (AMA) has pushed in the other direction, arguing that litigation costs incurred by contingent fee lawyers should be capitalized in all instances.30 Two dozen senators asserted that position in a 2009 letter to Treasury Secretary Timothy Geithner that called for the IRS to reaffirm its position in the 1997 field service advisory.31

Despite this recent activity, the IRS has remained steadfastly silent on the issue, responding to inquiries by explaining that it is continuing to study the matter.32 Meanwhile, as the back-and-forth lobbying proceeded, the Tax Court recently decided another case involving litigation costs. In Humphrey, decided in January, the court applied the traditional analysis and confirmed that advance arrangements, even if nonrecourse, required capitalization of litigation costs.33 The court rejected the taxpayer’s claims that the likelihood of repayment was sufficiently low to allow for immediate deduction of the litigation costs. The court initially determined that the likelihood of repayment was irrelevant to whether a loan existed for tax purposes. It went on to conclude that even if the likelihood of repayment was relevant to the analysis, the likelihood was high enough in the cases at issue to require capitalization.

D. The Correct Approach Under Current Law

In 2004 Treasury promulgated the INDOPCO regulations,34 which now govern the tax treatment of litigation costs. The recent Tax Court decision ignored the INDOPCO regulations, analyzing instead the traditional case law on litigation costs.35 Commentators on litigation costs likewise have thus far ignored the effect of the INDOPCO regulations.36

Nevertheless, it is clear that the INDOPCO regulations now govern the tax treatment of litigation costs because the costs create intangible, rather than tangible, value. The INDOPCO regulations apply to all costs that create intangible value, except for some intangible interests in real property.37 Advances give the contingent fee lawyer a right to repayment, which is an intangible asset. Costs paid by a lawyer under a gross fee arrangement enhance the lawyer’s right to a future contingent fee by bolstering the plaintiff’s legal claim. The right to a future contingent fee is also an intangible asset. The INDOPCO regulations therefore apply to the lawyer’s payment of litigation costs under either advance or gross fee arrangements.

The INDOPCO regulations generally require capitalization for four types of payments: (1) payments to acquire specified intangibles; (2) payments to create specified intangibles; (3) payments “to create or enhance a separate and distinct intangible asset”; and (4) to the extent identified by Treasury in future guidance, payments to create or enhance a future benefit.38 If a payment that creates intangible value does not fit within one of the four categories, it is immediately deductible.39

Applying the INDOPCO regulations to advances of legal costs is a fairly straightforward exercise. Advances are described in the second category of payments that are required to be capitalized — payments to create specified intangibles. One of the specified created intangibles is a debt instrument “or any other intangible treated as debt for Federal income tax purposes.”40 Debt exists for tax purposes when there is an “existing, unconditional, and legally enforceable obligation for the payment of a principal sum,”41 and advances qualify as debt under this definition. As discussed above, the nonrecourse nature of a loan does not cause a loan to be “not debt” for tax purposes even though repayment of principal could be considered conditional for nonrecourse debts. Accordingly, the INDOPCO regulations require the capitalization of advances regardless of whether they are made on a recourse or nonrecourse basis.42

While the tax treatment of advances under the INDOPCO regulations is clear, the treatment of costs paid under a gross fee contract is more complicated. Litigation costs incurred under a gross fee contract do not qualify as payments made to acquire one of the specified acquired intangibles for which capitalization is required.43 Nor do they qualify as payments made to create a specified created intangible for which capitalization is required.44 The client has no obligation to pay a principal sum; the client’s only obligation is to pay a percentage of the total recovery to the lawyer, and the amount of litigation costs expended by the lawyer has no effect on the amount due from the client.45 Accordingly, there is no creation of “debt” for tax purposes. Further, the fourth category — payments made for a future benefit identified in Treasury guidance — does not apply because the government has issued no such guidance on litigation costs, and the INDOPCO regulations make clear that that guidance, if issued in the future, would have only prospective application.46

Because the first, second, and fourth categories of payments that require capitalization do not apply, litigation costs under a gross fee contract may be required to be capitalized only under the third category. This category covers payments to create or enhance a separate and distinct intangible asset (SADIA).47 A SADIA is defined, subject to a few specific exceptions, as “a property interest of ascertainable and measurable value in money’s worth that is subject to protection under applicable State, Federal or foreign law and the possession and control of which is intrinsically capable of being transferred or pledged (ignoring any restriction on assignability) separate and apart from a trade or business.”48 The intangible right at issue is the right of a lawyer to receive a fee under the contingent fee agreement. This intangible right appears to satisfy all the conditions of a SADIA under this general definition. It is a property interest that can be valued, that is legally recognized, and that could (ignoring any restrictions imposed by state ethics rules or the contingent fee contract itself) be transferred separate and apart from the lawyer’s trade or business. Ignoring, as the definition of SADIA requires, contractual or ethical restrictions preventing an attorney from assigning his rights and obligations under a particular contingent fee agreement, an attorney could find a buyer to acquire those rights and obligations for money.49 Further, the attorney could hypothetically consummate that sale without also selling her entire law practice.50 Accordingly, the right to receive a fee appears to qualify as a SADIA under the regulations.

Once it is established that a lawyer’s right to a fee under a gross fee contract constitutes a SADIA, the next question is whether litigation costs paid by the lawyer create or enhance that right. It could be argued that the litigation costs do not create the right, which is initially created by the signing of the contingent fee agreement. Then again, if the lawyer does not pay the necessary costs of litigation, which the lawyer is required to do under a gross fee contract, the client can discharge the lawyer for cause, which would cause the lawyer to relinquish her right to a fee.51 Thus, in a sense, the lawyer’s performance of her obligations under the gross fee contract — by providing legal services and paying the necessary costs — create the lawyer’s right to a contingent fee. If litigation costs are determined not to create the right to a fee, they would certainly be considered to enhance the right to a fee. There is no definition of enhance in the INDOPCO regulations (or the preamble), although it seems clear that the lawyer’s payments of filing fees, expert witness fees, and other litigation costs are intended to enhance her right to a future fee. Otherwise, there would be no reason for a plaintiffs’ lawyer under a gross fee contract to pay those fees.

Payment of litigation costs under a gross fee contract therefore creates or enhances a SADIA. Accordingly, unless an exception applies, those costs would be required to be capitalized. The only relevant exception provides that “amounts paid in performing services under an agreement are treated as amounts that do not create a separate and distinct intangible asset . . . regardless of whether the amounts result in the creation of an income stream under the agreement.”52 This language is not artfully drafted, but it appears that litigation costs paid under a gross fee contract would constitute amounts paid in performing services under an agreement. This exception was not part of the proposed regulations but was added when the regulations were finalized.53 Despite the late addition of the exception, the extensive preamble to the final regulations did not even mention the new exception.54

Some insight into the meaning of the “in performing services” exception can be gleaned from Example 11 of the INDOPCO regulations,55 which likewise was added only when the regulations were finalized and also without comment in the preamble.56 In that example, a mutual fund distributor solicited sales of a mutual fund’s shares in exchange for the right to future fees to be paid by the fund. The distributor solicited sales directly to investors as well as through brokers. Under the agreement between the distributor and the mutual fund, when a sale was made through a broker, the distributor paid the broker’s commission. Before the promulgation of the INDOPCO regulations, the IRS’s position was that a mutual fund distributor’s payments of broker commissions were capital expenditures.57 However, Example 11 concluded that because the “in performing services” exception applied to the broker’s commissions, the payments did not create a SADIA and therefore the payments were immediately deductible.

A 2010 letter ruling likewise determined that marketing fees paid by an investment adviser were immediately deductible because of the “in performing services” exception.58 Under the investment advisory agreement between the adviser and an investment fund, the adviser was entitled to a fee, which was calculated as a percentage of the fund’s assets. The fee grew if the fund’s assets grew; accordingly, it was in the adviser’s interest to maximize the fund’s assets. To that end, the adviser entered into marketing agreements with agents to increase demand for investment in the fund. Under the marketing agreements, the adviser paid the agents’ fees for the marketing services, and under the investment advisory agreement, those fees were not reimbursed by the fund. The IRS ruled that payment of the marketing fees by the adviser did not create or enhance a SADIA, citing the “in performing services” exception:

The amounts paid to the marketing agents by [the adviser] are paid in performing services under the investment advisory agreement and, therefore, are treated as amounts that do not create a separate and distinct intangible asset. Although the amounts paid under the marketing agreements are intended to maximize the revenue of [the adviser’s] investment management business, they are not required to be capitalized.

The facts in Example 11 and the 2010 letter ruling are both analogous to litigation costs paid by lawyers under gross fee contracts. In each situation, the taxpayer provides services under an agreement that calls for the taxpayer to pay the incidental costs in providing those services, with no right of reimbursement for those costs. In Example 11, the taxpayer provided distribution services to the mutual fund and agreed to pay any broker fees incurred in connection with sales of the fund’s shares. In the 2010 letter ruling, the taxpayer provided investment advisory services to a fund and agreed to pay the costs of marketing the fund. In the gross fee contract situation, the taxpayer provides legal services to the client and agrees to pay the incidental litigation costs. Example 11 and the 2010 letter ruling therefore support the conclusion that the “in performing services” exception applies to litigation costs paid under a gross fee contract.

There is one lingering textual issue. A careful reader might notice that while payments that create or enhance a SADIA are generally capitalized, the “in performing services” exception appears to exempt only payments that would otherwise create a SADIA. The exception provides: “Amounts paid in performing services under an agreement are treated as amounts that do not create a separate and distinct intangible asset.”59 We concluded above that there was some uncertainty whether litigation costs create a SADIA, although it was clear that those costs either create a SADIA or enhance a SADIA. While payments that create or enhance a SADIA are capitalized under the general rule, the exception, if read literally, carves out only payments that create a SADIA but does not mention payments that enhance a SADIA. In other words, if a payment merely enhances a SADIA (as opposed to creating the SADIA), the exception, which says that some payments are treated as not creating a SADIA, would be irrelevant.

We believe, however, that a literal interpretation is inappropriate. First, and most significantly, there would be no reason for the INDOPCO regulations to give different treatment to amounts paid in performing services that create a SADIA (which would be deductible under a literal interpretation because the exception applies) over amounts paid in performing services that merely enhance a SADIA (which would be required to be capitalized under a literal interpretation).60 Second, if such a counterintuitive and subtle distinction was drawn by the drafters of the INDOPCO regulations, one would think they would have made it clearer in the regulations themselves or at least in the preamble. Third, a literal interpretation would put undue emphasis on the very slippery creation-versus-enhancement distinction. As discussed above, one could argue that litigation costs under a gross fee contract create a SADIA (namely, the right to receive a future fee) because if litigation costs were not paid by the lawyer, the lawyer could be discharged for cause, which would result in the lawyer forfeiting his right to the contingent fee.

We therefore believe the exception was simply poorly drafted and should be interpreted to read: “Amounts paid in performing services under an agreement are treated as amounts that do not create or enhance a separate and distinct intangible asset.” This interpretation is supported by the language used by the IRS in the 2010 letter ruling involving marketing agents’ fees paid by an investment adviser:

 

The payments under the marketing agreement are not required to be capitalized as amounts that create or enhance (or facilitate the creation or enhancement of) a separate and distinct intangible asset. Section 1.263(a)-4(b)(3)(iii) provides that amounts paid in performing services under an agreement are treated as amounts that do not create a separate and distinct intangible asset, regardless of whether the amounts result in the creation of an income stream under the agreement. The amounts paid to the marketing agents by [the adviser] are paid in performing services under the investment advisory agreement and, therefore, are treated as amounts that do not create a separate and distinct intangible asset. Although the amounts paid under the marketing agreements are intended to maximize the revenue of [the adviser’s] investment management business, they are not required to be capitalized under [the INDOPCO regulations].61

The first sentence of the above excerpt concludes that the payment of marketing agents’ fees does not create or enhance a SADIA. In support of that conclusion, the next sentence cites and paraphrases the “in performing services” exception, which literally covers only amounts that create a SADIA. The next sentence then applies the facts to the exception and concludes that the fees do not create a SADIA. The final sentence concludes that, as a result, the fees are not required to be capitalized. If the IRS had interpreted the “in performing services” exception literally, it would have been necessary for it to separately evaluate the possibility that marketing agents’ fees might have merely enhanced (as opposed to created) a SADIA. Instead, the ruling never addresses the creation-versus-enhancement issue and simply concludes that because the “in performing services” exception applies to the SADIA in question, the payments are not required to be capitalized. That approach is consistent with our suggested interpretation of the “in performing services” exception.

Accordingly, we conclude that under current law, litigation costs that are advanced must be capitalized under the INDOPCO regulations, regardless of whether the advances are made on a recourse or nonrecourse basis. However, litigation costs paid under a gross fee contract are immediately deductible.

E. Policy Issues

1. Treasury should issue guidance requiring litigation costs incurred under gross fee contracts to be capitalized. The previous section addressed the tax treatment of litigation costs under current law. This section asks whether, as a policy matter, litigation costs should be capitalized. This issue is relevant to Treasury and the IRS, which under the INDOPCO regulations, could issue guidance requiring that litigation costs under gross fee contracts be capitalized in the future.62 The question is also relevant to lawmakers, who have been lobbied on both sides of the issue. The AAJ has pushed for legislation that would allow litigators to deduct all litigation costs incurred by contingent fee lawyers, regardless of the type of fee agreement.63 The AMA has opposed that legislation and contends that the IRS’s current position — that all litigation costs must be capitalized — is correct and should be reaffirmed.64

A fundamental principle of income taxation is that costs that are incurred to produce future income should be capitalized and recovered as the income is realized.65 In fact, the key distinction between an income tax and a consumption tax is their disparate treatment of costs incurred to produce future income: An income tax requires those costs to be capitalized, while a consumption tax allows them to be immediately deducted.66 Although the capitalization principle — that in an income tax, costs incurred to produce future income should be capitalized — is easy to state, its application in practice has proven quite difficult. Professor Lawrence Lokken explains:

This conception of the capitalization requirement . . . cannot practicably be directly implemented as a rule of tax law. Many, perhaps most, costs incurred in everyday operation of a business yield some benefit continuing beyond the year in which they are incurred. Most marketing costs, for example, produce some future benefit in the form of repeat patronage, even if they are incurred principally to make current sales. Rigorous application of the [capitalization principle] would require most businesses to divide numerous costs between immediate and future benefits in ways that far exceed reasonable demands for cost accounting. The challenge in developing the capitalization requirement is to implement the essence of the [capitalization principle] without imposing unreasonable accounting burdens.67

Thus, income tax administrators who design capitalization rules must weigh the benefits of adhering closely to the capitalization principle against the practical administrative burdens imposed on taxpayers.

In the litigation cost context, plaintiffs’ lawyers incur upfront costs in order to produce future income: their contingent fee. Accordingly, the capitalization principle would require that those costs be capitalized and later offset against any recovery by the lawyer. If there is no recovery by the lawyer, or if the costs exceed any recovery, the lawyer would receive a deduction when the case is resolved.

Turning to the issue of administrative burdens, it would not be difficult for contingent fee lawyers to comply with a rule requiring the capitalization of litigation costs. When contingent fee lawyers pay those costs as advances, which is typical, they must bill them to the client and account for them when the case is resolved to determine how the case’s proceeds will be allocated. In gross fee contracts, however, there is no need to keep track of litigation costs to make this allocation, because the division of proceeds is unaffected by the costs incurred. Nevertheless, in light of the widespread traditional practice of keeping careful track of litigation costs, it would be hard for gross fee contract lawyers to argue that this sort of accounting is especially onerous.

The INDOPCO regulations allow the government to issue prospective-only guidance that requires capitalization of intangibles that should be capitalized but managed to slip through the cracks of those regulations.68 Because litigation costs are incurred to produce future income, and because requiring capitalization of those costs will not be costly, the government should issue guidance. That guidance should provide that litigation costs paid by plaintiffs’ lawyers in connection with a gross fee contract are payments that create or enhance a future benefit and, accordingly, must be capitalized. Litigation costs should be defined in the guidance as costs incurred by contingent fee litigators that have traditionally been billed to clients as advances, including court fees; jury fees; service of process charges; court and deposition reporters’ fees; photocopying and reproduction costs; notary fees; long distance telephone charges; messenger and other delivery fees; postage; deposition costs; travel costs, including parking, mileage, transportation, meals, and hotel costs; investigation expenses; consultant, expert witness, professional mediator, arbitrator, and special master fees; and other similar items. The guidance should also clarify that costs incurred by lawyers as advances, whether recourse or nonrecourse, are required to be capitalized under the INDOPCO regulations as a payment to create a debt instrument.69

This guidance is appropriate for two reasons. First, as previously explained, the capitalization of costs incurred to produce future income is a key principle of an income tax. Departures from this principle should not be taken lightly.70 Allowing some businesses to deduct costs incurred to produce future income gives them an advantage over businesses that are forced to capitalize similar costs. Because there is little administrative hardship imposed on litigators to keep track of their litigation costs, the benefit of hewing closely to the capitalization principle far outweighs any cost of departure. Second, the guidance would neutralize the tax treatment between contingent fee arrangements that use advances and those that are gross fee contracts. As the tax law stands now, there is a tax incentive for contingent fee lawyers to use gross fee contracts. This guidance would put advances and gross fee contracts on the same footing tax-wise.

2. Potential counterarguments are not persuasive. Proponents of immediate deduction of litigation costs can be expected to base their arguments on the risks taken on by contingent fee lawyers in paying litigation costs. In gross fee contracts, as well as in nonrecourse advance arrangements, if there is a defense verdict, the lawyer suffers a loss equal to the amount of the costs. Even if the plaintiff nominally prevails, the settlement or judgment may not cover the amount of costs, and the lawyer could bear the shortfall. Riskiness, however, simply has no relevance to the capitalization issue. For example, taxpayers who buy options must capitalize their purchase prices regardless of how risky the options might be. If and when a risky option becomes worthless, the purchase price will be recovered at that time as a loss deduction. There is no authority for the proposition that the riskiness of an investment makes its cost less of a candidate for capitalization, nor is there a good policy argument to support that proposition.

Table 2

____________________________________________________________________________

 

Year 1         Year 2          Year 3         Year 4

_____________________________________________________________________________

Gross income      $0 (no         $200x           $200x          $200x

settlements    (settlement     (settlement    (settlement

yet)           from case 1)    from case 2)   from case 3)

Deductions        $0 (case 1     -$100x          -$100x         -$100x

litigation     (litigation     (litigation    (litigation

costs          costs of        costs of       costs from

capitalized)   case 1          case 2         case 3

recovered)      recovered)     recovered)

Taxable           $0             $100x           $100x          $100x

income

Table 3

____________________________________________________________________________

Year 1         Year 2          Year 3         Year 4

_____________________________________________________________________________

Gross income      $0 (no         $200x           $200x          $200x

settlements    (settlement     (settlement    (settlement

yet)           from case 1)    from case 2)   from case 3)

Deductions        -$100x (case   -$100x (case    -$100x (case   $0 (no

1 litigation   2 litigation    3 litigation   litigation

costs          costs           costs          costs

deducted)      deducted)       deducted)      incurred in

year 4)

Taxable income    -$100x         $100x           $100x          $200x

Proponents of immediate deduction might also argue that because litigation costs are recurring expenditures, there is little cause for concern. To illustrate this argument, assume that a new law firm generates one new case per year for three years, incurs $100x of litigation costs attributable to each case, and all $100x of litigation costs are incurred in the year in which the case originated. Assume also that each of the three cases settle after one year for $200x. If the litigation costs were capitalized and recovered in the year of settlement (that is, the year after the case was originated and the costs incurred), the results in Table 2 (above) would occur.

If litigation costs were immediately deductible, the results in Table 3 (above) would occur.

Proponents of deductibility might point to years 2 and 3, which result in the same amount of taxable income ($100x) under both approaches. While this is true, the argument overlooks that the taxpayer is undertaxed by $100x in year 1 under the immediate deduction approach.71 Eventually, the error is “corrected” by overtaxing the taxpayer in year 4 by the same $100x, but, of course, that does not make the government whole because of the time value of money. More generally, when there are recurring expenditures, the amount of taxable income will be significantly distorted in build-up years, when investments are increasing, and in wind-down years, when investments are decreasing. This is true even though the interim “steady state” years will have similar taxable incomes. Because of the distortions in the build-up and wind-down years, recurring expenditures that relate to future income should be capitalized unless capitalization would be significantly burdensome.72 As argued above, requiring litigators on gross fee contracts to keep track of litigation costs on a client-by-client basis is not onerous, since this sort of accounting is routinely done by contingent fee litigators who advance litigation costs.

F. Conclusion

We have argued that the INDOPCO regulations now control the tax treatment of litigation costs incurred by contingent fee lawyers. When those lawyers advance costs that are reimbursed out of the eventual recovery, the INDOPCO regulations require the advances to be capitalized. This is true regardless of whether the client is liable for the shortfall if the amount advanced exceeds the recovery. However, if a contingent fee lawyer pays litigation costs under a gross fee contract, the INDOPCO regulations allow those costs to be immediately deducted, a result consistent with the Ninth Circuit’s holding in Boccardo.

We have also argued that as a policy matter, immediate deductions for litigation costs incurred by a contingent fee lawyer should not be allowed. These costs clearly relate to future income — namely, the future contingent fee. The administrative burdens of attributing litigation costs to particular client matters and keeping track of those costs is insignificant, as evidenced by the fact that contingent fee lawyers routinely perform these tasks for nontax reasons. The government therefore should issue prospective-only guidance requiring litigation costs to be capitalized in gross fee arrangements. For the same policy reasons, legislative proposals that would make all litigation costs immediately deductible should be rejected.

FOOTNOTES

1 The model contingency fee agreement provided by the California bar includes the following list of advanced expenses: “court fees, jury fees, service of process charges, court and deposition reporters’ fees, photocopying and reproduction costs, notary fees, long distance telephone charges, messenger and other delivery fees, postage, deposition costs, travel costs including parking, mileage, transportation, meals and hotel costs, investigation expenses, consultant, expert witness, professional mediator, arbitrator and/or special master fees and other similar items.”

2 See Robert W. Wood, “Another Tax Case Limits Lawyer Costs Deduction,” Tax Notes, Feb. 25, 2013, p. 997 .

3 See, e.g., TAM 9432002 (Aug. 12, 1994); 1997 FSA 442.

4 Boccardo v. Commissioner, 56 F.3d 1016 (9th Cir. 1995) .

5 1997 FSA 442.

6 Wood, “A Taxing Process,” L.A. Daily Journal, Jan. 13, 2009, at 5.

7 See, e.g., H.R. 2519, S. 437, 111th Cong. (introduced Feb. 13, 2009). The same proposal giving trial lawyers a tax deduction for litigation costs was attached to H.R. 6049, the Energy and Job Creation Act, also known as the “tax extenders” legislation in 2008.

8 The American Association for Justice (AAJ), the leading organization for plaintiffs’ lawyers, listed H.R. 2519, which would provide an immediate deduction for litigation costs, on its 2009 lobbying report, available at http://disclosures.house.gov/ld/pdfform.aspx?id=300181914. The AAJ also hired outside lobbying firms Patton Boggs (2009 lobbying report available at http://disclosures.house.gov/ld/pdfform.aspx?id=300181677) and the Palmetto Group (2009 lobbying report available at http://disclosures.house.gov/ld/pdfform.aspx?id=300142802) to work on the bill.

9 Most prominent among the groups opposing the legislative change is the American Medical Association. See infra text accompanying notes 29-30.

10 An interesting ancillary issue that Ethan Yale raised with us is whether those advances might result in imputed income under section 7872. Section 7872 applies only to specific below-market interest loans (BMLs). One type of BML to which section 7872 applies is a compensation-related loan, which includes loans “between an independent contractor [the lawyer] and a person for whom such independent contractor performs services [the client].” Section 7872(c)(1)(B)(ii). Thus, on its face, section 7872 would appear to apply to advances. However, it seems clear that the drafters of section 7872 were focused on loans that ran from service recipients to service providers, not in the opposite direction. In the blue book discussion of section 7872, the Joint Committee on Taxation, in its discussion of compensation-related loans, focused only on “loans to persons providing services,” and all of its examples of compensation-related loans flowed only in that direction. JCT, “General Explanation of the Revenue Provisions of the Deficit Reduction Act Of 1984,” JCS-41-84, at 528-530 (Dec. 31, 1984). Also, the JCT explained that “Congress intended that an arrangement be treated as a compensation-related loan if, in substance, there is a compensatory element arising from the transaction.” Id. at 530. Interest-free advances from service providers to service recipients do not involve a compensatory element. Further, the proposed regulations under section 7872 explain that in a compensation-related loan, “the imputed transfer (amount of money treated as transferred) by the lender to the borrower is compensation.” Prop. reg. section 1.7872-4(c)(1). This would mean that application of section 7872 under the proposed regulations would result in compensation being deemed paid by the service provider (the lawyer-lender) to the service recipient (the client-borrower), which is nonsensical. Instead, the deemed transfer from lawyer-lender to client-borrower would be characterized as a rebate or purchase price adjustment for the cost of the lawyer-lender’s services. In short, while the literal language of section 7872 seems to cover advances of litigation costs, those advances were not intended to be subject to section 7872 because they run in the opposite direction as the compensation-related loans that were targeted by that provision.

11 See Wood, supra note 2, at 997-998.

12 See “Lawyer’s Advances on Behalf of Clients — Application of the Trade or Business Expense Rules,” Federal Tax Coordinator, L-4103 (2d ed.) (“To maintain relative economic parity, an attorney would have to receive a higher percentage of the client’s recovery under a gross fee arrangement than under a net fee arrangement”).

13 See Hearn v. Commissioner, 36 T.C. 672 (1961), aff’d, 309 F.2d 431 (9th Cir. 1962); Burnett v. Commissioner, 42 T.C. 9 (1964), aff’d in part, remanded in part on other grounds, 356 F.2d 755 (5th Cir. 1966); Canelo v. Commissioner, 53 T.C. 217 (1969), aff’d per curiam, 447 F.2d 484 (9th Cir. 1971); Herrick v. Commissioner, 63 T.C. 562 (1975); Silverton v. Commissioner, T.C. Memo. 1977-198; Boccardo v. United States, 12 Cl. Ct. 184 (1987).

14 See Canelo, 53 T.C. at 225 (“If expenditures are made with the expectation of reimbursement, it follows that they are in the nature of loans, notwithstanding the absence of formal indebtedness”).

15 See, e.g., Burnett, 356 F.2d at 759-760 (holding that cases requiring “an unconditional obligation to repay are not controlling” and “the question of whether an expenditure constitutes an expense . . . must be determined by the circumstances and conditions under which it was made”).

16 See Commissioner v. Tufts, 461 U.S. 300, n.5 (explaining that nonrecourse debt could “be considered a contingent liability, under which the mortgagor’s payments on the debt gradually increase his interest in the property while decreasing that of the mortgagee”).

17 Id. (concluding that, even though nonrecourse debt could be considered a contingent liability, it remains “true debt” for tax purposes). In some cases, nonrecourse debt with a sufficiently high likelihood of default might be considered an option to buy the collateral or some other instrument other than debt. See, e.g., Estate of Franklin v. Commissioner, 64 T.C. 752, 766-767 (1975) (concluding that nonrecourse purchase money debt that was in excess of the property’s fair market value constituted an option for federal income tax purposes). For nonrecourse advances, it is unlikely that courts would consider the likelihood of default to be high enough to trigger this recharacterization. Even in the unlikely case that recharacterization along those lines would be appropriate, the purchase price of the resulting asset would still be capitalized.

18 See generally Frederick H. Robinson, “Nonrecourse Indebtedness,” 11 Va. Tax Rev. 1, 42 (1991) (describing how nonrecourse debt is equivalent to recourse debt plus a put option in favor of the borrower).

19 See Tufts, 461 U.S. at 300, n.5.

20 See, e.g., Miller v. United States, 679 F. Supp. 692, 694-695 (E.D. Mich. 1988).

21 See Burnett, 356 F.2d at 759; Canelo, 53 T.C. at 225.

22 Cf. Humphrey Farrington & McCain PC v. Commissioner, T.C. Memo. 2013-23, at 4  (concluding that the likelihood of repayment is irrelevant to the issue of deductibility).

23 Boccardo v. Commissioner, T.C. Memo. 1993-224, at 1 (describing the Boccardo Law Firm’s gross fee contract).

24 Id. at 4.

25 Boccardo, 56 F.3d 1016, 1018-1019 (9th Cir. 1995) (“It is difficult to see how the label of ‘advances’ with its implication of ‘loans’ can be applied as a matter of law to payments when there is no obligation on the part of the client to repay the money expended”).

26 1997 FSA 442. The 1997 field service advisory reiterated the IRS’s position in a 1994 technical advice memorandum (TAM 9432002), which required capitalization of advanced litigation expenses.

27 See Wood, supra note 2, at 1,000.

28 See supra note 8.

29 See supra note 7.

30 Carolyne Krupa, “Organized Medicine to Geithner: Don’t Give Lawyers Tax Breaks for Litigation Expenses,” amednews.com (Sept. 13, 2010).

31 Letter from 24 senators to Geithner (July 29, 2010) .

32 On May 6, 2010, Treasury responded  to a letter  from Senate Finance Committee Chair Max Baucus, D-Mont., and Majority Whip Richard J. Durbin, D-Ill., requesting clarification on Treasury’s position in light of Boccardo. The response simply stated that the Office of Tax Policy “is aware of the concerns . . . and is considering issuing guidance to clarify this issue.”

33 Humphrey Farrington & McCain PC v. Commissioner, T.C. Memo. 2013-23, at *6-*7. While some of the litigation matters were covered by arrangements characterized by the taxpayer and the court as “gross fee” arrangements, those arrangements were inconsistent with the gross fee contracts used by the Boccardo Law Firm. The contracts used by Boccardo split the proceeds of the litigation in accordance with the contingent fee percentage, with no reimbursement obligation running from the client to the lawyer; therefore, the amount of money that went to the lawyer was unaffected by the amount of costs paid by the lawyer. On the other hand, in the “gross fee” contracts analyzed in Humphrey, the proceeds were initially split between the plaintiff and the lawyer according to the contingent fee percentage, but the plaintiff then had to reimburse the lawyer for its costs out of the plaintiff’s initial share. Therefore, the gross fee contract in Humphrey simply involved advances of costs, because the plaintiff was required to reimburse them.

34 T.D. 9107 , 69 F.R. 436-465 (Jan. 5, 2004).

35 The taxpayer’s brief indicates that during the trial, the Tax Court inquired about the potential application of the INDOPCO regulations, but the decision does not mention them. Petitioner’s brief, Humphrey, T.C. Memo. 2013-23, at *17, n.12 (Aug. 9, 2010) (No. 21153-09).

36 It is clear that the INDOPCO regulations can overrule the earlier case law. In National Cable & Telecommunications Ass’n v. Brand X Internet Services, 545 U.S. 967 (2005), the Supreme Court determined that regulations that garner Chevron deference, such as Treasury regulations, can overrule interpretations by earlier inferior courts as long as the regulations’ interpretation is permitted by the underlying statute. In this case, the relevant statutes are sections 263 (which requires the capitalization of capital expenditures) and 162 (which allows the immediate deduction of ordinary and necessary business expenses), both of which provide no detail about how they should apply to litigation costs. Accordingly, the INDOPCO regulations supersede the earlier litigation cost cases.

37 See Yale, “The Final INDOPCO Regulations,” Tax Notes, Special Supplement, Oct. 25, 2004, p. 435 .

38 Reg. section 1.263(a)-4(b)(1)(i-iv). The regulations also require the capitalization of two types of indirect costs: costs incurred to facilitate the acquisition or creation of an intangible for which the direct costs must be capitalized; and costs to facilitate specific business acquisitions and restructurings. See reg. section 1.263(a)-4(b)(1)(v), and -4(e) (definitions and exceptions). Litigation costs incurred by litigators are direct costs, so these rules are not relevant.

39 See Yale, supra note 37, at 436 (noting that the preamble to the final regulations states that “an amount paid to acquire or create an intangible not otherwise required to be capitalized by the regulations is not required to be capitalized on the ground that it produces significant future benefits”). As mentioned in supra note 38, some facilitation expenses must also be capitalized, but the litigation costs in question are not facilitation costs.

40 Reg. section 1.263(a)-4(d)(2)(i)(B).

41 Noguchi v. Commissioner, 992 F.2d 226, 227 (9th Cir. 1993) .

42 The so-called 12-month rule is a potential exception to the requirement that payments that create specified intangibles be capitalized. However, the 12-month rule does not apply to the payments that create financial interests such as debt instruments. See reg. section 1.263(a)-4(f)(3).

43 See reg. section 1.263(a)-4(c)(1) (listing acquired intangibles for which capitalization is required).

44 See reg. section 1.263(a)-4(d) (listing created intangibles for which capitalization is required).

45 In contrast, in fee agreements that provide for advances, the client must repay a principal sum, i.e., the amount of litigation costs incurred by the lawyer out of the recovery. Therefore, in these cases, the amount of litigation costs affects the amount due to the lawyer under the contingent fee agreement.

46 See reg. section 1.263(a)-4(b)(2).

47 Reg. section 1.263(a)-4(b)(1)(iii).

48 Reg. section 1.263(a)-4(b)(3)(i).

49 The treatment of contingent fee agreements in divorce and bankruptcy illustrates that interests therein can be valued, are legally recognized, and could hypothetically be sold. For example, some state courts have found pending contingency fee cases to be marital property subject to equitable distribution upon divorce. See National Legal Research Group Inc., “Contingent Fee Contracts as Assets of a Law Practice,” 14 No. 3 Equitable Distribution J. 25 (Mar. 1997). Moreover, some courts have also held that contingency fee cases are included in a debtor-attorney’s bankruptcy estate. See, e.g., In re Carlson, 263 F.3d 748, 750 (7th Cir. 2001).

50 In other words, the attorney could sell her rights under one contingent fee agreement while retaining her rights under all of her remaining contingent fee agreements.

51 See, e.g., Hardison v. Weinshel, 450 F. Supp. 721, 723 (E.D. Wis. 1978); Gary v. Cohen, 231 N.Y.S. 2d 394, 398 (N.Y. Sup. Ct. 1962); Royden v. Ardoin, 331 S.W.2d 206, 209 (Tex. 1960).

52 Reg. section 1.263(a)-4(b)(3)(iii).

53 Compare prop. reg. section 1.263(a)-4(b)(3) with reg. section 1.263(a)-4(b)(3)(iii).

54 Preamble to final reg. section 1.263(a)-4, 69 F.R. 436 (Jan. 5, 2004), reprinted at 2004-1 C.B. 447.

55 Reg. section 1.263(a)-4(l), Example 11.

56 See supra notes 53-54.

57 See Rev. Proc. 2000-38, 2000-2 C.B. 310  (providing three safe harbor methods for recovering capitalized broker fees paid by mutual fund distributors).

58 LTR 201032023.

59 Reg. section 1.263(a)-4(b)(3)(iii).

60 Further, if there were to be different treatment, one would expect “creation” payments to be capitalized and mere “enhancement” payments to be deductible, not vice versa.

61 LTR 201032023 (emphasis added).

62 See reg. section 1.263(a)-4(b)(1)(iv), -4(b)(2).

63 See supra note 8.

64 See supra note 30.

65 See section 263 (capitalization is the norm, while expensing is the exception); section 263A (requiring capitalization for the costs of producing property); INDOPCO Inc. v. Commissioner, 503 U.S. 79 (1992) (requiring capitalization for costs producing a nonincidental future benefit); Commissioner v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345 (1971) (requiring capitalization for costs creating a separate and identifiable asset). This general principle is consistent with the Haig-Simons definition of income. Under that definition, “a cost should be considered a capital expenditure to the extent the value acquired . . . remains part of the taxpayer’s ‘store of property rights.'” Lokken, “Capitalization: Complexity in Simplicity,” Tax Notes, Special Supplement, May 28, 2001, p. 1357 . In other words, the making of a capital expenditure does not reduce Haig-Simons income because it merely changes the form of the property right from cash to noncash property. Id.

66 See Edward J. McCaffery, “Tax Policy Under a Hybrid Income-Consumption Tax,” 70 Tex. L. Rev. 1145, 1150-1151 (1992).

67 Lokken, supra note 65, at 1357.

68 See supra note 62. Yale explains that “among Treasury’s motivations for promulgating the INDOPCO regulations was dissatisfaction with the level of ambiguity under prior law and a desire to quell controversy by reticulating an exhaustive set of rules. Treasury is rightly concerned that it might have touched every base.” Yale, supra note 37, at 451.

69 A related issue is whether costs incurred by contingent fee lawyers that are not typically advanced to clients ought to be required to be capitalized. Contingent fee lawyers do not usually advance payroll costs (such as wages paid to associate lawyers and paralegals) or office overhead (e.g., rent, insurance, and utilities) to clients. In theory, those costs should be capitalized as well since they relate to future contingent fees; however, the “in performing services” exception exempts them from capitalization. See supra text accompanying notes 52 and 59. Should the guidance that we suggest cover these costs as well? On one hand, at least for associate and paralegal costs, personal injury firms are likely already attributing those employees’ time to client matters to better inform business decisions such as compensation, staffing, and case selection. Further, in matters in which the plaintiff could recover attorney fees, this information would be necessary to prove the amount of those fees, which are calculated based on the number of hours worked. On the other hand, the INDOPCO regulations generally allow compensation paid to employees as well as overhead attributable to intangible assets to be immediately deductible on administrative convenience grounds. See reg. section 1.263(a)-4(e)(4)(i)-(ii); see also supra note 60. This rule applies even if the taxpayer capitalizes the compensation and overhead for financial accounting purposes.

70 We recognize that the INDOPCO regulations themselves depart from this principle in a variety of circumstances that are unjustified. See generally Calvin H. Johnson, “Destroying Tax Base: The Proposed INDOPCO Capitalization Regulations,” Tax Notes, June 2, 2003, p. 1381 .

71 For a longer-period example of this phenomenon, see Johnson, “Soft Money Investing Under the Income Tax,” 1989 Ill. L. Rev. 1019, 1072-1077 (1989).

72 Id.; Thomas L. Evans and Gregory W. Gallagher, “INDOPCO — The Treasury Finally Acts,” 80 Taxes 47 (Mar. 2002).

by Gregg D. Polsky and R. Kader Crawford

Gregg D. Polsky is the Willie Person Mangum Professor of Law at the University of North Carolina School of Law in Chapel Hill, N.C. R. Kader Crawford is an associate at Robinson Bradshaw & Hinson PA in Charlotte, N.C. The authors thank Jordan Datchko, Brant Hellwig, Martin McMahon, Herman Spence, Kathleen Delaney Thomas, Ethan Yale, and Lawrence Zelenak for their comments and suggestions. The views expressed in this article are those of the authors and do not necessarily represent the views of their employers.

 




EO Update: e-news for Charities and Nonprofits - October 25, 2013.

1.  Use Form 8822-B to notify IRS of a change of address or responsible party

Effective January 1, taxpayers must use Form 8822-B to notify the IRS of a change of address or the identity of a responsible party. Form 8822-B must be filed within 60 days of the change. An updated Form 8822-B is available on IRS.gov. There is a box on the form that exempt organizations must check.  The updated form is available at: http://www.irs.gov/pub/irs-pdf/f8822b.pdf

2.  Delayed Start for PTIN Renewal Season.

Due to the lapse in government funding, the 2014 PTIN renewal season is delayed. An email or letter will be sent to all current PTIN holders notifying them when the 2014 renewal season opens. The online PTIN system is still available for users to log in and view or change information or to secure a PTIN for 2013 at: http://www.irs.gov/Tax-Professionals/PTIN-Requirements-for-Tax-Return-Preparers

3.  Reminder: Don’t Include Social Security Numbers on Publicly Disclosed Forms.

Because the IRS is required to disclose approved exemption applications and information returns, tax-exempt organizations should not include personal information, such as Social Security numbers, on these forms.

4.  Work Opportunity Tax Credit Expires Soon.

Employers, don’t forget to claim the Work Opportunity Tax Credit for all of the targeted group employee categories, including veterans, listed on Form 5884, if they were hired on or after Jan. 1, 2011, or before Jan.1, 2014.

Information on the Work Opportunity Tax Credit is available at:

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Work-Opportunity-Tax-Credit-1

Form 5884 is available at:

http://www.irs.gov/uac/Form-5884,-Work-Opportunity-Credit-1

5.  Register for EO Workshops.

Register for upcoming workshops for small and medium-sized 501(c)(3) organizations:

November 6-7 – Augusta, GA

Hosted by Augusta Technical College

December 10 – New York, NY

Hosted by Baruch College

Register at: http://www.irs.gov/Charities-%26-Non-Profits/Upcoming-Workshops-for-Small-and-Medium-Sized-501(c)(3)-Organizations

6.  IRS Provides Tax Relief to Victims of Colorado Storms.

The IRS is providing tax relief to individual and business taxpayers impacted by severe storms, flooding, landslides and mudslides in Colorado.

Information is available at: http://www.irs.gov/uac/Newsroom/IRS-Provides-Tax-Relief-to-Victims-of-Colorado-Storms




MSRB Provides New Resource for EMMA Users Interested in 529 College Savings Plan Information.

The Municipal Securities Rulemaking Board (MSRB) has enhanced its MyEMMA service to allow users to sign up for alerts about 529 college savings plans. The alerts notify users when new information about a 529 plan becomes available on EMMA, such as the posting of a new plan disclosure document. The MSRB provides information on EMMA about the essential terms of 529 plans, including investment options, fees and expenses, and any state tax benefits.

Explore 529 college savings plan information on EMMA: http://emma.msrb.org/Search/Plan529.aspx




Project Management Agency Requests Guidance on Low-Income Housing Tax Credit.

John Lamey Jr. of the Atlantic County Improvement Authority has written to the IRS and Treasury to express support for guidance that would clarify what happens when an existing low-income housing tax credit property that was previously allocated 9 percent credits is rehabilitated following a natural disaster or casualty loss.

September 19, 2013

Ms. Lee A. Kelley

Deputy Tax Legislative Counsel

Department of the U.S. Treasury

1500 Pennsylvania Avenue, N.W.

Washington, D.C. 20220

[email protected]

Mr. Paul F. Handleman

Branch Chief, 5 (CC:PSI:5)

Internal Revenue Service

Room 5111

1111 Constitution Avenue, NW

Washington, DC 20224

[email protected]

RE: Guidance to preserve 9% LIHTC buildings damaged by disasters or casualties

Dear Ms. Kelley and Mr. Handleman,

The Atlantic County Improvement Authority is a body corporate and politic of the State of New Jersey authorized to issue to sell private activity tax-exempt revenue bonds under Internal Revenue Code Section 142 allocated from the State of New Jersey’s volume cap. We are enabled under New Jersey law to lend the proceeds of such bond issues to qualified low- and moderate income rental housing projects in conjunction with allocations of 4% LIHTCs equity financing, both for new construction and rehabilitation.

We understand Treasury is considering guidance clarifying what happens in situations where an existing LIHTC property previously allocated 9% credits is rehabilitated following a natural disaster or casualty loss. The rules will clarify that the existing property retains the 9% credit and the rehabilitation can qualify as “New Property” under Internal Revenue Code section 42(e) and be eligible for allocations of tax exempt volume cap bond financing and the 4% credit.

We strongly support the publication of this guidance. It is common sense tax administrative guidance that will be an important tool for state housing agencies, state housing bond issuers, owners and investors in applicable circumstances for maintaining and rehabilitating the stock of low income rental housing in New Jersey and throughout the United States.

The Authority respectfully urges the immediate publication of the requested guidance, which is badly needed now because many months have passed since the impacts of Hurricane Sandy have dealt a serious setback to New Jersey’s affordable housing stock, a significant portion of which continues to need restoration. There are projects that could be rehabilitated now by bond and credit financings structured pursuant to the policy and technical parameters of the proposed guidance.

Sincerely.

John C. Lamey, Jr.

Executive Director

Atlantic County Improvement

Authority

Mays Landing, NJ

Mark J. Mazur,

Assistant Secretary (Tax Policy),

U.S. Treasury

Representative Frank LoBiondo,

Congressman

2nd District of New Jersey




Change to Tax Exemption for Nonprofit Bonds Would Hurt the Economy.

Federal proposals to curb or eliminate tax exemption for bonds used by nonprofits would result in losses in employment, gross domestic product and labor income, according to a report released Wednesday.

IHS Global Inc. prepared the report for the National Association of Health and Educational Facilities Finance Authorities.

The study analyzed the economic impacts of capping the value of the tax exemption for bonds used by nonprofits at 28%, as President Obama proposed in his fiscal year 2014 budget. It also looked at the impacts from completely eliminating the tax-exemption.

The reform proposals would increase borrowing costs, making it harder for nonprofits to fund capital projects. Most nonprofit bonds are used to finance health care and education projects, such as hospital, university and private-school facilities.

“Thousands of hospitals, clinics, colleges, job centers and boys and girls clubs throughout the United States depend on tax-exempt bonds to access capital. Often, particularly in smaller communities, these nonprofits are the largest employers in the area and engines for economic growth.” Pamela Lenane, NAHEFFA president and the Illinois Finance Authority’s vice president and acting general counsel, said in a release. “This study demonstrates in national terms the enormous economic burdens and job loss that will be suffered by charities and hundreds of thousands of others if the tax exemption is curtailed or eliminated.”

The analysis assumes that the 28% cap would result in a decrease in capital spending by nonprofits of $5.8 billion per year. Eliminating tax-exemption would lead to a drop in capital spending of $16.6 billion per year.

These figures are average amounts based on data from the last 10 years.

Capping the value of tax exemption on nonprofit bonds at 28% would cut the GDP by about $8.3 billion, cost the United States about 105,000 jobs and cost the country about $5.5 million in labor income each year, the report found.

Eliminating tax-exemption for nonprofit, also called 501(c)(3), bonds would cut the GDP by about $23.6 billion, cost the country almost 300,000 jobs and cost the U.S. about $15.6 billion in labor income annually, the report said.

The report also looked at how changes to tax-exempt financing for nonprofits would impact employment across economic sectors.

Curbing or eliminating tax exemption would cost the construction sector the most number of jobs, followed by professional and business services, the trade, transportation and utilities sector and manufacturing, according to the paper.

Employment in the construction sector has the largest direct benefits from the current tax-exemption. The professional and business services and manufacturing sectors have the most jobs associated with indirect benefits of tax exemption. Indirect effects are generated when construction companies make purchases for bond-financed projects from suppliers.

The trade, transportation and utilities sector and the education and health services sector have the most number of jobs associated with the economic stimulus stemming from using the proceeds of tax-exempt bonds to construct facilities.

BY NAOMI JAGODA




IRS Seeking Applications for Vacancies on the Advisory Committee on Tax Exempt and Government Entities.

This is a reminder that the Internal Revenue Service is seeking applications for vacancies on the Advisory Committee on Tax Exempt and Government Entities (ACT).

Applications will be accepted through Nov. 4, 2013.

Apply at: http://www.irs.gov/pub/irs-pdf/f12339c.pdf

A notice published in the Federal Register, dated Oct. 1, 2013, contains more details about the ACT and the application process. http://www.gpo.gov/fdsys/pkg/FR-2013-10-01/html/2013-23993.htm

More information about ACT is available at:

http://www.irs.gov/Government-Entities/Advisory-Committee-on-Tax-Exempt-and-Government-Entities-(ACT)




IRS LTR: Change in Accounting Method Won't Jeopardize Cooperative's Exemption.

The IRS ruled a rural electric cooperative can retire former members’ capital credit accounts by offsetting the amounts of their accounts against outstanding debt owed for electric services without adversely impacting its tax-exempt status.

UIL: 501.12-03

Release Date: 10/4/2013

Date: May 30, 2013

Dear * * *

We have considered your ruling request regarding the tax consequences relating to the proposed change of methodology for the retiring all, or portion, of your former members’ capital credit accounts, described below.

You were created on Date as a cooperative under the laws of State and have qualified as a cooperative electric company under I.R.C. § 501(c)(12) since that time. Your members elect the board of directors on a one member, one vote basis.

Pursuant to Article VII, Section 2 of your bylaws, you are obligated to account on a patronage basis to all your members for all amounts received and receivable from electric services in excess of operating costs and expenses properly chargeable against the furnishing of such services. Such excess of revenue over expenses is allocated each year to each member in an equity ownership account which you call a capital credit account in proportion to the amount of the member’s electrical usage. The amounts allocated to the capital credit accounts are paid out to the members when the Board determines that you are financially able and in retirement of the capital credit accounts to the extent a payment is made. Payments are only made when it is possible to do so and not violate the requirements of your bylaws to keep reserves for operations and maintenance, debt repayment requirements, working capital, and other specified requirements.

A large number of your former members have outstanding balances due on their accounts for electric services. At this time, and pursuant to Article VII, Section 2 of your bylaws, you offset any outstanding balance with the amount of the former member’s capital credit account that is scheduled to be retired in that year. In addition, pursuant to Board policy, a former member’s capital credit account is fully retired by offset against any outstanding balance due for non-payment for electric services or by payout (or both) after the member has been a former member for seven years.

You would like to change your current policies so that you do not wait for seven years to fully retire a former member’s capital account balance if that former member has an outstanding balance from non-payment for electric services. You would like to use the outstanding balance in the former member’s capital credit account to offset any outstanding account balance for non-payment for electric services at the end of fiscal year Year and periodically thereafter.

After the offset occurs, you would retire the former member’s capital credit account in accordance with its normal retirement schedule if there is a residual balance in the capital credit account. In addition, you would cease all collection activities with respect to the former member’s debt to you. If the former member later pays you amounts in excess of any debt remaining in their account, you will return that payment to the former member. The offset to the former member’s outstanding bill would be made at the full amount of the capital credit amount retired. No discount will apply.

You request the following ruling:

The revised method for retiring former members’ capital credit accounts by offsetting the amounts of their capital credit accounts against outstanding debt they owe to you for provision of electric services on an accelerated basis will not adversely affect your tax-exempt status as a rural electric cooperative under I.R.C. § 501(c)(12).

LAW

Section 501(c)(12)(A) of the Code provides for the exemption from federal income tax of benevolent life insurance associations of a purely local character, mutual ditch or irrigation companies, mutual or cooperative telephone companies, or like organizations, but only if 85 percent or more of the income consists of amounts collected from members for the sole purpose of meeting losses and expenses.

Rev. Rul. 72-36, 1972-1 C.B. 151, describes certain basic characteristics an organization must have in order to be a cooperative organization described in § 501(c)(12)(A) of the Code. These characteristics include the following: A cooperative must keep adequate records of each member’s rights and interest in the assets of the organization. A cooperative must not retain more funds than it needs to meet current losses and expenses. The rights and interests of members in the organization’s savings must be determined in proportion to their business with the organization. A member’s rights and interests may not be forfeited upon the withdrawal or termination of membership. Upon dissolution, gains from the liquidation of assets should be distributed to all current and former members in proportion to the value or quantity of business that each did with the cooperative over the years.

The ruling also addresses a situation involving forfeiture of a former member’s rights and interests where the bylaws provide for such action upon withdrawal from the cooperative or termination. It states that even if forfeiture is permitted by the bylaws, the organization has not operated on a cooperative basis and should not be recognized as tax-exempt.

In Puget Sound Plywood, Inc. v. Commissioner, 44 T.C. 305 (1965), acq. 1966-1 C.B. 3, the court stated that an organization must meet certain common law requirements in order to be a cooperative. These common law requirements include: democratic control of the organization by members, the organization operates at cost for the benefit of members, and the contributors of capital to the organization do not control or receive most of the pecuniary benefits of the organization’s operations (i.e. subordination of capital).

DISCUSSION

Section 501(c)(12) of the Code provides for the federal tax exemption of cooperative telephone companies or like organizations, including other cooperative organizations not relevant here. While the term “cooperative” is not defined in I.R.C. § 501(c)(12) or the regulations thereunder, a cooperative has been traditionally and historically defined as a voluntary, membership business organization that is organized in response to the economic needs of and to perform services for its members, and not to realize monetary gains as a separate legal entity. A cooperative is organized and operated for the benefit of and is democratically controlled by its members. See Puget Sound Plywood v. Commissioner, 44 T.C. 305 (1965), acq. 1966-1 C.B. 3. Hence, to qualify for exemption under I.R.C. § 501(c)(12), an organization must be a cooperative and organize and operate as such. Puget Sound Plywood v. Commissioner describes the principles that are fundamental to the organization and operation of cooperatives. They are: (1) democratic control by the members, (2) operation at cost, and (3) subordination of capital. These principles apply to organizations described in I.R.C. § 501(c)(12).

Democratic control requires that the cooperative be governed by members and on a one-member, one-vote basis. Each member has a single vote regardless of the amount of business he or she does with the organization. The issue of democratic control is a question of fact.

Operation at cost requires that the cooperative’s net earnings or savings derived from furnishing services in excess of costs and expenses be returned to its members in proportion to the amount of business conducted with them. This principle ensures that a cooperative’s net savings from members are returned to members in proportion to the amount of business each transacts with the cooperative. A cooperative satisfies this requirement by making annual allocations of patronage to members.

Subordination of capital has two requirements. First, control of the cooperative and ownership of the pecuniary benefits arising from the cooperative’s business remains in the hands of the members rather than with non-patron equity investors. Second, the returns on equity investments must be limited. Hence, the net savings that accrue to the cooperative from the business activities it transacts with its members will largely inure to the benefit of those members rather than to its equity investors. The rationale for these limitations is to ensure that the cooperative remains faithful to its purpose — providing services at the lowest possible prices (or highest possible prices for a marketing cooperative) to its members and not to realize profits for capital. If it were otherwise, the emphasis then would likely be on protection of returns of equity capital rather than services to members, and this would destroy the basic purpose of cooperatives. See Puget Sound Plywood v. Commissioner, Inc., 44T.C. 305 (1965), acq. 1966-1 C.B. 3.

Rev. Rul. 72-36, supra, describes additional fundamental requirements for operation of cooperatives described in IRC. § 501(c)(12). It requires that a member’s rights and interest in the assets of a cooperative cannot be forfeited upon termination of membership. It also requires that upon dissolution, a cooperative must distribute any gains from the sales of its assets to those who were members during the period that the assets were owned.

A fundamental tenet of cooperative operation is that the earnings of a cooperative are allocated and ultimately distributed to its members based on the amount of business (patronage) done with those members. The amount a cooperative member pays for the cooperative’s services less the cost of providing such services is allocated to the member. Thus, the presumption is that the cooperative’s services are provided at cost to the members. But it is impractical for such a cooperative to return immediately all the amounts or earnings to its members because the cooperative needs to have reserves in order to operate, meet unexpected expenses, or to expand. These amounts or earnings are held by the cooperative for a certain period of time as prescribed by cooperative bylaws and are allocated as capital credits to accounts kept for each member. These capital credits are returned to the members or former members when the cooperative redeems them (i.e., sends a check for the amount of the capital credits) at the end of the prescribed time.

The primary issue raised by the change in method for retirement of capital account credits for certain former members is whether it violates any of the cooperative requirements described Puget Sound Plywood, Inc. v. Commissioner, Inc., 44 T.C. 305 (1965), acq. 1966-1 C.B. 3, and Rev. Rul. 72-36. The cooperative principle of democratic control by members is satisfied because the redemption of capital credit accounts of former members by offsetting the amounts in their capital credit accounts against any outstanding balance they owe the cooperative for provision of electric services will not affect member voting rights or governing rights. We also note that the cooperative (and its board of directors and management) has fiduciary duties to former members, and the former members can enforce their rights in the courts. See Lamesa Cooperative Gin v. Commissioner, 78 T.C. 894 (1982). The cooperative principle of operating at cost is satisfied because the members’ right to receive the excess (i.e. capital credits) over the cost of electricity service is also not adversely affected since they will receive full credit against a debt owed by them to the cooperative in return for the retirement of the amount in their capital credit account. The debt will be fully extinguished. If they later try to pay the former debt, that money will be returned to them. No collection against the extinguished amount will be attempted once the offset has taken place.

The cooperative principle of subordination of capital is satisfied because the proposed redemption program does not adversely affect the members’ control and ownership of the cooperative assets. The cooperative requirement that there is no forfeiture of former members’ rights to assets of the cooperative is not violated since the new policy does not impact this aspect of the cooperative’s operations.

Accordingly, based on the foregoing facts and circumstances, we rule as follows:

1. The revised method for retiring former members’ capital credit accounts by offsetting the amounts of their capital credit accounts against outstanding debt they owe to you for provision of electric services will not adversely affect your tax-exempt status as a rural electric cooperative under I.R.C. § 501(c)(12).

This ruling is conditioned on the understanding that there will be no material changes in the facts upon which it based. Also, we express no opinion as to the tax consequences of the transactions under other provisions of the Code or state laws.

This ruling will be made available for public inspection under I.R.C. § 6110 of the Code after certain deletions of identifying information are made. For details, see enclosed Notice 437, Notice of Intention to Disclose. A copy of this ruling with deletions that we intend to make available for public inspection is attached to Notice 437. If you disagree with our proposed deletions you should follow the instructions in Notice 437.

Pursuant to a Power of Attorney on file in this office, a copy of this letter is being sent to your authorized representative. A copy of this letter should be kept in your permanent records.

This ruling is directed only to the organization that requested it. I.R.C. § 6110(k)(3) of the Internal Revenue Code provides that it may not be used or cited by others as precedent.

If you have any questions about this ruling, please contact the person whose name and telephone number are shown in the heading of this letter. You should keep a copy for your permanent records.

Sincerely,

Stephen M. Clarke

Acting Manager,

Exempt Organizations

Guidance Group 1

Citations: LTR 201340017




IRS Lists Factors for Determining if Entity Is an Instrumentality of State or Local Government.

The IRS listed the six factors that it takes into consideration when determining whether an entity is an instrumentality of a state or local government within the meaning of section 3121(b)(7)(F) for employment tax purposes.

UIL: 3121.02-08

Release Date: 9/27/2013

Date: July 30, 2013

Refer Reply To: CC:TEGE:EOEG:ET2 – GENIN-130256-13

Dear * * *:

This is in response to your request for a general information letter dated June 21, 2013, concerning whether a wholly privately owned company can be a political subdivision or an instrumentality of a State or political subdivision within the meaning of Internal Revenue Code (Code) § 3121(b)(7)(F).

Section 3121(b)(7) was added to the Code by the Omnibus Budget Reconciliation Act of 1990. This section generally expands the definition of employment for purposes of the Federal Insurance Contributions Act to include service as an employee for a state or local government entity. Section 3121(b)(7) requires in relevant part that an “instrumentality” be “wholly owned” by the state, or any political subdivision thereof. The fact that employees of an entity are members of a § 3121(b)(7)(F) “retirement system” is not determinative of whether the entity is an instrumentality of a state or political subdivision. An entity that is wholly privately owned cannot qualify as an instrumentality of a state or political subdivision within the meaning of § 3121(b)(7).

In Revenue Ruling 57-128, 1957-1 C.B. 311, the Service provided the following six factors to be taken into consideration when determining whether an entity is an instrumentality of a state or local government within the meaning of § 3121(b)(7): (1) whether it is used for a governmental purpose and performs a governmental function; (2) whether performance of its function is on behalf of one or more states or political subdivisions; (3) whether there are any private interests involved, or whether the states or political subdivisions involved have the powers and interests of an owner; (4) whether control and supervision of the organization is vested in public authority or authorities; (5) if express or implied statutory or other authority is necessary for the creation and/or use of such an instrumentality, and whether such authority exists; and (6) the degree of financial autonomy and the source of its operating expenses.

If an entity cannot satisfy the factors of Revenue Ruling 57-128, the entity is not an instrumentality of a state or local government within the meaning of § 3121(b)(7) even if its employees participate in a retirement system maintained by a state or local government.

We hope this general information is helpful. If you have any questions, please contact * * * of my staff. * * * can be reached at * * *.

Sincerely,

Lynne Camillo

Branch Chief, Employment Tax

Branch 2

(Exempt Organizations/

Employment Tax/Government Entities)

(Tax Exempt & Government Entities)




IRS Explains Valuation Process for Charitable Contributions of Property Other Than Money.

The IRS explained that, for charitable contributions made in property other than money, the amount of the contribution is the fair market value of the property at the time of the contribution, reduced by a set amount; in some cases, taxpayers may claim a higher deduction by using the so-called enhanced deduction.

UIL: 170.00-00

Release Date: 9/27/2013

Date: September 10, 2013

Refer Reply To: CONEX-137437-13

The Honorable Bill Huizenga

Member, U.S. House of Representatives

4555 Wilson Avenue SW, Suite 3

Grandville, MI 49418

Attention: * * *

Dear Congressman Huizenga:

I am responding to your letter dated July 3, 2013, on the behalf of your constituent, * * *, * * *. He requested an exemption from the provisions of section 170(e)(3) of the Internal Revenue Code (the Code) that currently prohibits charging the recipient of the donated food for the food or the cost of its distribution.

A taxpayer may deduct any charitable contribution that is paid within the taxable year under section 170(a) of the Code. For a charitable contribution made in property other than money, the amount of the contribution is the fair market value of the property at the time of the contribution, reduced by an amount as stated in the Code and accompanying Income Tax Regulations (section 1.170A-1(c)(1)). In general, the deduction is limited to the lesser of the fair market value or the taxpayer’s basis in the contributed property.

There is an exception to this general rule: taxpayers can claim a higher deduction amount if they meet certain requirements, including that the donee cannot transfer contributed property in exchange for money, other property, or services (often called the “enhanced deduction,” section 170(e)(3)(A) of the Code). Therefore, according to the tax law, the enhanced deduction only applies if the recipient does not transfer the donated food to its clients in exchange for money, other property, or services.

We administer the tax law as enacted. Any change in the law would require legislative action by the Congress.

I hope this information is helpful. If you have any questions, please contact * * *, Identification Number * * *, at * * *.

Sincerely,

Norma C. Rotunno

Acting Branch Chief, Branch 2,

Office of Associate Chief Counsel

(Income Tax and Accounting)




Graev: Conditional Facade Easement.

Wendy C. Gerzog discusses Graev v. Commissioner, in which the Tax Court decided whether the taxpayer’s donations of a facade easement and cash contributions were conditional gifts and therefore disallowable as charitable deductions.

In Graev v. Commissioner, the Tax Court decided whether the taxpayers’ donations of a facade easement and cash contributions were conditional gifts and therefore disallowable as charitable deductions under the requirements of the regulations.

* * * * *

The Tax Court decided Graev v. Commissioner1 under fully stipulated facts. In 1999, the taxpayers, residents of New York City, purchased property listed in the National Register of Historic Places for $4.3 million, subject to a mortgage.

Pre-2004 case law is replete with disallowed facade easements either for overvaluation or unenforceability issues.2 Under Notice 2004-41,3 the government advised that it would be scrutinizing the substance of transactions involving real property purchases, charitable organizations, and conservation easements. One example mentioned in the notice described a charitable organization that bought property, placed a conservation easement on the property, and sold the property at a substantially reduced price to a buyer who made a cash “charitable donation” to the organization to reimburse the charity for its financial loss. In that instance, the notice stated that the government may treat the cash donation as part of the buyer’s purchase price instead of as a charitable gift.

Later, the National Architectural Trust (NAT), a charitable organization with a mission “to preserve historic architecture in metropolitan areas across the United States,”4 approached Mr. Graev to make a facade easement gift. Having qualms about the latest government ruling, Graev, an attorney, sought the advice of his accountant. Graev then e-mailed NAT with his concerns after the accountants urged caution and Graev asked for NAT’s “thoughts especially as it relates to the side letter.”5

The side letter was NAT’s letter to Graev explaining that it was NAT’s standard policy to refund the applicable portion of Graev’s donation if he couldn’t get the promised favorable charitable deduction. Specifically, the letter promised “to join with Graev to immediately remove the façade easement from the property’s title.”6 Referencing the assurance made by NAT both to Graev and to his neighbor, Graev executed the facade easement agreement on September 20, 2004.

A firm appraised the value of the facade easement at $990,000. At or near the end of 2004, Graev executed a deed that granted a facade easement to NAT and the deed was recorded on February 17, 2005. The conservation deed provided that the easement grant would facilitate preservation, in perpetuity, of the historic structure and of the public open space, but it also stated that the provisions of the deed were not intended to limit the grantee’s right “to abandon some or all of its rights hereunder.”7 The mortgagee joined in the easement agreement and agreed to subordinate its rights to the enforcement of the conservation easement; however, the mortgagee declared to have claims, superior to the grantee, to all insurance or condemnation proceeds.

In 2004 Graev made a total of $99,000 in cash contributions to NAT, as requested by the trust to subsidize NAT’s operating and future monitoring and administrative expenses. In 2005 NAT sent Graev a written acknowledgement of his easement and cash donations, together with the applicable tax forms to submit with his return. Also in 2005, NAT sent two letters to Graev: the first, apprising him of upcoming reforms, including penalties and fines, applicable to taxpayers, promoters, and appraisers involved in “significantly overvalued” facade easement donations; and the second, informing him that the refund offer “may adversely affect the deductibility of the cash contribution as a charitable gift.”8 Graev did not ask NAT to remove the refund feature of his donation.

After those NAT letters, the Graevs filed their income tax returns for 2004 and 2005, taking deductions for both the easement and the cash contribution to NAT.9 In its September 22, 2008, notice of deficiency, the government disallowed the taxpayers’ charitable deductions because the donations were made “subject to subsequent events.” The taxpayers contended that the side letter agreement was unenforceable under New York law and a nullity under federal tax law.

The court reviewed the facts to determine whether the gifts were conditional donations or whether the condition was allowed under the regulations10 because it was “so remote as to be negligible.” Moreover, as the court stated, “Section 170 and the corresponding regulations provide instruction and limitations that, at least in part, ensure that the donor will be able to deduct only what the donee organization actually receives.”11 The court reviewed the background of the applicable regulation’s language (“so remote as to be negligible”) and the identical language in an older estate tax regulation.12

The Supreme Court interpreted the estate tax regulation in Sternberger.13 Concerned that the donation must match what the charity actually received, the court stated that deductible gifts must be unconditional “unless the possibility that the charity will not take is ‘negligible’ or ‘highly improbable.'”14 Applying that standard, the Tax Court held that the deduction was only allowable if the possibility that NAT would lose its easement and cash was so remote that it was a negligible risk.

The legislative history of charitable split interests accords with that emphasis. Section 170(f)(3) was enacted in 1969 and denied a deduction for most partial interests in property, including conservation easements, but also allowed a donation of an open space easement in gross that was donated to a charity in perpetuity. It wasn’t until the 1976 Tax Reform Act that Congress amended section 170(f)(3) to create a deduction for a conservation easement. That provision was later revised and expanded in 1980 to include subsection (h), which defines a qualified conservation contribution. The regulations define the perpetuities requirement as ensuring that the potential for the divestment of the easement be so remote as to be negligible.

The court held that at the time of the easement and cash donations, the potential for the IRS to disallow those deductions and for NAT to remove the easement and return the cash to Graev was not so remote as to be negligible. Although Graev argued that case law at the time of the donation allowed for a donation of between 10 and 15 percent of the value of the property, and that he had deducted a value constituting 11 percent of the property’s appraised value, the court emphasized that at that date, the potential for IRS disallowance was not negligible and that valuation was a separate issue. Indeed, the court stated that Graev acted (for example, filing returns with the deductions and failing to remove the refund feature) in response both to the IRS notice indicating additional scrutiny applicable to overvalued facade easements and to NAT’s second letter warning of the government’s disallowance of a deduction for facade easement donations coupled with refund provisions.

Responding to the Graevs’ argument that the one example provided in Notice 2004-41 did not apply to their specific transaction, the court found that the notice advised more generally that donations relating to conservation easements would involve greater scrutiny, and that Graev was well aware of this intensified IRS examination, as indicated in his correspondence with his accountants. NAT agreed to return Graev’s contributions if the government disallowed deductions for them. Thus the court held that the risk of the government’s disallowing the deduction was “well above ‘negligible.'”15 According to the court, Graev required NAT’s letter with the refund feature before making his contribution. Also, NAT understood that an IRS disallowance was more than a remote possibility and that was why NAT would routinely issue comfort letters to potential donors.

The court explained that Graev misinterpreted the court’s ruling in O’Brien v. Commissioner,16 in which the taxpayers created a charitable remainder trust in 1964, appointing themselves trustees with broad management powers. The issue in the case was whether the donors had retained control sufficient to cause the gift to be incomplete. The return of their contributions was solely in the government’s act of disallowance regardless of the correctness of its action, placing “the contingency ‘within the control of the Commissioner.'”17 In O’Brien, the court held that the taxpayers had the right to first litigate their position so that the return contingency was not applicable unless the taxpayers lost. The court held that O’Brien did not even address the issue of a tax contingency under the section 170 regulations and “did not hold that a tax-treatment contingency can never be a subsequent event that will defeat a contribution and a deduction.”18

The court also rejected Graev’s argument that there was no possibility that NAT would return the property. The court analyzed New York’s conservation easement law and held that while NAT’s letter alone would not satisfy the state’s extinguishment requirements, the recorded deed sufficiently reserved NAT’s power to abandon the easement in compliance with New York law. Therefore, the court found that this possibility was “more than negligible.”19

Likewise, the court was unmoved by Graev’s contention that the doctrine of merger extinguished NAT’s refund letter. The court cited, as an exception to that principle, a clear intention by the parties to have a particular provision of a contract survive the deed. Graev required NAT’s letter before making his donation and thus the letter clearly qualified as an inducement for him to make the contribution. Even when NAT offered to rescind the letter, Graev declined that offer. Therefore, the court found that the parties intended the letter to survive the deed and that the doctrine of merger did not apply.

Finally, Graev argued that the letter was a nullity under Commissioner v. Procter.20 In Procter, a trust provided that a noncharitable gift would revert to the donor if a court later determined that the transfer would be subject to gift tax. The court held that the trust provision was void as contrary to public policy because it (1) discourages the government’s tax collection by nullifying the audit of returns; (2) renders the court’s decision moot by canceling the gift the court has adjudged; and (3) disturbs a final judgment.

The taxpayer in Procter had asserted that under the terms of the trust, the gift was not to become effective if a court found the transfer to be subject to the gift tax. However, the circuit court held that such a clause in the trust could not prevent the imposition of the gift tax because the clause would discourage the government’s tax collection and the gift tax should not be so easily avoided. Furthermore, the court refused to allow that kind of “trifling with the judicial process.”

The Tax Court in Graev held that Procter was inapplicable because recognizing that the refund feature in NAT’s letter would not prevent Graev from being taxed on his contribution would not undo a judicial decision, would not discourage tax collection, would not render the case moot, and would not undo the judgment in the case. The court concluded that at the time of the donation, the possibility that the IRS would disallow Graev’s deduction and that NAT would thereby return both the easement and cash contributions to Graev was not “so remote as to be negligible” in contravention of the regulations. Therefore, the court disallowed both donation deductions.

Analysis and Conclusion

It is ironic that the taxpayers in Graev cited to Procter to sustain their position. If anything, the facts in Graev reflect the very behavior so repugnant to the Procter court.

When a charitable donation is conditional on receiving a tax deduction, it is difficult to accept that the primary goal of the taxpayer is to make a gift to a charity. In United States v. American Bar Endowment,21 donative intent was central to allowing a charitable deduction. That is, while the charitable deduction is often an incentive for making or increasing a charitable gift, no one may contract with a charity to make a donation dependent on getting a tax benefit. If all charitable gifts were conditional on receiving a tax deduction, that limitation would place a heavy burden on charities. They would not know if they were receiving funds and could not rely on using those “donations” until several years in the future. Yet, of course, most donors actually want the charity to be able to apply their funds to the charity’s exempt purpose.

It is also difficult to value a conditional gift at its fair market value, because a transfer of property with a refund feature must surely be heavily discounted. Alternatively, if the gift is viewed as a precondition, the completed gift and deduction should not occur until the statute of limitations has run.

As a general policy matter, extending that notion would add extreme complexity to tax administration. What if, for example, payments of expenses were refundable on the condition of a deduction disallowance? What possible positive policy goal would that serve?

This case and others suggest reasons to eliminate the facade easement deduction. The reduction in value because of the easement is often more hypothetical than real. Adding a refund “guarantee” based on the tax benefits to the donor makes the transfer more a commercial transaction than a charitable gift.

FOOTNOTES

1 140 T.C. No. 17 (2013) .

2 Id., slip op. at 6-7, 8-9, n.5.

3 2004-28 IRB 31.

4 Graev, at 5.

5 Id. at 8. The side letter is also referred to as NAT’s comfort letter.

6 Id. at 11.

7 Id. at 13.

8 Id. at 15.

9 Their 2004 return was filed on October 10, 2005, wherein they deducted the full $99,000 cash contribution and $544,449 for the easement deduction, as limited by section 170(b)(1)(C). They deducted the remaining $445,551 on their 2005 return. Id. at 16-17.

10 Reg. section 1.170A-1(e), -7(a)(3), and -14(g)(3).

11 Id. at 19.

12 Reg. section 20.2055-2(b).

13 Commissioner v. Estate of Sternberger, 348 U.S. 187, 194 (1955).

14 Id. at 22.

15 Id. at 33.

16 46 T.C. 583 (1966), acq. 1968-1 C.B. 2.

17 Graev, op. at 37, citing O’Brien, at 591 (quoting Surface Combustion Corp. v. Commissioner, 9 T.C. 631, 655 (1947), aff’d, 181 F.2d 444 (6th Cir. 1950)).

18 Id. at 38.

19 Id. at 45.

20 142 F.2d 824 (4th Cir. 1944).

21 477 U.S. 105, 117-118 (1986) (“The sine qua non of a charitable contribution is a transfer of money or property without adequate consideration. The taxpayer, therefore, must at a minimum demonstrate that he purposely contributed money or property in excess of the value of any benefit he received in return.” Id.).

Copyright 2013 Wendy C. Gerzog.

All rights reserved.

Wendy C. Gerzog is a professor at the University of Baltimore School of Law.

 




ABA Meeting: IRS Official Listens as Proposed Bond Arbitrage Regs Are Panned.

An official in the IRS Tax-Exempt Bonds Office listened quietly September 20 while tax attorneys criticized proposed regulations (REG-148659-07) on arbitrage restrictions on tax-exempt bonds that his agency and Treasury just published.

Todd Mitchell, group manager for compliance and program management (tax-exempt bonds), IRS Tax-Exempt and Government Entities Division, spoke briefly in San Francisco at the beginning of the meeting of the American Bar Association Section of Taxation’s Tax-Exempt Financing Committee, providing an update on various projects his office is working on. But when the discussion turned to the proposed regs and private letter rulings, he took a seat in the audience, explaining that his superiors did not want him to take part in the conversation. He said nothing about the proposed regs except that comments are welcome.

Moderator Stefano Taverna of McCall, Parkhurst & Horton LLP called the proposed regs a “significant departure from what the understanding of the market is.” He and other practitioners complained about undefined terms in the proposed regs.

Practitioners seemed particularly concerned about the proposed removal of the definition of “substantial amount” of bonds sold to the public as 10 percent and its replacement by a safe harbor. The preamble to the regs states that under the safe harbor, an issuer could treat as the issue price the first price at which a minimum of 25 percent of the bonds in an issue (with the same credit and payment terms) is sold to the public, “provided that all orders at this price received from the public during the offering period are filled (to the extent that the public orders at such price do not exceed the amount of bonds sold).”

Taverna and other practitioners appeared unhappy with that approach. “They say that basically they are not redefining what a substantial amount is for purposes of issue price; they’re just providing a safe harbor under which issue price is defined,” he said. “So now that leaves, obviously, the other question unanswered, which is: What is a substantial amount? It’s been taken away from the regulations; nobody really knows what that means.”

Taverna said he and other practitioners met with Treasury officials shortly after the proposed regs’ September 16 publication and expressed their concerns about the guidance, including the 25 percent threshold, which he said is too high, and the difficulty in trying to ascertain when the mandatory 25 percent safe harbors hit. He said the officials were asked how they arrived at 25 percent.

“There are a lot of undefined terms in the regulations that I think need to be discussed,” Taverna said. “I think the Treasury is aware of all that, and they requested comments on every single item that we brought up.”

New TEB Director

Before the discussion of the proposed regs, Mitchell provided an update on other things TEB is working on. He said Rebecca Harrigal will be TEB’s new director; an IRS spokesman later confirmed that she will start that position October 6. Mitchell said Harrigal has a lot of experience in exempt bonds, including service as the branch chief for the bonds office in the IRS Office of Chief Counsel.

Examinations

Mitchell said TEB will continue its market segment examinations, which cover different types of bond issues. The amount of time spent on a particular segment depends on the characteristics of the segment, the volume of bond issuance in the segment, and the significance of the segment’s compliance issues, he explained.

Mitchell also said subject matter experts in each market segment will help examiners during the examination process, although he added that he thinks the first point of contact when an examination begins will continue to be the examiner. The idea behind using subject matter experts is to make the process more efficient, he said.




Nebraska Issuer Pays $350K to Settle BAB Dispute With IRS.

The Nebraska Public Power District has agreed to pay $350,000 to the Internal Revenue Service to settle a tax law dispute regarding $50.36 million of Build America Bonds it issued in 2009.

NPPD disclosed the settlement in an event notice filed on the Municipal Securities Rulemaking Board’s EMMA system. The agreement appears to be the first publicly disclosed settlement of a BAB tax dispute.

The IRS concluded that some of the district’s 2009 Series A general revenue bonds were sold in its initial public offering at a price greater than the de minimis amount of premium permitted under the tax law. NPPD said in the notice that it disagrees the IRS’ finding but decided to resolve the matter in a closing agreement. The resolution allows NPPD to continue getting its full subsidy payment from the U.S. Treasury.

Neither Christine Pillen, NPPD’s deputy assistant treasurer, nor lawyers at Fulbright & Jaworski LLP, which was bond counsel for the BABs and represented the NPPD before the IRS, would provide further details about the dispute.

The BABs program allowed state and local governments to issue taxable bonds in 2009 and 2010 and receive subsidy payments equal to 35% of the interest costs. Under the tax law, a bond cannot be treated as a BAB if the issue price has more than a de minimis amount of premium, generally defined as 0.25% of the stated redemption price at maturity multiplied by the number of complete years from the bond’s issue date to its maturity date.

Last year, NPPD disclosed that the IRS believed $10 million of these bonds did not qualify for the 35% subsidy, based on the IRS’ determination of the bonds’ issue price. The loss of the subsidy on the bonds would have been about $260,000 per year or $6.5 million over the term of the bonds, the NPPD said in a notice filed in October.

IRS officials have contended for months that the issue prices stated for some BABS in bond documents were not the actual issue prices because on the day the BABs were issued, they immediately began trading up at higher prices. As a result, the actual issue prices should have higher, exceeding the de minimis amounts, and Treasury’s subsidy payments to the issuers should have been lower, according to the IRS officials.

The $50.36 million of bonds were issued along with $100 million of 2009 Series B taxable revenue bonds and $17.89 million of 2009 Series C revenue bonds, according to the official statement. Proceeds from the Series A and C bonds were used to finance about $66.6 million of the costs of generation and other transmission capital additions, as well as to add to a reserve fund and pay for financing costs. Proceeds from the Series B bonds were used to finance about $24.8 million of the costs of additions to the Cooper Nuclear Station in Brownville, Neb., to refund about $69.5 million of taxable series notes, and to add to a reserve fund and pay financing costs, the offering document said.

The bonds were underwritten by a syndicate led by Morgan Stanley. John C. McClure served as the issuer’s counsel.

by: NAOMI JAGODA




S. 1523 Would Modify Qualified School Construction and Zone Academy Bonds

S. 1523, the Rebuilding America’s Schools Act, introduced by Senate Finance Committee member John D. Rockefeller IV, D-W.Va., would make the qualified school construction and zone academy bonds permanent, treat qualified zone academy bonds as specified tax credit bonds, and modify the treatment of zone academy bonds.

113TH CONGRESS

1ST SESSION

S. 1523

To amend the Internal Revenue Code to make permanent qualified school construction bonds and qualified zone academy bonds, to treat qualified zone academy bonds as specified tax credit bonds, and to modify the private business contribution requirement for qualified zone academy bonds.

IN THE SENATE OF THE UNITED STATES

SEPTEMBER 18, 2013

Mr. ROCKEFELLER (for himself, Mr. BROWN, Mr. HARKIN, and Mr. JOHNSON

of South Dakota) introduced the following bill; which was read twice

and referred to the Committee on Finance

A BILL

To amend the Internal Revenue Code to make permanent qualified school construction bonds and qualified zone academy bonds, to treat qualified zone academy bonds as specified tax credit bonds, and to modify the private business contribution requirement for qualified zone academy bonds.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the “Rebuilding America’s Schools Act”.

SEC. 2. QUALIFIED SCHOOL CONSTRUCTION BONDS.

(a) IN GENERAL. — Subsection (c) of section 54F of the Internal Revenue Code of 1986 is amended to read as follows:

“(c) NATIONAL LIMITATION ON AMOUNT OF BONDS DESIGNATED. — There is a national qualified school construction bond limitation for each calendar year after 2013 in the amount of $11,000,000,000.”.

(b) EFFECTIVE DATE. — The amendment made by this section shall apply to obligations issued after December 31, 2013.

SEC. 3. MODIFICATIONS RELATING TO QUALIFIED ZONE ACADEMY BONDS.

(a) LIMITATION MADE PERMANENT. — Paragraph (1) of section 54E(c) of the Internal Revenue Code of 1986 is amended to read as follows:

“(1) NATIONAL LIMITATION. — There is a national zone academy bond limitation for each calendar year after 2013 in the amount of $1,400,000,000.”.

(b) MODIFICATION OF PRIVATE BUSINESS CONTRIBUTION REQUIREMENT. — Subsection (b) of section 54E of such Code is amended —

(1) by striking “if the eligible local education agency” and inserting “if —

“(1) the eligible local education agency”, and

(2) by striking the period at the end and inserting “, or

“(2) the issue will be pooled with other such issues through the acquisition by, or the sponsorship or assistance of, a private, nonprofit corporation established in the District of Columbia and specifically recognized by Congress for the purpose of leveraging resources and stimulating private investment in education technology infrastructure.”.

(c) DIRECT PAYMENT OPTION. — Clause (iii) of section 6431(f)(3)(A) of such Code is amended by striking “54E)” and all that follows and inserting “54E), or”.

(d) EFFECTIVE DATE. — The amendments made by this section shall apply to obligations issued after December 31, 2013.




IRS: Empowerment Zones Designations Continue Through the End of the Year.

WASHINGTON – The IRS today announced that all empowerment zone designations remain in effect through the end of the year. Empowerment Zones are certain urban and rural areas where employers and other taxpayers qualify for special tax incentives.

In May, the IRS issued Notice 2012-38 to address the relevant provision of the American Taxpayer Relief Act of 2012. Notice 2013-38 provided that any nomination for an empowerment zone in effect on Dec. 31, 2009, will have a new termination date of Dec. 31, 2013, unless the governing state or municipality declined the extension in a notification to the IRS. The deadline for notification was July 29, 2013, and no state or municipality contacted the IRS to decline the extension. Therefore, all empowerment zone designations in effect on Dec. 31, 2009, remain in effect through Dec. 31, 2013.

Empowerment Zones were created by legislation enacted in 1993, and most zones had an expiration date of Dec. 31, 2009. Subsequent legislation extended the expiration dates to Dec. 31, 2011, and then Dec. 31, 2013.

The American Taxpayer Relief Act of 2012 did not provide for the extension of the designation for the District of Columbia enterprise zone, and therefore that designation ended on Dec. 31, 2011.

For more information and complete lists of empowerment zone locations, see Form 8844, Empowerment Zone Employment Credit. http://www.irs.gov/uac/Form-8844,-Empowerment-Zone-and-Renewal-Community-Employment-Credit

IR-2013-78, Sept. 27, 2013




Treasury Responds to Senators' Concerns About Health Plan Fee for Tax-Exempt, Nonprofit Hospitals.

Treasury Assistant Secretary for Legislative Affairs Alastair Fitzpayne has explained to Sen. Sherrod Brown, D-Ohio, and other Democratic senators that proposed rules (REG-118315-12) on the annual health insurer fee under the Affordable Care Act require nonprofit, tax-exempt hospitals to take into account only a portion of their net premiums when calculating the fee.

September 12, 2013

The Honorable Elizabeth Warren

United States Senate

Washington, DC 20510

Dear Senator Warren:

Thank you for your follow up letter regarding the annual health insurer fee under section 9010 of the Patient Protection and Affordable Care Act. We received several comment letters on the proposed regulations, which were issued on March 1, 2013, from stakeholders regarding the issue raised in your letter. We are carefully considering these comments as we work to finalize the regulations.

As I mentioned in my response to your previous letter on this topic, proposed regulations on the annual health insurer fee reiterate the rule provided in the statute. Under the statute, the fee does not apply to the first $25 million of net premiums written, and it only applies to 50 percent of the net premiums written for amounts between $25 million and $50 million. After application of this rule and in accordance with the statute, the proposed regulations provide that a covered entity exempt from tax under section 501(a) and described in section 501(c)(3) (generally, a charity), 501(c)(4) (generally, a social welfare organization), section 501(c)(26) (generally, a high-risk health insurance pool), or section 501(c)(29) (a consumer operated and oriented plan health insurance issuer) will be required to take into account only 50 percent of its remaining net premiums written that are attributable to its exempt activities.

We appreciate the concerns expressed in your letter regarding the way the fee will be applied, and we look forward to working with you and your staff on these and other important ACA implementation issues.

Sincerely,

Alastair M. Fitzpayne

Assistant Secretary for Legislative




Tax Court Finds Facade Easement Appraisal Was Qualified After Reconsideration.

The Tax Court, in light of a change in law, held that the appraisal of development rights and a facade easement donated by a couple was a qualified appraisal under reg. section 1.170A-13(c)(3), allowing the court to decide later whether the couple was entitled to the charitable contribution deduction for the facade easement donation.

Citations: Barry S. Friedberg et ux. v. Commissioner; T.C. Memo. 2013-224; No. 9530-09

BARRY S. FRIEDBERG AND CHARLOTTE MOSS,

Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent*

UNITED STATES TAX COURT

Filed September 23, 2013

Kathleen M. Pakenham, for petitioners.

Robert W. Mopsick, for respondent.

SUPPLEMENTAL MEMORANDUM OPINION

WELLS, Judge: Respondent determined a deficiency of $1,321,250 and a penalty pursuant to section 6662(h)1 of $528,500 with respect to petitioners’ 2003 [*2] tax year. In a prior opinion filed September 3, 2011, Friedberg v. Commissioner, T.C. Memo. 2011-238, 2011 WL 4550136 (prior opinion), we granted partial summary judgment on the issue of whether the appraisal report prepared by Michael Ehrmann of Jefferson & Lee Appraisals, Inc., and attached to petitioners’ 2003 joint Federal income tax return (Ehrmann appraisal) was a qualified appraisal as defined in section 1.170A-13(c)(3), Income Tax Regs. We held that the Ehrmann appraisal was not a qualified appraisal as it related to petitioners’ facade easement. We further held that there remained issues of material fact regarding whether the Ehrmann appraisal was a qualified appraisal as it related to petitioners’ transfer of development rights. Petitioners move the Court, pursuant to Rule 161, to reconsider our prior opinion.

BACKGROUND

Many of the underlying facts are set out in detail in our prior opinion and are incorporated herein by reference. We summarize the factual and procedural background briefly here and make additional findings as required for our ruling on petitioners’ motion for reconsideration. The facts are based upon examination of [*3] the pleadings, moving papers, responses, and attachments, including numerous affidavits supplied by petitioners. Petitioners are husband and wife who resided in New York at the time they filed their petition.

During 2002, Mr. Friedberg purchased a residential townhouse in New York City on East 71st Street between Park Avenue and Lexington Avenue (subject property) for $9,400,000, and then paid approximately an additional $4 million for extensive renovations. The subject property is in Manhattan’s Upper East Side Historic District. On October 15, 2003, the National Park Service determined that the subject property “contributes to the significance of the * * *[Upper East Side Historic District] and is a ‘certified historic structure’ for a charitable contribution for conservation purposes in accordance with the Tax Treatment Extension Act of 1980.”

During 2003, the National Architectural Trust (NAT) contacted Mr. Friedberg to ask him to donate an easement on the subject property. Mr. Friedberg met with Sean Zalka, a representative from NAT, to discuss donating a facade easement and development rights related to the subject property. Mr. Zalka then sent Mr. Friedberg a spreadsheet that provided an estimate of the tax savings available to Mr. Friedberg should he decide to donate to NAT the facade easement [*4] and development rights for the subject property. Mr. Zalka’s spreadsheet read as follows:

THE NATIONAL ARCHITECTURAL TRUST

Profile of Estimated Tax Benefit1

134 East 71st Street (Development Rights Extinguished)

_____________________________________________________________________

 

Estimated Fair Market Value                              $13,000,000

Conservation Easement Value (11% of FMV)2                $ 1,430,000

Estimated Development Rights Value                       $ 2,070,000

(See Development Rights Analysis Worksheet)

Total Estimated Gross Tax Deduction                      $ 3,500,000

Tax-Deductible Cash Donations                            $   350,000

(10% of Gross Tax Deduction)

Appraisal                                                $    16,000

Lender Subordination Fee (if applicable)

Total Estimated Tax-Deductible Costs                     $   366,000

Total Estimated Charitable Contribution                  $ 3,866,000

Tax Deduction

Total Estimated Federal, State and City                  $ 1,643,050

Income Tax Savings (42.5% Tax Bracket)

Total Estimated Cash Savings                             $ 1,277,050

___________________________________________________________________

FOOTNOTES TO TABLE

1 For illustrative purposes only. Please consult your

tax advisor.

2 Actual figure determined by appraisal, typically 11%

of FMV for comparable properties.

END OF FOOTNOTES TO TABLE

[*5] After reviewing NAT’s materials, Mr. Friedberg decided to donate to NAT a facade easement and all of the development rights associated with the subject property.

Mr. Friedberg followed NAT’s recommendation and engaged Michael Ehrmann of Jefferson & Lee Appraisals, Inc., based in Pittsburgh, to appraise the subject property. Mr. Ehrmann visited the subject property and conducted an inspection during November 2003 and subsequently prepared the Ehrmann appraisal, which states that it “has been prepared for tax purposes, in order to determine the loss of value due to a facade easement to be donated on the subject property.” The Ehrmann appraisal includes a number of pages of background on the economic, social, cultural, environmental, and political forces that influence property values in New York City.

On the basis of the lot’s location in an R9X zoning district, permitting a “floor area ratio”2 (FAR) of 9.0 for residential property, Mr. Ehrmann calculated [*6] that the lot had a maximum development potential of 20,786.94 square feet, approximately 13,731 square feet of which was unused.3 Mr. Ehrmann wrote:

Although the underlying zoning would permit expansion of the subject property up to the maximum development potential, I believe that the New York City Landmarks Preservation Commission, which has authority over the Upper East Side Historical [sic] District, would block such an expansion. However, the subject owner clearly has the right to transfer/see [sic] these development rights for use on neighboring blocks within the Historical District. Furthermore, I believe that developments utilizing Transferable Development Rights (TDR) would [be] feasible in this area, particularly along Lexington Avenue.

New York statutes define transfer of development rights (TDR) as “the process by which development rights are transferred from one lot, parcel, or area of land in a sending district to another lot, parcel, or area of land in one or more receiving districts.” * * *

In many TDR programs, the zoning provisions applicable to the sending district are amended to reduce the density at which land can be developed. While losing their right to develop their properties at the formerly permitted densities, property owners in the sending district are awarded development rights. These development rights are regarded as severable from the land ownership and transferable by their owners. * * *

[*7] The Ehrmann appraisal then describes different aspects of transferable development rights programs in general, without any reference to the particular program implemented in New York City.

Mr. Ehrmann found that the “sales comparison approach” was the most appropriate valuation method for estimating the market value of the subject property before and after the donation. He wrote: “In the following sections of this report, I have estimated the market value of the subject property both before and after donation of the proposed easement utilizing the Sales Comparison Approach to value.” Mr. Ehrmann used the following sales to estimate the before value of the subject property:

Price                Histo-

per                  ric

Square     square    Adjusted   dis-

Date         Address       Sale price   feet       foot      $/sq ft    trict?

______________________________________________________________________________

 

4/15/03  36 East 67th St   $9,750,000   16,235   $1,216.51   $1,655.80   Yes

3/26/03  631 Park Ave       9,650,000    5,143    1,876.34    1,778.20   Yes

1/17/03  151 East 72d St    8,187,500    5,885    1,391.25    1,701.13   No

1/15/03  123 East 73d St   10,250,000    8,625    1,188.41    1,775.24   Yes

8/26/02  54 East 92d St     9,000,000    4,320    2,083.33    2,595.79   No

6/17/02  10 East 87th St    8,200,000    8,791      932.77    1,609.16   No

5/6/02   46 East 69th St   10,250,000    8,500    1,205.88    1,755.77   Yes

2/16/02  20 East 73d St    17,000,000    9,345    1,819.15    2,281.21   Yes

2/14/02  10 East 75th St    8,250,000    8,930      923.85    1,527.13   Yes

Mr. Ehrmann adjusted those sale prices to take into account differences between those properties and the subject property due to the following factors: time of [*8] sale; location; condition of the property; size; and whether the property included a finished basement. Although the properties were subject to different zoning, Mr. Ehrmann did not make any adjustments on that basis because, he wrote: “I do not believe that the varying zones have an impact on subject value.” After making all of his adjustments, Mr. Ehrmann averaged the adjusted prices and arrived at $1,853.27 per square foot, which he rounded to $1,855 and used as his estimate for the value of the subject property as of the appraisal date. On the basis of the subject property’s gross floor area of 7,056 square feet, Mr. Ehrmann estimated that the subject property’s total value was $13,090,000.

In addition to estimating the subject property’s fair market value, Mr. Ehrmann sought to appraise the development rights that “could be transferred to a nearby property s [sic] as TDRs.” To do so, he identified five transfers involving development rights on the east side of Manhattan. Three of the five transfers involved the sale of development rights by themselves; the other two each involved the sale of an entire tract that included development rights previously acquired. Mr. Ehrmann calculated the price per FAR foot for each of the sales and then averaged those figures to reach an average of $154 per FAR foot. He then considered some general categories of adjustments, including time, location, size, zoning, and historic restrictions. With regard to historic restrictions, he wrote:

[*9] The subject is part of the Upper East Side Historic District, with significant historic restrictions. None of the previous improvements on the comparable sites had a similar status. Furthermore, there do not appear to be historically protected properties in the immediate vicinities of the TDR comparables. As discussed previously, the subject TDRs can only be utilized in a limited geographic area near the site. However, the TDRs transferred to the comparable properties do not appear to have had the same restriction.

I believe that the restrictions on the subject TDRs make these development rights somewhat less valuable than the apparently unrestricted rights purchased in the comparable transactions.

Mr. Ehrmann’s comments reflect the fact that none of the other properties he considered was in a historic district. The average price per FAR foot of the comparable properties Mr. Ehrmann reported on was $154. However, Mr. Ehrmann estimated that the value of the unused development rights on the subject property was $170 per FAR foot. He explained his reasoning as follows:

I have identified five adjustment factors applicable to the TDR comparables. Three of the factors — time, location, and size of the TDR — support upward adjustments of a number of the comparable unit prices. The two other factors — zoning and landmark limitations — support downward adjustments of all of the comparable unit prices.

TDR transactions are complex. I have not made specific adjustments of each comparable for each adjustment factor discussed above. However, based on the overall adjustments, I estimate that the value of the TDRs on the subject property as of $170.00 per FAR foot.

[*10] Mr. Ehrmann calculated that the total value of the unused development rights associated with the subject property was $2,335,000. He then added that value to his before estimate of the value of the subject property to arrive at a total value for the subject property of $15,425,000.

The second half of the Ehrmann appraisal provides an estimate of the value of the subject property after the facade easement. In an introduction, Mr. Ehrmann explained that there are several reasons property values are negatively affected by facade easements. One of the factors he listed was “the loss of the right to develop the property up to the maximum density allowed under the subject zone.” Other factors included potentially increased maintenance costs, loss of flexibility in changing exterior design, and the inability of future owners to use the tax advantages from an easement contribution. Mr. Ehrmann noted:

The best measure of the impact of these elements on property values is the market place [sic]. I have been able to identify a number of examples of the impact of easements on properties in both New Orleans and Washington, two cities where facade easements have been most actively used.

Mr. Ehrmann provided six examples of sales of eased properties in Washington, D.C., during the mid-1980s and two examples of transactions involving eased properties in New Orleans during the mid-1990s. Mr. Ehrmann constructed the [*11] following table to summarize his research on sales of comparable properties involving facade easements:

Property #                         Easement loss

_____________________________________________________________________

 

1                                  27.9%

2                                  18.3%

3                                   8.9%

4                                  18.6%

5                                  22.5%

6                                     8%

7                  30-40% increase in renovation costs

8                                   11+%

The average facade “easement loss” of the six sales of eased properties (i.e., properties 1 through 6, the Washington, D.C., sales) was 17.4%. However, Mr. Ehrmann estimated that the facade easement on the subject property decreased its value by 11%. He provided the following analysis to explain his reasoning:

The comparable data shows estimated losses ranging from 8% to 27.9%. The residential properties had losses ranging from 8% to 22.5%. Most of the examples that I have identified took place during the 1980s, when the facade easement programs in both Washington and New Orleans were relatively new. Comparables #7 and #8 are based on recent market developments.

The subject property is a residential dwelling in excellent condition and degree of finish. Based on the comparable data, with particular emphasis on Eased Property #8, I estimate that [the] facade easement will result in a loss of value of 11% of the value of the actual subject improvement before donation of the easement.

[*12] On the basis of his estimate of 11%, Mr. Ehrmann calculated that the facade easement would reduce the value of the subject property by $1,439,000, which he rounded to $1,440,000. He stated that after the easement the unused development rights would have no value. He therefore estimated that the “after” value of the subject property was $11,650,000. Mr. Ehrmann concluded that the loss in value due to the facade easement was $3,775,000.4

Petitioners timely filed their joint 2003 Federal income tax return. They deducted $3,775,000 for the donation of the facade easement and development rights on the subject property. Petitioners appended Form 8283, Noncash Charitable Contributions, signed by Mr. Ehrmann and by the president of NAT. Petitioners also attached to their tax return a copy of the Ehrmann appraisal. On or about January 23, 2009, respondent mailed to petitioners’ last known address a statutory notice of deficiency. Petitioners timely filed their petition with this Court on April 20, 2009.

During December 2010, each party filed a motion for partial summary judgment. Petitioners moved that, inter alia, the Court grant summary judgment that the Ehrmann appraisal of the value of the easement was a “qualified [*13] appraisal” within the meaning of section 1.170A-13(c)(3), Income Tax Regs. Respondent moved that the Court grant summary judgment that petitioners are not entitled to a charitable contribution deduction related to their 2003 donation of the facade easement and development rights because, inter alia, “petitioners failed to substantiate their deduction * * * as required by section 155(a) of the Deficit Reduction Act of 1984, Pub. L. 98-369, 98 Stat. 691, (“DEFRA”) and Treas. Reg. § 1.170A-13(c).” Specifically, we were asked to determine whether the Ehrmann appraisal included the “method of valuation” and the “specific basis for the valuation” pursuant to section 1.170A-13(c)(3)(ii)(J) and (K), Income Tax Regs.

On October 3, 2011, we issued our prior opinion addressing the parties’ cross-motions for partial summary judgment. Relying in part on Scheidelman v. Commissioner, T.C. Memo. 2010-151, 2010 WL 2788205 (Scheidelman I), vacated and remanded, 682 F.3d 189 (2d Cir. 2012), we held that petitioners were not entitled to a deduction for the donation of the facade easement because the Ehrmann appraisal was not a “qualified appraisal” pursuant to section 1.170A-13(c)(3), Income Tax Regs., with respect to its valuation of the facade easement. Accordingly, we granted respondent’s motion for partial summary judgment with respect to that issue. However, with respect to the valuation of the development rights, we concluded that disputed issues of material fact remained as [*14] to whether the Ehrmann appraisal was a qualified appraisal. Accordingly, we denied both parties’ motions for partial summary judgment with respect to that issue.

On June 15, 2012, the U.S. Court of Appeals for the Second Circuit vacated our decision in Scheidelman I and remanded the case. Scheidelman v. Commissioner, 682 F.3d 189 (2d Cir. 2012) (Scheidelman II). On July 17, 2012, respondent deposed Mr. Ehrmann in the presence of petitioners’ counsel. During the deposition Mr. Ehrmann stated that he had never appraised other transferrable development rights before issuing the Ehrmann appraisal and that Mr. Friedberg knew of this fact.

On August 1, 2012, petitioners moved the Court to reconsider our prior opinion because of the change in law governing the issues noted above. On September 7, 2012, respondent filed a response to petitioners’ motion for reconsideration.

DISCUSSION

Reconsideration under Rule 161 is intended to correct substantial errors of fact or law and allow the introduction of newly discovered evidence that the moving party could not have introduced, by the exercise of due diligence, in the [*15] prior proceeding. See Knudsen v. Commissioner, 131 T.C. 185 (2008); Estate of Quick v. Commissioner, 110 T.C. 440, 441-442 (1998). We have broad discretion as to whether to grant a motion for reconsideration, but will not do so unless the moving party can point to unusual circumstances or substantial error. Estate of Quick v. Commissioner, 110 T.C. at 441-442; see also Vaughn v. Commissioner, 87 T.C. 164, 166-167 (1986). “Reconsideration is not the appropriate forum for rehashing previously rejected legal arguments or tendering new legal theories to reach the end result desired by the moving party.” Estate of Quick v. Commissioner, 110 T.C. at 441-442.

However, an intervening change of controlling law may warrant our exercising that discretion. See Doe v. N.Y.C. Dep’t of Soc. Servs., 709 F.2d 782, 789 (2d Cir. 1983); see also Alioto v. Commissioner, T.C. Memo. 2008-185, 2008 WL 2945349, at *8. We based our prior opinion in part on a similar legal analysis as that contained in Scheidelman I. The U.S. Court of Appeals for the Second Circuit vacated and remanded Scheidelman I, see Scheidelman II, 682 F.3d 189, and, absent stipulation to the contrary, this case is appealable to that court. In accordance with Golsen v. Commissioner, 54 T.C. 742, 757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971), we conclude that the decision by the Court of Appeals [*16] in Scheidelman II specifically alters the underlying law and, therefore, requires that we reconsider our prior opinion.

Petitioners ask us to reconsider whether the Ehrmann appraisal met the requirements of a “qualified appraisal” pursuant to section 1.170A-13(c)(3)(ii)(J) and (K), Income Tax Regs., with respect to both the facade easement and the development rights. We address each issue in turn.

I. Facade Easement

In our prior opinion we determined that Mr. Ehrmann’s approach to valuing the subject property after the facade easement donation diverged significantly from the accepted comparable sales method, which was the method Mr. Ehrmann claimed to apply. We determined that Mr. Ehrmann instead used sale and nonsale transactions of eased properties in locations other than New York City, which is the site of the subject property, to estimate a percentage diminution in value associated with a facade easement. Mr. Ehrmann then multiplied the before value of the subject property, the calculation of which respondent did not contest, by the percentage diminution that he purported to derive from the transactions noted above to estimate the loss in value on account of the facade easement.5 In [*17] Scheidelman I, we held that the mechanical application of a percentage diminution to the fair market value before donation of a facade easement does not constitute a method of valuation as contemplated under section 1.170A-13(c)(3), Income Tax Regs. Scheidelman I, 2010 WL 2788205, at *9. Accordingly, our prior opinion in this case held, consistent with our decision in Scheidelman I, that the Ehrmann appraisal was not a qualified appraisal with respect to the facade easement because it lacked a method and specific basis for the determined value.

The U.S. Court of Appeals for the Second Circuit vacated this Court’s decision in Scheidelman I and remanded the case. See Scheidelman II, 682 F.3d 189. Concerning whether an appraisal includes the method of valuation as required by section 1.170A-13(c)(3)(ii)(J), Income Tax Regs., the Court of Appeals in Scheidelman II stated:

For the purpose of gauging compliance with the reporting requirement, it is irrelevant that the * * * [Commissioner] believes the method employed was sloppy or inaccurate, or haphazardly applied * * *. The regulation requires only that the appraiser identify the valuation method “used”; it does not require that the method adopted be reliable. * * * By providing the information required by the regulation, * * * [the appraiser] enabled the * * * [Commissioner] to evaluate his methodology.

[*18] Id. at 196-197 (fn. ref. omitted). The Court of Appeals held that “the Commissioner’s interpretation, that an unreliable method is no method at all, goes beyond the wording of the regulation, which imposes only a reporting requirement.” Id. n.6. Concerning whether an appraisal includes the specific basis for the valuation as required by section 1.170A-13(c)(3)(ii)(K), Income Tax Regs., the Court of Appeals stated that the purpose of that reporting regulation was to provide the Commissioner with “sufficient information to evaluate the claimed deduction and ‘deal more effectively with the prevalent use of overvaluations.'” Id. at 198 (quoting Hewitt v. Commissioner, 109 T.C. 258, 265 (1997), aff’d, 166 F.3d 332 (4th Cir. 1998)). The Court of Appeals held that the requirement of section 1.170A-13(c)(3)(ii)(K), Income Tax Regs., is fulfilled if the appraiser’s analysis is present, even if the Commissioner deems it to be unconvincing. Scheidelman II, 682 F.3d at 198.

In their motion for reconsideration, petitioners contend that the Ehrmann appraisal included a method of valuation because it supplied enough information to enable the Commissioner to evaluate his methodology and showed how he applied the method. Petitioners acknowledge that we previously concluded that Mr. Ehrmann’s stated method was improperly applied and unreliable but contend that reliability is not a factor for purposes of determining whether the Ehrmann [*19] appraisal is a qualified appraisal. Respondent opposes petitioners’ motion for reconsideration with respect to the facade easement and contends that (1) petitioners misstate the proper standard articulated by the Court of Appeals in Scheidelman II, (2) the Ehrmann appraisal is not a qualified appraisal even if we apply the standard that petitioners advocate, and (3) the Ehrmann appraisal fails to include a specific basis for valuation.6 We disagree with all three of respondent’s contentions.

Respondent first contends that petitioners misstate the standard that the Court should apply and that the proper standard is to determine whether the method of valuation stated in the appraisal is the method actually used by the [*20] appraiser. We disagree. In Scheidelman II, 682 F.3d at 197, the Court of Appeals stated that the relevant question is whether the information provided “enabled the * * * [Commissioner] to evaluate * * * [the appraiser’s] methodology”. See also Rothman v. Commissioner, T.C. Memo. 2012-218, 2012 WL 3101513, at *4. Moreover, the Court of Appeals clarified that “it is irrelevant that the * * * [Commissioner] believes the method employed was sloppy or inaccurate, or haphazardly applied”. Scheidelman II, 682 F.3d at 197 (emphasis added). Scheidelman II is clear; the regulations are a reporting requirement. Id. at 197 & n.6. Thus, pursuant to Scheidelman II, any evaluation of accuracy is irrelevant for purposes of deciding whether the appraisal is qualified pursuant to section 1.170A-13(c)(3)(ii)(J), Income Tax Regs.

Respondent also contends that the Ehrmann appraisal fails to enable respondent to evaluate Mr. Ehrmann’s methodology. Respondent argues that the Ehrmann appraisal “merely set forth certain disconnected and meaningless steps that Mr. Ehrmann took” and that “the 11% value was arrived at in spite of his research.” While we note that we previously determined that “[n]othing in Mr. Ehrmann’s report supports his conclusion about the after value of the subject property”, Friedberg v. Commissioner, 2011 WL 4550136, at *15, we concede that reaching that determination first required us to evaluate Mr. Ehrmann’s [*21] methodology. Although we continue to question whether the Ehrmann appraisal is reliable or properly applied methodology to reach its conclusions, we conclude that it provides sufficient information to enable respondent to evaluate Mr. Ehrmann’s underlying methodology. Accordingly, we conclude that the Ehrmann appraisal includes a method of valuation as required by section 1.170A-13(c)(3)(ii)(J), Income Tax Regs., with respect to the facade easement.

Regarding the requirements of section 1.170A-13(c)(3)(ii)(K), Income Tax Regs., respondent contends that the Ehrmann appraisal did not provide a specific basis for the valuation because it lacked reasoned analysis and arrived at the value of the facade easement in spite of Mr. Ehrmann’s research, not because of it. The Court of Appeals held that there is a specific basis for the valuation if the appraiser’s analysis is present, even if the Commissioner deems it unconvincing. Scheidelman II, 682 F.3d at 198 (“The Commissioner may deem * * * [the appraiser’s] ‘reasoned analysis’ unconvincing, but it is incontestably there.”). As we stated in our prior opinion, the Ehrmann appraisal compared eight different properties with facade easements, for which Mr. Ehrmann allegedly considered, inter alia, each property’s location, size, local government laws and regulations, use, date of easement, appreciation of value, and improvements. Although we criticized and disagreed with Mr. Ehrmann’s analysis, it was “incontestably there”. [*22] See id. Indeed, respondent’s own argument concedes that the Ehrmann appraisal contained some research and analysis because respondent concludes that value was determined in spite of that research. Accordingly, we conclude that the Ehrmann appraisal includes a specific basis for Mr. Ehrmann’s valuation as required by section 1.170A-13(c)(3)(ii)(K), Income Tax Regs., with respect to the facade easement.

Consequently, pursuant to Scheidelman II, we conclude that the Ehrmann appraisal is a qualified appraisal pursuant to section 1.170A-13(c)(3)(ii), Income Tax Regs., with respect to petitioners’ facade easement. However, we specifically do not opine on the reliability and accuracy of the methodology and specific basis of valuation in the Ehrmann appraisal, a matter we leave to be decided at trial.

II. Development Rights

In our prior opinion we determined that Mr. Ehrmann’s method of using five comparable transactions involving development rights to estimate the value of the subject property’s unused development rights was inconsistent and contained mathematical errors and erroneous assumptions. Although we determined that Mr. Ehrmann claimed to be applying the comparable sales method to calculate a price per square foot of the development rights, we were not convinced that the comparable sales transactions were truly comparable. Instead of comparing the [*23] purchase prices per square foot for additional development rights, Mr. Ehrmann compared prices per square foot of properties that included no additional development rights or averaged prices per square foot for both development rights attached to the property and additional development rights. However, we determined that the Ehrmann appraisal nonetheless explained the method and specific basis of valuation with respect to the development rights. Because we questioned the Ehrmann appraisal’s accuracy and reliability and whether it adequately evaluated the market demand for and transferability of development rights, we held that issues of material fact remained regarding whether the Ehrmann appraisal was a qualified appraisal with respect to the development rights.7

In their motion for reconsideration, petitioners contend that our prior opinion concludes that the Ehrmann appraisal included the method of valuation and specific basis for the valuation of the development rights. Petitioners contend that remaining issues of material fact, which caused us to deny petitioners’ motion for summary judgment with respect to this issue in our prior opinion, are relevant [*24] only to determining the value of the development rights and not to determining whether the Ehrmann appraisal is qualified under the Scheidelman II analysis. We agree with petitioners. Under Scheidelman II, section 1.170A-13(c)(3)(ii)(J) and (K), Income Tax Regs., “imposes only a reporting requirement” and the taxpayer only needs to include sufficient information to allow the Commissioner to evaluate the methodology and specific basis for valuation. Scheidelman II, 692 F.3d at 196-198, n.6. In our prior opinion, we stated that, despite errors, the Ehrmann appraisal “explained the method of valuation and the specific basis for the valuation” of the development rights. Friedberg v. Commissioner, 2011 WL 4550136, at *22. The remaining issues of material fact (e.g., the effect of the market demand, the transferability of the development rights, and the accuracy and reliability of the Ehrmann appraisal) are relevant to our analysis of valuation but are irrelevant as to whether the Ehrmann appraisal is [*25] qualified pursuant to section 1.170A-13(c)(3), Income Tax Regs.8 See Scheidelman II, 692 F.3d at 196-198.

Respondent does not object to petitioners’ motion for reconsideration with respect to whether the Ehrmann appraisal is a qualified appraisal of development rights but contends that we should consider additional factual developments that have arisen since our prior opinion and, in result, grant summary judgment to respondent. Specifically, respondent contends that, at a deposition after our prior opinion, Mr. Ehrmann confirmed that he had never appraised other transferrable development rights before issuing the Ehrmann appraisal and that Mr. Friedberg knew of this fact. Consequently, respondent contends that Mr. Ehrmann was not a qualified appraiser of transferable development rights pursuant to section 1.170A-13(c)(5), [*26] Income Tax Reg., and therefore, the Ehrmann appraisal was not a qualified appraisal.9 We disagree.

Pursuant to section 1.170A-13(c)(5), Income Tax Regs.,10 a qualified appraiser is an individual who includes on the appraisal summary11 a declaration that: (1) the individual either holds himself or herself out to the public as an appraiser or performs appraisals regularly; (2) the appraiser is qualified to make appraisals of the type of property being valued;12 (3) the appraiser is not excluded [*27] from qualifying under section 1.170A-13(c)(5)(iv), Income Tax Regs.;13 and (4) the appraiser understands that an intentionally false or fraudulent overstatement of the value of the property described in the qualified appraisal or appraisal summary may subject the appraiser to a civil penalty under section 6701 for aiding and abetting an understatement of tax liability. According to the plain language of the regulation, an appraiser is a qualified appraiser if he or she makes the requisite declaration that he or she is qualified to appraise the value of the contributed property; the regulation does not direct the Commissioner to analyze the appraiser’s qualifications to determine whether he or she has sufficient education, experience, or other characteristics. We conclude that the analysis of the Court of Appeals for the Second Circuit in Scheidelman II regarding the method and specific basis of valuation of a qualified appraisal applies equally to the appraiser’s qualification for purposes of section 1.170A-13(c)(5)(i)(B), Income [*28] Tax Regs. Accordingly we conclude that section 1.170A-13(c)(5)(i)(B), Income Tax Regs., is a reporting requirement, i.e., an appraiser is qualified if the declaration is present, regardless of whether it is “unconvincing”. See Scheidelman II, 682 F.3d at 198. Accordingly, respondent’s contention that Mr. Ehrmann is not a qualified appraiser is without merit.

Respondent has conceded that Mr. Ehrmann signed the appraisal summary that contains the necessary declaration. Consequently, Mr. Ehrmann is a qualified appraiser pursuant to section 1.170A-13(c)(5), Income Tax Regs., and the Ehrmann appraisal is a qualified appraisal of the value of the development rights petitioners contributed.14

III. Conclusion

Upon due consideration of the foregoing, we hold that petitioners are entitled to summary judgment on the issue of whether the Ehrmann appraisal is a qualified appraisal pursuant to section 1.170A-13(c)(3), Income Tax Regs., with respect to both the facade easement and the development rights. Consequently, we reconsider our holding in our prior case that petitioners are not entitled to a [*29] charitable contribution deduction with respect to the facade easement. However, the other holdings of our prior opinion remain.

We have considered all arguments made, and to the extent not specifically addressed herein, conclude they have been previously addressed in our prior opinion in this case or are irrelevant, moot, or without merit.

To reflect the foregoing,

An appropriate order will be issued.

FOOTNOTES

* This opinion supplements Friedberg v. Commissioner, T.C. Memo. 2011-238.

1 Unless otherwise indicated, section references are to the Internal Revenue Code of 1986, as amended (Code) and in effect at all relevant times, and Rule references are to the Tax Court Rules of Practice and Procedure. We round all monetary amounts to the nearest dollar.

2 New York, N.Y. Zoning Resolution sec. 12-10 (2011) provides the following definition for “floor area ratio”:

“Floor area ratio” is the total floor area on a zoning lot, divided by the lot area of that zoning lot. If two or more buildings are located on the same zoning lot, the floor area ratio is the sum of their floor areas divided by the lot area. (For example, a zoning lot of 10,000 square feet with a building containing 20,000 square feet of floor area has a floor area ratio of 2.0, and a zoning lot of 20,000 square feet with two buildings containing a total of 40,000 square feet of floor area also has a floor area ratio of 2.0).

3 Respondent accepts those numbers as accurate for purposes of the parties’ cross motions for partial summary judgment addressed in our prior opinion.

4 That figure reflects the value of both the facade easement and the development rights, but Mr. Ehrmann stated that it represented “the estimated market value of the loss due to the easement.”

5 As we noted in our prior opinion in this case, it appears that Mr. Ehrmann arrived at 11%, the percentage of fair market value that NAT had told Mr. Friedberg was typical for facade easements, in spite of his research on comparable sales and not because of it.

6 Respondent also contends that we did not rest our prior opinion entirely on the legal analysis contained in Scheidelman v. Commissioner, T.C. Memo. 2010-151, 2010 WL 2788205 (Scheidelman I), vacated and remanded, 682 F.3d 189 (2d Cir. 2012) (Scheidelman II), pointing to our scarce citations of that case and that we instead relied on Friedman v. Commissioner, T.C. Memo. 2010-45, 2010 WL 845949, and Jacobson v. Commissioner, T.C. Memo. 1999-401, 1999 WL 1127811, which the Court of Appeals for the Second Circuit approved. Respondent’s contention is without merit. The Court of Appeals’ opinion in Scheidelman II vacated this Court’s decision in Scheidelman I with respect to the same analysis we used in this case in our prior opinion and distinguished both Friedman and Jacobson. See Scheidelman II, 682 F.3d at 197-198 (stating that the appraisals in those cases “failed altogether to ‘even indicate the valuation method used or the basis for the appraised values'” (quoting Friedman v. Commissioner, 2010 WL 845949, at *4) and “‘provided no methodology or rationale'” (quoting Jacobson v. Commissioner, 1999 WL 1127811, at *2). Pursuant to Golsen v. Commissioner, 54 T.C. at 757, the Court of Appeals’ opinion controls our analysis in the instant case.

7 This Court did not discuss qualified appraisals of development rights in Scheidelman I. However, the Court of Appeals for the Second Circuit’s analysis of sec. 1.170A-13(c)(3)(ii)(J) and (K), Income Tax Regs., applies as much to a valuation of development rights as it does to a valuation of a facade easement. We do not deem it necessary to restate that analysis, which we discussed above.

8 Respondent contends that the Ehrmann appraisal is not qualified because it assumed a highest and best use for the development rights without adequately assessing the market demand for those rights with a market study. We disagree. We have previously held that, when using the comparable sales method, the before value “is arrived at by first determining the highest and best use of the property in its current condition unrestricted by the easement.” Hilborn v. Commissioner, 85 T.C. 677, 689 (1985). However, valuation is not a precise science, and the fair market value of property on a given date is a question of fact to be resolved on the basis of the entire record. Kiva Dunes Conservation, LLC v. Commissioner, T.C. Memo. 2009-145, 2009 WL 1748862, at *3. Like the other questions of fact noted above, respondent’s contentions as to the defects of the Ehrmann appraisal are irrelevant as to whether the Ehrmann appraisal is a qualified appraisal pursuant to sec. 1.170A-13(c)(3), Income Tax Regs.

9 Pursuant to sec. 1.170A-13(c)(3)(i)(B), Income Tax Regs., a qualified appraisal must be “prepared, signed, and dated by a qualified appraiser (within the meaning of paragraph (c)(5) of * * * [that] section).”

10 While we recognize that “qualified appraiser” is now defined in sec. 170(f)(11)(E)(ii), that section was not in effect at the time petitioners filed the return for their 2003 tax year. See Pension Protection Act of 2006, Pub. L. No. 109-280, sec. 1219(c)(1), 120 Stat. at 1084 (effective for appraisals prepared with respect to returns filed after August 17, 2006).

11 Pursuant to sec. 1.170A-13(c)(2)(i)(B), Income Tax Regs., a fully completed appraisal summary must be attached to the tax return on which the deduction for contribution is first claimed. The appraisal summary, which differs from a qualified appraisal, must comply with the requirements set forth in sec. 1.170A-13(c)(4), Income Tax Regs.

12 Pursuant to sec. 1.170A-13(c)(3)(ii)(F), Income Tax Regs., the qualified appraisal should include “[t]he qualifications of the qualified appraiser who signs the appraisal, including the appraiser’s background, experience, education, and membership, if any, in professional appraisal associations”. Respondent makes no claim regarding whether Mr. Ehrmann failed to report his qualifications pursuant to sec. 1.170A-13(c)(3)(ii)(F), Income Tax Regs., so we do not further address that issue.

13 Pursuant to sec. 1.170A-13(c)(5)(iv), Income Tax Regs., an individual is not a qualified appraiser if the individual is, inter alia, the donor, the donee, any person employed by the donor or donee, or an appraiser who is regularly used by the donor or donee and who does not perform most of his or her appraisals for other persons. Respondent makes no claim regarding whether Mr. Ehrmann is excluded from qualifying as a qualified appraiser pursuant to sec. 1.170A-13(c)(5)(iv), Income Tax Regs., so we do not further address that issue.

14 However, we note that we do not at this time opine on whether Mr. Ehrmann’s qualifications are sufficient to qualify as an expert witness to testify in this Court regarding the value of the development rights in this case or whether the Ehrmann appraisal may be admitted as an expert report pursuant to Rule 143(g) for that purpose.




Market Has Concerns, Questions About IRS Issue Price Rules.

Internal Revenue Service’s proposed rules on issue price would drastically change market practices and raise major questions and concerns, representatives of issuer and dealer groups said Monday.

“It completely changes industry practices regarding issue price by eliminating reasonable expectations,” said Ben Watkins, chair of the Government Finance Officers Association’s debt committee and Florida’s bond finance director.

Watkins said that, in his view, the rules are unworkable and are “going to create a compliance nightmare.”

“They’re going to create problems for the entire industry — issuers, bond counsel and underwriters,” he said.

Michael Decker, managing director and co-head of municipal securities at the Securities Industry and Financial Markets Association, said, “This is kind of a watershed proposal.

“We’re really happy that they’re out. We’ve been waiting a long time for them,” he said, adding that SIFMA members are still studying the proposals and determining what they like and don’t like.

The proposed rules are “complex” and “raise some questions,” he added.

Issue price is important because it is used to determine bond yield and whether an issuer is complying with arbitrage rebate or yield restriction requirements, as well whether issuers are receiving the appropriate amount of federal subsidy payments in the case of direct-pay bonds such as Build America Bonds.

Under current tax rules and market prices, the issuer price is determined at issuance based on reasonable expectations. The issue price for each maturity of bonds publicly offered is the first price at which a substantial amount of the bonds is reasonably expected to be sold to the public, with substantial defined as 10%. Sales to underwriters and wholesalers are not considered to be the public and are excluded from the determination of whether the 10% amount has been reached.

But IRS officials were concerned, based on the Municipal Securities Rulemaking Board’s EMMA data, that bonds were being flipped, or almost simultaneously traded up between dealers and other dealers or institutional investors, so that retail investors paid the highest prices for the lowest yields. IRS officials felt the first 10% of sales at the lowest prices did not represent the true issue price, which should have been higher. If that were the case, the interest rate and bond yield should have been lower so the issuer’s investments would have to be at a lower yield to avoid arbitrage problems and the Treasury’s subsidy payments to BAB issuers should have been lower.

In its proposed rules, the IRS would eliminate the reasonable expectations standard and instead base issue price on actual sales. It also would expand the percentage of bond sales to be taken into account in determining issue price to 25% from 10%. The IRS would remove any mention of wholesalers. The proposed rules say sales to underwriters could not be counted toward the 25% amount. They would define the term underwriter somewhat broadly in a manner that is subject to interpretation.

Both Watkins and Decker said the proposed rules would mean the issuer and underwriter typically would not know what the issue price was at the time of issuance and without checking the prices on EMMA for several days or possibly even weeks.

Watkins is particularly concerned the proposed rules do not distinguish between negotiated and competitive transactions. In competitive deals, dealers bid to underwrite the bonds. Florida does a lot of competitive deals and typically chooses the underwriter willing to buy the bonds at the highest prices and lowest yields, Watkins said.

“If I take bids on bonds that ought to be prima facie evidence that this is the price and yield of the bonds,” he said. “But I’ve got to go check EMMA? Remember we’re not talking about one bullet maturity. There can be 20 or 30 maturities in any given bond issue. So I’ve got to go find the price at which 25% of each of those maturities was sold to the public? I think that’s wholly unworkable.”

“That’s just an indication of a lack of knowledge on the part of Treasury because these regulations are supposed to clarify the rules and this changes the standards,” he said. Watkins complained IRS officials are trying “to go after some perceived abuse that simply doesn’t exist and in the process of so doing, they are creating a muddled process of what the issue price is.”

“I’m not sure how they can have studied this for over three years and yet gotten it so wrong,” Watkins said.  “This will create a lot more problems than it solves.”

“This is so far from what we expected,” he said. Watkins said he thought Treasury might expand the percentage of sales used in the determination of issue price to 15% from 10%, but he never imagined the IRS would take away the reasonable expectations standard.

Decker was also surprised that the IRS did not distinguish between competitive and negotiated sales of bonds, as SIFMA had recommended. He said selling bonds competitively “should on its face establish a market price for the bonds.”

He said the elimination of the reasonable expectations standard would create “a big difference in the market.”

“You now have to wait until 25% of every maturity is sold or committed to investors that meet the criteria. That can take days or, in a worst case scenario, even weeks. And the market moves every day,” he said.

Decker also said the definition of underwriter and language on which sales can and cannot be counted toward the 25% is somewhat ambiguous.

The proposed rules say the issue price of tax-exempt bonds issued for money is the first price at which a substantial amount of the bonds is sold to the public. The proposed rules define public to mean any person other than the underwriter. They define underwriter as “any person that purchases bonds from the issuer for the purpose of effecting the original distribution of the bonds, or otherwise participates directly or indirectly in the original distribution.”

The IRS said an underwriter would include, besides the lead underwriter, an underwriting syndicate member, and a dealer “that purchases bonds for the purpose of effecting the original distribution.”

Decker pointed out that some dealers buy large portions or all of certain maturities for their inventories and may hold them for a while as an investment.  “How are you supposed to sell bonds to a dealer desk and know whether it’s for the purpose of a long-term investment or the purpose of distribution?” he asked. “It raises ambiguity.”

“There are some questions,” he said. Can primary market sales to hedge funds, that don’t typically hold bonds for any length of time, be counted toward the 25%, he asked.

Some underwriters sell the bonds to dealers who specialize in selling bonds to retail investors, he said. A lot of investors want their bonds distributed to retail investors. Some issuers require their underwriters to have retail order periods.

“It’s unclear how the dealers involved in retail distribution are going to be able to adapt to these,” he said.

Decker noted SIFMA members have several months to study the rule and said, “We’re certainly going to suggest some clarifications and changes.”

Comments on the proposed rules are due to be submitted to the IRS by Dec. 16 and a public hearing is to be held Feb. 5, 2014.

Bond Dealers of America also raised concerns about the proposed rules.

Susan Collet, BDA’s senior vice president for government relations, said: “BDA is reviewing the proposed rules and looks forward to the opportunity to comment to the IRS, including to relay concerns that the newly proposed framework on issue price sets up a process that could impede the ability of underwriters to execute transactions efficiently on a day-to-day basis and be detrimental to issuers seeking access to the marketplace.”

by: LYNN HUME and NAOMI JAGODA




Proposed Issue Price Definition Eliminates Reasonable Expectation Standard for Exempt Bonds.

Proposed regulations (REG-148659-07 ) released September 13 would amend the definition of issue price for tax-exempt bonds, requiring them to be based on the actual sale price as opposed to reasonable expectations. The proposed regs reflect Treasury and IRS concerns that the current regulations do not produce appropriate results.

Issue price is defined under reg. section 1.148-1 as the first price at which a substantial amount of the bonds in an issue are sold to the public. The reg currently allows the price of bonds issued in a public offering to be determined as of the sale date based on reasonable expectations.

The preamble to the proposed regulations suggests that that approach may not produce a representative price, based on market data that show actual sales to the public at significantly different prices than the issue price. As such, the regs propose eliminating the reasonable expectations standard, meaning the issue price would be based on actual sales.

Scott R. Lilienthal of Hogan Lovells described the rule change as a “significant change of direction.” Lilienthal, who is president of the National Association of Bond Lawyers, said that the reasonable expectation standard provided certainty for issuers, which would be lost under the proposed amendments. He added that the new rule would disproportionately affect competitive underwritings because it is more likely that the actual price will differ from the expectation of the issuer in those offerings.

Frederic L. Ballard Jr. of Ballard Spahr LLP said that the proposal would probably be criticized as administratively burdensome. “It would require bankers and lawyers to monitor trading activity in a way that is not required under the current regulations,” he said.

The proposed regs provide that in the case of a refunding issue when an issuer must estimate the yield before the issue price can be determined, the issuer would be allowed to make curative payments to the IRS to reconcile differences between expected and actual issue prices.

“The regs recognize that the actual yield can be lower than an estimated yield, but they don’t address the reverse situation, when the actual yield turns out to be higher,” said Ballard.

David J. Cholst of Chapman and Cutler LLP noted that determining yield is not the only use of issue price. Knowing the issue price is also necessary for applying volume caps and limits on the amount of bonds. “Without knowledge of the issue price, you may think you are in compliance when you are not,” said Cholst.

“We’ve gotten a number of comments requesting guidance on issue price over the last couple of years,” said Vicky Tsilas, attorney-adviser, Treasury Office of Tax Legislative Counsel. “The proposed regulations are a result of discussions between IRS, Treasury, and industry representatives. We welcome comments and concerns.”

The proposed regs also eliminate the mention of wholesaler from the issue price definition, and they define the term “underwriter” to mean any person who purchases bonds from the issuer for the purpose of effecting the original distribution of the bonds or who otherwise participates directly or indirectly in such original distribution. Lilienthal said that because of the broad definition of underwriter, there will continue to be questions about its application in some cases.

The proposed regs would also eliminate the definition of a substantial amount of an issue as 10 percent, citing instances of underwriters selling the first 10 percent at a lower price than the rest of an issue as a reason for changing the rule. Instead, the regs propose a safe harbor under which an issuer can treat the first price at which a minimum of 25 percent of bonds are sold as the issue price.

Working Capital Expenditures Proposals

The proposed regulations also amend the treatment of tax-exempt bond financings for working capital expenditures with the goal of simplifying the rules and providing objective guidelines for longer-term working capital financings.

Lorraine M. Tyson of Pugh, Jones & Johnson PC said that the proposals address many of the issues that have been raised by tax-exempt bond practitioners. “The most significant change is incorporating in the regulations an objective safe harbor against the creation of replacement proceeds for tax-exempt working capital financings with terms longer than 13 months,” said Tyson.

Arbitrage restrictions apply to replacement proceeds in order to discourage issuers from issuing tax-exempt bonds with very long maturities or from leaving bonds outstanding longer than necessary. Replacement proceeds arise if the term of an issue is longer than reasonably necessary and amounts are available for expenditures of the type being financed during the time the bond issue is outstanding beyond the reasonably necessary period.

The proposed safe harbor would require the issuer to determine the first year in which it expects to have funds available for working capital expenditures, monitor for actual available amounts beginning in that year, and apply those amounts to retire or invest in tax-exempt bonds that are not subject to the alternative minimum tax.

Tyson said that the change “recognizes the fiscal challenges many governmental issuers face with their long-term operating deficits and provides more definitive guidance to issuers who need to structure longer-term tax-exempt working capital financings.”

by Matthew Dalton




More Standards Coming for Resolving Exempt Bond Violations.

The IRS is preparing to add new resolution standards to its voluntary closing agreement program (VCAP) for issuers of tax-exempt bonds, an official with the agency said September 17.

During a phone forum presented by the IRS Office of Tax-Exempt Bonds (TEB), George Gurrola, a TEB tax law specialist, said the IRS “in the near future” will publish an update to its VCAP for exempt bond issuers. The update will include four new resolution standards, he said.

The first two standards will involve approval violations under the 1982 Tax Equity and Fiscal Responsibility Act. The first will cover instances in which issuers rely on a misinterpretation of the TEFRA approval exception for current refundings under section 147(f)(2)(D), Gurrola said. The standard generally will provide for a closing agreement payment of 7.5 percent of taxpayer exposure from the issue date to the date of the closing agreement.

The second TEFRA-related standard will address violations that take place when an issuer reasonably relies on an individual other than a qualifying, applicable, elected representative to approve an issuance of private activity bonds, Gurrola said. That standard will provide for a closing agreement payment of 5 percent of taxpayer exposure from the issue date to the date of the closing agreement.

The third new standard is intended to resolve violations involving some small-issue bonds issued as draw-down bonds in an amount that exceeds volume cap. The standard was developed after some issuers of small-issue bonds issued as draw-down bonds realized that some draws in calendar years after the calendar year of the issue date resulted in bonds issued above the applicable volume cap limits, Gurrola explained.

The new standard generally will require the closing agreement to include representations from the issuer and a closing agreement payment of $1,000 for each calendar year after the calendar year of the initial draw, Gurrola said.

The final new standard addresses violations that occur when an otherwise satisfactory effort to remediate deliberate actions fails because a Form 8038 series return is not filed. Under the new standard, when the issuer asks to resolve the violation through VCAP within six months of the end of the prescribed period to file the return, the violation will be resolved with a $1,000 closing agreement payment, Gurrola said.

There also will be updates to resolution standards for direct pay bonds. A significant change, Gurrola said, is the separation of the de minimis premium violation standard previously applicable to some direct pay bonds into two resolution standards, with one standard applying to Build America Bonds (BABs) and recovery zone economic development bonds and the other to specified tax credit bonds.

The new standards are designed to resolve violations that occur when direct pay bonds are issued with more than the permitted amount of premium, Gurrola explained. They will provide generally that the violations can be resolved with closing agreement payments representing the amount of the excess direct pay credits attributable to the excess premium, he said. The revised standard for BABs and recovery zone economic development bonds extends the date for submitting VCAP requests to October 1, 2014, but the closing agreement payment will be slightly higher than under the previous standard.

Gurrola said TEB realizes that many VCAP requests will not fit within the resolution standards. He said it often helps if the issuer’s proposed resolution terms have some consistency with or similarity to one of the resolution standards or a remedial action in the code or regulations, even if the standard or remedial action does not directly apply to the specific violation or facts and circumstances of the request.

by Fred Stokeld




IRS Publishes Proposed Regs on Arbitrage Rebate Overpayments on Tax-Exempt Bonds.

The IRS has published proposed regulations (REG-148812-11) that provide guidance on the recovery of overpayments of arbitrage rebate on tax-exempt bonds and other tax-advantaged bonds, including the deadline for filing a claim for an arbitrage rebate overpayment.

Comments and discussion topic outlines for the February 5 hearing are due by December 16.

Section 148(f)(1) generally provides that a bond that is part of an issue will be treated as an arbitrage bond unless the issuer pays to the United States the arbitrage rebate amounts described in section 148(f)(2). Reg. section 1.148-3(i) provides that an issuer may recover an overpayment of arbitrage rebate and similar payments on an issue of tax-exempt bonds if the issuer establishes to the satisfaction of the IRS that the overpayment occurred.

Rev. Proc. 2008-37 prescribed procedures for filing claims for a refund of arbitrage rebate and similar payments and imposed a filing deadline. In particular, a claim for a refund must be filed no later than two years after the final arbitrage computation date for the issue from which the claim arose. A transition rule applies to issues with a final computation date before June 24, 2008. The proposed regs include this two-year limitation on filing claims as well as the transition rule.

Under the proposed regs, the IRS may request additional information to support a claim, specify a date for a return of that information, and deny the claim if the information is not returned by the date specified or as extended by the IRS. If the IRS denies a claim because it was filed after the two-year deadline or if the Service doesn’t receive requested information by the date specified in the request for additional information, the issuer may appeal the denial to the Office of Appeals. If Appeals determines that the claim was timely filed or that the requested information was timely submitted, the case will be returned for further consideration of the claim’s merits.

Prop. reg. section 1.148-3(i)(3)(i) applies to refund claims arising from an issue of bonds to which reg. section 1.148-3(i) applies and for which the final computation date is after June 24, 2008. Issues for which the actual final computation date is on or before June 24, 2008, are deemed to have a final computation date of July 1, 2008. Prop. reg. section 1.148-3(i)(3)(ii) applies to refund claims arising from an issue of bonds to which reg. section 1.148-3(i) applies and for which the final computation date is after the date the proposed regs are published.

Arbitrage Rebate Overpayments on Tax-Exempt Bonds

[4830-01-p]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-148812-11]

RIN 1545-BK80

AGENCY: Internal Revenue Service (IRS), Treasury.ACTION: Notice of Proposed Rulemaking and Notice of Public Hearing.

SUMMARY: This document contains proposed regulations that provide guidance on the recovery of overpayments of arbitrage rebate on tax-exempt bonds and other tax-advantaged bonds. These proposed regulations provide the deadline for filing a claim for an arbitrage rebate overpayment and certain other rules. These proposed regulations affect issuers of tax-exempt and tax-advantaged bonds. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by December 16, 2013. Requests to speak and outlines of topics to be discussed at the public hearing scheduled for February 5, 2014, at 2 p.m., must be received by December 16, 2013.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-148812-11), Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered to: CC:PA:LPD:PR Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR, (REG-148812-11), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically via the Federal eRulemaking Portal at www.regulations.gov (IRS REG-148812-11). The public hearing will be held at the Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Timothy Jones at (202) 622-3980; concerning submissions of comments and the hearing, Oluwafunmilayo (Funmi) Taylor at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

This document contains proposed amendments to the Income Tax Regulations (26 CFR part 1) on the arbitrage investment restrictions on tax-exempt bonds and other tax-advantaged bonds under section 148 of the Internal Revenue Code (Code) (Proposed Regulations). Section 1.148-3(i) of the Income Tax Regulations provides that an issuer may recover an overpayment of arbitrage rebate and similar payments on an issue of tax-exempt bonds if the issuer establishes to the satisfaction of the IRS Commissioner that the overpayment occurred. Revenue Procedure 2008-37, 2008-2 CB 137, provides procedures for filing claims for a refund of arbitrage rebate and similar payments and imposes a deadline for filing such claims. In particular, a claim for a refund must be filed no later than 2 years after the final arbitrage computation date for the issue from which the claim arose. A transition rule applies to issues with a final computation date before June 24, 2008. The Proposed Regulations include this 2-year limitation on filing claims as well as the transition rule.

The Proposed Regulations also provide that the Commissioner may request additional information to support a claim, specify a date for a return of that information, and deny the claim if the information is not returned by the date specified or as extended by the Commissioner. Under the Proposed Regulations, if the Commissioner denies a claim because it was filed after the year deadline or requested information is not received by the date specified in the request for such additional information, the issuer may appeal the denial to the Office of Appeals. If Appeals concludes the claim was timely filed or the requested information was timely submitted, as applicable, the case will be returned to the Commissioner for further consideration of the merits of the claim. See 26 CFR 601.601(d)(2).

In accordance with section 7805(b)(1), § 1.148-3(i)(3)(i) of the Proposed Regulations applies to refund claims arising from an issue of bonds to which § 1.148-3(i) applies and for which the final computation date is after June 24, 2008. Issues for which the actual final computation date is on or before June 24, 2008, are deemed to have a final computation date of July 1, 2008. Section 1.148-3(i)(3)(ii) and (iii) of the Proposed Regulations apply to refund claims arising from an issue of bonds to which § 1.148-3(i) applies and for which the final computation date is after the date of publication of the Proposed Regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It is hereby certified that these Proposed Regulations will not have a significant economic impact on a substantial number of small entities. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. The proposed changes reaffirm or clarify filing deadlines previously published in other administrative guidance. Pursuant to section 7805(f) of the Internal Revenue Code, this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these Proposed Regulations are adopted as final regulations, consideration will be given to any comments that are submitted timely to the IRS as prescribed in this preamble under the “Addresses” heading. The IRS and the Treasury Department request comments on all aspects of the proposed rules. All comments will be available at www.regulations.gov or upon request.

A public hearing has been scheduled for February 5, 2014, at 2 p.m., in the IRS Auditorium, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For more information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit written or electronic comments and an outline of the topics to be discussed and the time to be devoted to each topic by December 16, 2013. Submit a signed paper original and eight (8) copies or an electronic copy. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal author of these regulations is Timothy Jones, Office of Associate Chief Counsel (Financial Institutions and Products), IRS. However, other personnel from the IRS and the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 — INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by removing the entry for § 1.148-6 and revising the entry for §§ 1.148-0 through 1.148-11 to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Sections 1.148-0 through 1.148-11 also issued under 26 U.S.C. 148(i). * * *

Par. 2. Section 1.148-0 is amended by adding entries to paragraph (c) for §§ 1.148-3(i)(3) and 1.148-11(k) and (l) and revising § 1.148-11 section heading to read as follows:

§ 1.148-0 Scope and table of contents.

(c) * * *

§ 1.148-3 General arbitrage rebate rules.

(i) * * *

(3) Time and manner for requesting refund.

§ 1.148-11 Effective/applicability dates.

(k) [Reserved]

(l) Additional arbitrage guidance updates.

(1) [Reserved]

(2) [Reserved]

(3) [Reserved]

(4) Application.

Par. 3. Section 1.148-3 is amended by adding paragraph (i)(3) to read as follows:

§ 1.148-3 General arbitrage rebate rules.

(i) * * *

(3) Time and manner for requesting refund — (i) An issuer must request a refund of an overpayment no later than the date that is 2 years after the final computation date for the issue to which the overpayment relates (the filing deadline). The request must be made using the form provided by the Commissioner for this purpose.

(ii) The Commissioner may request additional information to support a refund request. The issuer must file the additional information by the date specified in the Commissioner’s request which date may be extended by the Commissioner if unusual circumstances warrant.

(iii) A claim described in either paragraph (i)(3)(iii)(A) or (i)(3)(iii)(B) of this section that has been denied by the Commissioner may be appealed to the Office of Appeals under this paragraph (i)(3)(iii). Upon a determination in favor of the issuer, Appeals must return an undeveloped case to the Commissioner for further consideration of the substance of the claim.

(A) A claim is described in this paragraph (i)(3)(iii)(A) if the claim is filed after the filing deadline.

(B) A claim is described in this paragraph (i)(3)(iii)(B) if it is a claim for which additional information satisfactory to the Commissioner is not submitted within the time specified in the request for information or any extension of such specified time period.

Par. 4. Section 1.148-11 is amended by revising the section heading and adding paragraphs (k) and (l) to read as follows:

§ 1.148-11 Effective/applicability dates.

(k) [Reserved]

(l) Additional arbitrage guidance updates. (1) [Reserved]

(2) [Reserved]

(3) [Reserved]

(4) Application. (i) Section 1.148-3(i)(3)(i) applies to refund claims arising from an issue of bonds to which § 1.148-3(i) applies and for which the final computation date is after June 24, 2008. For purposes of this paragraph (l)(4), issues for which the actual final computation date is on or before June 24, 2008, are deemed to have a final computation date of July 1, 2008.

(ii) Section 1.148-3(i)(3)(ii) and (iii) apply to refund claims arising from an issue of bonds to which § 1.148-3(i) applies and for which the final computation date is after September 16, 2013.

Beth Tucker

Deputy Commissioner for Operations

Support




IRS Publishes Proposed Regs on Arbitrage Restrictions on Tax-Exempt Bonds.

The IRS has published proposed regulations (REG-148659-07) on the section 148 arbitrage investment restrictions applicable to tax-exempt bonds and other tax-advantaged bonds to amend the current rules to address market developments, simplify some provisions, explain technical issues, and improve administrability.

In September 2007, the IRS and Treasury published proposed regs (REG-106143-07) to update the rules related to the section 148 arbitrage investment restrictions applicable to some tax-exempt bonds. The new regs propose additional amendments. Comments and discussion topic outlines for the February 5 public hearing are due by December 16.

The issue price definition under the current rules applies a reasonable expectations standard for determining the issue price of bonds that are publicly offered. Treasury and the IRS have expressed concerns that some aspects of the current rules for determining the issue price of tax-exempt bonds are no longer appropriate in light of market developments. One concern is the ability of the reasonable expectations standard to produce a representative issue price. To address all concerns and provide greater certainty, the proposed regs amend the issue price definition used for arbitrage purposes. The regs provide that the issue price of tax-exempt bonds issued for money is the first price at which a substantial amount of the bonds is sold to the public. The regs replace the definition of substantial amount as 10 percent with a safe harbor. The regs provide relief in some cases involving refunding issues, allowing issuers to make curative payments to the IRS to reconcile differences between expected and actual issue prices of the refunding bonds for arbitrage compliance purposes. Under the regs, a person that holds bonds for investment isn’t an underwriter of those bonds. Comments are requested on whether specific identification rules should be provided for determining when a bond is held for investment.

The current rules impose a number of arbitrage investment restrictions to limit arbitrage incentives for excessive use of tax-exempt bond financing for working capital expenditures. The proposed regs amend the treatment of working capital financings to simplify this area and provide objective parameters for longer-term working capital financings. The regs remove a restriction against financing a working capital reserve, retain the general 5 percent test for the size of a permitted reasonable working capital reserve fund, provide that the maturity safe harbor against the creation of replacement proceeds for short-term working capital financings is 13 months, and provide a new objective safe harbor against the creation of replacement proceeds for working capital financings that have terms longer than the proposed 13-month safe harbor. The regs also add extraordinary working capital items to the list of factors that may justify a bond term beyond the maturity safe harbors against the creation of replacement proceeds.

In the 2007 proposed regs, comments were requested on the types of offsetting hedges that are necessary for valid business purposes and suggestions were solicited on how to clarify the current rule on offsetting hedges. In consideration of those comments, the new regs propose rules that provide greater certainty for hedge terminations and clarify and simplify the treatment of modifications and terminations of qualified hedges. The regs provide guidance on the treatment of modifications of qualified hedges while eliminating the concept of offsetting hedges and simplify the treatment of qualified hedges upon refunding hedged bonds when there is no actual termination of the associated hedge. The regs also provide guidance on the amount of a termination payment for both deemed and actual terminations of qualified hedges.

The preamble to the proposed regs describes other technical changes to the current rules. The regs generally are proposed to apply prospectively to bonds that are sold on or after the date that is 90 days after publication of the final regs in the Federal Register.

Arbitrage Restrictions on Tax-Exempt Bonds

[4830-01-p]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-148659-07]

RIN 1545-BH38

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of Proposed Rulemaking and Notice of Public Hearing.

SUMMARY: This document contains proposed regulations on the arbitrage restrictions under section 148 of the Internal Revenue Code applicable to tax-exempt bonds and other tax-advantaged bonds. These proposed regulations amend existing regulations to address certain current market developments, simplify certain provisions, address certain technical issues, and make the regulations more administrable. These proposed regulations affect issuers of tax-exempt and other tax-advantaged bonds. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by December 16, 2013. Requests to speak and outlines of topics to be discussed at the public hearing scheduled for February 5, 2014, at 10:00 a.m., must be received by December 16, 2013.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-148659-07), Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered to: CC:PA:LPD:PR Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-148659-07), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC, or sent electronically via the Federal eRulemaking Portal at www.regulations.gov (IRS REG-148659-07). The public hearing will be held at the Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Zoran Stojanovic at (202) 622-3980; concerning submissions of comments and the hearing, Oluwafunmilayo Taylor at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Management and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS Reports Clearance Officer, SE:CAR:MP:T:T:SP, Washington DC 20224. Comments on the collection of information should be received by November 15, 2013.

Comments are sought on whether the proposed collection of information is necessary for the proper performance of the Internal Revenue Service, including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of information;

How the quality, utility, and clarity of the information to be collected may be enhanced;

How the burden of complying with the proposed collection of information may be minimized, including through the application of automated collection techniques and other forms of information technology; and

Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of service to provide information.

The collection of information in this proposed regulation is in § 1.148-4(h)(2)(viii) which contains a requirement that the issuer maintain in its records a certificate provided by the hedge provider. Existing regulations require, among other items, that a hedge must be identified by the actual issuer on its books and records to be a qualified hedge. The identification must specify the hedge provider, the terms of the contract, and the hedged bonds. The proposed regulations require that the identification also include a certificate provided by the hedge provider specifying certain information regarding the hedge. The respondents are issuers of tax-exempt bonds that enter into hedges on their bonds and the hedge providers.

This document contains proposed amendments to the Income Tax Regulations (26 CFR part 1) on the arbitrage investment restrictions under section 148 of the Internal Revenue Code (Code) and related provisions. On June 18, 1993, the Department of the Treasury (Treasury) and the IRS published comprehensive final regulations in the Federal Register (TD 8476, 58 FR 33510) on the arbitrage investment restrictions and related provisions for tax-exempt bonds under sections 103, 148, 149, and 150, and, since that time, those final regulations have been amended in certain limited respects (the regulations issued in 1993 and the amendments thereto are collectively referred to as the Existing Regulations). A Notice of Proposed Rulemaking was published in the Federal Register (72 FR 54606; REG-106143-07) on September 26, 2007 (2007 Proposed Regulations), which proposes amendments to the Existing Regulations to address market developments, simplify certain provisions, address certain technical issues, and make the regulations more administrable. One notable change in the 2007 Proposed Regulations addresses a municipal market development in which issuers seek to modify interest rate risks by entering into hedging transactions that are based on taxable interest rate indexes (for example, LIBOR-based interest rate swaps). The 2007 Proposed Regulations clarify that these hedges qualify to be taken into account with the hedged bonds on a net basis in determining bond yield for arbitrage purposes. Among the other notable changes in the 2007 Proposed Regulations are (1) a revision to an investment bidding safe harbor to accommodate certain transparent internet-based electronic bidding procedures;(2) removal of the authority in the Existing Regulations to permit issuers of qualified mortgage bonds and qualified student loan bonds to compute a single joint bond yield for purposes of applying the arbitrage restrictions to two or more issues of these types of tax-exempt bonds; and (3) clarification that the amount an issuer is entitled to receive under a rebate refund claim is the excess of the total amount actually paid over the rebate amount. Among the technical changes in the 2007 Proposed Regulations are changes to the rules that address qualified hedges for arbitrage purposes and additions to the rules on permitted yield reduction payments. This document (the Proposed Regulations) proposes additional amendments to the Existing Regulations.

Explanation of Provisions

I. Definitions and Elections (§ 1.148-1).

A. Issue price definition. Section 148(h) provides that yield on an issue is to be determined on the basis of the issue price (within the meaning of sections 1273 and 1274). The issue price definition under the Existing Regulations generally follows the issue price definition used for computing original issue discount on debt instruments under sections 1273 and 1274 of the Code, with certain modifications. Specifically, the issue price definition under the Existing Regulations applies a reasonable expectations standard (rather than a standard based on actual sales) for determining the issue price of bonds that are publicly offered. Under this standard, the first price at which a substantial amount (defined to mean ten percent) of the bonds is reasonably expected to be sold to the public is treated as the issue price and is used in determining the yield on the issue.

The standard uses reasonable expectations to allow issuers of advance refunding bonds to estimate the yield on the issue before the actual sales prices of the bonds are known so that the issuer can purchase yield-restricted investments for a refunding escrow to defease the prior bonds at the time of the sale of the refunding bonds. The issue prices of bonds with different payment and credit terms are determined separately. Notice 2010-35 (2010-19 IRB 660) provides that the arbitrage definition of issue price also applies to other tax-advantaged bond programs, including Build America Bonds under section 54AA and other Qualified Tax Credit Bonds under section 54A. See 26 CFR 601.601(d)(2).

The Treasury Department and the IRS are concerned that certain aspects of the Existing Regulations for determining the issue price of tax-exempt bonds are no longer appropriate in light of market developments since those regulations were published. In particular, the Treasury Department and the IRS are concerned that the ten-percent test does not always produce a representative price for the bonds. Underwriters of tax-exempt bonds may sell bonds of an issue with the same payment and credit terms in an initial public offering at different prices but execute the first ten percent of the sales of those bonds at the lowest price (and thus the highest yield), causing the issue price of the bonds to be a lower price than is representative of the prices at which the remaining bonds were sold.

In addition, increasing transparency about pricing information in the municipal bond market (for example, publicly-available pricing information from the Municipal Securities Rulemaking Board through its Electronic Municipal Market Access (EMMA) platform) has led to heightened scrutiny of issue price standards. The reported data has shown, in certain instances, actual sales to the public at prices that differed significantly from the issue price used by the issuer. These price differences have raised questions about the ability of the reasonable expectations standard to produce a representative issue price. The reported trade data has also called into question whether sales to underwriters and security dealers have been included as sales to the public in determining issue price in certain instances.

To address these concerns and to provide greater certainty, the Proposed Regulations amend the issue price definition used for arbitrage purposes in certain significant respects. Consistent with section 148(h), the Proposed Regulations retain the rule that issue price generally will be determined under the rules of sections 1273 and 1274. The Proposed Regulations remove the reference to issue price of bonds that are “publicly offered” because the existing section 1273 regulations do not distinguish between public offering and private placement. The Proposed Regulations parallel the language in the existing section 1273 regulations that refer to debt instruments issued for money.

The Proposed Regulations provide that the issue price of tax-exempt bonds issued for money is the first price at which a substantial amount of the bonds is sold to the public. (As described further below, the Proposed Regulations define the term “public” to mean any person other than an “underwriter” and provide a new definition of the term “underwriter.”) The Proposed Regulations, however, remove the definition of substantial amount as ten percent. Instead, the Proposed Regulations provide a safe harbor under which an issuer may treat the first price at which a minimum of 25 percent of the bonds in an issue (with the same credit and payment terms) is sold to the public as the issue price, provided that all orders at this price received from the public during the offering period are filled (to the extent that the public orders at such price do not exceed the amount of bonds sold). Consistent with section 1273, the Proposed Regulations base the determination of issue price on actual sale prices instead of reasonably expected sale prices.

The Treasury Department and the IRS understand that, in the case of a refunding issue, an issuer may need to estimate the yield on the issue before the actual issue price can be determined so that the issuer can purchase yield-restricted investments for a refunding escrow to defease the prior bonds at the time of the sale of the refunding bonds. The Proposed Regulations provide relief in these situations by permitting issuers to make curative payments to the IRS, called “yield reduction payments,” to reconcile differences between expected and actual issue prices of the refunding bonds for arbitrage compliance purposes.

The Existing Regulations disregard sales to “underwriters” or “wholesalers” in determining the issue price of tax-exempt bonds that are offered to the public. The Proposed Regulations provide that the issue price of tax-exempt bonds issued for money is the first price at which a substantial amount of the bonds is sold to the public and, for this purpose, define the term “public” to mean any person other than an “underwriter.” The Proposed Regulations also define the term “underwriter” to mean any person that purchases bonds from the issuer for the purpose of effecting the original distribution of the bonds, or otherwise participates directly or indirectly in the original distribution. An underwriter includes a lead underwriter and any member of a syndicate that contractually agrees to participate in the underwriting of the bonds for the issuer. A securities dealer (whether or not a member of the issuer’s underwriting syndicate) that purchases bonds (whether or not from the issuer) for the purpose of effecting the original distribution of the bonds is also treated as an underwriter for this purpose. An underwriter generally includes a related party to an underwriter.

The Proposed Regulations eliminate the reference to “wholesalers” in the issue price definition, because the revised, more comprehensive definition of underwriter includes those persons who would otherwise be treated as “wholesalers” under the Existing Regulations.

Under the Proposed Regulations, a person that holds bonds for investment is not an underwriter with respect to those bonds. The Treasury Department and the IRS solicit public comment on whether specific identification rules, such as the section 1236(b) identification rules, should be provided for determining when a bond is held for investment.

B. Working capital expenditures and replacement proceeds definition. The Existing Regulations impose a number of arbitrage investment restrictions to limit arbitrage incentives for excessive use of tax-exempt bond financing for “working capital expenditures” (working capital), such as operating expenses or seasonal cash flow deficits (as distinguished from capital projects). The Proposed Regulations amend the treatment of working capital financings in several respects to simplify this area and to provide objective parameters for longer-term working capital financings.

An issuer is relieved of arbitrage investment restrictions on bond proceeds only after the proceeds are spent. The Existing Regulations impose a strict “bond proceeds-spent-last” accounting assumption for spending proceeds of tax-exempt bonds on working capital. This accounting rule recognizes that sources of funds are fungible and treats bond proceeds as spent for working capital purposes only after the issuer depletes other “available amounts” that the issuer otherwise could use for this purpose. An issuer, however, need not be “broke to borrow” for working capital purposes. Here, the Existing Regulations allow an issuer to maintain a “reasonable working capital reserve” fund that need not be spent before spending bond proceeds on working capital. The Existing Regulations provide a general rule that the permitted size of this reasonable working capital reserve fund is an objective measure equal to five percent of the issuer’s actual working capital expenditures in the previous fiscal year from operations. In addition, the Existing Regulations include a broad prohibition against direct or indirect financing of a working capital reserve itself. This prohibition against financing working capital reserves imposes another complex limit on the size of the permitted working capital reserve fund that requires analysis of amounts previously maintained for such purpose.

The Proposed Regulations remove the restriction against financing a working capital reserve. This restriction inappropriately penalizes those State and local governments that have previously maintained the least amount of working capital reserves and that may have the most bona fide need to finance working capital expenditures. Further, this restriction is complex. The Proposed Regulations retain the existing general five percent test for the size of a permitted reasonable working capital reserve fund.

The Existing Regulations also limit working capital financings through the concept of replacement proceeds. The arbitrage rules apply to more than the actual proceeds of the issue; they apply to gross proceeds, which include proceeds and replacement proceeds of an issue. The Existing Regulations provide broadly that replacement proceeds arise if an issuer reasonably expects as of the issue date that (1) the term of an issue will be longer than reasonably necessary for the governmental purposes of the issue, and (2) there will be available amounts for expenditures of the type being financed during the period that the issue remains outstanding longer than necessary. One purpose of the replacement proceeds rules is to discourage issuers from issuing tax-exempt bonds with unduly long maturities or leaving tax-exempt bonds outstanding longer than reasonably necessary. The replacement proceeds rules particularly affect working capital financings.

The Existing Regulations provide a safe harbor against the creation of replacement proceeds for short-term working capital bond financings that are outstanding for no longer than two years. To address concerns about arbitrage incentives associated with certain short-term financing practices, however, Rev. Proc. 2002-31 (2002-1 CB 916) shortened the safe-harbor for these financings from two years to 13 months in most circumstances. Questions have arisen with respect to the interaction between the Existing Regulations and Rev. Proc. 2002-31. See 26 CFR 601.601(d)(2).

The Proposed Regulations provide that the maturity safe harbor against the creation of replacement proceeds for short-term working capital financings is 13 months. This change conforms the regulatory safe harbor to the more recent administrative standard under Rev. Proc. 2002-31 for the traditional short-term working capital financings for seasonal cash flow deficits.

The Existing Regulations, however, provide no safe harbors against the creation of replacement proceeds or other specific guidance regarding appropriate limits for longer-term working capital financings, such as longer-term deficit financings for issuers experiencing financial distress. State and local governments have sought guidance on appropriate parameters for such financings. The Proposed Regulations provide a new objective safe harbor against the creation of replacement proceeds for working capital financings that have terms longer than the proposed 13-month safe harbor. This new safe harbor requires an issuer to determine the first year in which it expects to have available amounts for working capital expenditures, monitor for actual available amounts in each year beginning with the year it first expects to have such amounts, and apply such available amounts in each year either to retire or to invest in tax-exempt bonds that are not investment property under section 148(b)(3) of the Code (that is, tax-exempt bonds that are not subject to the alternative minimum tax). Consistent with the purpose of the replacement proceeds rules, this new safe harbor aims to control the burden of unnecessary tax-exempt financings on the tax-exempt bond market by requiring issuers to redeem or purchase tax-exempt bonds.

The Existing Regulations have a general arbitrage anti-abuse rule, which provides, in part, that specific factors (particularly bona fide cost under-runs and long-term financial distress) may justify a bond maturity that exceeds the maturity safe harbors against the creation of replacement proceeds. Separately, the Existing Regulations provide more favorable accounting rules for certain extraordinary, non-recurring working capital items, such as casualty losses. The Proposed Regulations add extraordinary working capital items to the factors that may justify a bond term beyond the maturity safe harbors against the creation of replacement proceeds.

II. Qualified Hedge Provisions (§ 1.148-4).

To determine the yield on hedged bonds for purposes of the arbitrage investment restrictions, the Existing Regulations permit issuers to take into account and integrate the net payments on certain qualified hedges entered into to modify the risk of interest rate changes with the payments on the associated hedged tax-exempt bonds. In general, to be a qualified hedge, the terms of the hedge must correspond closely with those of the hedged bonds, the issuer must identify the hedge, and the hedge must contain no significant investment element.

The Existing Regulations provide that a termination of a qualified hedge includes any sale or other disposition of the hedge by the issuer or the acquisition by the issuer of an offsetting hedge. The Existing Regulations further provide that a deemed termination of a qualified hedge occurs when certain material modifications or assignments of a hedge result in a realization event to the issuer under section 1001. Under the Existing Regulations, if a hedge is deemed terminated, the issuer is deemed to have made or received a termination payment and, if applicable (such as when there is a material modification of the hedge), a deemed acquisition payment for a “new” hedge. Because the hedge is integrated with the bond yield, the deemed payments, like actual termination payments, can affect the yield on the bonds.

Issues have arisen in this area as a result of market conditions during the last several years. State and local governments have faced a number of circumstances that have put pressure on issuers to modify or terminate their existing qualified hedges. Treasury and the IRS have also received questions indicating that there is uncertainty about what constitutes an “offsetting hedge” that terminates a qualified hedge.

In the 2007 Proposed Regulations, Treasury and the IRS solicited public comments regarding the types of offsetting hedges that are necessary for valid business purposes and recommendations on how to clarify the rule in the Existing Regulations regarding offsetting hedges. The Proposed Regulations consider those comments and propose rules that provide greater certainty regarding hedge terminations and clarify and simplify the treatment of modifications and terminations of qualified hedges.

A. Modifications of qualified hedges. The Proposed Regulations provide guidance on the treatment of modifications of qualified hedges while eliminating the concept of offsetting hedges. The Proposed Regulations provide that a modification, including an actual modification, an acquisition of another hedge, or an assignment, generally will result in a deemed termination of a hedge if the modification is material and results in a deemed disposition under section 1001.

The Proposed Regulations provide, however, that a material modification of a qualified hedge that otherwise would result in a deemed termination will not result in such a termination if the modified hedge is a qualified hedge. For this purpose, the Proposed Regulations require testing the modified hedge for compliance with the requirements for qualified hedges at the time of the modification.

These proposed changes generally produce results that are economically comparable to the Existing Regulations, but in a simpler manner. The Proposed Regulations reduce complexity associated with the approach under the Existing Regulations by eliminating the need to account for deemed hedge termination and acquisition payments, which deemed payments generally offset each other without substantive effect on the yield on the hedged bonds.

B. Continuations of qualified hedges in refundings. The Existing Regulations generally treat a refunding of hedged bonds as a deemed termination of a qualified hedge and require accounting for the deemed termination payment in the yield on the refunding bonds over the remaining term of the original hedge in accordance with economic substance. The Proposed Regulations simplify the treatment of qualified hedges upon refunding hedged bonds when there is no actual termination of the associated hedge. If the affected hedge meets the requirements for a qualified hedge of the refunding bonds as of the issue date of the refunding bonds, with certain exceptions, the Proposed Regulations treat the affected hedge as continuing as a qualified hedge of the refunding bonds instead of being terminated. Similar to the proposed treatment of hedge modifications, the proposed treatment of these continuations of qualified hedges in refundings under the Proposed Regulations generally produces economically comparable results as the Existing Regulations in a simpler manner.

C. Termination of hedges at fair market value. The 2007 Proposed Regulations clarify that the termination payment for a termination or a deemed termination of a qualified hedge is equal to the fair market value of the hedge on the termination date. In response to comments received on the clarification in the 2007 Proposed Regulation, these Proposed Regulations modify the 2007 proposed rule. For a deemed termination of a qualified hedge, the Proposed Regulations provide that the amount of the termination payment is equal to the fair market value of the qualified hedge on the termination date. For an actual termination of a qualified hedge, the Proposed Regulations provide that the amount of the hedge termination payment treated as made or received on the hedged bonds (i) may not exceed the fair market value of the qualified hedge if paid by the issuer, and (ii) may not be less than the fair market value of the qualified hedge if received by the issuer. Comments on the 2007 Proposed Regulations as well as comments received in response to these Proposed Regulations will be considered in connection with finalizing this rule.

III. Other Technical Changes.

The Proposed Regulations make other technical changes to the Existing Regulations. This section describes the technical changes.

A. Temporary period spending exception to yield restriction (§ 1.148-2). The Existing Regulations provide certain short-term exceptions, called “temporary period” exceptions, which allow investment of proceeds of tax-exempt bonds for fairly short periods without yield restriction. These exceptions reduce administrative burdens and recognize that limited arbitrage potential exists for bond proceeds that are spent promptly.

The Existing Regulations provide no express exceptions for proceeds used for certain types of working capital expenditures, such as certain extraordinary working capital items. The Proposed Regulations broaden the existing 13-month temporary period exception to yield restriction for restricted working capital expenditures to include all working capital expenditures.

B. Certification of hedge provider (§ 1.148-4). Concerns have been raised about pricing of hedges involving tax-exempt bonds. Existing regulations require, among other items, that a hedge must be identified by the actual issuer on its books and records to be a qualified hedge. The identification must specify the hedge provider, the terms of the contract, and the hedged bonds. To promote greater accountability and transparency about pricing of these hedges, the Proposed Regulations require that the identification also include a certificate provided by the hedge provider specifying certain information regarding the hedge including a statement about the bona fide, arm’s-length nature of the pricing and information about payments beyond those properly taken into account as payments to modify the risk of interest rate changes.

C. Yield and valuation of investments (§ 1.148-5). The Existing Regulations provide guidance on how to value investments allocated to an issue. Absent a special rule, the Existing Regulations give issuers the option to choose a valuation method, provided that the chosen method is consistently applied for arbitrage purposes on a valuation date. The special rules in the Existing Regulations leave some ambiguity about when the present value and the fair market value methods of valuation are permitted or required.

The Proposed Regulations clarify that the fair market value method of valuation generally is required for any investment (including a yield-restricted investment) on the date the investment is first allocated to an issue or first ceases to be allocated to an issue as a consequence of a deemed acquisition or a deemed disposition.

The Existing Regulations include only one exception to this mandatory fair market value rule. The issuer has the option to value an investment at present value when proceeds are allocated from one bond issue to another bond issue as transferred proceeds in refundings or universal cap allocations, provided that both affected bond issues consist exclusively of tax-exempt bonds. This exception applies only to transfers between two tax-exempt bond issues to address a concern about allocating excessive value to obligations without arbitrage restrictions. This exception, however, creates a disincentive against retiring tax-exempt bonds with taxable bonds, such as when the fair market value of the investment would cause investment yield to exceed the tax-exempt bond yield. Such a disincentive is inconsistent with the general policies behind the arbitrage rules as stated in § 1.148-0. To provide more appropriate incentives, the Proposed Regulations change this rule to require only that the issue from which the investment is allocated (that is, the first issue in an allocation from one issue to another) consists exclusively of tax-exempt bonds.

D. Authority of Commissioner under anti-abuse rule (§ 1.148-10). The Existing Regulations provide the Commissioner with authority to exercise discretion with respect to any transaction entered into for the principal purpose of obtaining a material financial advantage based on the difference between tax-exempt and taxable interest rates in a manner that is inconsistent with the arbitrage rules. The Proposed Regulations revise the Existing Regulations to clarify that the Commissioner has the authority to depart from the arbitrage rules as necessary to prevent such material financial advantage.

E. Transition provision for certain guarantee funds (§ 1.148-11). Section 1.148-11(d)(1) provides a transition rule that allows certain State perpetual trust funds (for example, certain state permanent school funds) to pledge funds to guarantee tax-exempt bonds without resulting in arbitrage-restricted replacement proceeds. In Notice 2010-5 (2010-2 IRB 256) the Treasury Department and the IRS proposed to increase the amount of tax-exempt bonds that such funds could guarantee under this special rule and stated their intent to issue proposed regulations to implement this change. The Proposed Regulations include these changes. The Proposed Regulations also extend this rule to cover certain tax-exempt bonds issued to finance public charter schools in response to comments received on the Notice. See 26 CFR 601.601(d)(2).

F. Definitions and special rules (§ 1.150-1).

1. Definition of tax-advantaged bonds. The Proposed Regulations provide a new definition of tax-advantaged bonds as tax-exempt bonds under section 103, taxable bonds that provide Federal tax credits to investors to subsidize the issuer’s borrowing costs, and taxable bonds that provide refundable Federal tax credits payable directly to issuers under section 6431, or any future similar bonds that provide a Federal subsidy for any portion of an issuer’s borrowing costs.

2. Definition of issue. The Existing Regulations provide that tax-exempt bonds and taxable bonds are not part of the same issue. Questions have arisen regarding the appropriate treatment of taxable tax-advantaged bonds for purposes of this composite issue provision. The Proposed Regulations clarify that taxable tax-advantaged bonds and other taxable bonds are treated as part of different issues. The Proposed Regulations also clarify that different types of tax-advantaged bonds are treated as parts of different issues.

3. Definition and treatment of grants. The Existing Regulations include a definition of a grant. The Existing Regulations also provide a special arbitrage spending rule that treats proceeds used by an issuer to make a grant to an unrelated party as spent for arbitrage investment tracking purposes when the grant is made. A longstanding question is whether an issuer may look at the grantee’s use of the grant funds to determine whether the bond issue complies with other arbitrage and general program restrictions on tax-exempt bonds. For example, taking into account the grantee’s use may impact whether the issue finances capital projects or working capital expenditures, and accordingly which arbitrage rules apply to that issue. The Proposed Regulations expand the application of the existing definition of grant for arbitrage purposes to apply that definition to other tax-exempt bond provisions. The Proposed Regulations clarify that the character and nature of a grantee’s use of proceeds generally is taken into account in determining whether other applicable non-arbitrage requirements of the issue are met.

IV. Effective/Applicability Dates

The Proposed Regulations generally are proposed to apply prospectively to bonds that are sold on or after the date that is 90 days after publication of final regulations in the Federal Register. Section 1.148-4(h)(2)(viii) is proposed to apply to qualified hedges that are entered into on or after the date that is 90 days after the date of publication of the final regulations in the Federal Register. Section 1.148-4(h)(3)(iv)(A) through (H) and (h)(4)(iv) are proposed to apply to hedges that are entered into on or after the date that is 90 days after the date of publication of final regulations in the Federal Register, to qualified hedges that are modified on or after such date with respect to such modifications, and to qualified hedges on bonds that are refunded on or after such date with respect to such refunding.

In addition, except as otherwise provided in the next paragraph, issuers may apply and rely upon the Proposed Regulations, in whole or in part, with respect to bonds that are sold on or after September 16, 2013, and before the date that is 90 days after publication of final regulations in the Federal Register.

Issuers may apply and rely upon § 1.148-4(h)(3)(iv)(A) through (H) and (h)(4)(iv) of the Proposed Regulations in whole to hedges that are entered into on or after September 16, 2013, and before the date that is 90 days after publication of final regulations in the Federal Register; to qualified hedges that are modified on or after September 16, 2013, and before the date that is 90 days after publication of final regulations in the Federal Register with respect to such modifications; and to qualified hedges on bonds that are refunded on or after September 16, 2013, and before the date that is 90 days after publication of final regulations in the Federal Register with respect to such refunding.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It is hereby certified that these proposed regulations will not have a significant economic impact on a substantial number of small entities. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required. Some of the proposed changes clarify or simplify existing regulatory provisions, or otherwise involve simplifying or clarifying changes that will not have a significant economic impact on governmental jurisdictions or other entities of any size. These proposed regulations amend the issue price definition used for arbitrage purposes and provide a new objective safe harbor against the creation for replacement proceeds for long term working capital financings. These proposed changes are not expected to have a significant economic impact because they provide greater certainty to issuers and assist issuers in complying with the arbitrage restrictions on tax-exempt bonds.

Other proposed changes involve the treatment of certain hedging transactions, including requiring a certificate from a hedge provider. Although there is a lack of available data regarding the extent of usage of these hedging transactions by small entities, the IRS and the Treasury Department understand that these hedging transactions are used primarily by larger State and local governments and large counterparties. The IRS and the Treasury Department specifically solicit comment from any party, particularly small entities, on the accuracy of this certification. Pursuant to section 7805(f) of the Code, this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Public Hearing

Before these Proposed Regulations are adopted as final regulations, consideration will be given to any comments that are submitted timely to the IRS as prescribed in this preamble under the “Addresses” heading. The IRS and the Treasury Department request comments on all aspects of the proposed rules. All comments that are submitted by the public will be available for public inspection and copying at www.regulations.gov or upon request.

A public hearing has been scheduled for February 5, 2014, at 10:00 a.m. in the IRS Auditorium, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For more information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit written or electronic comments and an outline of the topics to be discussed and the time to be devoted to each topic by December 16, 2013. Submit a signed paper original and eight (8) copies or an electronic copy. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Drafting Information

The principal authors of these regulations are Johanna Som de Cerff, Office of Associate Chief Counsel (Financial Institutions and Products), IRS, and Vicky Tsilas, Office of Tax Policy. However, other personnel from the IRS and Treasury participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1 — INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by removing the entry for § 1.148-6 and revising the entry for §§ 1.148-0 through 1.148-11 to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Sections 1.148-0 through 1.148-11 also issued under 26 U.S.C. 148(i). * * *

Par. 2. Section 1.141-0 is amended by revising the section heading for § 1.141-15 and adding new entries for § 1.141-15(l), (m), and (n) to read as follows:

§ 1.141-0 Table of contents.

§ 1.141-15 Effective/applicability dates.

(l) [Reserved]

(m) [Reserved]

(n) Effective/applicability dates for certain regulations relating to certain definitions.

Par. 3. Section 1.141-1 is amended by revising paragraph (a) to read as follows:

§ 1.141-1 Definitions and rules of general application.

(a) In general. For purposes of §§ 1.141-0 through 1.141-16, the following definitions and rules apply: the definitions in this section, the definitions in § 1.150-1, the definition of placed in service in § 1.150-2(c), the definition of reasonably required reserve or replacement fund in § 1.148-2(f), and the definitions in § 1.148-1 of bond year, commingled fund, fixed yield issue, higher yielding investments, investment, investment proceeds, issue price, issuer, nonpurpose investment, purpose investment, qualified guarantee, qualified hedge, reasonable expectations or reasonableness, rebate amount, replacement proceeds, sale proceeds, variable yield issue and yield.

Par. 4. Section 1.141-15 is amended by revising the section heading and adding paragraphs (l), (m), and (n) to read as follows:

§ 1.141-15 Effective/applicability dates.

(l)[Reserved]

(m)[Reserved]

(n) Effective/applicability dates for certain regulations relating to certain definitions. Revised § 1.141-1(a) applies to bonds that are sold on or after the date that is 90 days after publication of final regulations in the Federal Register.

Par. 5. Section 1.148-0 is amended by adding new entries in paragraph (c) for §§ 1.148-1(f) and 1.148-11(k) and (l); and revising the entries for §§ 1.148-2(e)(3) and 1.148-10(e) and section heading for § 1.148-11 to read as follows:

§ 1.148-0 Scope and table of contents.

(c) Table of contents. * * *

§ 1.148-1 Definitions and elections.

(f) Definition of issue price.

(1) In general.

(2) Tax-exempt bonds issued for money.

(3) Definitions.

(4) Special rules.

§ 1.148-2 General arbitrage yield restriction rules.

(e) * * *

(3) Temporary period for working capital expenditures.

§ 1.148-10 Anti-abuse rules and authority of Commissioner.

(e) Authority of the Commissioner to prevent transactions that are inconsistent with the purpose of the arbitrage rules.

§ 1.148-11 Effective/applicability dates.

(k) [Reserved]

(l) Certain arbitrage guidance updates.

Par. 6. Section 1.148-1 is amended by:

1. Revising the definition of issue price in paragraph (b).

2. Revising paragraphs (c)(4)(i)(B)(1) and (c)(4)(ii).

3. Removing the “or” at the end of paragraph (c)(4)(i)(B)(2).

4. Removing the period at the end of paragraph (c)(4)(i)(B)(3) and adding in its place a semi-colon and the word “or”.

5. Adding a new paragraphs (c)(4)(i)(B)(4) and (f).

The additions and revisions read as follows:

§ 1.148-1 Definitions and elections.

(b) * * *

Issue price means issue price as defined in paragraph (f) of this section.

(c) * * *

(4) * * *

(i) * * *

(B) * * *

(1) For the portion of an issue that is to be used to finance restricted working capital expenditures, if that portion is not outstanding longer than the temporary period under § 1.148-2(e)(3) for which the proceeds qualify;

(4) For the portion of an issue that is to be used to finance working capital expenditures and that is outstanding for a period longer than the temporary period under § 1.148-2(e)(3), if that portion satisfies paragraph (c)(4)(ii) of this section.

(ii) Safe harbor for longer-term working capital financings. A portion of an issue used to finance working capital expenditures satisfies this paragraph (c)(4)(ii) if the issuer meets the requirements of paragraphs (c)(4)(ii)(A) and (c)(4)(ii)(B) of this section.

(A) Determine expected available amounts. An issuer meets the requirements of this paragraph (c)(4)(ii)(A) if —

(1) On the issue date, the issuer determines the first fiscal year following the applicable temporary period (determined under § 1.148-2(e)) in which it reasonably expects to have available amounts for the financed working capital expenditures (first testing year), but in no event can the first testing year be later than five years after the issue date; and

(2) Beginning with the first testing year and for each subsequent fiscal year for which the applicable portion of the issue remains outstanding, the issuer determines its available amounts for the financed working capital expenditures as of the first day of the fiscal year (yearly available amount).

(B) Application of yearly available amount to reduce burden on tax-exempt bond market. An issuer meets the requirements of this paragraph (c)(4)(ii)(B) if, within 90 days after the start of each year in which it determines a yearly available amount, the issuer applies an amount equal to the yearly available amount for such year to redeem or invest in tax-exempt bonds that are excluded from investment property under section 148(b)(3) (that is, tax-exempt bonds that are not subject to the alternative minimum tax)(eligible tax-exempt bonds). The maximum amount required to be applied in such manner shall equal the outstanding principal amount of the applicable portion of the issue subject to the safe harbor in this paragraph (c)(4)(ii), determined as of the date of such redemption or investment. Any amounts invested in eligible tax-exempt bonds shall be invested or reinvested continuously in such tax-exempt bonds, except during a permitted reinvestment period of no more than 30 days in a fiscal year, for as long as the applicable portion of the issue remains outstanding.

(f) Definition of issue price — (1) In general. Except as otherwise provided in this paragraph (f), issue price is defined in sections 1273 and 1274 and the regulations under those sections. In determining the issue price under section 1274 of a bond that is issued for property, the adjusted applicable Federal rate, as computed for purposes of section 1288, is used in lieu of the applicable Federal rate in determining the issue price.

(2) Tax-exempt bonds issued for money — (i) In general. The issue price of tax-exempt bonds issued for money is the first price at which a substantial amount of the bonds is sold to the public (as defined in paragraph (f)(3)(i) of this section). See paragraph (f)(4)(ii) of this section for an issue including bonds with different payment and credit terms.

(ii) Safe harbor for determining issue price of tax-exempt bonds issued for money. For purposes of paragraph (f)(2)(i) of this section, the issuer may treat the first price at which a minimum of 25 percent of the bonds is sold to the public as the issue price. However the preceding sentence applies only if all orders at this sale price received from the public within the offering period are filled to the extent the public orders at such price do not exceed the amount of bonds sold.

(3) Definitions. For purposes of this paragraph (f), the following definitions apply:

(i) Public. Public means any person (as defined in section 7701(a)(1)) other than an underwriter.

(ii) Underwriter — (A) In general. Except as otherwise provided in paragraph (f)(3)(ii)(C) of this section, the term underwriter means any person (as defined in section 7701(a)(1)) that purchases bonds from an issuer for the purpose of effecting the original distribution of the bonds or that otherwise participates directly or indirectly in such original distribution. An underwriter includes a lead underwriter and any member of a syndicate that contractually agrees to participate in the underwriting of the bonds for the issuer. A securities dealer (whether or not a member of an underwriting syndicate for the issuer) that purchases bonds (whether or not from the issuer) for the purpose of effecting the original distribution of the bonds is also treated as an underwriter for purposes of this section

(B) Certain related parties included. Except as otherwise provided in paragraph (f)(3)(ii)(C) of this section, an underwriter includes any related party (as defined in § 1.150-1(b)) to an underwriter.

(C) Holding for investment. A person (as defined in section 7701(a)(1)) that holds bonds for investment is treated as a member of the public with respect to those bonds.

(iii) Securities dealer. Securities dealer means a dealer in securities, as defined in section 475(c)(1).

(4) Special rules. For purposes of this paragraph (f), the following special rules apply:

(i) Subsequent sale at a different price. The issue price as determined under paragraph (f)(1) or (2) of this section does not change if part of the issue is later sold at a different price.

(ii) Separate determinations. The issue price of bonds in an issue that do not have the same credit and payment terms is determined separately.

Par. 7. Section 1.148-2 is amended by revising paragraph (e)(3)(i) to read as follows:

§ 1.148-2 General arbitrage yield restriction rules.

(e) * * *

(3) * * *(i) General rule. The proceeds of an issue that are reasonably expected to be allocated to working capital expenditures within 13 months after the issue date qualify for a temporary period of 13 months beginning on the issue date. Paragraph (e)(2) of this section contains additional temporary period rules for certain working capital expenditures that are treated as part of a capital project.

Par. 8. Section 1.148-4 is amended by:

1. Revising paragraphs (h)(2)(viii) and (h)(3)(iv)(A).

2. Redesignating paragraph (h)(3)(iv)(B) as newly redesignated paragraph (h)(3)(iv)(E) and revising newly redesignated paragraph (h)(3)(iv)(E).

3. Redesignating paragraph (h)(3)(iv)(C) as newly redesignated paragraph (h)(3)(iv)(F) and revising the first sentence in newly redesignated paragraph (h)(3)(iv)(F).

4. Redesignating paragraph (h)(3)(iv)(D) as newly redesignated paragraph (h)(3)(iv)(G) and revising newly redesignated paragraph (h)(3)(iv)(G).

5. Redesignating paragraph (h)(3)(iv)(E) as newly redesignated paragraph (h)(3)(iv)(H) and revising the first sentence in newly redesignated paragraph (h)(3)(iv)(H).

6. Adding new paragraphs (h)(3)(iv)(B), (h)(3)(iv)(C), (h)(3)(iv)(D) and (h)(4)(iv).

The revisions and additions read as follows:

§ 1.148-4 Yield on an issue of bonds.

(h) * * *

(2) * * *

(viii) Identification — (A) In general. The contract must be identified by the actual issuer on its books and records maintained for the hedged bonds not later than 15 calendar days after the date on which the issuer and the hedge provider enter into the hedge contract. The identification must be maintained by the actual issuer and must specify the name of the hedge provider, the terms of the contract, the hedged bonds, and include a hedge provider’s certification as described in paragraph (h)(2)(viii)(B) of this section. The identification must contain sufficient detail to establish that the requirements of this paragraph (h)(2) and, if applicable, paragraph (h)(4) of this section are satisfied. In addition, the existence of the hedge must be noted on the first form relating to the issue of which the hedged bonds are a part that is filed with the Internal Revenue Service on or after the date on which the contract is identified pursuant to this paragraph (h)(2)(viii).

(B) Hedge provider’s certification. The hedge provider’s certification must provide that —

(1) The terms of the hedge were agreed to between a willing buyer and willing seller in a bona fide, arm’s-length transaction;

(2) The rate payable by the issuer under the hedge is comparable to the rate that the hedge provider would have quoted on the trade date to enter into a reasonably comparable hedge with a counterparty that is similarly situated to the issuer and that involves a hedge on debt obligations other than tax-exempt bonds, taking into account all the terms of the hedge;

(3) The hedge provider has not made, and does not expect to make, any payment to any third party in connection with the hedge, except for any such third-party payment that the hedge provider expressly identifies in documents for the hedge; and

(4) The amounts paid or received pursuant to the hedge do not include any payments other than payments reasonably allocable to the modification of risk of interest rate changes and to the hedge provider’s overhead that are properly taken into account under paragraph (h)(3)(i) of this section, unless the hedge provider separately identifies such payments.

(3) * * *

(iv) Accounting for modifications and terminations — (A) Modification defined. A modification of a qualified hedge includes, without limitation, a change in the terms of the hedge, an issuer’s acquisition of another hedge with terms that have the effect of modifying an issuer’s risks of interest rate changes or other terms of an existing qualified hedge, or an assignment of a hedge provider’s remaining rights and obligations under the hedge to a third party. For example, if the issuer enters into a qualified hedge that is an interest rate swap under which it receives payments based on LIBOR, and subsequently enters a second hedge (with the same or different provider) that limits the issuer’s exposure under the existing qualified hedge to variations in LIBOR, the new hedge modifies the qualified hedge.

(B) Termination defined. A termination means either an actual or a deemed termination of a qualified hedge. Except as otherwise provided, an actual termination of a qualified hedge occurs to the extent that the issuer sells, disposes of, or otherwise actually terminates all or a portion of the hedge. A deemed termination of a qualified hedge occurs if the hedge ceases to meet the requirements for a qualified hedge of the hedged bonds; the issuer makes a modification (as defined in paragraph (h)(3)(iv)(A) of this section) that results in a deemed exchange of the hedge and a realization event to the issuer under section 1001; or the issuer redeems all or a portion of the hedged bonds.

(C) Special rules for certain modifications when the hedge remains qualified. A modification of a qualified hedge that otherwise would result in a deemed termination under paragraph (h)(3)(iv)(B) of this section does not result in such a termination if the modified hedge meets the requirements for a qualified hedge, determined as of the date of the modification. For purposes of this paragraph (h)(3)(iv)(C), when determining whether the hedge is qualified, the fact that the existing qualified hedge is off-market as of the date of the modification is disregarded and the identification requirement in paragraph (h)(2)(viii) of this section applies by measuring the time period for identification from the date of the modification and without regard to the requirement for a hedge provider’s certification.

(D) Continuations of certain qualified hedges in refundings. If hedged bonds are redeemed using proceeds of a refunding issue, the qualified hedge is not actually terminated, and the hedge meets the requirements for a qualified hedge for the refunding bonds as of the issue date of the refunding bonds, then no termination of the hedge occurs and the hedge instead is treated as a qualified hedge for the refunding bonds. For purposes of this paragraph (h)(3)(iv)(D), when determining whether the hedge is a qualified hedge for the refunding bonds, the fact that the hedge is off-market with respect to the refunding bonds as of the issue date of the refunding bonds is disregarded and the identification requirement in paragraph (h)(2)(viii) of this section applies by measuring the time period for identification from the issue date of the refunding bonds and without regard to the requirement for a hedge provider’s certification.

(E) General allocation rules for hedge termination payments. Except as otherwise provided in paragraphs (h)(3)(iv)(F), (G), and (H) of this section, a payment made or received by an issuer to terminate a qualified hedge, or a payment deemed made or received for a deemed termination, is treated as a payment made or received, as appropriate, on the hedged bonds. Upon an actual termination of a qualified hedge, the amount of the payment that an issuer may treat as a termination payment made or received on the hedged bonds —

(1) May not exceed the fair market value of the qualified hedge on such date if paid by the issuer; and

(2) May not be less than the fair market value of the qualified hedge on such date if received by the issuer.

Upon a deemed termination of a qualified hedge, the amount of the termination payment is equal to the fair market value of the qualified hedge on the termination date. Except as otherwise provided, a termination payment is reasonably allocated to the remaining periods originally covered by the terminated hedge in a manner that reflects the economic substance of the hedge.

(F) Special rule for terminations when bonds are redeemed. Except as otherwise provided in this paragraph (h)(3)(iv)(F) and in paragraph (h)(3)(iv)(G) of this section, when a qualified hedge is deemed terminated because the hedged bonds are redeemed, the termination payment as determined under paragraph (h)(3)(iv)(E) of this section is treated as made or received on that date. * * *

(G) Special rules for refundings. When there is a termination of a qualified hedge because there is a refunding of the hedged bonds, to the extent that the hedged bonds are redeemed using the proceeds of a refunding issue, the termination payment is accounted for under paragraph (h)(3)(iv)(E) of this section by treating it as a payment on the refunding issue, rather than the hedged bonds. In addition, to the extent that the refunding issue is redeemed during the period to which the termination payment has been allocated to that issue, paragraph (h)(3)(iv)(F) of this section applies to the termination payment by treating it as a payment on the redeemed refunding issue.

(H) Safe harbor for allocation of certain termination payments. A payment to terminate a qualified hedge does not result in that hedge failing to satisfy the applicable provisions of paragraph (h)(3)(iv)(E) of this section if that payment is allocated in accordance with this paragraph (h)(3)(iv)(H). * * *

(4) * * *

(iv) Consequences of certain modifications. The special rules under paragraph (h)(4)(iii) of this section regarding the effects of terminations of qualified hedges of fixed yield hedged bonds also applies in the same manner to modifications of a qualified hedge under paragraph (h)(3)(iv)(C) of this section. Thus, for example, a modification may result in a prospective change in the yield on the hedged bonds for arbitrage rebate purposes under § 1.148-3.

Par. 9. Section 1.148-5 is amended by:

1. Revising paragraphs (c)(3), (d)(2) and (d)(3).

2. Revising the last sentence in paragraph (d)(6)(i) and adding a sentence at the end of the paragraph.

The revisions and additions read as follows:

§ 1.148-5 Yield and valuation of investments.

(c) * * *

(3) Applicability of special yield reduction rule — (i) through (ix) [Reserved].

(x) Investments allocable to gross proceeds of an issue to the extent that the yield reduction payments made with respect to such investments under paragraph (c)(1) of this section relate to any difference between the amount of the actual issue price of the issue and the issuer’s reasonable expectations regarding such issue price determined as of the sale date of the issue.

(d) * * *

(2) Mandatory valuation of certain yield restricted investments at present value. Except as otherwise provided in paragraphs (b)(3) and (d)(3) of this section, a yield restricted investment must be valued at present value.

(3) Mandatory valuation of certain investments at fair market value — (i) In general. Except as otherwise provided in paragraphs (d)(3)(ii) and (d)(4) of this section, an investment must be valued at fair market value on the date that it is first allocated to an issue or first ceases to be allocated to an issue as a consequence of a deemed acquisition or deemed disposition. For example, if an issuer deposits existing nonpurpose investments into a sinking fund for an issue, those investments must be valued at fair market value as of the date first deposited into the fund.

(ii) Exception to fair market value requirement for transferred proceeds allocations, universal cap allocations, and commingled funds. Paragraph (d)(3)(i) of this section does not apply if the investment is allocated from one issue to another as a result of the transferred proceeds allocation rule under § 1.148-9(b) or the universal cap rule under § 1.148-6(b)(2), provided that the issue from which the investment is allocated (that is, the first issue in an allocation from one issue to another) consists exclusively of tax-exempt bonds. In addition, paragraph (d)(3)(i) of this section does not apply to investments in a commingled fund (other than a bona fide debt service fund) unless it is an investment being initially deposited in or withdrawn from a commingled fund described in § 1.148-6(e)(5)(ii).

(6) * * *(i) * * *On the purchase date, the fair market value of a United States Treasury obligation that is purchased directly from the United States Treasury, including a State and Local Government Series (SLGS) security, is its purchase price. The fair market value of a SLGS security on any date other than the original purchase date is the redemption price for redemption on that date.

§ 1.148-6 [Amended]

Par. 10. In § 1.148-6, paragraph (d)(4)(iii) is removed.

Par. 11. Section 1.148-10 is amended by revising the last sentence of paragraph (a)(4) and the heading and first sentence of paragraph (e) to read as follows:

§ 1.148-10 Anti-abuse rules and authority of Commissioner.

(a) * * *

(4) * * *These factors may be outweighed by other factors, such as bona fide cost underruns, an issuer’s bona fide need to finance extraordinary working capital items, or an issuer’s long-term financial distress.

(e) Authority of the Commissioner to prevent transactions that are inconsistent with the purpose of the arbitrage rules. If an issuer enters into a transaction for a principal purpose of obtaining a material financial advantage based on the difference between tax-exempt and taxable interest rates in a manner that is inconsistent with the purposes of section 148, the Commissioner may exercise the Commissioner’s discretion to depart from the rules of §§ 1.148-1 through 1.148-11 as necessary to prevent such financial advantage. * * *

Par. 12. Section 1.148-11 is amended by:

1. Revising the section heading.

2. Redesignating paragraph (d)(1) as newly redesignated paragraph (d)(1)(i).

3. Redesignating paragraphs (d)(1)(i), (d)(1)(ii), (d)(1)(iii), (d)(1)(iv), (d)(1)(v), and (d)(1)(vi) as newly redesignated paragraphs (d)(1)(i)(A), (d)(1)(i)(B), (d)(1)(i)(C), (d)(1)(i)(D), (d)(1)(i)(E), and (d)(1)(i)(F), respectively.

4. Revising newly redesignated paragraphs (d)(1)(i)(B), (d)(1)(i)(D), and (d)(1)(i)(F), and adding new paragraphs (d)(1)(ii), (k) and (l).

The revisions and additions read as follows:

§ 1.148-11 Effective/applicability dates.

(d)* * *

(1)* * *

(i) * * *

(B) The corpus of the guarantee fund may be invaded only to support specifically designated essential governmental functions (designated functions) carried on by political subdivisions with general taxing powers or public elementary and public secondary schools;

(D) The issue guaranteed consists of obligations that are not private activity bonds (other than qualified 501(c)(3) bonds) substantially all of the proceeds of which are to be used for designated functions;

(F) As of the sale date of the bonds to be guaranteed, the amount of the bonds to be guaranteed by the fund plus the then-outstanding amount of bonds previously guaranteed by the fund does not exceed a total amount equal to 500 percent of the total costs of the assets held by the fund as of December 16, 2009.

(ii) The Commissioner may, by published guidance, set forth additional circumstances under which guarantees by certain perpetual trust funds will not cause amounts in the fund to be treated as replacement proceeds.

(k) [Reserved]

(l) Additional arbitrage guidance updates — (1) In general. Sections 1.148-1(b); 1.148-1(c)(4)(i)(B)(1); 1.148-1(c)(4)(i)(B)(4); 1.148-1(c)(4)(ii); 1.148-1(f); 1.148-2(e)(3)(i); 1.148-5(c)(3); 1.148-5(d)(2); 1.148-5(d)(3); 1.148-5(d)(6)(i); 1.148-6(d)(4); 1.148-10(a)(4); 1.148-10(e); 1.148-11(d)(1)(i)(B); 1.148-11(d)(1)(i)(D); 1.148-11(d)(1)(i)(F); and 1.148-11(d)(1)(ii) apply to bonds that are sold on or after the date that is 90 days after the date of publication of final regulations in the Federal Register.

(2) Section 1.148-4(h)(2)(viii) applies to hedges that are entered into on or after the date that is 90 days after the date of publication of the final regulations in the Federal Register.

(3) Section 1.148-4(h)(3)(iv)(A) through (H) and (h)(4)(iv) apply to —

(i) Hedges that are entered into on or after the date that is 90 days after the date of publication of the final regulations in the Federal Register;

(ii) Qualified hedges that are modified on or after the date that is 90 days after the date of publication of the final regulations in the Federal Register with respect to modifications on or after such date; and

(iii) Qualified hedges on bonds that are refunded on or after the date that is 90 days after the date of publication of the final regulations in the Federal Register with respect to the refunding on or after such date.

Par. 13. Section 1.150-1 is amended by:

1. Adding a new paragraph (a)(2)(iii).

2. Adding a definition for tax-advantaged bond in alphabetical order to paragraph (b).

3. Revising paragraph (c)(2).

4. Adding a new paragraph (f).

The revisions and additions read as follows:

§ 1.150-1 Definitions.

(a) * * *

(2) * * *

(iii) Special effective date for definitions of tax-advantaged bond, issue, and grant. The definition of tax-advantaged bond in paragraph (b) of this section, the revisions to the definition of issue in paragraph (c)(2) of this section, and the definition and rules regarding the treatment of grants in paragraph (f) of this section apply to bonds that are sold on or after the date that is 90 days after publication of final regulations in the Federal Register.

(b) * * *

Tax-advantaged bond means a tax-exempt bond, a taxable bond that provides a Federal tax credit to the investor with respect to the issuer’s borrowing costs, a taxable bond that provides a refundable Federal tax credit payable directly to the issuer of the bond for its borrowing costs under section 6431, or any future similar bond that provides a Federal subsidy for any portion of the borrowing costs.

Examples of tax-advantaged bonds include qualified tax credit bonds under section 54A(d)(1) and build America bonds under section 54AA.

(c) * * *

(2) Exceptions for different types of tax-advantaged bonds and taxable bonds. Each type of tax-advantaged bond that has a different structure for delivery of the borrowing subsidy or different program eligibility requirements is treated as part of a different issue under this paragraph (c). Further, tax-advantaged bonds and bonds that are not tax-advantaged bonds are treated as part of different issues under this paragraph (c). The issuance of tax-advantaged bonds in a transaction with other non tax-advantaged bonds must be tested under the arbitrage anti-abuse rules under § 1.148-10(a) and other applicable anti-abuse rules (for example, limitations against window maturity structures or unreasonable allocations of bonds).

(f) Definition and treatment of grants — (1) Definition. Grant means a transfer for a governmental purpose of money or property to a transferee that is not a related party to or an agent of the transferor. The transfer must not impose any obligation or condition to directly or indirectly repay any amount to the transferor or a related party. Obligations or conditions intended solely to assure expenditure of the transferred moneys in accordance with the governmental purpose of the transfer do not prevent a transfer from being a grant.

(2) Treatment. Except as otherwise provided (for example, § 1.148-6(d)(4), which treats proceeds used for grants as spent for arbitrage purposes when the grant is made), the character and nature of a grantee’s use of proceeds are taken into account in determining which rules are applicable to the bond issue and whether the applicable requirements for the bond issue are met.

For example, a grantee’s use of proceeds generally determines whether the proceeds are used for capital projects or working capital expenditures under section 148 and whether the qualified purposes for the specific type of bond issue are met.

Beth Tucker

Deputy Commissioner for Operations

Support

[FR Doc. 2013-21880 Filed 09/13/2013 at 8:45 am; Publication Date: 09/16/2013]




Law Professor Questions Costs of Tax-Exempt Hospitals.

Tax-exempt hospitals raise prices for consumers and contribute little in charity despite the requirements of their exempt status, Barak D. Richman of Duke University said at a September 19 hearing on healthcare reform held by the House Judiciary Regulatory Reform, Commercial and Antitrust Law Subcommittee.

http://judiciary.house.gov/hearings/113th/09192013_2/Prof%20Richman%20Testimony%20[9-19-13].pdf




IRS Releases Proposed Issue Price Rules, Draws Concerns.

The Treasury Department and Internal Revenue Service have proposed long-awaited rules on arbitrage restrictions for tax-exempt bonds, including issue price, as well as rules on arbitrage rebate overpayments.

The rules, which are to be published in the Federal Register on Monday, are scheduled to be the focus of a public hearing that is to be held on Feb. 5. In addition, public comments are due on the arbitrage rules 60 days after publication in the Federal Register and must be received by Dec. 16 on arbitrage rebate overpayment rules.

The proposed rules on issue price are more stringent than existing rules in an effort to address agency concerns. But market participants say they would represent a major change in the way the market works and question whether they would even be workable.

Issue price is extremely important because it is used to help determine the yield on bonds and whether the issuer is complying with arbitrage rebate or yield restriction requirements, as well as federal subsidy payments in the case of direct-pay bonds such as Build America Bonds. Issue price also plays a role in complying with other rules such as the 2% limit on issuance costs for private activity bonds and the size of debt service reserve funds.

Current tax rules say that the issue price of bonds that are publicly offered is the first price at which a substantial amount of the bonds is reasonably expected to be sold to the public, with substantial defined as 10%.

But in their 56-page proposal on arbitrage restrictions, the agencies say they “are concerned that the 10% test does not always produce a representative price for the bonds.”

The agencies also say they are concerned about flipping. They do not use the term, but describe the behavior.

“Underwriters of tax-exempt bonds may sell bonds of an issue with the same payment and credit terms in an initial public offering at different prices, but execute the first 10% of the sales of those bonds at the lowest prices (and thus the highest yield), causing the issue price of the bonds to be a lower price than is representative of the prices at which the remaining bonds are sold,” they said in the proposed rules.

The agencies said that improvements in price transparency, such as the muni prices reported on the Municipal Securities Rulemaking Board’s EMMA system “has led to heightened scrutiny of issue price standards.”

“The reported data has shown, in certain instances, actual sales to the public at prices that differed significantly from the issue price used by the issuer,” they said. “These price differences have raised questions about the ability of the reasonable expectations standard to produce a representative issue price. The reported trade data has also called into question whether sales to underwriters and security dealers have been included as sales to the public in determining issue price in certain instances.”

In the proposed rules, the agencies remove the reasonable expectations standard and substitute actual sales. They eliminate the reference to “publicly offered” so the rules would clearly cover private placements as well as public offerings.

The new rules would state: “The issue price of tax-exempt bonds issued for money is the first price at which a substantial amount of the bonds is sold to the public,” with substantial meaning 25% instead of 10% of the bonds.

The current rules disregard sales to underwriters or wholesalers when determining issue price.

The proposed rules state “the public” would be any person other than an underwriter. The term underwriter would be defined as “any person that purchases bonds from the issuer for the purpose of effecting the original distribution of the bonds, or otherwise participates directly or indirectly in the original distribution.”

The term would include the lead underwriter, any syndicate member, or “a securities dealer (whether or not a member of the issuer’s underwriting syndicate) that purchases bonds (whether or not from the issuer) for the purpose of effecting the original distribution of the bonds.” Also, “An underwriter generally includes a related party to the underwriter,” the proposed rules say.

Several lawyers have concerns and questions about the proposed rules.

“I think the market will act adversely to the proposed regulations,” said Rick Ballard, a partner at Ballard Spahr. “Financial and legal professionals would like to be able to determine issue price on the initial sale date and not have to worry about what happens later,” he said “You’re going to have to do a lot of post-tracking of sales on EMMA and figure you when you hit the 25%. It’s going to increase the amount of work and make it a lot more complicated.”

Scott Lilienthal, president of the National Bond Lawyers Association and a partner at Hogan Lovells US LLP, agreed, “We’re concerned about his move away from the reasonable expectations standard,” he said. “I’m worried that it’s going to create new problems for issuers.”

Lilienthal said, for example, that issuers trying to structure advance refunding escrows are not going to know what the issue price until later, and while the IRS permits issuers to make yield reduction payments if their estimates are wrong, they won’t be able to gauge the savings they will achieve until they know whether they have to make such payments.

Lilienthal also said the definition of underwriter is still somewhat ambiguous. “There’s a lot of interpretation that has to be done,” he said.

The proposal will create uncertainties for issuers and market participants trying to comply with other rules that rely on issue price such as limits on cost of issuance and the sizing of debt service reserve funds, he added.

The proposed arbitrage rules also codify private-letter ruling guidance on working capital financings, clarify issues related to qualified hedges and cover the valuation of investments.

The other set of proposed rules sets forth procedures for recovering overpayments of arbitrage rebate on tax-exempt bonds and other tax-advantaged bonds.

by: LYNN HUME




IRS Issues Proposed Regs on Arbitrage Rebate Overpayments on Tax-Exempt Bonds.

The IRS has issued proposed regulations that provide guidance on the recovery of overpayments of arbitrage rebate on tax-exempt bonds and other tax-advantaged bonds, including the deadline for filing a claim for an arbitrage rebate overpayment. (REG-148812-11)

http://www.ofr.gov/(S(cpohw1vx1p4rtqqy5mcjrmz4))/OFRUpload/OFRData/2013-21879_PI.pdf




IRS Issues Proposed Regs on Arbitrage Restrictions on Tax-Exempt Bonds.

The IRS has issued proposed regulations on the section 148 arbitrage investment restrictions applicable to tax-exempt bonds and other tax-advantaged bonds to amend the current rules to address market developments, to simplify some provisions, to explain technical issues, and to improve administrability. (REG-148659-07)

http://www.ofr.gov/(S(cpohw1vx1p4rtqqy5mcjrmz4))/OFRUpload/OFRData/2013-21880_PI.pdf




CRS Updates Report on Reauthorizing Compensation to Counties for Tax-Exempt Federal Land.

The reporting of legislation in the Senate and House to temporarily extend the Secure Rural Schools and Community Self-Determination Act of 2000, which compensates counties for the tax-exempt status of federal land, was the subject of a September 5 update to a Congressional Research Service report on reauthorization of the bill.

Reauthorizing the Secure Rural Schools and Community Self-Determination Act of 2000

Katie Hoover

Analyst in Natural Resources Policy

September 5, 2013

Congressional Research Service

7-5700

www.crs.gov

R41303

Summary

Many counties are compensated for the tax-exempt status of federal lands. Counties with national forest lands and with certain Bureau of Land Management (BLM) lands have historically received a percentage of agency revenues, primarily from timber sales. However, timber sales have declined substantially — by more than 90% in some areas. Thus, Congress enacted the Secure Rural Schools and Community Self-Determination Act of 2000 (SRS; P.L. 106-393) as a temporary, optional program of payments based on historic, rather than current, revenues.

Authorization for SRS payments originally expired at the end of FY2006, but through several reauthorizations the program was extended through FY2012. Congressional debates over reauthorization considered the basis and level of compensation (historical, tax equivalency, etc.); the source of funds (receipts, a new tax or revenue source, etc.); the authorized and required uses of the payments; interaction with other compensation programs (notably Payments in Lieu of Taxes); and the duration of any changes (temporary or permanent). In addition, legislation with mandatory spending, such as SRS reauthorization, raises policy questions about increasing the deficit; current budget rules to restrain deficit spending typically impose a procedural barrier to such legislation, generally requiring offsets by additional receipts or reductions in other mandatory spending.

In 2008, the Emergency Economic Stabilization Act (P.L. 110-343) enacted a four-year extension to SRS authorization through FY2011, with declining payments, a modified formula, and transition payments for certain areas. In 2012, Congress enacted a one-year extension through FY2012, and amended the program by slowing the decline in payment levels and tightening requirements that counties select a payment option promptly (P.L. 112-141).

Section 302 of the Budget Control Act (P.L. 112-25, as amended by P.L. 112-240) requires the President to order a sequester, or cancellation, of budgetary resources for FY2013. The sequester order took effect on March 1, 2013, and affected the SRS payment for FY2012, although BLM and Forest Service implemented the order differently from each other.

With the expiration of SRS at the end of FY2012, county compensation is again the subject of congressional debates. County payments are set to return to a revenue-based system for FY2013, and are likely to be significantly lower than the previous years’ payments. However, payments for FY2013 have not yet been made, and Congress may consider extending SRS (with or without modifications and with or without addressing the sequester order), implementing other legislative proposals to address the county payments, or taking no action. No action would continue the revenue-based system that took effect upon the program’s expiration. Discussion in the 113th Congress has focused on many of the same issues that were debated in 2006-2008 and again in 2012. On June 18, 2013, the Senate Energy and Natural Resources Committee ordered to be reported S. 783, the Helium Stewardship Act of 2013, which includes a one-year extension of SRS. On July 31, 2013, the House Committee on Natural Resources ordered to be reported H.R. 1526, the Restoring Healthy Forests for Healthy Communities Act, which includes a temporary extension of SRS.

Contents

Background

Receipt-Sharing Program Concerns and Responses

Concerns

Historical Proposals to Change the Receipt-Sharing System

Legislative History of the Secure Rural Schools and Community

Self-Determination Act of 2000, as Amended

Reauthorization Efforts in the 110th Congress

Four-Year Extension through FY2011 Enacted in the 110th

Congress

Full Funding

Calculated Payments

Transition Payments

Title II and Title III Activities

Income Averaging

Payments in Lieu of Taxes (PILT)

Reauthorization Efforts in the 112th Congress

One-Year Extension Enacted in the 112th Congress

Sequestration Issue

BLM Sequestration of SRS Funds

Forest Service Sequestration of SRS Funds

Legislative Issues

Offsets for New Mandatory Spending

Lands Covered

Basis for Compensation

Source of Funds

Authorized and Required Uses of the Payments

Duration of the Programs

Legislative Activity in the 113th Congress

Figures

Figure 1. Forest Service Cut Volume and Cut Value (2012 dollars)

Figure 2. FS Total Payments and Estimated Payments

Figure 3. Source and Distribution of FS Payments

Tables

Table 1. FY2012 FS and PILT Payments, by State

Table A-1. FY2006 and FY2009 FS and O&C Payments Under SRS, by State

Appendixes

Appendix. SRS Payments in FY2006 and FY2009

Contacts

Author Contact Information

Acknowledgments

Many counties are compensated for the tax-exempt status of federal lands within those counties. Counties with national forest lands and with certain Bureau of Land Management (BLM) lands have historically received a percentage of agency revenues, primarily from timber sales. However, timber sales have declined substantially since the historic high cut values in 1989 — by more than 90% in some areas. Congress enacted the Secure Rural Schools and Community Self-Determination Act of 2000 (SRS, P.L. 106-393) to provide a temporary, optional system to supplant the revenue-sharing programs for the national forests, managed by the Forest Service (FS) in the Department of Agriculture, and for certain public lands administered by the BLM in the Department of the Interior.

The law authorizing these payments expired at the end of FY2006. The 109th Congress considered the program, but did not enact reauthorizing legislation. The 110th Congress extended the payments for one year through FY2007, then enacted legislation to reauthorize the program for four years with declining payments, and to modify the formula for allocating the payments. The authorization for payments was set to expire again after payments were made for FY2011, but the 112th Congress extended the program for one more year through FY2012, and amended the program by slowing the decline in payments. The authorization expired after payments were made for FY2012. Currently, payments for FY2013 will revert to a percentage of agency revenues, primarily from timber sales and recreation fees. This report explains the changes enacted for the program by the amendments in 2008 and 2012, the effect of the sequester order on the payments, and then describes the issues that Congress has debated and continues to debate in the 113th Congress.

Background

In 1908, the FS began paying 25% of its gross receipts to the states for use on roads and schools in the counties where the national forests are located; receipts come from sales, leases, rentals, or other fees for using national forest lands or resources (e.g., timber sales, recreation fees, and communication site leases).1 This mandatory spending program was enacted to compensate local governments for the tax-exempt status of the national forests, but the compensation rate (10% of gross receipts in 1906 and 1907; 25% of gross receipts since) was not discussed in the 1906-1908 debates. This receipt-sharing program is called FS Payments to States (also referred to as the 1908 payment, or the 25% payment), because each state allocates the funds to road and school programs, although the FS determines the amount to be spent in each county based on the national forest acreage in each county. The states cannot retain any of the funds; they must be passed through to local governmental entities for use at the county level (but not necessarily to county governments) for authorized road and school programs. State law sets forth how the payments are to be allocated between road and school projects.

Congress has also enacted numerous programs to share receipts from BLM lands for various types of resource use and from various classes of land, but one program — the Oregon and California (O&C) payments — accounts for the vast majority (more than 95%) of BLM receipt-sharing.2 The O&C payments are made to the counties in western Oregon containing the revested Oregon and California grant lands returned to federal ownership for failure to fulfill the terms of the grant. The O&C counties receive 50% of the receipts from these lands. These mandatory payments go directly to the counties for any local governmental purposes. Concerns about, and proposals to alter, FS receipt-sharing payments also typically include the O&C payments, because both are substantial payments derived largely from timber receipts.

At their pre-SRS peaks in FY1989, FS 25% payments totaled $362 million, while O&C payments totaled $110 million. FS and O&C receipts have declined substantially since FY1989, largely because of declines in timber sales (see Figure 1). The decline began in the Pacific Northwest, owing in part to efforts to protect northern spotted owl habitat and other values.3 Provisions in the Omnibus Budget Reconciliation Act of 19934 directed FS payments for 17 national forests in Washington, Oregon, and California and BLM payments to the O&C counties at a declining percentage (beginning at 85% in FY1994 and declining by 3 percentage points annually through FY2003) of the average payments for FY1986-FY1990. Declining federal timber sales in other regions led to the nationwide SRS program replacing these safety net or “owl” payments in 2000.

Figure 1. Forest Service Cut Volume and Cut Value (2012

dollars)

Source: FY1977-FY2012 data: U.S. Forest Service, Forest Cut and Sold Reports, http://www.fs.fed.us/forestmanagement/products/sold-harvest/cut-sold.shtml, accessed November 16, 2012. FY1940-FY1976 data: U.S. Forest Service legislative affairs office.

Similar to the owl payments for the Pacific Northwest, the SRS program was an optional payment counties could elect to receive instead of receiving the 25% receipt-sharing payment. As originally enacted, the SRS payment was calculated as an average of the three highest payments between FY1986 and FY1999. With the extension in FY2007, the SRS payment calculation was modified to also consider county population and per capita income.

Payments under SRS are substantial, and significantly greater than the receipt-sharing payments would be. For example, the average annual total SRS payment for FY2001 through FY2011 was $383 million. In contrast, under the receipt-sharing system prior to the enactment of SRS, the average annual total payment was $273 million from FY1990 through FY2000. Figure 2 shows a comparison of the FS actual payments to estimates of what the payments would have been had SRS not been enacted. FS receipts (for receipt-sharing purposes) in FY2011 totaled $323 million.5 If receipt-sharing had been used rather than SRS payments then the 25% payments would have been less than $80 million. However, FY2011 payments under SRS actually totaled $308 million. Similarly, BLM timber receipts from western Oregon (which includes some non-O&C lands) totaled $22 million in FY2011.6 If 50% payments had been used, then $11 million would have been transferred to the counties, compared to SRS payments of $40 million in FY2011. If SRS is not reauthorized, FY2013 payments will again be based on a percentage of agency receipts, estimated to be $85 million for the Forest Service portion of the payment.7 The BLM estimates the O&C annual payment to be between $5.5 million and $8 million.8

In addition to these receipt-sharing programs, Congress enacted the Payments in Lieu of Taxes (PILT) Program.9 PILT payments to counties are based on “eligible” federal lands, including national forests and O&C lands, in each county (but are restricted in counties with very low populations). PILT payments are reduced (to a minimum payment per acre) by other payment programs — including FS Payments to States and BLM’s O&C payments — so changes to these latter programs may also affect a county’s payments under PILT. This also explains why FY2012 PILT payments to Colorado were double the PILT payments to Oregon, even though there is more federal land in Oregon (32.6 million acres) than in Colorado (23.8 million acres).

As enacted, PILT requires annual appropriations. If the appropriations are less than the authorized total payments, each county gets its calculated pro rata share of the appropriations. However, the 2008 and 2012 SRS amendments also made PILT payments mandatory spending for FY2008-FY2012. Thus, for those fiscal years, each county received 100% of its authorized PILT payment.

One issue of concern to Congress is the geographic allocation of the FS and PILT payments. Table 1 shows the payments for FY2012. The only O&C payment is made to Oregon, and Oregon also receives the largest FS payment. With the O&C payment of approximately $63 million, Oregon received nearly 35% of the total payments made in FY2012. The next-largest payments are in California, which received just over 10% of the total payments. PILT payments are more evenly distributed, with no state receiving more than 10% of the total payments.

Figure 2. FS Total Payments and Estimated Payments

Source: CRS. FS total payments are from the annual Forest Service report, All Service Receipts: Final Payment Summary Report PNF (ASR-10-01), available from http://www.fs.usda.gov/main/pts/home.

The estimated FS payments if SRS had not been enacted for FY2001-FY2007 are from an unpublished spreadsheet received from Rick Alexander, Secure Rural Schools Act National Program Manager, U.S. Forest Service, on November 30, 2011. The estimated payments for FY2008-FY2011 are from an FS spreadsheet available at http://www.fs.usda.gov/main/pts/home.

Notes: The data presented includes payments under the 25% Payments to States and SRS Title I and Title III programs, but does not include SRS Title II payments and miscellaneous county payments authorized through various other FS payment programs not discussed in this report, such as payments from land utilization projects.

Table 1. FY2012 FS and PILT Payments, by State

(in thousands of dollars)

______________________________________________________________________

 

FS                 PILT

______________________________________________________________________

 

Alabama                 $1,844.2            $805.2

Alaska                 $13,878.3         $26,894.5

Arizona                $13,080.4         $32,886.6

Arkansas                $6,653.1          $5,277.0

California             $35,777.1         $40,272.0

Colorado               $13,053.1         $27,724.6

Connecticut                 $0.0             $29.6

Delaware                    $0.0             $18.3

Florida                 $2,340.7          $4,891.7

Georgia                 $1,549.6          $2,242.6

Hawaii                      $0.0            $335.0

Idaho                  $26,628.3         $26,560.2

Illinois                  $253.9          $1,140.8

Indiana                   $269.0            $465.8

Iowa                        $0.0            $466.9

Kansas                      $0.0          $1,131.4

Kentucky                $1,586.5          $1,835.8

Louisiana               $1,734.5            $610.0

Maine                      $71.5            $316.0

Maryland                    $0.0            $102.4

Massachusetts               $0.0            $114.4

Michigan                $3,826.0          $4,150.5

Minnesota               $8,477.5          $1,944.1

Mississippi             $5,552.0          $2,736.8

Missouri                $3,352.7         $2,7346.8

Montana                $19,746.9         $26,152.0

Nebraska                  $196.8          $1,131.4

Nevada                  $3,630.3         $23,917.8

New Hampshire             $546.7          $1,800.9

New Jersey                  $0.0             $99.4

New Mexico             $10,264.3         $34,917.8

New York                   $18.8            $152.3

North Carolina          $1,902.5          $4,030.5

North Dakota                $0.6          $1,418.4

Ohio                      $268.4            $521.9

Oklahoma                  $916.7          $2,740.2

Oregon                 $63,015.5         $14,005.0

Pennsylvania            $3,330.6            $610.8

Rhode Island                $0.0              $0.0

South Carolina          $1,772.3            $406.0

South Dakota            $1,600.5          $5,363.8

Tennessee               $1,149.6          $1,826.5

Texas                   $2,331.1          $4,644.6

Utah                   $10,579.8         $36,038.6

Vermont                   $334.1            $942.2

Virginia                $1,625.1          $3,113.1

Washington             $20,094.8         $15,340.0

West Virginia           $1,788.6          $2,953.2

Wisconsin               $1,903.0          $1,087.2

Wyoming                 $4,309.9         $25,315.3

Othera                    $147.2             $63.9

Total                 $255,356.3        $381,647.9

______________________________________________________________________

Sources: FS: U.S. Dept. of Agriculture, Forest Service, “All

Service Receipts (ASR), Final Payment Summary Report PNF

(ASR-10-01),”

http://www.fs.usda.gov/Internet/FSE_DOCUMENTS/stelprdb5407120.pdf.

O&C: U.S. Dept. of the Interior, Bureau of Land Management,

FY2012 Secure Rural Schools Act Payments,

http://www.blm.gov/or/rac/files/rac-payments.pdf.  PILT: U.S.

Dept. of the Interior, Payments in Lieu of Taxes (PILT) Payments

by State, http://www.doi.gov/pilt/state-payments.cfm?fiscal_yr=2012.

FOOTNOTES TO TABLE 1

a “Other” includes the District of Columbia, Guam,

Puerto Rico, and the Virgin Islands.

END OF FOOTNOTES TO TABLE 1

Receipt-Sharing Program Concerns and Responses

Concerns

The counties and other observers have raised three concerns about FS and O&C receipt-sharing payments.10 The primary focus has been on the decline in FS and O&C receipts due to the decline in timber sales, particularly in Oregon (Figure 1). National forest receipts (subject to sharing) declined from their peak of $1.53 billion in FY1989 to $266 million in FY2003 — a drop of 83% from the FY1989 level. Estimated receipts for FY2012 were $340 million. In some areas, the decline was even greater; for example, payments to the eastern Oregon counties containing the Ochoco National Forest fell from $10 million in FY1991 to $309,000 in FY1998 — a decline of 97% in seven years.

Another concern has been annual fluctuations in the payments. Even in areas with modest declines or increases, the payments varied widely from year to year. From FY1985 to FY2000, the payments from each national forest had fluctuations of an average of nearly 30% annually — that is, on average, a county’s payment in any year was likely to be nearly 30% higher or lower than its payment the preceding year. Such wide annual fluctuations imposed serious budgeting difficulties on the counties.

A third, longer-term concern is referred to as linkage. Some observers have noted that, because the counties receive a portion of receipts, they are rewarded for advocating receipt-generating activities (principally timber sales) and for opposing management that might reduce or constrain such activities (e.g., designating wilderness areas or protecting commercial, tribal, or sport fish harvests). County governments have thus often been allied with the timber industry, and sometimes opposed to environmental and other interest groups, in debates over FS management and budget decisions. This source of funds was deemed appropriate when the FS program was created (albeit, prior to creation of federal income taxes). Some interests support retaining the linkage between county compensation and agency receipts; local support for receipt-generating activities is seen as appropriate by these constituencies, because such activities usually also provide local employment and income, especially in rural areas where unemployment is often high. Others assert that ending the linkage is important so that local government officials can be independent in supporting whatever management decisions benefit their locality, rather than having financial incentives to support particular decisions.

Historical Proposals to Change the Receipt-Sharing System

Concerns about the FS and BLM programs have led to various proposals over the years to alter the compensation system. Most have focused on some form of tax equivalency — compensating the states and counties at roughly the same level as if the lands were privately owned and managed. Many acknowledge the validity of this approach for fairly and consistently compensating state and county governments. However, most also note the difficulty in developing a tax equivalency compensation system, because counties and states use a wide variety of mechanisms to tax individuals and corporations — property taxes, sales taxes, income taxes, excise taxes, severance taxes, and more. Thus, developing a single federal compensation system for the tax-exempt status of federal lands may be very difficult if not impossible.

In his 1984 budget request, President Reagan proposed replacing the receipt-sharing programs with a tax equivalency system, with a guaranteed minimum payment. The counties argued that the proposal was clearly intended to reduce payments, noting that the budget request projected savings of $40.5 million (12%) under the proposal. The change was not enacted. The FY1986 FS budget request included a proposal to change the payments to 25% of net receipts (after deducting administrative costs). Legislation to effect this change was not offered.

In 1993, President Clinton proposed a 10-year payment program to offset the decline in FS and O&C timber sales, and thus payments, resulting from efforts to protect northern spotted owls and other values in the Pacific Northwest. Congress enacted this program in Section 13982 of the 1993 Omnibus Budget Reconciliation Act (P.L. 103-66). These “spotted owl” payments began in 1994 at 85% of the FY1986-FY1990 average payments, declining by 3 percentage points annually, to 58% in 2003, but with payments after FY1999 at the higher of either this formula or the standard payment.

In his FY1999 budget request, President Clinton announced that he would propose legislation “to stabilize the payments” by extending the spotted owl payments formula to all national forests. The proposal would have directed annual payments from “any funds in the Treasury not otherwise appropriated,” at the higher of (1) the FY1997 payment, or (2) 76% of the FY1986-FY1990 average payment. This approach would have increased payments in areas with large payment declines while decreasing payments in other areas, as well as eliminating annual fluctuations in payments and de-linking the payments from receipts. The Administration’s proposed legislation was not introduced in Congress. The FY2000 and FY2001 FS budget requests contained similar programs, but no legislative proposals were offered.

The National Association of Counties (NACo) proposed an alternative in 1999.11 The NACo proposal would have provided the counties with the higher of (1) the standard payment, or (2) a replacement payment determined by the three highest consecutive annual payments for each county between FY1986 and FY1995, indexed for inflation. NACo also proposed “a long-term solution . . . to allow for the appropriate, sustainable, and environmentally sensitive removal of timber from the National Forests” by establishing local advisory councils. The NACo approach would have maintained or increased the payments and might have reduced the annual fluctuations, but would likely have retained the linkage between receipts and payments in at least some areas.

Legislative History of the Secure Rural Schools and Community Self-Determination Act of 2000, as Amended

Several bills were introduced in the 106th Congress to alter FS and O&C payments. After extensive debates, Congress enacted the Secure Rural Schools and Community Self-Determination Act of 2000 (SRS, P.L. 106-393). The act established an alternative payment system for FY2001-FY2006. At each county’s discretion, the states with FS land and counties with O&C land received either the regular receipt-sharing payments or 100% of the average of the three highest payments between FY1986 and FY1999. Title I of the act directed that counties receiving less than $100,000 under the alternative system could distribute the entire payment to roads and schools in the same manner as the 25% payments. However, counties receiving at least $100,000 under the alternative system were required to spend 15%-20% of the payment on (1) federal land projects proposed by local resource advisory committees and approved by the appropriate Secretary if the projects met specified criteria, including compliance with all applicable laws and regulations and with resource management and other plans (identified in Title II of the act) or (2) certain county programs (specified in Title III of the act). Funds needed to achieve the full payment were permanently appropriated, and came first from agency receipts (excluding deposits to special accounts and trust funds) and then from “any funds in the Treasury not otherwise appropriated.”

With the enactment of SRS, the FS total payment to counties rose from $194 million in FY2000 (in nominal dollars) to $346 million in FY2001 (Figure 2). For the initial six years SRS was authorized, the average FS payment was $360 million annually, more than $130 million above the average annual FS payment for the six years prior to the enactment of SRS (FY1995-FY2000).

Reauthorization Efforts in the 110th Congress

SRS expired at the end of FY2006, with final payments made at the end of December 2006. Legislation to extend the program was considered in the 110th Congress; various bills would have extended the program for one or seven years, and one specified funding it with a miniscule (0.00086%) rescission of “any [FY2007] non-defense discretionary account.” An amendment to the FY2007 continuing resolution (H.R. 2) to extend the program for one year was offered and then withdrawn.

The debate continued in the Emergency Supplemental Appropriations Act for FY2007 (H.R. 1591, the U.S. Troop Readiness, Veterans’ Care, Katrina Recovery, and Iraq Accountability Appropriations Act, 2007). The House included a one-year extension of the program. The Senate amended the bill (S.Amdt. 709) to extend the program for five years (FY2008-FY2012) and significantly change the formula for allocating funds to the counties; the change was to address the concentration of payments in certain areas by spreading payments more broadly (as discussed below). The conference agreed to the House-passed version (a one-year extension), but the bill was vetoed by President George W. Bush.

A new version of Emergency Supplemental Appropriations for FY2007 (H.R. 2206) was introduced on May 8, 2007. This bill also included a one-year extension of SRS payments, and it was signed into law as P.L. 110-28 on May 25, 2007. Title V, Chapter 4, Section 5401, authorized payments of $100.0 million from receipts and of $425.0 million from appropriations, to “be made, to the maximum extent practicable, in the same amounts, for the same purposes, and in the same manner as were made to States and counties in 2006 under that Act.” Thus, preliminary FY2007 payments were made at the end of September 2007, with final payments made at the end of December 2007.

Another bill — the Public Land Communities Transition Assistance Act (H.R. 3058) — was introduced in July 2007 to extend, modify, and phase out the SRS payments; it was similar to the 2007 Senate Amendment to H.R. 1591. The House Natural Resources Committee held a subcommittee hearing on the bill on July 26, 2007, and a committee markup on September 26, 2007. The committee ordered the bill reported, amended, by voice vote. The bill was brought up on the House floor under suspension of the rules procedures, but did not garner the two-thirds vote needed to pass under this procedure, and it was not brought up later under other procedures.

Four-Year Extension through FY2011 Enacted in the 110th Congress

On October 1, 2008, the Senate passed H.R. 1424, the Emergency Economic Stabilization Act, with a provision similar to the 2007 Senate Amendment to H.R. 1591 in Section 601 (in Title VI — Other Provisions, Division C — Tax Extenders and Alternative Minimum Tax Relief). The House agreed to the Senate amendments on October 3, 2008, and President George W. Bush signed P.L. 110-343 into law.

Section 601(a) of H.R. 1424 extended the SRS payment program with several changes: “full funding” that declines over four years; the basis for calculating payments; transition payments for certain states; and the use of SRS funds for Title II and Title III activities. In addition, Section 601(b) modified the original FS 25% payment program (under which counties can get compensation in lieu of SRS payments and for payments after SRS expires). Finally, Section 601(c) provided five years of mandatory spending for the PILT program.

Full Funding

The act defined full funding for SRS in Section 3(11). For FY2008, full funding was $500 million; for FY2009-FY2011, full funding was 90% of the previous year’s funding. However, total payments exceeded the full funding amount in the first two years; payments under SRS totaled $572.9 million in FY2008 and $612.8 million in FY2009. This occurred because the calculated payments (discussed below) are based on full funding, as defined in the bill, but the act also authorized transition payments (discussed below) in lieu of the calculated payments in eight states. Since the transition payments exceeded the calculated payments for those states, the total payments were higher than the full funding amount.

Calculated Payments

SRS payments to each state (for FS lands) or county (for O&C lands) differed significantly from the payments made under the original SRS; Table A-1 shows the dollars and share of total SRS payments in each state in FY2006 and FY2009. Payments under Section 102 were based on historic revenue-sharing payments (like SRS), but modified based on each county’s share of federal land and relative income level. The payment calculations required a multiple-step process:

In essence, the amendment differed from the original SRS by basing half the payments on historic revenues and half on proportion of FS and O&C land, with an adjustment based on relative county income. This was done because of the concentration of payments under the original SRS to Oregon, Washington, and California (more than 75% of payments in FY2006; see Table A-1). Several counties opted out of the amended SRS system, while others opted in, because of the altered allocation. For example, in FY2006 100% of the payments to Pennsylvania were under SRS, but in FY2009 only 54% of the payments to Pennsylvania were under SRS. Conversely, in FY2006 none of the payments to New Hampshire were under SRS, but in FY2009, 44% of the payments to New Hampshire were under SRS.

In addition, the act set a full payment amount allocated among all counties that chose to participate in the program (eligible counties). Thus, the fewer counties that participated (i.e., the more that opted for the original payment programs), the more each participating county received.

Transition Payments

In lieu of the calculated payments under Section 102, the counties in eight states — California, Louisiana, Oregon, Pennsylvania, South Carolina, South Dakota, Texas, and Washington — received transition payments for three fiscal years, FY2008-FY2010. These counties were included in the calculations, but received payments of a fixed percentage of the FY2006 payments under SRS, instead of their calculated payments. The schedule in the act specified FY2008 payments equaling 90% of FY2006 payments, FY2009 payments at 81% of FY2006 payments, and FY2010 payments at 73% of FY2006 payments. Because the transition payments were higher than the calculated payments (using the multi-step formula, above), total payments have been greater than the “full funding” defined in the act.

Title II and Title III Activities

As with the original SRS, the amended version allowed counties with less than $100,000 in annual payments to use 100% of the payments for roads and schools (or any governmental purpose for O&C counties). However, it modified the requirement that counties with “modest distributions” (annual payments of more than $100,000 but less than $350,000) use 15%-20% of the funds for Title II projects (reinvestment in federal lands). Instead, these counties could use the required 15%-20% either for Title II projects or for Title III projects (county projects). Counties with payments of more than $350,000 were limited to 7% of the payments for Title III programs. The amendment also modified the authorized uses of Title III funds, deleting some authorized uses (e.g., community work centers) while expanding authorized uses related to community wildfire protection.

Income Averaging

The extension also altered the FS 25% Payment to States program. It changed the payment from 25% of current-year gross receipts to 25% of average gross receipts over the past seven years — essentially a seven-year rolling average of receipts. This reduced the annual fluctuation in payments, providing more stability in the annual payments. Thus payments increase more slowly than in the past when and where national forest receipts are rising, but decline more slowly when and where receipts are falling. This change immediately affected counties with FS land that chose not to participate in the SRS payment program, and will affect all counties with FS land in FY2013 (unless SRS is reauthorized or some other alternative is enacted).

Payments in Lieu of Taxes (PILT)

Section 601(c) of the act provided mandatory spending for the PILT program for five years, FY2008-FY2012. This meant that eligible counties received the full calculated PILT payment for those five years — a significant increase in PILT payments, since appropriations averaged less than two-thirds of the calculated payments over the past decade. After FY2012, PILT would again require annual appropriations, unless Congress extends mandatory spending for the program.

Reauthorization Efforts in the 112th Congress

SRS expired at the end of FY2011, with final payments made at the end of December 2011. Legislation to extend the program for five years was considered in the 112th Congress. The County Payments Reauthorization Act of 2011 (S. 1692 and H.R. 3599) would have extended SRS through 2016 and included provisions to slow the decline of the full funding levels to 95% of the preceding fiscal year. Neither the Senate nor the House version was reported out of committee.

One-Year Extension Enacted in the 112th Congress

On April 24, 2012, the Senate passed S. 1813, the Moving Ahead for Progress in the 21st Century Act (MAP-21), with a one-year extension for SRS. The companion legislation in the House did not contain the extension, but the House agreed to the Senate amendments on June 29, 2012. On July 6, 2012, President Obama signed P.L. 112-141 into law.

Section 100101 of P.L. 112-141 extended the SRS program through FY2012 with funding at 95% of the FY2011 level, and included requirements for the counties to select their payment option in a timely manner. The program expired on September 30, 2012, meaning that payments will revert to the original 25% receipt-sharing formula for FY2013 (or the 50% receipt-sharing formula for the O&C lands), absent further action by Congress.

Sequestration Issues

Section 302 of the Budget Control Act (BCA; P.L. 112-25, as amended by P.L. 112-240) required the President to order a sequester, or cancellation, of budgetary resources for FY2013, in the event that Congress did not enact deficit reduction of at least $1.2 trillion by January 15, 2012.13 Congress did not enact such deficit reduction by that date, and on March 1, 2013, the Office of Management and Budget (OMB) determined the amount of the total sequestration for FY2013 to be approximately $85 billion.14

Under the BCA, half of the total reduction calculated pursuant to paragraph (3) for FY2013 is allocated to defense spending, and the other half to non-defense spending.15 Within each half, the reductions are further allocated between discretionary appropriations and direct spending.16 Discretionary appropriations are defined in the BCA as budgetary resources provided in annual appropriations acts.17 In contrast, direct spending is defined to include budget authority provided by law other than appropriations acts.18 The BCA further requires OMB to calculate a uniform percentage reduction that is to be applied to each program, project, or activity within the direct spending category.19 For the direct spending category, OMB has determined this percentage to be 5.1% for FY2013.

Section 102(d)(3)(e) of SRS directs that payments for a fiscal year are to be made to the state as soon as practicable after the end of that fiscal year, meaning that the FY2012 payment is made in FY2013.20 Because the authority to make these payments is not provided in an annual appropriations act, such payments are not discretionary spending for purposes of the BCA. These payments are classified as non-defense, direct spending for purposes of sequestration, as direct spending is defined to include all budget authority provided in law other than annual appropriations acts.21 The BCA exempts a number of programs from sequestration; however, the payments under SRS do not appear to be identified as exempt.22 Consequently, these payments would appear to be subject to sequestration as non-defense, direct spending.

BLM Sequestration of SRS Funds

BLM only issues SRS payments for the O&C lands in Oregon. In February 2013, BLM distributed $36 million to the 18 O&C counties in Oregon for FY2012 SRS payments. However, DOI held back 10% of the scheduled payments across all three titles in anticipation of the possibility of sequestration. The reduction to DOI’s SRS program required by sequestration was 5.1% of the total payment, or $2.0 million.23 Since the sequestered amount was less than the amount withheld, DOI-BLM owed an additional SRS payment for the difference. In May 2013, BLM distributed the remaining 4.9% of the payment, resulting in a total $38 million SRS payment to the O&C counties for FY2012.24

Forest Service Sequestration of SRS Funds

The Forest Service distributed the full FY2012 SRS payments in January and February 2013, without withholding any amount in preparation for the potential sequester order. On March 19, 2013, the Forest Service announced it would seek to recover from the states the 5.1% of the payments that were subject to sequestration.25 In letters sent to each affected governor, the Forest Service outlined two repayment options and asked for the states to respond by April 19, 2013, with how they planned to repay. Invoices for repayment were not included. In addition to repaying the 5.1%, the FS offered the states the option of having the full sequestered amount taken out of Title II funds (for those states with enough Title II money). Three states — Alaska, Washington, and Wyoming — have publicly indicated their intention to not repay the SRS funds.26 In an April 16, 2013, hearing before the Senate Committee on Energy and Natural Resources, the FS indicated that invoices for the repayment would be sent in late April 2013.

On August 5, 2013, the Forest Service sent additional letters which included invoices for the repayment to the governors of the 18 states with insufficient Title II money to cover the sequestered amount.27 The invoices outline three options for the affected states to take within 30 days: pay the debt in full; agree to a payment plan; or petition for administrative review of the debt. The invoices also included a Notice of Indebtedness to the U.S. Forest Service and Intent to Collect by Administrative Offset, which describes the basis of the indebtedness and the Forest Service’s intent to offset future payments — without assessing penalties — from future Forest Service and Department of Agriculture state payments.

On August 20, 2013, the Forest Service sent additional letters to the governors of the 22 states that had sufficient Title II money to cover the sequestered amount.28 The letters informed the governors that the Title II allocations are being reduced by the sequestered amount.

On September 4, 2013, House Natural Resources Committee Chairman Doc Hastings issued subpoenas to the Secretary of Agriculture and the Director of OMB seeking documents related to the decision to sequester the SRS payment by September 18, 2013.29

Legislative Issues

Congress may consider extending SRS, with or without modifications, implementing other legislative proposals to address the county payments, or taking no action (thus continuing the revenue-based system that took effect upon the program’s expiration). Generally, six issues commonly have been raised about compensating counties for the tax-exempt status of federal lands: the lands covered; the basis for compensation; the source of funds; the authorized and required uses of the payments; interaction with other compensation programs; and the duration of the new system. In addition, any new mandatory spending in excess of the baseline that would result in an increase in the deficit may be subject to budget rules, such as congressional pay-as-you-go (PAYGO) rules, which generally require budgetary offsets.30

Offsets for New Mandatory Spending

One policy issue concerns legislation with mandatory spending that would increase federal expenditures, and whether such spending should be offset so as not to increase the deficit. Congress has enacted a set of budget rules requiring that most legislation that creates new or extends existing mandatory spending (in excess of the baseline) be balanced — offset — by increases in receipts or decreases in other mandatory spending. The budget rules may be waived or set aside in particular instances, but the increased deficit spending remains a consideration.

Legislation to reauthorize the Secure Rural Schools and Community Self-Determination Act of 2000 (with or without other modifications), or to enact a different alternative, would require an offset — increased revenues or decreased spending from other mandatory spending accounts — or a waiver to the budget rules. In 2000, Congress provided such a waiver by including a specific type of provision, called a reserve fund, in the budget resolution.

In 2006, to fund a six-year reauthorization of SRS, the Bush Administration proposed selling some federal lands. To fund the O&C payments, the BLM would have accelerated its land sales under Section 203 of the Federal Land Policy and Management Act of 1976 (FLPMA; 43 U.S.C. § 1713). For the FS payments, estimated at $800 million, the FS would have sold approximately 300,000 acres of national forest land. This would have required legislation, as the FS currently has only very narrow authority to sell any lands. The Administration offered draft legislation to authorize these land sales, but no bill to authorize that level of national forest land sales was introduced in the 109th Congress. Instead, Congress again included a reserve fund for SRS payments in the budget resolution.

In 2007, the Bush Administration again proposed selling national forest lands to fund a phase-out of SRS payments, with half of the land sale revenues to be used for other programs (including land acquisition and conservation education). Again, no legislation to authorize national forest land sales was introduced.

Lands Covered

SRS includes payments only for national forests and for the O&C lands. Some observers have noted that these compensation programs provide substantial funding for the specified lands, while other federal lands that are exempt from state and local taxation receive little or nothing. The easiest comparison is with the national grasslands. Some have questioned the logic of compensating national forest counties with 25% of gross receipts and protecting these counties from declines in receipts under SRS, while compensating national grassland counties with 25% of net receipts and excluding them from SRS. Both forests and grasslands are part of the National Forest System, although the laws authorizing their establishment differ.

More significantly, many other tax-exempt federal lands provide little compensation to local governments. The BLM has numerous compensation programs, but generally the payments are quite small. (The O&C payments account for about 95% of BLM compensation payments, but O&C lands are only about 1% of BLM lands.) The National Park Service has two small compensation programs related to public schooling of park employees’ children at two parks. PILT provides some compensation for most federal lands, but many lands — inactive military bases, Indian trust lands, and certain wildlife refuge lands, for example — are excluded, and the national forests and O&C lands get PILT payments in addition to other compensation. In 1992, the Office of Technology Assessment recommended “fair and consistent compensation for the tax exempt status of national forest lands and activities.”31 This concept of fair and consistent compensation could be extended to all tax-exempt federal lands. Others argue that the limited costs imposed on local governments by federal land ownership may lead to overcompensating state and local governments.

Basis for Compensation

The legislative histories of the agriculture appropriations acts establishing the FS payments to states (the last of which, enacted on May 23, 1908, made the payments permanent) indicate that the intent was to substitute receipt-sharing for local property taxation, but no rationale was discussed for the level chosen (10% in 1906 and 1907; 25% since). Similarly, the rationale was not clearly explained or discussed for the Reagan tax-equivalency proposal, for the spotted owl payments (a declining percent of the historical average), or for the legislation debated and enacted by the 106th Congress (generally the average of the three highest payments during a specified historical period). The proposals’ intents were generally to reduce (Reagan Administration) or increase (more recently) the payments.

The geographic basis is also a potential problem for FS payments. FS 25% payments are made to the states, but are calculated for each county with land in each national forest.32 Depending on the formula used — the average of selected historical payments from each national forest or to each county or each state — the calculations could result in different levels of payments in states with multiple national forests.33 (This is not an issue for O&C lands, because the O&C payments are made directly to the counties.)

Source of Funds

As noted above, the FS 25% payments are permanently appropriated from agency receipts, and were established prior to federal income taxes and substantial federal oil and gas royalties. Most of the proposals for change also would establish mandatory payments; lacking a specified funding source, mandatory spending would come from the General Treasury. SRS directed payments first from receipts, then from the General Treasury. Figure 3 shows the breakdown of SRS funding between receipts and the General Treasury. Critics are concerned that retaining the linkage between agency receipts (e.g., from timber sales) and county payments (albeit less directly than for the 25% payments) still encourages counties to support timber sales over other FS uses.

Figure 3. Source and Distribution of FS Payments

Source: CRS. Data from Forest Service, FY2010-FY2013 Budget Justifications, available from http://www.fs.fed.us/aboutus/budget/.

Notes: SRS Title I and Title III payments are passed through the state to the counties to use for specified purposes. SRS Title II payments are retained by the Forest Service for use on approved National Forest projects.

Authorized and Required Uses of the Payments

The FS 25% payments can be spent only on roads and schools in the counties where the national forests are located. State law dictates which road and school programs are financed with the payments, and the state laws differ widely, generally ranging from 30% to 100% for school programs, with a few states providing substantial local discretion on the split. The O&C payments are available for any local governmental purpose.

SRS modified these provisions by requiring (for counties with at least $100,000 in annual payments) that 15%-20% of the payments be used for other specified purposes: certain local governmental costs (in Title III); federal land projects recommended by local advisory committees and approved by the Secretary (under Title II); or federal land projects as determined by the Secretary (under § 402). Use of the funds for federal land projects has been touted as “reinvesting” agency receipts in federal land management, but opponents argue that this “relinks” county benefits with agency receipt-generating activities and reduces funding for local schools and roads. The Forest Counties Payments Committee recommended granting local governments more flexibility in their use of the payments. The committee also recommended that the federal government prohibit the states from adjusting their education funding allocations because of the FS payments.34

Duration of the Programs

The questions Congress may consider are (1) how often should Congress review the payment systems (these or all county compensation programs, or the lack thereof) to assess whether they still function as intended; and (2) what options are available (e.g., a sunset provision) to induce future Congresses to undertake such a review? The FS 25% payments and the O&C payments are permanently authorized. The FS 25% payments were established in 1908 (after having been enacted as a one-year program in 1906 and again in 1907). The O&C payments were established in 1937. The owl payments were to be a 10-year program, enacted in 1993. SRS was originally enacted as a six-year program that expired on September 30, 2006, but was extended an additional six years through September 30, 2012. The Forest Counties Payments Committee recommended a permanent change based on SRS, with some adjustments.

Legislative Activity in the 113th Congress

The 113th Congress is considering options for reauthorizing or modifying SRS for FY2013. On March 19, 2013, the Senate Energy and Natural Resources committee held a hearing to discuss options for reauthorizing and reforming SRS and PILT.35 On June 18, 2013, the Senate Energy and Natural Resources Committee ordered to be reported S. 783, the Helium Stewardship Act of 2013, which includes a one-year extension of SRS at 95% of the FY2012 SRS payment.

On July 31, 2013, the House Committee on Natural Resources ordered to be reported H.R. 1526, the Restoring Healthy Forests for Healthy Communities Act. In Section 501, H.R. 1526 directs the FS and BLM to distribute, no later than February 2014, a payment to eligible counties in the amount equal to the FY2010 payment. In Section 502, H.R. 1526 changes the calculation formula for the FS 25% Payment to States program. It changes the payment from 25% of average gross receipts over the past seven years to 25% of current-year gross receipts.

The President’s FY2014 budget request for the Forest Service and the BLM proposes a five-year reauthorization of SRS, with mandatory funding, starting at $278 million for FY2014 and declining to $106 million by FY2017.36 The President’s proposal also includes decreasing the Title I and Title III allocation while increasing the Title II allocation.

The 113th Congress is also conducting oversight on the decision to sequester the SRS FY2012 payment. On September 4, 2013, House Natural Resources Committee Chairman Doc Hastings issued subpoenas to the Secretary of Agriculture and the Director of OMB seeking documents related to the sequester decision by September 18, 2013.37

Appendix. SRS Payments in FY2006 and FY2009

As described in the text, under “Four-Year Extension Enacted in the 110th Congress,” the SRS payment formula was modified in the extension to include federal acreage and relative income in each county, as well as transition payments in some states. The result was a change in the payments and the allocation of total payments in the modified formula. These changes are shown in Table 2. Note, however, that the change in the payment formula led some counties that had chosen 25% payments for FY2006 to opt for SRS payments for FY2009, and vice versa. Some of the increase in SRS payments in FY2009 is due to more counties opting for SRS payments in some states, such as Michigan, New Hampshire, Ohio, Puerto Rico, and Wisconsin. In at least one state — Pennsylvania — a portion of the decline is due to some counties opting for 25% payments in FY2009.

Table A-1. FY2006 and FY2009 FS and O&C Payments Under SRS,

by State

(in thousands of dollars and percent of total SRS funding

for all of U.S.)

______________________________________________________________________

 

FY2006                     FY2009

____________________       ____________________

 

Dollars      Percent       Dollars      Percent

______________________________________________________________________

 

AL       2,133.8       0.44%        2,236.2       0.44%

AK       9,377.2       1.92%       18,760.5       3.68%

AZ       7,289.8       1.50%       16,688.2       3.27%

AR       6,568.0       1.35%        8,309.6       1.63%

CA      65,279.3      13.44%       50,125.6       9.83%

CO       6,338.7       1.31%       14,641.3       2.87%

FL       2,504.5       0.52%        2,862.3       0.56%

GA       1,304.6       0.27%        1,864.1       0.37%

ID      21,173.5       4.36%       34,900.0       6.85%

IL         304.2       0.06%          107.6       0.02%

IN         130.2       0.03%          337.4       0.07%

KY         682.1       0.14%        2,596.9       0.51%

LA       3,726.1       0.77%        2,620.1       0.51%

ME          41.4       0.01%           99.3       0.02%

MI         789.8       0.16%        3,397.1       0.67%

MN       1,468.8       0.36%        3,330.1       0.65%

MS       8,287.2       1.71%        7,705.7       1.51%

MO       2,767.2       0.57%        4,681.7       0.92%

MT      12,934.8       2.66%       24,523.6       4.81%

NE          55.6       0.01%          584.4       0.11%

NV         408.8       0.08%        5,174.2       1.02%

NH           0.0       0.00%          275.2       0.05%

NM       2,383.6       0.49%       18,185.9       3.57%

NY          16.9      <0.01%           29.5       0.01%

NC       1,020.9       0.21%        2,326.6       0.46%

ND           0.0       0.00%            0.8      <0.01%

OH          68.8       0.01%          339.7       0.07%

OK       1,238.9       0.26%        1,192.4       0.23%

OR-

FS     149,153.3      30.72%      121,316.4      23.80%

OR-    108,852.0      22.42%       87,175.0      17.10%

O&C

OR-    258,005.3      53.13%      208,491.4      40.91%

Total

PA       6,491.6       1.34%        2,505.6       0.49%

PR           0.0       0.00%          184.7       0.04%

SC       3,288.2       0.68%        2,498.4       0.49%

SD       3,823.4       0.79%        2,931.1       0.58%

TN         560.3       0.12%        1,428.4       0.28%

TX       4,688.8       0.97%        3,655.9       0.72%

UT       1,872.5       0.39%       14,177.0       2.78%

VT         392.3       0.08%          400.7       0.08%

VA         925.2       0.19%        2,093.7       0.41%

WA      42,293.9       8.71%       33,990.9       6.67%

WV       2,006.3       0.41%        2,356.8       0.46%

WI         577.6       0.12%        2,730.1       0.54%

WY       2,387.4       0.49%        4,357.6       0.85%

Total  485,567.7                  509,667.8

______________________________________________________________________

Sources: FS: U.S. Dept. of Agriculture, Forest Service, “All

Service Receipts (ASR), Final Payment Summary Report PNF

(ASR-10-01),” unpublished reports. O&C: U.S. Dept. of the

Interior, Bureau of Land Management, FY2011 Budget

Justification, p. X-6,

http://www.doi.gov/budget/2011/data/greenbook/FY2011_BLM_Greenbook.pdf.

Note: Counties could choose to receive the regular 25% FS

payments or 50% O&C payments, rather than the SRS payments, and in

many cases opted for the 25% in FY2006 or FY2009, and sometimes in

both fiscal years. Thus, a change in the SRS payments in the table

might not reflect the total change in FS payments to that state.

Author Contact Information

Katie Hoover

Analyst in Natural Resources Policy

[email protected], 7-9008

Acknowledgments

Ross Gorte, retired CRS Specialist in Natural Resources Policy, made important contributions to this report.

FOOTNOTES

1 16 U.S.C. § 500. For more on these and other county-compensation programs with mandatory spending for federal lands, see CRS Report RL30335, Federal Land Management Agencies’ Mandatory Spending Authorities.

2 For more information, see CRS Report R42951, The Oregon & California Railroad Lands (O&C Lands): Issues for Congress.

3 The decline in timber harvests is attributable to a variety of factors, including a combination of forest management policies and practice, increased planning and procedural requirements, changing public preferences, economic, and industry factors.

4 P.L. 103-66 § 13982-3.

5 Data provided by the Forest Service Legislative Affairs office, February 21, 2013.

6 U.S. Dept. of the Interior, Bureau of Land Management, Public Land Statistics, 2011, Table 3-12, http://www.blm.gov/public_land_statistics/pls11/pls2011.pdf.

7 Forest Service, FY2013 Budget Justification, pp. 12-40, http://www.fs.fed.us/aboutus/budget/.

8 Personal communication with BLM Legislative Affairs office, July 2013.

9 See CRS Report RL31392, PILT (Payments in Lieu of Taxes): Somewhat Simplified.

10 Forest Counties Payments Committee, Recommendations for Making Payments to States and Counties: Report to Congress (Washington, DC: U.S. GPO, 2003). The committee was established in § 320 of the FY2001 Interior and Related Agencies Appropriations Act, P.L. 106-291.

11 National Association of Counties, NACo Resolution in Support of a Forest Counties “Safety Net,” Washington, DC, April 21, 1999.

12 Eligible counties are those that choose to receive payments under this program; counties that choose to continue to receive payments under the original revenue-sharing programs are excluded from these calculations.

13 2 U.S.C. § 901A. The sequester was originally supposed to be ordered on January 2, 2013, but was delayed by the American Taxpayer Relief Act of 2012, P.L. 112-240, until March 1, 2013. For more information on sequestration issues, see CRS Report R42972, Sequestration as a Budget Enforcement Process: Frequently Asked Questions.

14 This amount was identified based on a formula set forth in § 302.

15 2 U.S.C. § 901A(4).

16 2 U.S.C. § 901A(6).

17 2 U.S.C. § 900(7).

18 2 U.S.C. § 900(8). Budget authority is further defined as “the authority provided by Federal law to incur financial obligations.” 2 U.S.C. § 622.

19 Although not relevant here, additional restrictions are placed on the degree by which Medicare payments in the direct spending category may be reduced. 2 U.S.C. § 901a(8).

20 16 U.S.C. § 7112(e).

21 2 U.S.C. § 900(8).

22 2 U.S.C. § 905.

23 Testimony of DOI Deputy Assistant Secretary Pamela K. Haze, in U.S. Congress, Senate Committee on Energy and Natural Resources, Keeping the Commitment to Rural Communities, hearing, 113th Cong., 1st sess., March 19, 2013.

24 Personal communication with BLM Legislative Affairs office, June 19, 2013.

25 Testimony of Forest Service Chief Thomas Tidwell, in U.S. Congress, Senate Committee on Energy and Natural Resources, Keeping the Commitment to Rural Communities, hearing, 113th Cong., 1st sess., March 19, 2013. SRS payments are made from the Forest Service to the states, which then distribute the payment to the eligible counties.

26 Phil Taylor, “Hastings probes Forest Service’s withholding of timber payments,” E&E News, May 21, 2013.

27 The following states did not have sufficient Title II funds to cover the sequester and received invoices: AL, AR, GA, IL, IN, ME, MN, MO, NC, ND, NE, NH, NY, OH, PA, PR, TN, VT, and VA. WA received a letter and invoice to collect money from a special act payment, but the letter also indicated the total SRS Title II reduction.

28 The following states had the sequester withheld entirely from their Title II funds: AK, AZ, CA, CO, FL, ID, KY, LA, MI, MS, MT, NM, NV, OK, OR, SC, SD, TX, UT, WI, WV, and WY.

29 House Natural Resources Committee, Press Release September 4, 2013, http://naturalresources.house.gov/news/documentsingle.aspx?DocumentID=347606.

30 For an overview of federal budget procedures, see CRS Report 98-721, Introduction to the Federal Budget Process. For background on PAYGO rules, see CRS Report RL34300, Pay-As-You-Go Procedures for Budget Enforcement.

31 U.S. Congress, Office of Technology Assessment, Forest Service Planning: Accommodating Uses, Producing Outputs, and Sustaining Ecosystems, OTA-F-505 (Washington: U.S. GPO, Feb. 1992), p. 8.

32 There was no discussion in the legislative history of why the payments were made to the states, and not directly to the counties.

33 The complexity of this situation is shown using Arizona as an example in out-of-print CRS Report RL30480, Forest Service Revenue-Sharing Payments: Legislative Issues (available from the author).

34 Some states include FS payments allocated for education in their calculations allocating state education funds to the counties.

35 U.S. Congress, Senate Energy and Natural Resources, Keeping the Commitment to Rural Communities, 113th Cong., 1 sess., March 19, 2013, pp. http://www.energy.senate.gov/public/index.cfm/2013/3/full-committee-hearing-funding-programs-for-rural-communities.

36 U.S. Forest Service, FY2014 Budget Justification, pp. 12-58, http://www.fs.fed.us/aboutus/budget/.

37 House Natural Resources Committee, Press Release September 4, 2013, http://naturalresources.house.gov/news/documentsingle.aspx?DocumentID=347606.




IRS Releases Publication Containing Guidance on Applying for Tax-Exempt Status.

The IRS has released Publication 4220 (rev. Aug. 2013), Applying for 501(c)(3) Tax-Exempt Status, which provides general guidelines for organizations that seek exemption from federal income tax under section 501(c)(3).

http://www.irs.gov/pub/irs-pdf/p4220.pdf




IRS Releases Publication for Public Charity Compliance.

The IRS has released Publication 4221-PC (rev. Aug. 2013), Compliance Guide for 501(c)(3) Public Charities, which identifies activities that could jeopardize a public charity’s tax-exempt status and addresses general compliance requirements on record keeping, reporting, and disclosure for exempt organizations.

http://www.irs.gov/pub/irs-pdf/p4221pc.pdf




IRS Releases Publication on Charitable Contributions.

The IRS has released Publication 1771 (rev. Jul. 2013), Charitable Contributions — Substantiation and Disclosure Requirements, which explains general rules and specifications for documenting charitable deductions and explains new guidelines that allow charities to electronically mail documentation to donors.

http://www.irs.gov/pub/irs-pdf/p1771.pdf




IRS Releases Publication Containing Guidance for Charitable Donations of Vehicles.

The IRS has released Publication 4303 (rev. Aug. 2013), A Donor’s Guide to Vehicle Donations, which provides general guidelines for individuals who donate their vehicles to a charity

http://www.irs.gov/pub/irs-pdf/p4303.pdf




IRS Previewing Interactive Exemption Application.

The IRS is previewing an interactive version of Form 1023, “Application for Recognition of Exemption Under Section 501(c)(3),” online and is seeking comments.

The interactive application was posted September 6 and is available until September 20 at www.stayexempt.irs.gov, the IRS announced in an electronic newsletter.

Users cannot now print or submit the interactive version of the application, according to the newsletter. However, when testing is finished later this year, users will be able to print and mail the form and its attachments.

The interactive form should allow users to submit a more complete application and help the agency speed up processing times and provide faster determinations, the newsletter says.

The IRS developed the interactive application from recommendations made in the Advisory Committee on Tax-Exempt and Government Entities report , the newsletter says. The application was also listed in the agency’s fiscal 2013 exempt organizations workplan .

The IRS requests that comments on the interactive application be sent to [email protected].




Final Regs Remove References to Credit Ratings in Tax Code Rules.

The IRS has issued final regulations that remove any reference to, or requirement of reliance on, credit ratings in various tax code rules and provide substitute standards of creditworthiness where appropriate. (T.D. 9637)

[4830-01-p] DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 48 [TD 9637] RIN 1545-BK27 Modification of Treasury Regulations Pursuant to Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations and removal of temporary regulations. SUMMARY: This document contains final regulations that remove any reference to, or requirement of reliance on, “credit ratings” in regulations under the Internal Revenue Code (Code) and provides substitute standards of credit-worthiness where appropriate. This action is required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. These regulations affect persons subject to various provisions of the Code. DATES: Effective Date: These regulations are effective on September 6, 2013.

Applicability Dates: For dates of applicability, see §§1.150-1(a)(4), 1.171-1 (f), 1.197-2(b)(7), 1.249-1(f)(3), 1.475(a)-4(d)(4), 1.860G-2(g)(3), 1.1001-3(d), (e), and (g), and 48.4101-1(l)(5). FOR FURTHER INFORMATION CONTACT: Arturo Estrada, (202) 622-3900 (not a toll- free number). SUPPLEMENTARY INFORMATION: Background

Doc 2013-21135 (17 pgs)

Section 939A(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203 (124 Stat. 1376 (2010)) (the “Dodd-Frank Act”), requires each Federal agency to review its regulations that require the use of an assessment of credit- worthiness of a security or money market instrument, and to review any references or requirements in its regulations regarding credit ratings. Section 939A(b) directs each agency to modify any regulation identified in the review required under section 939A(a) by removing any reference to, or requirement of reliance on, credit ratings and substituting a standard of credit-worthiness that the agency deems appropriate. Numerous provisions under the Internal Revenue Code (Code) are affected.

These regulations amend the Income Tax Regulations (26 CFR part 1) under sections 150, 171, 197, 249, 475, 860G, and 1001 of the Code (the existing regulations). These sections were added to the Code during different years to serve different purposes. These regulations also amend the Manufacturers and Retailers Excise Tax Regulations (26 CFR part 48) under section 4101, which provides registration requirements related to Federal fuel taxes.

On July 6, 2011, temporary regulations (TD 9533) under sections 150, 171, 197, 249, 475, 860G, and 1001 of the Code were published in the Federal Register (76 FR 39278) that modify or eliminate the reference to credit ratings in the relevant regulations. Additional temporary regulations (26 CFR part 48) under section 4101 were published as part of TD 9533. A notice of proposed rulemaking (REG-118809-11) cross-referencing the temporary regulations was published in the Federal Register the same day (76 FR 39341). No written comments responding to the notice of proposed rulemaking were received. No public hearing was requested or held. The regulations are adopted as proposed without substantive changes. Explanation of Provisions

These regulations remove references to “credit ratings” and “credit agencies” or functionally similar terms in the existing regulations. Some changes involve simple word deletions or substitutions. Others reflect the revision of one or more sentences to remove the credit rating references. Where appropriate, substitute standards of credit- worthiness replace the prior references to credit ratings, credit agencies, or functionally similar terms. Language revisions serve solely to remove the references prohibited by section 939A of the Dodd-Frank Act and no additional changes to the existing regulations are intended. Special Analyses

It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. Because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, these regulations have been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. No comments were received.

Drafting Information

These regulations were drafted by personnel in the Office of Associate Chief Counsel (Financial Institutions and Products), the Office of Associate Chief Counsel (Income Tax and Accounting), the Office of the Associate Chief Counsel (International) and the Office of the Associate Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and the Treasury Department participated in the development of the regulations. List of Subjects 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements. 26 CFR Part 48

Excise taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 48 are amended as follows: PART 1–INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.150-1 is amended as follows: 1. Paragraph heading (a)(2) is revised.

2. Paragraph (a)(4) is revised. 3. In paragraph (b), the definition of “Issuance costs” is revised. The revisions read as follows:

§1.150-1 Definitions.

4

Doc 2013-21135 (17 pgs)

(a) * * *

(2) Effective/applicability date * * * *****

(4) Additional exception to the general applicability date. Section 1.150-1(b), Issuance costs, applies on and after July 6, 2011.

(b) * * *

Issuance costs means costs to the extent incurred in connection with, and allocable to, the issuance of an issue within the meaning of section 147(g). For example, issuance costs include the following costs but only to the extent incurred in connection with, and allocable to, the borrowing: underwriters’ spread; counsel fees; financial advisory fees; fees paid to an organization to evaluate the credit quality of an issue; trustee fees; paying agent fees; bond registrar, certification, and authentication fees; accounting fees; printing costs for bonds and offering documents; public approval process costs; engineering and feasibility study costs; guarantee fees, other than for qualified guarantees (as defined in §1.148–4(f)); and similar costs. ***** §1.150-1T [Removed]

Par. 3. Section 1.150-1T is removed.

Par. 4. Section 1.171-1(f) Example 2 is revised to read as follows: §1.171-1 Bond premium.

***** (f) * * *

Example 2. Convertible bond–(i) Facts. On January 1, A purchases for $1,100 B corporation’s bond maturing in three years from the purchase date, with a stated principal amount of $1,000, payable at maturity. The bond provides for unconditional payments of interest of $30 on January 1 and July 1 of each year. In addition, the bond is convertible into 15 shares of B corporation stock at the option of the holder. On the purchase date, B corporation’s nonconvertible, publicly-traded, three-year debt of comparable credit quality trades at a price that reflects a yield of 6.75 percent, compounded semiannually.

(ii) Determination of basis. A’s basis for determining loss on the sale or exchange of the bond is $1,100. As of the purchase date, discounting the remaining payments on the bond at the yield at which B’s similar nonconvertible bonds trade (6.75 percent, compounded semiannually) results in a present value of $980. Thus, the value of the conversion option is $120. Under paragraph (e)(1)(iii)(A) of this section, A’s basis is $980 ($1,100 – $120) for purposes of this section and §§1.171-2 through 1.171-5. The sum of all amounts payable on the bond other than qualified stated interest is $1,000. Because A’s basis (as determined under paragraph (e)(1)(iii)(A) of this section) does not exceed $1,000, A does not acquire the bond at a premium.

(iii) Applicability date. Notwithstanding §1.171-5(a)(1), this Example 2 applies to bonds acquired on or after July 6, 2011. §1.171-1T [Removed]

Par. 5. Section 1.171-1T is removed. Par. 6. Section 1.197-2 is amended by revising paragraph (b)(7) to read as

follows: §1.197-2 Amortization of goodwill and certain other intangibles. *****

(b) * * * (7) Supplier-based intangibles–(i) In general. Section 197 intangibles include any

supplier-based intangible. A supplier-based intangible is the value resulting from the future acquisition, pursuant to contractual or other relationships with suppliers in the ordinary course of business, of goods or services that will be sold or used by the taxpayer. Thus, the amount paid or incurred for supplier-based intangibles includes, for example, any portion of the purchase price of an acquired trade or business attributable to the existence of a favorable relationship with persons providing distribution services (such as favorable shelf or display space at a retail outlet), or the existence of favorable supply contracts. The amount paid or incurred for supplier-based intangibles does not include any amount required to be paid for the goods or services themselves pursuant to the terms of the agreement or other relationship. In addition, see the exceptions in paragraph 2(c) of this section, including the exception in paragraph 2(c)(6) of this section for certain rights to receive tangible property or services from another person.

(ii) Applicability date. This section applies to supplier-based intangibles acquired after July 6, 2011.

*****

§1.197-2T [Removed]

Par. 7. Section 1.197-2T is removed.

Par. 8. Section 1.249-1 is amended by revising paragraphs (e)(2)(ii) and (f)(3) to read as follows:

§1.249-1 Limitation on deduction of bond premium on repurchase. *****

(e) * * * (2) * * * (ii) In determining the amount under paragraph (e)(2)(i) of this section,

appropriate consideration shall be given to all factors affecting the selling price or yields of comparable nonconvertible obligations. Such factors include general changes in prevailing yields of comparable obligations between the dates the convertible obligation was issued and repurchased and the amount (if any) by which the selling price of the nonconvertible obligation was affected by reason of any change in the issuing corporation’s credit quality or the credit quality of the obligation during such period (determined on the basis of widely published financial information or on the basis of other relevant facts and circumstances which reflect the relative credit quality of the corporation or the comparable obligation).

*****

(f) * * * (3) Portion of repurchase premium attributable to cost of borrowing. Paragraph

(e)(2)(ii) of this section applies to any repurchase of a convertible obligation occurring on or after July 6, 2011. ***** §1.249-1T [Removed]

Par. 9. Section 1.249-1T is removed.

Par. 10. Section 1.475(a)-4 is amended by revising paragraph (d)(4) Example 1, Example 2, and Example 3 to read as follows: §1.475(a)-4 Valuation safe harbor. *****

(d) * * * (4) * * *

Example 1. (i) X, a calendar year taxpayer, is a dealer in securities within the meaning of section 475(c)(1). X generally maintains a balanced portfolio of interest rate swaps and other interest rate derivatives, capturing bid-ask spreads and keeping its market exposure within desired limits (using, if necessary, additional derivatives for this purpose). X uses a mark-to-market method on a statement that it is required to file with the United States Securities and Exchange Commission and that satisfies paragraph (d)(2) of this section with respect to both the contracts with customers and the additional derivatives. When determining the amount of any gain or loss realized on a sale, exchange, or termination of a position, X makes a proper adjustment for amounts taken into account respecting payments or receipts. X and all of its counterparties on the derivatives have the same general credit quality as each other.

(ii) Under X’s valuation method, as of each valuation date, X determines a mid- market probability distribution of future cash flows under the derivatives and computes the present values of these cash flows. In computing these present values, X uses an industry standard yield curve that is appropriate for obligations by persons with this same general credit quality. In addition, based on information that includes its own knowledge about the counterparties, X adjusts some of these present values either upward or downward to reflect X’s reasonable judgment about the extent to which the true credit status of each counterparty’s obligation, taking credit enhancements into account, differs from the general credit quality used in the yield curve to present value the derivatives.

(iii) X’s methodology does not violate the requirement in paragraph (d)(3)(iii) of this section that the same cost or risk not be taken into account, directly or indirectly, more than once.

(iv) Applicability date. This Example 1 applies to valuations of securities on or after July 6, 2011.

Example 2. (i) The facts are the same as in Example 1, except that X uses a better credit quality in determining the yield curve to discount the payments to be received under the derivatives. Based on information that includes its own knowledge about the counterparties, X adjusts these present values to reflect X’s reasonable judgment about the extent to which the true credit status of each counterparty’s obligation, taking credit enhancements into account, differs from this better credit quality obligation.

(ii) X’s methodology does not violate the requirement in paragraph (d)(3)(iii) of this section that the same cost or risk not be taken into account, directly or indirectly, more than once.

(iii) Applicability date. This Example 2 applies to valuations of securities on or after July 6, 2011.

Example 3. (i) The facts are the same as in Example 1, except that, after computing present values using the discount rates that are appropriate for obligors with the same general credit quality, and based on information that includes X’s own knowledge about the counterparties, X adjusts some of these present values either upward or downward to reflect X’s reasonable judgment about the extent to which the true credit status of each counterparty’s obligation, taking credit enhancements into account, differs from a better credit quality.

(ii) X’s methodology violates the requirement in paragraph (d)(3)(iii) of this section that the same cost or risk not be taken into account, directly or indirectly, more than once. By using the same general credit quality discount rate, X’s method takes into account the difference between risk-free obligations and obligations with that lower credit quality. By adjusting values for the difference between a higher credit quality and that lower credit quality, X takes into account risks that it had already accounted for through the discount rates that it used. The same result would occur if X judged some of its counterparties’ obligations to be of a higher credit quality but X failed to adjust the values of those obligations to reflect the difference between a higher credit quality and the lower credit quality.

(iii) Applicability date. This Example 3 applies to valuations of securities on or after July 6, 2011.

*****

§1.475(a)-4T [Removed]

Par. 11. Section 1.475(a)-4T is removed.

Par. 12. Section 1.860G-2 is amended by revising paragraphs (g)(3)(ii)(B), (g)(3)(ii)(C) and (g)(3)(ii)(D) to read as follows: §1.860G-2 Other rules. *****

(g) * * * (3) * * * (ii) * * * (B) Presumption that a reserve is reasonably required. The amount of a reserve fund is presumed to be reasonable (and an excessive reserve is presumed to have

been promptly and appropriately reduced) if it does not exceed the amount required by a third party insurer or guarantor, who does not own directly or indirectly (within the meaning of section 267(c)) an interest in the REMIC (as defined in §1.860D-1(b)(1)), as a condition of providing credit enhancement.

(C) Presumption may be rebutted. The presumption in paragraph (g)(3)(ii)(B) of this section may be rebutted if the amounts required by the third party insurer are not commercially reasonable considering the factors described in paragraph (g)(3)(ii)(A) of this section.

(D) Applicability date. Paragraphs (g)(3)(ii)(B) and (g)(3)(ii)(C) of this section apply on and after July 6, 2011. ***** §1.860G-2T [Removed]

Par. 13. Section 1.860G-2T is removed. Par. 14. Section 1.1001-3 is amended as follows: 1. Paragraph (d) Example 9 is revised. 2. Paragraph (e)(4)(iv)(B) is revised. 3. Paragraph (e)(5)(ii)(B)(2) is revised. 4. Paragraph (g) Examples 1, 5 and 8 are revised. The revisions read as follows:

§1.1001-3 Modifications of debt instruments. *****

(d) * * *

Example 9. Holder’s option to increase interest rate. (i) A corporation issues an 8-year note to a bank in exchange for cash. Under the terms of the note, the bank has the option to increase the rate of interest by a specified amount if certain covenants in the note are breached. The bank’s right to increase the interest rate is a unilateral option as described in paragraph (c)(3) of this section.

(ii) A covenant in the note is breached. The bank exercises its option to increase the rate of interest. The increase in the rate of interest occurs by operation of the terms of the note and does not result in a deferral or a reduction in the scheduled payments or any other alteration described in paragraph (c)(2) of this section. Thus, the change in interest rate is not a modification.

(iii) Applicability date. This Example 9 applies to modifications occurring on or after July 6, 2011.

*****

(e) * * * (4) * * * (iv) * * * (B) Nonrecourse debt instruments. (1) A modification that releases, substitutes, adds or otherwise alters a substantial amount of the collateral for, a guarantee on, or other form of credit enhancement for a nonrecourse debt instrument is a significant modification. A substitution of collateral is not a significant modification, however, if the collateral is fungible or otherwise of a type where the particular units pledged are unimportant (for example, government securities or financial instruments of a particular type and credit quality). In addition, the substitution of a similar commercially available credit enhancement contract is not a significant modification, and an improvement to the property securing a nonrecourse debt instrument does not result in a significant modification.

(2) Applicability date. Paragraph (e)(4)(iv)(B)(1) of this section applies to modifications occurring on or after July 6, 2011. *****

(5) * * * (ii) * * * (B) * * * (2) Original collateral. (i) A modification that changes a recourse debt instrument to a nonrecourse debt instrument is not a significant modification if the instrument continues to be secured only by the original collateral and the modification does not result in a change in payment expectations. For this purpose, if the original collateral is fungible or otherwise of a type where the particular units pledged are unimportant (for example, government securities or financial instruments of a particular type and credit quality), replacement of some or all units of the original collateral with other units of the same or similar type and aggregate value is not considered a change in the original collateral.

(ii) Applicability date. Paragraph (e)(5)(ii)(B)(2)(i) of this section applies to modifications occurring on or after July 6, 2011. *****

(g) * * *

Example 1. Modification of call right. (i) Under the terms of a 30-year, fixed-rate bond, the issuer can call the bond for 102 percent of par at the end of ten years or for 101 percent of par at the end of 20 years. At the end of the eighth year, the holder of the bond pays the issuer to waive the issuer’s right to call the bond at the end of the tenth year. On the date of the modification, the issuer’s credit quality is approximately the same as when the bond was issued, but market rates of interest have declined from that date.

(ii) The holder’s payment to the issuer changes the yield on the bond. Whether the change in yield is a significant modification depends on whether the yield on the modified bond varies from the yield on the original bond by more than the change in yield as described in paragraph (e)(2)(ii) of this section.

(iii) If the change in yield is not a significant modification, the elimination of the issuer’s call right must also be tested for significance. Because the specific rules of paragraphs (e)(2) through (e)(6) of this section do not address this modification, the significance of the modification must be determined under the general rule of paragraph (e)(1) of this section.

(iv) Applicability date. This Example 1 applies to modifications occurring on or after July 6, 2011.

Example 5. Assumption of mortgage with increase in interest rate. (i) A recourse debt instrument with a 9 percent annual yield is secured by an office building. Under the terms of the instrument, a purchaser of the building may assume the debt and be substituted for the original obligor if the purchaser is equally or more creditworthy than the original obligor and if the interest rate on the instrument is increased by one-half percent (50 basis points). The building is sold, the purchaser assumes the debt, and the interest rate increases by 50 basis points.

(ii) If the purchaser’s acquisition of the building does not satisfy the requirements of paragraph (e)(4)(i)(B) or paragraph (e)(4)(i)(C) of this section, the substitution of the purchaser as the obligor is a significant modification under paragraph (e)(4)(i)(A) of this section.

(iii) If the purchaser acquires substantially all of the assets of the original obligor, the assumption of the debt instrument will not result in a significant modification if there is not a change in payment expectations and the assumption does not result in a significant alteration.

(iv) The change in the interest rate, if tested under the rules of paragraph (e)(2) of this section, would result in a significant modification. The change in interest rate that results from the transaction is a significant alteration. Thus, the transaction does not meet the requirements of paragraph (e)(4)(i)(C) of this section and is a significant modification under paragraph (e)(4)(i)(A) of this section.

(v) Applicability date. This Example 5 applies to modifications occurring on or after July 6, 2011.

*****

Example 8. Substitution of credit enhancement contract. (i) Under the terms of a recourse debt instrument, the issuer’s obligations are secured by a letter of credit from a specified bank. The debt instrument does not contain any provision allowing a substitution of a letter of credit from a different bank. The specified bank, however, encounters financial difficulty. The issuer and holder agree that the issuer will substitute a letter of credit from another bank.

(ii) Under paragraph (e)(4)(iv)(A) of this section, the substitution of a different credit enhancement contract is not a significant modification of a recourse debt instrument unless the substitution results in a change in payment expectations. While the substitution of a new letter of credit by a different bank does not itself result in a change in payment expectations, such a substitution may result in a change in payment expectations under certain circumstances (for example, if the obligor’s capacity to meet payment obligations is dependent on the letter of credit and the substitution substantially enhances that capacity from primarily speculative to adequate).

(iii) Applicability date. This Example 8 applies to modifications occurring on or after July 6, 2011.

*****

§1.1001-3T [Removed]

Par. 15. Section 1.1001-3T is removed.

PART 48–MANUFACTURERS AND RETAILERS EXCISE TAXES Par. 16. The authority citation for part 48 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 17. Section 48.4101-1 is amended as follows: 1. Paragraph (f)(4)(ii)(B) is revised. 2. Paragraph (l)(5) is revised. The revisions read as follows:

§48.4101-1 Taxable fuel; registration. *****

(f) * * * (4) * * * (ii) * * * (B) Basis for determination. The determination under §48.4101-1(f)(4)(ii) must be based on all information relevant to the applicant’s financial status. *****

(5) Applicability date. Paragraph (f)(4)(ii)(B) of this section applies on and after July 6, 2011.

§48.4101-1T [Removed]

Par. 18. Section 48.4101-1T is removed.

Approved: August 14, 2013

Beth Tucker Deputy Commissioner for Operations Support.

Mark J. Mazur Assistant Secretary of the Treasury (Tax Policy).

[FR Doc. 2013-21752 Filed 09/05/2013 at 8:45 am; Publication Date: 09/06/2013]




IRS Revising Guidelines for Exempt Bond Exams.

The IRS is revising its guidelines on conducting examinations regarding the post-issuance compliance of tax-exempt bonds, officials in the agency’s Tax-Exempt Bonds Office (TEB) said August 27.

During a teleconference on monitoring post-issuance compliance, Alma Dripps, a TEB senior tax law specialist, said the IRS is revising the guidelines found in Internal Revenue Manual section 4.82, though she did not say what the revisions will be. The revised guidelines will be released later this year, she said.

During the course of an examination, Dripps explained, examiners may review any records needed to determine tax compliance of the bonds. Evaluation of internal controls, including post-issuance compliance procedures, is critical in determining the reliability of books and records, she said.

“This type of evaluation aids in determining the appropriate audit techniques to be used during the examination,” Dripps said.

Lance Fullmer, also a senior tax law specialist in TEB, noted that in June the IRS released Publication 5091, Voluntary Compliance for Tax-Exempt & Tax Credit Bonds. Part I discusses tax-advantaged bond compliance and Part II covers TEB’s voluntary closing agreement program, he said.

Earlier this year, TEB released a report, “Avoiding Troubled Tax-Advantaged Bonds,” which seeks to help issuers of tax-advantaged bonds by offering items to consider that might help ensure compliance, Fullmer said. He said three IRS compliance guides covering exempt bonds for charities (Publication 4077), private activity bonds (Publication 4078), and governmental bonds (Publication 4079) are being updated and will be released later this year.

TEB Senior Tax Law Specialist Marie Sullivan said the IRS will continue its outreach to the exempt financing community. In September there will be a telephone forum on voluntary compliance, she said.

by Fred Stokeld




EO Update: e-news for Charities and Nonprofits - September 6, 2013.

1.  New interactive Form 1023 available for review

In an effort to make applying for tax exemption easier, the IRS Exempt Organizations (EO) office is in the development stage of an alternate version of Form 1023, Application for Recognition of Exemption. The new application is available for preview until September 20, 2013.

The Interactive Form 1023 (i1023) features pop-up information boxes for most lines of the form. These boxes contain explanations and links to related information on IRS.gov and StayExempt.irs.gov, EO’s educational website. When final testing is completed later this year, you’ll print and mail the form and its attachments just like the standard Form 1023.

Although viewers are unable to print or submit this “review” version of i1023, EO encourages the public to click through its new features and promote the i1023 to colleagues and business associates. After reviewing the i1023, please send your comments to [email protected].

Anticipated i1023 benefits:

Interactive Form 1023 is available at: http://www.stayexempt.irs.gov/StartingOut.aspx

2.  Register for EO workshops

Register for upcoming workshops for small and medium-sized 501(c)(3) organizations:

Sept. 9  – St. Paul, MN

Hosted by Hamline University

Sept. 10 – Minneapolis, MN

Hosted by University of St. Thomas

Sept. 27 – Albuquerque, NM

Hosted by University of New Mexico

Oct. 16-17 – Lakeland, FL

Hosted by Florida Southern College

Register at: http://www.irs.gov/Charities-&-Non-Profits/Upcoming-Workshops-for-Small-and-Medium-Sized-501(c)(3)-Organizations

3.  Sign up for upcoming phone forums

Exempt Organizations and Employment Taxes (Sept. 10, 2 p.m., EDT)

Even organizations that don’t use paid workers on a regular basis should be aware of employment tax issues. http://ems.intellor.com/index.cgi?p=204698&t=71&do=register&s=&rID=417&edID=305

Stay Exempt: A guide for charitable organizations with changing leadership (Sept. 18, 2 p.m. EDT)

Helps organizations stay tax-exempt – organized and operated exclusively for exempt purposes.

http://ems.intellor.com/index.cgi?p=204707&t=71&do=register&s=&rID=417&edID=305




IRS Publishes Final, Temporary Regs on Excise Tax Return Requirement for Charitable Hospitals.

The IRS has published final and temporary regulations (T.D. 9629) requiring charitable hospital organizations that are liable for an excise tax for failing to meet the community health needs assessment (CHNA) requirements for any tax year to file Form 4720, “Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.”

The Patient Protection and Affordable Care Act enacted sections 501(r) and 4959. A hospital organization seeking to obtain or maintain tax-exempt status as a charitable organization must comply with the requirements of section 501(r), including the requirement to conduct a CHNA under section 501(r)(3). Section 4959 imposes a $50,000 excise tax if a hospital organization to which section 501(r) applies fails to meet the requirements of section 501(r)(3) for any tax year.

In April 2013 the IRS issued proposed regs (REG-106499-12) that provided guidance to charitable hospital organizations on CHNA requirements and related excise tax and reporting obligations. Those regs, however, didn’t include amendments to the rules under sections 6011 and 6071 on the return required to accompany a section 4959 excise tax payment and when to file the return.

Accordingly, the temporary regs provide that a charitable hospital organization that is liable for the section 4959 excise tax must file a return on Form 4720 by the 15th day of the fifth month after the end of the organization’s tax year during which the liability under section 4959 was incurred. The text of the temporary regs also serves as the text of concurrently issued proposed regs (REG-115300-13). The regs are effective August 15, 2013.




IRS Publishes Proposed Regs on Excise Tax Return Requirement for Charitable Hospitals.

The IRS has published proposed regulations (REG-115300-13) requiring charitable hospital organizations that are liable for an excise tax for failing to meet the community health needs assessment requirements for any tax year to file Form 4720, “Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.”

The text of simultaneously issued temporary regs (T.D. 9629) also serves as the text of the proposed regs. Comments and public hearing requests are due by November 13.

Requirement of a Section 4959 Excise Tax Return

and Time for Filing the Return

[4830-01-p]

DEPARTMENT OF THE TREASURY

26 CFR Part 53

[REG-115300-13]

RIN 1545-BL57

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking by cross-reference to temporary regulations.

SUMMARY: In the Rules and Regulations section of this issue of the Federal Register, the IRS is issuing regulations requiring hospital organizations liable for the excise tax for failure to meet the community health needs assessment requirements for any taxable year to file Form 4720, “Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.” The regulations also specify the due date for such returns. The text of those temporary regulations also serves as the text of these proposed regulations. DATES: Written or electronic comments and requests for a public hearing must be received by November 13, 2013.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-115300-13), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-115300-13), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC, or sent electronically via the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG-115300-13).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Amy F. Giuliano at (202) 622-6070; concerning submission of comments and request for hearing, Oluwafunmilayo Taylor at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

Temporary regulations in the Rules and Regulations section of this issue of the Federal Register amend the existing regulations under sections 6011 and 6071 to (1) specify the form that must be used to accompany payment of the excise tax imposed by section 4959 for failure to meet the community health needs assessment requirements of section 501(r)(3), and (2) provide the due date for filing the form. Section 501(r) and section 4959 were enacted by section 9007 of the Patient Protection and Affordable Care Act, Public Law 111-148 (124 Stat. 119 (2010)).

The text of those temporary regulations also serves as the text of these proposed regulations. The preamble to the temporary regulations explains the amendments.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866, as supplemented by Executive Order 13563. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. It is hereby certified that this rule will not have a significant economic impact on a substantial number of small entities. This certification is based on the fact that this rule merely provides guidance as to the timing and filing of Form 4720 for charitable hospital organizations liable for the section 4959 excise tax, and completing the applicable portion (Schedule M) of the Form 4720 for this purpose imposes little incremental burden in time or expense. The liability for the section 4959 excise tax is imposed by statute, and not these regulations. In addition, a charitable hospital organization may already be required to file the Form 4720 under the existing final regulations in sections 53.6011-1 and 53.6071-1 if it is liable for another Chapter 41 or 42 excise tax. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. Chapter 6) is not required. Pursuant to section 7805(f) of the Code, these proposed regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business, and no comments were received.

Comments and Requests for Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any comments that are submitted timely to the IRS as prescribed in this preamble under the “Addresses” heading. The Treasury Department and the IRS request comments on all aspects of the proposed rules. All comments will be available at www.regulations.gov or upon request.

A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register.

Drafting Information

The principal author of these regulations is Amy F. Giuliano, Office of Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 53

Excise taxes, Foundations, Investments, Lobbying, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 53 is proposed to be amended as follows:

PART 53 — FOUNDATION AND SIMILAR EXCISE TAXES

Paragraph 1. The authority citation for part 53 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 53.6011-1 is amended by:

1. Redesignating paragraphs (c) through (e) as (d) through (f).

2. Adding new paragraphs (c) and (g).

The addition reads as follows:

§ 53.6011-1 General requirement of return, statement or list.

(c) [The text of paragraph (c) of this section is the same as the text of § 53.6011-1T(c) published elsewhere in this issue of the Federal Register ].

(g) [The text of paragraph (g) of this section is the same as the text of § 53.6011-1T(g) published elsewhere in this issue of the Federal Register ].

Par. 3. Section 53.6071-1 is amended by:

1. Revising paragraph (h).

2. Adding paragraph (i).

The revision and addition read as follows:

§ 53.6071-1 Time for filing returns.

[The text of paragraphs (h) and (i) of this section is the same as the text of §§ 53.6071-1T(h) and (i)(1) and (2) published elsewhere in this issue of the Federal Register ].

Heather C. Maloy

Acting Deputy Commissioner for

Services and Enforcement.




FASB Looks to Improve Nonprofit Reporting of Net Assets.

The Financial Accounting Standards Board on September 4 tentatively decided that it should revise the existing requirements for the presentation, classification, and disclosure of information about the funding and resources of nonprofit organizations.

The Financial Accounting Standards Board on September 4 tentatively decided that it should revise the existing requirements for the presentation, classification, and disclosure of information about the funding and resources of nonprofit organizations.

At a meeting in Norwalk, Conn., FASB members unanimously supported the staff recommendation to replace existing rules that require a nonprofit to present on the face of its statement of financial position the totals for three classes of net assets that are used to fund the entity’s operations. Current requirements also dictate that an entity present the changes in each of the classes on the face of its statement of activities.

Based on the staff’s recommendation, the board will pursue guidance that instead requires totals for two classes of net assets to be presented on the face of the financial statements: those with donor-imposed restrictions and those without donor-imposed restrictions.

FASB also agreed to replace the definitions of two donor-restricted classes of net assets — temporarily restricted net assets and permanently restricted net assets — with a single definition for net assets with donor-imposed restrictions. The board will retain the substance of the definition of unrestricted net assets but will change its label to “net assets without donor-imposed restrictions.”

To further improve disclosures about net asset restrictions, the board tentatively decided that it will require nonprofit entities to provide information in the financial statement footnotes about the composition of net assets at the balance sheet date.

According to FASB, the guidance will require an entity to describe how and when its resources can be used and provide information on the net assets without donor-imposed restrictions that have been “board-designated or otherwise authorized by the board for particular uses.”

Ronald Bossio, a senior project manager at FASB, said the net asset composition can be an important part of nonprofit financial reporting if an entity’s communications about its liquidity are perceived to be less than adequate. For some financial statement users, such as creditors, the net asset disclosure is a backdoor way of understanding the liquidity of a nonprofit organization, he added.

According to Bossio, the staff recommendations on improving the information that nonprofit entities provide on their liquidity and cash flow will be presented to the board in October.

FASB’s latest decisions were made as part of its project on reexamining the standards for nonprofit financial statement presentation. The board previously decided on how intermediate operating measures should be defined in the financial statements of nonprofit entities. (Prior coverage .)

Share-Based Payments

The board also unanimously voted against adding to its technical agenda a new project on how to determine the grant date of share-based payments when the conditions of those awards contain discretionary provisions and clawback arrangements.

Lauren Mottley, a FASB practice fellow, said the request for additional guidance was brought to the board’s attention because the Dodd-Frank Wall Street Reform and Consumer Protection Act includes a provision that requires public companies to have a clawback policy on the restatement of their financial statements.

According to Mottley, the staff recommended that the board not pursue a project on the topic because they believed that sufficient guidance was provided in Accounting Standards Codification (ASC) Topic 718, “Compensation — Stock Compensation,” and that additional guidance might not be able to resolve the diversity in practice.

FASB member Thomas Linsmeier supported the staff recommendation, adding that the board’s guidance on stock-based compensation is converged with the related international financial reporting standards. “I don’t see a reason at this point to diverge,” he said.

Linsmeier said the board will have another opportunity to reconsider the topic after a post-implementation review of FASB Statement No. 123(R), “Share-Based Payment,” is completed by the Financial Accounting Foundation.

by Thomas Jaworski




Tax-Exempt and Government Entities Advisory Committee Announces Meeting.

The IRS’s Advisory Committee on Tax Exempt and Government Entities announced it will hold a public meeting on September 12, 2013, at the IRS in Washington to discuss issues regarding employee plans, exempt organizations, and government entities; for more information, contact Mark Kirbabas at (202) 283-9742.

DEPARTMENT OF THE TREASURY Internal Revenue Service

Advisory Group to the Internal Revenue Service Tax Exempt and Government Entities Division (TE/GE); Meeting

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice.

SUMMARY: The Advisory Committee on Tax Exempt and Government Entities (ACT) will hold a public meeting on Thursday, September 12, 2013.

FOR FURTHER INFORMATION, CONTACT:

Mark Kirbabas, Acting Designated Federal Officer, TE/GE Communications and Liaison; 1111 Constitution Ave. NW.; SE:T:CL—NCA 679; Washington, DC 20224. Telephone: 202–283–9742 (not a toll-free number). Email address: [email protected].

SUPPLEMENTARY INFORMATION: By notice herein given, pursuant to section 10(a)(2) of the Federal Advisory Committee Act, 5 U.S.C. App. (1988), a public meeting of the ACT will be held on Thursday, September 12, 2013, from 9:30 a.m. to 11:30 a.m., at the Internal Revenue Service; 1111 Constitution Ave. NW.; Room 3313; Washington, DC. Issues to be discussed relate to Employee Plans, Exempt Organizations, and Government Entities.

Reports from five ACT subgroups cover the following topics:

Employee Plans

• Analysis and Recommendations Regarding the Employee Plans Compliance Resolution System (EPCRS)

Exempt Organizations

• Leveraging Limited IRS Resources in the Tax Administration of Small Tax- Exempt Organizations

Federal, State and Local Governments

• Leveraging Internal Controls of State and Local Governments to Improve Tax Compliance

• Government Levy Processing Improvements

Indian Tribal Governments

• Supplemental Report on the General Welfare Doctrine as Applied to Indian Tribal Governments and Their Members

Tax Exempt Bonds

• A Roadmap To Arbitrage Requirements For Tax-Exempt Governmental Bonds and Qualified Section 501(c)(3) Bonds of Smaller Issuers and Conduit Borrowers

Last minute agenda changes may preclude advance notice. Due to limited seating and security requirements, attendees must call Cynthia Phillips- Grady to confirm their attendance. Ms. Phillips-Grady can be reached at (202) 283–9954.

Attendees are encouraged to arrive at least 30 minutes before the meeting begins to allow sufficient time for security clearance. Photo identification must be presented. Please use the main entrance at 1111 Constitution Ave. NW., to enter the building. Should you wish the ACT to consider a written statement, please call (202) 283–9742, or write to: Internal Revenue Service; 1111 Constitution Ave. NW.; SE:T:CL—NCA– 679; Washington, DC 20224, or email [email protected].

Dated: August 22, 2013.

Mark J. Kirbabas,

Acting Designated Federal Officer, Tax Exempt and Government Entities Division.




IRS EO Update - e-news for Charities & Nonprofits - August 30, 2013.

1.  IRS describes Code Section 4959 excise tax reporting for charitable hospitals

The IRS has issued temporary and proposed regulations under sections 6011 and 6071 for charitable hospital organizations on how to report any Code Sec.4959 excise tax for failing to meet the community health needs assessment (CHNA) requirements described in Code Sec. 501(r)(3).

The temporary regulations state that a charitable hospital organization liable for the Code Sec. 4959 excise tax must file a return on Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code. The form must be filed by the 15th day of the fifth month after the end of the charitable hospital organization’s tax year during which the liability under Code Sec. 4959 was incurred.

The proposed regulations provide that written or electronic comments and requests for a public hearing must be received by November 13, 2013.

The temporary regulations are available at:

http://www.gpo.gov/fdsys/pkg/FR-2013-08-15/pdf/2013-19931.pdf

The proposed regulations are available at:

http://www.gpo.gov/fdsys/pkg/FR-2013-08-15/pdf/2013-19930.pdf

Form 4720 is available at:

http://www.irs.gov/pub/irs-pdf/f4720.pdf

2.  EO’s latest changes to implement the TIGTA recommendations

Check out the status of improvements at:

http://www.irs.gov/uac/Newsroom/IRS-Charts-a-Path-Forward-with-Immediate-Actions

3.  IRS offers alternative solution for political organizations filings made July/August

While Exempt Organizations’ political organizations disclosure search and download applications are temporarily unavailable, the IRS has an alternative solution for filings made in July and August 2013.

http://www.irs.gov/Charities-&-Non-Profits/Political-Organizations/Political-Organization-Filing-and-Disclosure

These filings include copies of Forms 8871, 8872 and 990 filed by 527s. We anticipate the IRS will re-launch its database this fall, at a date to be determined.

The IRS regrets any inconvenience as it continues to work through this complex situation to ensure the public disclosure of these documents while appropriately protecting important personal information.

4.  Sign up for upcoming IRS Exempt Organizations phone forums

Exempt Organizations and Employment Taxes (Sept. 10, 2 p.m., EDT)

Even organizations that don’t use paid workers on a regular basis should be aware of employment tax issues.

http://ems.intellor.com/index.cgi?p=204698&t=71&do=register&s=&rID=417&edID=305

Stay Exempt: A guide for charitable organizations with changing leadership (Sept. 18, 2 p.m. EDT)

Tax-exempt organizations must be organized and operated exclusively for exempt purposes.

http://ems.intellor.com/index.cgi?p=204707&t=71&do=register&s=&rID=417&edID=305

5.  Review the 2013–2014 Priority Guidance Plan

The 2013–2014 Priority Guidance Plan contains 324 projects that are IRS priorities through June 2014, including:

http://www.irs.gov/pub/irs-utl/2013-2014_pgp.pdf

6.  Register for EO workshops

Register for upcoming workshops for small and medium-sized 501(c)(3) organizations:

Sept. 9  – St. Paul, MN

Hosted by Hamline University

Sept. 10 – Minneapolis, MN

Hosted by University of St. Thomas

Sept. 27 – Albuquerque, NM

Hosted by University of New Mexico

October 16-17 – Lakeland, FL

Hosted by Florida Southern College

http://www.irs.gov/Charities-&-Non-Profits/Upcoming-Workshops-for-Small-and-Medium-Sized-501(c)(3)-Organizations




Comments Sought on Regs on Standards for State, Local Bond Opinions.

The IRS requested comments on regulations (REG-138367-06) that update the Circular 230 practice standards, adopting one standard for all written tax advice under proposed section 10.37; comments are due by October 21, 2013.

DEPARTMENT OF THE TREASURY Internal Revenue Service

Proposed Collection; Comment Request Regulation Project

AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice and request for comments.

SUMMARY: The Department of the Treasury, as part of its continuing effort to reduce paperwork and respondent burden, invites the general public and other Federal agencies to take this opportunity to comment on proposed and/or continuing information collections, as required by the Paperwork Reduction Act of 1995, Public Law 104–13 (44 U.S.C. 3506(c)(2)(A)). Currently, the IRS is soliciting comments concerning regulations governing practice before the Internal Revenue Service. DATES: Written comments should be received on or before October 21, 2013 to be assured of consideration. ADDRESSES: Direct all written comments to Yvette B. Lawrence, Internal Revenue Service, room 6129, 1111 Constitution Avenue NW., Washington, DC 20224. FOR FURTHER INFORMATION CONTACT: Requests for additional information or copies of the form and instructions should be directed to Gerald J. Shields at Internal Revenue Service, room 6129, 1111 Constitution Avenue NW., Washington, DC 20224, or through the internet at [email protected]. SUPPLEMENTARY INFORMATION:

Title: Regulations Governing Practice Before the Internal Revenue Service.

OMB Number: 1545–1916. Form Number: REG–138367–06. Abstract: This collection of

information is necessary to ensure practitioners comply with minimum standards when writing a State or local bond opinion. A practitioner may provide a single opinion or may provide a combination of documents, but only if the documents, taken together, satisfy the requirements of 31 CFR 10.39. In addition, the collection of information will assist the Commissioner, through the Office of Professional Responsibility, to ensure that practitioners properly advise taxpayers regarding state or local bonds. On September 17, 2012, Treasury and the IRS published a notice of proposed rulemaking that would amend the regulations at 31 CFR Part 10. That notice of proposed rulemaking also withdrew the notice of proposed rulemaking (REG–159824–04) that was published in the Federal Register on December 20, 2004 (69 FR 75887). See 77 FR 57055.

Current Actions: There is no change in the paperwork burden previously approved by OMB. This information collection is being submitted for renewal purposes only.

Type of Review: Extension of a currently approved collection.

Affected Public: Individuals and Households.

Estimated Number of Respondents:

1,500. Estimated Time per Respondent: 2

hours.

Estimated Total Annual Burden Hours: 30,000.

The following paragraph applies to all of the collections of information covered by this notice:

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid OMB control number.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

Request for Comments: Comments submitted in response to this notice will be summarized and/or included in the request for OMB approval. All comments will become a matter of public record. Comments are invited on: (a) Whether the collection of information is necessary for the proper performance of the functions of the agency, including whether the information shall have practical utility; (b) the accuracy of the agency’s estimate of the burden of the collection of information; (c) ways to enhance the quality, utility, and clarity of the information to be collected; (d) ways to minimize the burden of the collection of information on respondents, including through the use of automated collection techniques or other forms of information technology; and (e) estimates of capital or start-up costs and costs of operation, maintenance, and purchase of services to provide information.

Approved: August 15, 2013.

Allan M. Hopkins,

IRS Tax Analyst.

[FR Doc. 2013–20286 Filed 8–20–13; 8:45 am]

BILLING CODE 4830–01–P




IRS Releases Publication on Tax Status of Veterans Organizations.

The IRS has released Publication 3386 (rev. Aug. 2013), Tax Guide — Veterans’ Organizations, to explain tax exemptions available to veterans organizations that qualify for tax-exempt status under section 501(c).

http://www.irs.gov/pub/irs-pdf/p3386.pdf




IRS: Community Development District Doesn't Qualify as Political Subdivision.

In technical advice, the IRS concluded that a community development district established under a town ordinance wasn’t a political subdivision under reg. section 1.103-1(b) at any time when the district issued bonds to acquire assets from a developer because it was not a division of a state or local governmental unit during that period.

A state corporation owned by an individual and his family developed a retirement community within a town. The developer petitioned the town to create the community development district, which is governed by its own board of supervisors who are elected by a majority vote of landowners in the district. The developer owned enough land to appoint the board throughout the relevant period.

A political subdivision is defined under reg. section 1.103-1(b) as any division of any state or local governmental unit that is a municipal corporation or that has been delegated the right to exercise part of the sovereign power of the unit. The district concedes that it isn’t a municipal corporation but claims it has the right to exercise sovereign powers. However, the IRS determined that the district also must demonstrate that it is a division of a state or local governmental unit.

The IRS determined that an entity can’t be a political subdivision of a state if it is organized and operated in a manner intended to perpetuate private control and to indefinitely avoid responsibility to a public electorate. Here, the developer was always in a position to select all the board members. It was contemplated that a board would be elected by the qualified electorate when a district acquired a sufficient number of residents. However, that hasn’t happened in this case, even after 20 years. And the IRS determined that the facts show that the district was intentionally structured to make sure that it would never happen. The board and its manager controlled the district’s daily operations and neither the state nor local government participated in or had authority to overrule the board’s decisions. Accordingly, the IRS concluded that the district was organized and operated in a way that ensured continued effective control of the board by the developer, rather than by a general electorate or an existing governmental body.

The district argued that it’s a political subdivision because it’s sufficiently controlled by the state and because the district and the board are subject to several legal restrictions. Rejecting this argument, the IRS noted that the restrictions don’t address the fact that the district was organized and operated to perpetuate private control and indefinitely avoid responsibility to a public electorate. Having concluded that the district isn’t a state or political subdivision thereof for purposes of section 103(c)(1), the IRS determined that it need not examine the extent to which the district has been delegated sovereign powers.

________________________________

ISSUE

Whether the Issuer was a political subdivision within the meaning of section 1.103-1(b) of the Income Tax Regulations during the period of Date 1 through Date 2.

CONCLUSION

The Issuer was not a political subdivision within the meaning of section 1.103-1(b) at any time during the period of Date 1 through Date 2 because it was not a division of a state or local governmental unit during that period. Because we find that the Issuer was not a division, we do not address the delegation of sovereign power.

FACTS

The Developer

The Developer is a State corporation incorporated in Year 1. At all times relevant to the legal issue in this case, Date 1 through Date 2, the Developer was directly or indirectly owned by A and his family.

The Development

In Year 2, the Developer began development of a retirement community within Town and an unincorporated area of County. As part of that development, the Developer constructed, owned and operated various recreation facilities, postal facilities, water management and control systems, fire equipment, and fire stations (“Amenity Facilities”). As the development became profitable, the Developer purchased additional tracts of land for development.

In Year 3, the Developer petitioned the Town to create a community development district in accordance with Act, and, later in Year 3, Town established Issuer as a community development district pursuant to Ordinance. Thereafter, the Developer acquired substantial amounts of additional land and successfully petitioned for the creation of a other separate community development districts, eventually resulting in b community development districts. The b community development districts include c districts that consist of primarily residential areas (“Residential Districts”), the Issuer, which has been solely a commercial area, and d other solely commercial district. The b community development districts, along with certain other areas in County and Town, are known as the Development.

During the relevant years, the Issuer’s board of supervisors petitioned the Town for four separate changes to Issuer’s geographical boundaries. On Date 3, the Town approved the first change, which reduced Issuer’s acreage from e acres to f acres. The removed land was used for g residential dwellings approximately h years after the boundary change. On Date 4, the Town approved the second change, which reduced Issuer’s acreage from f acres to i acres and removed j existing (but then unoccupied) dwellings from Issuer boundaries. The remainder of the land removed from the Issuer’s acreage was used to construct k residential units approximately l years after the change. On Date 5, the Town approved a third change, which corrected a boundary error and reduced Issuer’s acreage from i acres to m acres, and on Date 6, the Town approved the fourth change, increasing Issuer’s acreage to o acres consisting of commercial properties.

Lots within the Development are sold subject to deed restrictions (“deed restrictions”), requiring services to be provided by the Developer including an obligation to “perpetually provide the recreational facilities.” The deed restrictions require property owners to pay the Developer a monthly fee (“Amenities Fee”). Owners of property within the Residential Districts are required to pay the Amenities Fee even if the recreational facilities are located outside of, and are not owned by, their respective Residential District. The Developer’s rights and obligations may be assigned.

Governing Body of Issuer

Each community development district in State is governed by its own board of supervisors. Under the Act, a majority of the board constitutes a quorum and action is taken by majority vote of the members present unless general law or a rule of the district requires a greater number. The board of supervisors is initially elected by landowners, generally based on acreage owned, with a majority of votes controlling. In community development districts such as Issuer, beginning after o years, when there are p or more residents within the district eligible to vote (“Qualified Electors”), the election process changes and the board is thereafter elected by the Qualified Electors at a general election.

Issuer is governed by a g-member board of supervisors (“Board”). Because the Issuer has never had p or more Qualified Electors, landowners in the Issuer have always elected the Board despite the fact that the Issuer has been in existence for well over 20 years. In fact, Issuer expressed intention was that there would never be p or more Qualified Electors residing within Issuer. The Official Statement for bonds issued on Date 7 states that there will be no residential development within the Issuer, and the Offering Statement for Issuer’s Date 8 bond issuance confirmed that, because of the non-residential nature of the development in the Issuer, it was unlikely that there would ever be Qualified Electors in the Issuer. During the relevant years, the q-member Board consisted of A, members of his family, directors, officers, or employees of the Developer, and the chief executive officer of the Bank, a majority of the stock of which was at all times owned by A and his family. For a short period in Year 4, the Board also included an employee of an investment bank not affiliated with A.

The Board appoints a district manager who is accountable to the Board. The district manager has charge and supervision of the works of Issuer, is responsible for preserving and maintaining any improvement or facility constructed or erected pursuant to the provisions of Act, for maintaining and operating equipment owned by Issuer, and for performing such other duties as may be prescribed by the Board.

Landowners

The Board always has been appointed by the landowners in Issuer. The Developer, either alone (from Date 1 through Date 9) or in conjunction with the Partnership, has owned sufficient land to appoint the Board throughout the relevant period.

The Partnership has been controlled at all relevant times directly or indirectly by A, B and C. C is an immediate family member of A, and B at the time was an officer and director or the Developer and served, on at least some occasions, as legal counsel to the Developer. Prior to Date 10, A, B and C served directly as the general partners of the Partnership. On Date 10, the Corporation was formed to serve as the corporate sole general partner, and A, B and C became the owners and directors of the Corporation. The Partnership functioned as an employment incentive for employees of the Developer, and the limited partners in Partnership consisted solely of A, B, A’s family members, current or former directors, officers, or employees of the Developer, or trustees or beneficiaries of trusts established by such individuals.

Issuer’s Powers and Limitations under the Act

The Act defines a community development district as a local unit of special-purpose government limited to the performance of functions authorized by the Act, the governing body of which is authorized to function to deliver urban community development services, and for which the operation, duration, accountability, disclosure requirements, and termination are determined by general law. The stated primary purpose of community development districts is to provide for specified capital infrastructure, such as that provided by the Issuer.

The Department, which is a department of State, is required by the Act to annually monitor the status of Issuer under the Act. The Issuer must provide financial reports and audits to State, and is required to use a qualified public depository.1 The Issuer must comply with bidding requirements under State law when seeking to construct or improve a public building or structure. Board meetings are open to the public, the Board must keep permanent records of all proceedings, and such records are open to inspection in the same manner as government records in State. Issuer’s properties are exempt from execution and sale by general creditors.

The Board approves the Issuer’s annual budget after a hearing. The proposed budget is then submitted to the local general purpose governmental unit for disclosure and information purposes only. The local general purpose governmental unit may review the proposed budget and submit written comments for assistance and information purposes.

The Issuer will remain in existence unless (a) it is merged with another district; (b) all of its facilities and services are transferred to a local general-purpose government unit, subject to the underlying debts being assumed and guaranteed by such unit;2 or (c) it is dissolved due to inactivity. Upon dissolution, assets of the district would be liquidated to pay the district debts and the remainder, if any, would be transferred to an appropriate local government or political subdivision.

Board members are subject to general laws relating to public officers and employees, including ethical standards requiring that public officials be independent and impartial, and that public office not be used for private gain other than the remuneration provided by law. Public officials must discharge their duties in the public interest and must act as agents of the people in holding their positions for the benefit of the public.3 The Act also provides that it shall not be a conflict of interest for a board member, district manager or other employee of the district to be a stockholder, officer, or employee of a landowner.

The Issuer is vested with limited powers. Issuer can exercise the power of condemnation to acquire public easements, dedications to public use, platted reservations for public purposes, or any reservations for those purposes authorized by the Act. The Act allows the Issuer to exercise eminent domain over any property within the state, except municipal, county, state, and federal property. If the property that is the subject of the eminent domain is outside Issuer, Issuer must obtain the prior approval of the governing body of the jurisdiction in which the property is located. The Issuer may exercise eminent domain solely for uses relating to water, sewer, district roads, and water management. Any exercise of eminent domain by the Issuer is in the Issuer’s name and results in title to the condemned land being transferred to the Issuer. The Issuer is authorized to impose user charges or fees and special assessments to finance the Issuer’s activities authorized by the Act. The Act provides that community districts generally may levy and assess ad valorem taxes, but this power applies only when all Board members are elected by Qualified Electors at a general election and is not available to the Issuer. The Issuer may not exercise any “police power,” as that term is used under the Act and must obtain prior consent from the local general-purpose government agencies to provide security services within the Issuer.

Outstanding Bonds

Between Date 1 and Date 2, Issuer issued Bonds in the total principal amount of $r to acquire or refinance the acquisition of assets from Developer and its affiliates, along with the right to collect related Amenities Fees from current residents of the Development. The Issuer asserts that interest on these bonds is exempt from tax under § 103. We do not have information on all of these sales, but in the sales for which we have information, the amount of proceeds paid to the Developer and its affiliates significantly exceeded the Developer’s costs for the assets acquired, with the remaining proceeds having been allocated to the right to collect future Amenity Fees from then current residents. Developer retained the right, however, to collect Amenities Fees from future residents of the Development who purchased their property from the Developer. Such future residents would have the right to use the Amenity Facilities owned by the Issuer, despite retention of the Amenity Fees by the Developer.4

The information we have indicates that, on Date 11, Issuer issued $s in bonds to purchase recreational and utility facilities from the Developer along with related Amenity Fees. The Developer’s cost in these facilities was $t, and almost 70% of the purchase price was allocated to future Amenity Fees. On Date 12, Issuer issued $u in bonds to acquire recreational facilities and Amenity Fees from the Developer. The Developer’s cost in these facilities was $v, which left almost 67% of the proceeds allocated to future Amenity Fees. Similarly, on Date 13, Issuer used $w to purchase recreational facilities and future Amenity Fees from the Developer. The Developer’s cost for these facilities was $x, leaving almost 89% of the proceeds allocated to future Amenity Fees, and on Date 14, the Issuer issued $y in bonds to purchase a utility system from a utility affiliated with Developer; the utility’s cost for the system was $z, leaving about 54% of the proceeds allocated to transferred utility fees. Finally, on Date 2, Issuer issued $aa in bonds for recreational facilities for which the Developer’s cost was $bb, resulting in 83% of the proceeds being allocated to future Amenity Fees. The monthly Amenities Fees and utility fee payments assigned to the Issuer are pledged to secure the Bonds, along with other sources of Issuer revenue.

LAW AND ANALYSIS

Section 103(a) of the Internal Revenue Code (“Code”) provides that gross income does not include interest on any State or local bond. Section 103(c) provides that the term “State or local bond” means an obligation of a State or political subdivision thereof.

The term “political subdivision” is defined in Treasury Regulations § 1.103-1(b) as “any division of any state or local governmental unit which is a municipal corporation or which has been delegated the right to exercise part of the sovereign power of the unit.” Under this definition, Issuer cannot qualify as a political subdivision whether or not it is a municipal corporation (which Issuer concedes that it is not) or has the right to exercise sovereign powers (which Issuer claims that it has) unless it also can demonstrate that it is a division of a state or local government. See Rev. Rul. 78-276, 1978-2 C.B. 256.

Is Issuer a Division of a State or Local Government?

The phrase “division of a state or local government” must be read in the context of the purpose of § 103, which is to provide subsidized financing for State and local government purposes. The Code permits the benefit of this subsidy to be passed on to private persons under some circumstances, but only if a governmental unit determines that the issuance of such bonds is appropriate. A governmental unit is inherently accountable, directly or indirectly, to a general electorate. In effect, § 103 relies, in large part, on the democratic process to ensure that subsidized bond financing is used for projects which the general electorate considers appropriate State or local government purposes. A process that allows a private entity to determine how the bond subsidy should be used without appropriate government safeguards cannot satisfy § 103.

For these reasons, the mere delegation of sovereign power is not sufficient to create a political subdivision. If it were sufficient, then a clearly private entity with powers of eminent domain, including some railroads and utilities, could issue bonds without any political oversight.

We believe that an entity that is organized and operated in a manner intended to perpetuate private control, and to avoid indefinitely responsibility to a public electorate, cannot be a political subdivision of a State. Cf. Revenue Ruling 83-131, 1983-2 C.B. 184 (concluding that certain corporations did not qualify as political subdivisions, in part because they were “not controlled directly or indirectly by a state or local government,” but rather by a board of directors “independent of such authority”).

In this case, the Issuer was organized and operated in manner that insured continued effective control of the Board by A, rather than a general electorate or an existing governmental body. The Board was selected by majority vote of landowners, and, at all times, A was in a position, through entities under his control, to select all members of the Board. During the relevant period, two landowners, the Developer and the Partnership, held a clear majority of the land within the boundaries of the Issuer. The Developer was owned and controlled by A and A’s family members. The Partnership was controlled by A, B and C, first as general partners and later as the owners and directors of the sole corporate general partner. The result was that during the relevant years, the Board was composed of individuals who, in all but one limited case, consisted of A, members of his family, directors, officers, or employees of the Developer, and the chief executive officer of Bank owned and controlled by A and his family.

The Act contemplated that a board would be elected by the Qualified Electorate when a district acquired a sufficient number of residents. Even after over 20 years, this has not happened in the Issuer’s case. Indeed, the facts indicate that Issuer was intentionally structured to ensure that this never could happen. Bond offering documents indicate that there would be no residential development in the Issuer and that it was unlikely that there ever would be Qualified Electors in the Issuer. Consistent with these statements, on at least two occasions the Board successfully petitioned the Town to change the Issuer’s boundaries in such a way that land on which current or future residential development would be located would be removed from within the Issuer’s boundaries.

Throughout all relevant years, the Board and its district manager controlled the day-to-day operations of the Issuer. Neither the State nor local government participated in or had authority to overrule decisions of the Board, including decisions to purchase assets from the Developer whose owner controlled the Board. Although a government received the Issuer’s financial reports, audits, and budget, this was largely for informational purposes only.

The Issuer argues that it is a political subdivision because it is sufficiently controlled by the State and serves a public purpose, although the Issuer claims that the threshold is too high if it requires that the entity be motivated wholly by a public purpose. See Revenue Ruling 83-131 (indicating entity must be motivated by a wholly public purpose). The Issuer argues that it was created to fulfill the public purpose of managing and financing basic community development services. The Issuer points out that the Act placed a number of legal restrictions on it and the Board. In particular, the Issuer notes that —

1) Issuer had financial and reporting requirements to the State,

2) Issuer was subject to bidding requirements when seeking to construct or improve a public building or structure,

3) Issuer was required to use a qualified public depository,

4) Issuer was subject to open record and open meeting requirements,

5) Issuer was required to submit its budget for disclosure purposes,

6) Issuer was required to comply with the State administrative procedure act,

7) Issuer’s property was exempt from sale by general creditors,

8) The local government could adopt and submit a nonemergency plan providing for the transfer of assets or services from a district to the local general-purpose government under certain limited circumstances;

9) On dissolution all of Issuer’s assets transferred to public entities,

10) Under State ethics laws, the Board members were required to be independent and impartial; public office could not be used for private gain other than remuneration; board members were required to discharge their duties in the public interest and must act as agents of the people; and financial interests were required to be publicly disclosed, among other requirements.

These restrictions, however, do not address the fact that the Issuer was organized and operated to perpetuate private control and avoid indefinitely responsibility to a public electorate, either directly or through another elected State or local governmental body. That fact is not consistent with qualification as a political subdivision. We need not discuss any other requirements that a division of a State or local governmental unit might need to meet to qualify as an issuer of tax exempt bonds. Issuer is not a “state or political subdivision thereof” for purposes of section 103(c)(1).

Has Issuer been Delegated Sovereign Power?

Having concluded that the Issuer is not a division of a State or local government, we need not examine the extent to which the Issuer has been delegated sovereign powers.

CAVEAT(S)

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

FOOTNOTES

1 When there was uncertainty about how to interpret the State statutes, including the Act, we generally used the Issuer’s interpretations.

2 Act provides that the local general purpose government within the boundaries of which Issuer lies may adopt a nonemergency ordinance providing for a plan for the transfer of a specific community development service to the local general purpose government. The plan must provide for the assumption and guarantee of Issuer’s debt that is related to the service by the local general purpose government and must demonstrate the ability of the local general purpose government to provide such service (a) as efficiently as the district, (b) at a level of quality equal to, or higher than, the level of quality actually delivered to the users of the service, and (c) at a charge equal to, or lower than, the actual charge by Issuer to the users of the service.

3 * * *

4 It appears from the submissions that current residents and their grantees and successors who pay Amenities Fees to the Issuer received an easement to use future facilities constructed by the Developer without making payments to the Developer.

Citations: TAM-127670-12

[Editor’s Note: The IRS has not formally released this document. Identifying numbers may be updated or changed on its official release date.]




Chevron Step Zero After City of Arlington.

Patrick J. Smith looks at how the Supreme Court in City of Arlington rejected the contention that Chevron does not apply to questions concerning the scope of an agency’s jurisdiction, and he notes that the most unsatisfactory aspect of Mead’s test for determining when Chevron applies has been eliminated.

City of Arlington was not a tax case, but is still relevant for the tax world because the Supreme Court clarified when the Chevron two-step test for evaluating the validity of some agency interpretations of statutory provisions applies. This issue is generally referred to as “Chevron step zero.” The main holding of City of Arlington was that issues of statutory interpretation related to the scope of the agency’s jurisdiction or authority to act are subject to the Chevron two-step test. However, the decision also suggests that the most unsatisfactory aspect of the Mead test for answering Chevron step zero may have been eliminated.

Introduction

The Supreme Court’s recent decision in City of Arlington, Texas v. FCC1 did not involve a tax issue, so most tax professionals are probably unaware of the decision. However, the case addresses an aspect of the two-part test for evaluating the validity of agency actions that was established in Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc.2 Because Mayo Foundation for Medical Education and Research v. United States3 made clear that the Chevron two-part test applies to actions taken by the IRS, just as it does to those taken by all other federal agencies, City of Arlington is relevant to the tax world.4

In City of Arlington, the Court granted certiorari on the question whether the Chevron test applies to issues of statutory interpretation of the scope of a federal agency’s jurisdiction or authority to act. The answer, in an opinion written by Justice Antonin Scalia, is an emphatic yes. That holding in and of itself is important enough, but perhaps even more important is what the decision suggests about other aspects of what is now usually referred to as Chevron step zero — namely, determining when the Chevron two-part test applies.5

The decision in which the Court has most comprehensively addressed Chevron step zero is United States v. Mead Corp.6 What is most interesting about the City of Arlington decision is the likelihood that the decision has eliminated the most unsatisfactory aspect of the Chevron step zero test articulated in Mead.

While most of Mead’s Chevron step zero test is straightforward, in one respect it is vague, undefined, and open-ended. It is that aspect of the Mead test that seems to have been eliminated by City of Arlington. If that element of the City of Arlington decision holds up, this modification of the Chevron step zero test would be most welcome.

The Chevron Two-Step Test

The Chevron two-step test applies to judicial review of an agency interpretation of a statutory provision the agency is responsible for administering. Chevron describes the first step of the test as follows:

First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress.7

In an important elaboration of the step one analysis, the Chevron Court emphasized that the step one inquiry should be based on an application of the “traditional tools of statutory construction”:

The judiciary is the final authority on issues of statutory construction and must reject administrative constructions which are contrary to clear congressional intent. If a court, employing traditional tools of statutory construction, ascertains that Congress had an intention on the precise question at issue, that intention is the law and must be given effect.8

If the issue of statutory interpretation can be resolved by the reviewing court in step one of the Chevron two-part test, the agency interpretation is given no special weight. If, under step one, the court’s interpretation of the statutory provision is different from the agency’s interpretation, the agency’s interpretation is rejected. If the court’s interpretation of the statutory provision coincides with the agency’s interpretation, that shared interpretation is the law, not because it is the agency’s interpretation, but because the court has concluded that this interpretation is the required interpretation under Chevron step one.

If the issue of statutory interpretation cannot be resolved by the reviewing court in step one of the Chevron two-part test, the court must turn to step two, which Chevron describes as follows:

If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. Rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency’s answer is based on a permissible construction of the statute.9

A court may not substitute its own construction of a statutory provision for a reasonable interpretation made by the administrator of an agency.10

The court need not conclude that the agency construction was the only one it permissibly could have adopted to uphold the construction, or even the reading the court would have reached if the question initially had arisen in a judicial proceeding.11

Left open in Chevron was the step zero issue of which agency interpretations are evaluated under the Chevron two-step test.12 The Court did not provide a comprehensive answer to that question until Mead.

Mead’s Answer to Step Zero

Mead described its answer to the Chevron step zero issue as follows:

We hold that administrative implementation of a particular statutory provision qualifies for Chevron deference when it appears [1] that Congress delegated authority to the agency generally to make rules carrying the force of law, and [2] that the agency interpretation claiming deference was promulgated in the exercise of that authority.13

Like the Chevron test itself, Mead’s answer to the Chevron step zero question has two parts. The first part is that for Chevron to apply, Congress must have “delegated authority to the agency generally to make rules carrying the force of law,” usually by notice-and-comment rulemaking but sometimes by case-by-case formal adjudication.14 The second part is that for Chevron to apply, the agency must have promulgated the “interpretation claiming deference . . . in the exercise of that authority” — namely, the authority “to make rules carrying the force of law.”15

In almost all cases, the first part of this two-part test will be easily answered and satisfied because Congress authorizes most federal agencies to issue regulations with the force of law, as long as they issue regulations using the notice-and-comment procedures required by the Administrative Procedure Act.16 Therefore, in most cases, the resolution of the Chevron step zero issue will not turn on the first part of Mead’s Chevron step zero test, but instead on whether the second part of this test is satisfied.

Ordinarily, it is also relatively easy to determine whether the second part of this test is satisfied. Agency guidance that is the product of notice-and-comment rulemaking will satisfy the second part of the test, while agency guidance that is not the product of notice-and-comment rulemaking will not, and therefore will not be subject to Chevron.

Thus, in most of Mead’s operation, its answer to the Chevron step zero question is straightforward, sensible, and relatively easy to understand and apply. If Mead’s answer to the Chevron step zero question had stopped there, step zero would be in good shape.

Unfortunately, Mead’s answer went on to suggest that both parts of the test can become more complex than the simple task of asking whether Congress has given the agency at issue rulemaking authority through a statute and whether that agency has adopted the interpretation in question through the use of that authority:

Delegation of such authority [to make rules carrying the force of law] may be shown in a variety of ways, as by an agency’s power to engage in adjudication or notice-and-comment rulemaking, or by some other indication of a comparable congressional intent.17

As significant as notice-and-comment is in pointing to Chevron authority, the want of that procedure here does not decide the case, for we have sometimes found reasons for Chevron deference even when no such administrative formality was required and none was afforded.18

Thus, under Mead’s test for Chevron step zero, the fact that the agency does not have the authority to issue regulations that have the force of law through notice-and-comment rulemaking, or the fact that an agency that has that authority has not used notice-and-comment rulemaking to adopt the interpretation that is at issue, does not always resolve the Chevron step zero inquiry. Consequently, even though the agency document at issue in Mead was not the product of notice-and-comment rulemaking, the Mead Court did not treat that fact as dispositive in resolving the Chevron step zero inquiry, but instead engaged in the open-ended, multifactor analysis contemplated by the above quotations. The Court analyzed different factors and concluded that the agency document did not satisfy Chevron step zero. However, Mead provided no general guidance for the application of this multifactor analysis aspect of the Chevron step zero test.

The category of agency interpretations in which the Chevron two-step test may apply under the multifactor analysis approach to Chevron step zero, even though notice-and-comment rulemaking is not authorized or the agency did not follow it, is so vague and open-ended that it is almost impossible to predict which interpretations it will apply to. As a result, this part of Mead’s answer to the Chevron step zero issue is unsatisfactory.

Mead not only established the test for answering the Chevron step zero issue, but it also clarified that an agency interpretation that does not qualify for the Chevron two-step test under Mead’s Chevron step zero analysis is not, as a consequence, given no weight. Mead held that such an agency interpretation is given weight according to its power to persuade.19 Mead derived this power to persuade standard from the Court’s 1944 decision in Skidmore v. Swift & Co, in which it said:

The weight [accorded to an administrative] judgment in a particular case will depend upon 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, if lacking power to control.20

As discussed below, the Skidmore standard is relevant to a consideration of the multifactor analysis approach to Chevron step zero because the two inquiries are so similar.

Barnhart v. Walton

The Supreme Court applied the multifactor analysis aspect of Mead’s Chevron step zero test in Barnhart v. Walton.21 That case turned not only on the validity of an agency regulation’s interpretation of what the Court concluded was an ambiguous statutory provision, but also on the validity of the agency’s interpretation of its own regulation. The Court’s analysis of the relationship between those two issues was far from clear.

After concluding that the interpretation in the regulation was permissible under step two of Chevron’s two-part test, the Court provided the following commentary regarding the Chevron step zero issue in response to the argument that the agency arrived at its interpretation without the benefit of notice-and-comment procedures:

The fact that the Agency previously reached its interpretation through means less formal than “notice and comment” rulemaking, does not automatically deprive that interpretation of the judicial deference otherwise its due. . . .

In this case, the interstitial nature of the legal question, the related expertise of the Agency, the importance of the question to administration of the statute, the complexity of that administration, and the careful consideration the Agency has given the question over a long period of time all indicate that Chevron provides the appropriate legal lens through which to view the legality of the Agency interpretation here at issue.22

That discussion illustrates how difficult it is to predict the outcome of the multifactor analysis aspect of Mead’s Chevron step zero test in a given case. Vague concepts such as “the interstitial nature of the legal question,” “the importance of the question to administration of the statute,” and “the complexity of that administration” provide no useful guidance for predicting what the outcome of an analysis based on those concepts will be in other cases.

That analysis from Barnhart v. Walton also illustrates how hard it is to distinguish that mode of analysis from the Skidmore standard, which applies to determine the weight of an agency interpretation in cases in which the Chevron step zero test is not met. In light of both of those considerations, it is difficult to justify the multifactor analysis aspect of the Chevron step zero test.

Finally, the Barnhart v. Walton commentary illustrates that the multifactor analysis aspect of Mead’s Chevron step zero test ordinarily relates to the second part of the test — namely, whether the agency interpretation should be viewed as an exercise of the agency’s authority to act with the force of law in a case in which that interpretation is not the product of notice-and-comment rulemaking. The application of the multifactor analysis aspect of Mead’s Chevron step zero test in Barnhart v. Walton clearly does not represent the application of the first part of Mead’s Chevron step zero test — namely, whether Congress gave the agency the authority to act with the force of law.

In the tax world, the area in which that multifactor analysis aspect of Mead’s Chevron step zero test has the most obvious potential significance is in the treatment of temporary regulations, which are almost always issued without prior notice-and-comment procedures, but which the government nevertheless ordinarily claims satisfy the Chevron step zero test so as to qualify for the Chevron two-step test despite that lack.23 A principal argument the government ordinarily makes in applying the Chevron two-step test to temporary regulations is that temporary regulations come within this vague and undefined multifactor analysis aspect of Mead’s Chevron step zero test.

City of Arlington

As noted above, in City of Arlington the Court rejected the proposition that questions of statutory interpretation relating to the scope of an agency’s jurisdiction are excluded from the Chevron two-step test. If the Court had instead accepted this proposition, the consequence would have been that for any issue relating to the scope of the agency’s jurisdiction that could not be resolved at step one of the Chevron two-part test, the agency’s interpretation would not get the benefit of Chevron step two. Thus, the agency interpretation would not be upheld merely because it was reasonable or permissible.

In that instance, the reviewing court would decide the question of statutory interpretation based on the court’s best judgment, as is the case under Chevron step one. However, in contrast to the decision the court makes in Chevron step one, the court would make its decision based on what it concluded to be the best reading of the statute, rather than on the basis of determining what was the only permissible interpretation.

In rejecting the proposition that questions of statutory interpretation relating to the scope of an agency’s jurisdiction are excluded from the Chevron two-step test, Scalia’s majority opinion notes that this proposition was derived from the important distinction between jurisdictional requirements and non-jurisdictional requirements for bringing a case in court that may be imposed by the statutory provisions that apply to the type of case being brought, a distinction that the Court has tried to clarify in recent decisions.24 Scalia noted that while this distinction between jurisdictional requirements and non-jurisdictional requirements for bringing a case in court has significant consequences because it relates to the authority of the Court to hear the case,25 the distinction between jurisdictional issues and non-jurisdictional issues relating to the scope of the authority of agencies has no comparable significance.

Scalia reasons that for issues of statutory interpretation relating to the scope of an agency’s authority, the supposed distinction between jurisdictional and non-jurisdictional issues is illusory, because every issue relating to whether the agency’s action was consistent with the terms of the relevant statutory provision (and thus every issue to which Chevron could potentially apply) could be reframed as an issue of whether the agency had exceeded its authority:

The label is an empty distraction because every new application of a broad statutory term can be reframed as a questionable extension of the agency’s jurisdiction.26

No matter how it is framed, the question a court faces when confronted with an agency’s interpretation of a statute it administers is always, simply, whether the agency has stayed within the bounds of its statutory authority.27

The question . . . is always whether the agency has gone beyond what Congress has permitted it to do.28

The question in every case is, simply, whether the statutory text forecloses the agency’s assertion of authority, or not.29

Thus, according to Scalia’s analysis, limiting Chevron’s scope by holding that it does not apply to issues relating to an agency’s jurisdiction would essentially eliminate Chevron entirely: “Make no mistake — the ultimate target here is Chevron itself.”30 Finally, in response to concerns that Chevron gives agencies too much power, Scalia notes that this concern should be addressed through a robust, rather than permissive, application of Chevron:

The fox-in-the-henhouse syndrome is to be avoided not by establishing an arbitrary and undefinable category of agency decisionmaking that is accorded no deference, but by taking seriously, and applying rigorously, in all cases, statutory limits on agencies’ authority. Where Congress has established a clear line, the agency cannot go beyond it; and where Congress has established an ambiguous line, the agency can go no further than the ambiguity will fairly allow. But in rigorously applying the latter rule, a court need not pause to puzzle over whether the interpretive question presented is “jurisdictional.”31

Scalia does not cite Mead in his primary discussion of the issue in City of Arlington, even though both cases deal with the Chevron step zero issue of when the Chevron two-step test applies, and even though Mead is clearly the authoritative decision on Chevron step zero. His failure to cite Mead in his primary discussion is not surprising, because he dissented vigorously in Mead, contending that Mead improperly restricted the cases in which the Chevron two-step test applies.32 His dissent in Mead also correctly predicted that the multifactor analysis aspect of Mead’s Chevron step zero test would lead to confusion, uncertainty, and unpredictability.33 Moreover, in his dissent in National Cable & Telecommunications Ass’n v. Brand X Internet Services,34 in which the majority held that agencies are permitted to overrule court decisions on issues of statutory construction as long as the court decision did not conclude that its interpretation was the only permissible one, he reiterates his opposition to Mead,35 and in his concurring opinion in United States v. Home Concrete & Supply LLC,36 he reiterated his opposition to Brand X.37

However, in a later section of the City of Arlington opinion in which he responds to the dissent, Scalia seems finally to have accepted Mead:

The dissent is correct that United States v. Mead Corp. requires that, for Chevron deference to apply, the agency must have received congressional authority to determine the particular matter at issue in the particular manner adopted. No one disputes that.38

Nevertheless, having accepted Mead, Scalia proceeds to rewrite it:

But Mead denied Chevron deference to action, by an agency with rulemaking authority, that was not rulemaking. What the dissent needs, and fails to produce, is a single case in which a general conferral of rulemaking or adjudicative authority has been held insufficient to support Chevron deference for an exercise of that authority within the agency’s substantive field.39

By describing Mead as having “denied Chevron deference to action, by an agency with rulemaking authority, that was not rulemaking,” Scalia makes it appear that the denial of Chevron deference in Mead followed directly from the fact that the agency action at issue in Mead was not rulemaking. That ignores the analysis that Mead went through in explaining why, even though the agency action in Mead was not the product of notice-and-comment rulemaking, that fact alone was not enough to decide that Chevron did not apply: “The fact that the tariff classification here was not a product of such formal process does not alone, therefore, bar the application of Chevron.”40

However, while Scalia’s characterization of Mead in this respect is inaccurate, he was able to get four other justices to join his opinion without any of them objecting to this inaccuracy in his characterization of Mead. Moreover, the same narrowing of the Mead test for Chevron step zero is present in his statement that the dissent had cited no case “in which a general conferral of rulemaking or adjudicative authority has been held insufficient to support Chevron deference for an exercise of that authority.” This statement leaves no room for the application of the multifactor analysis aspect of Mead’s Chevron step zero test, which contemplates that under some circumstances, an agency action that does not represent an exercise of rulemaking authority might nevertheless satisfy Chevron step zero.

Moreover, the majority opinion goes on to describe “the preconditions to deference under Chevron” in the following terms:

It suffices to decide this case that the preconditions to deference under Chevron are satisfied because Congress has unambiguously vested the FCC with general authority to administer the Communications Act through rulemaking and adjudication, and the agency interpretation at issue was promulgated in the exercise of that authority.41

According to this passage, “the preconditions to deference under Chevron” are that “Congress has unambiguously vested the [agency] with general authority to administer the [relevant] Act through rulemaking and adjudication, and the agency interpretation at issue was promulgated in the exercise of that authority.” This restatement of “the preconditions to deference under Chevron” (the requirements for satisfying Chevron step zero) makes no reference to the multifactor analysis aspect of Chevron step zero that was identified in Mead and then applied in Barnhart v. Walton, under which an agency interpretation that does not represent an exercise of rulemaking authority might still satisfy Chevron step zero. Once again, although this is a departure from Mead, four other justices joined Scalia in his opinion without objecting to this departure.

Consequently, Scalia’s majority opinion suggests that the multifactor analysis aspect of Mead’s Chevron step zero test has no vitality. Moreover, additional support for this reading of the decision is presented by Justice Stephen G. Breyer’s concurring opinion in the case. Breyer’s vote was not necessary to Scalia’s five-vote majority, so his concurring opinion represents only his own views. However, Breyer’s objection to the majority opinion provides insight into the meaning of that opinion.

Further, in considering Breyer’s concurring opinion, it is significant that Breyer was the author of the Court’s opinion in Barnhart v. Walton. (Scalia concurred in that case but without joining most of Breyer’s analysis.42) It is not surprising that Breyer’s concurring opinion in City of Arlington disagrees with the streamlined, simplified version of Chevron step zero articulated in Scalia’s majority opinion, in light of Breyer’s opinion for the Court in Barnhart v. Walton and his general preference for applying open-ended, multifactor forms of analysis rather than bright-line tests.

However, one notable thing about Breyer’s concurring opinion in City of Arlington is that it focuses Breyer’s disagreement exclusively on the first part of the two-step Chevron step zero test from Mead and not at all on the second part of that test:

The existence of statutory ambiguity is sometimes not enough to warrant the conclusion that Congress has left a deference-warranting gap for the agency to fill because our cases make clear that other, sometimes context-specific, factors will on occasion prove relevant. . . . In Mead, for example, we looked to several factors other than simple ambiguity to help determine whether Congress left a statutory gap, thus delegating to the agency the authority to fill that gap with an interpretation that would carry “the force of law.”43

That passage focuses on whether Congress has given the agency the authority to act with the force of law, rather than on whether the agency interpretation represents an exercise of that authority. Breyer then quotes the above passage from his opinion in Barnhart v. Walton as supposedly providing an additional example of the use of the multifactor analysis in the first part of Mead’s Chevron step zero test, even though that passage actually addressed the second part of Mead’s step zero test.

As his discussion continues, however, it clearly focuses on the first part of the step zero test:

The subject matter of the relevant provision — for instance, its distance from the agency’s ordinary statutory duties or its falling within the scope of another agency’s authority — has also proved relevant.

Moreover, the statute’s text, its context, the structure of the statutory scheme, and canons of textual construction are relevant in determining whether the statute is ambiguous and can be equally helpful in determining whether such ambiguity comes accompanied with agency authority to fill a gap with an interpretation that carries the force of law.44

Breyer then acknowledges the view that this type of approach is difficult to apply and makes it virtually impossible to predict the outcome in any particular case, but he dismisses that concern:

Although seemingly complex in abstract description, in practice this framework has proved a workable way to approximate how Congress would likely have meant to allocate interpretive law-determining authority between reviewing court and agency.45

By focusing his attention on the first part of Mead’s Chevron step zero test and disagreeing with the streamlining of that part of the test adopted in Scalia’s majority opinion, Breyer not only confirms that the majority opinion represents a departure from Mead in abandoning the application of the open-ended, multifactor analysis aspect of the step zero test but also fails to raise any comparable objection to the streamlining effect on the second part of the test. While it might be argued that the focus on the first part of the Mead Chevron step zero test can be explained by the fact that it was this part of the test that was at issue in City of Arlington, the breadth of the language in Scalia’s majority opinion cannot be overlooked.

In light of Breyer’s concurring opinion, it cannot be claimed that the four other members of the Court who joined Scalia’s majority opinion might have overlooked that Scalia’s opinion streamlines the step zero test. Thus, by joining the majority opinion, they must be taken to have assented to the streamlining effect.

Chief Justice John G. Roberts Jr. dissented in City of Arlington in an opinion that was joined by justices Anthony Kennedy and Samuel Alito. The main idea of the dissent was similar to that in Breyer’s concurring opinion, in that it approached the first part of the Chevron step zero inquiry, which asks whether the agency has the statutory authority to address the particular issue in a way that has the force of law, using a case-by-case approach. The dissent calls for the more open-ended analysis rather than simply asking whether the agency has the general authority to issue rules with the force of law and concluding that if the agency has that general authority, the authority necessarily covers the provision at issue.

In light of this similarity between the dissent and Breyer’s concurrence, Scalia’s response to the dissent is equally a response to Breyer:

Where we differ from the dissent is in its apparent rejection of the theorem that the whole includes all of its parts — its view that a general conferral of rulemaking authority does not validate rules for all the matters the agency is charged with administering. Rather, the dissent proposes that even when general rulemaking authority is clear, every agency rule must be subjected to a de novo judicial determination of whether the particular issue was committed to agency discretion. It offers no standards at all to guide this open-ended hunt for congressional intent (that is to say, for evidence of congressional intent more specific than the conferral of general rulemaking authority). It would simply punt that question back to the Court of Appeals, presumably for application of some sort of totality-of-the-circumstances test — which is really, of course, not a test at all but an invitation to make an ad hoc judgment regarding congressional intent. Thirteen Courts of Appeals applying a totality-of-the-circumstances test would render the binding effect of agency rules unpredictable and destroy the whole stabilizing purpose of Chevron. The excessive agency power that the dissent fears would be replaced by chaos.46

This passage leaves no doubt that after City of Arlington, the first part of the Chevron step zero test looks exclusively to whether the agency has general rulemaking authority, and likewise leaves no doubt that the answer to that question is dispositive on this part of the test. Thus, it is clear now that the multifactor analysis aspect of Mead’s Chevron step zero test has no application to the first part of the test. Moreover, while this vigorous rejection of the multifactor approach is nominally directed at the first part of the Chevron step zero test, the reasoning based on the need for predictability under the approach that is applied, and the fact that that predictability would be defeated by a requirement to engage in a totality-of-the-circumstances, case-by-case analysis in applying that first part of the Chevron step zero test, is equally applicable to the second part of the Chevron step zero test. That clearly leads to a rejection of the undefined, open-ended, multifactor analysis aspect for both parts of the Chevron step zero test established in Mead.

Conclusion

City of Arlington’s negative answer to whether issues of statutory interpretation relating to the scope of an agency’s authority are excluded from the Chevron two-step test for evaluating the validity of agency interpretations is clearly important in and of itself. More significant, however, is the decision’s streamlining of Mead’s Chevron step zero test by eliminating the multifactor analysis approach that had been the most unpredictable aspect of that test.

FOOTNOTES

1 133 S. Ct. 1863 (2013) .

2 467 U.S. 837 (1984).

3 131 S. Ct. 704 (2011) .

4 For prior commentary making this same point, see Kristin E. Hickman, “Don’t Overlook City of Arlington, Texas v. FCC,” TaxProf Blog (May 22, 2013).

5 The term “Chevron step zero” was first used in Thomas W. Merrill and Hickman, “Chevron’s Domain,” 89 Geo. L.J. 833, 836 (2001). See also Cass R. Sunstein, “Chevron Step Zero,” 92 Va. L. Rev. 187 (2006).

6 533 U.S. 218 (2001). Neither Chevron itself, Mead, nor City of Arlington uses the term “step zero.”

7 467 U.S. at 842-843.

8 Id. at 843, n.9 (citations omitted).

9 Id. at 843 (footnotes omitted).

10 Id. at 844.

11 Id. at 843, n.11.

12 Chevron step zero might be described more accurately as Chevron step one and a half, because a reviewing court faced with an issue of statutory interpretation must always undertake the Chevron step one analysis regardless of whether there has been an agency interpretation that might be subject to step two. It is only after the step one analysis has been performed without resolving the question of statutory interpretation that it becomes necessary to ask whether there is an agency interpretation that would be accepted as controlling under step two. Nevertheless, the term “Chevron step zero” is now so widely used that there is no point in quibbling with its accuracy.

13 533 U.S. at 226-227 (numbers added).

14 In the discussion that follows, the focus will be on agency action through rulemaking rather than through adjudication, because the IRS, like most agencies, makes rules that have the force of law through rulemaking rather than through adjudication.

15 For a wide-ranging recent discussion of the force of law concept, see Hickman, “Unpacking the Force of Law,” 66 Vand. L. Rev. 465 (2013).

16 See 5 U.S.C. section 553.

17 533 U.S. at 227 (emphasis added).

18 Id. at 230-231 (emphasis added).

19 Id. at 235 (quoting Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944)).

20 533 U.S. at 228 (quoting 323 U.S. at 140) (alteration in original).

21 535 U.S. 212 (2002).

22 Id. at 221-222 (citation omitted).

23 The relevance of Chevron step zero in the tax world is limited to temporary regulations because the IRS and the Justice Department do not claim that the Chevron two-step test applies to any form of IRS guidance other than regulations. See Marie Sapirie, “DOJ Won’t Push Chevron Deference for Revenue Rulings,” Tax Notes, May 16, 2011, p. 674 .

24 133 S. Ct. at 1868-1869. For a discussion of some of these cases, see Patrick J. Smith, “Is the Anti-Injunction Act Jurisdictional?” Tax Notes, Nov. 28, 2011, p. 1093 .

25 Thus, if a statutory requirement for bringing a case in court is determined to be jurisdictional, the issue may be raised at any stage of the litigation, including by the court itself, and it cannot be waived or forfeited by a party for failing to raise it sooner during the litigation.

26 133 S. Ct. at 1870.

27 Id. at 1868 (emphasis in original).

28 Id. at 1869.

29 Id. at 1871.

30 Id. at 1873.

31 Id. at 1874.

32 533 U.S. at 239-240 (Scalia, J., dissenting).

33 Id. at 245-246.

34 545 U.S. 967 (2005).

35 Id. at 1014-1015 and 1018 (Scalia, J., dissenting).

36 132 S. Ct. 1836 (2012) .

37 Id. at 1848 (Scalia, J., dissenting).

38 133 S. Ct. at 1874 (citation omitted).

39 Id.

40 533 U.S. at 231.

41 133 S. Ct. at 1874.

42 535 U.S. at 226-227 (Scalia, J., concurring).

43 133 S. Ct. at 1875 (Breyer, J., concurring).

44 Id. at 1875-1876 (citations omitted).

45 Id. at 1876 (emphasis added).

46 133 S. Ct. at 1874 (emphasis in original).

Patrick J. Smith

Patrick J. Smith is a partner at Ivins, Phillips & Barker in Washington.




IRS EO Update: e-news for Charities and Nonprofits.

1.  IRS website explains tax provisions of the health care law; provides guide to online resources

The IRS has launched a new Affordable Care Act Tax Provisions website at IRS.gov/aca to educate individuals and businesses on how the health care law may affect them. The new home page has three sections, which explain the tax benefits and responsibilities for individuals and families, employers, and other organizations, with links and information for each group. The site provides information about tax provisions that are in effect now and those that will go into effect in 2014 and beyond.

http://www.irs.gov/uac/Affordable-Care-Act-Tax-Provisions-Home

2.  Disclosure of return information

On Aug. 13, 2013, the Department of the Treasury and the IRS issued final regulations with rules for disclosure of return information to the Department of Health and Human Services that will be used to carry out eligibility determinations for advance payments of the premium tax credit, Medicaid and other health insurance affordability programs. For additional information on the final regulations, see questions and answers.

http://www.gpo.gov/fdsys/pkg/FR-2013-08-14/pdf/2013-19728.pdf

http://www.irs.gov/uac/Newsroom/IRC-Section-6103(l)(21)-Questions-and-Answers

3.  IRS web pages provide information on group exemptions and group returns

These pages explain how to obtain and maintain group exemptions and file group returns.

Group exemptions: http://www.irs.gov/Charities-&-Non-Profits/Group-Exemption-Resources

Group returns: http://www.irs.gov/Charities-&-Non-Profits/Returns-Filed-by-Organizations-in-Group-Rulings-Resources

4.  Register for EO workshops

Register for upcoming workshops for small and medium-sized 501(c)(3) organizations:

August 20-21 – San Francisco, CA

Hosted by Golden Gate University

August 28-29 – Anaheim, CA

Hosted by Trinity Law School

http://www.irs.gov/Charities-%26-Non-Profits/Upcoming-Workshops-for-Small-and-Medium-Sized-501(c)(3)-Organizations

5.  IRS open Aug. 30 as cost cutting continues; will reevaluate need for furlough day in September

Read news release: http://www.irs.gov/uac/Newsroom/IRS-Open-Aug.-30-as-Cost-Cutting-Continues;-Will-Reevaluate-Need-for-Furlough-Day-in-September

6.  Six good reasons to become a tax volunteer

If you’re looking for a way to help your community, consider becoming a tax volunteer. The IRS is looking for volunteers now who will provide free tax help next year. Read tax tip: http://www.irs.gov/uac/Newsroom/Six-Good-Reasons-Why-You-Should-Become-a-Tax-Volunteer

7.  Ten cool reasons to visit IRS.gov in Espanol this summer

Tax information can be difficult to understand in any language. It can be even more difficult if English is not your first language. The IRS provides a wide range of free products and services on its Spanish language web pages. Visit IRS.gov/espanol to get federal tax help in Spanish. Read all about it: http://www.irs.gov/uac/Newsroom/Ten-Cool-Reasons-to-Visit-IRS.gov-in-Espanol-This-Summer




Nonprofit Housing Organization Requests Guidance on Low-Income Housing Tax Credit.

B. Susan Wilson of Enterprise, responding to a request (Notice 2013-22) for items to include on the 2013-2014 priority guidance list, has asked the IRS to address issues relating to the low-income housing tax credit, including bond issuance costs, casualty losses, over-income tenants, and the applicability of the economic substance doctrine.

Internal Revenue Service

Attn: CC:PA:LPD:PR (Notice 2013-22)

Room 5203

P.O. Box 7604

Ben Franklin Station

Washington, D.C. 20044

Re: Notice 2013-22 Recommendations for 2013-2014 Guidance Priority List

Ladies and Gentlemen:

We are writing in response to Notice 2013-22, in which the Service invited public comment on items that should be included on the 2013-2014 Guidance Priority List.

Enterprise is a national nonprofit organization that creates opportunity for low- and moderate-income people through affordable housing in diverse, thriving communities. For more than 30 years, Enterprise has introduced neighborhood solutions through public-private partnerships with financial institutions, governments, community organizations and others that share our vision. Enterprise has raised and invested more than $13.9 billion in equity, grants and loans to help build or preserve 300,000 affordable rental and for-sale homes to create vital communities. As a key part of our affordable housing finance work, Enterprise is a leading national syndicator of Low-Income Housing Tax Credits (LIHTC).

Below, we have outlined five guidance issues that we believe impact many transactions and propose solutions that we believe would result in the credit working more efficiently and being more effective. Please note that these are the same items that we submitted last year, but we believe that these issues continue to be important and should be considered in the plan.

Inclusion of Bond Issuance Costs in Eligible Basis: We would like the Internal Revenue Service to reconsider the rule that bond issuance costs, including those associated with construction period bonds, cannot be included in basis.

TAM 200043015, issued on October 27, 2000, concludes that Bond Issuance Costs cannot be capitalized and included in eligible basis since they are not subject to depreciation, but are amortizable costs. However, while these costs are amortizable, a portion of the amortization would then be capitalized and depreciable under Internal Revenue Code Section 168. Therefore, to the extent these costs would ultimately be depreciable, they would also be includible in eligible basis.

In many cases, owners use tax-exempt bonds to fund the construction or rehabilitation of the project. In some cases, the bonds are completely paid off at or soon after completion of the project and in other cases, a portion of the bonds are paid off at or near completion of the project, with the balance remaining outstanding for a longer period of time.

Internal Revenue Code Section 42(d)(1) provides that the eligible basis of a building is its adjusted basis at the close of the first taxable year of the credit period.

Generally, costs incurred in obtaining a loan are capitalized and amortized over the life of the loan. Internal Revenue Code Section 263A provides that indirect costs allocable to the production of real or tangible property are to be capitalized into the basis of the produced property.

Such allocable costs would include points and other financing costs associated with a loan used entirely or in part for construction or rehabilitation of the project, as well as interest incurred during the construction or rehabilitation of the project.

To the extent that these costs are amortizable, the amortization associated with the construction or rehabilitation period would be capitalized under Internal Revenue Code Section 263A.

In those cases where the bond is a source of construction financing, the points and other costs of the bonds should be treated as an allocable cost and the portion relating to the construction and rehabilitation of the project should be capitalized into the basis of the building, pursuant to Internal Revenue Code Section 263A.

Loss of Low Income Housing Tax Credits upon a Casualty Loss: We would like the Internal Revenue Service to reconsider its position that credits are not allowed for a year to the extent that the building or units are not available for occupancy on December 31st of that year, due to a casualty loss that is not part of a presidentially declared disaster area, even though the owner is in the process of a timely restoration of the damaged units or building.

Internal Revenue Code Section 42(j)(4) states that there should be no tax credit recapture resulting from a reduction in qualified basis by reason of a casualty loss to the extent that such loss is restored by reconstruction or replacement within a reasonable period established by the Secretary.

In Revenue Procedure 2007-54, which superseded Revenue Procedure 95-28, the IRS stated that the owner of a building that is beyond the first year of the credit period has suffered a reduction in qualified basis that would cause it to be subject to a recapture or loss of credit will not be subject to recapture or loss of credit if the building’s qualified basis is restored within a reasonable period. However, the Revenue Procedure addressed this relief to casualties that resulted from a disaster that caused the President to issue a major disaster declaration since that was the general topic of the Revenue Procedure and it did not address casualty losses that did not result from such disasters.

In CCA 200134006 and CCA 200913012, the Chief Counsel to the Internal Revenue Service stated that the ability of the owner to claim credits on units while out of service is limited to those casualties resulting from a presidential declared disaster and is not appropriate for a casualty that resulted form some other cause, such as a fire experienced by a specific project, stating that the exception in Revenue Procedure 95-28 was limited to that.

In the latter case, while recapture does not result if the building or units are restored within a reasonable period of time, if not restored by the end of the year, pursuant to CCA 200134006, no credits are allowed for that year. Although credits would resume for the year in which the project is returned to service, these are credits that the owner would have been entitled to had the casualty not occurred. Credits would be lost for any year in which the units are not returned to service by the end of the year, regardless of when the casualty occurred, and these credits are not made up later, as in the 11th year, so it is a permanent loss of credits. This result is somewhat punitive to an owner who suffered a loss through no fault of its own, despite acting prudently to restore the unit or building in a reasonable period.

The distinction provided in CCA 200134006 was based on Revenue Procedure 95-28, which only provided relief in the form of the ability to claim credits during the replacement period if the property was in a location being designated as a major disaster area. However, that distinction is inappropriate. The Revenue Procedure was only dealing with such disaster areas, which is why relief was only given to such an area. In addition, in CCA200134006, it states that “Such an event is quite distinct from the general casualty loss situation confronting property owners.” While being in a disaster area can make replacements and restoration more challenging, an owner suffering a casualty loss of any sort has similar challenges.

We request that the Service consider revising its policy and provide the same treatment for casualty losses that are not located in a presidentially-declared disaster area. In general, tax law provides a time period for replacements to be completed for casualties, even if not located in a disaster area. If restored within that time period, there should be no loss of tax credit, even if the building is not restored until after the end of the year. This was the treatment accorded to casualty losses that occurred in a disaster area. There is no reason why the rule should be different in a disaster area than outside of it. The rules for casualty losses are the same.

Application of the Economic Substance Doctrine: We would like the Internal Revenue Service to issue official guidance that the Economic Substance Doctrine does not apply to tax credit transactions, including the low income housing credit, new markets credit, rehabilitation credit, and the energy credit.

The Patient Protection and Affordable Care Act and the Health Care and Education Affordability Reconciliation Act codified the common law economic substance doctrine under which federal income tax benefits of a transaction are disallowed if the transaction does not have economic substance or lacks a business purpose, and imposes significant penalties on taxpayers that enter into transactions that lack economic substance.

The Joint Committee on Taxation description of the economic substance doctrine provides that the doctrine is not intended to disallow tax benefits if the realization of those tax benefits is consistent with the Congressional purpose or plan that the tax benefits are designed to effectuate, such as low income housing, new markets, rehabilitation and energy credit transactions.

The Joint Committee on Taxation’s description is an interpretation and is not part of the Statute. Without formal guidance of the inapplicability of this statute to the programs named above, potential investors will perceive this to be a risk, which can interfere with the effectiveness of the programs.

We request that the Internal Revenue provide formal guidance that states that the economic substance doctrine provided by The Patient Protection and Affordable Care Act and the Health Care and Education Affordability Reconciliation Act not apply to low income housing, new markets, rehabilitation and energy credit transactions.

Continued qualification of over-income tenants covered by an extended use agreement after a transfer of project: We would like the Internal Revenue Service to issue formal guidance that would state that any household determined to be income qualified at the time of move-in for purpose of the extended use agreement is a qualified household for any subsequent allocation of Internal Revenue Code Section 42 or allowable through the issuance of tax-exempt bonds pursuant to Internal Revenue Code Section 42(h)(4).

In the Guide for Completing Form 8823 Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition (Revised October 2009), (“The Guide”) the Internal Revenue states that “any household determined to be income qualified at the time of move-in for purposes of the extended use agreement is a qualified low-income household for any subsequent allocation of IRC § 42.” (p. 4-27)

This is a reasonable position since these tenants may not be evicted without cause and relocation of the tenants will be very costly and inefficient.

Rev. Proc. 2003-82 provides a safe harbor that will allow an owner to treat a unit occupied by a tenant whose income exceeds the maximum qualified income as qualified if “The unit has been a low-income unit under § 42(i)(3)(B), (C), (D), and (E) from either the date the existing building was acquired by the taxpayer or the date the individuals started occupying the unit, whichever is later, to the beginning of the first taxable year of the building’s credit period. Further, the safe harbor provided by the Revenue Procedure provides that in order for the unit to be qualified, “The individuals occupying the units have incomes that are at or below the applicable income limitation under 42(d)(4)(B)(i) on either the date the existing building was acquired by the taxpayer or the date the individuals started occupying the unit, whichever is later.”

The Revenue Procedure does not state that there would be a different result if an extended use agreement were in effect at the time of the transfer. However, since the purpose of the Rev. Proc. was to provide a safe harbor that would allow tenants to qualify in some situations, it presumably was not intended to cover all situations.

Although The Guide does not have the standing of official guidance from the Office of the Chief Counsel, state agencies and developers rely on it. However, because it is not official guidance, investors and their counsel are reluctant to rely upon it and, in some cases, it forces the owner to relocate tenants that, according to the Service (as stated in The Guide) may not be necessary. This results in additional costs to the owner and displacement of the tenants.

We request that the Internal Revenue Service issue formal guidance that would be consistent with The Guide.

Definition of federally- or state-assisted building for purposes of qualification for exception from ten year rule requirements for the acquisition credit: We would like the Internal Revenue to issue formal guidance on the minimum requirements that a project would need to meet in order to be deemed “a federally- or state-assisted building, which would allow the building to be exempt from the requirement that there be a period of at least ten years between the date the building is being acquired by the taxpayer and the date the building was last placed in service by the previous owner.

The Housing and Economic Recovery Act of 2008 (“HERA”) expanded the exceptions from the ten year rule to include federally- or State-Assisted Buildings. HERA defined a federally-assisted building to be “any building which is substantially assisted, financed, or operated under section 8 of the United States Housing Act of 1937, section 221(d)(3), 221(d)(4), or 236 of the National Housing Act, section 515 of the Housing Act of 1949, or any other housing program administered by the Department of Housing and Urban Development or by the Rural Housing Service of the Department of Agriculture.” HERA defined a state-assisted building as a building “which is substantially assisted, financed, or operated under any State law similar in purpose to any of the laws” described under the federal definition.

While HERA provided a broad list of the programs that qualified a building for the exception, they did not define “substantially assisted”.

Without a definition or guidance of “substantially assisted”, taxpayers are unsure whether a buiding qualifies and investors are reluctant to invest in these credits due to the uncertainty.

We request that the Internal Revenue Service provide guidance as to what would be deemed substantially federally subsidized. Without such guidance, the purpose of creating this exception to the ten year rule will not be achieved.

We appreciate the opportunity to present our recommendations on items that should be included in the 2012-2013 Priority Guidance Plan. We believe that these changes will improve the use of the tax credits to provide affordable housing that is needed in this country. Thank you in advance for your consideration of these suggestions. If you have any questions about any of the items described above, please feel free to contact Susan Wilson at 410-772-2539 or [email protected] or Peter Lawrence at 202-649-3915 or [email protected].

Very truly yours,

B. Susan Wilson

Vice-President

Enterprise Community Investment,

Inc.

Washington, DC




Affordable Housing Association Requests Guidance on Low-Income Housing Tax Credit.

Kris Cook of the National Affordable Housing Management Association, responding to a request (Notice 2013-22) for items to include on the 2013-2014 priority guidance list, has asked the IRS to address issues relating to the low-income housing tax credit, including the utility allowance submetering rule and the treatment of casualty losses.

May 1, 2013

Internal Revenue Service

Attn: CC:PA:LPD:PR

(Notice 2013-22)

Room 5203

P.O. Box 7604

Ben Franklin Station

Washington, D.C. 20044

Re: Notice 2013-22 Recommendations for 2013-2014 Guidance Priority List

Thank you for this opportunity to submit recommendations for the 2013-2014 Guidance Priority List on behalf of the National Affordable Housing Management Association (NAHMA). NAHMA members manage and provide quality affordable housing to more than two million Americans with very low to moderate incomes. Presidents and executives of property management companies, owners of affordable rental housing, public agencies and national organizations involved in affordable housing, and providers of supplies and services to the affordable housing industry make up the membership of NAHMA. In addition, NAHMA serves as the national voice in Washington for 19 regional, state and local affordable housing management associations (AHMAs) nationwide. NAHMA’s comments will focus on two important matters related to the Section 42 Low Income Housing Tax Credit (LIHTC) program, namely the utility allowance submetering rule and treatment of casualty losses.

Utility Allowances (UA) Submetering

On August 7, 2012, the Internal Revenue Service (IRS) — Treasury Department issued the “Utility Allowances Submetering Notice of Proposed Rulemaking and Notice of Public Hearing” [REG-136491-09], RIN 1545-BI91. NAHMA respectfully requests that IRS-Treasury add finalization of this rule, with certain changes, to its 2013-2014 Guidance Priority List.

Before releasing the final rule, NAHMA strongly urges IRS-Treasury to revise its interpretation of State housing agencies’ authority to disapprove UA estimation methods permitted under current policies. Under the section, “Summary of Comments on Notice 2009-44 and Explanation of Provisions,” the August 7 Notice states:

“A commentator asked whether State housing agencies are allowed to disapprove of certain methods for determining utility allowances listed in § 1.42-10(b)(4)(ii). Existing rules address the role of the State housing agencies in determining utility allowances. Thus, depending on the particular method under § 1.42-10(b)(4)(ii), State housing agencies may require certain information before a method can be used, or they may disapprove of a method.”

NAHMA stands by the position articulated by nine national organizations which represent property owners and managers, developers and lenders who participate in the LIHTC program. The joint industry comments, submitted on October 4, 2012, stated:

“We disagree with the general implication of this language that State housing agencies may arbitrarily choose to disapprove any method described in the regulation. . . .”

“As written, the language in the August 7, 2012, proposed rule would give State housing agencies authority to ignore the intent of the existing regulation, which is to recognize accurate estimates that encourage energy efficiency and are based on reliable methods that are easily verifiable. We are concerned that agencies may impose less accurate methods for calculating utility allowances on an arbitrary basis. We recommend that the IRS direct State housing agencies to review the data and information provided by project sponsors and make a determination based on the facts of the individual project submission. Applicants for LIHTC credits should be encouraged to engage with the State housing agency to determine what, if any, issues or concerns the approving agency may have.”

NAHMA urges IRS-Treasury to issue a final rule that reaffirms LIHTC property owners’ options for selecting an appropriate UA estimation method available under current IRS policies.

Section 42 Low Income Housing Tax Credit Buildings Damaged by Casualty Events

NAHMA respectfully requests that IRS-Treasury include harmonization of casualty loss policies for LIHTC properties on its 2013-2014 Guidance Priority List.

Under current policies, casualties are treated differently depending on whether they are the result of a presidentially declared disaster. As described in Revenue Procedure 2007-54, a taxpayer can continue to claim the credits for casualty events in presidentially declared disaster areas. Low Income Housing Tax Credits will not be subject to recapture or loss of credit if the building’s qualified basis is restored within a reasonable restoration period — which may not exceed 24 months after the end of the calendar year in which the president issued a major disaster declaration for the area where the building is located. However, properties that suffer casualty losses outside of these declared disaster areas operate under different terms. Internal Revenue Code 42(j)(4)(E) provides relief from recapture of previously earned credits if the building is restored by reconstruction or replacement within a reasonable time.

However, it does not provide authority for claiming the credit during the time that the building is being restored.

As stated by the IRS, the credit is determined at the close of the taxable year under IRC § 42(c)(1). Credit is determined on a monthly basis only for the first year of the credit period under IRC § 42(f)(2)(A), and for additions to qualified basis under IRC § 42(f)(3)(B). Otherwise, there is no authority to disallowing credits on a monthly basis. Owners of buildings in presidentially declared disaster areas will not lose credits if the building is not placed back in service by the end of the year. However, owners of buildings not in a declared disaster area will lose credits for the year if their units are not back online by December 31. This means an owner could have a unit that was in compliance for the entire year, but have a fire in December that is not restored by December 31, and the owner would not be eligible to take credits for the entire year. If this is not done on December 31, then credits cannot be claimed for the entire year, no matter if the units were in compliance every other day of the calendar year.

NAHMA urges IRS-Treasury to apply the same casualty loss policies across the board. Properties should be able to continue to take the credits during the restoration period, regardless of whether or not the property is in a presidentially declared disaster area. It is reasonable, however, for IRS to establish criteria for owners to demonstrate they took prompt action to begin the restoration process following the casualty event when the loss occurs outside of a presidentially declared disaster area.

Thank you again for the opportunity to offer these recommendations for the Guidance Priority List.

Sincerely,

Kris Cook, CAE

Executive Director

National Affordable Housing

Management Association

Washington, DC




IRS Issues Final, Temporary Regs on Excise Tax Return Requirement for Charitable Hospitals.

The IRS has issued final and temporary regulations requiring charitable hospital organizations that are liable for an excise tax for failing to meet the community health needs assessment requirements for any tax year to file Form 4720, “Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.” (T.D. 9629)




IRS May Make New Jersey Authority's Municipal Bonds Taxable Because of Total Return Swap.

Aug 5 (Reuters) – The Internal Revenue Service has taken a major step toward declaring millions of dollars of revenue bonds issued by the New Jersey Health Care Facilities Financing Authority in violation of U.S. tax law, which could make the interest paid by the debt taxable.

The authority said on Monday it has requested a 90-day extension to evaluate settlement possibilities and to look into seeking advice from the IRS and appealing any determination.

For nearly three years, the tax agency has investigated whether “total return swaps” and other post-issuance transactions associated with bonds sold in 1993 and 1994 led to arbitrage. In a total return swap, an issuer pays a counterparty using the returns on its bonds in exchange for set payments.

At the end of July, the IRS issued notices of “proposed adverse determination” for bonds sold for a loan to the Deborah Heart and Lung Center and a loan to the Jersey Shore Medical Center. It gave the authority 30 days to request a review of the determination.

The IRS contends “that the transactions utilized an abusive arbitrage device, ‘creating additional arbitrage investment opportunities for the borrower,” Mark Hopkins, the authority’s executive director, said in a statement.

The tax exemption for municipal bond interest is considered the chief selling point for the debt and often allows issuers to pay buyers lower interest rates. Most issuers in the $3.7 trillion U.S. municipal bond market work with the IRS to prevent their interest payments from being taxed.

The authority “intends to take whatever steps it deems prudent to prevent the bonds from becoming taxable,” said Hopkins. “The NJHCFFA is not aware of any other issues of its bonds that are under similar examination by the IRS.”

For the Deborah debt sale, the swaps occurred in 2004, according to a notice posted by the non-profit cardiac organization that was dated August 1. Of the $37.41 million in bonds originally issued, $17.61 million is still outstanding, the notice said.

For the Jersey Shore Medical Center, $87.49 million in bonds were issued, according to a November filing from the Meridian Hospitals Corporation, which includes the center. It said that $16.56 million was outstanding.

Hopkins said lawyers for the authority and hospitals had provided detailed responses to the IRS on two separate occasions, disputing its “purported facts, assumptions and conclusions.”




IRS Audits Spell Potential Trouble for Dozens of Jail Bond Deals in Border States.

The Internal Revenue Service is auditing dozens of tax-exempt bond-financed jails, particularly in border states, and suggesting in some cases that, if the jails hold significant amounts of federal inmates, the bonds are no longer tax-exempt and are instead taxable private-activity bonds, sources said Thursday.

Many of these jails were built by state or local governments with tax-exempt bonds or certificates of participation, primarily to hold state and local inmates. But when the jails have additional space or nearby federal facilities are full, the local governments take inmates from U.S. Citizenship and Immigration Service or the U.S. Marshals Service. The federal government typically pays more to house its inmates than state and local governments, the sources said.

Under the federal tax laws and rules that apply to private-activity bonds, state and local governments are considered to be governments but the federal government is a nongovernmental or private entity. Tax-exempt bonds are private-activity bonds if more than 10% of the proceeds are for private use and more than 10% of the payments for debt service are from private parties. But PABs are not tax-exempt unless they are issued for “qualified” purposes and a jail is not considered to be a qualified purpose.

This week, U.S. Bank N.A. filed event notices for two separate issuers that financed jails saying the IRS had indicated the tax-exempt bonds or COPs were not tax-exempt. The bank was trustee for both sets of bonds.

One notice said the Burnet County, Tex., Public Facility Corp. has received four letters from the IRS, the first on Dec. 12, 2011 and the most recent on April 12 of this year, seeking information about $35.38 million of project revenue bonds that were issued in 2008 to build a jail.

The bank said that, in the most recent IRS letter, the issuer was asked to provide information “regarding a preliminary conclusion by the IRS that the … bonds … violate certain Internal Revenue Code rules that cause [them] to be taxable.” The notice said the issuer is cooperating with the IRS and that “it is unknown at this time what the outcome of the IRS examination will be.”

Bill Neve, president of the Burnet County Public Facility Corp., said the county built the 586-bed jail to hold county prisoners but provided for some extra space so it wouldn’t have to expand the jail during the next 20 years or so. The IRS is concerned about the number of federal prisoners in the jail, many of whom were housed for less than 100 days, he said.

The PAB rules contain an exception for short-term private use and define that to be less than 100 days. But Neve and other sources indicated that if the IRS thinks there is a significant number of federal inmates, it does not take that exemption into account.

U.S. Bank, NA also issued an event notice stating that the IRS sent the Village of Epps, La., a Notice of Proposed Issue on July 30 “indicating that [$10.3 million of certificates of participation] may not be qualified or exemption from federal income taxation.”

The COPs, part of a total $13.65 million issue, were sold in May 2003 and were used to finance the acquisition and improvement of a 592-bed, 48445 square foot detention facility on 10 acres of land in West Carroll Parish, La., according to the official statement.

Epps essentially purchased the detention facility from the corporation through a lease with an option to buy, but the corporation manages the facility. The lease is put into a trust and COP holders get interest payments from the rental payments. Epps’ rental payments under the lease, along with other money held by the trustee, support the debt service payments on the COPs, according to the OS.  The detention facility was inspected and approved to house U.S. Marshals Service inmates at the time of issuance, the OS said.

The trustee bank said in the event notice that the IRS “suggests that the COPs may be characterized as ‘private-activity bonds’ under the Internal Revenue Code” and asked Epps to respond by Aug. 30.

Once the IRS sends a Notice of Proposed Issue, which is a preliminary determination that bonds are taxable, the issuer has 30 days to appeal to the IRS’ internal administrative appeals office, sources said.




Treasury Responds to McDermott's Request for Updated Tax-Exempt Bond Guidance.

Treasury Assistant Secretary for Legislative Affairs Alastair Fitzpayne has thanked Rep. Jim McDermott, D-Wash., for suggesting an update of Rev. Proc. 97-13, which describes the conditions under which a management contract does not result in private business use under section 141(b) for tax-exempt bond purposes.

July 31, 2013

The Honorable Jim McDermott

U.S. House of Representatives

Washington, DC 20515

Dear Representative McDermott:

Thank you for your letter regarding the desirability of updating Revenue Procedure 97-13 to recognize new types of arrangements encouraged by the Affordable Care Act (ACA). In your letter, you state that Revenue Procedure 97-13 should be updated because the existing safe harbors it provides may not cover the types of arrangements contemplated by the ACA. This results in uncertainty as to whether these arrangements will result in “private business use” in tax-exempt bond financed facilities.

The Administration shares your interest in advancing coordinated care among hospitals, physicians, and other health care professionals, and in successfully implementing the ACA. Treasury is carefully considering the concerns expressed in your letter as well as all comments we receive on the subject as we develop our plans for future guidance.

Should you have any additional questions, please contact Sandra Salstrom, Office of Legislative Affairs, at (202) 622-1900.

Sincerely

Alastair M. Fitzpayne

Assistant Secretary for

Legislative Affairs




Bond Lawyers Request Guidance on Definition of Issue Price, Other Bond Matters.

Scott Lilienthal of the National Association of Bond Lawyers has asked the IRS to include on its 2013-2014 priority guidance list (Notice 2013-22) guidance on the definition of issue price under section 148, on reissuance, and on the application of the private business use tests to accountable care organizations and some other arrangements.

April 30, 2013

RE: 2013-2014 Guidance Priority List

Ladies and Gentlemen:

The National Association of Bond Lawyers (“NABL”) respectfully suggests the following items for inclusion in the 2013-2014 Guidance Priority List. Unless otherwise indicated, section references are to the Internal Revenue Code of 1986.

1. Guidance on the definition of “issue price” under Section 148.

2. Guidance regarding reissuance, including the application of the reissuance rules to multi-modal private placements.

3. Guidance concerning application of the private business use tests to “accountable care organizations” and other arrangements entered into under the Patient Protection and Affordable Care Act.

4. Update to the management and service contract safe harbors in Revenue Procedure 97-13.

5. Reviewing, revising and finalizing proposed regulations concerning (a) public approval under Section 147(f), (b) allocation and accounting of proceeds and projects under Section 141, and (c) yield computation in connection with certain qualified hedges under Section 148 and related matters.

These items are suggested as priority items. These items are not listed in any specific order of priority. Nor by suggesting them do we mean to withdraw any other items we suggested for any prior list.

The list of suggested items was compiled by a NABL task force. If you have any questions concerning them, please contact Michael Larsen (Chair of the NABL Tax Law Committee) at (843) 727-6311 or [email protected].

Sincerely,

Scott R. Lilienthal

National Association of Bond

Lawyers

Washington, DC




State Housing Council Seeks Guidance on Low-Income Housing Tax Credit, Tax-Exempt Bond Issues.

Garth Rieman of the National Council of State Housing Agencies has asked the IRS to include on its 2013-2014 priority guidance list (Notice 2013-22) guidance that the group says is critical to the effective state administration of the low-income housing tax credit and tax-exempt bond programs.

May 1, 2013

Internal Revenue Service

Attn: CC:PA:LPD:PR (Notice 2013-22)

Room 5203

P.O. Box 7604

Ben Franklin Station

Washington, D.C. 20044

RE: Notice 2013-22, Recommendations for 2012-2013 Guidance Plan

To Whom It May Concern:

Thank you for the opportunity to recommend for inclusion on the Department of Treasury/Internal Revenue Service (IRS) 2013-2014 Priority Guidance Plan subjects critical to effective state administration of the Low Income Housing Tax Credit (Housing Credit) and Tax Exempt Bond programs.

As the Washington representative of the agencies that administer the Housing Credit and Bond programs, including the MCC program, in all 50 states, the District of Columbia, New York City, Puerto Rico, and the U.S. Virgin Islands, the National Council of State Housing Agencies (NCSHA) appreciates the Treasury Department’s and IRS’ expert oversight of these programs, your continued cooperative attitude toward NCSHA and state housing agencies, and your timely provision of program guidance.

To support continued effective state administration of the Housing Credit and tax-exempt Housing Bonds, we urge you to issue the following guidance as quickly as possible.

(1) Guidance concerning the exception under § 42(d)(6) for any federally or State assisted building.

The Housing and Economic Recovery Act of 2008 exempts federally-or state-assisted buildings from the 10-year prior placement in service rule under § 42(d)(2)(B)(ii). The term federally-assisted building means any building which is substantially assisted, financed or operated under section 8 of the United States Housing Act of 1937, section 221(d)(4), or 236 of the National Housing Act, Section 515 of the Housing Act of 1949 or any other housing program administered by the Department of Housing and Urban Development or by the Rural Housing Service of the Department of Agriculture. The term state-assisted building means any building which is substantially assisted, financed, or operated under any State law similar in purposes to any laws relating to the definition of federally-assisted building. We urge the IRS to promptly issue guidance concerning how it defines “substantially” in this context, keeping in mind the need for as much flexibility as possible.

(2) Regulations concerning utility allowances under § 42(g)(2)(B)(ii) for sub-metered buildings.

NCSHA urges the IRS to issue final guidance concerning utility allowance calculations for Housing Credit developments that sub-meter. In prior comments on proposed utility allowance regulations, NCSHA has expressed its appreciation that regulations generally allow for more accurate utility allowance determinations, provide greater flexibility to make such determinations, and help HFAs promote energy efficiency in Housing Credit properties. We have also maintained that more accurate utility allowances help keep Housing Credit properties financially sustainable. We reiterate these principles and urge the IRS to ensure that any final guidance concerning utility allowances for sub-metered buildings does not impose any unnecessary administrative burdens or complexity on HFAs.

(3) Regulations concerning § 1.42-5 for compliance monitoring

Last year, the IRS issued proposed regulations concerning HFA Housing Credit monitoring procedures, in response to which NCSHA submitted comments suggesting a number of changes to the physical inspection and tenant file review requirements. To ensure that the Section 1.42-5 regulations continue to provide an efficient framework for compliance with Section 42 and provide the information necessary for IRS oversight, while allowing the greatest possible efficiency and effectiveness for the agencies charged with compliance monitoring, we urge IRS to issue final regulations as soon as possible, consistent with NCSHA’s comments submitted in response to Notice 2012-18.

(4) Regulations concerning record retention requirements under § 103 for tax-exempt bonds.

NCSHA urges the IRS to issue final guidance concerning the length of time issuers of tax-exempt bonds must maintain loan files. The IRS last requested comments on this issue in Notice 2006-63 but has not since issued final regulations. The current rules, requiring issuers to maintain loan records for the life a bond issue, as well as any refundings of that bond issue plus an additional 6 years, regardless of when the loan is paid off, generate excessive compliance costs, particularly with regard to older loans which are not stored electronically.

(5) Public hearing requirements under § 147(f) for issuance of tax-exempt bonds.

On September 9, 2008, the IRS issued proposed regulations that would simplify the public approval requirements applicable to tax-exempt private activity bonds issued by state and local governments. The proposed regulations would permit the use of electronic notifications if a state’s opening meeting laws so allow and cut in half the public notice requirement from 14 to 7 days. The proposed regulations are, however, applicable only after publication of final regulations and may not be applied until such time. NCSHA urges the IRS to issue final regulations consistent with the proposed changes referenced above, allowing HFAs to save time and money while bringing the federal rules in line with current technology and state laws.

NCSHA recommends that the IRS issue guidance on the above referenced items as soon as possible this year, as well as other guidance it believes necessary for the efficient implementation of the Housing Bond and Credit programs.

Thank you for this opportunity to provide input on the Department of Treasury/Internal Revenue Service 2013-2014 Priority Guidance Plan.

If you have any questions, please do not hesitate to contact me.

Sincerely,

Garth Rieman

Director, Housing Advocacy and

Strategic Initiatives




Treasury Will Consider Request on Health Plan Fee for Tax-Exempt, Nonprofit Hospitals.

Treasury Assistant Secretary for Legislative Affairs Alastair Fitzpayne has assured Rep. Tim Walberg, R-Mich., that Treasury will take into consideration his request to classify health plans owned by nonprofit, tax-exempt hospitals or hospital systems in the same category as other nonprofit, tax-exempt health plans.

July 31, 2013

The Honorable Tim Walberg

U.S. House of Representatives

Washington, DC 20515

Dear Representative Walberg:

Thank you for your letter regarding the annual health insurer fee under section 9010 of the Patient Protection and Affordable Care Act.

Proposed regulations on the annual health insurer fee were released through the Federal Register on March 1, 2013. Under the statute, the fee does not apply to the first $25 million of net premiums written, and it only applies to 50 percent of the net premiums written for amounts between $25 million and $50 million. After application of this rule and in accordance with the statute, the proposed regulations provide that a covered entity exempt from tax under section 501(a) and described in section 501(c)(3) (generally, a charity), 501(c)(4) (generally, a social welfare organization), section 501(c)(26) (generally, a high-risk health insurance pool), or section 501(c)(29) (a consumer operated and oriented plan health insurance issuer), will be required to take into account only 50 percent of its remaining net premiums written that are attributable to its exempt activities.

We appreciate the concerns expressed in your letter regarding the way the fee will be applied. We will carefully consider all comments we receive on the proposed regulations, and we intend to continue to work with health insurance providers as the fee is implemented.

If you have any further questions, please contact Sandra Salstrom, Office of Legislative Affairs, at (202) 622-1900.

Sincerely,

Alastair M. Fitzpayne

Assistant Secretary for

Legislative Affairs




IRS LTR: Employee Plan Constitutes Defined Benefit Plan

In technical advice, the IRS concluded that an employee plan for police officers and firefighters, after the adoption of a deferred retirement option plan (DROP) amendment, is a defined benefit plan that provides a benefit derived from employer contributions that is based partly on the balance of the separate account of a participant.

The plan is maintained by a municipality in Michigan and is a governmental plan within the meaning of section 414(d). The plan is also a defined benefit plan under section 414(j).

The IRS determined that allocations of 75 percent of the otherwise payable pension benefits to the DROP accounts are annual additions subject to the limitations of section 415(c)(1). Moreover, the distribution of the DROP account to a retired plan participant is an eligible rollover distribution under section 402(c)(4) and is eligible for the direct rollover provision of section 401(a)(31).

ISSUES

(1) Whether the Plan, after the deferred retirement option plan (DROP) amendment, is a defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant.

(2) Whether allocations to the DROP accounts are annual additions subject to the limitations under section 415(c)(1) of the Code.

(3) Whether the distribution of the DROP account to a retired plan participant is an eligible rollover distribution under section 402(c)(4) of the Code and eligible for the direct rollover provision of section 401(a)(31) of the Code.

FACTS

The above-named Plan is maintained by the Taxpayer, a municipality within the State of Michigan, and is a governmental plan within the meaning of section 414(d) of the Code.2 The Plan is also a defined benefit plan under section 414(j) of the Code. Only policemen and firemen employed by the Taxpayer are eligible to participate in the Plan.

The System and Plan were established by the Taxpayer effective July 1, 1941. The most recent determination letter issued to the Plan is dated March 5, 1987. The Taxpayer submitted a request for a determination letter (Form 5300, Application for Determination for Employee Benefit Plan) to the Internal Revenue Service (Service), on January 26, 2004.

During the processing of the determination letter request, the Service determined that the Plan had not been timely amended with respect to TRA ’86, UCA ’92, OBRA ’93, GATT, SBJPA, TRA ’97, and GUST in violation of section 401(a) of the Code. On June 10, 2004, the Service and the System entered into a closing agreement to resolve these issues.

On February 27, 2002, the System’s Board of Trustees adopted a resolution pursuant to the collective bargaining process to adopt the DROP. The provisions of the DROP are effective the later of (1) March 1, 2003, and (2) the date the Service issues a determination that the DROP does not adversely affect the qualified status of the Plan.

Article II of the Plan describes the various definition of terms used in the Plan in determining retirement benefits. Section 2 of this article defines “policemen” as all employees of the Taxpayer’s Police Department.

Article II, section 3 defines “firemen” as all employees of the Taxpayer’s Fire Department, except those excluded by their classification as civilian employees.

Article II, section 4 defines “member” as any policeman or fireman.

Article II, section 8 defines “service” as service as a policeman or fireman.

Article II, section 10 defines “membership service” as the total service rendered as a policeman or fireman.

Article II, section 14 defines “average final compensation” as:

(a) the average earnable compensation of a member during his last 5 years of service, or total years of service if less than five, for a member described in article IV, section 1(a), (b), or (c); or

(b) the highest average annual compensation received by a member during any 5 consecutive years of credited service selected by the member contained within his 10 years of credited service immediately preceding the date of his employment with the city last terminated, or total years of service if less than five, for a member described in article IV, section 1(d).

Article II, section 15 defines “final compensation” as the annual rate of earnable compensation of a member at the time of termination of employment.

Article II, section 16 defines “earnable compensation” as the compensation fixed by the budget for the rank, grade, or position of member.

Article II, section 17 defines “annuity” as the payments derived from the accumulated contributions of a member.

Article II, section 18 defines “pension” as the payments derived from money provided by the Taxpayer.

Article II, section 19 defines “retirement allowance” as the sum of the annuity and the pension.

Article II, section 20 defines “retirement” as withdrawal from active service with a retirement allowance or pension.

Article IV of the Plan describes membership. Section 1 states that membership of the System generally consists of:

(a) All policemen and firemen, as defined in section 2 and 3 of Article II, who are in service on or after July 1, 1941, but prior to January 1, 1969;

(b) All persons who become policemen and firemen on or after July 1, 1941, but prior to January 1, 1969, and who are confirmed, subject to special provisos for those who are at an attained age of 31 years or more, appointive officials of the Police Department or Fire Department, and any policeman or fireman who is killed or totally incapacitated on active duty prior to being confirmed;

(c) Any member described in (a) or (b) who is transferred to a civilian position in his department;

(d) All persons who become policemen or firemen on or after January 1, 1969, and who are confirmed, subject to special provisos for those who are at an attained age of 31 years or more, appointive officials of the Police Department or Fire Department, any policeman or fireman who is killed or totally incapacitated on active duty prior to being confirmed, any member who under section 1(a), (b), or (c) who separated from service and was subsequently again becomes a member, and any member described in section 1(d) who is transferred to a civilian position in his department.

Article VI, Part A of the Plan describes the service retirement allowance. Section 1 describes the petition for and mandatory age for retirement. Section 1(a) states that any member described in article IV, section 1(a), (b), or (c) in service may file a written application for retirement setting forth a date not less than 15 days nor more than 90 days subsequent thereof, with a total creditable service of 25 years or more. However, firemen with 25 years of creditable service or more may be retired by the Board of Trustees upon recommendation of the Board of Fire Commissioners.

Article VI, Part A, section (1)(b) states that any member described in article IV, section 1(d) in service may file a written application for retirement setting forth a date not less than 15 days nor more than 90 days subsequent thereof, with a total creditable service of 25 years or more and attained age of 55. However, firemen with 25 years of creditable service or more, and who have attained age 55, may be retired by the Board of Trustees upon recommendation of the Board of Fire Commissioners.

Article VI, Part A, section (1)(c) states that any member described in article IV, section 1(a), (b), (c), or (d) who shall reach age 60 shall be retired forthwith. However, such member may continue in service for a maximum of two 2-year terms beyond age 60 with written permission.

Article VI, Part A, section (2) states that upon retirement, a member described in article IV, section 1(a), (b), or (c) shall receive a straight life retirement allowance described in (a) and (b) below:

(a) an annuity which will be the actuarial equivalent of his accumulated contributions standing to his credit in the Annuity Savings Fund at the time of his retirement, and

(b) a pension, which when added to the annuity in (a), will provide a straight life retirement allowance equal to 2% of his average final compensation, multiplied by the number of years, and fraction of a year, of his creditable service, not to exceed 25 years, provided that the pension of a policeman will not exceed 15/22 of the maximum earnable compensation of a patrolman and the pension of a fireman will not exceed 15/22 of the maximum earnable compensation of a firefighter.

Article VI, Part A, section 2.1 states that upon retirement, a member as defined in Article IV, section 1(d) who has at least 25 years of service and who has attained at least age 55 shall receive a straight life retirement allowance descried in (a) and (b) below, and shall have the right to elect an option provided for in part H of Article VI:

(a) an annuity which will be the actuarial equivalent of his accumulated contributions standing to his credit in the Annuity Savings Fund at the time of his retirement, and

(b) a pension, which when added to the annuity in (a), will provide a straight life retirement allowance equal to 2% of his average final compensation, multiplied by the number of years, and fraction of a year, of his creditable service, not to exceed 35 years.

Article VI, Part H, describes the optional forms of benefit election including a cash refund annuity, a joint and last survivorship retirement allowance, a modified joint and last survivorship retirement allowance, and a single sum distribution of his accumulated contributions to the Annuity Savings Fund.

The DROP applies with respect to those members of the System who are covered by a collective-bargaining agreement with a DROP program.

Section 1 of the DROP states that in lieu of terminating employment and accepting a service retirement allowance under the Plan provisions, any applicable member of the System who is eligible for the DROP program and who is eligible to immediately receive a 25-year service retirement allowance may elect to participate in the DROP and defer receipt of retirement benefits, effective for DROP eligible members retiring on or after the later of March 1, 2002, or after Service approval of the DROP provisions.

Section 2 of the DROP states that no additional service credit will be earned by a participant in the DROP.

Section 3 of the DROP states that there is no limit to the duration of participation in the DROP.

Section 5 of the DROP states that upon the effective date of commencement of participation in the DROP, active membership in the System shall terminate. However, employer contributions shall continue to be paid to the System for the DROP participant as if the DROP participant was not a DROP participant. For purposes of this section, compensation and credit service shall remain as they existed on the effective date of commencement of participation in the DROP. Seventy-five (75%) percent of the monthly retirement benefits (including applicable escalator increases) that would have been payable had the member elected to cease employment and receive a service retirement allowance, shall be paid into the DROP account, a separate account established for each DROP participant. Upon termination of employment, deferred benefits (the DROP account balance) shall be paid as provided in the DROP.

Section 6 of the DROP names the DROP Trust as the initial DROP depositor entity.

Section 7 of the DROP states that the DROP applicable amounts will be invested as directed by the member within the investment choices provide by the DROP Trust.

Section 9 of the DROP states that upon termination of employment, a participant in the DROP shall receive, at his or her option, either a single sum payment from the DROP account equal to the payments to the account plus earnings adjusted for any losses, a true annuity based upon his or her adjusted account, or any other method of payment allowed by the DROP Trust. The participant’s monthly benefits that would have been otherwise paid at retirement prior to participation in the DROP shall be paid to the retiree. Termination of employment includes termination of any kind.

Section 18 of the DROP states that the effective date of the DROP provisions is subject to confirmation from the Service that the DROP does not adversely affect the qualified status of the Plan.

Section 33(N) of the Master Agreements between the Taxpayer and Association 1 (Agreement 1) references the DROP and states the DROP shall be made available July 21, 2000.

Section 33(N)(1) of Agreement 1 states that a member covered by Agreement 1 must have at least 25 years of active service with the Taxpayer as a member of the System, Section 33(N)(2) states that there will be no limit on the number of years that a member may participate in the program.

Section 33(N)(4) of Agreement 1 states that a DROP accumulation account will be established with an outside investment company chosen by the Union.

Section 33(N)(5) of Agreement 1 states that the amount paid into the DROP accumulation account shall be 75% of the member’s regular retirement allowance plus the annual escalator (2.25% times the full regular retirement allowance times 75%).

Section 33(N)(6) of Agreement 1 states that once a member has chosen to place his DROP proceeds into the DROP accumulation account, the member shall not be allowed to remove those funds until the member permanently retires.

Section 33(N)(7) of Agreement 1 states that upon permanent retirement, the member shall be given the right to remove funds from the DROP accumulation account.

Section 33(N)(8) of Agreement 1 states that when the member permanently retires, the member will receive a regular retirement allowance calculated as if the member retired on the day that the DROP account started. The member’s retirement allowance shall include all annual escalator amounts (2.25%) that would have been added while the member was participating in the DROP.

Section 33(N)(9) of Agreement 1 states that the DROP will not be put into effect unless it is approved by the Service.

Section 42 of the Master Agreement between the Taxpayer and Association 2 (Agreement 2) references the DROP.

Section 42(1) of Agreement 2 states that a member covered by Agreement 2 must have at least 25 years of active service with the Taxpayer as a member of the System. Section 42(2) states that there will be no limit on the number of years that a member may participate in the program.

Section 42(4) of Agreement 2 states that a DROP accumulation account will be established with an outside investment company chosen by the Union.

Section 42(5) of Agreement 2 states that the amount paid into the DROP accumulation account shall be 75% of the member’s regular retirement allowance plus the annual escalator (2.25% times the full regular retirement allowance time 75%).

Section 42(6) of the Agreement 2 states that once a member has chosen to place his DROP proceeds into the DROP accumulation account, the member shall not be allowed to remove those funds until the member permanently retires.

Section 42(7) of Agreement 2 states that upon permanent retirement, the member shall be given the right to remove funds from the DROP accumulation account.

Section 42(8) of Agreement 2 states that when the member permanently retires, the member will receive a regular retirement allowance calculated as if the member retired on the day that the DROP account started. The member’s retirement allowance shall include all annual escalator amounts (2.25%) that would have been added while the member was participating in the DROP.

Section 42(9) of Agreement 2 states that the DROP will not be put into effect unless it is approved by the Service.

Section 22(B)(14)(p) of the Master Agreement between the Taxpayer and Association 3 (Agreement 3) references the DROP.

Section 22(B)(14)(p)(1) of Agreement 3 states that a member covered by Agreement 3 must have at least 25 years of active service with the Taxpayer as a member of the System. Section 33(N)(2) states that there will be no limit on the number of years that a member may participate in the program.

Section 22(B)(14)(p)(4) of Agreement 3 states that a DROP accumulation account will be established with an outside investment company chosen by the Union.

Section 22(B)(14)(p)(5) of Agreement 3 states that the amount paid into the DROP accumulation account shall be 75% of the member’s regular retirement allowance plus the annual escalator (2.25% times the full regular retirement allowance times 75%).

Section 22(B)(14)(p)(6) of Agreement 3 states that once a member has chosen to place his DROP proceeds into the DROP accumulation account, the member shall not be allowed to remove those funds until the member permanently retires.

Section 22(B)(14)(p)(7) of Agreement 3 states that upon permanent retirement, the member shall be given the right to remove funds from the DROP accumulation account.

Section 22(B)(14)(p)(8) of Agreement 3 states that when the member permanently retires, the member will receive a regular retirement allowance calculated as if the member retired on the day that the DROP account started. The member’s retirement allowance shall include all annual escalator amounts (2.25%) that would have been added while the member was participating in the DROP.

Section 22(B)(14)(p)(9) of Agreement 3 states that the DROP will not be put into effect unless it is approved by the Service.

APPLICABLE LAW

Section 401(a) of the Code provides the requirements for a qualified pension plan.

Section 401(a)(25) of the Code provides that a defined benefit pension plan shall not be treated as providing definitely determinable benefits unless, whenever the amount of any benefit is to be determined on the basis of actuarial assumptions, such assumptions are specified in the plan in a way which precludes employer discretion.

Section 401(a)(31)(A) of the Code provides that a trust shall constitute a section 401(a) qualified trust only if the plan of which such trust is a part provides that if the distributee of any eligible rollover distribution (i) elects to have such distribution paid directly to an eligible retirement plan, and (ii) specifies such eligible retirement plan to which such distribution is to be paid (in such form and at such time as the plan administrator may prescribe), such distribution shall be in the form of a direct trustee-to-trustee transfer to the eligible retirement plan so specified.

Section 402(c)(4) of the Code provides that the term “eligible rollover distribution” means any distribution to an employee of all or any portion of the balance to the credit of the employee in a qualified trust except the following distributions: (A) any distribution which is one of a series of substantially equal periodic payments (not less frequently than annually) made (i) for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and the employee’s designated beneficiary, or (ii) for a period of 10 years or more; (B) any distribution to the extent the distribution is required under section 401(a)(9); and (C) any distribution which is made upon hardship of an employee.

Section 414(d) of the Code provides, in part, that the term “governmental plan” means a plan established and maintained for its employees by a State or political subdivision thereof.

Section 414(i) of the Code provides that the term “defined contribution plan” means a plan which provides for an individual account for each participant and for benefits based solely on the amount contributed to the participant’s account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant’s account.

Section 414(j) of the Code provides that the term “defined benefit plan” is any plan that is not a defined contribution plan.

Section 414(k) provides that a defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant shall:

(1) for purposes of section 410 (relating to minimum participation standards), be treated as a defined contribution plan,

(2) for purposes of sections 72(d) (relating to treatment of employee contributions as separate contract), 411(a)(7)(A) (relating to minimum vesting standards), 415 (relating to limitations on benefits and contributions under qualified plans), and 401(m) (relating to nondiscrimination tests for matching requirements and employee contributions), be treated as consisting of a defined contribution plan to the extent benefits are based on the separate account of a participant and as a defined benefit plan with respect to the remaining portion of benefits under the plan, and

(3) for purposes of section 4975 (relating to tax on prohibited transactions), be treated as a defined benefit plan.

Section 415 of the Code provides for certain limitations on contributions and benefits under qualified plans. Section 415(c) of the Code limits the annual additions to which a participant may be entitled under a defined contribution plan during any limitation year.

Section 415(c)(1) provides that, in general, contributions and other additions with respect to a participant exceed the limitation of this subsection if, when expressed as an annual addition (within the meaning of paragraph (2)) to the participant’s account, such annual addition is greater than the lesser of (A) $40,000, or (B) 100 percent of the participant’s compensation.

Section 415(c)(2) of the Code provides that for purposes of paragraph (1), the term “annual addition” means the sum for any year of (A) employer contributions, (B) the employee contributions, and (C) forfeitures. For the purposes of this paragraph, employee contributions under subparagraph (B) are determined without regard to any rollover contributions (as defined in sections 402(c), 403(a)(4), 403(b)(8), 408(d)(3), and 457(e)(16)) without regard to employee contributions to a simplified employee pension which are excludable from gross income under section 408(k)(6). Subparagraph (B) of paragraph (1) shall not apply to any contribution for medical benefits (within the meaning of section 419A(f)(2)) after separation from service which is treated as an annual addition.

Section 415(d) of the Code requires that the Commissioner annually adjust these limits for years after 1987 for cost-of-living increases using procedures similar to procedures used to adjust benefit amounts under § 215(i)(2)(A) of the Social Security Act. Sections 1.415-5 and 1.415-6 of the regulations provide rules regarding these adjustments.

Section 1.401(a)(31)-1, Q&A-1, of the regulations provides that for purposes of section 401(a)(31) of the Code, eligible rollover distribution has the meaning set forth in section 402(c)(4) of the Code and section 1.402(c)-2 of the regulations.

Section 1.402(c)-2, Q&A-3(a), of the regulations provides that, unless specifically excluded, an eligible rollover distribution means any distribution to an employee of all or any portion of the balance to the credit of the employee in a qualified plan.

Section 1.402(c)-2, Q&A-3(b), of the regulations provides that an eligible rollover distribution does not include the following:

(1) Any distribution that is one of a series of substantially equal periodic payments made (not less frequently than annually) over any one of the following periods — (i) the life of the employee (or the joint lives of the employee and the employee’s designated beneficiary); (ii) the life expectancy of the employee (or the joint life and last survivor expectancy of the employee and the employee’s designated beneficiary); or (iii) a specified period often years or more;

(2) Any distribution to the extent the distribution is a required minimum distribution under section 401(a)(9) of the Code; or

(3) The portion of any distribution that is not includible in gross income.

Section 1.402(c)-2, Q&A-4, of the regulations provides that an eligible rollover distribution does not include the following:

(1) Elective deferrals, as defined in section 402(g)(3), that, pursuant to § 1.415-6(b)(6)(iv), are returned as a result of the application of the section 415 limitations, together with the income allocable to these corrective distributions.

(2) Corrective distributions of excess deferrals as described in § 1.402(g)-1(e)(3), together with the income allocable to these corrective distributions.

(3) Corrective distributions of excess contributions under a qualified cash or deferred arrangement described in § 1.401(k)-2(b)(2) and excess aggregate contributions described in § 1.401(m)-2(b)(2), together with the income allocable to these distributions.

(4) Loans that are treated as deemed distributions pursuant to section 72(p).

(5) Dividends paid on employer securities as described in section 404(k).

(6) The costs of life insurance coverage (P.S. 58 costs).

(7) Similar items designated by the Commissioner in revenue rulings, notices, and other guidance published in the Internal Revenue Bulletin.

Section 1.402(c)-2, Q&A-6(a), of the regulations provides that a payment is treated as independent of the payments in a series of substantially equal payments, and thus not part of the series, if the payment is substantially larger or smaller than the other payments in the series. An independent payment is an eligible rollover distribution if it is not otherwise excepted from the definition of eligible rollover distribution. This is the case regardless of whether the payment is made before, with, or after payments in the series. For example, if an employee elects a single payment of half of the account balance with the remainder of the account balance paid over the life expectancy of the distributee, the single payment is treated as independent of the payments in the series and is an eligible rollover distribution unless otherwise excepted.

Section 1.415-6(b)(1) of the regulations (as in effect prior to April 5, 2007) provides the definition of annual addition for a defined contribution plan. In general, for limitation years beginning after December 31, 1986, annual addition means the sum credited to a participant’s account for any limitation year of (a) employer contributions, (b) employee contributions, and (c) forfeitures.

Section 1.415-6(b)(2)(iv) of the regulations (as in effect prior to April 5, 2007) provides that for purposes of determining the limitation under section 415(c) of the Code, the transfer of funds from one qualified plan to another will not be considered an annual addition for the limitation year for which the transfer occurs.

Section 1.415-6(b)(3) of the regulations provides that the term “annual additions” Includes, to the extent employee contributions would otherwise be taken into account under this section as an annual addition, mandatory employee contributions as well as voluntary employee contributions. The term “annual addition” does not include the direct transfer of employee contributions from one qualified plan to another.

Section 1.415-6(b)(5) of the regulations provides that forfeitures (as well as any income attributable to the forfeiture) will be considered to be an annual addition to the plan if such forfeitures are allocated to the account of the participant.

On April 5, 2007, a new set of final regulations (new regulations) under section 415 of the Code were issued with a general effective date of limitation years beginning on or after July 1, 2007. For governmental plans, the effective date of the new regulations is limitation years that begin more than 90 days after the close of the first regular legislative session of the legislative body with authority to amend the plan that begins on or after July 1, 2007. However, a governmental plan is permitted to apply the provisions of the new regulations to limitation years beginning on or after July 1, 2007.

Section 1.415(c)-1(b)(1) of the new regulations provides the definition of annual addition for a defined contribution plan. In general, annual addition means the sum credited to a participant’s account for any limitation year of (a) employer contributions, (b) employee contributions, and (c) forfeitures.

Section 1.415(c)-1(b)(4) of the new regulations provides that the Commissioner may in an appropriate case, considering all of the facts and circumstances, treat transactions between the plan and the employer, transactions between the plan and the employee, or certain allocations to participants’ accounts as giving rise to annual additions. Further, where an employee or employer transfers assets to a plan in exchange for consideration that is less than the fair market value of the assets transferred to the plan, there is an annual addition in the amount of the difference between the value of the assets transferred and the consideration. A transaction described in this paragraph may constitute a prohibited transaction.

Rev. Rul. 79-259, 1979-2 C.B. 197, provides that for purposes of section 414(k), the plan provisions regarding a participant’s separate account must satisfy the requirements of a defined contribution plan under 414(i).

ANALYSIS

Issue 1

Section 9 of the DROP states that upon termination of employment, a participant in the DROP shall receive, at his or her option, either a single sum payment from the DROP account equal to the payments to the account plus earnings adjusted for any losses, a true annuity based upon his or her adjusted account, or any other method of payment allowed by the DROP Trust. The participants monthly benefits that would have been otherwise paid at retirement prior to participation in the DROP shall be paid to the retiree. Termination of employment includes termination of any kind. Based on this section of the DROP, a member’s retirement benefit is the sum of two amounts:

(a) a retirement allowance based on the defined benefit plan formula in the Plan, as of the date the participant elected to participate in the DROP, and

(b) a benefit based on the amount in his DROP account.

In a letter dated January 26, 2007, the System’s authorized representative argued that the DROP benefit is merely an internal crediting to the DROP account from within the Plan of 75% of the monthly retirement benefit that would have been paid to the participant had the participant retired and that the benefit under the Plan with the DROP is not based on the balance of a separate account of a participant.3 Furthermore, the representative argues that the amounts allocated to the DROP account are not employer contributions but are based upon the internal transfer within the Plan, and that employer contributions are only made to fund the pension benefits.

Plainly, the retirement allowance part of the benefit is based upon a defined benefit formula, thus causing the Plan to be a defined benefit plan. The focus of our analysis is whether the DROP account is considered a separate account within the meaning of section 414(k) of the Code. Therefore, it must be determined whether the DROP account meets the requirements of section 414(i) of the Code.

While we do not have a copy of the DROP Trust, it is our understanding that the amounts contributed to the DROP are placed in an individual account for each participant, and that the DROP benefit is based solely on the amounts contributed to the participant’s DROP account, adjusted for income, expenses, and gains and losses based on the investment choices made by the participant. In other words, after the allocations to the DROP account, the DROP accounts are maintained the same as any defined contribution plan.

Based on the letter dated January 26, 2007, it appears that the Taxpayer’s representative does not dispute our understanding of how the DROP accounts operate. Rather, the representative has focused upon the character of the allocations to the DROP accounts. By characterizing the allocations as transfers, the representative seeks to assert that the DROP account is not an individual account with benefits based solely on the amount contributed to the account (and earnings thereon).

Whether the funds are contributed directly by the Taxpayer to the DROP account, or indirectly contributed to the DROP account through the System, does not affect the analysis of the transaction. The pension benefits are funded by employer contributions and earnings thereon. Had an employee continued to work and could not (because there was no DROP account) make the DROP election, or chose not to make the election, the benefits otherwise paid would be lost to the employee. Because these amounts are not paid to the Taxpayer, the Taxpayer has an economic gain,4 which would result in lower future contributions to the System. It is this gain that allows the Taxpayer to create the DROP accounts at no increase over already expected costs in the Plan. The Taxpayer is in the same approximate economic position as if the DROP accounts were funded directly by new employer contributions while future contributions for pension benefits were reduced because of the economic gain. Furthermore, the original source of the funds allocated to the DROP accounts (the unpaid retirement allowances) are the employer contributions and earnings thereon. The amount of pension benefits otherwise payable is simply a convenient way to measure the amount allocated to the DROP accounts but the source of the funds is employer contributions.

Note that a defined contributions plan does not necessarily have forfeitures reallocated to participants’ accounts. Instead, a defined contribution plan can use forfeitures to reduce employer contributions or to pay expenses. Thus, whether or not these are forfeitures (however defined) does not affect the analysis of whether an arrangement is a defined contribution plan. Therefore, we have not addressed the question of whether the unpaid pension benefits, or a portion thereof, are forfeitures when employment continues.

The Plan, after the DROP amendment, is a defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant. If the Taxpayer desires to have the DROP accounts not considered as a defined contribution plan, and thus subject to the provisions of section 415(b) of the Code, it is relatively easy to do so. A plan amendment introducing a guarantee feature (such as principal protection) would bring about such a result, because the DROP benefits would not be based solely upon the earnings of the DROP accounts.

Issue 2

Section 414(k) provides in part, that a defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant shall be treated as consisting of a defined contribution plan to the extent benefits are based on the separate account of a participant and as a defined benefit plan with respect to the remaining portion of benefits under the plan for purposes of section 415 of the Code (relating to limitations on benefits and contributions under qualified plans).

As discussed in Issue 1 above the Plan, after the DROP amendment, is a defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant. Following that analysis, the Plan, after the DROP amendment, will be treated as consisting of a defined contribution plan with respect to the DROP benefits, and will be treated as a defined benefit plan with respect to the retirement allowance under the Plan. The allocations of 75% of the unpaid pension benefits made to the participant’s DROP account are considered annual additions under section 415(c)(2) of the Code, and these annual additions are subject to the limitations under section 415(c)(1) of the Code.

The Taxpayer’s representative has misread the regulations under section 415 of the Code. On page 3 of the representative’s letter dated January 26, 2007, the second sentence in the last paragraph misstates the rule on transfers between plans. The quoted regulation section talks merely about the limitation year for which the transfer occurs. One purpose is not to cause an annual addition simply due to transfers covered by or similar to those described in section 414(l) of the Code. For example, the transfer of accounts and assets from one defined contribution plan to another would not constitute an annual addition. Note that in this case there is no transfer from one plan to another covered by or similar to those described in section 414(l) of the Code, merely an allocation within one plan. The Taxpayer has not even addressed the provisions of section 1.415-6(b)(3) and (5) of the regulations.5

Issue 3

As discussed in Issue 1 above, a participant who elects to participate in the DROP receives a two-tiered retirement benefit upon termination of employment:

(a) a retirement allowance based on the defined benefit plan formula in the Plan, as of the date the participant elected to participate in the DROP, and

(b) a benefit based on the amount in his DROP account.

Essentially, the retirement allowance described in (a) is a benefit that can be considered to be derived from a defined benefit plan, and the benefit in (b) can be considered to be derived from a defined contribution plan. Under section 9 of the DROP, the participant may elect to receive his DROP benefit in the form of a single sum distribution of his DROP account balance.

Section 402(c)(4) of the Code provides that the term “eligible rollover distribution” means any distribution to an employee of all or any portion of the balance to the credit of the employee in a qualified trust except the following distributions: (A) any distribution which is one of a series of substantially equal periodic payments (not less frequently than annually) made (i) for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of the employee and the employee’s designated beneficiary, or (ii) for a period of 10 years or more; (B) any distribution to the extent the distribution is required under section 401(a)(9); and (C) any distribution which is made upon hardship of an employee. Because the distribution of the DROP benefit as a single sum does not fall into any of the exceptions under section 402(c)(4), and is a distribution to an employee of all of the balance to the credit of the employee in his DROP account, the distribution is an eligible rollover distribution under section 402(c)(4) of the Code.

The Plan does not currently provide for the direct rollover of the distribution of the DROP account as a single sum. However, because this distribution is an eligible rollover distribution, the distribution would be eligible for the direct rollover provision of section 401(a)(31)(A) of the Code if the Plan is amended accordingly.

CONCLUSIONS

(1) The Plan, after the DROP amendment, is a defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant. The Plan is a 414(k) plan after the amendment adding the DROP.

(2) The allocations of 75% of the otherwise payable pension benefits to the DROP accounts are annual additions subject to the limitations under section 415(c)(1) of the Code.

(3) The distribution of the DROP account to a retired plan participant is an eligible rollover distribution under section 402(c)(4) of the Code, and such distribution would be eligible for the direct rollover provision of section 401(a)(31) of the Code if the Plan is amended as described above.

FOOTNOTES

1 For purposes of this memorandum, “System” is generally used to refer to the administration of the Plan, while “Plan” is used to refer to the terms of the Plan. However, either term can be used interchangeably.

2 We are accepting the Taxpayer’s representation that it is a governmental plan within the meaning of section 414(d) of the Code. We have neither analyzed this issue, nor are we ruling on this issue.

3 However, the representative states in the same letter that there is a DROP account for each participant in the DROP, that the participants in the DROP may direct the investment of their account balances, and, upon termination of employment, the DROP account balance is paid in the form of a single-sum distribution or other form of distribution allowed by the Plan.

4 Because the amount going into the DROP account is only 75% of the normal retirement allowance, the other 25% represents a net gain to the System.

5 It should be noted that section 1.415(c)-1(b)(4) of the new regulations allows transactions to give rise to annual additions.

Citations: TAM 053107A




LTR: IRS Addresses Treatment of Deferred Retirement Option Plan With Guarantee Feature.

In technical advice, the IRS concluded that an employee plan for firefighters, which was amended to add a deferred retirement option plan (DROP) with a guarantee feature, is a defined benefit plan that doesn’t provide a benefit derived from employer contributions that’s based partly on the balance of the separate account of a participant.

The plan, which is maintained by a municipality within a state, is a section 414(d) governmental plan and a section 414(j) defined benefit plan. A DROP participant’s DROP pension amount is a normal retirement pension based on a defined benefit formula plus a benefit based on the amount of his DROP account.

The IRS analyzed whether the DROP account is considered a separate account under section 414(k) based on a determination of whether the DROP account meets the requirements of section 414(i). The IRS determined that the plan, after being amended to add the DROP, is a defined benefit plan that provides a benefit derived from employer contributions that is based partly on the balance of the separate account of a participant. The IRS suggested that if the municipality didn’t want the DROP accounts to be considered a defined contribution plan it should amend the plan to add a guarantee feature. Accordingly, the plan was amended to provide a guaranteed rate of return on the DROP account. Once that amendment is adopted, the DROP pensions are not solely based on the earnings of the DROP accounts. As a result, the IRS determined that the DROP accounts are no longer considered a separate account of a DROP participant, and the plan is subject only to the provisions of section 415(b).

The IRS also determined that after the adoption of the plan amendment adding the guarantee feature, the allocations to the DROP accounts aren’t annual additions subject to the limitations under section 415(c)(1). Thus, the IRS concluded that the plan isn’t a plan described under section 414(k), and the benefits paid from the plan, including the DROP benefits, are subject only to the provisions of section 415(b).

ISSUES

(1) Whether the Plan, after the amendment dated December 12, 2002, adding the deferred retirement option plan (DROP), is a defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant.

(2) Whether allocations to the DROP accounts are annual additions subject to the limitations under section 415(c)(1) of the Code.

FACTS

The above-named Plan is maintained by the Taxpayer, a municipality within the State, and is a governmental plan within the meaning of section 414(d) of the Code.1 The Plan is also a defined benefit plan under section 414(j) of the Code. Only firemen employed by the Taxpayer are eligible to participate in the Plan.

The Plan was established by the Taxpayer effective January 1, 1986. The most recent determination letter issued to the Plan is dated May 7, 1997. The Taxpayer submitted a request for a determination letter (Form 5300, Application for Determination for Employee Benefit Plan) to the Internal Revenue Service (Service), on December 31, 2002.

On December 12, 2002, the Plan’s Board of Trustees adopted a resolution to adopt the DROP. The provisions of the DROP were effective as of January 1, 2002, and the Plan has been operating accordingly since the amendment was adopted.

Article I of the Plan describes the various definition of terms used in the Plan in determining retirement benefits. Section 1.02 of this article defines “accrued benefit” as a participant’s normal retirement pension, deferred vested pension, and DROP pension.

Section 1.09 defines “compensation” as total regular salary and regular hourly wages of the employee concerned as determined by the employer under its current employment policies.

Section 1.12 defines the “DROP pension” as the benefit provided in Article XV.

Section 1.13 defines “effective date” as the plan year and limitation year beginning on or after January 1, 2002.

Section 115 defines “employee” as any person (a) who is employed by the employer on the effective date, (b) whose most recent employment commenced prior to April 8, 1978, (or whose most recent service commenced prior to April 8, 1978, but before January 1, 1980, and who complies with the requirements set forth in the revised statutes of the State), (c) who is paid by the employer on a full-time salary basis, (d) whose duties are directly involved with the provision of fire protection as certified by the employer, and (e) who can normally be expected to be credited with at least 1,600 hours of service each plan year.

Section 1.16 defines “employer” as the Taxpayer.

Section 1.17 defines “employment commencement date” as the date the employee first performs an hour of service for the employer.

Section 1.24 defines “normal retirement pension” as the benefit described in Article V.

Section 1.25 defines “participant” as an employee who is eligible to be and who becomes a participant in accordance with section 2.01.

Section 1.30 defines “service” as any period of time the employee is in the employ of the employer as an employee.

Section 1.35 defines “valuation date” as the accounting date or other date chosen to value the assets in the Plan.

Article II of the Plan describes the eligibility rules for the Plan. Section 2.01 provides that only those employees employed on January 1, 1986, and who were eligible to accrue retirement benefits then provided by the employer under the revised statute of the State, shall be participants in the Plan.

Article III of the Plan describes employer contributions to the Plan. Section 3.01(b) provides that the employer will contribute to the Plan on behalf of each eligible DROP participant who has elected the DROP pension pursuant to Article XV an amount which equals 8% of such participant’s plan year compensation each plan year.

Section 3.06(a)(6) defines “year of participation” as a year of service, but only if the Plan was in existence for such year of service.

Article IV of the Plan describes participant contributions to the Plan. Section 4.01(b) provides that any eligible DROP participant who has elected the DROP pension pursuant to Article XV shall be required to contribute an amount which equals 8% of such participant’s plan year compensation each plan year.

Article V of the Plan describes the normal retirement pension under the Plan. Section 5.01 provides that the “normal retirement age” is the date the participant attains 50 years of age, and that each participant who retires from service on or after reaching the normal retirement age and after accruing 10 years of service shall receive a normal retirement pension.

Section 5.02 provides that a participant’s normal retirement pension shall be computed on a monthly basis as a percentage of the amount of the monthly compensation being paid to such participant as of the date of such participant’s actual retirement based on a schedule set forth in this section according to years of participation as of the participant’s actual retirement date.

Section 5.03 provides that the participant’s normal retirement pension shall be computed in the form of a straight life annuity commencing at the participant’s normal retirement age and shall be paid in accordance with the provisions of Article IX.

Article IX of the Plan describes the optional forms of payment available for a participant’s accrued benefit.

Article XV of the Plan describes the DROP. Section 15.02 provides that in order to be eligible to elect a DROP pension, a participant must be an eligible DROP participant and comply with the requirements of Article XV.

Section 15.03 defines “eligible DROP participant” as any participant who has attained normal retirement age and who is entitled to a normal retirement pension under section 5.01.

Section 15.04 provides that in order to accrue and receive a DROP pension, an eligible DROP participant must execute a written DROP participant agreement with the employer. Such agreement shall contain an irrevocable election by the eligible DROP participant to (a) elect to participate in the DROP pension and a DROP participation date, (b) to waive all rights to his or her normal retirement pension, (c) to agree to continue employment with the employer after the DROP participation date for a period not to exceed 5 years (the “maximum DROP employment period”), (d) agree to have the employer make the participant DROP contribution required under section 4.01(b) on his or her behalf, (e) to elect and agree to freeze the normal retirement pension determined as of the DROP participation date, (f) to elect payment on a monthly basis, determined as of the DROP participation date, of the normal retirement pension into the DROP account in the form of a straight life annuity or one of the other annuity distribution methods described provided in Article IX.

Section 15.05 describes the DROP account. Section 15.05(a) provides that commencing on the participant’s DROP participation date, an individual DROP account will be established for each eligible DROP participant who has elected to participate in the DROP pension. Each DROP account will continue to be an asset of the Plan, but shall be held in an individual investment account in the name of each eligible DROP participant. The investment of each DROP account is subject to participant self-direction pursuant to section 15.09. Each DROP account receives all income it earns and bears all expense or loss it incurs. The Trustees shall be authorized to charge each DROP account for fees associated with the administration of the account.

Section 15.05(b) provides that commencing on the DROP participation date, the following amounts will be allocated and credited to the participant’s DROP account: (i) the monthly payment of the DROP participant’s normal retirement pension, (ii) the employer DROP contributions as required by section 3.01(b), and (iii) the participant DROP contribution required by section 4.01(b).

Section 15.06 provides that commencing on the participant’s DROP participation date, the DROP participant shall remain an active participant of the Plan, but shall earn no additional years of participation, service credit or additional benefits with respect to the normal retirement pension, the normal retirement pension will be frozen, and the participant will only be entitled to the DROP pension.

Section 15.07 provides that the amount of the DROP pension shall be equal to the fair market value of the DROP participant’s DROP account as of the valuation date, plus the balance of the participant’s normal retirement pension. For purposes of a distribution, the fair market value of the DROP participant’s DROP account is its fair market value as of the valuation date immediately preceding the date of the distribution. Upon the actual separation from service of a DROP participant, the portion of the DROP pension attributable to the DROP account shall be paid in accordance with the provisions of Article IX, and the balance of the normal retirement pension elected pursuant to section 15.04(f) shall continue to be payable from and after the DROP participant’s actual separation from service in the manner so selected.

Section 15.09 describes participant direction of investment, Section 15.09(a) provides that the DROP participant has the right to direct the investment or reinvestment of the DROP account if the Plan trustees consent in writing to such self direction.

APPLICABLE LAW

Section 401(a) of the Code provides the requirements for a qualified pension plan.

Section 414(d) of the Code provides, in part, that the term “governmental plan” means a plan established and maintained for its employees by a State or political subdivision thereof.

Section 414(i) of the Code provides that the term “defined contribution plan” means a plan which provides for an individual account for each participant and for benefits based solely on the amount contributed to the participant’s account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant’s account

Section 414(j) of the Code provides that the term “defined benefit plan” is any plan that is not a defined contribution plan.

Section 414(k) provides that a defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant shall:

(1) for purposes of section 410 (relating to minimum participation standards), be treated as a defined contribution plan,

(2) for purposes of sections 72(d) (relating to treatment of employee contributions as separate contract), 411(a)(7)(A) (relating to minimum vesting standards), 415 (relating to limitations on benefits and contributions under qualified plans), and 401(m) (relating to nondiscrimination tests for matching requirements and employee contributions), be treated as consisting of a defined contribution plan to the extent benefits are based on the separate account of a participant and as a defined benefit plan with respect to the remaining portion of benefits under the plan, and

(3) for purposes of section 4975 (relating to tax on prohibited transactions), be treated as a defined benefit plan.

Section 415 of the Code provides for certain limitations on contributions and benefits under qualified plans. Section 415(c) of the Code limits the annual additions to which a participant may be entitled under a defined contribution plan during any limitation year.

Section 415(c)(1) provides that, in general, contributions and other additions with respect to a participant exceed the limitation of this subsection if, when expressed as an annual addition (within the meaning of paragraph (2)) to the participant’s account, such annual addition is greater than the lesser of (A) $40,000, or (B) 100 percent of the participant’s compensation.

Section 415(c)(2) of the Code provides that for purposes of paragraph (1), the term “annual addition” means the sum for any year of (A) employer contributions, (B) the employee contributions, and (C) forfeitures. For the purposes of this paragraph, employee contributions under subparagraph (B) are determined without regard to any rollover contributions (as defined in sections 402(c), 403(a)(4), 403(b)(8), 408(d)(3), and 457(e)(16)) without regard to employee contributions to a simplified employee pension which are excludable from gross income under section 408(k)(6). Subparagraph (B) of paragraph (1) shall not apply to any contribution for medical benefits (within the meaning of section 419A(f)(2)) after separation from service which is treated as an annual addition.

Section 415(d) of the Code requires that the Commissioner annually adjust these limits for years after 1987 for cost-of-living increases using procedures similar to procedures used to adjust benefit amounts under § 215(i)(2)(A) of the Social Security Act. Sections 1.415-5 and 1.415-6 of the regulations provide rules regarding these adjustments.

Section 1.415-6(b)(1) of the regulations (as in effect prior to April 5, 2007) provides the definition of annual addition for a defined contribution plan. In general, for limitation years beginning after December 31, 1986, annual addition means the sum credited to a participant’s account for any limitation year of (a) employer contributions, (b) employee contributions, and (c) forfeitures.

Section 1.415-6(b)(2)(iv) of the regulations (as in effect prior to April 5, 2007) provides that for purposes of determining the limitation under section 415(c) of the Code, the transfer of funds from one qualified plan to another will not be considered an annual addition for the limitation year for which the transfer occurs.

Section 1.415-6(b)(3) of the regulations provides that the term “annual additions” includes, to the extent employee contributions would otherwise be taken into account under this section as an annual addition, mandatory employee contributions as well as voluntary employee contributions. The term “annual addition” does not include the direct transfer of employee contributions from one qualified plan to another.

Section 1.415-6(b)(5) of the regulations provides that forfeitures (as well as any income attributable to the forfeiture) will be considered to be an annual addition to the plan if such forfeitures are allocated to the account of the participant.

On April 5, 2007, a new set of final regulations (new regulations) under section 415 of the Code were issued with a general effective date of limitation years beginning on or after July 1, 2007. For governmental plans, the effective date of the new regulations is limitation years that begin more than 90 days after the dose of the first regular legislative session of the legislative body with authority to amend the plan that begins on or after July 1, 2007. However, a governmental plan is permitted to apply the provisions of the new regulations to limitation years beginning on or after July 1, 2007.

Section 1.415(c)-1(b)(1) of the new regulations provides the definition of annual addition for a defined contribution plan. In general, annual addition means the sum credited to a participant’s account for any limitation year of (a) employer contributions, (b) employee contributions, and (c) forfeitures.

Section 1.415(c)-1(b)(4) of the new regulations provides that the Commissioner may in an appropriate case, considering all of the facts and circumstances, treat transactions between the plan and the employer, transactions between the plan and the employee, or certain allocations to participants’ accounts as giving rise to annual additions. Further, where an employee or employer transfers assets to a plan in exchange for consideration that is less than the fair market value of the assets transferred to the plan, there is an annual addition in the amount of the difference between the value of the assets transferred and the consideration. A transaction described in this paragraph may constitute a prohibited transaction.

Rev. Rul. 79-259, 1979-2 C.B. 197, provides that for purposes of section 414(k), the plan provisions regarding a participant’s separate account must satisfy the requirements of a defined contribution plan under 414(i).

ANALYSIS

Issue 1

Section 15,07 of the Plan states that upon separation from service, a participant in the DROP shall receive, at his or her option, the portion of the DROP pension attributable to the DROP account paid in accordance with the provisions of Article IX, and the balance of the normal retirement pension that had been paid in to the DROP account prior to the participant’s separation from service. Based on this section of the Plan, a DROP participant’s DROP pension is the sum of two amounts:

(a) a normal retirement pension based on the defined benefit plan formula in the Plan, as of the date the participant elected to participate in the DROP, and

(b) a benefit based on the amount in his DROP account.

Under Section 15.05(a) of the Plan, an individual DROP account is established for each eligible DROP participant who has elected to participate in the DROP pension commencing on the participant’s DROP participation date. While this section of the Plan states that each DROP account continues to be an asset of the Plan, the DROP account is held in an individual investment account in the name of each DROP participant. The investment of each DROP account is subject to participant self-direction pursuant to section 15.09. Each DROP account receives all income it earns and bears all expense or loss it incurs. The Trustees shall be authorized to charge each DROP account for fees associated with the administration of the account.

Clearly, the normal retirement pension part of the benefit is based upon a defined benefit formula, thus causing the Plan to be a defined benefit plan. The focus of our analysis is whether the DROP account is considered a separate account within the meaning of section 414(k) of the Code. Therefore, it must be determined whether the DROP account meets the requirements of section 414(i) of the Code.

While we do not have a copy of the Plan Trust, it is our understanding that the amounts contributed to the DROP are placed in an individual account for each participant, and that the DROP benefit is based solely on the amounts contributed to the participant’s DROP account, adjusted for income, expenses, and gains and losses based on the investment choices made by the participant. In other words, after the allocations to the DROP account, the DROP accounts are maintained the same as any defined contribution plan.

The Plan, after being amended to add the DROP, is a defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant. During the conference of right held on May 9, 2007, we explained to the Taxpayer’s authorized representative that if the Taxpayer desired to have the DROP accounts not considered as a defined contribution plan, and thus subject to the provisions of section 415(b) of the Code, it would be is relatively easy to do so. A plan amendment introducing a guarantee feature (such as principal protection) would bring about such a result, because the DROP benefits would not be based solely upon the earnings of the DROP accounts.

In a letter dated May 30, 2007, the Taxpayer’s authorized representative provided a copy of an executed amendment to the Plan which was adopted on May 29, 2007, and effective January 1, 2002 (unless expressly set forth to the contrary). This amendment added a new section 15.09(c) to the Plan (effective January 1, 2002) providing a guaranteed rate of return on the DROP account. Under this section, if the trustees of the Plan consent to a DROP participant’s self-direction of investment under section 15.09(a), and if the actual net income and earnings of such DROP participant’s DROP account do not equal at least 4% on an annualized basis for any plan year, then the Plan shall guaranty any such DROP participant an aggregate guaranteed rate of return on the DROP account of 4% on an annualized basis for such plan year. Hence, after the adoption of this amendment, DROP pensions are not solely based upon the earnings of the DROP accounts. Accordingly, the DROP accounts are no longer considered a separate account of a DROP participant and the Plan is subject solely to the provisions of section 415(b) of the Code.

Issue 2

Section 414(k) provides in part, that a defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant shall be treated as consisting of a defined contribution plan to the extent benefits are based on the separate account of a participant and as a defined benefit plan with respect to the remaining portion of benefits under the plan for purposes of section 415 of the Code (relating to limitations on benefits and contributions under qualified plans).

As discussed in Issue 1 above, the Plan, after being amended to add the DROP, is a defined benefit plan which provides a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant. Following that analysis, the Plan, after being amended to add the DROP, will be treated as consisting of a defined contribution plan with respect to the DROP account, and will be treated as a defined benefit plan with respect to the normal retirement pension under the Plan, The allocations made to the DROP participant’s DROP account would be considered annual additions under section 415(c)(2) of the Code, and these annual additions would be subject to the limitations under section 415(c)(1) of the Code.

However, after the adoption of the May 29, 2007, amendment described above adding guaranteed rate of return in the DROP accounts, the DROP account is no longer considered a separate account of a DROP participant because the DROP benefits are not solely based upon the earnings of the DROP accounts. The allocations made to the DROP participant’s DROP account would not be considered annual additions under section 415(c)(2) of the Code, and these annual additions would not be subject to the limitations under section 415(c)(1) of the Code. Hence, the Plan is not a plan described under section 414(k) of the Code, and the benefits paid from the Plan, including the DROP benefits, are subject solely to the provisions of section 415(b) of the Code.

CONCLUSIONS

(1) The Plan, after being amended to add the DROP on December 12, 2002, and after being amended to add the guaranteed rate of return on DROP accounts on May 29, 2007, is a defined benefit plan which does not provide a benefit derived from employer contributions which is based partly on the balance of the separate account of a participant. The Plan is not a 414(k) plan after the amendment adding the DROP.

(2) Allocations to the DROP accounts under the Plan are not annual additions subject to the limitations under section 415(c)(1) of the Code.

FOOTNOTE

1 We are accepting the Taxpayer’s representation that it is a governmental plan within the meaning of section 414(d) of the Code. We have neither analyzed this issue, nor are we ruling on this issue.

Citations: TAM 071907




Firm Requests Guidance on Recognizing Nonprofit News Organizations as Exempt From Tax.

Celia Roady of Morgan, Lewis, and Bockius LLP, in response to a request for items to be placed on the IRS 2013-2014 priority guidance plan (Notice 2013-22), has asked for guidance on the standards for recognizing nonprofit news organizations as exempt from tax under section 501(c)(3).

April 29, 2013

Internal Revenue Service

Attn: CC:PA:LPD:PR (Notice 2013-22)

1111 Constitution Avenue, N.W.

Washington, D.C. 20224

Re: 2013-2014 Treasury/IRS Guidance Priority List

Dear Sir or Madam:

The purpose of this letter is to propose guidance for inclusion on the 2013-2014 Treasury/IRS Guidance Priority List. We recommend that the list include guidance about the standards for recognizing organizations engaged in the publication of information that is useful to the individual and beneficial to the community, including general news, as exempt under Section 501(c)(3). In this letter, we refer to such organizations as “nonprofit news organizations.”

As background, in 2011 the Federal Communications Commission (the “FCC”) issued a report, The Information Needs of Communities: The Changing Media Landscape in a Broadband Age, which documents the substantial decrease in accountability reporting by commercial news organizations. For example, the FCC report points to a study conducted by the Pew Center for Excellence in Journalism which found that in 2009 the Baltimore Sun produced 32 percent fewer investigative stories than it did in 1999 and 73 percent fewer stories than in 1991.1 It explains that financial pressures are forcing commercial news organizations to reduce coverage of investigative pieces involving lengthy documents and records searches or stories requiring a reporter to develop comprehensive knowledge of a particular subject matter. This cut-back affects coverage of issues that Americans care about — such as schools, health care, the environment, and local public affairs — and that offer substantial public benefit and civic value. The FCC report also describes the serious consequences that result from communities losing information that can improve government responsiveness and accountability. It explains that nonprofit news organizations can help to fill the gap in coverage and notes that uncertainty about the standards required for nonprofit news organizations to obtain tax exemption under Section 501(c)(3) is a significant barrier to this evolution.

The FCC report recommended that tax and journalism experts study the tax exemption requirements for nonprofit news organizations more carefully, and the Council on Foundations convened a working group of such experts. The group released its findings in a report issued earlier this year, The IRS and Nonprofit Media: Toward Creating a More Informed Public. The report is available online at http://www.cof.org/files/Bamboo/home/documents/Nonprofit-Media-Full-Report-03Q42013.pdf.

The working group report confirms that many nonprofit news organizations have experienced lengthy delays and even rejections of their applications for exemption. It concludes that the Internal Revenue Service (“IRS”) approach for evaluating whether an organization primarily engaged in publishing qualifies for tax exemption under Section 501(c)(3), namely Revenue Ruling 67-4,2 needs to be modernized. The working group report notes that Revenue Ruling 67-4 was issued decades before the advent of the digital era. That ruling establishes four criteria for analyzing the tax-exempt status of nonprofit news organizations, whether; (1) the content of the publication is educational, (2) the preparation of material follows methods generally accepted as “educational” in character, (3) the distribution of the materials is necessary or valuable in achieving the organization’s educational and scientific purposes, and (4) the manner in which the distribution is accomplished is distinguishable from ordinary commercial practices. The fourth criterion, in particular, does not reflect dramatic changes in the manner of dissemination of information by all news organizations, nonprofit and for-profit alike.

This request for guidance is consistent with the recommendations of the working group report, and the discussion below explains how such guidance meets the factors that Treasury/IRS considers in choosing to add an item to the priority list.

1. The guidance will resolve significant issues relevant to many taxpayers.

The Section 501(c)(3) status of nonprofit news organizations is of great importance to the millions of Americans who seek information about the events shaping their lives. According to the FCC report, “communities and citizens are seriously harmed — including financially — if there is not a critical mass of full-time professional journalists watching over the key institutions — such as state and local government, local schools, state and local courts, police, environmental planning, land use, transportation, and public health.”3 Nonprofit news organizations offer an additional source of information on these topics just as the for-profit news sector is cutting back. These stories help Americans gain useful and beneficial information that allows them to make more-informed decisions.

Moreover, investigative reporting benefits residents of communities whether or not they are readers of a particular paper. For example, the working group report points to an in-depth series in the Raleigh News & Observer on the quality of the city’s parole system that helped take criminals off the streets in the Raleigh-Durham area, thereby improving safety for all residents, regardless of whether they were readers of the paper.4 Nonprofit news organizations, often with philanthropic support from foundations, are the hope of the future for this type of reporting.

Section 501(c)(3) status is critical for nonprofit news organizations, in part because their ability to provide or expand accountability coverage on subjects such as local government, schools, and healthcare often hinges on philanthropic support from funders that require such exemption as a prerequisite for providing support. These organizations also want to structure their activities in a manner consistent with the requirements for Section 501(c)(3), but lack guidance about how to do so. In this regard, the working group report notes that the operator of the Oshkosh Community News Network, a Section 501(c)(3) nonprofit news organization, shut down the organization in part because of uncertainty regarding the tax laws.5 Updated guidance will help these organizations gain important information about how to structure their activities in order to ensure continued qualification as a Section 501(c)(3) organization.

Finally, private foundations are investing in nonprofit news organizations, with one report estimating contributions of nearly $128 million to news and information projects since 2005.6 The guidance will facilitate and streamline the grant-making programs of these foundations and help ensure their investments are advancing charitable and educational purposes.

2. The guidance will promote sound tax administration.

As noted above and in the working group report, nonprofit news organizations have experienced substantial delays associated with the processing of their applications for exemption under Section 501(c)(3). Recently, the IRS centralized a group of applications submitted by nonprofit news organizations as it attempted to understand, analyze, and apply the rules for exemption to these organizations and needed to ensure consistent treatment. Providing updated guidance about how nonprofit news organizations advance Section 501(c)(3) purposes will facilitate the IRS’s processing of applications for exemption, as well as nonprofit news organizations’ compliance with the law.

3. The guidance can be drafted in a manner that will enable taxpayers to easily understand and apply the guidance.

The guidance can be drafted in a form such as a revenue procedure that provides background on the rules for evaluating the Section 501(c)(3) status of nonprofit news organizations, outlines the various factors the IRS will consider in evaluating whether a nonprofit news organization is advancing charitable and educational purposes, and identifies the factors that are not relevant in such a determination. The IRS has issued similar types of revenue procedures in the past to help give guidance about how a particular sector or industry advances tax-exempt purposes. For example, Revenue Procedure 96-32 provides a safe harbor for organizations providing low-income housing to qualify as Section 501(c)(3) organizations, and this has proved to be an invaluable tool for low-income housing organizations seeking to apply for exemption, and for IRS agents processing such applications.

4. The guidance involves regulations that are outmoded, ineffective, insufficient, or excessively burdensome and that should be modified, streamlined, expanded, or repealed.

As noted above and in the working group report, the IRS is relying on outdated standards for evaluating whether nonprofit news organizations are furthering charitable and educational purposes. For example, Revenue Ruling 67-4 evaluates whether an organization’s manner of distribution of a publication is distinguishable from ordinary commercial publishing practices. However, since the publication of Revenue Ruling 67-4, advances in the development of technology and devices that facilitate the low-cost dissemination of information have made the distribution of free or low-cost content to the public an ordinary practice by Section 501(c)(3) organizations and commercial publishers alike.

5. The Service can administer the guidance on a uniform basis.

The IRS has faced challenges with applying the rules for tax exemption under Section 501(c)(3) on a uniform basis to nonprofit news organizations, in part because the current outdated guidance does not reflect changes in the manner of dissemination of useful and beneficial public information. Updated guidance will enable the IRS to administer the tax laws on a more uniform basis.

6. The guidance will reduce controversy and lessen the burden on taxpayers and the Service.

As noted above, the guidance will have a substantial positive impact on the American public, nonprofit news organizations, private foundations, and the IRS. It will enable new nonprofit news organizations to move forward to meet the information and accountability needs of their communities. It will provide certainty to philanthropy funders. It will provide clear standards for the IRS to apply. And it will avoid litigation that will inevitably result if the IRS does not address the need for updated guidance in this area.

We appreciate your consideration of this request. We believe the time is right and the time is now for the IRS to issue updated guidance. Every month more commercial newspapers close their doors or reduce new coverage to the detriment of their communities. Nonprofit news organizations can and will emerge to help address this problem, but they need Section 501(c)(3) status to do so. Updated guidance is essential to allow that to happen.

Sincerely,

Celia Roady

Morgan, Lewis & Bockius LLP

Washington, DC

cc:

The Honorable Mark Mazur

Assistant Secretary for Tax Policy

Department of the Treasury

The Honorable William J. Wilkins

Chief Counsel

Internal Revenue Service

FOOTNOTES

1 S. Waldman and the Working Group on Information Needs of Communities, The Information Needs of Communities: the Changing Media Landscape in a Broadband Age, 123 (July 2011).

2 Revenue Ruling 67-4, 1967-1 CB 121.

3 S. Waldman and the Working Group on Information Needs of Communities, The Information Needs of Communities: the Changing Media Landscape in a Broadband Age, 263 (July 2011).

4 See S. Waldman and the Working Group on Information Needs of Communities, The Information Needs of Communities: the Changing Media Landscape in a Broadband Age, 18 (July 2011).

5 Council on Foundations, The IRS and Nonprofit Media: Toward Creating a More Informed Public, 12 (2013).

6 J. Schaffer, New Media Makers: A Toolkit for Innovators in Community Media and Grantmaking 2 (2009).




Nonprofit Association Requests Guidance on Program-Related Investments.

Robert Collier of the Council of Michigan Foundations, in response to a request for items to be placed on the IRS 2013-2014 priority guidance plan (Notice 2013-22), has asked for guidance on program-related investments.

April 30, 2013

Internal Revenue Service

Attn: CC:PA:LPD:PR (Notice 2013-22)

Room 5203

P.O. Box 7604

Ben Franklin Station

Washington, DC 20044

Re: 2013-2014 Guidance Priority List

Sir/Madam:

This letter is in response to Notice 2013-22 and the Department of Treasury and the Internal Revenue Service’s invitation for public comment on recommendations for items that should be included on the 2013-2014 Guidance Priority List. We appreciate the opportunity to provide input to formulate a guidance plan that focuses on guidance items that are important to taxpayers and tax administration.

As a Section 501(c)(3) membership association encompassing more than 350 grantmaking organizations, The Council of Michigan Foundations (“CMF”) strongly urges the Department and Service to include in its Guidance Priority List guidance relating to program-related investments (“PRI” or “PRIs”). PRIs are an important, yet underutilized vehicle by which grantmakers may accomplish their charitable purposes. PRIs are underutilized, however, due to minimal guidance regarding qualifying investments and lack of a timely process for approving PRIs.

In 2012, the IRS issued proposed amendments to 26 C.F.R. § 53.4944-3 concerning PRIs. We expressed our comments to the amendments in a letter dated July 16, 2012, a copy of which is attached. We request that the Department and Service consider our letter and recommended course of action for improving the guidance relating to PRIs as part of the 2013-2014 Guidance Priority List.

Additionally, we recommend that further guidance be provided with respect to jeopardizing investments under Section 4944 of the Internal Revenue Code (the “Code”), and offer one other suggestion to allow private foundations to share rulings related to PRIs.

First, we request that the Service issue guidance that a mission-related investment (“MRI”) made primarily for charitable purposes is not a jeopardizing investment under Section 4944 of the Code. A “mission-related investment” is a commonly used term among grantmakers and refers to an investment made by a charitable organization to further one or more social objectives. Often, mission-related investments are made primarily for charitable purposes, and as such, are similar to PRIs in that the primary purpose of the investment is to accomplish one or more of the purposes described in Section 170(c)(2)(B). However, MRIs differ from program related investment in that the decision to make the investment is treated primarily as an investment decision rather than a programmatic decision by the foundation. Also, an MRI, whether or not made primarily for charitable reasons, is not treated as a qualifying distribution under Section 4942 of the Code.

Section 4944 of the Code and the regulations thereunder impose taxes on investments made by private foundations which jeopardize charitable purposes. 26 C.F.R. § 53.4944-1 contains care and prudence standards for making a determination as to whether an investment is a jeopardizing one. Guidance is requested to clarify that a mission-related investment made primarily for charitable purposes, or more broadly, any investment, the primary purpose of which is to accomplish one or more of the purposes described in Section 170(c)(2)(B), is not a jeopardizing investment under Section 4944 of the Code.

Finally, as described in the attached letter, we previously requested that the Service amend the regulations to allow rulings relating to PRIs to be relied upon by other parties. While we still urge the Service to give consideration to this suggestion, we offer one other recommendation regarding reliance on PRI rulings.

As you know, currently the Code and revenue procedures indicate that a taxpayer may not rely on a letter ruling issued to another taxpayer or use another taxpayer’s written determination as precedent. At least with respect to PRIs, this prohibition on reliance is especially frustrating. Often with economic development projects where a project cannot be financed on traditional commercial terms, multiple foundations may make substantially identical PRIs in the same project. We ask that the Service consider a procedure which would allow a ruling or determination issued to one foundation to be shared among, and relied upon by, foundations investing in the same project so long as the investments are made on substantially similar terms.

For example, assume XYZ Foundation applies for a private letter ruling that its investment in an urban investment fund will qualify as a PRI. The fund will make loans to growth-oriented businesses in target urban core areas. The target businesses face obstacles to traditional financing by being above the credit risk threshold for commercial bank loans and below the size and return threshold for other mezzanine financing. The fund’s principal purpose in making the loans is charitable, and more specifically, is intended to promote economic development, relieve the underprivileged, eliminate prejudice and discrimination and combat community deterioration. The loans significantly further the accomplishment of XYZ Foundation’s exempt activities and would not have been made but for such relationship between the loans and XYZ Foundation’s exempt activities. The urban investment fund is organized as a limited partnership and governed by a limited partnership agreement. Each private foundation investor will execute the limited partnership agreement of the fund and participate in the investment on substantially identical terms.

Assume that the Service makes a determination that XYZ Foundation’s investment in the urban investment fund constitutes a PRI. We request that this ruling be shared and relied upon by other private foundations that invest in the urban investment fund pursuant to the limited partnership agreement. Alternatively, each private foundation may make a loan to the urban investment fund utilizing template loan documents. Assuming that the Service makes a determination that XYZ Foundation’s loan to the urban investment fund constitutes a PRI, we request that this ruling be shared and relied upon by other private foundations that loan to the urban investment fund utilizing the template loan documents.

On behalf of CMF, and our 350 member foundations, we thank you for the opportunity to provide recommendations for guidance on PRIs for inclusion on the 2013-2014 Guidance Priority List. We welcome future dialogue regarding our comments and suggested guidance for PRIs. If we can be of additional assistance, please let me know.

Sincerely,

Robert Collier

President and CEO

Council of Michigan Foundations

Grand Haven, MI




IRS Phone Forum: 501(c)(7) Social and Recreational Organizations – How to Stay Tax-Exempt, August 21, 2013 2-3 p.m. ET

Fraternities, country clubs, hobby clubs and sports clubs all are examples of groups organized for social, recreational and similar nonprofit purposes that are tax exempt under Section 501(c)(7) of the Internal Revenue Code.

This instructive phone forum will discuss:

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TIGTA Finds Potential for Fraudulent Bond Tax Credit Claims.

Changes to tax credit bonds allowing the tax credits to be separated from bonds and sold to investors have increased the risk for improper or fraudulent tax credit claims, and more IRS oversight is required, the Treasury Inspector General for Tax Administration said in a partially redacted June 26 report.

Vulnerabilities Exist for Improper or

Fraudulent Claims for Bond Tax Credits

HIGHLIGHTS

Final Report issued on June 26, 2013

Highlights of Reference Number: 2013-10-060 to the Internal Revenue Service Office of the Deputy Commissioner for Services and Enforcement.

IMPACT ON TAXPAYERS

Nearly $5 billion in tax credit bonds were issued in Calendar Years 2009 and 2010, resulting in millions of dollars of bond tax credits claimed each year.  Without effective IRS oversight, improper or fraudulent credits may be claimed, thereby reducing Federal Government revenue.

WHY TIGTA DID THE AUDIT

This review was initiated as part of TIGTA’s Fiscal Year 2013 Annual Audit Plan and addresses the major management challenge of Tax Compliance Initiatives. The overall objective of this review was to evaluate the IRS’s progress in identifying and addressing bond tax credit noncompliance.

WHAT TIGTA FOUND

TIGTA conducted an analysis of corporate and individual returns and determined that more than $700 million in bond tax credits were claimed in Tax Years 2010 and 2011.

Changes to the law in Calendar Year 2008 allowed bond tax credits to be stripped, or separated, from the bonds and sold to other investors who could use the credits to reduce their tax liability. These changes increased the risk for improper or fraudulent claims for bond tax credits because the population of taxpayers holding the credits became more diverse and there were no requirements for third-party reporting of information on the stripping and transfer of these credits.

In the first quarter of Calendar Year 2013, the IRS began collecting information via the new information return, Form 1097-BTC, Bond Tax Credit, to begin addressing the vulnerabilities in this area. Research shows that compliance increases when taxpayers know that the IRS receives data from third parties.

WHAT TIGTA RECOMMENDED

In their response, IRS management agreed to the recommendation and plans to analyze the population of bond tax credits and determine whether changes to the compliance strategy are needed to address and prevent the improper or fraudulent claiming of bond tax credits.

June 26, 2013

MEMORANDUM FOR

OFFICE OF THE DEPUTY COMMISSIONER FOR

SERVICES AND ENFORCEMENT

FROM:

Michael E. McKenney

Acting Deputy Inspector General for Audit

SUBJECT:

Final Audit Report — Vulnerabilities Exist for Improper or

Fraudulent Claims for Bond Tax Credits (Audit # 201210032)

This report presents the results of our review to evaluate the Internal Revenue Service’s progress in developing and implementing a process to identify and address bond tax credit noncompliance. This review was conducted as part of the Treasury Inspector General for Tax Administration’s Fiscal Year 2013 Annual Audit Plan and addresses the major management challenge of Tax Compliance Initiatives.

Management’s complete response to the draft report is included as Appendix VII.

Copies of this report are also being sent to the Internal Revenue Service managers affected by the report recommendations. If you have any questions, please contact me or Gregory D. Kutz, Assistant Inspector General for Audit (Management Services and Exempt Organizations).

Table of Contents

Background

Results of Review

* * * 2 * * *

Recommendation 1:

Appendices

Appendix I   — Detailed Objective, Scope, and Methodology

Appendix II  — Major Contributors to This Report

Appendix III — Report Distribution List

Appendix IV  — Tax Credit Bonds Authorized by Congress

Appendix V   — Internal Revenue Service Forms Used in This

Report

Appendix VI  — Glossary of Terms

Appendix VII — Management’s Response to the Draft Report

Abbreviations

IRS       Internal Revenue Service

TCB       Tax Credit Bond

TIGTA     Treasury Inspector General for Tax Administration

Background

The Taxpayer Relief Act of 19971 introduced a type of tax-preferred bond known as tax credit bonds (TCB). TCBs were first available in 1998 and provide a credit that can be used on the investor’s Federal tax return to reduce the tax liability in lieu of receiving interest. Bond tax credits are nonrefundable,2 but credits that are not allowable in the current year can generally be carried forward.3 Although TCBs have not been issued as frequently as tax-exempt bonds, according to the Internal Revenue Service’s (IRS) Statistics of Income Division, 378 TCBs totaling $3.7 billion were issued in Calendar Year 2009 and 199 TCBs totaling $1.1 billion were issued in Calendar Year 2010.4 While no additional TCBs have been authorized since February 2009, the tax credits for outstanding TCBs may be claimed on tax returns for more than 20 years.5

Each type of TCB is authorized by Congress and, with the exception of Build America Bonds, is designated for a specific purpose or project. According to a September 2012 Congressional Research Service report,6 issuers have used the proceeds for public school construction and renovation, clean renewable energy projects, refinancing outstanding Government debt in regions affected by natural disasters, conservation of forest land, investment in energy conservation, and economic development purposes. See Appendix IV for a list of TCBs authorized by Congress.

Early issuances of TCBs were privately placed and held as investments primarily by large financial institutions instead of being sold on the open market. However, in May 2008, the Food, Conservation, and Energy Act of 20087 made it possible for bond tax credits to be stripped from the bonds and sold to other investors who could use the credit to reduce their tax liability and allowed Regulated Investment Companies and Real Estate Investment Trusts to pass bond tax credits to investors, such as investors in mutual funds.

Traditionally, taxpayers claimed bond tax credits by entering the amount of the credit, or multiple credits, on Form 8912, Credit to Holders of Tax Credit Bonds. The sum of the credits was then transferred to the taxpayer’s income tax return and the Form 8912 was submitted along with the return to the IRS. However, after the credits became more freely transferable, * * * 2 * * *.

Internal Revenue Bulletin Notice 2010-28, issued on March 23, 2010, introduced the proposed third-party information reporting requirements for bond tax credits, including the new Form 1097-BTC, Bond Tax Credit. The Tax Forms and Publications office developed Form 1097-BTC in Calendar Year 2010 for this purpose.8 Beginning the first quarter of Tax Year 2013, bond issuers, entities that sell bond tax credits to other recipients and investors, are required to use the process outlined in Figure 1 to report bond tax credits.

Figure 1: Reporting Bond Tax Credits9

Source: Compilation of information obtained from interviews with IRS management and review of the instructions for Forms 1097-BTC and 8912.

Bondholders that receive a Form 1097-BTC also use this form to report tax credits sold to another recipient. For example, if a Regulated Investment Company receives a Form 1097-BTC from an issuer and transfers it to a mutual fund with 100 holders who are rightful owners of a portion of that credit, the broker would prepare a Form 1097-BTC for each of the 100 mutual fund holders disclosing their portion of the credit and send a copy of the Forms 1097-BTC to the IRS. Similarly, if credits have been stripped from the TCB and resold, the original owner of the credits receives a Form 1097-BTC and must prepare a Form 1097-BTC to provide to the new owner disclosing their portion of the credits and must send a copy to the IRS.

This review was performed at the Wage and Investment Division’s Tax Forms and Publications office and the Office of Chief Counsel in Washington, D.C. We also interviewed and received information from the Small Business/Self-Employed Division’s Office of Business Modernization and Campus Compliance Services and Examination functions and from the Wage and Investment Division’s Reporting Compliance function during the period July 2012 through February 2013. We conducted this performance audit in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objective. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objective. Detailed information on our audit objective, scope, and methodology is presented in Appendix I. Major contributors to the report are listed in Appendix II.

Results of Review

* * * 2 * * *.

* * * 2 * * *

* * * 2 * * *. First, the sale of TCBs moved from primarily being privately placed with large financial institutions to being sold on the open market. Additionally, financial institutions purchased bonds to use the credits to reduce their tax liabilities, but with the downturn of the economy, many found they also had reduced taxable income and could not use the bond tax credits to reduce tax liability. Also, mutual funds started investing in TCBs, and the legal changes allowed them to pass the credits on to their investors. Collectively, these changes made the population of owners of these credits more diverse. Because the bond tax credits could be stripped and sold, and because institutional investors, such as mutual funds, could pass the credits on to their investors. * * * 2 * * *.

Because of these weaknesses, the Department of the Treasury expressed concern that multiple taxpayers could improperly or fraudulently claim the same bond tax credit, thereby reducing the amount of taxes paid to the Federal Government. In Calendar Year 2009, the Department of the * * * 2 * * *.

In Calendar Year 2010, the Tax Forms and Publications office developed Form 1097-BTC for this purpose. Beginning the first quarter of Tax Year 2013, Form 1097-BTC, sent from a third party to the IRS, will provide the IRS with information that can be used to verify that a taxpayer is eligible to claim the bond tax credits listed on a tax return if the return is selected for an examination and the bond tax credit amount is identified as a potential examination issue.

Research shows that when taxpayers know that the IRS receives data from third parties, they are more likely to correctly report the income or expenses to the IRS. The IRS estimates that income subject to substantial information reporting, such as pension, dividend, interest, unemployment, and Social Security income, was misreported at an 8 percent rate compared to a 56 percent misreporting rate for income with little or no information reporting, such as sole proprietor, rent, and royalty income.10 Through the use of Form 1097-BTC, the IRS has taken the first step in reducing the risk for improper or fraudulent claims for bond tax credits.

* * * 2 * * *

The IRS Strategic Plan states that, to succeed, the IRS “…must become faster at processing information, identifying areas of noncompliance, and applying the appropriate enforcement tools in a timely manner.” * * * 2 * * *

To determine the number and significance of bond tax credits being used to reduce tax liabilities, we quantified the bond tax credits taken on Form 1120 and the Form 1040 series tax returns11 for Tax Years 2010 and 2011. As shown in Figure 2, bond tax credit claims totaled more than $700 million during the two tax years for the types of tax returns we reviewed.12

Figure 2: Bond Tax Credits Claimed on Forms 1120 and Form 1040

Series Tax Returns (Tax Years 2010 and 2011)13

________________________________________________________________

Form 1120     Number of    Form 1040         Number of

Tax Year      Credits       Returns      Series Credits    Returns

_____________________________________________________________________

2010      $366,800,000        192         $2,200,000        1,118

2011      $334,900,000        212         $3,100,000        1,153

_____________________________________________________________________

Source: Treasury Inspector General for Tax Administration (TIGTA)

analysis of Form 1120 data from the Business Return Transaction File

and Form 1040 series data from the Tax Return Database and the

Modernized Tax Return Database.

While the number of tax returns filed claiming bond tax credits is small, the dollar value of bond tax credits claimed per return can be significant and ranged from $1 to approximately $244,000 for individual returns and up to approximately $83 million for corporate returns.

Figure 3 shows that the majority of bond tax credits filed on corporate returns totaled between $10,000 and $1 million each.

Figure 3: Form 1120 Bond Tax Credits

(Tax Years 2010 and 2011)

Source: TIGTA analysis of Form 1120 data from the Business Return Transaction File.

In contrast, Figure 4 shows that individuals filing Form 1040 returns with bond tax credits claimed smaller credits, primarily under $1,000.

Figure 4: Form 1040 Series Bond Tax Credits

(Tax Years 2010 and 2011)

Source: TIGTA analysis of Form 1040 series data from the Tax Return Database and the Modernized Tax Return Database.

* * * 2 * * *. The IRS reported that, of the approximately 148 million individual and corporate income tax returns filed each year, only approximately 1.5 million (1 percent) are examined.14 * * * 2 * * * Moreover, because the amount of some of the claims is large, inappropriate claims for bond tax credits could result in significant loss of revenue for the Federal Government.15

* * * 2 * * *. Bond tax credits can be claimed by different types of taxpayers (individuals, corporations, partnerships, etc.) that for compliance purposes are handled by different IRS operating divisions. In addition, the IRS has not had third-party reporting on Form 1097-BTC in the past.

In April 2012, TIGTA testified that: 1) the IRS does not have reliable third-party data for all categories of taxpayers and for all types of tax returns and 2) the IRS reported that, without these data, it cannot easily detect errors or potential fraud except through expensive and intrusive examinations.16 * * * 2 * * *.

Recommendation

Recommendation 1: * * * 2 * * *.

Management’s Response: IRS management agreed with this recommendation and plans to perform an analysis of the population of bond tax credits. The findings will be considered in determining any changes needed to enhance the compliance strategy for detecting improper or fraudulent claims for bond tax credits.

FOOTNOTES

1 Pub. L. No. 105-34, 111 Stat. 788 (codified as amended in scattered sections of the U.S. Code).

2 See Appendix VI for a glossary of terms.

3 Credits from Qualified Tax Credit Bonds and Build America Bonds can be carried forward. Credits for Clean Renewable Energy Bonds, Midwestern Tax Credit Bonds, or Qualified Zone Academy Bonds cannot be carried forward.

4 The latest year for which statistics are available.

5 The maximum term for TCBs is determined using a discount rate equal to the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month. For example, as of February 19, 2013, the term on a qualified TCB was listed as 24 years on www.treasurydirect.gov.

6 Congressional Research Service, Tax Credit Bonds: Overview and Analysis (Sept. 2012).

7 Pub. L. No. 110-234, Stat. 1509.

8 During development of Form 1097-BTC and the related process for reporting bond tax credits, Tax Forms and Publications management coordinated with and considered recommendations from the Information Return Program Advisory Committee on the impact of the reporting process for taxpayers and for the financial community. The Information Return Program Advisory Committee was established in 1991 in response to a recommendation in the Conference Report of the Omnibus Budget Reconciliation Act of 1989 (P.L. 101-239). The Committee has worked closely with the IRS to provide recommendations on a wide range of issues intended to improve the information reporting program and achieve fairness to taxpayers. Committee members are drawn from, and represent, a broad sample of the payer community, including major professional and trade associations, colleges and universities, and State taxing agencies.

9 See Appendix V for a list of IRS forms used throughout this report.

10 Government Accountability Office, GAO-12-652T, Opportunities to Improve the Taxpayer Experience and Voluntary Compliance (Apr. 2012).

11 Form 1040, Form 1040A, Form 1040-C, Form 1040-ES, Form 1040NR, Form1040-PR, Form 1040-SS, and Form 1040-V were included in this analysis. Bond tax credits can be claimed on various other tax forms, such as Form 1041, Form 1065, Form 990-T, and Form 1120-C.

12 We limited our analysis to Forms 1120 and the 1040 series. The amounts presented in Figure 2 do not include credits claimed on various other tax returns. Therefore, the total bond tax credits claimed on all returns could be greater than what is presented.

13 Dollar amounts have been rounded to the nearest $100,000.

14 Based on an average of IRS Statistics of Income Division examination coverage data, Table 9a, IRS Data Book, Fiscal Years 2009 through 2011.

15 IRS management did inform us that bond tax credits were examined on less than five individual and corporate tax returns from Fiscal Years 2009 through 2012, but none were found to be fraudulent.

16 Problems at the Internal Revenue Service: Closing the Tax Gap and Preventing Identity Theft, 112th Cong. (April 19, 2012) (statement of The Honorable J. Russell George, TIGTA).

END OF FOOTNOTES

* * * * *

Appendix I

Detailed Objective, Scope, and Methodology

Our overall objective was to evaluate the IRS’s progress in developing and implementing a process to identify and address bond tax credit noncompliance. To accomplish this objective, we:

I. Determined IRS requirements for issuer and bondholder reporting of bond tax credits.

A. Obtained and reviewed documentation of the Department of the Treasury’s proposal for the new bond tax credit information reporting requirements.

B. Interviewed IRS management and reviewed available documentation to identify issuer requirements for reporting bond tax credits to bondholders and the IRS for bond issuers and pass-through entities.

C. Interviewed IRS management and reviewed available documentation to identify the requirements for bondholders reporting bond tax credits to the IRS.

D. Interviewed IRS management and reviewed available documentation to identify the process for tracking credits that have been stripped from the bonds and sold separately.

II. Evaluated IRS management’s plans to identify and address improper or fraudulent claims for bond tax credits on tax returns and determined whether these plans met the Department of the Treasury’s intent and purpose for the program.

III. Determined the number and amount of bond tax credits claimed in Tax Years1 2010 and 2011.

A. Interviewed IRS management to determine if the total amount of bond tax credits claimed on the Form 10402 series of returns and Forms 1120 in Tax Years 2010 and 2011 has been quantified to determine the risk of noncompliance.

B. Quantified the total bond tax credits taken on the Form 1040 series of returns and Forms 1120 in Tax Years 2010 and 2011 by analyzing bond tax credits from the Tax Return Database, the Modernized Tax Return Database, and the Business Return Transaction File that were $1 or greater but limited to the amount of total tax on the taxpayers’ Federal tax return. Bond tax credits are not separately listed on Form 1040; therefore, we quantified the allowable credit from Form 8912 attached to the Form 1040 series returns. Validation testing of both data sets was completed by reviewing the data for reasonableness and duplicates. Form 1120 data were additionally validated by comparing data from the Business Return Transaction File to the Business Master File data. These data were determined to be reliable for the purposes of this report.

Internal controls methodology

Internal controls relate to management’s plans, methods, and procedures used to meet their mission, goals, and objectives. Internal controls include the processes and procedures for planning, organizing, directing, and controlling program operations. They include the systems for measuring, reporting, and monitoring program performance. We determined the following internal controls were relevant to our audit objective: the IRS’s controls for reviewing tax returns claiming bond tax credits and Forms 1097-BTC to determine compliance. We evaluated these controls by interviewing IRS and Department of the Treasury officials, reviewing applicable documentation, and quantifying bond tax credit claims.

FOOTNOTES TO APPENDIX II

1 See Appendix VI for a glossary of terms.

2 See Appendix V for a list of IRS forms used throughout this report.

END OF FOOTNOTES TO APPENDIX II

* * * * *

Appendix II

Major Contributors to This Report

Gregory D. Kutz, Assistant Inspector General for Audit (Management Services and Exempt Organizations)

Troy D. Paterson, Director

Gerald T. Hawkins, Audit Manager

Melinda H. Dowdy, Lead Auditor

Julia Moore, Senior Auditor

David M. Bueter, Auditor

Joseph C. Butler, Information Technology Specialist

Brian W. Hattery, Information Technology Specialist

* * * * *

Appendix III

Report Distribution List

Principal Deputy Commissioner

Office of the Commissioner — Attn: Chief of Staff C

Commissioner, Small Business/Self-Employed Division SE:S

Acting Commissioner, Tax Exempt and Government Entities Division SE:T

Commissioner, Wage and Investment Division SE:W

Director, Office of Legislative Affairs CL:LA

Chief Counsel CC

National Taxpayer Advocate TA

Director, Office of Legislative Affairs CL:LA

Director, Office of Program Evaluation and Risk Analysis RAS:O

Office of Internal Control OS:CFO:CPIC:IC

Audit Liaisons:

Director, CSO Headquarters Operations, Small Business/Self-Employed Division SE:S:CSO:SL:HQ

Director, Communications and Liaison, Tax Exempt and Government Entities Division SE:T:CL

Director, Compliance, Wage and Investment Division SE:W:CP

* * * * *

Appendix IV

Tax Credit Bonds Authorized by Congress

The following table lists all TCBs authorized by Congress as of September 2012. Although the authorized issuance amount is listed in this table, information is not available to determine the actual amounts issued for each of these bonds. The IRS Statistics of Income Division has issuance data available from Fiscal Years1 2007 to 2010; however, data were not available prior to Fiscal Year 2007 due to the lack of information reporting requirements (Form 8038, Information Return for Tax-Exempt Private Activity Bond Issues) and low issuance volume.

______________________________________________________________________________

 

Authorized                Tax

Tax Credit          Issuance     Expired      Credit

Bond                Amount       After        Amount       Purpose of Bond

______________________________________________________________________________

 

Energy

______________________________________________________________________________

 

Clean             $1.2 billion     2009     100 percent   These bonds were

Renewable                                                 issued to finance

Energy Bonds I                                            renewable energy

facilities, such

as wind,

geothermal,

landfill gas, or

solar energy, and

must be owned by a

public power

provider, State or

local government

body, or

cooperative

electric company.

 

New Clean         $800 million     2010      70 percent   These bonds were

Renewable                                                 issued to finance

Energy Bonds I                                            renewable energy

facilities, such

New Clean         $1.6 billion     2010      70 percent   as wind,

Renewable                                                 geothermal,

Energy Bonds II                                           landfill gas, or

solar energy. Not

more than one-

third of the new

bonds could be

allocated to

public power

providers,

government bodies,

or cooperative

electric

companies.

Qualified         $800 million  No expira-   70 percent   These bonds are

Energy                          tion                      issued to finance

Conservation                                              energy

Bonds I                                                   conservation

efforts such as

Qualified         $2.4 billion  No expira-   70 percent   reducing energy

Energy                          tion                      consumption in

Conservation                                              public buildings

Bonds II                                                  and mass

transportation or

implementing green

community

programs.

______________________________________________________________________________

 

General Government, Economic Development, and Forest Conservation

______________________________________________________________________________

 

Qualified         $500 million     2010      100 percent  These bonds were

Forestry                                                  issued for a

Conservation                                              qualified forestry

Bonds                                                     conservation

purpose for the

purchase of at

least 40,000 acres

of land subject to

a native fish

habitat

conservation plan

approved by the

U.S. Fish and

Wildlife Service.

The land must be

adjacent to the

U.S. Forest

Service Land and

at least half of

the land must be

transferred to the

U.S. Forest

Service at no net

cost to the United

States.

Build America     No limit         2010      35 percent2  There were two

Bonds                                                     types of Build

America Bonds: tax

credit and direct

payment.

o Build America

Tax Credit bonds

were issued to

finance any

governmental

purpose for

which tax-exempt

governmental

bonds (excluding

private activity

bonds) can be

issued.

o Build America

Direct Payment

bonds were more

limited in their

use than the tax

credit bond

option.

 

Midwest           $450 million     2009      100 percent  These bonds were

Disaster Bonds                                            designated for

areas affected by

the severe storms

and flooding in

the Midwest that

occurred in 2008.

These bonds could

only be issued in

Calendar Year 2009

and had a maximum

term of two years.

 

Recovery Zone     $10 billion      2010      45 percent3  These bonds were

Economic                                                  issued to finance

Development                                               economic

Bonds                                                     development and

activity in areas

designated as

recovery or

empowerment zones.

______________________________________________________________________________

 

School Construction

______________________________________________________________________________

 

Qualified Zone    $4.4 billion     2008      100 percent  These bonds were

Academy                                                   issued to finance

Bonds I                                                   public school

programs designed

Qualified Zone    $3.2 billion     2011      100          in cooperation

Academy                                      percent      with business to

Bonds II                                                  enhance the

academic

curriculum,

increase

graduation and

employment rates,

and prepare

students for

college and the

workforce.

Qualified         $22.4 billion    2010      100 percent  These bonds were

School                                                    issued to finance

Construction                                              the construction,

Bonds                                                     rehabilitation, or

repair of public

school facilities

or to acquire the

land for such a

facility.

______________________________________________________________________________

 

Source: Congressional Research Service, Tax Credit Bonds: Overview and

Analysis (Sept. 2012).

FOOTNOTES TO APPENDIX IV

1 See Appendix VI for a glossary of terms.

2 The underlying interest rate is market determined, not established by the Secretary of the Treasury as with the other TCBs. The credit is 35 percent of the market-determined interest rate.

3 The credit amount is determined in the same manner as Build America Bonds.

END OF FOOTNOTES TO APPENDIX IV

* * * * *

Appendix V

Internal Revenue Service Forms Used in This Report

Term                               Definition

_____________________________________________________________________

 

Form 990-T          Exempt Organization Business Income Tax Return

Form 1040           U.S. Individual Income Tax Return

Form 1040A          U.S. Individual Income Tax Return

Form 1040-C         U.S. Departing Alien Income Tax Return

Form 1040-ES        Estimated Tax for Individuals

Form 1040NR         U.S. Nonresident Alien Income Tax Return

Form 1040-PR        U.S. Self-Employment Tax Return-Puerto Rico

Form 1040-SS        U.S. Self-Employment Tax Return (Including the

Additional Child Tax Credit for Bona Fide

Residents of Puerto Rico)

Form 1040-V         Payment Voucher

Form 1041           U.S. Income Tax Return for Estates and Trusts

Form 1065           U.S. Return of Partnership Income

Form 1097-BTC       Bond Tax Credit

Form 1120           U.S. Corporation Income Tax Return

Form 1120-C         U.S. Income Tax Return for Cooperative

Associations

Form 8038           Information Return for Tax-Exempt Private

Activity Bond Issues

Form 8912           Credit to Holders of Tax Credit Bonds

* * * * *

Appendix VI

Glossary of Terms

Automated Underreporter

The Automated Underreporter function matches information return data received from third parties with the income and deductions reported on tax returns and informs taxpayers when discrepancies are found.

Business Master File

The IRS database that consists of Federal tax-related transactions and accounts for businesses. These include employment taxes, income taxes on businesses, and excise taxes.

Business Return Transaction File

A computer file of transcribed line items on all business returns and their accompanying forms and schedules.

Calendar Year

The 12-consecutive-month period ending on December 31.

Fiscal Year

A 12-consecutive-month period ending on the last day of any month. The Federal Government’s fiscal year begins on October 1 and ends on September 30.

Modernized Tax Return Database

The legal repository for original electronically filed tax returns received by the IRS through the Modernized e-File system.

Nonrefundable Credit

A nonrefundable credit can only reduce the tax liability to zero, whereas a refundable credit can reduce a taxpayer’s liability to zero and any credit amount over the tax liability can be refunded to the taxpayer.

Private Placement

A private placement is a nonpublic offering of securities, mostly to a small number of chosen investors.

Strippable Credits

The credits on TCBs are “strippable,” meaning the credits can be separated from the underlying bond.

Tax-Exempt Bond

A municipal bond with interest payments that are not subject to Federal income tax.

Tax Return Database

The Tax Return Database contains tax return source information for all electronically filed tax returns.

Tax Year

A 12-month accounting period for keeping records on income and expenses used as the basis for calculating the annual taxes due. For most individual taxpayers, the tax year is synonymous with the calendar year.

* * * * *

Appendix VII

Management’s Response to the Draft Report

May 29, 2013

MEMORANDUM FOR

MICHAEL E. MCKENNEY

ACTING DEPUTY INSPECTOR GENERAL FOR AUDIT

FROM:

Peggy Bogadi

Commissioner, Wage and Investment Division

SUBJECT:

Draft Audit Report — Vulnerabilities Exist for Improper

or Fraudulent Claims for Bond Tax Credits (Audit # 201210032)

Thank you for the opportunity to review the subject draft report. As noted in the report, legislative changes and the economic downturn have contributed to the diversification of the population of taxpayers claiming benefits associated with Bond Tax credit (BTC). Consequently, those changes have commensurately increased the complexity associated with the administration of BTC attributes. * * * 2 * * *. We will evaluate the compliance risks associated with BTC and determine strategies that may be implemented to mitigate those risks.

Attached are our comments to your recommendations. If you have any questions, please contact me, or a member of your staff may contact Steve Klingel, Director, Reporting Compliance, Wage and Investment Division, at (404) 338-9085.

Attachment

* * * * *

Attachment

RECOMMENDATION 1

* * * 2 * * *.

CORRECTIVE ACTION 1

An analysis of the population of bond tax credits will be completed and the findings will be considered in determining any changes needed to enhance our compliance strategy for detecting improper or fraudulent claims for bond tax credits.

IMPLEMENTATION DATE:

Bond Tax Credit Analysis — December 15, 2013

Evaluation of Compliance Strategy — June 15, 2015

RESPONSIBLE OFFICIALS

Bond Tax Credit Analysis —

Director, Reporting Compliance, Wage and Investment Division

Evaluation of Compliance Strategy —

Director, Examination Policy, Small Business/Self-Employed Division,

and

Director, Planning, Analysis, Inventory and Research, Large Business

and International Division

CORRECTIVE ACTION MONITORING PLAN

We will monitor this corrective action as part of our internal management control system.




Published Volume Cap Limit for Tribal Economic Development Bonds.

In Notice 2012-48, 2012-31 I.R.B. 102 (July 30, 2012), the Treasury Department and the IRS provided guidance regarding applications for allocations of the available amount of national bond volume limitation authority (volume cap) for tribal economic development bonds. The Notice provides that, except as otherwise provided in the Notice, for applications filed with the IRS that meet the requirements detailed in the Notice, the IRS will allocate an amount of available volume cap equal to the amount requested in the application on a first-come, first-served basis by order of submission date (as defined in the Notice).

The Notice also provides that no Indian tribal government will receive an allocation of volume cap that would cause the aggregate amount of volume cap allocated to that Indian tribal government pursuant to the Notice (not including certain amounts forfeited as described in the notice) to exceed the Published Volume Cap Limit in effect for the period that includes the submission date. The Published Volume Cap Limit for any period is the greater of (1) 20% of the amount of available volume cap as of the first day of such period (determined as described in the Notice); or (2) $100 million.

The Published Volume Cap Limit for the period commencing August 1, 2013 is $297,605,846 (20% of the amount of available volume cap of $1,488,029,230 determined as described in the Notice).

For purposes of this limitation, an Indian tribal government includes the Indian tribal government, together with any political subdivisions of the Indian tribal government, and any entities controlled by the Indian tribal government. An application that requests an allocation of volume cap in an amount that would cause the Published Volume Cap Limit in effect on the date of submission to be exceeded will be treated as incomplete until the day the applicant supplements the application in a manner that complies with the requirements of the notice and does not cause such limit to be exceeded.

In accordance with the Notice, the IRS plans to publish updated Published Volume Cap Limits on the IRS website at Information for Tax Exempt Bonds.

The full Volume Cap Limit is available at:

http://www.irs.gov/pub/irs-drop/n-12-48.pdf




IRS: Free Online Presentation: Rehired Annuitants.

Date:  August 15, 2013

Time: 2 p.m. Eastern Time

Learn About:  The payroll tax treatment of a former government employee that returns to work for the same entity may be different than it was prior to their retirement or separation. This presentation will help government employers understand how to comply with the complicated and often misunderstood tax implications of hiring a former employee.

Topics covered

Click here to register for this event: https://events.na.collabserv.com/portal/wippages/register.php?id=7f4fdef683&l=en-US

Please register as soon as possible because space is limited.




Group Suggests Bond Project for 2013-2014 Priority Guidance List.

Michael Deane of the National Association of Water Companies has asked Treasury and the IRS to include on the 2013-2014 priority guidance list (Notice 2013-22) guidance on the rules relating to remedial actions for tax-exempt bonds under reg. section 1.141-12, asserting that the defeasance requirement imposes a major burden on issuers seeking to take advantage of public-private partnerships.

July 19, 2013

Internal Revenue Service

Attn: CC:PA:LPD:PR (Notice 2013-22)

Room 5203

P.O. Box 7604

Ben Franklin Station

Washington, DC 20044

Mark J. Mazur

Assistant Secretary (Tax Policy)

Department of the Treasury

1500 Pennsylvania Avenue, N.W.

Washington, D.C. 20220

Subject: Request for priority guidance under Notice 2013-22

Ladies and gentlemen:

This is to request that the Treasury Department and IRS provide guidance as described below on the rules related to remedial actions for tax-exempt bonds under section 1.141-12 of the Treasury Regulations. We also request that you include this issue in the 2013-2014 Guidance Priority List.

The remedial action requirements apply when an issuer of outstanding tax-exempt bonds takes an action that causes the bonds to no longer satisfy the private activity bond restrictions under section 141 of the Code. For example, a city or county may arrange for a private-sector business to assume the ownership or management of public facilities that were financed with tax-exempt bonds and that are used to provide services to residents. Such arrangements — often termed public-private partnerships (PPPs) — let public bodies tap into the expertise, experience, and efficiency of the private sector. Where the public facilities were financed with tax-exempt debt previously issued by the public body, Treasury regulations require that one of three remedial actions be taken in connection with the transfer of the facilities to the private sector to avoid triggering tax on the bond interest for the holders of those bonds.

In a letter last year (attached) to then-Acting Assistant Secretary of the Treasury for Tax Policy Emily McMahon, we outlined reasons why the existing remedial alternatives are inadequate. In particular, we explained that the first alternative — defeasance — is impractical and extremely costly in the current interest-rate environment. To defease bonds bearing an interest rate of, for example, five percent, requires capital outlays far exceeding the face amount of the bonds. A second alternative — a deemed reissuance of the bonds — requires the state to apply its annual volume cap to the reissuance in the case of water and wastewater treatment facilities. This requirement makes the deemed reissuance impractical. The third alternative is for the public body to agree to use the proceeds from the disposition of the public facilities for governmental purposes (i.e., for purposes that do not cause the bonds to be considered private activity bonds). The precise application of this rule to long-term concession arrangements is unclear in the regulations.

We believe the IRS and Treasury have multiple options for modifying one or more of the remedial action rules to reduce hindrances to public-private partnerships due to outstanding tax-exempt bonds. Perhaps the simplest approach would be for the IRS and Treasury to clarify that an issuer’s expenditure of lease payments, or ongoing payments under a concession arrangement, for governmental purposes satisfies the remedial action rules for alternative uses of disposition proceeds. This change would clarify that leases and concession arrangements are eligible for the same remedial action relief as outright sales of facilities. Under the existing regulations, the issuer must reasonably expect to expend the disposition proceeds for governmental purposes within two years of the disposition. Where the issuer receives the proceeds from a lease or concession arrangement over time, rather than up front, the policy behind the existing requirement should logically be considered as satisfied if the issuer were required to expend those proceeds within a time certain following their receipt. We are not aware of a policy basis for a different result.

An alternative approach for the IRS and Treasury to take would be to waive the defeasance requirement where the concessionaire does not receive the benefit of the tax-exempt bonds through an assumption of the debt service. A third approach would be for the IRS and Treasury to waive the requirement that the state allocate volume cap to the bonds at the time of the concession arrangement.

As you know, the President has proposed removing the issuances of tax-exempt bonds for water infrastructure from state private activity bond volume caps. That proposal reflects a policy decision to promote PPPs for development of water infrastructure. The President’s budget contains a number of other proposals that would foster PPPs. Any regulatory adjustments by the IRS and Treasury that remove hindrances to the use of such partnerships in cases where there is outstanding tax-exempt debt would be fully consistent with the President’s proposals.

Under current economic conditions it is clear that the defeasance requirement imposes a major burden on issuers that desire to take advantage of public-private partnerships. That burden, together with the administration policy favoring expanded use of such partnerships, should satisfy the requirements of Notice 2013-22 for inclusion of this issue on the 2013-2014 Guidance Priority List. We are confident the IRS and Treasury can eliminate or reduce the burden through clarifications in the regulatory requirements for remedial actions.

We appreciate your attention to this matter. Please let us know if you have any questions about this.

Sincerely,

Michael Deane

National Association of Water

Companies

Washington, DC




IRS EO Update.

1.  IRS Pub. 5093 provides a list of online ACA health care resources

This electronic flyer provides a list of online Affordable Care Act resources provided by various federal agencies.

http://www.irs.gov/pub/irs-pdf/p5093.pdf

2.  Upcoming IRS phone forums cover important topics

Learn about upcoming forums including:

http://www.irs.gov/Charities-&-Non-Profits/Phone-Forums-Exempt-Organizations

3.  Register for EO workshops

Register for upcoming workshops for small and medium-sized 501(c)(3) organizations:

August 13 – Highland Heights, KY

Hosted by University of Kentucky

August 15 – Lexington, KY

Hosted by University of Kentucky

August 20-21 – San Francisco, CA

Hosted by Golden Gate University

August 28-29 – Anaheim, CA

Hosted by Trinity Law School

September 9 – St. Paul, MN

Hosted by Hamline University

September 10 – Minneapolis, MN

Hosted by University of St. Thomas

http://www.irs.gov/Charities-&-Non-Profits/Upcoming-Workshops-for-Small-and-Medium-Sized-501(c)(3)-Organizations




Mortgage, Credit Card, and Utility Payments Were Income to Minister.

The Tax Court, stating that an accuracy-related penalty may apply, held that mortgage, credit card, and utility payments a minister received for services were unreported self-employment income, finding that he failed to show that the mortgage payments were excluded under section 107 or that he was exempt from self-employment income tax.

Citations: Donald L. Rogers et ux. v. Commissioner; T.C. Memo. 2013-177; No. 13138-11

 

DONALD L. ROGERS AND VYON M. ROGERS,

Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

UNITED STATES TAX COURT

Filed August 1, 2013

Scott W. Gross, for petitioners.

Frederic J. Fernandez and Mark J. Miller, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

PARIS, Judge: On March 7, 2011, respondent issued to petitioners a notice of deficiency for tax year 2007 determining a deficiency in Federal income tax of [*2] $29,479 and an accuracy-related penalty under section 6662(a)1 of $5,895.80. Petitioners seek redetermination of the deficiency and the penalty.

On November 5, 2012, the parties submitted a joint stipulation of settled issues reflecting the resolution of a number of issues with respect to petitioners’ 2007 tax year. The remaining issues for decision are:

(1) whether petitioners failed to report income of $43,2002 related to Mr. Rogers’ services as a pastor for tax year 2007; and

(2) whether petitioners are liable for the accuracy-related penalty imposed under section 6662(a) for tax year 2007.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The proposed stipulations deemed admitted under Rule 91(f) on October 26, 2012, the stipulation of facts filed and supplemented on November 6, 2012, and the associated exhibits received in evidence are incorporated herein by this reference. Petitioners resided in Wisconsin when the petition was filed.

[*3] Petitioner Donald Rogers is a pastor at the Pentecostals of Wisconsin (PoW). He was formerly employed in the fields of sales and marketing but has been involved in ministry for over 30 years. Mr. Rogers’ duties as a pastor include free home Bible studies, new life classes, men’s and women’s ministries, marriage outreach, youth outreach, and children’s outreach. In return for these services, PoW pays petitioners’ personal credit card bills, utility bills, and home mortgage payments.3

Mr. Rogers registered PoW in 1995 as a nonstock corporation in the State of Wisconsin, for which Mr. Rogers was listed as a registered agent. PoW operated in this fashion until 2005, when Mr. Rogers and other members of PoW sought dissolution of the entity in favor of setting up a corporation sole. Mr. Rogers and the other members sought out SACM Management (SACM) to help facilitate the steps necessary to complete the conversion to a corporation sole.

On February 1, 2005, Mr. Rogers signed a document entitled “Vow of Poverty, Statement of Faith” detailing that any donation/honorarium, and/or and endowment given to Mr. Rogers personally will be considered the property of [*4] PoW, and that PoW will in turn provide for Mr. Rogers’ needs. The document further states that

[Mr. Rogers] further understands that any honorarium, donation, and/or endowment received by * * * [him] when performing ministerial duties among any other membership of the ecclesiastical church body or among the public that is required by the church is not mine personally, but is actually that of * * * [PoW] and will be turned over to same. * * * Even though * * * [Mr. Rogers] has taken this vow of poverty, * * * [he] further understands that any income/wages * * * [he] would received outside of * * * [PoW] that is not done on behalf of, or is not required by church ministry, is considered a third party and will be considered income to * * * [him] and is taxable.

On February 22, 2005, an entity registered as “The Office of Presding [sic] Pastor Donald L. Rogers and his successors, a Corporation Sole” was created in the State of Nevada. On April 14, 2005, PoW filed articles of dissolution in the State of Wisconsin. Despite the corporation sole’s having been set up as a Nevada entity with a Nevada address, PoW continued to operate in the Milwaukee, Wisconsin, area.

In tax year 2007 various amounts were paid on petitioners’ behalf by PoW in return for Mr. Rogers’ ministerial services. PoW made $30,612 of home mortgage payments, $8,268 in personal credit card payments, and $4,320 of utility payments on petitioners’ behalf for a total of $43,200. Petitioners timely filed a joint Federal income tax return for tax year 2007 by April 15, 2008. On their [*5] return, petitioners reported wage income from Victory Christian Academy of $53,770. Petitioners also reported itemized deductions for home mortgage interest and charitable contributions of $17,965 and $10,820, respectively. Petitioners did not report any income from amounts PoW paid on their behalf, nor did they file a timely certificate of exemption from self-employment tax in accordance with section 1402(e).

On March 7, 2011, respondent issued to petitioners a notice of deficiency for tax year 2007, determining a deficiency of $29,479 and an accuracy-related penalty under section 6662(a) of $5,895.80. This determination reflected, in part, respondent’s finding that petitioners failed to report $43,200 of taxable income4 for amounts PoW paid on their behalf for tax year 2007.5 On June 3, 2011, petitioners timely filed a petition in this Court for redetermination.

[*6] OPINION

I. Unreported Income

Section 61(a) defines gross income as “all income from whatever source derived”, including compensation for services. This definition includes all accessions to wealth, clearly realized, and over which the taxpayers have complete dominion. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).

Section 1401 imposes a tax on an individual’s self-employment income, which is defined as the “net earnings from self-employment” derived by an individual during a taxable year. Sec. 1402(b). “Net earnings from self-employment” is the gross income derived by an individual from any trade or business carried on by that individual less the deductions attributable to that trade or business. Sec. 1402(a). Pursuant to section 1402(c)(4), a “duly ordained, commissioned, or licensed minister of a church in the exercise of his ministry” is engaged in carrying on a trade or business unless the minister is exempt from self-employment tax pursuant to section 1402(e). Unless an exemption certificate is timely filed, the minister is liable for self-employment tax on income derived from the ministry.6 Sec. 1402(e)(3). The time limitation imposed by section 1402(e)(3) [*7] is mandatory and is to be complied with strictly. Wingo v. Commissioner, 89 T.C. 922, 930 (1987); Bennett v. Commissioner, T.C. Memo. 2007-355; sec. 1.1402(e)-3A, Income Tax Regs. Petitioners did not file a timely application for exemption from self-employment tax for tax year 2007. Petitioners therefore do not qualify for an exemption from self-employment tax for amounts PoW paid on their behalf.

Section 107 provides that gross income does not include, in the case of a minister of the gospel, “the rental allowance paid to him as part of his compensation, to the extent used by him to rent or provide a home”. In order for a minister to be eligible for this exclusion, the following requirements must be met: (1) the home or rental allowance must be provided as remuneration for services which are ordinarily the duties of a minister of the gospel; (2) before the payment of this rental allowance, the employing church or other qualified organization must designate the rental allowance pursuant to official action, which may be evidenced in an employment contract or by any other appropriate instrument; and (3) the designation must be sufficient in that it clearly identifies the portion of the minister’s salary that is the rental allowance. Sec. 1.107-1(a) and (b), Income Tax Regs.

[*8] There is no evidence that a rental allowance was designated in an official action between PoW and petitioners. In fact, Mr. Rogers testified at trial that PoW never considered the mortgage payments made on petitioners’ behalf to be parsonage allowances. Accordingly, petitioners are not entitled to exclude mortgage payments PoW made on their behalf as a parsonage allowance under section 107.

Petitioners failed to avail themselves of either the exemption from self-employment tax under section 1402(e) or the exclusion for rental allowance under section 107. Instead, petitioners’ primary contention at this point is that Mr. Rogers’ vow of poverty insulated them from being taxed on the compensation they received for Mr. Rogers’ services to PoW.

Petitioners point to several cases and a revenue ruling issued by the Commissioner to illustrate that while members of religious orders who have taken a vow of poverty are subject to tax for income received in their individual capacities, they are not subject to tax on income received by them merely as agents of the orders of which they are members. See Schuster v. Commissioner, 800 F.2d 672, 677 (7th Cir. 1986), aff’g 84 T.C. 764 (1985); Fogarty v. United States, 780 F.2d 1005, 1012 (Fed. Cir. 1986); McEneany v. Commissioner, T.C. Memo. 1986413; Rev. Rul. 77-290, 1977-2 C.B. 26. However, petitioners’ reliance on these [*9] authorities is misguided. In each of these cases, the taxpayer was paid a salary by a third party and remitted this salary to the religious order by assignment in accordance with the vow of poverty.

Here, petitioners did not receive a salary from a third party and did not remit any income to PoW by assignment. Mr. Rogers provided services to PoW and received compensation for those services in the form of payments PoW made on petitioners’ behalf. The critical difference is that, in this case, there was no income transferred to PoW from petitioners pursuant to their vow of poverty. The mortgage payments PoW made were applied toward a house owned solely by petitioners and titled in petitioners’ names. Similarly, the credit card payments and utility payments PoW made on behalf of petitioners served only to benefit petitioners in meeting their basic living expenses. It would be a mischaracterization of the facts to state that petitioners were paid a “salary” as agents of PoW and that this salary was assigned for the benefit of PoW when, in fact, no such salary was paid and all income issued to petitioners was used solely for their benefit. Accordingly, the authorities cited by petitioners are inapplicable in this particular case.

PoW paid $43,200 on petitioners’ behalf for tax year 2007, consisting of $30,612 in home mortgage payments, $8,268 in credit card payments, and $4,320 [*10] in utility payments. Petitioners failed to show that they were entitled to an exemption from self-employment tax for these amounts under section 1402(e). Petitioners likewise failed to show that they were entitled to exclude mortgage payments PoW made on their behalf as a parsonage allowance under section 107. Accordingly, respondent’s determination that petitioners received $43,200 of unreported self-employment income for tax year 2007 is sustained.

II. Section 6662(a) Accuracy-Related Penalty

Section 6662(a) and (b)(2) imposes an accuracy-related penalty equal to 20% of an underpayment attributable to any substantial understatement of income tax. Under section 7491(c), the Commissioner has the burden of production to show that the imposition of a penalty under section 6662(a) is appropriate. However, this does not mean the Commissioner bears the burden of proof with regard to penalties, only that the Commissioner “must come forward with sufficient evidence indicating that it is appropriate to impose the relevant penalty.” Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). Further, the Commissioner does not have the burden to introduce evidence regarding reasonable cause or substantial authority. Id.

Section 6662(d) defines a “substantial understatement” of income tax as one which exceeds the greater of: (1) 10% of the amount of tax required to be shown [*11] on the return; or (2) $5,000. In a case such as this where the return shows a zero tax liability, the understatement and the amount of tax required to be shown on the return are the same. Accordingly, the understatement of income tax will be “substantial” only if the amount of tax required to be shown on the return exceeds $5,000.

No penalty will be imposed under section 6662(a) if the taxpayer establishes that he acted with reasonable cause and in good faith. Sec. 6664(c)(1). Circumstances that indicate reasonable cause and good faith include reliance on the advice of a tax professional or an honest misunderstanding of the law that is reasonable in light of all the facts and circumstances. Sec. 1.6664-4(b), Income Tax Regs. The taxpayer has the burden of proving that he acted with reasonable cause and in good faith. Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447. Regulations promulgated under section 6664(c) further provide that the determination of reasonable cause and good faith “is made on a case-by-case basis, taking into account all pertinent facts and circumstances.” Sec. 1.6664-4(b)(1), Income Tax Regs.

It may be argued that petitioners acted with reasonable cause and in good faith when they relied on advice from SACM to set up a corporation sole structure for PoW. However, Mr. Rogers testified at trial that he and the members of PoW [*12] had done the research over a number of years and decided to convert PoW to the corporation sole structure. He further testified that they sought SACM’s advice merely to effect the organization of PoW as a corporation sole. It is clear that the members of PoW chose to convert PoW into a corporation sole and that any reliance on SACM was in the execution of that decision. Accordingly, petitioners did not rely on a tax professional such that the reliance would constitute reasonable cause under section 6664(c)(1).

Alternatively, it may be argued that petitioners made a reasonable and honest mistake of law that using the corporation sole structure in conjunction with their vow of poverty would exempt them from tax on amounts PoW paid on their behalf. In actuality, restructuring PoW as a corporation sole on its own did nothing to shield petitioners from tax on the amounts paid on their behalf. Petitioners’ understanding of the pertinent law seems to be that the vow of poverty protects them from income tax in all circumstances, particularly when the religious entity is set up as a corporation sole. Petitioners mistook the body of law surrounding the vow of poverty to apply to their circumstances. As explained above, it does not. Petitioners’ failure to avail themselves of the established exemption under section 1402(e) in favor of the tenuous corporation sole theory [*13] they espoused was not a reasonable mistake of law given all the facts and circumstances.

Petitioners have failed to present a colorable argument that they acted with reasonable cause and in good faith in filing a tax return reflecting zero income tax due for tax year 2007. Accordingly, if the final computations under Rule 155 reflect an understatement of income tax exceeding $5,000 for tax year 2007, petitioners will be liable for the accuracy-related penalty under section 6662(a).

Respondent alternatively asserts that if the understatement of income tax for tax year 2007 does not exceed $5,000, petitioners should still be liable for the accuracy-related penalty under section 6662(b)(1) because they acted with negligence or disregard of rules or regulations. Negligence is defined as a lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances. Neely v. Commissioner, 85 T.C. 934, 947 (1985); sec. 1.6662-3(b)(1), Income Tax Regs. While the Court finds that petitioners’ mistake of law in this instance was not reasonable for the purposes of establishing reasonable cause, the Court will not go so far as to say that petitioners acted with negligence or disregard of rules and regulations in the preparation of their 2007 return. Accordingly, if petitioners’ understatement of income tax for tax year 2007 does not exceed $5,000 (i.e., it is not a “substantial” understatement), [*14] petitioners will not be liable for the accuracy-related penalty for an underpayment of tax attributable to negligence under section 6662(b)(1).

The Court has considered all of the arguments made by the parties and, to the extent they are not addressed herein, they are considered unnecessary, moot, irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered under Rule 155.

FOOTNOTES

1 Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the year in issue, and Rule references are to the Tax Court Rules of Practice and Procedure.

2 This amount consists of $30,612 in home mortgage payments, $8,268 in credit card payments, and $4,320 in utility payments made on behalf of petitioners.

3 The mortgage payments made by PoW on petitioners’ behalf were for a house solely owned by petitioners and titled in their names. The house was originally transferred to PoW in 1995 but was transferred back to petitioners in 1997.

4 The notice further determined that this income should be reported as profit or loss from a business and that petitioners were liable for self-employment tax on that income.

5 The remainder of respondent’s determinations have been resolved through the stipulation of settled issues lodged by the parties on November 5, 2012, as referenced above.

6 The operative document used to apply for this exemption is Form 4361, Application for Exemption From Self-Employment Tax for Use by Ministers, Members of Religious Orders and Christian Science Practitioners.




Comments Requested on Notice for Exempt Organizations.

The IRS has requested comments on Form 990-N, “Electronic Notice (e-Postcard) for Tax-Exempt Organizations Not Required to File Form 990 or Form 990-EZ”; comments are due by September 30, 2013.




IRS LTR: Loan Sale Won't Cause State Agency to Be Treated as Taxable Mortgage Pool.

The IRS ruled that a state government agency’s proposed sale of certain mortgage loans purchased with tax-exempt bond proceeds won’t cause any portion of the agency to be classified as a taxable mortgage pool under section 7701(i).

Citations: LTR 201330008

Index Number: 7701.26-00, 115.03-00

Release Date: 7/26/2013

Date: April 24, 2013

Dear * * *:

This letter responds to a letter dated August 17, 2012, and supplemental correspondence dated September 24, 2012, January 8, 2013, and January 16, 2013, requesting a ruling on behalf of Taxpayer that Taxpayer’s proposed sale of certain mortgage loans that it purchased with the proceeds of tax-exempt bonds will not cause any portion of Taxpayer to be classified as a “taxable mortgage pool” (a “TMP”) as defined in section 7701(i) of the Internal Revenue Code (the “Code”).

FACTS

Taxpayer is a public and official governmental agency of State and a body corporate and politic that was created by State Legislature in Year 1 pursuant to and in accordance with State Law. One of the purposes of Taxpayer is to provide for the housing needs of individuals and families of low and moderate income in State. Taxpayer is governed by a governing board consisting of A public members, appointed by the governor of State. Pursuant to State Law, Taxpayer may issue revenue bonds the debt service of which is payable from, and secured by, the repayments of mortgage loans. Such bonds must be authorized by Taxpayer’s governing board and approved by the attorney general of State prior to issuance.

Taxpayer has established its Single Family Mortgage Revenue Bond Program (the “Program”) pursuant to State Law for the purpose of assisting in financing the costs of acquisition of residences within the State by first-time homebuyers. Through the Program, Taxpayer finances mortgage loans that meet the requirements imposed by section 143 of the Code, including but not limited to requirements that borrowers be first-time homebuyers and meet specified income limits and that the property financed meet certain purchase price limits.

Funds used by Taxpayer to acquire mortgage loans are derived principally from its sale of bonds that meet all the requirements necessary to be “qualified mortgage bonds” as defined in section 143 and all other requirements for interest on the bonds to be excludable from gross income under section 103. The repayment of the tax-exempt bonds issued by Taxpayer is secured by mortgage loans, cash, and other investments held pursuant to a master indenture structure.

Taxpayer entered into a Single Family Mortgage Revenue Bond Trust Indenture, dated Date 1 (the “Master Indenture”), pursuant to which it issues tax-exempt bonds through a trust (the “Trust”). In connection with each separate “issue” (as defined in section 1.150-1(b) of the Income Tax Regulations) of tax-exempt bonds (each referred to herein as an “Issue”), Taxpayer enters into one or more supplemental indentures (each, a “Supplemental Indenture”) that supplements the Master Indenture.

Each Issue is secured by the Trust estate and held by the trustee pursuant to the Master Indenture, as supplemented by any Supplemental Indentures (collectively, the “Indenture”). Taxpayer is the only entity that holds an interest in the Trust estate. The Trust estate generally includes revenues, mortgage loans, investments, and money held in any funds established under the Indenture. However, compliance with the requirements of section 143 and the Code is determined and monitored separately for each Issue. This results in mortgage loans being allocated in whole or in part to the Issue or Issues whose proceeds were used to acquire the mortgage loan. The amount of each separate Issue issued by Taxpayer, as well as the maturities and projected debt-service schedules with respect to debt obligations that comprise each Issue, is determined by reference to the timing and amount of projected payments on the mortgage loans to be acquired with proceeds of that Issue.

Taxpayer’s ownership of mortgage loans held in the Trust estate is most often evidenced by a pass-through certificate representing multiple, identical mortgage loans. Mortgage loans are originated by lenders that have been approved by Taxpayer and have agreed to originate mortgage loans in accordance with the requirements of the Program. The originating lenders are required to sell the mortgage loans made under the Program to the Program’s servicer. The servicer purchases qualified mortgage loans on scheduled dates to form loan pools eligible to constitute mortgage backed, pass-through certificates that are guaranteed as to timely payment of principal and interest by the Government National Mortgage Association, Freddie Mac, or Fannie Mae. The trustee for the tax-exempt bonds purchases the mortgage certificates with proceeds of the tax-exempt bonds on behalf of Taxpayer. The mortgage certificates are transferable.

Under the Program, Taxpayer, through its approved lenders, is able to originate mortgage loans to first-time homebuyers with low and moderate incomes that might not otherwise be able to obtain affordable financing. The purposes of the Program, the issuance of the tax-exempt bonds, and the purchase of the mortgage loans, is to address the housing needs of the State’s low and moderate income residents. Assuming a continuation of the market conditions on the date of issuance of an Issue of tax-exempt bonds, Taxpayer generally expects that it will retain ownership of the mortgage loans until those loans are fully repaid or prepaid. However, the Indenture does permit Taxpayer to sell mortgage loans without any modification or alteration of the tax-exempt bonds or the Indenture.

Current market conditions have resulted in the fair market value of certain of Taxpayer’s mortgage loans exceeding their amortized principal balances by a significant amount. Taxpayer represents that it would benefit Taxpayer to sell certain of its mortgage loans while these market conditions exist and that such sale would permit Taxpayer to use the amounts realized for use in furtherance of the Program and its stated purpose. As such, Taxpayer proposes to sell (the “Proposed Sale”) certain mortgage loans with an amortized principal balance, as of Date 2, of approximately B (the “Selected Mortgage Loans”). The majority of each Selected Mortgage Loan is allocated to an Issue of tax-exempt bonds issued by Taxpayer in Year 2 (“Issue 1”), but a portion of each Selected Mortgage Loan is also allocated to an issue of tax-exempt bonds issued by Taxpayer in Year 3 (“Issue 2”) and an issue of tax-exempt bonds issued by Taxpayer in year 4 (“Issue 3”) (all such bond issues, collectively, “debt obligations”).

The tax-exempt bonds comprising Issue 1 have more than one maturity and all of the Issue 1 bonds that remain outstanding are currently callable at the option of Taxpayer. The tax-exempt bonds comprising Issue 2 have more than one maturity and none of those bonds outstanding are subject to optional redemption until Date 3. However, the Supplemental Indenture for Issue 2 does provide that the bonds of such Issue are subject to special redemption from mortgage loan prepayments. The tax-exempt bonds comprising Issue 3 were issued as variable-rate bonds, all of which have a single maturity date and are subject to optional redemption on any business day.

The buyer of the Selected Mortgage Loans in the Proposed Sale will be selected pursuant to a competitive bid process conducted by Taxpayer’s financial advisor. Documentation of the transfer of the Selected Mortgage Loans will be accomplished by a transfer of the mortgage certificates evidencing ownership of the Selected Mortgage Loans. Homeowners whose mortgage loans are included among the Selected Mortgage Loans will be unaffected by the Proposed Sale. Additionally, the Proposed Sale will not affect the legal rights of the holders of any tax-exempt bonds issued by Taxpayer related to the Selected Mortgage Loans or such holders’ expectation of repayment in full of their tax-exempt bonds; Taxpayer will remain obligated on its debt obligations.

Upon receipt of the proceeds of the Proposed Sale, Taxpayer intends to allocate the proceeds to accounts established under the Supplemental Indenture for each of the three Issues in an amount proportionate to each of the three Issues’ participation percentage in the Selected Mortgage Loans. Taxpayer expects to use the proceeds from the Proposed Sale allocated to each of the three Issues as follows:

(1) The mortgage sale proceeds allocated to Issue 1 will be used to retire immediately (subject to any notice requirements) all bonds of Issue 1 that remain outstanding. Any amounts remaining after redemption of Issue 1 will be used to support Taxpayer’s programs, including the origination of additional mortgage loans to low and moderate income first-time homebuyers in furtherance of its governmental purpose.

(2) The mortgage sale proceeds allocated to Issue 2 will be invested in nonpurpose investments the yield on which is not materially higher than the yield on Issue 2 and used to (a) effect prepayment redemptions, and (b) to the extent amounts are remaining on Date 3, call a portion of Issue 2 on such date.

(3) The mortgage sale proceeds allocated to Issue 3 will be used to retire immediately (subject to any notice requirements) a portion of Issue 3 and to pay any fees associated with a change in the notional amount of an interest rate swap entered into in connection with Issue 3.

Any amounts not used to redeem bondholders will be held by the Trust. Taxpayer represents that it will use all proceeds from the Proposed Sale in compliance with the rules of sections 143 and 148 and any other relevant section of the Code in order to maintain the tax-exempt status of Issues 1, 2, and 3 under section 103.

LAW AND ANALYSIS

Section 7701(i)(1) provides that a TMP shall be treated as a separate corporation which may not be treated as an includible corporation with any other corporation for purposes of section 1501.

Section 7701(i)(2)(A) provides that in general, a TMP is any entity (other than a REMIC) if (i) substantially all of the assets of such entity consists of debt obligations (or interests therein) and more than 50 percent of such debt obligations (or interests) consists of real estate mortgages (or interests therein), (ii) such entity is the obligor under debt obligations with 2 or more maturities, and (iii) under the terms of the debt obligations referred to in clause (ii) (or underlying arrangement), payments on such debt obligations bear a relationship to payments on the debt obligations (or interests) referred to in clause (i).

Section 7701(i)(2)(B) provides that any portion of an entity which meets the definition of subparagraph (A) shall be treated as a TMP.

Section 301.7701(i)-4(a)(1) of the Procedure and Administration Regulations (the “Regulations”) excludes certain governmental bond programs from TMP treatment. It provides that regardless of whether an entity satisfies any of the requirements of section 7701(i)(2)(A), an entity is not classified as a TMP if (i) the entity is a State, territory, a possession of the United States, the District of Columbia, or any political subdivision thereof (within the meaning of section 1.103-1(b) of this chapter), or is empowered to issue obligations on behalf of one of the foregoing; (ii) the entity issues the debt obligations in the performance of a governmental purpose; and (iii) the entity holds the remaining interests in all assets that support those debt obligations until the debt obligations issued by the entity are retired.

Section 301.7701(i)-4(a)(2) provides that the term “governmental purpose” means an essential governmental function within the meaning of section 115 and does not include the mere packaging of debt obligations for resale on the secondary market even if any profits from the sale are used in the performance of an essential governmental function.

Taxpayer is an entity described in section 301.7701(i)-4(a)(1)(i). Thus, in order for the Proposed Sale not to cause any portion of Taxpayer to become treated as a TMP, it must be found that the Proposed Sale is in furtherance of Taxpayer’s performance of a governmental purpose and that the Proposed Sale meets the requirements of section 301.7701(i)-4(a)(1)(iii). In order to meet the requirement of “performance of a governmental purpose,” the Proposed Sale must satisfy the requirements under section 301.7701(i)-4(a)(2) that the Proposed Sale (1) is in performance of an essential governmental function within the meaning of section 115, and (2) is not the mere packaging of debt obligations for resale in the secondary market. In order to satisfy section 301.7701(i)-(a)(1)(iii), it must be found that the Proposed Sale does not violate the requirement that Taxpayer hold the remaining interests in all assets that support the debt obligations until the debt obligations issued by Taxpayer are retired.

In providing an exclusion from gross income, section 115 requires, among other things, that the income be derived in “the exercise of any essential governmental function.”

Rev. Rul. 77-261, 1977-2 C.B. 45, holds, “Income from a fund, established under a written declaration of trust by a State, for the temporary investment of cash balances of the State and its political subdivisions . . . is excludable from gross income. . . .” The ruling reasons that the “investment of positive cash balances . . . in order to receive some yield on the funds until needed to meet expenses is a necessary incident of the power of the State or political subdivision to collect taxes and other revenues for use in meeting governmental expenses.” In addressing the meaning of an “essential governmental function” for purposes of section 115, the ruling states, “Congress did not desire in any way to restrict a State’s participation in enterprises that might be useful in carrying out those projects desirable from the standpoint of the State government which, on a broad consideration of the question, may be the function of the sovereign to conduct.”

In this case, the proceeds of the Proposed Sale will be used by Taxpayer primarily to redeem holders of tax-exempt bonds issued by Taxpayer and to further support Taxpayer’s programs, including the origination of additional mortgage loans to low and moderate income first-time homebuyers in furtherance of its governmental purpose. Thus, the Proposed Sale will be in furtherance of Taxpayer’s performance of a governmental purpose and satisfies section 301.7701(i)-4(a)(ii).

The Proposed Sale will result in a sale of mortgage loans that currently support Taxpayer’s debt obligations; however, the Proposed Sale is a sale of unencumbered mortgage loans and, after the Proposed Sale Taxpayer will remain obligated on its debt obligations. After the Proposed Sale, while the Selected Mortgage Loans will no longer support any of Taxpayer’s debt obligations, amounts not used to redeem bonds will be held in the Trust, and Taxpayer will continue to own the entire interest in the pool of mortgages not sold pursuant to the Proposed Sale and other assets that continue to support the debt obligations issued by Taxpayer. Thus, Taxpayer will continue to own the remaining interest in all assets that support Taxpayer’s debt obligations, and the Proposed Sale satisfies section 301.7701(i)-4(a)(1)(iii).

CONCLUSION

Based on the information submitted and representations made, we conclude that the Proposed Sale will not cause Taxpayer to fail to satisfy the requirements of section 301.7701(i)-4(a)(1) of the Regulations to be exempt from the TMP rules and, thus, will not cause Taxpayer or any portion of Taxpayer to be treated as a TMP.

This ruling is limited to the Proposed Sale. This ruling’s application is limited to the facts, representations, Code sections, and regulations cited herein. No opinion is expressed with regard to whether Taxpayer’s Program could meet the requirements of a REMIC under section 860D(a), whether Taxpayer or any portion of Taxpayer would otherwise be a TMP under section 7701(i), whether Taxpayer’s Program satisfies either the accrual requirement or the private benefit requirement of section 115, or whether the proposed Sale will cause the bonds financed by the Selected Mortgage Loans to be arbitrage bonds under section 148 or cause the Issue of which such bonds are a part to fail to meet the requirements of section 143(g).

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any aspect of any transaction or item discussed or referenced in this letter.

This ruling is directed only to the taxpayer that requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent. In accordance with the provisions of a Power of Attorney on file, we are sending a copy of this ruling letter to your authorized representatives.

The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.

Sincerely,

Diana Imholtz

Branch Chief, Branch 1

(Financial Institutions &

Products)




IRS Grants Extension of Expenditure Period for Qualified School Construction Bond Proceeds.

The IRS granted a state school district an extension of the expenditure period for available project proceeds of qualified school construction bonds on determining that the district’s failure to spend its bond proceeds was due to reasonable cause and that the district will spend its remaining proceeds for qualified purposes with due diligence.

Citations: LTR 201330003

Index Number: 54F.00-00

Release Date: 7/26/2013

Date: April 24, 2013

Dear * * *:

This is in response to your request under § 54A(d)(2)(B)(iii) of the Internal Revenue Code for an extension of the expenditure period for the available project proceeds of qualified tax credit bonds.

FACTS AND REPRESENTATIONS

You make the following factual representations. District is a political subdivision of State and provides educational services and facilities for grades kindergarten through 12.

District issued the Bonds on Date 1, and designated the Bonds as qualified school construction bonds within the meaning of § 54F(a)(3). The original three-year expenditure period for the Bonds under § 54A(d)(2)(B)(i) will expire on Date 2 (the “Original Expenditure Period”).

All available project proceeds of the Bonds were to be spent on construction costs of the School (the “Project”), and were expected to be spent before Date 2. The Project began on Date 3, or shortly before the Bonds were issued. However, both the subcontractor responsible for the School foundation and the subcontractor responsible for the electrical system defaulted on their contracts and District had to pursue remedies and correct the defective work. As a result of these unexpected delays, District does not expect to complete the School by Date 2. Construction of the School is proceeding, and District expects to spend all available project proceeds not later than Date 4.

District submitted this request for a ruling prior to Date 2.

LAW AND ANALYSIS

Section 54A(d)(1) provides that a qualified school construction bond is treated as a qualified tax credit bond for purposes of Section 54A.

Section 54A(d)(2)(B)(i) provides in part that to the extent that less than 100 percent of the available project proceeds of the issue are expended by the close of the expenditure period for 1 or more qualified purposes, the issuer shall redeem all of the nonqualified bonds within 90 days after the end of such period.

Section 54A(d)(2)(B)(ii) provides that for purposes of this subpart, the term “expenditure period” means, with respect to any issue, the 3-year period beginning on the date of issuance. Such term shall include any extension of such period under clause (iii).

Section 54A(d)(2)(B)(iii) provides that upon submission of a request prior to the expiration of the expenditure period (determined without regard to any extension under this clause), the Secretary may extend such period if the issuer establishes that the failure to expend the proceeds within the original expenditure period is due to reasonable cause and the expenditures for qualified purposes will continue to proceed with due diligence.

Section 54A(d)((2)(C)(iv) provides that for purposes of this paragraph, in the case of a qualified zone academy bond, a “qualified purpose” means a purpose specified in § 54E(a)(1).

Section 54A(e)(4) of the Code defines “available project proceeds” to mean (A) the excess of (i) the proceeds from the sale of an issue, over (ii) the issuance costs financed by the issue (to the extent that such costs do not exceed 2 percent of such proceeds), and (B) the proceeds from any investment of the excess described in subparagraph (A).

The Project was identified prior to the issuance of the Bonds and District reasonably expected to spend all of its allocable available project proceeds within the three-year period. The expected failure to spend all the available project proceeds of the Bonds by the expiration of the three-year period on Date 2 has been caused by events that were not reasonably expected at the time the Bonds were issued and were beyond the control of District. However, District to the extent possible considering the described unexpected external events that resulted in unforeseen delays, has and will continue to exercise due diligence in spending the remaining available project proceeds on the Project. District expects to spend all available project proceeds not later than Date 4.

CONCLUSION

Under the facts and circumstances of this case, we conclude that District’s expected failure to expend the available project proceeds of the Bonds by Date 2 is due to reasonable cause and that District’s continued expenditure of the proceeds for qualified purposes will proceed with due diligence. Therefore, City is granted an extension of the Original Expenditure Period with respect to the Bonds until Date 4.

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any transaction or item discussed or referenced in this letter.

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.

In accordance with a Power of Attorney on file with this office, a copy of this letter is being sent to District’s authorized representative.

The ruling contained in this letter is based upon information and representations submitted by District and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the materials submitted in support of the request for a ruling, it is subject to verification upon examination.

Sincerely,

Associate Chief Counsel

(Financial Institutions & Products)

By: Timothy L. Jones

Senior Counsel, Branch 5




Brookings Fellow Recommends Infrastructure Incentives.

To support infrastructure, Congress should expand Build America Bonds to support state and local investments, exempt private activity bonds from the alternative minimum tax, and provide a repatriation holiday to fund a national infrastructure bank, Robert Puentes of the Brookings Institution said at a July 24 Joint Economic Committee hearing.

http://www.jec.senate.gov/republicans/public/?a=Files.Serve&File_id=74829efd-ce22-4e8c-9c03-9d937a52f22a




Tax Policy Center: Quarterly Appraisal of State Economic Conditions.

The inaugural edition of the state economic monitor reviews the health of various aspects of state economies, including employment, housing, state finances, and economic growth. This monitor documents key economic conditions through June 2013 in all 50 states, and also serves as a valuable collection of various state-level economic data. One key finding in this monitor is the remarkable breath of the economic recovery, with all but six states showing gains over the past three months and past year in indices of economic activity.

http://www.taxpolicycenter.org/UploadedPDF/412856-SEM-070913-Q1.pdf




ABA Members Request Additional Guidance on Accountable Care Organizations.

Rudolph Ramelli of the American Bar Association Section of Taxation and David Douglass of the ABA Health Law Section have responded to a request for comments (Notice 2011-20) on tax-exempt hospitals or other tax-exempt healthcare organizations participating in the Medicare Shared Savings Program (MSSP) through an accountable care organization (ACO).

The tax section and health law section are grateful for the guidance in Notice 2011-20 explaining that a tax-exempt organization that participates in the MSSP through an ACO will not jeopardize its tax-exempt status, will not violate the private inurement or private benefit doctrines, and will not be subject to the unrelated business income tax. However, section members ask that the guidance be formalized in a revenue ruling and have provided an example on which that ruling can be based.

Section members note that Notice 2011-20 focuses primarily on the exempt purpose of lessening the burdens of government, while leaving open the question of whether the promotion of health would qualify as an exempt purpose to support an ACO’s tax-exempt status. Members recommend that in general, the promotion of health should be recognized as an exempt purpose for MSSP ACOs as well as non-MSSP ACOs.

Section members also address whether non-MSSP activities will result in private inurement or impermissible private benefit and provide examples of guidelines that can be used to make the determination. Another example is used to illustrate that a tax-exempt organization should not be subject to UBIT when it participates in non-MSSP activities through an ACO joint venture.

Members request guidance confirming that an ACO would qualify for section 501(c)(3) status if it is organized as a nonprofit subsidiary of a tax-exempt organization and is subject to the same safeguards that the IRS has approved for integrated healthcare systems and in other contexts in which ultimate control of an entity resides in the parent’s community-controlled board of directors. Lastly, members recommend that a tax-exempt organization that provides services to an ACO in which it participates or which it controls, including project management, actuarial, population management, and clinical care design services, should not be subject to UBIT on payments it receives from the ACO for those services.




IRS Releases Publication on Return Disclosure.

The IRS has released Publication 3373 (rev. Jul. 2013), Disclosure of Information to Federal, State and Local Agencies, outlining the procedures for officers and employees of federal, state, and local agencies to obtain return information from the IRS.

http://www.irs.gov/pub/irs-pdf/p3373.pdf




IRS Spending Bill Would Bar Warrantless E-Mail Searches.

The IRS would be prohibited from accessing private e-mails or other electronic communications without a warrant under a provision added to the agency’s annual spending bill July 17.

House Appropriations Committee member Kevin Yoder, R-Kan., added the language as an amendment  during the committee’s markup of the House’s fiscal 2014 financial services and general government spending package . The provision would apply to other departments and agencies under the bill’s jurisdiction, including the Treasury Department and the SEC. The amendment was approved by voice vote.

The American Civil Liberties Union in April alleged that the IRS, lacking a definitive policy on taxpayers’ e-mail privacy, has permitted its employees to obtain e-mails and other communications stored on Internet service providers’ servers without a warrant if the e-mails were more than 180 days old. The ACLU said the IRS’s practice was based on “hopelessly outdated” law and could put the agency in violation of the Fourth Amendment.

The spending package would cut IRS funds by 24 percent. A date has not been set for its consideration by the full House.




EO Update: e-news for Charities and Nonprofits - July 19, 2013.

Inside This Issue:

1.  Upcoming IRS phone forums cover important topics

For a list of upcoming phone forums, go to the phone forums section of the Calendar of Events page. http://www.irs.gov/Charities-&-Non-Profits/Phone-Forums-Exempt-Organizations

“Charities and their Volunteers” – July 24

Go to the registration link to sign up for this encore session.

http://ems.intellor.com/index.cgi?p=204749&t=71&do=register&s=&rID=417&edID=305

“Veterans Organizations – Complying with IRS Rules” — July 30

This phone forum provides information to help veterans organizations stay tax exempt.

Topics include:

Click here to register for this event.

http://ems.intellor.com/index.cgi?p=204705&t=71&do=register&s=&rID=417&edID=305

“What’s Special about Schedule K (Form 990)?” – July 31

Topics covered include:

Helpful resources for completion of Schedule K

Detailed discussion of Schedule K information requirements

Helpful compliance monitoring procedures

Space is limited so register quickly.

2.  Register for EO workshops

Register for upcoming workshops for small and medium-sized 501(c)(3) organizations:

August 13 – Highland Heights, KY

Hosted by University of Kentucky

August 15 – Lexington, KY

Hosted by University of Kentucky

August 20-21 – San Francisco, CA

Hosted by Golden Gate University

August 28-29 – Anaheim, CA

Hosted by Trinity Law School

September 9 – St. Paul, MN

Hosted by Hamline University

September 10 – Minneapolis, MN

Hosted by University of St. Thomas

http://www.irs.gov/Charities-%26-Non-Profits/Upcoming-Workshops-for-Small-and-Medium-Sized-501(c)(3)-Organizations

3.  Reminder: Tax credit extension for hiring veterans ends December 31

Review the following links regarding the Work Opportunity Tax Credit and its extension:

Work Opportunity Tax Credit

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Work-Opportunity-Tax-Credit-1

Work Opportunity Tax Credit Extended

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Expanded-Work-Opportunity-Tax-Credit-Available-for-Hiring-Qualified-Veterans

Work Opportunity Tax Credit – frequently asked questions and answers

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Expanded-Work-Opportunity-Tax-Credit-Available-for-Hiring-Qualified-Veterans

4.  Tips for taxpayers who travel for charity work

Do you plan to travel while doing charity work this summer? Some travel expenses may help lower your taxes if you itemize deductions when you file next year. Here are five tax tips the IRS wants you to know about travel while serving a charity.

http://www.irs.gov/uac/Newsroom/Tips-for-Taxpayers-Who-Travel-for-Charity-Work




IRS Releases FAQ on Governance Section of Exempt Organizations' Annual Return.

The IRS has released a list of frequently asked questions on Part VI of the exempt organization return, which focuses on who is responsible for governing the organization, noting in part that the IRS will use the information to assess noncompliance and the risk of noncompliance for individual organizations and across the broader exempt sector.

Form 990, Part VI — Governance, Management, and Disclosure

Frequently Asked Questions

1. Are all organizations required to complete Part VI and answer all of its questions regarding an organization’s governance structure, policies and practices?

Yes, all organizations that file Form 990 are required to answer all of the questions in Part VI. However, refer to Appendix E of the instructions to the Form 990 for instructions regarding how to complete Part VI in the case of a group return.

2. Are all the policies and practices described in Part VI required by the Internal Revenue Code? If not, what happens if an organization reports that it does not have such policies in place?

In general, the policies and practices described in Part VI are not required by the Internal Revenue Code. However, organizations are required by the Code to make publicly available some of the items described in Question 18 of Part VI. This includes the Forms 990 of all organizations for their three most recent tax years; the Form 1023 or 1024 of all organizations that filed such forms on or after July 15, 1987, or had a copy on such date; and the Forms 990-T of a section 501(c) (3) organization for its three most recent tax years, if such forms were filed after August 17, 2006. The IRS will use the information reported in Part VI, along with other information reported on the form, to assess noncompliance and the risk of noncompliance with federal tax law for individual organizations and across the broader exempt sector.

3. If an organization adopted a policy or practice after the close of its tax year but before it filed the Form 990 for such year, may it report that it had such policy or practice in place for purposes of answering Part VI?

In most instances, the instructions to the Part VI questions state the specific time or period to be used to answer a particular question. For example, Question 12a asks whether as of the end of the organizations tax year it had a written conflict of interest policy. An organization that did not have a written conflict of interest policy in place on such date must answer no. If that same organization adopted a written policy after the close of the tax year but before it filed its return, it may describe doing so in Schedule O. If the instructions to a particular question do not provide a specific time or period to be used to answer the question, the organization may take into account practices undertaken after the close of the tax year in its response to that question (e.g., Question 12b regarding whether certain persons are required to disclose potential conflicts). Question 10 regarding whether the organization provided a copy of the Form 990 to its governing body before filing the form, and the process (if any) used by the organization to review the form, necessarily involves activity conducted after the close of the tax year.

4. Can our organization answer yes to a question about having a policy if a committee of the board, rather than the board itself, adopted the policy, and was authorized to do so?

Yes. The organization may answer Yes to any question in Section B of Part VI, Form 990, that asks whether the organization has a particular policy if the organization’s governing body (or a committee of the board, if the board delegated authority to that committee to adopt the policy) adopted the policy by the end of its tax year.

5. Part VI asks for information regarding an organization’s members, if any, and any local chapters, branches or affiliates. Why is the IRS concerned about an organization’s members and local units?

Much of Part VI focuses on who is responsible for governing the organization. In most organizations this includes a governing body, such as a board of directors, or trustees. Many organizations, however, also have members, who may be vested with certain governance or financial rights with regard to the organization. Part VI, Questions 6 and 7, ask whether an organization has members, and if so what their governance rights are, in order to provide a more complete and accurate picture about where governance authority is vested and about the organization’s legal structure. Part VI, Question 9 asks about local chapters, branches and affiliates to obtain information about whether and how the organization exercises supervision and control over its chapters, branches, and affiliates to ensure that their activities are consistent with those of the organization. This question is designed to obtain information about the extent to which the filing organization’s policies and practices extend to all of its parts or to affiliated entities.

6. Is an organization required by federal tax law to provide a copy of Form 990 to its board or governing body, or have its board or governing body review the form, before it is filed with the IRS?

No. Nonetheless, it is required to answer Question 10 regarding these matters.

7. Question 1b asks for the number of independent voting members of the governing body. May an organization use its own definition of independence to answer this question?

No, the organization must use the three-part definition contained in the instructions to this question to determine whether a particular voting member of its governing body is independent for purposes of Form 990 reporting. Note that this definition will vary from other meanings of the term independent that may apply to the organization, such as for state law or internal conflict of interest policy purposes.

8. How hard do we have to look for the information requested in Questions 1 and 2 of Form 990, Part VI regarding independent directors and business and family relationships among Board members, officers, and key employees? What if we are unable to obtain and report all the reportable information?

As described in the instructions, the organization need not engage in more than a reasonable effort to obtain the necessary information to answer these questions. An example of a reasonable effort would be for the Form 990 preparer or an officer eligible to sign the Form 990 to distribute a questionnaire annually to each of the organization’s officers, directors, trustees and key employees asking for the information that needs to be reported in response to Questions 1 and 2. The questionnaire could include the name, title, date and signature of the person reporting information, and contain the Form 990 Glossary definitions of independent voting member of governing body, family relationship, business relationship and key employee. The organization may rely on information it obtains in response to such a questionnaire in answering Questions 1 and 2.

9. Does the IRS intend to provide model or sample policies (e.g., joint venture policy) that organizations could adopt in order to answer yes to the questions in Part VI regarding such policies or practices?

The IRS does not plan to provide model or sample policies to be used for this purpose. Whether an organization adopts a policy of the type referred to in Part VI of Form 990 is a decision to be made by each individual organization. If an organization decides to adopt such a policy, it should consider its own particular facts and circumstances, including its size, culture, type and structure, in designing and implementing the policy.

10. Must the filing organization provide governance information regarding its related organizations?

In general, no. Part VI is to be completed with respect to the facts and circumstances of the filing organization. Thus, an organization is not required to provide information regarding the composition of the governing body or policies or practices of a related organization, such as a joint venture, for-profit subsidiary, parent, or brother-sister exempt organization.

However, Appendix E provides information regarding how Part VI is to be completed in the case of a group return, Question 1b asks about compensation from transactions with related organizations for purposes of determining a governing board member’s independence, and Question 9 asks whether the organization’s policies and practices extend to local affiliates.

11. If the filing organization is controlled by an organization with a conflicts of interest policy, whistleblower policy, and document retention and destruction policy, should the filing organization answer yes or no to Part VI, Questions 12a, 13 and 14?

Because these questions ask whether the filing organization has these policies, answer yes only if the filing organization’s governing body has adopted the policies of the controlling organization or other such policies. Otherwise, answer no. The filing organization can explain in Schedule O how it is governed or otherwise affected by the policies of its parent.

12. What are the governance reporting requirements for organizations that file Form 990-EZ?

Form 990-EZ was not revised to include a governance section. However, Question 34 (regarding changes to organizing documents), which was included in the 2007 Form 990-EZ, has been retained.




IRS Releases FAQ on Compensation Section of Exempt Organizations' Annual Return.

The IRS has released a list of frequently asked questions on sections of the exempt organization return that focus on the compensation of officers, directors, trustees, key employees, and independent contractors.

Exempt Organizations Annual Reporting Requirements — Form 990,

Part VII and Schedule J — Compensation Information

The questions below relate to Schedule J (Compensation Information) and Part VII (Compensation of Officers, Directors, Trustees, Key Employees, Highest Compensated Employees, and Independent Contractors), Form 990, Return of Organization Exempt From Income Tax.

A. Questions for All Filers

1. Which persons must be listed as officers, directors, trustees, key employees and five highest compensated employees on Part VII of Form 990?

The organization must list all of its current officers, directors and trustees, as those terms are defined in the Glossary in the instructions, regardless of whether any compensation was paid to such individuals. The organization must also list up to 20 current employees who satisfy the definition of key employee (persons with certain responsibilities and reportable compensation greater than $150,000 from the organization and related organizations), and its five current highest compensated employees with reportable compensation greater than $100,000 from the organization and related organizations who are not officers, directors, trustees or key employees of the organization.

Special filing amounts and requirements apply for a former–a person who was an officer, director, trustee, key employee or one of the organization’s five highest compensated employees, in one of the five prior reporting years.

TIP: All filing organizations (not just section 501(c)(3) organizations) must list and report compensation paid to the organization’s five highest compensated employees with reportable compensation greater than $100,000 from the organization and related organizations, as well as to its five highest compensated independent contractors to which the organization paid more than $100,000 for services. See Part VII and related instructions.

2. Form 990 reporting requirements refer to reportable compensation and other compensation. How does an organization know which types and amounts of compensation are included in each, and where to report these types and amounts on the form?

Reportable compensation generally means compensation reported in Box 5 of the employee’s Form W-2, or in Box 7 of a non-employee’s Form 1099-MISC. Special rules apply if an employee does not have any amount reported in Box 5 of Form W-2. Other compensation generally means compensation that is not reportable compensation. The instructions to Part VII explain these terms, and also provide a table listing various types of compensation and where to report them in Part VII or in Schedule J. A specific type of other compensation that is less than $10,000 for a given person does not need to be reported in Part VII, except tax-deferred contributions by the employer to a defined contribution retirement plan, the annual increase in the actuarial value of a defined benefit plan, and the value of health benefits not includible in reportable compensation. This $10,000 exception only applies to reporting in Part VII of Form 990; it does not apply to Schedule J.

TIP: As stated above, the $10,000 exclusions for reporting related organization compensation (described in Reporting Compensation Paid by Related Organizations ) and certain types of other compensation (described in this Q&A) apply only to Part VII reporting, and are not available for Schedule J reporting. Accordingly, the compensation amounts required to be reported on Schedule J may exceed the amounts required to be reported on Part VII for the same person. Organizations are not required to use the available reporting exclusions for Part VII. Organizations that prefer to report the same total reportable compensation and other compensation amounts in both Part VII and Schedule J for a person listed in Schedule J may do so by reporting otherwise excludible amounts in Part VII.

3. Schedule J, Part VII, contains questions about an organization’s executive compensation practices and policies. Are these questions to be answered for all of the persons listed in Form 990, Part VII, or only those persons listed in Schedule J, Part II?

Question 3 of Schedule J, Part I, must be answered with respect to the organization’s top management official (e.g., CEO/Executive Director). All other Part I questions are to be answered for all persons listed in the core form Part VII, not just those also required to be listed in Schedule J.

4. The organization uses a fiscal year as its tax year for completing Form 990. May it report executive compensation in Part VII based on its fiscal year, rather than the calendar year amounts reported on Form W-2 or Form 1099?

No. A fiscal year filing organization must report amounts in Form 990, Part VII, as well as any amounts reported in Schedule J, on the calendar year ending with or within the organization’s fiscal year. This is the same requirement for organizations filing a Form 990 on a calendar year basis.

TIP: In contrast to the calendar year reporting required in Part VII, an organization filing Form 990 for a fiscal year must report compensation expense amounts in its Statement of Expenses (Part IX of Form 990) based on its fiscal year.

5. How should an organization list in Part VII, Form 990, a person who is a current officer or director for part of the year and a former officer or director for the rest of the year — as a current, former or both? What about persons who are key employees or highest compensated employees for only part of the year?

The filer should list in Part VII, Section A, Form 990, any person who was a current officer or director at any time during the tax year, even if the person is not an officer or director at the end of the year. All of that person’s compensation from the organization should be listed in Part VII, Section A, whether received as a current officer or director, a former officer or director or in another capacity (e.g., independent contractor). A current key employee or highest compensated employee is a person who was a key employee or highest compensated employee for the calendar year ending with or within the organization’s tax year, even if he or she is not an employee of the organization at the end of that year. A former officer, director, trustee, key employee or highest compensated employee should be listed in Part VII, Section A, only if such person is not listed in Part VII, Section A, in any other capacity.

6. Under what circumstances must compensation paid by a related organization be reported on Form 990?

For purposes of Form 990, related organization generally means a parent, subsidiary, brother or sister organization under common control, a sponsoring organization of or contributing employer to a voluntary employee beneficiary association (VEBA), or a section 509(a)(3) supporting or supported organization of the filing organization. An organization need not list individuals who are officers, directors, trustees, key employees or the five highest compensated employees of a related organization unless that person also serves in one or more of these capacities with the filing organization. Once a person is required to be listed in Part VII, Section A, however, compensation paid by a related organization to such person generally must be reported in Part VII if it equals or exceeds $10,000 from that organization. The $10,000 exception for amounts paid by a related organization only applies to reporting in Part VII of the core form; it does not apply to Schedule J.

7. The reporting requirements refer to reportable compensation and other compensation. Which types and amounts of compensation are included in each, and where should we report these types and amounts on Form 990?

Reportable compensation generally means compensation reported in Box 5 of the employee’s Form W-2, or in Box 7 of a non-employee’s Form 1099-MISC. Special rules apply if an employee does not have any amount reported in Box 7 of Form W-2. Other compensation generally means compensation that is not reported on Forms W-2 or 1099. A specific type of other compensation that is less than $10,000 for a given person does not need to be reported in Part VII, except tax-deferred contributions by the employer to a defined contribution retirement plan, the annual increase in the actuarial value of a defined benefit plan, and the value of health benefits not includable in reportable compensation. This $10,000 exception only applies to reporting in Part VII of Form 990; it does not apply to Schedule J.

The instructions to Part VII explain these terms, and also provide a table listing various types of compensation and where to report them in Part VII and in Schedule J.

TIP: As stated above, the $10,000 exclusions for related organization compensation and certain types of other compensation (described above) apply only to Part VII reporting, and are not available for Schedule J reporting. Accordingly, compensation amounts required to be reported on Schedule J may exceed amounts required to be reported on Part VII for the same person. Organizations are not required to use the available reporting exclusions for Part VII. Organizations that prefer to report the same total reportable compensation and other compensation amounts in both Part VII and Schedule J for a person listed in Schedule J may do so by reporting otherwise excludable amounts in Part VII.

8. Form 990, Part VII, Section A instructions say to list persons in a particular order, beginning with trustees or directors, followed by officers, then key employees, then highest compensated employees, then former such persons. Why should these persons be listed in this order?

If a person is a director, trustee or officer of the organization, he or she cannot be listed as a key employee of that organization in Part VII of Form 990. Accordingly, officers, directors or trustees should be listed in Part VII before the organization determines which key employees to list. Likewise, in determining its five highest compensated employees who received more than $100,000 of reportable compensation, the organization is not to consider persons who are already listed in Part VII as officers, directors, trustees or key employees of the organization.

9. Because some of our managers report to the CEO or other executives, they don’t have ultimate authority over the organization, so we don’t need to report them as key employees on Form 990, right?

The answer depends on whether those employees manage a discrete segment or activity of the organization that represents 10 percent or more of the organization’s assets, income, activities or expenses, or whether they have authority to control or determine 10 percent or more of the organization’s capital expenditures, operating budget or employee compensation. If so, and if their reportable compensation from the organization and related organizations during the tax year exceeds $150,000, then they must be reported as key employees. If the organization has over 20 employees who meet these tests, then it would only report the top 20 most highly compensated as key employees.

Additional information:

Form 990, Return of Organization Exempt From Income Tax

Form 990 instructions

10. Are all organizations that list individuals in Form 990, Part VII also required to complete Schedule J?

No. An organization is required to complete Schedule J only if it satisfied at least one of three separate requirements:

1. It is required to list any former officer, director, trustee, key employee or highest compensated employee in Part VII, Form 990;

2. The sum of reportable compensation and other compensation paid to any individual listed in Part VII by the filing organization and related organizations exceeds $150,000, or

3. It participated in an arrangement in which compensation was paid by an unrelated organization to at least one of its officers, directors, trustees, key employees or five highest compensated employees for services provided to the filing organization.

The thresholds for completing Schedule J are contained in Questions 3-5 of Part VII, Section A.

TIP: Organizations required to complete Schedule J are not required to list and report compensation for all individuals listed and reported in core form Part VII. They only must list and report in Schedule J, Part II, those individuals who receive compensation for the tax year that exceeds the applicable reporting thresholds described in Questions 3-5 of Part VII, Section A (e.g., $150,000 for current officers, directors, trustees and key employees).

11. Some amounts reported on Form 990 as current year compensation may have also been reported in a prior year’s Form 990 or 990-EZ. This could overstate the cumulative compensation reported as paid to the individual. May the organization back out this duplicate amount on the current year’s form?

Part VII core form reporting does not permit amounts to be backed out if they were reported in a prior filing of Form 990; such double reporting may be explained in Schedule O. However, for persons listed in Schedule J, column (F) of that schedule allows for a backing out of duplicate amounts that were included in the current year’s reportable compensation amount as well as in a prior year’s Form 990 filing. This may occur for compensation deferred in a prior year but paid in the current year. This allows the organization to depict more accurately the cumulative compensation paid to individuals listed on Schedule J.

12. May an organization report base pay at full amount on Form 990, Schedule J, including deferrals to 401(k) and 403(b) plans, rather than separating deferrals from other base pay and reporting them in Schedule J as other reportable compensation?

A table in the core Form 990 Part VII instructions indicates that employee deferrals to 401(k) and 403(b) plans should be reported in other reportable compensation on Schedule J, column (B)(iii). The sum of the amounts reported by the organization for an individual in Schedule J columns (B)(i)-(iii) must equal the total reportable compensation amount (generally the Form W-2 Box 5 amount) for that person. The organization may report the 401(k) or 403(b) employee deferral in either column (B)(i) as base pay, or in column (B)(iii) as other reportable compensation. For instance, if an employee has Box 5 compensation of $200,000, including $5,000 of 401(k) employee deferrals, the organization may report $200,000 in base pay, or $195,000 in base pay and $5,000 in other reportable compensation in Schedule J, column (B).

TIP: Certain pre-tax deductions from Box 5 compensation raise reporting issues not expressly addressed by the instructions. These include pre-tax deductions for certain health insurance premiums, the value of which is not included in Box 5. For example, an employee with base pay of $200,000 before a pre-tax deduction of $5,000 for health insurance premiums might have $195,000 reported in Box 5 of the Form W-2. The organization should report $195,000 in column (B)(i) of Schedule J, and $5,000 in column (D).

13. How do we know whether the compensation we’re paying to our officers and key employees is reasonable?

Reasonable compensation is the value that would ordinarily be paid for like services by like enterprises under like circumstances. Reasonableness is determined based on all the facts and circumstances. For more information on reasonable compensation, see Form 990 instructions, Appendix G, Section 4958 Excess Benefit Transactions, and Form 990-EZ instructions, Appendix E, Section 4958 Excess Benefit Transactions.

B. Questions for Political Organizations

1. What does a political organization report in Part VII of Form 990?

Internal Revenue Code section 527 does not require political organizations to be organized with boards of directors, officers and trustees, but if the political organization is organized in this way, it must provide the names, addresses, title, average hours worked and compensation of those officers, directors and trustees, key employees, highest compensated employees and independent contractors.

2. What is a related organization for purposes of reporting compensation paid by related organizations on Form 990?

A related organization is any organization that meets one of the following tests:

Fifty percent or more of the political organization’s officers, directors, trustees or key employees are also officers, directors, trustees or key employees of the other organization.

The political organization appoints fifty percent or more of the other organization’s officers, directors, trustees or key employees.

Fifty percent or more of the political organization’s officers, directors, trustees or key employees are appointed by the other organization.




AICPA Seeks Guidance Limiting Required Disclosure of Exempt Org Returns.

Jeffrey Porter of the American Institute of Certified Public Accountants has suggested that Treasury issue guidance clarifying that the public inspection requirements only apply to items required to be filed under sections 6033 and 6011 to protect sensitive tax information of taxpayers and related parties from tax identity theft and tax fraud.

July 12, 2013

Ms. Emily McMahon

Deputy Assistant Secretary (Tax Policy)

Department of the Treasury

1500 Pennsylvania Avenue, N.W.

3112 MT

Washington, D.C. 20220

Re: Clarification of Public Disclosure Requirements for Exempt Organization Returns

Dear Ms. McMahon:

The American Institute of Certified Public Accountants (AICPA) appreciates the opportunity to provide comments regarding clarification of the public disclosure requirements for returns filed by exempt organizations. These comments were developed by the AICPA Exempt Organizations Taxation Technical Resource Panel, and approved by the AICPA Tax Executive Committee.

The AICPA is the world’s largest membership association representing the accounting profession, with nearly 386,000 members in 128 countries and a 125-year heritage of serving the public interest. Our members advise clients on federal, state and international tax matters and prepare income and other tax returns for millions of Americans. Our members provide services to individuals, not-for-profit organizations, small and medium-sized businesses, as well as America’s largest businesses.

We commend the Internal Revenue Service (IRS) and the Department of Treasury (“Treasury”) for annually updating forms and instructions of exempt organization returns. However, the AICPA recommends that the IRS and Treasury modify the requirements and add additional instruction guidance for information to be publicly disclosed on exempt organization returns. Implementation of this recommendation would protect sensitive tax information of the taxpayer and related parties from tax identity theft and tax fraud.

Background

Under Internal Revenue Code (IRC) section 6104(d),1 exempt organizations are required to publicly disclose tax returns filed under sections 6033 and 6011 (in the case of IRC section 501(c)(3) organizations). Section 6033 requires exempt organizations to file the Form 990, Return of Organization Exempt from Income Tax, Form 990EZ, Short Form Return of Organization Exempt From Income Tax, Form 990-N, e-Postcard, or the Form 990PF, Return of Private Foundation or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation. The Form 990-T, Exempt Organization Business Income Tax Return (and proxy tax under section 6033(e)), is required to be filed under section 6011 for certain qualifying exempt organizations. Certain exceptions from public disclosure are provided in section 6104(d)(3), such as the identity of donors.

Exempt organizations are frequently required to file additional tax returns and forms not required by sections 6033 and 6011, and these filings are often transmitted to the IRS when attached to a Form 990 series return or Form 990-T. Examples include the Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations (required under IRC section 6038) and Form 8865, Information Return of U.S. Persons with Respect to Certain Partnerships (required under section 6038B). These additional forms and returns often have sensitive information that is not intended to be included in the public disclosure of the exempt organization tax return filings.

Congress, Treasury, the IRS, and the Treasury Inspector General for Tax Administration have increased their focus on the potential concern for tax identity theft. However, requiring exempt organizations to publicly disclose sensitive information in their additional tax return attachments (e.g., Form 5471 and Form 8865), that are not required by sections 6033 and 6011, creates the potential for tax identity theft and tax fraud as well as potentially placing the employees, officers, and volunteers of an exempt organization at physical risk. We have recommendations, discussed below, to mitigate this risk.

Recommendations

The AICPA recommends that Treasury issue guidance in the form of a Notice or Regulation clarifying the public inspection requirements applicable to Form 990, Return of Organization Exempt from Income Tax, Form 990-PF, Return of Private Foundation or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation, and Form 990-T, Exempt Organization Business Income Tax Return (and proxy tax under section 6033(e)). Specifically, guidance should be issued clarifying that the public inspection requirements only apply to items required to be filed under Sections 6033 and 6011. This change would reduce the likelihood of incidental release of sensitive information that is included on other additional forms and returns and is not intended to be viewed by the public or potentially abused and misused by third parties.

Additionally, a list of forms that are excluded from the public inspection requirement can be included as part of the instructions to the Form 990 series of returns and Form 990-T. However, merely listing the forms in the instructions (without the Notice or Regulation) is not our preference. We believe the issue is of great importance and a list in the instructions may not be timely updated.

Schedules, attachments, and supporting documents filed with the Form 990-T that are not associated with unrelated business taxable income (UBTI) should not be available for public inspection. The provisions of Notice 2008-49 — Public Inspection of Form 990-T, Exempt Organization Business Income Tax Return — should be retained, e.g., the requirement to publicly disclose Form 990-T and include any schedules, attachments, and supporting documents that relate to the imposition of tax on the UBTI of the charitable organization.

Both of these recommendations would remediate the risk of tax identity theft, tax fraud, and physical risk to the employees, officers, and volunteers of exempt organizations and other parties, by limiting the disclosure of sensitive information not intended to be publicly disclosed.

Conclusion

We appreciate your consideration of our comments. The AICPA believes that the above recommended revisions limit the disclosure of forms not intended for the public and reduce the risk of misusing sensitive tax information of taxpayers and related parties. If you have any questions regarding this submission, please feel free to contact me at (304) 522-2553 or [email protected]; Jeffrey D. Frank, Chair, AICPA Exempt Organizations Taxation Technical Resource Panel, at (317) 656-6921, or [email protected]; or Amy Wang, AICPA Technical Manager — Taxation, at (202) 434-9264, or [email protected].

Respectfully submitted,

Jeffrey A. Porter, CPA

Chair, AICPA Tax Executive

Committee

American Institute of CPAs

Washington, DC




IRS LTR: IRS Denies Tax Exemption to Shareholder Organization.

Citations: LTR 201329024

The IRS denied tax-exempt status to an organization formed to promote shareholders’ interests in publicly traded companies, finding that its activities don’t improve business conditions along one or more lines of business or of a certain area but rather are services for member convenience.

Person to Contact: * * *

UIL: 501.06-00, 501.36-00

Release Date: 7/19/2013

Date: April 26, 2013

Taxpayer Identification Number: * * *

Tax Period(s) Ended: * * *

Dear * * *:

We considered your appeal of the adverse action proposed by the Director, Exempt Organizations, Rulings and Agreements. This is our final determination that you do not qualify for exemption from Federal income tax under Internal Revenue Code (the “Code”) section 501(a) as an organization described in section 501(c)(6) of the Code.

Our adverse determination was made for the following reason(s):

You are not described within the purview of section 501(c)(6) of the Code because your purpose, as stated in the Restated Articles of Incorporation, is to restore and then maintain appropriate and effective control of shareholders over the US corporations they own.

Your membership consists of individual investors of equity investment firms who wish to preserve and strengthen their shareholder rights.

You are required to file Federal income tax returns on Forms 1120 for the tax periods stated in the heading of this letter and for all tax years thereafter. File your return with the appropriate Internal Revenue Service Center per the instructions of the return. For further instructions, forms, and information please visit www.irs.gov.

Please show your employer identification number on all returns you file and in all correspondence with Internal Revenue Service.

You also have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate assistance is not a substitute for established IRS procedures, such as the formal appeals process. The Taxpayer Advocate cannot reverse a legally correct tax determination, or extend the time fixed by law that you have to file a petition in a United States Court. The Taxpayer Advocate can however, see that a tax matters that may not have been resolved through normal channels get prompt and proper handling. If you want Taxpayer Advocate assistance, please contact the Taxpayer Advocate for the IRS office that issued this letter. You may call toll-free, 1-877-777-4778, for the Taxpayer Advocate or visit www.irs.gov/advocate for more information.

If you have any questions about this letter, please contact the person whose name and telephone number are shown in the heading of this letter.

Sincerely Yours,

Karen A. Skinder

Appeals Team Manager

* * * * *

Contact Person: * * *

Identification Number: * * *

Contact Number: * * *

FAX Number: * * *

UIL 501.06-00, 501.36-00

Date: August 2, 2012

Employer Identification Number: * * *

LEGEND:

C = individual

J = business

P = state

u = date

y = year

w = dollar amount

x = dollar amount

y = dollar amount

Dear * * *:

We have considered your application for recognition of exemption from federal income tax under Internal Revenue Code (“Code”) section 501(a). Based on the information provided, we have concluded that you do not qualify for exemption under Code section 501(c)(6). The basis for our conclusion is set forth below.

This letter supersedes our letter dated September 20, 2011

ISSUE

Do you qualify for exemption under section 501(c)(6) of the Code? No, for the reasons stated below.

FACTS

You are a corporation formed on u, and operate pursuant to the laws of the State of P. Your Articles of Incorporation state that your purpose is to restore and then maintain appropriate and effective control of shareholders over the US corporations they own. Your Articles of Incorporation also state that you shall not carry on any activities not permitted to be carried on by a corporation exempt from federal income tax under section 501(c)(6) of the Internal Revenue Code, or the corresponding section of any future federal tax code.

You initially applied for exemption under IRC 501(c)(3), then re-applied under IRC 501(c)(6). You state that you are a chamber of commerce with shareholders of various unrelated corporations as members that seek to improve business conditions for publicly traded US corporations by enhancing the effectiveness with which shareholders contribute to running those corporations. To accomplish this goal, you conduct the following activities:

You organize collective action by shareholders on matters pertinent to effectively running the corporation they own through virtual shareholder meetings, where the organized shareholders pressure public corporations to use remote communications technology in shareholder meetings such as online forums. This work is conducted by your membership — perhaps with leadership by your board or officers — primarily out of their homes. It will consume about * * *% of your time.

You advocate for effective legislation and regulation. Examples of this work include the letters you sent to the SEC in v to comment on proposed regulations on behalf of shareholders. These letters were primarily written by your executive director working out of his office, but many shareholders contributed to and co-signed the letters. This will consume about * * *% of your time.

You organize conferences, media events, rallies or other events that draw attention to critical issues affecting shareholders’ ability to effectively run the corporations they own. This work is conducted by your membership — perhaps with leadership by your board or officers — primarily out of their homes. It will consume about * * *% of your time.

You improve shareholders ability to effectively run the corporations they own by helping shareholders engage qualified proxies, agents or board members to represent their interests. While you have facilitated a number of grants of proxies in the past, these efforts will be advanced through implementing social networking software. You have a team of volunteer information technology professionals who will implement that technology. The general membership will also be engaged, with direction from your officers. Work is conducted primarily from members’ homes. It will consume about * * *% of your time.

You improve shareholders ability to effectively run the corporations they own by mitigating the risk of frivolous corporate lawsuits against shareholders who exercise their rights or responsibilities as owners of corporations. This work entails securing legal advice for shareholders who are sued by corporations. You have, for example, been assisting shareholder C who was sued by J over a shareholder resolution he submitted for inclusion in that corporation’s 2010 proxy materials. You will also form a legal defense trust for shareholders who are victimized by such lawsuits. This work is conducted by your membership — perhaps with leadership by your board or officers — primarily out of their homes. It will consume about * * *% of your time.

Your members are owners of various unrelated publicly traded US corporations who share a common business interest of improving the effectiveness with which the corporations they own are managed. Currently, your members consist solely of your board members. Your membership requirements, duties, and privileges are as follows:

You distinguish members who have not yet reached the age of majority.

You grant full voting rights only to members who have demonstrated commitment to your cause.

You separate classes of membership for shareholders who are natural persons and shareholders that are institutions.

You grant honorary — non-voting — memberships to certain parties, such as academics or service providers who are not shareholders but have knowledge or expertise that could be useful to your organization.

You grant non-honorary membership only to shareholders. Individuals are considered shareholders if they satisfy either the first or both the second and third of the following criteria:

Currently owns at least $* * * in publicly traded US equities, either directly or indirectly, through a mutual fund or other pooled investment vehicle.

Has owned at least $* * * in publicly traded US equities in the past, either directly or indirectly, through a mutual fund or other pooled investment vehicle.

Will very likely own at least $* * * in publicly traded US equities within the next three years, either directly or indirectly, through a mutual fund or other pooled investment vehicle.

An institution is considered a shareholder if it is an institutional investor that routinely invests * * *% or more of its portfolio in publicly traded US equities, either directly or indirectly, through mutual funds or other pooled investment vehicles.

You have nine classes of members that include:

Nominal individual — an individual of any age who is not a shareholder. This honorary membership provides member benefits but no voting rights.

Junior individual — an individual who is a shareholder but has not yet reached his 18th birthday. This membership provides member benefits but no voting rights.

Associate individual — an adult shareholder who has not been promoted to general member. This membership provides member benefits but limited voting rights on policy issues, as permitted by the board.

General institutional — an associate institutional member can be promoted to general institutional member in recognition of service and commitment to the organization. Provides for full voting rights.

Nominal charitable — Essentially nominal institutional membership but for a 501(c)(3). Membership dues are lower.

Associate charitable — Essentially associate institutional membership but for a 501(c)(3). Membership dues are lower.

General charitable — Essentially general institutional membership but for a 501(c)(3). Membership dues are lower.

Membership dues are:

w dollars a month for all individual memberships

x dollars annually for institutional memberships

y dollars annually for charitable memberships

You have estimated membership to be the following:

Year 1: approximately 20 individual, 2 institutional, 2 charitable

Year 2: approximately 30 individual, 4 institutional, 4 charitable

Year 3: approximately 40 individual, 6 institutional, 6 charitable

LAW

Section 501(c)(6) of the Code provides exemption from federal income tax for “business leagues, chambers of commerce, real-estate boards, boards of trade, or professional football leagues (whether or not administering a pension fund for football players), not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual.”

Section 1.501(c)(6)-1 of the Income Tax Regulations states, “A business league is an association of persons having some common business interest, the purpose of which is to promote such common interest and not to engage in a regular business of the kind ordinarily carried on for profit. It is an organization of the same general class as a chamber of commerce or board of trade. Thus, its activities should be directed to the improvement of business conditions of one or more lines of business as distinguished from the performance of particular services for individual persons. An organization whose purpose is to engage in a regular business of a kind ordinarily carried on for profit, even though the business is conducted on a cooperative basis or produces only sufficient income to be self-sustaining, is not a business league.”

In Revenue Ruling. 59-391, 1959-2 C.B. 151, exemption under 501(c)(6) was denied to an organization composed of individuals, firms, associations, and corporations, each representing a different trade, business, occupation, or profession. The organization was created for exchanging information on business prospects and has no common business interest other than a desire to increase sales of members. The revenue ruling found that the members of the instant organization had no common business interest other than a mutual desire to increase their individual sales. It stated that the organization’s activities were not directed to the improvement of business conditions of one or more lines of business, but rather to the promotion of the private interests of its members.

In Revenue Ruling 67-176, 1967-1, CB 140, the organization was formed to advance a given profession, contribute to the welfare and education of students preparing for that profession, to furnish financial aid to that profession in the form of grants and loans and to do other things for the benefit, welfare and security of its members. The ruling found that the emergency loan plan, among other activities served primarily as a convenience and for the economy of the members in providing financial aid, which is found to be the performance of particular services to members as opposed to improving a line of business. Thus, exemption under section 501(c)(6) was not afforded to the organization.

In Revenue Ruling 76-38, 1976-1 C.B. 157, the organization in question was formed to maintain the goodwill and reputation of the credit unions in a particular state. To achieve this goal, they maintained a fund for assistance to credit unions having financial difficulty to keep them solvent so that their members would not lose deposits upon liquidation. They allowed member credit unions to take interest free loans from the fund. The loans were to be repaid only if the borrowers were financially able to do so. The ruling found that the loan activities were not solely calculated to accomplish the objective of improving the industry’s image by protecting depositors. Further, the favorable terms of the loans to members was done in a manner that would provide little or no additional security to depositors and is clearly for the convenience (and economy) of the members in their business and does not constitute an exempt activity under section 501(c)(6).

In MIB, Inc. v. Commissioner, 734 F.2d 71 (1986), an organization whose membership consisted of insurance companies was denied exemption as a business league under section 501(c)(6) of the Internal Revenue Code. The principal activity carried on by MIB was the maintenance and operation of a computerized system for compiling, storing and distributing information about applicants for life insurance. MIB argued that its activities created a deterrent to fraud, which created benefits to the industry through reduced investigation expenses and reduced losses due to misclassification of applicants. The Court held MIB’s activities by their nature consisted of rendering particular services for individual member companies and served to benefit the individual members’ businesses. The Court also stated that even though the services produced various indirect and intangible benefits for the industry as a whole, the fact remained that the rendered services were in form and substance particular services for individual member companies. According to the Court in this case, the ultimate inquiry is whether the association’s activities advance the members’ interests generally, by virtue of their membership in the industry, or whether they assist members in the pursuit of their individual businesses.

APPLICATION OF THE LAW

You are not described within section 501(c)(6) of the Code as you are not a business league, chamber of commerce, real-estate board, board of trade, or professional football league. You are instead an entity that promotes shareholders’ interests in publicly traded corporations.

You are not operated as described in section 1.501(c)(6)-1 of the regulations because your activities are not directed to the improvement of business conditions of one or more lines of business. Rather, your activities provide particular services for individual persons. Additionally, because of the nature of your activities, you do not have a line of business to improve. Your members are individuals and institutions who are in various occupations and business. The only common interest is protecting and improving stockholders’ rights. All of your activities consist of promoting the exercise of the rights of shareholders of publicly traded corporations and offering members legal advice. Such programs constitute a particular service to individuals because you vote on behalf of the individuals who delegate their rights to you and provide legal advice to the shareholder who are in litigation with publicly traded corporations.

You state that you are improving the common interest of your member organizations that consist of economic and community development; thus, you qualify for exemption under section 501(c)(6) of the Code. However, there is no common interest since your members own shares of various publicly traded corporations that conduct all kinds of business. There is also no defined geographic area for the improvement of business conditions for a certain area because your members and the stock corporations are all over the world. Like Revenue Ruing 59-391, you are an organization composed of individuals, firms, associations, and corporations, each representing a different trade or business, having no common business interest other than to advocate for shareholder rights. For these reasons you do not meet the qualifications for a 501(c)(6) entity.

The organizations in Revenue Rulings 67-176 and 76-38, above, ran a fund for their members. The rulings conclude that it is the performance of particular services to members as opposed to improving a line of business since it is for the convenience and economy of the members. You are providing a specific service to your members through your programs. You provide direct services to your members for their convenience and economy because your purpose is to maximize members’ voice as a shareholder for the company in which the member owns stocks.

In MIB, Inc. v. Commissioner the Court found that even though services produced various indirect and intangible benefits for the industry as a whole, the fact remained that the rendered services were in form and substance particular services for individual member companies. Even if your programs bring some general benefits to the industry under which the companies perform, or benefits to various companies themselves operating under a common line of business, it still holds that programs and services are performed first to benefit your members. In advocating for shareholder rights you are benefitting members specifically, not generally, in pursuing their own interests. Because of this any indirect benefit to the industry does not overcome your main purpose of providing individualized service to members.

PROTEST FROM APPLICANT

You protested our initial adverse ruling in that first, certain facts were not accurate and second, you disagreed with the application of relevant law.

Regarding bullet point five, above, Facts section, you have indicated that you have not and will not provide legal services. Rather, you have petitioned for and prepared amicus curiae briefings, in this instance, regarding the case against C. You were not representing C, but were instead submitting protest to a position you felt could harm you or any U.S. shareholders. Any benefit received on the part of C was incidental and not intentional. You have filed no other briefs, but will do so in the future if the need arises. You have also canceled any attempt at forming any form of legal defense fund.

Regarding our positions stated in the Application of Law section, you disagree with the statement that you do not improve any line of business. The line of business you improve is that of equity finance of corporations and for investment by equity shareholders. You have cited the case of Associated Industries of Cleveland v. Commissioner, 7 TC 1449 (1946) in arguing your members share a common business interest. Petitioner in this case was an association of persons, firms and corporations with offices in Cleveland, OH, meeting to consider labor problems and difficulties confronting industry in that city following the first World War. Petitioner was a business league; members cooperated to employ labor under circumstances deemed advantageous.

You disagree with the position that your activities are not improving business conditions but are instead providing particular services to members. Your efforts are devoted towards communication among shareholders, and facilitating this communication is not a service to members but improves business conditions.

You disagree with the position that you have no defined geographic area in improving business. You focus exclusively on improving business conditions for equity investment in U.S. corporations.

You cited three other entities, all of which are exempt under 501(c)(6), and indicated similar goals and agendas, missions and operations.

SERVICE RESPONSE TO PROTEST FROM APPLICANT

Removing the activity of securing legal advice for shareholders does not change the primary reason for which you are formed, as this made up only * * *% of your total activities. The submission of briefs, which may serve to benefit your position or that of other shareholders, still serves no common business interest nor improves any particular line of business. The changing of this initial fact does not alter the position on our ruling.

You are different from the organization in Associated Industries in that you are advocating for all shareholders across the U.S, rather than employers in a particular city, and your members are individuals who hold stock in any company whereas the members of the organization in Associated Industries were workers and owners of businesses in one geographic area.

While you are improving communication among shareholders, this in and of itself improves no particular business conditions. It serves as a service to your members allowing them to share responsibility in serving proxies, when needed, and acting in place when they are unable to be personally present to protect or represent their interests.

The particular geographic area is not determinate in this particular case. Instead, it is the fact you are composed of individuals, firms, association and corporations, each representing a different trade or business, having no common interest other than to advocate for shareholder rights.

Regarding the entities you referenced currently exempt under 501(c)(6). The qualification of another entity is not a basis for a similar ruling as each application for exemption is determined on its own merits.

CONCLUSION

Based on the information submitted, your primary purpose is to promote shareholders’ interests in publicly traded corporations and provide legal advice to your members. Such activities do not improve business conditions along one or more lines of business or of a certain area but instead are services for the convenience of your members. Therefore, you do not qualify for exemption under IRC 501(c)(6).

You have the right to file a protest if you believe this determination is incorrect. To protest, you must submit a statement of your views and fully explain your reasoning. You must submit the statement, signed by one of your officers, within 30 days from the date of this letter.

We will consider your statement and decide if that information affects our determination. If your statement does not provide a basis to reconsider our determination, we will forward your case to our Appeals Office. You can find more information about the role of the Appeals Office in Publication 892, Exempt Organization Appeal Procedures for Unagreed Issues.

Types of information that should be included in your appeal can be found on page 2 of Publication 892, under the heading “Regional Office Appeal”. The statement of facts (item 4) must be declared true under penalties of perjury. This may be done by adding to the appeal the following signed declaration:

“Under penalties of perjury, I declare that I have examined the statement of facts presented in this appeal and in any accompanying schedules and statements and, to the best of my knowledge and belief, they are true, correct, and complete.”

Your appeal will be considered incomplete without this statement.

If an organization’s representative submits the appeal, a substitute declaration must be included stating that the representative prepared the appeal and accompanying documents; and whether the representative knows personally that the statements of facts contained in the appeal and accompanying documents are true and correct.

An attorney, certified public accountant, or an individual enrolled to practice before the Internal Revenue Service may represent you during the appeal process. To be represented during the appeal process, you must file a proper power of attorney, Form 2848, Power of Attorney and Declaration of Representative, if you have not already done so. For more information about representation, see Publication 947, Practice Before the IRS and Power of Attorney. All forms and publications mentioned in this letter can be found at www.irs.gov, Forms and Publications.

If you do not intend to protest this determination, you do not need to take any further action. If we do not hear from you within 30 days, we will issue a final adverse determination letter to you. That letter will provide information about filing tax returns and other matters.

Please send your protest statement, Form 2848 and any supporting documents to the applicable address:

Mail to:

Internal Revenue Service

EO Determinations Quality Assurance

Room 7-008

P.O. Box 2508

Cincinnati, OH 45201

Deliver to:

Internal Revenue Service

EO Determinations Quality Assurance

550 Main Street, Room 7-008

Cincinnati, OH 45202

You may also fax your statement using the fax number shown in the heading of this letter. If you fax your statement, please call the person identified in the heading of this letter to confirm that he or she received your fax.

If you have any questions, please contact the person whose name and telephone number are shown in the heading of this letter.

Sincerely,

Holly O. Paz

Director, Exempt Organizations

Rulings and Agreements




IRS LTR: IRS Revokes Exempt Status of Real Estate Trade Group.

Citations: LTR 201329023

The IRS revoked the tax-exempt status of a trade group that supports the real estate industry, saying it primarily engages in nonexempt activities and performs particular services for members.

Person to Contact/ID Number: * * *

Contact Numbers:

Voice: * * *

Fax: * * *

501-06.00

Release Date: 7/19/2013

Date: January 27, 2012

Taxpayer Identification Number: * * *

Form: * * *

Tax Years Ended: * * *

LEGEND:

ORG = Organization name

XX = Date

Address = address

Dear * * *:

In a determination letter dating from October 19XX, you were held to be exempt from Federal income tax under section 501(c)(6) of the Internal Revenue Code (the Code).

Based on recent information received, we have determined you have not operated in accordance with the provisions of section 501(c)(6) of the Code. Accordingly, your exemption from Federal income tax is revoked effective January 1, 20XX. This is a final adverse determination letter with regard to your status under section 501(c)(6) of the Code.

We previously provided you a report of examination explaining why we believe revocation of your exempt status is necessary. At that time, we informed you of your right to contact the Taxpayer Advocate, as well as your appeal rights. On September 23, 20XX, you signed Form 6018-A, Consent to Proposed Action, agreeing to the revocation of your exempt status under section 501(c)(6) of the Code.

You are required to file Federal income tax returns for the tax periods shown above. If you have not yet filed these returns, please file them with the Ogden Service Center within 60 days from the date of this letter, unless a request for an extension of time is granted, or unless an examiner’s report for income tax liability was issued to you with other instructions. File returns for later tax years with the appropriate service center indicated in the instructions for those returns.

You have the right to contact the Office of the Taxpayer Advocate. Taxpayer Advocate assistance is not a substitute for established IRS procedures, such as the formal Appeals process. The Taxpayer Advocate cannot reverse a legally correct tax determination, or extend the time fixed by law that you have to file a petition in a United States court. The Taxpayer Advocate can, however, see that a tax matter that may not have been resolved through normal channels gets prompt and proper handling. You may call toll-free, 1-877-777-4778, and ask for Taxpayer Advocate Assistance. If you prefer, you may contact your local Taxpayer Advocate at:

* * *

If you have any questions, please contact the person whose name and telephone number are shown at the beginning of this letter.

Sincerely,

Nanette M. Downing

Director, EO Examinations

* * * * *

Person to Contact/ID Number: * * *

Contact Numbers:

Telephone: * * *

Fax: * * *

501-06.00

Date: November 1, 2011

Employer Identification Number: * * *

LEGEND:

ORG = Organization name

XX = Date

Address = address

Dear * * *:

In a determination letter dated March 28, 19XX, you were held to be exempt from Federal income tax under section 501(c)(6) of the Internal Revenue Code (the Code).

Based on recent information received, we have determined you have not operated in accordance with the provisions of section 501(c)(6) of the Code. Accordingly, your exemption from Federal income tax is revoked effective January 1, 20XX. This is a final adverse determination letter with regard to your status under section 501(c)(6) of the Code.

We previously provided you a report of examination explaining why we believe revocation of your exempt status is necessary. At that time, we informed you of your right to contact the Taxpayer Advocate, as well as your appeal rights. On September 23, 20XX, you signed Form 6018-A, Consent to Proposed Action, agreeing to the revocation of your exempt status under section 501(c)(6) of the Code.

You are therefore required to file Form[s] 1120, U.S. Corporation Tax Return, for the year[s] ended December 31, 20XX, 20XX, and 20XX with the Ogden Service Center. For future periods, you are required to file Form 1120 with the appropriate service center indicated in the instructions for the return.

You have the right to contact the Office of the Taxpayer Advocate. Taxpayer Advocate assistance is not a substitute for established IRS procedures, such as the formal Appeals process. The Taxpayer Advocate cannot reverse a legally correct tax determination, or extend the time fixed by law that you have to file a petition in a United States court. The Taxpayer Advocate can, however, see that a tax matter that may not have been resolved through normal channels gets prompt and proper handling. You may call toll-free, 1-877-777-4778, and ask for Taxpayer Advocate Assistance. If you prefer, you may contact your local Taxpayer Advocate at:

* * *

If you have any questions, please contact the person whose name and telephone number are shown at the beginning of this letter.

Sincerely,

Nanette M. Downing

Director, EO Examinations

* * * * *

LEGEND:

ORG = Organization name

EIN = ein

XX = Date

State = state

CO-1, CO-2 & CO-3 = 1st, 2nd & 3rd COMPANIES

ISSUES

Whether this exempt organization’s (EO) activities permit it to continue to be exempt under § 501(c)(6).

FACTS

ORG (hereinafter, “ORG”) was formed with the filing of Articles of Incorporation with the State Corporation Commission on March 28, 19XX.

ORG is a subsidiary of the CO-1 and received its letter of exemption under § 501(c)(6) with an effective date of March 28, 19XX.

The purpose of the organization stated in the original Articles of Incorporation are:

(a) To unite those engaged in the recognized branches of the real estate profession in this community for the purpose of exerting the beneficial influence upon the profession and related interests.

(b) To promote and maintain high standards of conduct in the real estate profession as expressed in the code of Ethics of the CO-2.

(c) To provide a unified medium for real estate owners and those engaged in the real estate profession whereby they may be safe guarded and advanced.

(d) To further the interest of home and other real property ownership.

(e) To unite those engaged in the real estate profession in this community with a CO-1 and the CO-2, thereby furthering their own objectives throughout the state and nation, and obtaining the benefits and privileges of membership therein.

(f) To designate, for the benefit of the public, those individuals within its jurisdiction authorized to use the term Realtor and Realtor Associates as licensed, prescribed, and controlled by the CO-2.

ORG Articles of incorporation also contains the following:

Article XVIII — Multiple Listing

The CO-3® shall maintain for the use of it Members a Multiple Listing Service which shall be a lawful corporation of the state of STATE, all the stock of which shall be owned by the CO-3®.

Section 2. Purpose. A Multiple Listing Service is a means by which authorized Participants make blanket unilateral offers of compensation to other Participants (acting as subagents, buyer agents, or in other agency or nonagency capacities defined by law); by which disseminated to enable authorized Participants to prepare appraisals, analyses, and other valuations of real property for bona fide clients and customers; by which Participants engaging in real estate appraisal contribute to common databases; and is a facility for the orderly correlation and dissemination of listing information so participants may better serve their clients and the public. Entitlement to compensation is determined by the cooperating broker’s performance as a procuring cause of the sale (or lease). Amended 11/XX)

The activity pertinent to this discussion is the level of activities devoted to the multiple listing services (hereinafter, MLS) provided to the members of the Association.

There are six classes of members. Only licensed real estate agents, brokers and realtors can list property for sale on the MLS and see sold information within the database.

ORG maintains a committee on its board that is dedicated to the MLS program. The organization generated more income from the MLS than from it membership dues.

A prior examination of the ORG books and records by the Internal Revenue Service Tax Exempt & Government Entities: Exempt Organization Division in calendar year 20XX resulted in the organization being issued an Advisory Letter. The advisory issued cautioned the organization on the impact of its exempt status with regard to the level of non-exempt activities.

The organization prepared and filed Form 990-T for the tax year ending December 31, 20XX to report all unrelated business income.

The 20XX Form 990-EZ states that the organization’s primary purpose is “ORG”.

Information from the “EO” 20XX Form 990-EZ:

LAW

In Section 501(c)(6) of the Code, it defines business leagues, chambers of commerce, real-estate boards, boards of trade, or professional football leagues (whether or not administering a pension fund for football players), not organized for profit and no part of the net earnings of which inures to the benefit of any private shareholder or individual.

In Section 1.501(c)(6)-1 of the regulations, it provides that a business league is an association of persons having some common business interest the purpose of which is to promote such common interest and not to engage in a regular business of a kind ordinarily carried on for profit. It is an organization of the same general class as a chamber of commerce or board of trade. Thus, its activities should be directed to the improvement of business conditions of one or more lines of business as distinguished from the performance of particular services for individual persons. An organization, whose purpose is to engage in a regular business of a kind ordinarily carried on for profit, even though the business is conducted on a cooperative basis or produces only sufficient income to be self sustaining, is not a business league.

Section 1.513-1(b) of the regulations provides that the term “trade or business” for purposes of section 513 of the Code has the same meaning it has in section 162 and generally includes any activity carried on for the production of income from the sale of goods or services.

In section 1.513-1(d)(2) of the regulations, in defining unrelated trade or business provides that where the production or distribution of the goods or the performance of the services does not contribute importantly to the accomplishment of the exempt purposes of an organization, the income from the sale of the goods or the performance of the services does not derive from the conduct of related trade or business.

In Rev. Rul. 56-65, it states that a local organization whose principle activity consists of furnishing particular information and specialized individual services to its individual members through publications and other means is performing particular services for individual persons. Such an EO is therefore not entitled to exemption under § 501(c)(6).

Rev. Rul. 68-264 defines a particular service for the purposes of section 501(c)(6) of the Code as an activity that serves as a convenience or economy to the members of the organization in the operation of their own businesses.

In Rev. Rul. 59-234 it states, the purpose of a multiple listing service is:

(a) to assist members of the board in rendering better services to the public by creating a broader and more active market for real estate;

(b) to stimulate and facilitate the transaction of business between members of the board through cooperation and exchange of exclusive listings;

(c) to provide a medium through which real estate may be merchandised more efficiently and expeditiously to the advantage of both buyer and seller and

(d) to encourage realtors to uphold high standards of business practice and to further educate them in adhering to the principles of Realtor’s code of Ethics.

Rev Rul. 73-411 states, Trade associations or business leagues under section 501(c)(6) are similar to chambers of commerce, except that they serve only the common business interests of the members of a single line of business or of the members of closely related lines of business within a single industry.

Rev. Rul. 81-175 defines the term “particular services” for the purposes of section 501(c)(6) of the Code, as acting in a manner which provides an economy or a convenience for members in the operation of their own businesses.

In Retailers Credit Ass’n of Alameda County v. Commissioner of Internal Revenue 90 F.2d 47, C.A.9 1937. May 10, 1937, Exemption from petitioner from taxation must be denied on the ground that the purpose to engage in a business of a kind ordinarily carried on for profit is not incidental to a main or principal purpose, but is in fact a principal or main purpose.

In Southern Hardwood Traffic Ass’n v. U.S. 283 F.Supp. 1013 D.C.Tenn. 1968. March 13, 1968, the District Court, Bailey Brown, Chief Judge, held that unincorporated association engaged in regular business of providing, as one of its two main purposes and as substantial part of its total activity, majority of its members with individual services of kind ordinarily carried on for profit was not a ‘business league’ entitled to tax exempt status.

In Associated Master Barbers and Beauticians of America, Inc., 69 T.C. 53 (1977), the court held that an organization did not qualify as a tax-exempt business league because it both engaged in a regular business of a kind ordinarily carried on for profit and its activities were directed to the performance of particular services for individual members.

In Carolinas Farm & Power Equipment Dealers Ass’n, Inc. v. U.S. 699 F.2d 167, C.A.N.C., 1983. January 24, 1983, we must conclude that the Association’s insurance service primarily advances the interests of participating members, and so it is not related to its charitable purpose.

The presence of a single substantial nonexempt purpose can destroy the exemption regardless of the number of exempt purposes. Better Bus. Bureau v. United States, 326 U. S. 279. 283, 90 L. Ed. 67, 66 S. Ct. 112 (1945); Am. Campaign Acad. v. Commissioner, 92 T.C. 1056, 1065 (19XX).

TAXPAYER’S POSITION

ORG agrees that it is not entitled to exemption under section 501(c)(6) because its primary purpose is the daily operations of the Multiple Listing Services (MLS) in which * * *% of the organization’s activities are devoted too.

GOVERNMENT’S POSITION

ORG provides professional development, research, and exchange of information among its members.

ORG’s book and records demonstrates the Multiple Listing Services primarily advances the interests of participating members, and so it is not related to its exempt purpose.

In order to qualify for exemption as a business league under Reg. § 1.501(c)(6)-1, an exempt organization must meet all of 6 tests:

(1) Persons having a common business interest

(2) Whose purpose is to promote the common business interest

(3) Not organized for profit

(4) That does not engage in a business ordinarily conducted for profit

(5) Whose activities are directed at improvement of one or more lines of business as distinguished from the performance of particular services

(6) Of the same general class as a chamber of commerce or a board of trade

A review of the ORG books and records indicates the Association fail test 1, 4 and 5 under Reg. § 1.501(c)(6)-1.

ORG fails test (1) — Persons having a common business interest. Rev. Rul. 81-175 defines the term “particular services” for the purposes of section 501(c)(6) of the Code, as acting in a manner which provides an economy or a convenience for members in the operation of their own businesses. A review of the ORG books and record indicates its primary activity is operating a multiple listing service for its members, which is not a common business interest, but rather providing a convenience to members in the operation of their own businesses and thus performing particular services for members.

ORG fails test (4) — Not being engaged in a business ordinarily carried on for profit. The MLS is a database of homes for sale. Real Estate Agents use the MLS to find homes for buyers that they represent. Listing a home on the MLS notifies all local brokers that the home is for sale. If an agent other than the listing agent sees a listing and brings a buyer, the listing agent must pay the buyer’s agent a commission if the buyer accepts the offer. The commission is negotiated on an agent by agent basis. Services to members are an activity ordinarily conducted for profit. These services are of the same character of services provided by Real Estate firms. The membership dues may be construed as being of the same character as that of a professional charging a retainer fee against which future services are applied.

ORG fails test (5) Whose activities are directed at improvement of one or more lines of business as distinguished from the performance of particular services Rev. Rul. 81-175 defines the term “particular services” for the purposes of section 501(c)(6) of the Code, as acting in a manner which provides an economy or a convenience for members in the operation of their own businesses. ORG’s primary activity is providing member with a medium through which real estate may be merchandised more efficiently and expeditiously to the advantage of both buyer and seller. Operation of the MLS provides a convenience to members in the operation of their own businesses and thus is performing particular services for the members.

In Better Bus. Bureau v. United States, 326 U. S. 279. 283, 90 L. Ed. 67, 66 S. Ct. 112 (1945) and Am. Campaign Acad. v. Commissioner, 92 T.C. 1056, 1065 (19XX), it is stated that the presence of a single substantial nonexempt purpose can destroy the exemption regardless of the number of exempt purposes. In Associated Master Barbers and Beauticians of America, Inc., 69 T.C. 53 (1977), the court held that an organization did not qualify as a tax-exempt business league because it both engaged in a regular business of a kind ordinarily carried on for profit and its activities were directed to the performance of particular services for individual members.

The primary activity of providing a multiple listing services to members is an activity ordinarily carried on for profit and therefore is nonexempt. The EO’s primary activity is one involving providing particular services to individual members in providing member with a medium through which real estate may be merchandised more efficiently and expeditiously to the advantage of both buyer and seller which conflicts with the EO’s tax-exempt status.

Rev. Rul. 56-65 states that a local organization whose principle activity consists of furnishing particular information and specialized individual services to its individual members through publications and other means is performing particular services for individual persons. Such an EO is therefore not entitled to exemption under section 501(c)(6). The subject EO’s principle activity consists of furnishing particular and specialized individual services to its individual members through response to individual requests for human resource information specific to the individual member; the EO is therefore performing particular services for individual persons.

This organization fails three of the six tests under section 1.501(c)(6)-1 and as a result, is not entitled to remain exempt. The organization engages in primary nonexempt activities involving activities normally conducted for profit and performs particular services for members.

CONCLUSION

Based on the foregoing reasons, ORG does not qualify for exemption under section 501(c)(6) and its tax exempt status should be revoked effective January 1, 20XX.




IRS LTR: Homeowners Association Loses Exemption.

Citations: LTR 201329022

The IRS revoked the tax-exempt status of a homeowners association because its communal property isn’t made available to the general public, but the IRS determined that the organization may make an election to be treated as a taxable homeowners association under section 528.

Person to Contact/ID Number: * * *

Contact Numbers:

Phone: * * *

Fax: * * *

501-04.00

Date: July 7, 2012

Taxpayer Identification Number: * * *

Form: * * *

Tax Period(s) Ended: * * *

LEGEND:

ORG = Organization name

XX = Date

Address = address

Dear * * *,

In a determination letter dated June, 19XX, you were held to be exempt from Federal income tax under section 501(c)(4) of the Internal Revenue Code (the Code).

Based on recent information received, we have determined you have not operated in accordance with the provisions of section 501(c)(4) of the Code. Accordingly, your exemption from Federal income tax is revoked effective May 1, 20XX. This is a final letter with regard to your exempt status.

We previously provided you a report of examination explaining why we believe revocation of your exempt status was necessary. At that time, we informed you of your right to contact the Taxpayer Advocate, as well as your appeal rights. On [date] you signed Form 6018-A, Consent to Proposed Action, agreeing to the revocation of your exempt status under section 501(c)(4) of the Code.

You are required to file Federal income tax returns for the tax period(s) shown above. If you have not yet filed these returns, please file them with the Ogden Service Center within 60 days from the date of this letter, unless a request for an extension of time is granted. File returns for later tax years with the appropriate service center indicated in the instructions for those returns.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate assistance is not a substitute for established IRS procedures, such as the formal appeals process. The Taxpayer Advocate cannot reverse a legally correct tax determination, or extend the time fixed by law that you have to file a petition in a United States court. The Taxpayer Advocate can, however, see that a tax matter that may not have been resolved through normal channels gets prompt and proper handling. You may call toll-free, 1-877-777-4778, and ask for Taxpayer Advocate Assistance. If you prefer, you may contact your local Taxpayer Advocate at:

* * *

If you have any questions, please contact the person whose name and telephone number are shown at the beginning of this letter.

Thank you for your cooperation.

Sincerely,

Nanette M. Downing

Director, EO Examinations

* * * * *

Person to Contact/ID Number: * * *

Contact Numbers:

Telephone: * * *

Fax: * * *

Date: November 15, 2011

Taxpayer Identification Number: * * *

Form: * * *

Tax Period(s) Ended: * * *

LEGEND:

ORG = * * *

ADDRESS = * * *

Dear * * *,

We have enclosed a copy of the preliminary findings of our examination, explaining why we believe revocation of your exempt status under section 501(a) of the Internal Revenue Code (IRC) is necessary. Your organization may instead make an election to be treated as a taxable homeowner’s association under IRC § 528.

If you accept our findings, please sign and return the enclosed Form 6018-A, Consent to Proposed Action, to the individual listed above. We will then send you a final letter revoking your exempt status. Please also file Federal income tax return Form 1120-H for the tax year ending April 30, 20XX, with the individual listed above.

If you disagree with our findings, please provide in writing any additional information you believe may alter the findings. Your reply should include a statement of the facts, the applicable law, and arguments that support your position. Please also include any corrections to the facts that have been stated, if in dispute.

Upon receipt of your response, we will evaluate any additional information you have provided prior to issuing any final report of examination.

Please respond within 30 days from the date of this letter.

Thank you for your cooperation.

Sincerely,

Anne Jewell

Revenue Agent

Enclosure:

Form 886-A, Explanation of Items

Form 6018-A, Consent to Proposed Action

* * * * *

LEGEND:

ORG = Organization name

XX = Date

EIN = ein

State = state

County = county

POA = poa

Treasurer = treasurer

RA-1 = 1st RA

CO-1, CO-2, CO-3, CO-4 & CO-5 = 1ST, 2ND,

3RD, 4TH & 5TH COMPANIES

ISSUES

1. Does ORG (ORG) qualify as a tax exempt homeowners association under § 501(c)(4) of the Internal Revenue Code (IRC)?

2. Does ORG qualify as a for-profit homeowners association under IRC § 528?

3. What are the exempt and non-exempt function income and expenses as defined in IRC § 528?

4. If so, what are the tax implications of the revocation and reclassification of the organization under IRC § 528?

An alternative position based on if the organization continued to qualify as an organization exempt under IRC § 501(c)(4) is included at the end of the primary position.

FACTS

ORG, * * * (ORG) is currently classified as a tax-exempt organization under § 501(c)(4) of the Internal Revenue Code (IRC). Per the Articles of Incorporation (“Articles”), the organization was originally organized in State on October 3, 19XX. These Articles were later amended on October 3, 20XX to expand the stated purpose. The organization was created to “acquire, maintain and conduct building and property and activities for a community life and center at the ORG as above described, to engage in educational and recreational facilities for members; to acquire other property and construct buildings for such proposes; to foster and promote good citizenship among is members; to promote and foster educational, recreational; physical and social activities of its members and their friends; to engage in such activities as shall raise the standards of civic morality and community welfare.” The 19XX Articles were expanded with the following language during the 20XX revision, “ORG’s primary purpose is to own, repair, maintain, and improve the roads within the ORG, and to collect and disperse road maintenance fees related to the private roads within the plats of the Assessor’s Plat of ORG in Volume 16 of Plats, records of County, State, or in Volumes 17, 18, and 19 of said records, or any additions thereto as platted.”

The bylaws were also amended at this time. The current bylaws provide the following definition of a member:

“. . . any Property Owner who chooses to pay an annual membership fee established by the Board of Directors to ORG for the rights to enjoy ORG Member Properties and the secondary purposes of ORG as outlined in the Amended Articles of Incorporation.”

On October 22, 20XX, a Form 2848, Power of Attorney and Declaration of Representative, was received by the Internal Revenue Service allowing POA authority to discuss income tax for the tax periods ending April 30, 20XX through April 30, 20XX.

On September 20, 20XX, a Letter 3611 and Publication 1, Your Rights as a Taxpayer, and a Form 4564, Information Document Request (‘IDR”), were issued to notify the organization of an examination of the Form 990, Return of Organization Exempt from Income Tax, for the year ended April 30, 20XX. The initial appointment was held November 5, 20XX, at POA’s office. Treasurer, the Treasurer, and POA, POA, were present on behalf of the organization. The following is a summary of the relevant points of the initial interview (questions asked in bold and response in italics).

To get a full understanding of your organization, please describe the history of your organization and all of its activities.

The organization was started in 19XX as a group of owners who purchased property from the RA-1. The original plan had 1100 lots which were completely undeveloped and were mostly for tents. The mission is to manage and maintain the roads of ORG. The roads were later deeded to ORG. The organization has changed several times over the years based on who has had power over the board of directors. The organization has been involved in 2 major law suits. The first in 20XX was based around additional assessments made to replace a bridge, the organization won the right to make assessments against the owners based on a formula but the formula was not specified. According to the organization, this suit also stated that the organization was not a homeowners association under state law. The formula determined was based on how many of the main and side roads were used when accessing the properties. The second law suit was a class action suit against the owners of the organization who were not paying assessments. This suit validated the formula used before with minor changes to make it more fair. The new formula was * * *% the old formula and * * *% the assessed value of the property. The suit also allowed the organization to place liens or even foreclose on properties. The organization currently has 95 owners in collections. This case also allowed them to collect for administrative and legal costs.

The organization had a road budget of $$* * * and an Admin budget of $* * * ~ $* * * (used for bookkeeping and lawyers as the organization has no employees). The organization is also in the process of selling some of their properties (some gained through foreclosure and some were road accesses). The properties owned by the organization include two beach access points and a stretch of river beach.

What are the rules for non-owners being on the property?

The road is not open to the public except in limited ways. The CO-1 road to the first arch is public access and the organization has an easement across the land from the first arch to the second arch (~1.5 miles). ORG owns the roads while the CO-1 has an easement. Per the CO-1, the only people who should be on the roads after the first gate are owners or those on official CO-1 business. The remainder of the road is marked as being for property owners and guests only. There are signs on both arches which state that the road is private.

The organization requires stickers to be present on cars that enter the property. If the sticker is not present on the car, the organization will place a note on the car. When asked, the treasurer stated that usually if a person is on the property, they are instructed to carry out their business, leave the premises and that they are not to return.

Does the organization have a gate or security guard shack?

The organization does have a guard shack but it has not been used in years.

How commonly does the organization receive income from logging?

This happens once every 100 years or so and was not for the sale of lumber but instead was compensation for use of the roads. The organization was paid $$.00. The lumber company was required to pay repair costs for any damage done to the roads. Per the treasurer, the money was used to pay for flood damage and the class action lawsuit.

For what reason was the organization property logged?

The logging was occurring on the land on the other side of the property and the logging company had an easement across the organization in order to reach their property.

What access is given to the general public to view the waterfalls and the river?

The public are not given access to view the waterfalls and river. The waterfalls are located beyond the area with the CO-1 easement.

What benefit do you provide to the general public?

No benefit is provided to the public.

What are the requirements for being a property owner?

They must own property within the organization’s serviced area.

What classes of members or property owners are there and are there any differences in voting rights?

There are no classes of property owners and in order to vote you must be in good standing (have paid all assessments).

What are the dues & initiation fees for the various classes of members?

Assessments are between $$* * * and $$* * * a year based on the formula.

Does the organization own, lease or sublease any real property? If so, is the property encumbered by debt?

The organization owns roads and other properties. None are encumbered by debt.

Per the transcript of the class action law suit posted on the organization’s website, the organization is not primarily a membership based organization. The determination was made that the organization may solicit voluntary membership and dues for all purposes besides the maintenance of the roads.

The law suit establishes the validity of the agreement between ORG and the CO-1. This agreement establishes a basis for dues assessments to the ORG members to maintain the .6 of a mile that is owned by the CO-1.

The law suit finds that the administrative costs of the organization, including legal fees from this lawsuit, may be assessed against the owners.

The Class Action finds that the correct assessment formula would be * * *% of the implied easement formula (IE) and * * *% the assessed value of the property. The determination of commercial use of the property is also important as commercial activity increases traffic on the roads. The determination was made that a surcharge of $* * * per lot may be assessed for commercial use.

The minutes for the board meeting held March 7, 20XX, state that there was an issue with guests being on the property and being told that they were not allowed to have access to the property. The organization requires that owners display a sticker on their car to show that they are allowed to park on the property. Guests would receive a hanging tag. These plans were finalized January 9, 20XX with each owner receiving two guest tags with the option to purchase more for $* * * a pair. The minutes for June 6, 20XX state that a sign should be posted at CO-2 to notify non-residents that only residents and their guests may park on CO-3. Money was allocated for this activity.

During the tour of the facility, several posted signs were observed. The signs stated that the roads are private roads for owners only. Signs were observed on both the first and second arches.

The following are the income and expenses as reported by the organization.

Income Statement

Per further discussion, it was noted that the logging company owned property within the organization’s boundaries. The logging company paid a total of $$* * * as a “special assessment” for the use of the roads by the logging trucks. The logged area was located behind the land owned by the organization. The logging activity was in process from October 20XX through April 20XX, a total of 26 weeks.

Per the ORG response to an IDR dated January 4, 20XX, the organization noted two expenses which could be directly related to the existence of logging trucks on the roads. These expenses as shown below are for lumber and repairs on a bridge within the organization’s boundaries. The expenses were incurred in the next fiscal year, ten months after the end of the logging activity.

Per an ORG IDR response, there are a total of 405 property owners in the organization. Of these, 160 are permanent residents who are likely to drive on the roads an average of twice a day, once as they leave and once when they return.

The remaining 245 property owners are non-residents and more likely to use the roads on a more intermittent basis. On average, they may drive the roads twice per time in residence. Per the ORG IDR response, it is likely that the non-residents used the facility an average of 7 times during the six months that the logging company was using the roads.

Per the ORG IDR response, “A large logging truck does much more damage to a road than a passenger car or pickup truck. For purposes of this analysis, it is assumed that a logging truck does twice as much damage as a passenger car or pickup truck.”

ORG spent a total of $$* * * on road maintenance during the year ended April 30, 20XX.

LAW

IRC § 501(c)(4)

IRC § 501(c)(4)(A) holds that civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare, or local associations of employees, the membership of which is limited to the employees of a designated person or persons in a particular municipality, and the net earnings of which are devoted exclusively to charitable, educational, or recreational purposes.

It also requires that no part of the net earnings of such entity inures to the benefit of any private shareholder or individual.

Revenue Ruling 74-99, 1974-1 C.B. 131, modifies Rev. Rul. 72-102, to make clear that a homeowners’ association, oft the kind described in Rev. Rul. 72-102 must, in addition to otherwise qualifying for exemption under section 501(c)(4) of the Code, satisfy the following requirements: (1) It must engage in activities that confer benefit on a community comprising a geographical unit which bears a reasonably recognizable relationship to an area ordinarily identified as a governmental subdivision or a unit or district thereof; (2) It must not conduct activities directed to the exterior maintenance of private residences; and (3) It owns and maintains only common areas or facilities such as roadways and parklands, sidewalks and street lights, access to, or the use and enjoyment of which is extended to members of the general public and is not restricted to members of the homeowners’ association.

Flat Top Lake Ass’n, Inc v. US holds that an organization will not qualify for tax exempt status under IRC § 501(c)(4) if it restricts its facility and activities only to members. It sites Rev Rul 74-99 which states that a homeowner’s association must serve a “community” which bears a reasonably, recognizable relationship to an area ordinarily identified as a governmental subdivision or unit. Second it must not conduct activities directed to the exterior maintenance of any private residence, Third common areas or facilities that the homeowners’ association owns and maintains must be for the use and enjoyment of the general public.

IRC § 528

IRC § 528(a) holds that a homeowners association (as defined in subsection (c)) shall be subject to taxation under this subtitle only to the extent provided in this section. A homeowners association shall be considered an organization exempt from income taxes for the purpose of any law which refers to organizations exempt from income taxes. A tax is imposed for each taxable year on the homeowners’ association taxable income of every homeowners association. Such tax shall be equal to 30 percent of the homeowners’ association taxable income.

IRC § 528(c) defines a homeowners association as an organization which is a condominium management association, a residential real estate management association, or a timeshare association if such organization is organized and operated to provide for the acquisition, construction, management, maintenance, and care of association property, 60 percent or more of the gross income of such organization for the taxable year consists solely of amounts received as membership dues, fees, or assessment’s from owners of residences or residential lots in the case of a residential real estate management association, or 90 percent or more of the expenditures of the organization for the taxable year are expenditures for the acquisition, construction, management, maintenance, and care of association property and, in the case of a timeshare association, for activities provided to or on behalf of members of the association, no part of the net earnings of such organization inures (other than by acquiring, constructing, or providing management, maintenance, and care of association property, and other than by a rebate of excess membership dues, fees, or assessments) to the benefit of any private shareholder or individual, and such organization elects (at such time and in such manner as the Secretary by regulations prescribes) to have this section apply for the taxable year.

IRC § 528(c)(3) defines the term “residential real estate management association” as any organization meeting the requirements of subparagraph (A) of paragraph (1) with respect to a subdivision, development, or similar area substantially all the lots or buildings of which may only be used by individuals for residences.

IRC § 528(c)(5) defines “association property” as property held by the organization, property commonly held by the members of the organization, property within the organization privately held by the members of the organization, and property owned by a governmental unit and used for the benefit of residents of such unit.

IRC § 528(d) For purposes of this section, defines homeowners association taxable income as an amount equal to the excess (if any) of the gross income for the taxable year (excluding any exempt function income), over the deductions allowed by this chapter which are directly connected with the production of the gross income (excluding exempt function income). The section also allows for the following modifications, there shall be allowed a specific deduction of $100, no net operating loss deduction shall be allowed under Link section 172, and no deduction shall be allowed under part VIII of subchapter B (relating to special deductions for corporations).

IRC § 528(d)(3) defines “exempt function income” as any amount received as membership dues, fees, or assessments from owners of real property in the case of a residential real estate management association.

Federal Tax Regulations (Regulations) § 1.528-1., Homeowners associations

(c) Residential real estate management association. — Residential real estate management associations are normally composed of owners of single-family residential units located in a subdivision, development, or similar area. However, they may also include as members owners of multiple-family dwelling units located in such area. They are commonly formed to administer and enforce covenants relating to the architecture and appearance of the real estate development as well as to perform certain maintenance duties relating to common areas.

TAXPAYER’S POSITION

The taxpayer’s position is being solicited at this time.

GOVERNMENT’S POSITION

Issue #1

Does ORG (ORG) qualify as a tax exempt homeowners association under § 501(c)(4) of the IRC?

ORG does not qualify as a tax exempt homeowners association. Per the findings of Revenue Ruling 74-99 and Flat Top Lake Ass’n Inc v. U.S., there are three requirements for a homeowners association to be considered tax exempt under IRC § 501(c)(4). One, the organization must engage in activities that confer benefit on a community comprising a geographical unit which bears a reasonably recognizable relationship to an area ordinarily identified as a governmental subdivision or a unit or district thereof. Two, it must not conduct activities directed to the exterior maintenance of private residences. Finally, it must own and maintain only common areas or facilities such as roadways and parklands, sidewalks and street lights, access to, or the use and enjoyment of which is extended to members of the general public and is not restricted to members of the homeowners’ association.

The organization satisfies the first and second requirements for exemption but does not satisfy the third requirement The organization, as stated during the initial interview and seen during the tour of the road, does not allow members of the general public access to their road or the common areas maintained by the organization. As noted in the facts above, ORG will ask persons who do not have a parking decal or hanging tag not enter their property again. The organization also posted signs in several locations along the road which state that only members and their guests are allowed access to the road. As such, the communal property of ORG is not made available to the general public and the organization can not qualify under IRC § 501(c)(4).

Issue #2

Does ORG qualify as a for-profit homeowners association under IRC § 528?

Per their bylaws, ORG is organized as a for-profit homeowners association under IRC § 528, as a residential real-estate management association.

IRC § 528 defines a homeowners association as an organization which is organized and operated to provide for the acquisition, construction, management, maintenance, and care of association property. A residential real-estate management association is any organization meeting the requirements of a subdivision, development, or similar area substantially all the lots or buildings of which may only be used by individuals for residences.

Given the conclusion reached in Issue #1, ORG is operated to manage and maintain the roads of CO-3. Per the current articles of incorporation, the organizations primary purpose “is to own, repair, maintain, and improve the roads within the ORG, and to collect and disperse road maintenance fees related to the private roads within the plats of the Assessor’s Plat of ORG in Volume 16 of Plats, records of County, State, or in Volumes 17, 18, and 19 of said records, or any additions thereto as platted.” This furthers the argument that the organization is organized in such a way as to qualify for exemption under IRC § 528.

Issue #3

What are the exempt and non-exempt function income and expenses as defined in IRC § 528?

Per IRC § 528(d), the taxable income of a homeowners association is the gross income for the taxable year less any exempt function income and any deductions that are directly connected with the production of the gross income. IRC § 528(d)(3) further defines “exempt function income” as any amount received as membership dues, fees, or assessments from owners of real property in the case of a residential real estate management association.

As noted in the initial interview and the books and records of the organization, the organization receives the majority of their money from assessments made for road and administrative fees. These amounts would be considered “exempt function income” to an IRC § 528 organization. The organization’s purpose is to conduct activities which support the community as a whole rather than provide a specific benefit. To support this purpose the organization may impose annual or special assessments for road maintenance.

As noted in the initial interview, the organization also received $$* * * from a logging company for use of the road. This income was classified as a “special assessment.” The fundamental difference between a special assessment for road maintenance and the “special assessment” made against the logging company is in the purpose for which it is assessed. A valid special assessment would be assessed against the entire property owner community or a distinct portion of such community in order to pay for an unusual repair, such as the replacement of a culvert or to fix the damage from a flood. In comparison, the “special assessment” made against the logging company was not made in response to the need for an unusual repair, nor was it an assessment that was paid by any distinct portion of the community. The assessment was instead a payment for use of the road by an outside party to alleviate some of the cost of maintaining the road as well as paying for any additional costs associated with increased traffic. As such, this income would not be considered “exempt function income.”

The total exempt function income is $* * * in the year ended April 30, 20XX and $* * * in the year ended April 30, 20XX. The non-exempt function income includes all investment and other income that is not related to the exempt purpose of an IRC § 528 organization. This is income is as follows.

Non-Exempt Function Income

The Non-exempt function expenses are those expenses which are directly connected to the production of the non-exempt income. In this instance, while the organization may not deduct any portion of expenses from the interest income as it has not directly related expenses, it may deduct any expenses which are directly related to the income from the logging company. These expenditures have been allocated using the method below:

Per IRC § 528(d), the organization may deduct only those expenses which are directly related to the production of the non-exempt function income.

The organization identified the following transactions as directly related to damage caused by the logging trucks.

While these transactions are directly related to the unrelated business activity, they may not be deducted in the year ended April 30, 20XX as they were not incurred until the following year. However, these costs are fully deductable in the following year as valid road maintenance expenses.

The organization may deduct an allocated portion of the years total road maintenance expenses to the unrelated business activity. Using a slightly modified version of the allocation method provided by ORG, the road maintenance costs may be allocated using the estimated road use by logging trucks shown below.

Estimated Road use by Logging Trucks

The estimated number of trips made by logging trucks was calculated using the following calculation method provided by ORG.

Estimated number of Trips by Logging Trucks

The explanation for the damage severity factor per ORG is as follows, “A large logging truck does much more damage to a road than a passenger car or pickup truck. For purposes of this analysis, it is assumed that a logging truck does twice as much damage as a passenger car or pickup truck.” The organization used a damage severity factor of 3 to represent this increased damage.

The estimated number of trips by property owners was calculated using the following calculation method provided by ORG.

Estimated number of Trips by Property Owners

In addition to the allocation factor shown above, the agent also allocated the portion of road maintenance expenses that would have been incurred during the logging assuming that the maintenance expense was incurred evenly over the course of the year. This calculation has been shown below.

Allocated Total Maintenance Expenses

This maintenance cost figure is then multiplied by the estimated use by logging trucks to calculation the total maintenance expense allocable to the logging activity as shown below.

Given the above calculation the organization may deduct a total of $* * * from the income received from the logging trucks using the roads.

As such the total net non-exempt function income is shown in the following table.

Net Non-Exempt Function Income

Issue #4

If so, what are the tax implications of the revocation and reclassification of the organization under IRC § 528?

Given the conclusions reached in Issues #1 through 3, the organization can possibly qualify as an organization exempt under IRC § 528. However, this Code section requires that in any given year the organization have either 60% of the total income of the organization consist of membership dues, fees, or assessments from owners of residences or residential lots, or 90% or more of the expenditures of the organization are for the acquisition, construction, management, and care of association property.

ORG, given the income statement shown above, has the following percentages of income from membership dues, fees and assessments.

Percentage of Exempt Function Income

As noted in the figures above, the organization meets the 60% exempt function income test in only the year ended April 30, 20XX. The year ended April 30, 20XX, did not qualify due to the non-exempt function income received from the logging company.

ORG, given the income statement above, has the following percentages of expenditures made for the acquisition, construction, management, maintenance, and care of association property. This figure includes all expenditures made including those made as a result of the logging trucks using the road.

Percentage of Exempt Function Expenditures

The organization also does not qualify for this Code section under the expenditure test as in nether year do they meet the 90% requirement. As such, the organization may not make the election to be treated as a homeowners association under IRC § 528 for the year ended April 30, 20XX but may for the year ended April 30, 20XX.

IRC § 528(d) defines a homeowners association taxable income as the amount equal to the excess (if any) of the gross income, less the exempt function income, for the taxable year, less any deductions which are directly connected with the production of those non-exempt activities. Exempt function income is defined as any membership dues, fees, or assessments from owners of real property.

The calculation of taxable income for the year ended April 31, 20XX has been shown in the first table below and includes investment income and any additional income that is received by the organization in a given year.

Form 1120-H

U.S. Income Tax Return for Homeowners Associations

For Year Ended April 31, 20XX

The second table calculates the taxable income for the year ended April 31, 20XX as that year does not qualify for the IRC § 528 election. This has been calculated using the corporate tax rate.

Form 1120

U.S. Corporation Income Tax Return

For Year Ended April 31, 20XX

CONCLUSION

As noted in the above analysis, the organization does not qualify for exemption under § 501(c)(4) of the IRC but does qualify under IRC § 528 as a taxable homeowners association for the year ended April 30, 20XX. As such, the organization may make an election in the year ended April 30, 20XX and all subsequent years when filing the Form 1120, to instead file the Form 1120-H if they continue to qualify. In the year ended April 30, 20XX, the organization would be assessed $* * * in income tax.

In the year ended April 30, 20XX, the organization does not qualify for exemption under either IRC § 501(c)(4) or § 528. As such, they must file Form 1120 for the year in question. The tax to be assessed in the prior year would be $* * *.

Treatment under IRC § 528 is an election made every year upon the filing of the tax return. An organization may qualify for exemption in one year but not the next due to unusual income. As such, the total tax to be assessed against the organization is $* * *.

ALTERNATIVE POSITION

In the alternative, if the organization continues to qualify for exemption under IRC § 501(c)(4), should the income from logging truck using the road received by the organization in the year ended April 30, 20XX be considered unrelated businesses income under IRC § 511.

ISSUES

1. Is the revenue received from the logging company related to the exempt purpose of the organization?

2. If not, what expenses may be allocated to the unrelated business income?

3. What is the total unrelated business income tax due?

FACTS

On September 20, 20XX, a Letter 3611 and Publication 1, Your Rights as a Taxpayer; and a Form 4564, Information Document Request (IDR) were issued to notify the organization of an examination of the Form 990, Return of Organization Exempt From Income Tax, for the year ended April 31, 20XX. The initial appointment was held November 5, 20XX at the Power of Attorney’s Office. Treasurer, the Treasurer, and POA, POA, were present on behalf of the organization. The following is a summary of the relevant points of the initial interview in relation to the income from the Logging activity.

How commonly does the organization receive income from logging?

This happens once every 100 years or so and was not for the sale of lumber but instead was compensation for use of the roads. The organization was paid $* * * as well as the lumber company fixing any damage done to the roads. Per the treasurer, the money was used to pay for flood damage and the class action lawsuit.

For what reason was the organization property logged?

The logging was happening on the land on the other side of the property and the logging company had an easement across the organization in order to reach their property.

Per further discussion, it was noted that the logging company owned property within the organization and paid a total of $$* * * as a “special assessment” for the use of the roads by the logging trucks. The area being logged is behind the area owned by the organization. The logging activity was in process from October 20XX through April 20XX, a total of 26 weeks.

Per the Information Document Request (IDR) response dated January 4, 20XX, the organization noted two expenses which could be directly related to the existence of logging trucks on the roads. These expenses as shown below are for lumber and repairs on a bridge within the organization. The expenses were incurred in the next fiscal year, ten months after the end of the logging activity.

Per IDR response, there are a total of 405 property owners in the organization. Of these 160 are permanent residents who are likely to drive the roads an average of twice a day, once as they leave and once when they return.

The remaining 245 property owners are non residents and more likely to use the roads on a more intermittent basis. On average, they may drive the roads twice per time in residence. Per the ORG, it is likely that the non-residents used the facility an average of 7 times during the six months that the logging company was using the roads.

Per ORG, “A large logging truck does much more damage to a road than a passenger car or pickup truck. For purposes of this analysis, it is assumed that a logging truck does twice as much damage as a passenger car or pickup truck.”

ORG spent a total of $$* * * on road maintenance during the year ended April 30, 20XX. ORG did not file a Form 990-T for the period in question.

LAW

IRC § 512(a)(1) provides that the term “unrelated business taxable income” means the gross income derived by any organization from any unrelated trade or business regularly carried on by it, less the deductions which are directly connected with the carrying on of such trade or business.

Treasury Regulations (Regulations) § 1.512(a)-1(a) defines “unrelated business taxable income” as the gross income derived from any unrelated trade or business regularly carried on, less those deductions allowed by chapter 1 of the Code which are directly connected with the carrying on of such trade or business, subject to certain modifications referred to in § 1.512(b)-1. To be deductible in computing unrelated business taxable income, therefore, expenses, depreciation, and similar items not only must qualify as deductions allowed by chapter 1 of the Code, but also must be directly connected with the carrying on of unrelated trade or business. Except as provided in paragraph (d)(2) of this section, to be “directly connected with” the conduct of unrelated business for purposes of section 512, an item of deduction must have proximate and primary relationship to the carrying on of that business. In the case of an organization which derives gross income from the regular conduct of two or more unrelated business activities, unrelated business taxable income is the aggregate of gross income from all such unrelated business activities less the aggregate of the deductions allowed with respect to all such unrelated business activities. For the treatment of amounts of income or loss of common trust funds, see § 1.584-2(c)(3).

Regulations § 1.512(a)-1(b) defines expenses, depreciation, and other similar items that are attributable solely to the conduct of unrelated business activities as those which are proximately and primarily related to that business activity. Such expenses qualify for deduction to the extent that they meet the requirements of IRC § 162, IRC § 167, or other relevant section of the Internal Revenue Code. Thus, the wages of personnel employed full-time in carrying on unrelated business activates are directly connected with the conduct of said activity and are deductable in computing unrelated business taxable income if they otherwise qualify under the requirements of IRC § 162.

Regulations § 1.512(a)-1(c) provides that when facilities or personnel are used for both exempt activities and the conduct of an unrelated trade or business, expenses, depreciation, and similar items shall be allocated between the two activities on a reasonable basis. The portion of any such item so allocated to the unrelated trade or business is proximately and primarily related to that business activity and shall be allowable as a deduction in computing unrelated business taxable income to the extent provided by IRC § 162, IRC § 167, or other relevant Code section.

TAXPAYER’S POSITION

The taxpayer’s position is unknown at this time.

GOVERNMENT’S POSITION

ISSUE # 1

Is the revenue received from the logging company related to the exempt purpose of the organization?

The income received from the logging company is not related to the exempt purpose of the organization.

Per the Bylaws of the organization, the organization is organized “acquire, maintain and conduct building and property and activities for a community life and center at the ORG as above described, to engage in educational and recreational facilities for members; to acquire other property and construct buildings fur such proposes; to foster and promote good citizenship among is members; to promote and foster educational, recreational; physical and social activities of its members and their friends; to engage in such activities as shall fraise the standards of civic morality and community welfare.” As such, the organizations purpose is to conduct activities which support the community as a whole rather than provide a specific benefit. To support this purpose the organization may impose annual or special assessments for road maintenance.

The fundamental difference between a special assessment for road maintenance and the “special assessment” made against the logging company is in the purpose for which it is assessed. A valid special assessment would be assessed against the entire property owner community or a distinct portion of such community in order to pay for an unusual repair, such as the replacement of a culvert or to fix the damage from a flood. In comparison, the “special assessment” made against the logging company was not made in response to the need for an unusual repair, nor was it an assessment that was paid by any distinct portion of the community. The assessment was instead a payment for use of the road by an outside party to alleviate some of the cost of maintaining the road as well as paying for any additional costs associated with increased traffic.

As such, the $$* * * paid by the logging company was a payment for use rather than a valid assessment and is therefore unrelated to the exempt purpose of a IRC § 501(c)(4) homeowner’s organization.

ISSUE #2

If not, what expenses may be allocated to the unrelated business income?

Per IRC § 512(a)(1), the organization may deduct only those expenses which are directly related to the production of the unrelated business income.

The organization identified the following transactions as directly related to damage caused by the logging trucks.

While these transactions are directly related to the unrelated business activity, they may not bee deducted in the year ended April 30, 20XX as they were not incurred until the following year. However, these costs are fully deductable in the following year as valid road maintenance expenses.

The organization may take deduction of a portion of the years total road maintenance expenses as allocated to the unrelated business activity. Using a slightly modified version of the allocation method provided by ORG, the road maintenance costs may be allocated using the estimated road use by logging trucks shown below.

Estimated Road use by Logging Trucks

The estimated number of trips made by logging trucks was calculated using the following calculation method provided by ORG.

Estimated number of Trips by Logging Trucks

The explanation for the damage severity factor per ORG is as follows, “A large logging truck does much more damage to a road than a passenger car or pickup truck. For purposes of this analysis, it is assumed that a logging truck does twice as much damage as a passenger car or pickup truck.” The organization used a damage severity factor of 3 to represent this increased damage. The agent disagrees with the damage factor used by the organization as it would represent three times as much damage rather than twice as much damage. As such, the agent has used 2 as the damage factor.

The estimated number of trips by property owners was calculated using the following calculation method provided by ORG.

Estimated number of Trips by Property Owners

In addition to the allocation factor shown above, the agent also allocated the portion of road maintenance expenses that would have been incurred during the logging assuming that the maintenance expense was incurred evenly over the course of the year. This calculation has been shown below.

Allocated Total Maintenance Expenses

This maintenance cost figure is then multiplied by the estimated use by logging trucks to calculation the total maintenance expense allocable to the logging activity as shown below.

Given the above calculation the organization may deduct a total of $* * * from the income received from the logging trucks using the roads.

ISSUE # 3

What is the total unrelated business income tax due?

Per the calculations shown in Issue #1 and 2, the organization owes $* * * in unrelated business income tax. This figure has been calculated as follows: Unrelated business income tax is a * * *% tax on the unrelated income less any directly related expenses.

Allocation of Income and Expenses from the Logging Company

Unrelated Business Income Tax

CONCLUSION

ORG allowed a logging company to use their roads for a fee. As this transaction is not typical of organizations defined under IRC § 501(c)(4) it is considered to be unrelated to the exempt purpose of the organization and is therefore subject to Unrelated Business Income Tax In this case the total tax due was calculated at $* * * for the transaction in question.




IRS LTR: University's Tax-Exempt Status Is Revoked.

Citations: LTR 201329020

The IRS revoked the tax-exempt status of an online university, concluding that the university’s net earnings routinely and continuously inured to its president, vice president, and secretary.

Person to Contact: * * *

Employee Identification Number: * * *

Employee Telephone Number:

(Phone): * * *

(Fax): * * *

501-03.00

Release Date: 7/19/2013

Date: January 7, 2013

Taxpayer Identification Number: * * *

LEGEND:

ORG = organization name

xx = Date

Address = address

Officer — 1-3 = 1st, 2nd & 3rd Officer

Dear * * *:

This is a final adverse determination regarding your exempt status under section 501(c)(3) of the Internal Revenue Code. Our favorable determination letter to you dated February 3, 20XX is hereby revoked and you are no longer exempt under section 501(a) of the Code effective January 1, 20XX.

The revocation of your exempt status was made for the following reason(s):

Organizations described in IRC 501(c)(3) and exempt under section 501(a) must be both organized and operated exclusively for exempt purposes. You must establish that you are operated exclusively for exempt purposes and that no part of your net earnings inures to the benefit of private shareholders or individuals.

Your earnings have inured to the benefit of three of your officers, Officer-1, Officer-2, and Officer-3. This inurement totaled $* * * during the years 20XX, 20XX, and 20XX. This is a substantial amount of inurement, and violates section 1.501(c)(3)-1(c)(2) of the Treasury Regs. Given the routine and continuous nature of the inurement, this warrants revocation of your 501(c)(3) status effective January 1, 20XX.

Contributions to your organization are no longer deductible under IRC § 170 after January 1, 20XX.

You are required to file income tax returns on Form 1120. These returns should be filed with the appropriate Service Center for the tax year ending December 31, 20XX, and for all tax years thereafter in accordance with the instructions of the return.

Processing of income tax returns and assessments of any taxes due will not be delayed should a petition for declaratory judgment be filed under section 7428 of the Internal Revenue Code.

If you decide to contest this determination under the declaratory judgment provisions of section 7428 of the Code, a petition to the United States Tax Court, the United States Claims Court, or the district court of the United States for the District of Columbia must be filed before the 91st Day after the date this determination was mailed to you. Please contact the clerk of the appropriate court for rules regarding filing petitions for declaratory judgments by referring to the enclosed Publication 892. You may write to the United States Tax Court at the following address:

* * *

You also have the right to contact the Office of the Taxpayer Advocate. Taxpayer Advocate assistance is not a substitute for established IRS procedures, such as the formal Appeals process. The Taxpayer Advocate cannot reverse a legally correct tax determination, or extend the time fixed by law that you have to file a petition in a United States court. The Taxpayer Advocate can, however, see that a tax matter that may not have been resolved through normal channels gets prompt and proper handling. You may call toll-free, 1-877-777-4778, and ask for Taxpayer Advocate Assistance. If you prefer, you may contact your local Taxpayer Advocate at:

* * *

If you have any questions, please contact the person whose name and telephone number are shown in the heading of this letter.

Sincerely,

Nanette M. Downing

Director, EO Examinations

* * * * *

Person to contact/ID number: * * *

Contact numbers: * * *

Manager’s name/ID number: * * *

Manager’s contact number: * * *

Response due date: * * *

Date: July 24, 2012

Taxpayer Identification Number: * * *

Form: * * *

Tax year(s) ended: * * *

LEGEND:

ORG = * * *

ADDRESS = * * *

Dear * * *:

WHY YOU ARE RECEIVING THIS LETTER

We propose to revoke your status as an organization described in section 501(c)(3) of the Internal Revenue Code (Code). Enclosed is our report of examination explaining the proposed action.

WHAT YOU NEED TO DO IF YOU AGREE

If you agree with our proposal, please sign the enclosed Form 6018, Consent to Proposed Action — Section 7428, and return it to the contact person at the address listed above (unless you have already provided us a signed Form 6018). We’ll issue a final revocation letter determining that you aren’t an organization described in section 501(c)(3).

After we issue the final revocation letter, we’ll announce that your organization is no longer eligible for contributions deductible under section 170 of the Code.

IF WE DON’T HEAR FROM YOU

If you don’t respond to this proposal within 30 calendar days from the date of this letter, we’ll issue a final revocation letter. Failing to respond to this proposal will adversely impact your legal standing to seek a declaratory judgment because you failed to exhaust your administrative remedies.

EFFECT OF REVOCATION STATUS

If you receive a final revocation letter, you’ll be required to file federal income tax returns for the tax year(s) shown above as well as for subsequent tax years.

WHAT YOU NEED TO DO IF YOU DISAGREE WITH THE PROPOSED REVOCATION

If you disagree with our proposed revocation, you may request a meeting or telephone conference with the supervisor of the IRS contact identified in the heading of this letter. You also may file a protest with the IRS Appeals office by submitting a written request to the contact person at the address listed above within 30 calendar days from the date of this letter. The Appeals office is independent of the Exempt Organizations division and resolves most disputes informally.

For your protest to be valid, it must contain certain specific information including a statement of the facts, the applicable law, and arguments in support of your position. For specific information needed for a valid protest, please refer to page one of the enclosed Publication 892, How to Appeal an IRS Decision on Tax-Exempt Status, and page six of the enclosed Publication 3498, The Examination Process. Publication 3498 also includes information on your rights as a taxpayer and the IRS collection process. Please note that Fast Track Mediation referred to in Publication 3498 generally doesn’t apply after we issue this letter.

You also may request that we refer this matter for technical advice as explained in Publication 892. Please contact the individual identified on the first page of this letter if you are considering requesting technical advice. If we issue a determination letter to you based on a technical advice memorandum issued by the Exempt Organizations Rulings and Agreements office, no further IRS administrative appeal will be available to you.

CONTACTING THE TAXPAYER ADVOCATE OFFICE IS A TAXPAYER RIGHT

You have the right to contact the office of the Taxpayer Advocate. Their assistance isn’t a substitute for established IRS procedures, such as the formal appeals process. The Taxpayer Advocate can’t reverse a legally correct tax determination or extend the time you have (fixed by law) to file a petition in a United States court. They can, however, see that a tax matter that hasn’t been resolved through normal channels gets prompt and proper handling. You may call toll-free 1-877-777-4778 and ask for Taxpayer Advocate assistance. If you prefer, you may contact your local Taxpayer Advocate at:

Internal Revenue Service

Office of the Taxpayer Advocate

* * *

FOR ADDITIONAL INFORMATION

If you have any questions, please call the contact person at the telephone number shown in the heading of this letter. If you write, please provide a telephone number and the most convenient time to call if we need to contact you.

Thank you for your cooperation.

Sincerely,

Nanette M. Downing

Director, EO Examinations

Enclosures:

Report of Examination

Form 6018

Publication 892

Publication 3498

* * * * *

LEGEND:

ORG = Organization name

XX = Date

Address = address

City = city

State = state

President = president

Vice-President = vice president

Secretary = secretary

CPA = CPA

Founder = founder

RA-1 = 1st RA

CO-1 through CO-11 = 1st through 11th COMPANIES

ISSUE

Should ORG’S 501(c)(3) status be revoked on the grounds that its net earnings inured to the benefit of its president, vice-president, and secretary?

FACTS

ORG, formerly known as CO-1 (“ORG”), is an online university. Its corporate office is located at Address, City, State. It offers degrees in * * * and * * *. Its enrollment was approximately 200 students during the years under examination. ORG also conducts live training seminars approximately 30 times throughout each school year. These seminars are held in locations throughout the United States and Canada.

During the years under examination, ORG’s president and vice-president were President and Vice-President (husband and wife), respectively. ORG’s board secretary was Secretary.

ORG filed with the IRS a Form 1023, Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, on May 13, 20XX. On February 3, 20XX, the IRS issued a ruling letter to ORG, recognizing it as a tax-exempt public charity under section 501(c)(3) of the Internal Revenue Code (“Code”), effective April 26, 20XX.

On April 28, 20XX, ORG filed a Plan of Conversion with the State of State to convert back to for-profit status as of June 1, 20XX. The State of State certified this conversion. According to a valuation prepared by CO-2 ORG’s value was appraised to be zero. This was primarily due to ORG’s outstanding debt of $$* * * to CO-3 (“CO-3”). President owns * * *% of CO-3’s stock. At conversion, the debt was extinguished in exchange for ORG’s stock. ORG formally changed its name from CO-1 to ORG on December 13, 20XX.

The examining IRS agent contacted ORG president President on December 8, 20XX and advised him of the audit of ORG’s year 20XX Form 990. The agent mailed the audit letter to ORG on December 10, 20XX. The agent conducted the field audit at the City office of ORG’s representative, CPA, CPA on January 10, 20XX. CPA was replaced as representative by CPA, CPA, on March 2, 20XX.

BACKGROUND OF ORG

ORG operated as a for-profit corporation from 19XX until 20XX. ORG was incorporated in City, State on December 13, 19XX. It was a correspondence school organized to train individuals in various self-improvement techniques developed by its founder, Founder. Founder is the father of President.

CO-3 was ORG’s predecessor. It was incorporated November 12, 19XX as a for-profit State corporation. All of the rights, title and interest in programs, training, books, recordings and videos were held either by CO-3 or Founder, personally. Ownership of CO-3 passed from Founder to President in 20XX.

According to ORG’s meeting minutes dated September 18, 20XX, ORG’s board voted unanimously to remove Founder from his position as president of the board of ORG. President was voted to take the position as president.

Following Founder’ termination, he demanded that ORG and CO-3 cease using his registered marks, name and likeness. ORG and CO-3, however, continued to use his marks, name and likeness in their print advertisements and on their web sites. As a result, President brought suit against ORG, CO-3, President, and Vice-President. Founder was granted a Motion for Temporary Restraining Order on March 6, 20XX.

Forms 990 and Payments to Officers

ORG’s Forms 990 for the years under examination reported as follows:

Figure 1: Forms 990

Among the disbursements ORG made during the years under examination were the following:

Figure 2 — Payments 20XX

Figure 3 — Payments 20XX

Figure 4 — Payments 20XX

Secretary’ City Apartment

The payments to CO-4, in 20XX and 20XX, were for ORG board secretary Secretary’ apartment at Address in City, State. ORG did not report these payments as compensation to Secretary on its own Forms 990, or on Secretary’ Forms W2.

The revenue agent asked ORG, in Information Document Request (“IDR”) #3, issued March 16, 20XX, the following question regarding these payments:

Question: What was the reason for not including the value of the City apartment in the W2 of Secretary as a fringe benefit?

ORG’s response to IDR #3, received May 16, 20XX, included the following answer to the above question:

Answer: We did not include the value of the City apartment in the W2 of Secretary due to an oversight. We would be issuing a 1099 for this.

On December 13, 20XX, Secretary sent the agent an email regarding the $$* * * in apartment payments in the year 20XX, which stated as follows:

Unfortunately, I was unable to locate the email correspondence via my old laptop as the PC was non-functional. I had hoped to find the email stating that I was accepting the position with the information included that housing was a condition of employment. As such, for now, I have paid the $$* * * to ORG and have attached evidence of this.

Attached to the email was a scanned check written by Secretary to ORG for $$* * *, and a scanned letter from ORG, signed by President, acknowledging receipt of the check.

On February 8, 20XX, Secretary sent the agent an email regarding the $$* * * in apartment payments in the year 20XX, which stated as follows:

ORG did not report the payment to me of the apartment I resided in as compensation. As I stated in my earlier correspondence with you, as well as, via telephone, provision of housing was offered by the university as part of my original offer of employment. I also indicated to you previously, that the correspondence which references this is unavailable.

There is no discussion in ORG’s Board Meeting minutes of paying for Secretary’ apartment as part of her compensation or as a condition of her working for ORG.

Payments to President and Vice-President

The agent requested source documents (e.g. invoices or receipts) to support the payments made to President and Vice-President in 20XX via IDRs #2 and #3. ORG did not initially provide any source documents.

With respect to check #* * * for $* * * ORG stated that $* * * of this went to President “for his 20th anniversary gift in 20XX, to be included in his 20XX payroll”. ORG stated that the other $* * * went to Vice-President “for her 10th anniversary gift in 20XX, included in her 20XX payroll”.

Regarding the $* * * payment to CO-5, ORG’s explanation was as follows:

The payment to CO-5 was classified as consulting fee due to the styling, makeup and other tips they were giving us during the big public relations push to increase marketing. Once we understood the styling tips there were (sic) no need for their services anymore. Their services include hair maintenance and make up services. These were for the benefit of President, President and Lead Trainer.

With respect to check #* * * for $* * *, ORG stated that $* * * of it went to two employees’ payroll, and the other $* * * went to Vice-President for “personal” purposes. ORG stated that this amount was “to be included in her 20XX payroll”.

On October 11, 20XX, the agent sent reports to President and Vice-President, proposing excise taxes on excess benefit transactions (“EBTs”), as described in Code section 4958, for the year 20XX disbursements shown in Figure 2, above.

On January 17, 20XX, CPA responded to the reports on behalf of the President and Vice-President1. The response had attached to it five “employee expense reports”, none of which are legible. It also had attached about 30 receipts, many of which are also not legible. The response included the following statements:

Taxpayers will agree to reimburse the Company for $* * * for the watch that was purchased for Vice-President.

Taxpayers will agree to reimburse the Company for the $$* * * 20th Anniversary gift to President.

The response argued that the $$* * * payment to CO-5 was justified because, at the time, President was having to make TV appearances to talk about RA-1 (a former ORG student) and the deaths at his State sweat lodge, in an effort to save ORG’s public image. The examining agent later viewed footage of President’ TV appearances, including one on the CO-6 show.

The response argued that the $$* * * of the $$* * * from check ##* * * that went to Vice-President was included in her reported 20XX compensation prior to the examining agent’s January 10, 20XX initial audit appointment, and that it should therefore not be included in EBTs.

Finally, the response went on to state that the President and Vice-President could only produce $$* * * of the requested receipts2. It argued, however, that all of the remaining disbursements to the President and Vice-President were for reimbursements of travel expenses related to conducting ORG’s exempt activities, and that the per diem for the dates and locations of this travel amounts to $$* * * for President and $$* * * for Vice-President. The response argues that these per diem amounts, when added to the receipts, comes to $$* * * ($$* * * + $$* * * + $$* * *) and that, compared to this amount, the disbursements made to the President and Vice-President in the year 20XX were reasonable.

On March 26, 20XX, the agent requested source documents to support the disbursements to the President and Vice-President in 20XX and 20XX (in Figures 3 and 4) via IDRs #6 and #7. On May 10, 20XX, ORG responded by providing a CD with a number of receipts and invoices. Many of these receipts are either illegible or bear no relationship to carrying out ORG’s exempt activities. For example, ORG submitted, in support of checks #* * * and #* * *, two receipts from CO-7, a luxury watch dealer in City, State and City, State. The receipts reflect the purchase of four Rolex watches; two “Oyster” models” one “Yachtmaster”, and one “Submariner”, totaling $$* * *. For check #* * *, ORG submitted $$* * * in receipts from CO-8, CO-9, and the CO-10 boutique in City. In support of check #* * *, ORG produced a receipt for a $$* * * CO-11 men’s bag.

The agent reviewed all legible receipts that could conceivably be related to ORG’s exempt activities, and subtracted them from the corresponding disbursements in Figures 3 and 4. The detailed analysis of valid and invalid receipts is attached as Exhibit A. The results are as follows:

Figure 5 — Unsubstantiated Payments 20XX

Figure 6 — Unsubstantiated Payments 20XX

Figure 7 — Unsubstantiated Payments 20XX

LAW

Internal Revenue Code

Section 501(c)(3) of the Internal Revenue Code provides for exemption from Income Tax for corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual.

Section 4958(c) defines the term “excess benefit transaction” as any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit. For purposes of the preceding sentence, an economic benefit shall not be treated as consideration for performance of services unless such organization clearly indicated its intent to so treat such benefit.\

Section 4958(e) defines “applicable tax-exempt organization” as an organization described in either section 501(c)(3) or 501(c)(4) of the Internal Revenue Code or an organization which was so described at any time during the five-year period ending on the date of the excess benefit transaction.

Section 4958(f)(1) defines a “disqualified person” as (A) any person who was, at any time during the five-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization, (B) a member of the family of a disqualified person, and (C) a 35% controlled entity.

Section 4958(f)(6) of the Code defines “correction”, with respect to any excess benefit transaction, as the undoing of the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.

Treasury Regulations

Section 1.501(c)(3)-1(a)(1) of the Treasury Regulations (“Regs”) provides that, in order to be exempt as an organization described in Section 501(c)(3), an organization must be both organized and operated exclusively for one or more of the purposes specified in such section. If an organization fails to meet either the organizational test or the operational test, it is not exempt.

Section 1.501(c)(3)-1(c)(2) of the Regs provides that an organization is not operated exclusively for one or more exempt purposes if its net earnings inure in whole or in part to the benefit of private shareholders or individuals.

Section 1.501(c)(3)-1(f)(2)(ii) of the Regs provides that, in determining whether to continue to recognize the tax-exempt status of an applicable tax-exempt organization described in section 501(c)(3) that engages in one or more excess benefit transactions that violate the prohibition on inurement under section 501(c)(3), the Commissioner will consider all relevant facts and circumstances, including, but not limited to, the following:

(A) The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions occurred;

(B) The size and scope of the excess benefit transaction or transactions (collectively, if more than one) in relation to the size and scope of the organization’s regular and ongoing activities that further exempt purposes;

(C) Whether the organization has been involved in multiple excess benefit transactions with one or more persons;

(D) Whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions; and

(E) Whether the excess benefit transaction has been corrected (within the meaning of section 4958(f)(6) and section 53.4958-7), or the organization has made good faith efforts to seek correction from the disqualified person(s) who benefited from the excess benefit transaction.

Section 53.4958-3(c)(2) of the Regs describes individuals having “substantial influence over the affairs of the organization” (per Code section 4958(f)(1)) as including presidents, chief executive officers, chief operating officers, or any person who, regardless of title, has ultimate responsibility for implementing the decisions of the governing body or for supervising the management, administration, or operation of the organization. A person who serves as president, chief executive officer, or chief operating officer has this ultimate responsibility unless the person demonstrates otherwise. If this ultimate responsibility resides with two or more individuals (e.g., co-presidents), who may exercise such responsibility in concert or individually, then each individual is in a position to exercise substantial influence over the affairs of the organization.

Section 53.4958-4(a)(4) provides that certain economic benefits are disregarded for purposes of section 4958, including (i) Nontaxable fringe benefits. An economic benefit that is excluded from income under section 132, except any liability insurance premium, payment, or reimbursement that must be taken into account under paragraph (b)(1)(ii)(B)(2) of this section, and (ii) Expense reimbursement payments pursuant to accountable plans. Amounts paid under reimbursement arrangements that meet the requirements of section 1.62-2(c) of this chapter.

Section 53.4958-4(c)(1) provides that an economic benefit is not treated as consideration for the performance of services unless the organization providing the benefit clearly indicates the intent to treat the benefit as compensation when the benefit is paid. An applicable tax exempt organization is treated as clearly indicating its intent to provide an economic benefit as compensation for services only if the organization provided written substantiation that is contemporaneous with the transfer of the economic benefit at issue. If an organization fails to provide this contemporaneous substantiation, any services provided by the disqualified person will not be treated as provided in consideration for the economic benefit for purposes of determining the reasonableness of the transaction. In no event shall an economic benefit that a disqualified person obtains by theft or fraud be treated as consideration for the performance of services.

Section 53.4958-4(c)(3)(i)(A) provides that an organization’s reporting constitutes contemporaneous substantiation to treat a benefit as compensation if the organization reports the benefit as compensation on an original Federal tax information return with respect to the payment (e.g., Form W-2 or 1099); or the recipient disqualified person reports the benefit as income on the person’s original Federal tax return (e.g., Form 1040); or there is an approved written employment contract executed on or before the date of the transfer indicating the benefit is compensation; or there is documentation by the organization’s authorized body approving the transfer as compensation for services on or before the date of the transfer; or there was written evidence in existence before the due date of the applicable Federal tax return indicating a reasonable belief by the organization that the benefit was a nontaxable benefit as described in Regs section 53.4958-4(c)(2).

Section 53.4958-7(e) provides that when the applicable tax-exempt organization is no longer described in section 501(c)(3), the disqualified person must make correction to another organization described in sections 501(c)(3) and 170(b)(1)(A) (other than sections 170(b)(1)(A)(vii) or (viii)) which has been so described for at least 60 months ending on the date of correction. It further provides that the disqualified person must not be a disqualified person with respect to the organization which receives the correction, and that the organization receiving the correction amount must not allow the disqualified person to make or recommend any grants or distributions by the organization.

Section 1.62-2(b) provides that for purposes of determining “adjusted gross income,” section 62(a)(2)(A) allows an employee a deduction for expenses paid by the employee, in connection with the performance of services as an employee of the employer, under a reimbursement or other expense allowance arrangement with a payor. Section 62(c) provides that an arrangement will not be treated as a reimbursement or other expense allowance arrangement for purposes of section 62(a)(2)(A) if —

(1) Such arrangement does not require the employee to substantiate the expenses covered by the arrangement to the payor, or

(2) Such arrangement provides the employee the right to retain any amount in excess of the substantiated expenses covered under the arrangement.

(c) Reimbursement or other expense allowance arrangement — (1) Defined. For purposes of sections 1.62-1, 1.62-1T, and 1.62-2, the phrase “reimbursement or other expense allowance arrangement” means an arrangement that meets the requirements of paragraphs (d) (business connection), (e) (substantiation), and (f) (returning amounts in excess of expenses) of this section.

(2) Accountable plans — (i) In general. Except as provided in paragraph (c)(2)(ii), if an arrangement meets the requirements of paragraphs (d), (e), and (f) of this section, all amounts paid under the arrangement are treated as paid under an “accountable plan.”

(ii) Special rule for failure to return excess. If an arrangement meets the requirements of paragraphs (d), (e), and (f) of this section, but the employee fails to return, within a reasonable period of time, any amount in excess of the amount of the expenses substantiated in accordance with paragraph (e) of this section, only the amounts paid under the arrangement that are not in excess of the substantiated expenses are treated as paid under an accountable plan.

(3) Nonaccountable plans — (i) In general. If an arrangement does not satisfy one or more of the requirements of paragraphs (d), (e), or (f) of this section, all amounts paid under the arrangement are treated as paid under a “nonaccountable plan.” If a payor provides a nonaccountable plan, an employee who receives payments under the plan cannot compel the payor to treat the payments as paid under an accountable plan by voluntarily substantiating the expenses and returning any excess to the payor.

(ii) Special rule for failure to return excess. If an arrangement meets the requirements of paragraphs (d), (e), and (f) of this section, but the employee fails to return, within a reasonable period of time, any amount in excess of the amount of the expenses substantiated in accordance with paragraph (e) of this section, the amounts paid under the arrangement that are in excess of the substantiated expenses are treated as paid under a nonaccountable plan.

(4) Treatment of payments under accountable plans. Amounts treated as paid under an accountable plan are excluded from the employee’s gross income, are not reported as wages or other compensation on the employee’s Form W-2, and are exempt from the withholding and payment of employment taxes.

(5) Treatment of payments under nonaccountable plans. Amounts treated as paid under a nonaccountable plan are included in the employee’s gross income, must be reported — as wages or other compensation on the employee’s Form W-2, and are subject to withholding and payment of employment taxes (FICA, FUTA, RRTA, RURT, and income tax). See paragraph (h) of this section. Expenses attributable to amounts included in the employee’s gross income may be deducted, provided the employee can substantiate the full amount of his or her expenses (i.e., the amount of the expenses, if any, the reimbursement for which is treated as paid under an accountable plan as well as those for which the employee is claiming the deduction) in accordance with sections 1.274-5T and 1.274(d)-1 or section § 1.162-17, but only as a miscellaneous itemized deduction subject to the limitations applicable to such expenses (e.g., the 80-percent limitation on meal and entertainment expenses provided in section 274(n) and the 2-percent floor provided in section 67).

(d) Business connection — (1) In general. Except as provided in paragraphs (d)(2) and (d)(3) of this section, an arrangement meets the requirements of this paragraph (d) if it provides advances, allowances (including per diem allowances, allowances only for meals and incidental expenses, and mileage allowances), or reimbursements only for business expenses that are allowable as deductions by part VI (section 161 and the following), subchapter B, chapter 1 of the Code, and that are paid or incurred by the employee in connection with the performance of services as an employee of the employer. The payment may be actually received from the employer, its agent, or a third party for whom the employee performs a service as an employee of the employer, and may include amounts charged directly or indirectly to the payor through credit card systems or otherwise. In addition, if both wages and the reimbursement or other expense allowance are combined in a single payment, the reimbursement or other expense allowance must be identified either by making a separate payment or by specifically identifying the amount of the reimbursement or other expense allowance.

(3) Reimbursement requirement — (i) In general. If a payor arranges to pay an amount to an employee regardless of whether the employee incurs (or is reasonably expected to incur) business expenses of a type described in paragraph (d)(1) or (d)(2) of this section, the arrangement does not satisfy this paragraph (d) and all amounts paid under the arrangement are treated as paid under a nonaccountable plan. See paragraphs (c)(5) and (h) of this section.

(ii) Per diem allowances. An arrangement providing a per diem allowance for travel expenses of a type described in paragraph (d)(1) or (d)(2) of this section that is computed on a basis similar to that used in computing the employee’s wages or other compensation (e.g., the number of hours worked, miles traveled, or pieces produced) meets the requirements of this paragraph (d) only if, on December 12, 1989, the per diem allowance was identified by the payor either by making a separate payment or by specifically identifying the amount of the per diem allowance, or a per diem allowance computed on that basis was commonly used in the industry in which the employee is employed. See section 274(d) and section 1.274(d)-1. A per diem allowance described in this paragraph (d)(3)(ii) may be adjusted in a manner that reasonably reflects actual increases in employee business expenses occurring after December 12, 1989.

(e) Substantiation — (1) In general. An arrangement meets the requirements of this paragraph (e) if it requires each business expense to be substantiated to the payor in accordance with paragraph (e)(2) or (e)(3) of this section, whichever is applicable, within a reasonable period of time. See section 1.274-5T or section 1.162-17.

(2) Expenses governed by section 274(d). An arrangement that reimburses travel, entertainment, use of a passenger automobile or other listed property, or other business expenses governed by section 274(d) meets the requirements of this paragraph (e)(2) if information sufficient to satisfy the substantiation requirements of section 274(d) and the Regs thereunder is submitted to the payor. See section 1.274-5. Under section 274(d), information sufficient to substantiate the requisite elements of each expenditure or use must be submitted to the payor. For example, with respect to travel away from home, section 1.274-5(b)(2) requires that information sufficient to substantiate the amount, time, place, and business purpose of the expense must be submitted to the payor. Similarly, with respect to use of a passenger automobile or other listed property, section 1.274-5(b)(6) requires that information sufficient to substantiate the amount, time, use, and business purpose of the expense must be submitted to the payor. See section 1.274-5(g) and (j), which grant the Commissioner the authority to establish optional methods of substantiating certain expenses. Substantiation of the amount of a business expense in accordance with rules prescribed pursuant to the authority granted by section 1.274-5(g) or (j) will be treated as substantiation of the amount of such expense for purposes of this section.

(3) Expenses not governed by section 274(d). An arrangement that reimburses business expenses not governed by section 274(d) meets the requirements of this paragraph (e)(3) if information is submitted to the payor sufficient to enable the payor to identify the specific nature of each expense and to conclude that the expense is attributable to the payor’s business activities. Therefore, each of the elements of an expenditure or use must be substantiated to the payor. It is not sufficient if an employee merely aggregates expenses into broad categories (such as “travel”) or reports individual expenses through the use of vague, nondescriptive terms (such as “miscellaneous business expenses”). See section 1.162-17(b).

(f) Returning amounts in excess of expenses — (1) In general. Except as provided in paragraph (f)(2) of this section, an arrangement meets the requirements of this paragraph (f) if it requires the employee to return to the payor within a reasonable period of time the amount paid under the arrangement in excess of the expenses substantiated in accordance with paragraph (e) of this section. The determination of whether an arrangement requires an employee to return amounts in excess of substantiated expenses will depend on the facts and circumstances. An arrangement whereby money is advanced to an employee to defray expenses will be treated as satisfying the requirements of this paragraph (f) only if the amount of money advanced is reasonably calculated not to exceed the amount of anticipated expenditures, the advance of money is made on a day within a reasonable period of the day that the anticipated expenditures are paid or incurred, and any amounts in excess of the expenses substantiated in accordance with paragraph (e) of this section are required to be returned to the payor within a reasonable period of time after the advance is received.

GOVERNMENT’S POSITION

ORG’s 501(c)(3) status should be revoked, effective January 1, 20XX, based on the substantial inurement evidenced by the payments shown in Figures 5, 6, and 7 above. The examining agent has requested documentation and explanations for the above payments. ORG, the President and Vice-President, and Secretary have provided what documentation and explanations they could. The payments to or for these individuals that have either been acknowledged as benefiting them, or that still remain unsubstantiated total $* * * for 20XX, $* * * for 20XX, and $* * * for 20XX. This inurement violates section 501(c)(3) of the Internal Revenue Code and section 1.501(c)(3)-1(c)(2) of the Treasury Regulations.

The payments for Secretary’ City apartment constitute inurement and EBTs. They benefited her through the provision of free housing. There was no contemporaneous substantiation that it was ORG’S intent to treat these payments as compensation for services.

The $$* * * from check ##* * * constitutes inurement and an EBT to President. It was not reported as compensation to President on any Form W2 issued to him, nor on any of ORG’s Forms 990s filed prior to the December 20XX commencement of the IRS examination. This payment should have been included in President’ year 20XX Form W2, issued in January of 20XX. The President and Vice-President acknowledged in the January 17th response that this $$* * * “gift” should be reimbursed.

The $* * * from check #* * * constitutes inurement and an EBT to Vice-President. The January 17th response acknowledged that this was for the purchase of a watch for Vice-President, and that it should be reimbursed.

The $$* * * from check ##* * * constitutes inurement and an EBT to Vice-President. It was not reported as compensation to Vice-President on any Form W2 issued to her, nor on any of ORG’s Forms 990s filed prior to the December 20XX commencement of the IRS examination. This payment should have been included in Vice-President’ year 20XX Form W2, issued in January of 20XX. In any event, ORG’s issuing of Vice-President’ 20XX W2 in January 20XX came after the commencement of the IRS examination. It therefore does not meet the contemporaneous substantiation requirement of Regs section 53.4958-4(c)(3)(i)(A). ORG’s inclusion of this amount on President and Vice-President compensation for the year 20XX is not a mitigating factor.

The rest of the unsubstantiated payments to President and Vice-President, shown in Figures 5, 6, and 7 also constitute inurement and EBTs. They benefited the President and Vice-President in the form of outright cash payments, mostly in $* * * denominations. These payments were not part of an accountable plan. They failed, variously, sections (d), (e), and (f) of Regs section 1.62-2. The shopping at CO-11 and other boutiques, and purchases of multiple Rolex watches fail the section 1.62-2(d) business connection requirement. And the rest of the unexplained excess reimbursements fail both the section 1.62-2(e) and (f) substantiation and return of excess requirements.

The argument in the January 17th response to the Code section 4958 reports that the total of receipts should be added to the total of per diem is not logical. Reimbursement arrangements are either “actual” or “per diem”. To the extent that ORG had a particular reimbursement arrangement in place, it is clear, from the fact that it used “employee expense reports”, that it was not based on per diem. It should be noted that this report only cites the excess of reimbursements over what has been substantiated as having a business connection. An employee would never be entitled to “reimbursement” of both actual and per diem, as was suggested in the response. The unsubstantiated payments in Figures 5, 6, and 7 thus constitute inurement and EBTs.

With respect to section 1.501(c)(3)-1(f)(2)(ii) of the Treasury Regs, the analysis of the five factors set forth therein is as follows:

(A) The size and scope of the organization’s regular and ongoing activities that further exempt purposes before and after the excess benefit transaction or transactions

No evidence was gathered during the examination to suggest that there was any fluctuation in ORG’s activities. Furthermore, due to the frequency of the payments at issue, being evenly spread throughout each year, no distinction can be made between ORG’s activities “before and after” these payments. The qualification of ORG’s activities for 501(c)(3) status are not being challenged in this report. Thus, this factor weighs neither in favor of, nor against, revocation.

(B) The size and scope of the excess benefit transaction or transactions in relation to the size and scope of the organization’s regular and ongoing exempt activities

ORG does not have any “ongoing” exempt activities. It voluntarily became a for-profit entity on June 1, 20XX. Inasmuch as ORG’s revenues reflect its exempt activities, its revenues during the years under examination, while it was still exempt, was $* * *. The inurement and EBTs cited above total $* * *, or about * * *%. This is a significant amount of inurement and EBTs, and weighs in favor of revocation.

(C) Whether the organization has been involved in multiple excess benefit transactions with one or more persons

ORG engaged in over sixty EBTs during the years under examination. These transactions involved three different officers; President, Vice-President, and Secretary. This weighs in favor of revocation.

(D) Whether the organization has implemented safeguards that are reasonably calculated to prevent excess benefit transactions

ORG forfeited its own 501(c)(3) exemption June 1, 20XX. At issue, then, is whether its exemption should also be revoked for the period of January 1, 20XX to May 31, 20XX. It is evident that no safeguards were put in place to prevent EBTs from 20XX to 20XX, or from 20XX to 20XX. On the contrary, President has even more unfettered control over ORG’s assets, now that ORG is owned by his wholly-owned company, CO-3. This factor weighs in favor of revocation.

(E) Whether the excess benefit transaction has been corrected (within the meaning of section 4958(f)(6)), or the organization has made good faith efforts to seek correction from those who benefited from the excess benefit transaction

As of the date of this report, ORG is no longer described in section 501(c)(3) of the Internal Revenue Code. Repayments to ORG would not qualify as “correction” within the meaning of section 4958(f)(6). Therefore, per Regs section 53.4958-7(e), any correction to be made by the President and Vice-President or Secretary would have to go to a different 501(c)(3) organization. As of the date of this report, no correction has been made to such a 501(c)(3) organization. Therefore, applying this factor would weigh in favor of revocation.

TAXPAYER’S POSITION

ORG has not yet taken a position with respect to this report.

CONCLUSION

ORG’s earnings have inured to the benefit of three of its officers, President, Vice-President, and Secretary. This inurement totaled $* * * during the years 20XX, 20XX, and 20XX. This is a substantial amount of inurement, and violates section 1.501(c)(3)-1(c)(2) of the Treasury Regs. Given the routine and continuous nature of the inurement, this warrants revocation of ORG’s 501(c)(3) status effective January 1, 20XX. ORG should file Form 1120, U.S. Corporation Income Tax Return, for the years 20XX and 20XX, and for the period ended May 31, 20XX. If the proposed revocation becomes final, appropriate State officials will be notified in accordance with Code section 6104(c).

FOOTNOTES

1 CPA also represented the President and Vice-President in their Code section 4958 examinations until March 20XX, when they appointed CPA as their representative.

2 The agent found that the legible receipts only totaled $$* * * which included $$* * * in hotel receipts. The $$* * * CO-5 invoice was discussed separately and so presumably was not included in the $$* * *.




Comments Requested on Information Return for Tax Credit Bonds.

The IRS has requested comments on Form 8038-TC, “Information Return for Tax Credit Bonds”; comments are due by September 6, 2013.

http://services.taxanalysts.com/taxbase/eps_pdf2013.nsf/DocNoLookup/16344/$FILE/2013-16344-1.pdf




Comments Requested on Regs on Remedial Actions for QZABs.

The IRS has requested comments on regulations (T.D. 9339) on the maximum term and permissible use of proceeds of qualified zone academy bonds and on specified remedial actions for curing some violations of the rules for those bonds; comments are due by September 6, 2013.

http://services.taxanalysts.com/taxbase/eps_pdf2013.nsf/DocNoLookup/16360/$FILE/2013-16360-1.pdf




IRS: FSLG July 2013 Newsletter.

Inside This Issue

http://www.irs.gov/Government-Entities/Federal,-State-&-Local-Governments/Current-Edition-of-the-FSLG-Newsletter




IRS LTR: Supporting Organization's Ownership Interest in For-Profit Won't Jeopardize Exemption.

The IRS ruled a supporting organization’s ownership interest in a newly formed holding company resulting from a restructuring transaction won’t adversely affect its tax-exempt status.

Employer Identification Number: * * *

LEGEND:

Center = * * *

Group = * * *

Network = * * *

Health = * * *

Dear * * *:

This is in reply to your letter of June 30, 2011, in which you request a ruling on the effect to your tax-exempt status of your proposed ownership (through a wholly-owned disregarded entity) in a for-profit Subchapter S corporation.

FACTS

You are tax-exempt under I.R.C. § 501(c)(3), and a § 509(a) supporting organization of the Center and its School of Medicine. The Center is part of a state-chartered university system. You are a faculty group practice that assists the Center in carrying out its mission, particularly as it relates to the Center’s clinical practice function. You consist of the faculty of the clinical departments of the Center. Through you, the Center’s faculty is able to enter into contractual relationships with health plans, community providers, and businesses to provide health care services and thereby operate a health care delivery system. The health care delivery system, which you facilitate, promotes the charitable, educational, and research programs of the Center by providing it with the clinical programs and patient populations with which to educate its students and conduct research, while also providing healthcare services to the public regardless of ability to pay.

You are the sole member of the Group, a wholly owned subsidiary that is treated as a disregarded entity for federal tax purposes. The Group provides professional medical services as a participating independent physician association (“IPA”) in the Network. The Network is organized as a for-profit corporation, and serves as a third party administrator providing medical necessity review organization services to its clients under state licenses. The Group owns * * * percent of the issued and outstanding common shares of the Network. The Network has six additional IPA shareholders that are unrelated to the Group. The Network is currently a C corporation for federal income tax purposes. These six additional IPA shareholders comprise for-profit corporations and a partnership.

The Network has four wholly owned subsidiaries. Three of the subsidiaries are limited liability companies that are disregarded as separate entities for federal income tax purposes. The fourth subsidiary, Health, is a C corporation and insurance company for federal income tax purposes. All four wholly owned subsidiaries are involved in healthcare or healthcare related services.

In addition to being a participant IPA in, and shareholder of, the Network, the Group has an exclusive management agreement with the Network under which the Network provides certain administrative and contract services to the Group. These services include collecting revenue, paying claims, contracting with healthcare providers, and performing other administrative functions necessary to manage the Group. For its services, the Network collects * * *% of all collected revenues. At the year-end, the Network reconciles its actual management costs incurred on behalf of the Group and remits any overpayments to the Group. The Group remits to you the overpayments it receives from the Network.

Proposed Restructuring Transaction

In order to achieve an ownership structure that is eligible for S corporation status, the following restructuring transaction is proposed:

A new entity, the “Holding Company,” will be established, and will make an “S” election as of the date of formation.

The Group and the other shareholders of the Network will contribute their shares of the Network to the capital of the Holding Company, thus making the Network a wholly owned subsidiary of the Holding Company.

The Holding Company will make a qualified subchapter “S” subsidiary (“QSSS”) election for the Network.

The Network will distribute its membership interests in its three subsidiaries that are disregarded entities for federal tax purposes to the Holding Company. The Network will continue to own all of the issued and outstanding common shares of Health.

Once the proposed transaction is completed, the Group will hold * * *% of the Holding Company. The remaining * * * % will be owned by the 54 individuals that currently own the six other shareholders of the Network. All of the entities involved in the proposed transaction will continue to operate for the same business purposes as they did prior to the transaction.

The Holding Company will have a board or directors consisting of seven members. The Group will have the right to elect one board member and the other unrelated shareholders will elect the remaining six board members. The Network will have a board of directors consisting of 14 members. The Group will have the right to elect two board members and the other unrelated shareholders will elect the remaining 12 board members.

Health will have a board of directors consisting of six members. Three of the members will be selected by the Network’s board of directors from among its members, and the other three members will be selected from the Network’s senior management team. The three subsidiaries of the Holding Company that are disregarded entities for federal income tax purposes will be managed by a non-shareholder manager selected by the Holding Company.

The Holding Company and its subsidiaries will each develop, maintain, and manage its own financial systems independent of you and the Group. The Holding Company and its subsidiaries will each by operated by a professional staff with expertise in the relevant business areas, which are independent and unrelated to you. Neither you nor the Group will be involved in the day-to-day management of the Holding Company or any of its subsidiaries.

RULING REQUESTED

You have requested the following ruling:

Your ownership, through your wholly-owned disregarded entity, Group, in a for-profit Subchapter “S” corporation, together with the flow-through allocation of “S” tax items subject to the unrelated business income tax, has no effect on the your tax exempt status.

LAW

I.R.C. § 501(c)(3) provides for the exemption from federal income tax of organizations that are organized and operated exclusively for religious, charitable, scientific, or educational purposes, provided no part of the net earnings inure to the benefit of any private shareholder or individual.

Treas. Reg. § 1.501(c)(3)-1(a)(1) provides that, in order to qualify as an organization described in § 501(c)(3), an organization must be both organized and operated exclusively for one or more of the purposes specified in such section. If an organization fails to meet either the organizational test or the operational test, it does not qualify for exemption.

Treas. Reg. § 1.501(c)(3)-1(c)(1) provides that an organization will be regarded as “operated exclusively” for one or more exempt purposes only if it is engaged primarily in activities which accomplish one or more of such exempt purposes specified in § 501(c)(3). An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.

I.R.C. § 511(a) imposes a tax on the unrelated business taxable income of organizations exempt from federal income tax under I.R.C. § 501(c).

I.R.C. § 512(e) provides that if an organization described in § 1361(c)(6) holds stock in a S corporation — (A) such interest shall be treated as an interest in an unrelated trade or business; and, (B) notwithstanding any other provisions of this part — (i) all items of income, loss, or deduction taken into account under § 1366(a), and (ii) any gain or loss on the disposition of the stock in the S corporation shall be taken into account in computing the unrelated business taxable income of such organization.

I.R.C. § 1361(c)(6) provides that, for purposes of subsection (b)(1)(B) (which defines the term “small business corporation”), an organization which is (A) described in § 401(a) or 501(c)(3), and (B) exempt from taxation under § 501(a), may be a shareholder in an S corporation.

In Moline Properties, Inc. v. Comm’r, 319 U.S. 436, 438-39 (1943), the Supreme Court said that “[t]he doctrine of corporate entity fills a useful purpose in business life. Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator’s personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity. . . . In general, in matters relating to the revenue, the corporate form maybe disregarded where it is a sham or unreal. In such situations the form is a bald and mischievous fiction.” In response to the argument that a corporation is a mere agent of its sole stockholder, the court said that “the mere fact of the existence of a corporation with one or several stockholders, regardless of the corporation’s business activities, does not make the corporation the agent of its stockholders. Id. at 440.

In National Carbide Corp. v. Comm’r, 336 U.S. 422, 437 (1949), the Supreme Court said that a finding of a “true agency” relationship turns on several factors. “Whether the corporation operates in the name and for the account of the principal, binds the principal by its actions, transmits money received to the principal, and whether receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal are some of the relevant considerations in determining whether a true agency exists. If the corporation is a true agent, its relations with the principal must not be dependent upon the fact that it is owned by the principal, if such is the case. Its business purposes must be the carrying on of the normal duties of an agent.”

In National Investors Corp. v. Hoey, 144 F.2d 466, 468 (2nd Cir. 1944), the court said that “to be a separate jural person for purposes of taxation, a corporation must engage in some industrial, commercial, or other activity besides avoiding taxation; in other words, that the term ‘corporation’ will be interpreted to mean a corporation which does some ‘business’ in the ordinary meaning; and that escaping taxation is not ‘business’ in the ordinary meaning.”

In Britt v. U.S., 431 F.2d 227, 237 (5th Cir. 1970), the court said that “business activity is required for recognition of the corporation as a separate taxable entity; the activity may be minimal.”

In Krivo Indus. Supply Co. v. Nat’l Distillers & Chem. Corp., 483 F.2d 1098, 1106 (5th Cir. 1973), the Court said that “the control required for liability under the ‘instrumentality’ rule amounts to total domination of the subservient corporation, to the extent that the subservient corporation manifests no separate corporate interests of its own and functions solely to achieve the purposes of the dominant corporation.”

ANALYSIS

For taxable years beginning before January 1, 1998, tax exempt organizations described in § 501(c)(3) could not be shareholders in an S corporation. In 1996, Congress enacted the Small Business Job Protection Act, Pub. L. No. 104-188, 110 Stat. 1755, authorizing the ownership of S corporation stock by tax-exempt organizations described in § 501(c)(3). The Joint Committee on Taxation’s General Explanation of Tax Legislation Enacted in the 104th Congress (JCS-12-96), December 18, 1996, Sec. 1316, p. 130, describes the reason for the change in law as follows —

The Congress believed that the present-law prohibition of certain tax-exempt organizations being S corporation shareholders may have inhibited employee ownership of closely-held businesses, frustrated estate planning, discouraged charitable giving, and restricted sources of capital for closely-held businesses. The Congress sought to lift these barriers by allowing certain tax-exempt organizations to be shareholders in S corporations. However, the provisions of subchapter S were enacted in 1958 and substantially modified in 1982 on the premise that all income of the S corporation (including all gains on the sale of the stock) would be subject to a shareholder-level income tax. This underlying premise allows the rules governing S corporations to be relatively simple . . . because of the lack of concern about “transferring” income to non-taxpaying persons. Consistent with this underlying premise of subchapter S, the provision treats all the income flowing through to a tax-exempt shareholder, and gains and losses from the disposition of the stock, as unrelated business taxable income.

As a result of the legislation, tax-exempt organizations described in § 501(c)(3) are allowed to be shareholders in an S corporation under § 1361(c)(6). Furthermore, under § 512(e), items of income or loss of an S corporation will flow through to tax-exempt shareholders as unrelated business taxable income regardless of the source or nature of such income. In addition, gain or loss on the sale or other disposition of stock of an S corporation will be treated as unrelated business taxable income. These provisions, however, do not cause the for-profit activities of the S corporation to be attributed to the tax-exempt shareholder. See Moline Properties, Inc., 319 U.S. at 440. In determining whether the activities of a for-profit S corporation subsidiary is attributable to its tax-exempt parent, the separate identity principles annunciated in Moline Properties, Inc. v. Comm’r should apply lest the intent of Congress to remove barriers for investment in S corporations by tax-exempt entities be frustrated.

For federal income tax purposes, a parent corporation and its subsidiaries are treated as separate and distinct taxable corporate entities as long as each entity has a valid business purpose and engages in at least a minimal amount of business activity. See Moline Properties, Inc., 319 U.S. at 438; National Investors Corp., 144 F.2d at 468; Britt, 431 F.2d at 234. However, where the parent corporation so controls the affairs of the subsidiary that it is merely an instrumentality of the parent, the corporate identity of the subsidiary may be disregarded. See, Krivo, 483 F.2d at 1106.

Hence, the activities of a for-profit subsidiary will not be attributed to its tax-exempt parent unless (1) the subsidiary lacks a business purpose, or (2) the subsidiary is an arm or agent of the parent.

In your case, your relationship with the Holding Company does not fail the first prong, i.e., that the subsidiary have a business purpose and conduct some amount of business activity. The Holding Company and its four subsidiaries have been, or will be, organized to perform bona fide and substantial business functions. The Holding Company and all of its subsidiaries maintain activities that are separate, distinct, and independent from you. Therefore, their existence may not be disregarded for tax purposes.

Additionally, your relationship with the Holding Company does not fail the second prong, i.e., that the parent not control the day-to-day operations of the subsidiary. The Holding Company has its own corporate identity and interests, and its own independent board of seven directors, only one of which is chosen by you. The other six directors are chosen by unrelated shareholders. Furthermore, each of the Holding Company’s subsidiaries has its own management and employees independent of you. Furthermore, neither your investment in the Holding Company nor your management agreement with the Network exhibits any of the attributes of a “true agency” relationship identified in National Carbide Corp., 336 U.S. at 437. Therefore, neither the Holding Company nor its subsidiaries can be considered a sham or under your “total domination.” Consequently, the activities of the Holding Company and its subsidiaries would not be attributable to you.

CONCLUSION

In light of the foregoing, we rule as follows:

Your ownership interest in the Holding Company, a for-profit subchapter S corporation, through Group, together with the flow-through allocation of the Holding Company’s “S” tax items subject to the unrelated business income tax, would have no effect on your tax-exempt status as an organization described in § 501(c)(3).

This ruling will be made available for public inspection under section 6110 of the Code after certain deletions of identifying information are made. For details, see enclosed Notice 437, Notice of Intention to Disclose. A copy of this ruling with deletions that we intend to make available for public inspection is attached to Notice 437. If you disagree with our proposed deletions, you should follow the instructions in Notice 437.

This ruling is directed only to the organization that requested it. Section 6110(k)(3) of the Code provides that it may not be used or cited by others as precedent.

This ruling is based on the facts as they were presented and on the understanding that there will be no material changes in these facts. This ruling does not address the applicability of any section of the Code or regulations to the facts submitted other than with respect to the sections described. Because it could help resolved questions concerning your federal income tax status, this ruling should be kept in your permanent records.

If you have any questions about this ruling, please contact the person whose name and telephone number are shown in the heading of this letter.

In accordance with the Power of Attorney currently on file with the Internal Revenue Service, we are sending a copy of this letter to your authorized representative.

Sincerely,

Peter A. Holiat

Acting Manager,

Exempt Organizations

Technical Group 1

Citations: LTR 201328035




IRS LTR: Foundation Granted More Time to Dispose of Stock.

The IRS granted a private foundation an additional five years to dispose of excess holdings of corporate stock after concluding the foundation made diligent efforts to dispose of the shares but was unable to do so except at a price substantially below the fair market value.

Employer Identification Number: * * *

LEGEND:

Corporation = * * *

Founder = * * *

Brand = * * *

Date 1 = * * *

Date 2 = * * *

Dear * * *:

This is in response to your ruling request dated November 28, 2012, requesting an extension for an additional five years under I.R.C. § 4943(c)(7) for disposing of certain excess business holdings.

FACTS

You are a private foundation organized as a nonprofit corporation to further the charitable interests of your Founder. You have been recognized as an organization exempt under § 501(c)(3) and are classified as a private foundation within the meaning of § 509(a). You state that you operate exclusively for charitable and educational purposes through the making of grants and contributions to charities. You acquired * * * percent of Corporation stock as a donation from your Founder after his death. You have excess business holdings in Corporation under § 4943(c)(1). Your initial five-year period for disposing of these excess business holdings will end on Date 1.

During the initial five-year period for disposing of excess business holdings under § 4943(c)(6), you have created a more formal management and governance structure for Corporation, and taken steps to unify the Brand with respect to * * *. Your managers have consulted with advisors, valuation specialist and legal counsel to discuss the various disposition options available to you.

You represent that, because of the size, value, nature, and complexity of this business holding, you have, despite your best efforts, been unable to complete the sale of Corporation stock within the prescribed five-year period except at a price substantially below fair market value. You represent that you will be better able to determine and realize the full fair market value of your interest in Corporation after the expiration of the initial five-year period.

Your directors have established a plan of disposition that includes either selling your Corporation stock to an unaffiliated third party or donating Corporation shares to one or more charitable organizations. Your directors expect that they can dispose of the Corporation stock no later than Date 2. You submitted the plan to your appropriate state Attorney General and are waiting for a response. If and when a response is received from the Attorney General, a copy will be submitted to the Secretary in accordance with § 4943(c)(7)(B)(ii).

Prior to the end of the initial five-year period for disposing of excess business holdings under § 4943(c)(6), you submitted a request to the Internal Revenue Service for an extension of five years to complete the required disposition.

RULING REQUESTED

You requested a ruling extending the five-year period of time for disposing of excess business holdings for an additional five years under § 4943(c)(7).

LAW

I.R.C § 4943(a)(1) imposes excise taxes on the excess business holdings of any private foundation in a business enterprise.

I.R.C. § 4943(c)(1) provides that the term “excess business holdings” means, with respect to the holdings of any private foundation in any business enterprise, the amount of stock or other interest in the enterprise which the foundation would have to dispose of to a person other than a disqualified person in order for the remaining holdings of the foundation in such enterprise to be permitted holdings.

I.R.C. § 4943(c)(2) provides in part that the permitted holdings of any private foundation in an incorporated business enterprise are 20 percent of the voting stock, reduced by the percentage of the voting stock owned by all disqualified persons.

I.R.C. § 4943(c)(6)(A) provides that, if there is a change in the holdings in a business enterprise (other than by purchase by the private foundation or by a disqualified person) which causes the private foundation to have excess business holdings in such enterprise, the interest of the foundation in such enterprise (immediately after such change) shall (while held by the foundation) be treated as held by a disqualified person (rather than by the foundation) during the 5-year period beginning on the date of such change in holdings.

I.R.C. § 4943(c)(7) provides that the Internal Revenue Service may extend for an additional five years the initial five-year period for disposing of excess business holdings in the case of an unusually large gift or bequest of diverse business holdings or holdings with complex corporate structures if:

(A) The foundation establishes that: (i) it made diligent efforts to dispose of such holdings during the initial five-year period, and (ii) disposition within the initial five-year period has not been possible (except at a price substantially below fair market value) by reason of such size and complexity or diversity of holdings;

(B) Before the close of the initial five-year period: (i) the private foundation submits to the Internal Revenue Service a plan for disposing of all of the excess business holdings involved in the extension, and (ii) the private foundation submits the plan to the Attorney General (or other appropriate State official) having administrative or supervisory authority or responsibility with respect to the foundation’s disposition of the excess business holdings involved and submits to the Internal Revenue Service any response the private foundation received during the five-year period; and

(C) The Internal Revenue Service determines that such plan can reasonably be expected to be carried out before the close of the extension period.

ANALYSIS

You are subject to § 4943, which imposes a tax on the excess business holdings of private foundations. Generally, under § 4943(c)(2)(A), a private foundation and its disqualified persons are permitted to hold twenty percent of the voting stock in a business enterprise, with any excess constituting excess business holdings. However, if a private foundation acquires holdings in a business enterprise other than by purchase (e.g., by gift) which causes the foundation to have excess business holdings, then the interest of the foundation in such business enterprise shall be treated as held by a disqualified person (rather than the foundation) for a five-year period beginning on the date such holdings were acquired by the foundation, under § 4943(c)(6)(A).

Under § 4943(c)(7), the Internal Revenue Service may extend the initial five-year period for disposing of excess business holdings for an additional five years if a foundation establishes that: (i) it made diligent efforts to dispose of such holdings during the initial five-year period, and disposition within the initial five-year period has not been possible (except at a price substantially below fair market value) by reason of the size and complexity or diversity of holdings, (ii) before the close of the initial five-year period it submits to the Internal Revenue Service, and to the Attorney General (or other appropriate State official) having administrative or supervisory authority or responsibility with respect to the foundation’s disposition of the excess business holdings, a plan for disposing of all of the excess business holdings involved during the extension and (iii) the Internal Revenue Service determines that such plan can reasonably be expected to be carried out before the close of the extension period.

You received a donation of * * *% of the Corporation stock from Founder, a disqualified person under § 4946. You have stated that you consequently have excess business holdings in Corporation under § 4943(c)(1). Therefore, you are required under § 4943(c)(6) to dispose of these holdings during the initial five-year period that will end on Date 1. You have established that during the initial five-year period you have made diligent efforts to dispose of the Corporation stock, but disposition within this period has not been possible (except at a price substantially below fair market value) because of the size and complexity or diversity of your holdings. Before the end of the initial five-year period, you submitted a request to the Internal Revenue Service under § 4943(c)(7) for an additional five-year period within which to dispose of your excess business holdings in Corporation and you described your plan for disposing of these holdings. You also submitted the plan to the Attorney General of your state, who is expected to approve the plan. Based on the information submitted, we have determined that your plan to dispose of your excess business holdings in Corporation within an additional five-year period can reasonably be expected to be carried out. Therefore, we conclude that you do meet the requirements under § 4943(c)(7) for an extension of five years to dispose of your excess business holdings in Corporation.

RULING

Under § 4943(c)(7), the period during which you may dispose of your excess business holdings in Corporation is extended for an additional five years, until Date 2.

We are not ruling on whether your interest in Corporation constitutes excess business holdings.

This ruling will be made available for public inspection under § 6110 after certain deletions of identifying information are made. For details, see enclosed Notice 437, Notice of Intention to Disclose. A copy of this ruling with deletions that we intend to make available for public inspection is attached to Notice 437. If you disagree with our proposed deletions, you should follow the instructions in Notice 437.

This ruling is directed only to the organization that requested it. Section 6110(k)(3) provides that it may not be used or cited by others as precedent.

This ruling is based on the facts as they were presented and on the understanding that there will be no material changes in these facts. This ruling does not address the applicability of any section of the Code or regulations to the facts submitted other than with respect to the sections described. Because it could help resolve questions concerning your federal income tax status, this ruling should be kept in your permanent records.

If you have any questions about this ruling, please contact the person whose name and telephone number are shown in the heading of this letter.

In accordance with the Power of Attorney currently on file with the Internal Revenue Service, we are sending a copy of this letter to your authorized representative.

Sincerely,

Ronald Shoemaker

Manager, Exempt Organizations

Technical Group 2

Citations: LTR 201328034




LTR: Issuance of New Bonds Determined to Be Refunding of the Bonds.

The IRS ruled that the issuance of new bonds is a refunding of the bonds within the meaning of reg. section 1.150-1(d)(1), notwithstanding that the technical termination of a partnership that held the principal under reg. section 1.708-1(b)(2) occurred within six months of the date of the refinancing.

Citations: LTR 201326007

LEGEND:

Issuer = * * *

Borrower = * * *

Facility = * * *

Principal = * * *

Partnership = * * *

Holding Company = * * *

Bank A = * * *

Bank B = * * *

Date 1 = * * *

Date 2 = * * *

Date 3 = * * *

Bonds = * * *

New Bonds = * * *

Dear * * *:

This responds to your request for a ruling that notwithstanding the purchases on Date 1 and Date 3 (as described below) and the technical termination of Partnership under § 1.708-1(b)(2) of the Income Tax Regulations, all within six months of the date of the Refinancing (as described below), the issuance of the New Bonds is a refunding of the Bonds within the meaning of Treas. Reg. § 1.150-1(d)(1).

FACTS AND REPRESENTATIONS

You make the following representations. Issuer is a governmental agency constituting a public benefit corporation authorized to issue bonds and responsible for providing low-income housing.

Borrower is a limited-liability company formed for the purpose of constructing and developing Facility, a multi-family rental housing development. For Federal income tax purposes, Borrower is a disregarded entity. Through several single-member limited liability companies that are disregarded for Federal income tax purposes, Principal (or New Principal, as described below) at all relevant times has owned all of the capital and profits interest in Borrower. At all relevant times, Partnership (or New Partnership, as described below) directly has owned * * * percent of Principal.

Immediately prior to Date 1, Bank A and Bank B owned approximately * * * percent of Partnership, and Holding Company owned approximately percent of Partnership. Third parties that include certain Partnership employees and officers unrelated to Bank A, Bank B, or Holding Company (the “Third Parties”), owned the remaining approximate * * * percent of the capital and profits interest in Partnership.

On Date 1, Holding Company exercised an option to acquire half of the capital and profits interests in Partnership that had been owned by Bank A and Bank B (the “Date 1 Purchase”). Thus, after Date 1, Bank A and Bank B owned approximately * * * percent and * * * percent of the capital and profits interests in Partnership, respectively. Holding Company owned approximately * * * percent of the capital and profits interests in Partnership. The Third Parties continued to own the remaining approximate * * * percent of the capital and profits interest in Partnership.

Facility is financed by a mortgage loan (the “Mortgage Loan”) from Issuer to Borrower. The Bonds were issued by Issuer to provide a portion of the funding for the Mortgage Loan. Because Borrower is a disregarded entity for Federal income tax purposes, Principal is treated as the obligor on the Bonds. On Date 2, less than four months after Date 1, the Bonds were remarketed such that a reissuance occurred (the “Refinancing”). Borrower is the obligor on the reissued bonds (the “New Bonds”) but because Borrower is a disregarded entity, Principal is treated as the obligor on the New Bonds. The proceeds of the New Bonds were used to pay the principal of the Bonds.

On Date 3, less than six months after Date 1, Holding Company acquired from Bank A and Bank B, respectively, their remaining * * * percent and * * * percent of the capital and profits interests in Partnership (the “Date 3 Purchase”). Thus, as of Date 3 Holding Company owned * * * percent of Partnership, and the Third Parties owned the approximate * * * percent of Partnership which remained. Neither Borrower nor Issuer had any control over the sales by Bank A and Bank B of their interests in Partnership.

Borrower represents that the Refinancing was not related to, or contingent in any way upon, the Date 1 Purchase or the Date 3 Purchase, and that the Date 1 Purchase and the Date 3 Purchase were not related to, or contingent in any way upon, the Refinancing. Borrower represents that the Refinancing would have occurred regardless of whether the Date 1 Purchase or the Date 3 Purchase occurred.

Issuer represents that it is applying Prop. Treas. Reg. § 1.150-1(d)(2)(ii) and (v), 67 Fed Reg 17509 (April 10, 2002), to the New Bonds.

LAW AND ANALYSIS

Treas. Reg. § 1.150-1(a)(1) provides that the definitions of § 1.150-1 apply for all purposes of I.R.C. §§ 103 and 141 through 150. Treas. Reg. § 1.150-1(d)(1) provides, in general, that a refunding issue is an issue of obligations the proceeds of which are used to pay principal, interest, or redemption price on another issue (a prior issue, as more particularly defined in paragraph (d)(5)), including the issuance costs, accrued interest, capitalized interest on the refunding issue, a reserve or replacement fund, or similar costs, if any, properly allocable to that refunding issue.

Treas. Reg. § 1.150-1(b) defines related party in part to mean, with reference to any person that is not a governmental unit or 501(c)(3) organization, a related person (as defined in § 144(a)(3)). Section 144(a)(3) provides in part that a person is a related party to another person if the relationship between such persons would result in a disallowance of losses under §§ 267 or 707(b). Section 707(b)(1)(B) states that no deduction shall be allowed in respect of losses from sales or exchanges of property (other than an interest in the partnership), directly or indirectly, between two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests. Section 707(b)(3) provides that for this purpose, the ownership of a capital or profits interest in a partnership shall be determined in accordance with the rules for constructive ownership of stock provided in section 267(c) other than paragraph (3) of such section. Section 267(c)(1) provides, in part, that stock owned, directly or indirectly, by or for a partnership shall be considered as being owned proportionately by or for its partners.

Issuers may apply proposed regulations amending Treas. Reg. § 1.150-1(d) published in the Federal Register on April 10, 2002 (67 Fed. Reg. 17509) (the “Proposed Regulations”), in whole, but not in part, to any issue that is sold on or after April 10, 2002, and before the applicability date of the final regulations.

Prop. Treas. Reg. § 1.150-1(d)(2)(ii)(A) provides in part that an issue is not a refunding issue to the extent that the obligor (as defined in paragraph (d)(2)(ii)(B)) of one issue is neither the obligor of the other issue nor a related party with respect to the obligor of the other issue. The determination of whether persons are related for this purpose is generally made immediately before the issuance of the refinancing issue.

Prop. Treas. Reg. § 1.150-1(d)(2)(ii)(B) provides in part that the obligor of an issue means the actual issuer of the issue, except that the obligor of the portion of an issue properly allocable to an investment in a purpose investment means the conduit borrower under that purpose investment.

Prop. Treas. Reg. § 1.150-1(d)(2)(ii)(C) provides in part that if, within six months before or after a person assumes (including taking subject to) obligations of an unrelated party in connection with an acquisition transaction (other than a transaction to which § 381(a) applies), the assumed issue is refinanced, the refinancing issue is not a refunding issue. An acquisition transaction is a transaction in which a person acquires assets (other than an equity interest in an entity) from an unrelated party.

Section 708(a) provides that, for purposes of subchapter K, an existing partnership shall be considered as continuing, if it is not terminated.

Section 708(b)(1)(B) provides that, for purposes of § 708(a), a partnership shall be considered as terminated only if within a 12-month period there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits.

Treas. Reg. § 1.708-1(a) provides that for purposes of subchapter K, chapter 1 of the Code, an existing partnership shall be considered as continuing if it is not terminated. Section 1.708-1(b)(2) provides, in part, that a partnership shall terminate when 50 percent or more of the total interest in partnership capital and profits is sold or exchanged within a period of 12 consecutive months. Moreover, if the sale or exchange of an interest in a partnership (upper-tier partnership) that holds an interest in another partnership (lower-tier partnership) results in a termination of the upper-tier partnership, the upper-tier partnership is treated as exchanging its entire interest in the capital and profits of the lower-tier partnership. If the sale or exchange of an interest in an upper-tier partnership does not terminate the upper-tier partnership, the sale or exchange of an interest in the upper-tier partnership is not treated as a sale or exchange of a proportionate share of the upper-tier partnership’s interest in the capital and profits of the lower-tier partnership.

Treas. Reg. § 1.708-1(b)(4) provides, in part, that if a partnership is terminated by a sale or exchange of an interest, the following is deemed to occur: The partnership contributes all of its assets and liabilities to a new partnership in exchange for an interest in a new partnership; and, immediately thereafter, the terminated partnership distributes interests in the new partnership to the purchasing partner and the other remaining partners in proportion to their respective interests in the terminated partnership in liquidation of the terminated partnership, either for the continuation of the business by the new partnership or for its dissolution and winding up.

Issuer is applying the Proposed Regulations to the New Bonds. At the time of the Refinancing on Date 2, the obligor of the Bonds was Borrower/Principal and the obligor of the New Bonds was Borrower/Principal. No change occurred at that time in the ownership of either Principal or Partnership. However, on Date 3, within 6 months of the Refinancing, a termination and transfer of assets and liabilities of Partnership occurred pursuant to § 708(b), when Holding Company acquired Bank A’s and Bank B’s remaining shares in Partnership. Further, Partnership is treated as exchanging its percent interest in Principal, resulting in a termination and transfer of assets and liabilities of Principal.

Under Prop. Treas. Reg. § 1.150-1(d)(2)(ii)(C), a refinancing issue is not treated as refunding issue if, within six months before or after a person assumes (including taking subject to) obligations of an unrelated party in connection with an asset acquisition from an unrelated party, the assumed obligation is refinanced. That section requires an analysis of whether the debt was assumed by, and the deemed transfer of the assets was to, an unrelated party.

As a result of the technical termination, the assets and liabilities of Partnership were deemed transferred to a new partnership (“New Partnership”), * * * percent of which is owned by Holding Company. Immediately prior to the Date 3 purchase, Holding Company owned * * * of Partnership. Therefore, because Holding Company’s ownership interests in Partnership and in New Partnership are both greater than * * * percent, Partnership and New Partnership are related parties for purposes of § 1.150-1(b). Similarly, the assets and liabilities of Principal were deemed transferred to a new partnership (“New Principal”). Thus, Partnership owned * * * percent of Principal before the Date 3 purchase and New Partnership owned * * * percent of New Principal after the Date 3 purchase. Because of Holding Company’s interests in Partnership and New Partnership, Principal and New Principal also are related parties.

Accordingly, the New Bonds are refunding bonds because the obligors of the Bonds and the New Bonds were the same on Date 2 and the transfers of assets and liabilities of Principal and Partnership on Date 3 were between related parties.

CONCLUSION

Under the facts and circumstances of this case, notwithstanding the technical termination of Partnership under Treas. Reg. § 1.708-1(b)(2) (all within six months of the date of the Refinancing), we conclude that the New Bonds are refunding bonds

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any transaction or item discussed or referenced in this letter.

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.

In accordance with a Power of Attorney on file with this office, a copy of this letter is being sent to the authorized representative of Issuer and Borrower.

The ruling contained in this letter is based upon information and representations submitted by Issuer and Borrower and accompanied by penalty of perjury statements executed by the appropriate parties. While this office has not verified any of the materials submitted in support of the request for a ruling, it is subject to verification upon examination.

Sincerely,

Associate Chief Counsel

(Financial Institutions & Products)

By: Timothy L. Jones

Senior Counsel, Branch 5




IRS: Exempt Organization Update.

 

  1. IRS announces Optional Expedited Process for certain 501(c)(4) Exemption Applications
  2. IRS Nationwide Tax Forums begin next week
  3. Check out this summer’s IRS phone forums
  4. Register for EO workshops
  5. Section 509(a)(3) Supporting Organizations pages updated
  6. IRS accepting applications for Low Income Taxpayer Clinic grants
  7. IRS Electronic Tax Administration Advisory Committee delivers report to Congress

 

1.  IRS announces Optional Expedited Process for certain 501(c)(4) Exemption Applications

The IRS announced an optional expedited process for certain Section 501(c)(4) applications. To qualify, organizations must have applied for 501(c)(4) exempt status, their application must be pending for more than 120 days as of May 28, 2013, and their cases must involve possible political campaign intervention or issue advocacy.

http://www.irs.gov/Charities-&-Non-Profits/New-Review-Process-and-Expedited-Self-Certification-Option

2.  IRS Nationwide Tax Forums begin next week

The IRS Nationwide Tax Forums, which begin next week in Orlando, Fla., offer three full days of seminars with the latest word from IRS leadership and experts in the fields of tax law, compliance and ethics.

Attendees can:

http://www.irs.gov/Tax-Professionals/IRS-Nationwide-Tax-Forum-Information

3.  Check out this summer’s IRS phone forums

For a list of upcoming phone forums, go to the phone forums section of the Calendar of Events page.

“Charities and their Volunteers” – July 24

We’ve scheduled an encore session! The registration link on our phone forums page will be live soon.

“Veterans Organizations – Complying with IRS Rules” — July 30

Veterans organizations occupy a special place in the world of exempt organizations. Not only are most veterans organizations exempt from tax, but contributions to them may be deductible, and some are permitted to set aside amounts that are used to provide insurance benefits to members.

This combination — tax-exempt status, deductibility of contributions and the ability to pay benefits to members — is relatively rare and is evidence of Congress’s intent to provide special tax treatment for veterans organizations. This phone forum provides information to help them stay tax exempt.

Topics include:

“What’s Special about Schedule K (Form 990)?” – July 31

Topics covered include:

http://www.irs.gov/Charities-&-Non-Profits/Phone-Forums-Exempt-Organizations

4.  Register for EO workshops

Register for upcoming workshops for small and medium-sized 501(c)(3) organizations:

August 13 – Highland Heights, KY

Hosted by University of Kentucky

August 15 – Lexington, KY

Hosted by University of Kentucky

August 20-21 – San Francisco, CA

Hosted by Golden Gate University

August 28-29 – Anaheim, CA

Hosted by Trinity Law School

September 9 – St. Paul, MN

Hosted by Hamline University

September 10 – Minneapolis, MN

Hosted by University of St. Thomas

http://www.irs.gov/Charities-&-Non-Profits/Upcoming-Workshops-for-Small-and-Medium-Sized-501(c)(3)-Organizations

5.  Section 509(a)(3) Supporting Organizations pages updated

These updated pages illustrate the new rules for certain organizations that carry out their exempt purposes by supporting other public charities. This classification is important because it is one means by which a charity can avoid classification as a private foundation, a status that is subject to a more restrictive regulatory regime.

http://www.irs.gov/Charities-&-Non-Profits/Section-509(a)(3)-Supporting-Organizations

6.  IRS accepting applications for Low Income Taxpayer Clinic grants

The IRS recently announced the opening of the 2014 Low Income Taxpayer Clinic grant application process. Read news release.

http://www.irs.gov/uac/Newsroom/IRS-Accepting-Applications-for-Low-Income-Taxpayer-Clinic-Grants-2013

7.  IRS Electronic Tax Administration Advisory Committee delivers report to Congress

The Electronic Tax Administration Advisory Committee recently presented its 2013 Annual Report to Congress. The report discusses five groups of recommendations on issues in electronic tax administration.

http://www.irs.gov/pub/irs-pdf/p3415.pdf




IRS Grants Extension of Expenditure Period for Qualified Zone Academy Bond Proceeds.

The IRS granted a city an extension of the expenditure period for available project proceeds of qualified zone academy bonds on determining that the city’s failure to spend its bond proceeds was due to reasonable cause and that the city would spend its remaining proceeds for qualified purposes with due diligence.

Citations: LTR 201326001

This is in response to your request under Section 54A(d)(2)(B)(iii) of the Internal Revenue Code for an extension of the expenditure period for the available project proceeds of qualified tax credit bonds.

FACTS AND REPRESENTATIONS

You make the following factual representations. City is a municipal corporation of State and is largely responsible for the financing of local primary and secondary educational expenditures. The Board of Education (the “Board”) is the official policy making body of District. Board is composed of members appointed by the Mayor of City, and administers City’s school system within District. The school system collectively operates a elementary, middle, and high schools. Board’s operations are solely funded through City appropriations, Federal and State aid to education, grants, and locally generated revenues of Board.

The Bonds were issued on Date 1 by City, and were designated by City as qualified zone academy bonds within the meaning of § 54E(a). Pursuant to § 54E (c)(4), State allocated to the Bonds $b of its carryforward allocation of the national zone academy bond limitation from Year 1. In preparing to issue the Bonds, District identified a pool of public school facilities located within District that met the requirements for being treated as qualified zone academies within the meaning of § 54E(d)(1) and were in urgent need of rehabilitation and repair, and equipment. The Bond proceeds were allocated among 17 public school facilities of such previously identified pool of public school facilities located within District (the “Project”).

Each of these school facilities was budgeted a specific stated amount of the Bond proceeds. The original three-year expenditure period for the Bonds under § 54A(d)(2)(B)(i) will expire on Date 2. However, several unexpected events have resulted in an unforeseen delay in the expenditure of the available project proceeds of the Bonds. As of Date 3, the date of your request for a ruling, $c of the available project proceeds of the Bonds remains unspent.

With respect to five of the 17 school facilities, although the rehabilitation work has been completed, the State-required “as-built” drawings from electrical contractors installing wiring and electrical equipment at those five schools have not been received by District. District is working with the electrical contractors to receive these drawings. Also, reduced clerical staffing necessitated by budget cutbacks has resulted in unexpected delays in various areas of project administration, including the processing of the documentation for, and payments for, contracts with respect to another five of the 17 school facilities under which the rehabilitation and repair work had already been completed. District expects to expend the allocated available project proceeds with respect to these 10 school facilities by Date 4.

A lengthy review process by State with respect to the rehabilitation and repair design plans of another one of the 17 school facilities has resulted in a delay in the rehabilitation work with respect to that facility. At the time the Bonds were issued, District did not foresee that this review process, which includes delays associated with the project designer’s plans and specifications, would take such an extended period of time. District expects the repair and rehabilitation of this school facility and the expenditure of available project proceeds allocated thereto to be completed by Date 5.

The reduced clerical staffing referenced above has also caused an unexpected delay in title transfer and control of the land and thus rehabilitation work with respect to one of the 17 school facilities. District cannot commence the rehabilitation of the school facility without the ownership and possession of the property. District will reallocate the available project proceeds for this project to the “Rehabilitation Project” described below.

The rehabilitation and repair work at another one of the 17 school facilities has been completed. This project, however, is subject to litigation that arose after the work was completed but before the allocable available project proceeds was expended. This expenditure is delayed until the lawsuit is resolved. District will reallocate the available project proceeds for this project to the Rehabilitation Project described below.

At another one of the 17 school facilities, the rehabilitation and repair work was proceeding towards timely completion until it was discovered that the facility was contaminated with polychlorinated biphenyl (“PCB”). The PCB contamination was unexpected and has significantly expanded the scope of the project at this school, and has also significantly increased its cost (collectively referred to herein as the “Rehabilitation Project”) to approximately $d from the $e budgeted for the original rehabilitation and repair project. Both the original portion and the expanded portion of the Rehabilitation Project may not be completed, and the allocable available project proceeds may not be expended, prior to Date 2. District expects to completely spend the available project proceeds allocated to the Rehabilitation Project not later than Date 6.

The actual costs of the rehabilitation and repair of several of the 17 schools, some of which are described above, unexpectedly were less than the original budgeted amounts. The available project proceeds that were originally budgeted for those projects but were not expended, will be reallocated to the Rehabilitation Project.

This unexpected series of events has resulted in an unforeseen delay in the spend-down of the available project proceeds.

City submitted this request for a ruling prior to Date 2.

LAW AND ANALYSIS

Section 54A(d)(1) provides that a qualified zone academy bond is treated as a qualified tax credit bond for purposes of Section 54A.

Section 54A(d)(2)(B)(i) provides in part that to the extent that less than 100 percent of the available project proceeds of the issue are expended by the close of the expenditure period for 1 or more qualified purposes, the issuer shall redeem all of the nonqualified bonds within 90 days after the end of such period.

Section 54A(d)(2)(B)(ii) provides that for purposes of this subpart, the term “expenditure period” means, with respect to any issue, the 3-year period beginning on the date of issuance. Such term shall include any extension of such period under clause (iii).

Section 54A(d)(2)(B)(iii) provides that upon submission of a request prior to the expiration of the expenditure period (determined without regard to any extension under this clause), the Secretary may extend such period if the issuer establishes that the failure to expend the proceeds within the original expenditure period is due to reasonable cause and the expenditures for qualified purposes will continue to proceed with due diligence.

Section 54A(d)((2)(C)(iv) provides that for purposes of this paragraph, in the case of a qualified zone academy bond, a “qualified purpose” means a purpose specified in § 54E(a)(1).

Section 54A(e)(4) of the Code defines “available project proceeds” to mean (A) the excess of (i) the proceeds from the sale of an issue, over (ii) the issuance costs financed by the issue (to the extent that such costs do not exceed 2 percent of such proceeds), and (B) the proceeds from any investment of the excess described in subparagraph (A).

The Project was identified prior to the issuance of the Bonds and District reasonably expected to spend all of its allocable available project proceeds within the three-year period. The failure to spend all the available project proceeds of the Bonds by the expiration of the three-year period on Date 2 was caused by events that were not reasonably expected at the time the Bonds were issued and were beyond the control of either City or District. However, City and District to the extent possible considering all of the described unexpected external events that resulted in unforeseen delays, have and will continue to exercise due diligence in spending the remaining available project proceeds on the Project. City and District expect to spend all available project proceeds not later than Date 6.

CONCLUSION

Under the facts and circumstances of this case, we conclude that District’s failure to expend its allocable portion of the available project proceeds of the Bonds was due to reasonable cause and that District’s expenditures of the proceeds for qualified purposes will proceed with due diligence. Therefore, City is granted an extension of the expenditure period with respect to the Bonds until Date 6.

Except as expressly provided herein, no opinion is expressed or implied concerning the tax consequences of any transaction or item discussed or referenced in this letter.

This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent.

In accordance with a Power of Attorney on file with this office, a copy of this letter is being sent to City’s authorized representative.

The ruling contained in this letter is based upon information and representations submitted by City and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the materials submitted in support of the request for a ruling, it is subject to verification upon examination.

Sincerely,

Associate Chief Counsel

(Financial Institutions & Products)

By: Timothy L. Jones

Senior Counsel, Branch 5




ACA Provisions: What You Need to Know Phone Forum Recording Now Available.

If you want to listen to the April 30th ACA Provisions: What you need to know! Phone Forum, click the link below. The 60 minute presentation covers:

What is included in the cost of coverage (i.e. health, dental/vision, FSA benefits).

Additional Medicare Tax: application, calculation, and reporting.

http://www.irsvideos.gov/Governments/Employers/ACAProvisionsWhatYouNeedtoKnow




TEB Phone Forum: What's Special about Schedule K (Form 990)?

The Office of Tax Exempt Bonds will host a free phone forum on July 31, 2013 at 2:00 p.m. (Eastern Time) to discuss Schedule K (Form 990). To learn more and register, click the following link.

What’s Special about Schedule K (Form 990)?

http://ems.intellor.com/index.cgi?p=204720&t=71&do=register&s=&rID=427&edID=305




McDermott Calls on IRS to Update Safe Harbor Guidelines for Health Care Facilities to Better Implement Affordable Care Act.

In a letter to Assistant Secretary for Tax Policy Mark Mazur, Congressman Jim McDermott (D-WA) today called on the IRS to review outdated “safe harbor” provisions that inhibit the ability of certain new payment models, such as accountable care organizations, to flourish. Updated provisions would help clear obstacles to many of the innovative and more efficient payment models outlined by the Affordable Care Act (ACA), and improve efforts to coordinate care between hospitals and health care professionals.

IRS Revenue Procedure 97-13, which creates safe harbors that protect the tax-exempt status of certain bonds issued by health care facilities, was issued in 1997. Since then, new compensation models, such as bundled payments, have shown promising results for improving care and reducing costs. Updates to the safe harbors will give providers and bondholders certainty that new payment models are protected under the IRS guidance.

“Stakeholders generally structure arrangements to fit squarely within a safe harbor with respect to their compensation arrangements, as they are aware that the IRS is closely scrutinizing these issues,” wrote McDermott. “As a result, hospitals have some anxiety with entering into new and innovative arrangements encouraged by the ACA.”

As the ACA ramps up to full implementation, any revisions to the relevant tax guidance should be made in time to provide certainty so that the new models can be quickly adopted. “It is imperative that the IRS begin to consider such modifications immediately, since under the Affordable Care Act, models that emerge as successful from [Center for Medicare and Medicaid Innovation] can be rapidly expanded throughout the country,” urged McDermott.

* * * * *

July 1, 2013

Mr. Mark Mazur

Assistant Secretary for Tax Policy

Department of Treasury

1500 Pennsylvania Ave N.W.

Washington, DC 20220

Re: Potential Updates to Rev. Proc. 97-13

Dear Mr. Mazur:

As Ranking Member of the Subcommittee on Health of the Committee on Ways and Means, I am deeply interested in initiatives that advance better coordinated care among hospitals, physicians, and other health care professionals. Such coordinated care is not only good for the patient, it is also good for the economy since coordinated care results in a decrease in the number of duplicative tests performed on patients, and can decrease the potential for medical errors that lead to readmissions and other negative consequences.

Many of the reforms in the Affordable Care Act are intended to promote better care coordination. In fact, the Center for Medicare and Medicaid Innovation (“CMMI”) was tasked with developing new, replicable models where health care professionals and hospitals provide high quality care at a lower cost on a population-wide basis. CMMI is now in the process of testing various permutations of accountable care organizations, as well as various bundled payment initiatives. It is my hope that these programs result in savings to the Medicare program and that patients see demonstrable, measurable improvements in the quality of care that they are provided.

However, I am aware that stakeholders are concerned about the implications that participating in such innovative programs may have on tax-exempt bond financed facilities. As you know, facilities that are financed with tax-exempt bonds attempt to structure their contractual arrangements to fit within the safe harbors of Rev. Proc. 97-13. The safe harbors are narrow and limit the terms of such arrangements. Also, the safe harbors limit the types of permissible compensation arrangements and may not address innovative payment methods such as payment bundles. Because of the limited nature of the safe harbors, some of the newly emerging innovative methods by which a hospital may want to compensate a physician do not fit squarely within the existing safe harbors. Of course, this does not automatically make the bonds that finance the health care facility taxable. However, stakeholders generally structure arrangements to fit squarely within a safe harbor with respect to their compensation arrangements, as they are aware that the IRS is closely scrutinizing these issues, particularly since it is easier to do so given the Form 990 redesign. As a result, stakeholders may have some anxiety with entering into new and innovative arrangements encouraged by the Affordable Care Act.

While I understand and fully support the intended purpose behind Rev. Proc. 97-13 and believe it should be retained, I believe it should be updated to recognize the newly emerging compensation models between hospitals and physicians. It is imperative that the IRS begin to consider such modifications immediately, since under the Affordable Care Act, models that emerge as successful from CMMI can be rapidly expanded throughout the country. Thus, it is important to update the guidance and allow providers time to gain an understanding of how they can fit squarely within a safe harbor before such programs are expanded on a nationwide basis.

Thank you for your consideration of this important matter. Should you wish to discuss this matter further, please do not hesitate to contact Tiana Korley on my staff at (202) 225-3106 or at [email protected].

Regards,

Hon. Jim McDermott

Member of Congress




IRS Publication: Voluntary Compliance for Tax-Exempt and Tax-Credit Bonds.

Part one of this publication is a summary of highlighted considerations to help issuers of tax-advantaged bonds comply with related federal tax law requirements. Part two is a summary of Tax-Exempt Bonds Voluntary Closing Agreement Program (TEB VCAP) provisions.

http://www.irs.gov/pub/irs-pdf/p5091.pdf




Guidance Clarifies 'Begins Construction' Standard for Renewable Energy Tax Credit, Treasury Says.

Treasury Assistant Secretary for Legislative Affairs Alastair Fitzpayne has advised Rep. Michael Coffman, R-Colo., that recent guidance (Notice 2013-29) clarifies the new “begins construction” standard for wind investment tax credits and provides “the desired degree of certainty” in the marketplace and allows renewable energy projects to move forward.

June 17, 2013

The Honorable Mike Coffman

U.S. House of Representatives

Washington, DC 20515

Dear Representative Coffman:

Thank you for your letter concerning changes made by the American Taxpayer Relief Act of 2012 (ATRA) to the renewable energy production tax credit (PTC) under section 45 of the Internal Revenue Code and the energy investment tax credit (ITC) under section 48.

As you note, ATRA modified the PTC and ITC to apply to projects that “begin construction” by the end of 2013 instead of projects that are “placed in service” by the end of 2013. On April 15, 2013, Treasury and the Internal Revenue Service issued Notice 2013-29 to clarify this new “begins construction” standard. This notice sets forth two ways that a taxpayer can satisfy the standard in 2013:

(1) beginning physical work of a significant nature,

or (2) paying or incurring 5 percent of the total cost of the project.

These tests are similar to those used for payments under section 1603 of the American Recovery and Reinvestment Act of 2009. A copy of the notice is enclosed. We believe this guidance provides the desired degree of certainty in the marketplace and allows renewable energy projects to move forward.

If you have further questions, please contact Sandra Salstrom, Office of Legislative Affairs, at (202) 622-1900.

Sincerely,

Alastair M. Fitzpayne

Assistant Secretary for

Legislative Affairs




Treasury Informs Oklahoma Governor About Relief From Some Bond and Low-Income Housing Credit Requirements.

Treasury Secretary Jacob Lew has informed Oklahoma Gov. Mary Fallin (R) of Treasury’s decision to provide relief (Notice 2013-40) from some low-income housing credit requirements and relief (Notice 2013-39) from some bond requirements due to severe storms and tornadoes in the state.

June 18, 2013

The Honorable Mary Fallin

Governor of Oklahoma

State Capitol Building

2300 N. Lincoln Blvd.

Suite 212

Oklahoma City, OK 73105

Dear Governor Fallin:

Thank you for your letter to me of May 23, 2013, requesting relief from some of the requirements of the low-income housing tax credit program due to the recent tornadoes in Oklahoma.

In response to your letter, the Treasury Department and the Internal Revenue Service (IRS) issued Notice 2013-40, which makes it possible for Low Income Housing Credit projects anywhere in the country to suspend the income limits and provide temporary housing to victims of the Oklahoma tornadoes. At the same time, Treasury and the IRS also issued Notice 2013-39, which makes it possible for qualified residential rental projects financed with exempt facility bonds to provide temporary housing for these victims. These notices, which went into effect on May 20, 2013, are enclosed. Certain filing and payment deadlines have also been extended for affected taxpayers.

We hope that this relief will play a meaningful role in Oklahoma’s response to the devastation caused by these terrible disasters. Please contact us again if there are other ways in which we can help.

Sincerely,

Jacob J. Lew




Conditional Donation of Conservation Easement and Cash Precludes Charitable Contribution Deduction.

The Tax Court held that a couple wasn’t entitled to charitable contribution deductions for their gift of cash and a conservation easement to an architectural trust, finding that the donation was improperly conditioned on whether the IRS would allow their claimed deductions.

Lawrence Graev agreed to contribute a façade conservation easement on his property to the National Architectural Trust (NAT), a qualified charitable organization. Before the donation, Graev’s accountants advised him of Notice 2004-41 and the IRS’s increased scrutiny of deductions for conservation easement donations. Graev sought assurances from NAT regarding his donation and his ability to claim deductions. NAT issued Graev a letter in which it agreed to refund any disallowed cash contributions and remove the easement from the property title if the deduction was disallowed.

Graev contributed the easement and made a cash contribution to NAT in 2004. On his 2004 and 2005 joint returns with his wife, Graev claimed charitable contribution deductions for his easement contribution and accompanying cash contribution to NAT. The IRS disallowed the deductions as conditional gifts and imposed accuracy-related penalties against the couple.

The Tax Court, in an opinion by Judge David Gustafson, considered whether the promises made in NAT’s letter to Graev made the gift conditional and whether the chance that the condition would occur was so remote as to be negligible under reg. section 1.170A-1(e). Gustafson wrote that “what is determinative under the section 170 ‘remote’ regulations is the possibility, after considering all the facts and circumstances, that NAT’s reception and retention of the easement and cash would be defeated.”

The court concluded that the IRS’s disallowance of the deductions and NAT’s return of the cash and removal of the easement was not so remote as to be negligible at the time of the contribution. The court found that there was a substantial risk of disallowance based on the IRS’s announcement of increased scrutiny and that the risk was evident based on Graev’s request for assurances from NAT. That NAT had issued “comfort letters” to other donors was further evidence of a non-negligible risk that the IRS would disallow the deduction.

Gustafson rejected the Graevs’ argument that the letter from NAT was not enforceable under state law, finding that NAT could abandon the easement under the deed. The court also held that NAT intended to honor its promise if the deduction was disallowed. The court rejected the couple’s argument that the doctrine of merger extinguished the terms of the letter once the deed for the easement was recorded. Gustafson wrote, “We find that NAT’s promises in the side letter to return to the easement and cash were enforceable because we find a clear intent evidenced by the parties that the side letter would survive the deed.”

The Tax Court concluded that there was substantial risk that the IRS would challenge the deductions, that enforcement of the letter wasn’t precluded by state or federal law, and that NAT would act as promised in the letter. As a result, the gifts were conditional and the charitable contribution deductions should be disallowed, the court said.

LAWRENCE G. GRAEV AND LORNA GRAEV,

Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

Citations: Lawrence G. Graev et ux. v. Commissioner; 140 T.C. No. 17; No. 30638-08

UNITED STATES TAX COURT

Filed June 24, 2013

Petitioner husband (“P-H”) contributed cash and a conservation easement to N, a charitable organization. Before the contribution, N at P-H’s request issued to P-H a side letter which promised that, in the event R disallows Ps’ charitable contribution deductions, N “will promptly refund your entire cash endowment contribution and join with you to immediately remove the facade conservation easement from the property’s title”. Ps claimed charitable contribution deductions for the cash and easement donations. R contends the side letter made those contributions conditional gifts that are not deductible under I.R.C. sec. 170, since the likelihood that N would be divested of the cash and easement was not negligible.

Held: Ps’ charitable contribution deductions are not allowed because at the time of P-H’s contributions, the possibility that the deductions would be disallowed and, as a result, that N would return the contributions was not “so remote as to be negligible”, under 26 C.F.R. secs. 1.170A-1(e), 1.170A-7(a)(3), and 1.170A-14(g)(3), Income Tax Regs.

Frank Agostino, Eduardo S. Chung, Jeremy M. Klausner, and Reuben G. Miller, for petitioners.

Shawna A. Early, for respondent.

CONTENTS

FINDINGS OF FACT

NAT

The property

Increased IRS scrutiny of easement contributions

NAT’s solicitation

The side letter

Appraisal

Noncash contribution to NAT

Cash contribution to NAT

Subsequent communications from NAT

2004 and 2005 Federal income tax returns

Notice of deficiency

OPINION

I. Charitable contributions

A. Generally

B. Conditional gifts

C. Partial interests in general

D. Conservation easements

E. Construing “so remote as to be negligible”

II. Analysis

A. The possibility of disallowance by the IRS

1. The possibility of disallowance as a matter of fact

a. Increased IRS scrutiny

b. The side letter

2. Disallowance as a subsequent event

B. The possibility of return of the contributions

1. Conservation easements under New York law

2. Merger doctrine

3. Nullity

4. Voluntary removal of the easement

III. Conclusion.

GUSTAFSON, Judge: Pursuant to section 6212(a),1 the Internal Revenue Service (“IRS”) determined deficiencies in tax for petitioners, Lawrence and Lorna Graev, in the amounts of $237,481 for 2004 and $412,620 for 2005, resulting from the disallowance of charitable contribution deductions the Graevs claimed for those years. The IRS also determined that Mr. and Mrs. Graev are liable for accuracy-related penalties under section 6662(h) and alternatively under section 6662(a) for 2004 and 2005. Mr. and Mrs. Graev petitioned this Court, pursuant to section 6213(a), for redetermination of these deficiencies and penalties. The issue for decision at present is whether the deductions that the Graevs claimed for charitable contributions of cash and a conservation easement they donated to the National Architectural Trust (“NAT”) should be disallowed because they were conditional gifts.2 We hold that the Graevs’ contributions were conditional, non-deductible gifts.

FINDINGS OF FACT

The parties submitted this issue fully stipulated pursuant to Rule 122, reflecting their agreement that the relevant facts could be presented without a trial.3 The stipulated facts are incorporated herein by this reference. Mr. and Mrs. Graev resided in the State of New York when they filed the petition.

NAT

The parties have stipulated that, “[f]or purposes of the Court’s decision regarding” the conditional gift issue, NAT is a “qualified organization” under section 170(h)(3), to which a charitable contribution can be made that is deductible for tax purposes. NAT’s stated mission is to preserve historic architecture in metropolitan areas across the United States. NAT solicits the contribution of facade conservation easements by owners of property with historic significance as determined by the National Park Service. When NAT solicits potential donors, it features the potential charitable deductions that owners may receive by contributing a facade conservation easement and a corresponding cash endowment to NAT. In addition, NAT considered it “standard Trust policy”, regarding donors of easements and cash, to return a cash contribution to the extent the IRS disallowed a deduction therefor. In numerous instances NAT issued “comfort letters” assuring donors of this policy.

The property

In 1999 Mr. Graev purchased property in a historic preservation district in New York, New York, for $4.3 million. The property is listed on the National Register of Historic Places. During the years at issue Mr. Graev was the sole fee simple owner of the property, and he held the property subject to a mortgage.

Increased IRS scrutiny of easement contributions

On June 30, 2004, the IRS released IRS Notice 2004-41, 2004-2 C.B. 31, which addressed charitable contributions and conservation easements and stated in part:

The Internal Revenue Service is aware that taxpayers who (1) transfer an easement on real property to a charitable organization, or (2) make payments to a charitable organization in connection with a purchase of real property from the charitable organization, may be improperly claiming charitable contribution deductions under § 170 of the Internal Revenue Code. The purpose of this notice is to advise participants in these transactions that, in appropriate cases, the Service intends to disallow such deductions and may impose penalties and excise taxes. * * *

* * * * * * *

Some taxpayers are claiming inappropriate charitable contribution deductions under § 170 for cash payments or easement transfers to charitable organizations in connection with the taxpayers’ purchases of real property.

In some of these questionable cases, the charitable organization purchases the property and places a conservation easement on the property. Then, the charitable organization sells the property subject to the easement to a buyer for a price that is substantially less than the price paid by the charitable organization for the property. As part of the sale, the buyer makes a second payment, designated as a “charitable contribution,” to the charitable organization. The total of the payments from the buyer to the charitable organization fully reimburses the charitable organization for the cost of the property.

In appropriate cases, the Service will treat these transactions in accordance with their substance, rather than their form. Thus, the Service may treat the total of the buyer’s payments to the charitable organization as the purchase price paid by the buyer for the property.

Thus, the IRS publicly announced its awareness of abuses related to easement contribution deductions, putting potential donors and donees on notice that easement contribution deductions might be examined and challenged. We find that there was at least a non-negligible possibility that the IRS would challenge an easement contribution deduction thereafter claimed by Mr. Graev.

NAT’s solicitation

In the summer of 2004, a representative from NAT contacted Mr. Graev regarding a potential easement donation to NAT. Mr. Graev became aware that he had a “neighbor across the street” who had contributed a facade easement to NAT and who had received from NAT a side letter that promised return of contributions if deductions were disallowed. Mr. Graev evidently expressed to NAT an interest in making an easement contribution like his neighbor’s, but on September 15, 2004, he sent an email to NAT explaining a concern that had arisen:

My accountants have referred me to Notice 2004-41 * * * issued by the IRS on June 30, 2004, in which the IRS has indicated that it will, in “appropriate cases”, disallow charitable deductions to organizations that promote conservation easements and may impose penalties and excise taxes on the taxpayer. They have not advised me to abandon this idea, but they have advised me to be very cautious. What are your thoughts especially as it relates to the side letter, etc.

(The “side letter” to which Mr. Graev referred was NAT’s comfort letter assuring that it would refund a contribution in the event that the favorable tax results anticipated from a contribution were not achieved.) Mr. Graev indicated that he had consulted his accountants, and in 2004 those accountants would surely have been aware of published court decisions issued over the past decade that disallowed deductions claimed for the contribution of facade easements.4 On his tax returns Mr. Graev listed his occupation as “attorney”, and we infer that he is an individual of above-average sophistication who, with the help of his accountants, was capable of identifying tax risks. We find that Mr. Graev did in fact identify non-negligible risks regarding the deductibility of facade easements, as evidenced by his September 15 email and subsequent dealings with NAT.

In a response to Mr. Graev’s concerns, NAT sent him an email dated September 16, 2004, that stated:

The IRS notices to which you refer were prompted by recently exposed improprieties at the Nature Conservancy, the nation’s largest land conservation easement holding organization. The practice the IRS is concerned with here is when a non-profit acquires property, puts an easement on it and sells it for a reduced price plus a tax-deductible contribution. * * *

It is important to distinguish between these activities, which certainly warrant scrutiny, and those engaged in by the National Architectural Trust. * * * We have been in contact with the IRS since the notices were issued and, based upon our discussion with them, have no reasons to expect that we or any of the donations we have received (easement or cash) will be reviewed.

Thus far not a single donation made to the Trust has been disallowed by the IRS (400+ in New York City alone). * * *

With regard to side letters in particular, NAT wrote:

[W]e don’t believe they compromise the tax-deductibility of cash donations in the present tax year, as they are simply a confirmation of standard Trust policy. However, we do not believe this would be the case with a legal agreement that explicitly made the cash donation contingent on the survival of the deduction. In such a case, we would recommend that the cash donation be treated as tax-deductible once the contingency period has expired. * * *

That is, it was “standard Trust policy” to refund a cash contribution to the extent the IRS disallowed the donor’s deduction for the related easement.

Evidently reassured, Mr. Graev executed a facade conservation easement application to NAT on September 20, 2004. In a cover letter to NAT transmitting the application, Mr. Graev stated: “I will also be looking for the NAT to issue the ‘side’ letter we discussed (similar to the one being issued to my neighbor across the street).”

The side letter

On September 24, 2004 NAT sent the side letter to Mr. Graev. The side letter read in pertinent part:

1. In the event the IRS challenges the appraisal of your facade conservation easement and the tax deductions derived therefrom are reduced as a result, we will make a proportionate reduction to your cash endowment contribution and promptly refund the difference to you.

2. In the event the IRS disallows the tax deductions in their entirety, we will promptly refund your entire cash endowment contribution and join with you to immediately remove the facade conservation easement from the property’s title.

Neither the side letter nor any other evidence in our record suggests that, in the event the IRS disallowed his contribution, Mr. Graev would have to sue NAT in order to induce it to “remove” the easement. Rather, NAT promised upon disallowance to “join with [him] * * * to immediately remove the facade conservation easement from the property’s title”. Mr. Graev took NAT at its word, and so do we. That is, we find that there was at least a non-negligible possibility, if the IRS successfully disallowed Mr. Graev’s easement contribution deduction, that NAT would do what it said it would do.

Appraisal

Mr. Graev retained the firm of Miller Samuel, Inc. (“MSI”), to prepare an appraisal of the facade easement. In October 2004, MSI issued its appraisal report to Mr. Graev appraising the property at $9 million and concluding that the easement would reduce the value by 11% (or $990,000). Thus, the report appraised the easement at $990,000.

Noncash contribution to NAT

In late 20045 Mr. Graev executed a conservation deed granting a facade easement on the property to NAT. The deed in pertinent part provides:

The Property constitutes an important element in the architectural ensemble of the Treadwell Farms Historic District, and the grant of the Easement as set forth in this instrument will, inter alia, assist in preserving this certified historic structure and in preserving open space for the scenic enjoyment of the general public.

* * * * * * *

The Grantor does hereby grant and convey to the Grantee, TO HAVE AND TO HOLD, an Easement in gross, in perpetuity, in, on and to the Property, the Building and the Facade, being an Open Space and Architectural Facade Conversation Easement on the Property * * *

* * * * * * *

A. * * * This Easement shall survive any termination of Grantor’s or the Grantee’s existence. The rights of the Grantee under this instrument shall run for the benefit of an may be exercised by its successor and assigns, or by its designees duly authorized in a deed of Easement.

B. Grantee covenants and agrees that it will not transfer, assign or otherwise convey its rights under this Easement except to another “qualified organization” described in Section 170(h)(3) of the Internal Revenue Code of 1986 and controlling Treasury regulations, and Grantee further agrees that it will not transfer this Easement unless the transferee first agrees to continue to carry out the conservation purposes for which this Easement was created, provided, however, that nothing herein contained shall be constructed to limit the Grantee’s right to give its consent (e.g., to changes in a Protected Facade(s)) or to abandon some or all of its rights hereunder. [Emphasis added.]

C. In the event this Easement is ever extinguished through a judicial decree, Grantor agrees on behalf of itself, its heirs, successors and assigns, that Grantee, or its successors and assigns, will be entitled to receive upon the subsequent sale, exchange or involuntary conversion of the Property, a portion of the proceeds from such sale, exchange or conversion equal to the same proportion that the value of the initial Easement donation bore to the entire value of the property at the time of donation * * *. Grantee agrees to use any proceeds so realized in a manner consistent with the conservation purposes of the original contribution.

* * * * * * *

Citimortgage Inc. (“Mortgagee/Lender”) hereby joins in the execution of this CONSERVATION DEED OF EASEMENT for the sole and limited purpose of subordinating its rights in the Property to the right of the Grantee, its successors or assigns, to enforce the conservation purposes of this Easement in perpetuity under the following conditions and stipulations:

(a) The Mortgagee/Lender and its assignees shall have a prior claim to all insurance proceeds * * * and all proceeds from condemnation, and shall be entitled to same in preference to Grantee until the Mortgage/the Deed of Trust is paid off and discharged, notwithstanding that the Mortgage/the Deed of Trust is subordinate in priority to the Easement.

The deed did not expressly refer to the side letter or incorporate its terms. The City of New York recorded the deed on February 17, 2005.

Cash contribution to NAT

In conjunction with an easement donation, NAT asks a donor to make a cash contribution to NAT equal to 10% of the appraised easement value, in order to pay for NAT’s current operating costs and to fund its long-term monitoring and administration needs. In compliance with NAT’s request, Mr. Graev made an initial deposit of $1,000 to NAT on September 15, 2004. On December 17, 2004, the same day he delivered the signed deed to NAT, Mr. Graev made a $98,000 cash contribution to NAT, bringing his cash contributions to NAT to a total of $99,000. On January 25, 2005, NAT gave Mr. Graev written acknowledgment of his 2004 cash and non-cash contributions. That correspondence also included a copy of Form 8283, executed by the appraiser, MSI, and NAT.

Subsequent communications from NAT

Also on January 25, 2005, NAT sent a letter to Mr. Graev informing him that the U.S. Senate Committee on Finance had announced in a press release their “intent to implement reforms to the tax laws governing facade easements that will increase and create additional fines and penalties on promoters, taxpayers and appraisers who participate, aid or assist in the donation of facade easements that are found to be significantly overvalued.” Several months later, in August 2005, NAT sent Mr. Graev another letter which read:

The purpose of this letter is to bring to your attention a development that may be relevant to the tax deductibility of the cash contributions that you made to the National Architectural Trust * * *

In connection with your donation of a facade conservation easement and cash contribution and per your request, we sent you a letter dated September 24, 2004, stating, among other things, that the cash contribution would be refunded in whole or in part if your tax deduction for the easement were reduced or disallowed by the Internal Revenue Service. It has recently been brought to our attention by our attorney that this offer of a refund may adversely affect the deductibility of the cash contribution as a charitable gift. * * *

We urge you to contact your professional tax advisor to determine the actual impact of the refund offer. Of course, if you determine that you would prefer that we withdraw the refund offer, which according to our attorney should restore the deductibility of your cash contribution, the Trust will promptly do so. * * *

Mr. Graev did not ask NAT to withdraw the refund offer. We find that NAT’s formal offer to withdraw the refund offer — made after NAT consulted with its attorney — further indicates that NAT intended to honor its promises in the side letter (even if the promises may not have been legally enforceable), unless Mr. Graev directed otherwise.

2004 and 2005 Federal income tax returns

Mr. and Mrs. Graev filed joint Forms 1040, U.S. Individual Income Tax Return, for taxable years 2004 and 2005. On their 2004 return, which they filed on or around October 10, 2005 (i.e., after the January and August 2005 letters from NAT, discussed above), Mr. and Mrs. Graev reported a charitable contribution of $990,000 for the facade easement contribution and $99,000 for the cash contribution to NAT. Mr. and Mrs. Graev claimed a deduction for the entire cash contribution in 2004, but because of the limitations on charitable contribution deductions in section 170(b)(1)(C), they claimed a charitable contribution deduction with respect to the facade easement of only $544,449 on their 2004 return.

On their 2005 return, filed on or around October 6, 2006, Mr. and Mrs. Graev claimed a carryover charitable contribution deduction of $445,551 relating to the facade easement contribution in 2004.

Notice of deficiency

By a statutory notice of deficiency dated September 22, 2008, the IRS disallowed Mr. and Mrs. Graev’s cash and non-cash charitable contribution deductions relating to their contributions to NAT and determined deficiencies in tax for both 2004 and 2005. In the notice of deficiency the IRS stated: “[T]he noncash charitable contribution of a qualified conservation contribution is disallowed because it was made subject to subsequent event(s)”. The notice disallowed the Graevs’ cash charitable contribution deduction for the same reason. The IRS also determined that Mr. and Mrs. Graev are liable for accuracy-related penalties under section 6662 for 2004 and 2005.

OPINION

The question now before the Court is whether deductions for Mr. Graev’s contributions of cash and the easement to NAT should be disallowed because they were conditional gifts. The answer depends on whether NAT’s promises in the side letter made the gifts conditional and whether the chance that the condition would occur was “so remote as to be negligible”. See 26 C.F.R. secs. 1.170A-1(e), 1.170A-7(a)(3), 1.170A-14(g)(3), Income Tax Regs.

The Graevs argue that under New York law the agreement in the side letter is unenforceable because conditions in the side letter were not included in the recorded deed and that under Federal tax law the side letter was a nullity. We conclude that NAT’s promises in the side letter were not a nullity and were not extinguished and that NAT could and would honor its promises both as to the easement and as to the cash contribution.

I. Charitable contributions

A. Generally

Section 170(a)(1) generally allows a deduction for any “charitable contribution” made during the taxable year. Section 170(c)(2) defines a “charitable contribution” for this purpose to include “a contribution or gift to or for the use of” a trust organized and operated exclusively for charitable or educational purposes. The parties agree for purposes of the conditional gift issue that NAT is such an organization.

Application of the general rule in section 170(a)(1) may be complicated — especially with regard to the amount and timing of a charitable contribution deduction — if a donor contributes a property interest to a charity but, at the time of the contribution, there is uncertainty about the amount of property that will actually reach the charity — e.g., when a donor contributes a remainder interest in property to a charity, or (as in this case) the donor contributes property subject to a condition. Section 170 and the corresponding regulations provide instruction and limitations that, at least in part, ensure that the donor will be able to deduct only what the donee organization actually receives. See, e.g., sec. 170(f)(2), (3), (11). Three such limitations are pertinent in this case: (1) 26 C.F.R. section 1.170A-1(e), which limits deductions for conditional gifts; (2) section 170(f)(3)(A) and the corresponding regulations, which limit deductions for contributions of partial interests in property; and (3) section 170(f)(3)(B)(iii) and corresponding regulations, which provide special rules for conservation easements.

B. Conditional gifts

The general rule of section 170(a)(1) allows a deduction for a charitable contribution only when “payment * * * is made within the taxable year.” (Emphasis added.) Regulations corresponding to section 170(a) clarify this rule with a limitation particularly relevant in this case:

If an interest in property passes to, or is vested in, charity on the date of the gift and the interest would be defeated by the subsequent performance of some act or the happening of some event, the possibility of occurrence of which appears on the date of the gift to be so remote as to be negligible, the deduction is allowable. [26 C.F.R. sec. 170A-1(e).]

That is, the deduction may be considered “made” notwithstanding a possibility that the contribution will be defeated by a subsequent event, but only if that possibility is “so remote as to be negligible”. Although the parties agree that the side letter recited conditions on Mr. Graev’s contributions, the parties disagree about whether this regulation disallows deductions for those contributions.

A brief discussion of the history of 26 C.F.R. section 1.170A-1(e) is helpful in understanding the regulation’s application in this case. The Secretary promulgated the first version of this regulation in1959 to correspond to section 170(a) of the 1954 Code.6 The operative language in that 1959 regulation was identical to an older regulation that had limited deductions for estate tax purposes for certain conditional charitable bequests. See 26 C.F.R. sec. 81.46(a), Estate Tax Regs. (1949).7 Given this similarity, we consider interpretations of 26 C.F.R. section 20.2055-2(b), Estate Tax Regs., and its history instructive in construing 26 C.F.R. section 170A-1(e). See Briggs v. Commissioner, 72 T.C. 646, 657 (1979), aff’d without published opinion, 665 F.2d 1051 (9th Cir. 1981).

The Supreme Court in Commissioner v. Estate of Sternberger, 348 U.S. 187, 194 (1955), discussed the estate tax regulations at length, stating:

The predecessor of [26 C.F.R.] s[ec.] 81.46 confined charitable deductions to outright, unconditional bequests to charity. It expressly excluded deductions for charitable bequests that were subject to conditions, either precedent or subsequent. While it encouraged assured bequests to charity, it offered no deductions for bequests that might never reach charity. Subsequent amendments have clarified and not changed that principle. Section 81.46(a) today yields to no condition unless the possibility that charity will not take is “negligible” or “highly improbable.” * * *

Similarly, a fundamental principle underlying the charitable contribution deduction is that the charity actually receive and keep the contribution. 26 C.F.R. section 1.170A-1(e) clarifies that principle: no deduction for a charitable contribution that is subject to a condition (regardless of what the condition might be) is allowable, unless on the date of the contribution the possibility that a charity’s interest in the contribution “would be defeated” is “negligible”.

Accordingly, under section 1.170A-1(e) of the regulations (construing the statutory requirement of section 170(a)(1) that a gift actually “is made”), the Graevs’ deductions are not allowable unless the possibility that NAT’s interests in the easement and cash would be defeated was “so remote as to be negligible”.

C. Partial interests in general

Logically related to but distinct from the disallowance of deductions for conditional gifts is the limitation in section 170(f)(3) on deductions for contributions of partial interests in property. One is generally allowed a deduction only for the contribution of one’s entire interest in property. Congress enacted what is now section 170(f)(3)(A) as part of the Tax Reform Act of 1969, Pub. L. No. 91-172, sec. 201, 83 Stat. at 549. Section 170(f)(3)(A) allows a deduction for a charitable contribution “of an interest in property [not made in trust] which consists of less than the taxpayer’s entire interest in such property” only to the extent it would be allowable under section 170 “if such interest had been transferred in trust”. This is a narrow allowance, since the rules that allow charitable contribution deductions for partial interests transferred in trust allow deductions only for interests that can be valued using prescribed methods (e.g., actuarial tables promulgated in the regulations) and that have assurances that the charity will receive payments from the trust. See, e.g., sec. 170(e)(2); 26 C.F.R. sec. 1.170A-6, Income Tax Regs.

In this case, since Mr. Graev reserved the right to have NAT return the easement and the cash if certain events occurred, the contributions of both the easement and the cash were less than Mr. Graev’s entire interest in the contributed property. Accordingly, Mr. Graev’s contributions appear subject to the limitation in section 170(f)(3). However, 26 C.F.R. section 1.170A-7(a)(3) provides the following mitigation of this limitation:

A deduction shall not be disallowed under section 170(f)(3)(A) * * * merely because the interest which passes to, or is vested in, the charity may be defeated by the performance of some act or the happening of some event, if on the date of the gift it appears that the possibility that such act or event will occur is so remote as to be negligible. * * *

Thus, under this regulation, even though the contributions did not consist of Mr. Graev’s entire interest in the cash and the easement, the Graevs’ deductions for contributions would not be disallowed under section 170(f)(3)(A) if the likelihood that NAT’s interests in the cash and the easement would be defeated was “so remote as to be negligible”.

D. Conservation easements

An easement is “[a]n interest in land owned by another person, consisting in the right to use or control the land, or an area above or below it, for a specific limited purpose”. Black’s Law Dictionary 585-586 (9th ed. 2009). Consequently, an easement — whether or not it is subject to any condition — is by definition a partial interest in property, and it would therefore be non-deductible under section 170(f)(3)(A), apart from any further statutory provision. However, further provision is made in subsections (f)(3)(B)(iii) and (h) of section 170, the history of which we briefly survey:

The disallowance of a deduction for partial interests was added to the Code as section 170(f)(3) by the Tax Reform Act of 1969. In that provision’s original form, the only exceptions to disallowance of a deduction for contributions of partial interests were for contributions of “a remainder interest in a personal residence or farm” and “an undivided portion of the taxpayer’s entire interest in property”. That is, no exception was made for a qualified conservation contribution. However, the Staff of Joint Committee on Taxation opined in its General Explanation of the Tax Reform Act of 1969, at 80 (J. Comm. Print 1970), that “a gift of an open space easement in gross is to be considered a gift of an undivided interest in property where the easement is in perpetuity.”

Congress made explicit an exception for (i.e., permitted a deduction for) certain easements in the Tax Reform Act of 1976, Pub. L. No. 94-455, sec. 2124(e), 90 Stat. at 1919, which amended section 170(f)(3)(B) to provide in clause (iii) that a donor may claim a deduction for the contribution of an “easement with respect to real property of not less than 30 years’ duration granted to * * * [a charitable organization] exclusively for conservation purposes”. The following year Congress revised that exception, eliminating the “30 years’ duration” provision and limiting deductibility to an “easement with respect to real property granted in perpetuity”. (Emphasis added.) Tax Reduction and Simplification Act of 1977, Pub. L. No. 95-30, sec. 309(a), 91 Stat. at 154. In the Tax Treatment Extension Act of 1980, Pub. L. No. 96-541, sec. 6(a), 94 Stat. at 3206, Congress amended section 170(f)(3) and added subsection (h), which have remained in effect since then and work in tandem to keep the perpetuity requirement for conservation easement donations.

Section 170(f)(3)(B)(iii) exempts, from the general disallowance of deductions for contributions of partial interests, contributions of “a qualified conservation contribution” — a term defined in section 170(h)(1) as a contribution of a “qualified real property interest,” to a “qualified organization”, “exclusively for conservation purposes.” A “qualified real property interest” must have “a restriction (granted in perpetuity) on the use which may be made of the real property.” Sec. 170(h)(2)(C) (emphasis added).8 Regulations describing the perpetuity requirement provide:

A deduction shall not be disallowed under section 170(f)(3)(B)(iii) * * * merely because the interest which passes to, or is vested in, the donee organization may be defeated by the performance of some act or the happening of some event, if on the date of the gift it appears that the possibility that such act or event will occur is so remote as to be negligible. * * * [26 C.F.R. sec. 1.170A-14(g)(3).]

(The “so remote as to be negligible” phrase is the familiar term first used in the 1949 estate tax regulations cited above.) Accordingly, a conservation easement fails to be “in perpetuity” — and is therefore not excepted from the general rule of section 170(f)(3)(A) disallowing deductions for contributions of partial interests — if, on the date of the donation, the possibility that the charity may be divested of its interest in the easement is not so remote as to be negligible.

E. Construing “so remote as to be negligible”

Each of the issues discussed above — i.e., whether a charitable contribution was effectively “made”, whether it consisted of an “entire interest”, and whether it was a “qualified conservation contribution” — essentially turns on the same question: At the time of Mr. Graev’s contributions, was the possibility that NAT’s interest in the cash and the easement would be defeated “so remote as to be negligible”? In prior cases, we have defined “so remote as to be negligible” as “‘a chance which persons generally would disregard as so highly improbable that it might be ignored with reasonable safety in undertaking a serious business transaction.'” 885 Inv. Co. v. Commissioner, 95 T.C. 156, 161 (1990) (quoting United States v. Dean, 224 F.2d 26, 29 (1st Cir. 1955)). Stated differently, it is “a chance which every dictate of reason would justify an intelligent person in disregarding as so highly improbable and remote as to be lacking in reason and substance.” Briggs v. Commissioner, 72 T.C. at 657. What is determinative under the section 170 “remote” regulations is the possibility, after considering all the facts and circumstances, that NAT’s reception and retention of the easement and cash would be defeated.

II. Analysis

The side letter provides that the occurrence that would defeat NAT’s interest in the easement and cash is the IRS’s successful disallowance of the Graevs’ charitable contribution deductions and NAT’s consequent promised “removal” of the easement and return of the cash. We hold that at the date of the contribution the possibility that the IRS would disallow the deductions and that NAT would return the cash to Mr. Graev and “remove” the easement was not “so remote as to be negligible”.

A. The possibility of disallowance by the IRS

1. The possibility of disallowance as a matter of fact

The Graevs argue that as of December 2004, the caselaw supported an easement valuation of 10% to 15% of Mr. Graev’s property and that it was therefore reasonable to conclude that Mr. Graev’s easement donation had a value of $990,000 (i.e., 11% of the appraised value of the property). They assert that the possibility the IRS would disallow their deductions was so remote as to be negligible. However, on the undisputed facts of this case, it is self-evident that the risk of IRS disallowance was not negligible.9 A substantial risk obviously arose from the IRS’s then-announced intention to scrutinize charitable contribution deductions for facade easement contributions, and that risk is evident from Mr. Graevs’ insistence on NAT’s issuing the side letter. We need not wonder how a donor or donee would have responded to this risk if he had foreseen it; we know how Mr. Graev did respond when he did foresee it: He did not “disregard” or “ignore[ ]” it, see 885 Inv. Co. v. Commissioner, 95 T.C. at 161; Briggs v. Commissioner, 72 T.C. at 657, but rather went out of his way to address it and hedge against it.

a. Increased IRS scrutiny

The Graevs note that at the time of their contribution in December 2004, no charitable contribution deduction arising from a contribution to NAT had been disallowed (to their knowledge). However, the enforcement landscape regarding deductions for facade easement donations was visibly changing at the time of his contribution. As is discussed above, the IRS released Notice 2004-41, supra, on June 30, 2004. In that notice the IRS stated:

The Internal Revenue Service is aware that taxpayers who (1) transfer an easement on real property to a charitable organization, or (2) make payments to a charitable organization in connection with a purchase of real property from the charitable organization, may be improperly claiming charitable contribution deductions under § 170 of the Internal Revenue Code. The purpose of this notice is to advise participants in these transactions that, in appropriate cases, the Service intends to disallow such deductions and may impose penalties and excise taxes. * * *

Notice 2004-41 goes on to give a specific example of the second instance, i.e., a taxpayer makes a cash contribution to a charitable organization in addition to purchasing (at a discount) from the same organization real property that was subject to a conservation easement, where the total amount of contribution and purchase price equals the charity’s initial cost of the real property. The Graevs argue that since Notice 2004-41 specifically described a transaction that did not apply in their case, the notice was not applicable to them.

We disagree. While Notice 2004-41 did list one specific transaction that the Commissioner had determined was inappropriate, the Commissioner’s general warning against “improperly claiming charitable contribution deductions” connected with transfers of conservation easements to charities was still very much applicable to the Graevs. Notice 2004-41 made clear before Mr. Graev’s transfer that his transaction with NAT would be subject to heightened scrutiny and that if any of the Graevs’ positions were susceptible to challenge, the Commissioner would likely enforce a contrary position. Mr. Graev’s September 15, 2004, email to NAT reflects his understanding of this possibility, stating that in light of Notice 2004-41 his accountants “have advised [him] to be very cautious.”

The Graevs argue that their valuation of the contributed easement was reasonable. Since the valuation issue will be resolved by the parties’ stipulation to be bound by the outcome of another case that is still pending, see note 2 above, we do not decide valuation now but assume that the Graevs’ valuation was reasonable. However, the fact that a valuation is reasonable does not mean that it is correct; a reasonable but incorrect valuation may be challenged and disallowed; consequently, someone who assigns a reasonable value to his donation may nonetheless face a non-negligible risk of disallowance.

Moreover, valuation is not the only potential issue faced by a taxpayer claiming a deduction for a contributed easement, and it was not the only issue as to which NAT promised to return Mr. Graev’s contributions. The first numbered paragraph of the side letter did address valuation (“In the event the IRS challenges the appraisal”), but the second numbered paragraph made the distinct promise to return the contributions “[i]n the event the IRS disallows the tax deductions in their entirety”. There are multiple requirements in section 170 and the corresponding regulations that, if not followed, may lead to disallowance — and valuation is only one of them. For example, an easement contribution may be disallowed where —

The donee fails to be a “qualified organization” described in section 170(h)(3).

The property subject to the easement fails to be of a “historically important land area” or a “certified historic structure.” Sec. 170(h)(4)(iv); see Turner v. Commissioner, 126 T.C. 299, 316 (2006).

The taxpayer fails to contribute a “qualified real property interest”. Sec. 170(a)(2); see Belk v. Commissioner, 140 T.C. __ (Jan. 28, 2013).

The easement fails to preserve conservation purposes “in perpetuity”. Sec. 170(h)(5); see Carpenter v. Commissioner, T.C. Memo. 2012-1; Herman v. Commissioner, T.C. Memo. 2009-205.

The parties fail to subordinate the rights of a mortgagee in the property “to the right of the qualified organization to enforce the conservation purposes of the gift in perpetuity.” 26 C.F.R. sec. 1.170A-14(g)(2); see Mitchell v. Commissioner, 138 T.C. 324, 331-332 (2012).

The taxpayer fails to “[a]ttach a fully complete appraisal summary * * * to the tax return”. 26 C.F.R sec. 1.170A-13(c)(2)(B). But see Kaufman v. Shulman, 687 F.3d 21, 28-30 (1st Cir. 2012), aff’g in part, vacating in part, and remanding in part Kaufman v. Commissioner, 136 T.C. 294 (2011), and 134 T.C. 182 (2010).

The appraisal fails to be a “qualified appraisal”. 26 C.F.R. sec. 1.170A-13(c)(3); see Friedberg v. Commissioner, T.C. Memo. 2011-238.

The appraiser fails to be a “qualified appraiser”. 26 C.F.R. sec. 1.170A-13(c)(5); see Rothman v. Commissioner, T.C. Memo. 2012-218 (reserving the question on whether an appraiser was “qualified”).

The parties fail to record the easement or otherwise fail to effect “legally enforceable restrictions”. 26 C.F.R. sec. 1.170A-14(g)(1); see Satullo v. Commissioner, T.C. Memo. 1993-614, aff’d without published opinion, 67 F.3d 314 (11th Cir 1995).

The taxpayer fails to “[m]aintain records” necessary to substantiate the charitable contribution. 26 C.F.R. sec. 1.170A-13(c)(2)(C), Income Tax Regs.

Mr. Graev’s September 15, 2004, correspondence with NAT reflects his clear understanding that charitable contribution deductions for contributions “to organizations that promote conservation easements” were going to be the subject of IRS scrutiny and could be disallowed for failing to satisfy any one of the requirements in section 170. Mr. Graev’s accountants advised him “to be very cautious” with such transactions. Clearly, the risk that the IRS might disallow a deduction for the contribution of an easement was well above “negligible”.

b. The side letter

Informed by his accountants’ warning, Mr. Graev initially asked NAT about the possibility of a side letter from NAT that promised the return of contributions if deductions were disallowed. NAT eventually gave Mr. Graev such a letter on September 24, 2004. The mere fact that he required the side letter is strong evidence that, at the time of Mr. Graev’s contribution, the risk that his corresponding deductions might be disallowed could not be (and was not) “ignored with reasonable safety in undertaking a serious business transaction.” 885 Inv. Co. v. Commissioner, 95 T.C. at 161.

Mr. Graev was not alone in his assessment of the risk of disallowance. NAT considered it “standard Trust policy” to return a cash contribution to the extent a deduction therefor was disallowed by the IRS. In numerous instances NAT issued “comfort letters” assuring donors of this policy. The very essence of a comfort letter implies a non-negligible risk; and the author uses the letter to induce the recipient to enter into a transaction. In this case the risk was either partial or complete disallowance of Mr. Graev’s claimed charitable contribution deductions. NAT’s course of dealing confirms that the possibility that the IRS might disallow Mr. Graev’s deductions was not “so remote as to be negligible”. See 26 C.F.R. secs. 1.170A-1(e), 1.170A-7(a)(3), 1.170A-14(g)(3).

3. Disallowance as a subsequent event

The Graevs argue:

Forty-four years ago, this Court ruled that the [subsequent] events referred to by Treas. Reg. § 1.170A-1(e) do not include contingencies created by Respondent’s examination or contingencies within Respondent’s control. O’Brien v. Commissioner, 46 T.C. 583, 592 (1966), acq., 1968-1 C.B. 2.[ 10 ]

O’Brien v. Commissioner, 46 T.C. 583 (1966), did involve a charitable contribution that was contingent on subsequent favorable tax treatment; but the Graevs’ characterization of our ruling in O’Brien is flatly incorrect, and their reliance on it is therefore mistaken.

O’Brien addressed two issues — a charitable remainder trust issue (which we describe here first) and a related but distinct tax-treatment contingency issue. The taxpayers created a charitable remainder trust in June 1964 — of which they made themselves trustees with broad powers to manage the trust — and then made contributions to the trust in December 1964. Id. at 584. The Commissioner argued that the taxpayers were not entitled to charitable contribution deductions derived from the taxpayers’ contributions to the trust because the complete management power given to the donor-trustees enabled them to defeat the remainder interests and therefore prevented the deduction. Id. at 591. We rejected that argument and concluded —

that it is highly improbable that the petitioners in their fiduciary capacity will ever perform an act which will defeat the charitable remainders they have created in the trust. All of the conditions and circumstances surrounding the transfers of property interests to the trust persuade us that the named charities, or other qualified ones, will eventually receive the beneficial enjoyment thereof. * * * [ Id. at 596; emphasis added.]

We thus decided this remainder trust issue under “[t]he guidelines * * * set forth in section 1.170-1(e), Income Tax Regs.”11 Id. at 594.

The Commissioner’s tax contingency argument (discussed first in O’Brien) was based on paragraph 16 of the trust instrument, under which contributions to the trust were “subject to the condition that such contribution shall be repaid to the contributor by the Trustees * * * only in the event and to the extent that the Commissioner of Internal Revenue does not allow [it] as a deduction”. Id. at 588. In the notice of deficiency issued in September 1965, the Commissioner had disallowed the charitable contribution deductions (for the sole reason that the donor-trustees had power over the trust). We “disposed of [the contingency issue] summarily”, id. at 591, so it is not entirely clear what the Commissioner had argued; but it appears that the Commissioner’s contention was simply that “the literal meaning of paragraph 16”, id., called for return of the contributions upon the mere act of disallowance by the Commissioner, whether or not the Commissioner’s position was valid or was upheld. This position would have put the contingency “‘within the control * * * of the Commissioner'”, O’Brien v. Commissioner, 46 T.C. at 591(quoting Surface Combustion Corp. v. Commissioner, 9 T.C. 631, 655 (1947), aff’d, 181 F.2d 444 (6th Cir. 1950)),12 without regard to the merits of the Commissioner’s decision. We held, to the contrary, that despite “the narrow wording of the trust instrument”, “[t]he petitioners have a right to litigate respondent’s determination”, so that the contributions would not be subject to return “unless the petitioners are unsuccessful in this litigation.” Id. at 592.

That is, in O’Brien the Commissioner evidently argued that the charitable contribution deductions were improper simply because, under the trust instrument, the charitable contributions were defeated by the IRS’s mere disallowance (whether or not that disallowance was upheld in litigation). We held, however, that if the taxpayers successfully challenged that disallowance, then the contributions were not defeated (and the contribution deductions could therefore be allowed). We thus held that a contingency expressed in terms of “disallowance” of a deduction actually looked to the merits of the deduction. Contrary to the Graevs’ argument, our O’Brien Opinion did not analyze the tax contingency issue under the section 170 regulations,13 and we did not hold that a tax-treatment contingency can never be a subsequent event that will defeat a contribution and a deduction. We simply did not address that issue.

This case, unlike O’Brien, clearly presents the issue of whether the promised return of a charitable contribution upon the disallowance of the charitable contribution deduction can constitute a subsequent event the possibility of which, if not negligible, renders the deduction not allowable. O’Brien sheds no light on that question.

B. The possibility of return of the contributions

If the risk of IRS disallowance was non-negligible, then so was the prospect that NAT would be called on to honor its side letter and “promptly refund * * * [Mr. Graev’s] entire cash endowment contribution and join with * * * [Mr. Graev] to immediately remove the facade conservation easement from the property’s title”. Given that non-negligible risk, Mr. Graev’s contributions fell afoul of the section 170 regulations implementing the statutory requirements that a gift be effectively “made”, that it consist of an “entire interest”, and that it be a “qualified conservation contribution”. The Graevs argue, however, that as a matter of law NAT could not be held to the promises it made in its side letter, so that there was in fact no possibility that the property would be returned.

The Graevs contend that NAT could not be divested of its interest in the easement because the side letter is not enforceable under New York law and that, as a result, the contributions were not really conditional.14 In particular, the Graevs argue that New York’s environmental conservation statutes, N.Y. Envtl. Conserv. Law secs. 49-0301 to 49-0311 (McKinney 2008 & Supp. 2013), would prevent the side letter from being enforced, and alternatively, that the common law doctrine of merger extinguished the side letter upon NAT’s recording the easement deed. They also contend that under principles of tax law the promises in the side were a nullity. We disagree.

1. Conservation easements under New York law

In general, property interests are determined by State law. United States v. Nat’l Bank of Commerce, 472 U.S. 713, 722 (1985). In 1983 New York enacted the New York Conservation Easement Statute. See N.Y. Envtl. Conserv. Law secs. 49-0301 to 49-0311. For purposes of these statutes a “conservation easement” is defined as:

an easement, covenant, restriction or other interest in real property, created under and subject to the provisions of this title which limits or restricts development, management or use of such real property for the purpose of preserving or maintaining the scenic, open, historic, archaeological, architectural, or natural condition, character, significance or amenities of the real property * * * [ Id. sec. 49-0303(1).]

Under these New York statutes, a conservation easement is enforceable even though “[i]t is not appurtenant to an interest in real property” and even though “[i]t can be or has been assigned to another holder”.15 N.Y. Envtl. Conserv. Law sec. 49-0305(5). Since an easement with these characteristics would not have been enforceable under New York common law, see Gross v. Cizauskas, 385 N.Y.S.2d 832 (App. Div. 1976), a conservation easement in New York is authorized only by statute and thus is subject to several statutory restrictions. We assume the easement in this case is enforceable only under New York’s Environmental Conservation Law and (as the Graevs contend) is subject to the restrictions therein, especially restrictions on how an easement can be extinguished.

The manner and circumstances in which parties can modify or extinguish a conservation easement under New York’s Environmental Conservation statutes are clear:

A conservation easement shall be modified or extinguished only pursuant to the provisions of section 49-0307 of this title. Any such modification or extinguishment shall be set forth in an instrument which complies with the requirements of section 5-703 of the general obligations law or in an instrument filed in a manner prescribed for recording a conveyance of real property pursuant to section two hundred ninety-one of the real property law. [N.Y. Envtl. Conserv. Law sec. 49-0305(2).]

The Graevs argue that NAT’s promise in the side letter to “remove the facade conservation easement from the property’s title” purports to retain for Mr. Graev a right to extinguish the easement that does not comply with the provisions of N.Y. Envtl. Conserv. Law section 49-0307, and as a result, any attempt to remove the easement pursuant to the promise in the side letter would be unlawful.

Pursuant to N.Y. Envtl. Conserv. Law section 49-0307, cross-referenced in the statute quoted above, a conservation easement held by a “not-for-profit conservation organization”16 may be modified or extinguished only: (1) “as provided in the instrument creating the easement”; (2) “in a proceeding pursuant to section nineteen hundred fifty-one of the real property actions and proceedings law”; or (3) “upon the exercise of the power of eminent domain.” NAT’s promise in the side letter to remove the easement, standing alone, does not appear to comply with any of the three permissible modification or extinguishment methods provided in N.Y. Envtl. Conserv. Law section 49-0307.

The Commissioner argues that the side letter should be considered part of “the instrument creating the easement”. That argument fails because the side letter was not “subscribed by the person * * * granting [the deed]”, N.Y. Gen. Oblig. Law sec. 5-703 (McKinney 2012), nor was it recorded, which are both required under N.Y. Envtl. Conserv. Law section 49-0305 (cross-referencing N.Y. Gen. Oblig. Law sec. 5-703) in order for a document to be considered an “instrument creating the easement”.

However, we hold that NAT had the ability to honor its promises in the side letter because the subscribed and recorded deed — which clearly is “the instrument creating the easement” — reserved for NAT the power to do so. Paragraph IV.B. of the duly recorded deed granting the easement explicitly gives NAT the right to “abandon” the easement, and that deed does comply with one of the three permissible methods — i.e., the first (allowing modification or extinguishment “as provided in the instrument creating the easement”). The recorded deed provides:

Grantee further agrees that it will not transfer this Easement unless the transferee first agrees to continue to carry out the conservation purposes for which this Easement was created, provided, however, that nothing herein contained shall be constructed to limit the Grantee’s right to give its consent (e.g., to changes in a Protected Facade(s)) or to abandon some or all of its rights hereunder. [Emphasis added.]

We have found that at the time Mr. Graev made the contribution, NAT intended to honor its promise to “join with * * * [Mr. Graev] to immediately remove the facade conservation easement from the property’s title”, and we hold that NAT had the ability to honor this promise by exercising its right to abandon the easement as set forth in paragraph IV.B. of the recorded deed.17

Accordingly, we find that the Commissioner has shown that the possibility that NAT would actually abandon its rights was more than negligible.

2. Merger doctrine

Alternatively, the Graevs argue that the entire side letter was extinguished under the common law doctrine of merger. This argument is also without merit. While the doctrine of merger generally extinguishes terms of preliminary contracts or negotiations upon the recording of a deed, so that only the terms in the recorded deed remain, there are exceptions to this general rule. 91 N.Y. Jur. 2d Real Property Sales and Exchanges, sec. 140 (2011). Assuming the doctrine of merger applies to the side letter, the provisions in the side letter would fall within one of these exceptions and survive the deed.

The merger rule does not apply where there is a clear intent evidenced by the parties that a particular provision of the contract shall survive the deed. See Novelty Crystal Corp. v. PSA Institutional Partners, L.P., 850 N.Y.S.2d 497, 500 (App. Div. 2008). “Intention of the parties may be derived from the instruments alone or from the instruments and the surrounding circumstances”. Goldsmith v. Knapp, 637 N.Y.S.2d 434, 436 (App. Div. 1996). In Seibros Fin. Corp. v. Kirman, 249 N.Y.S. 497, 499 (App. Div. 1931), a New York court held that because an agreement giving the purchaser a right to reconvey property that was claimed to be the “inducing cause which persuaded the plaintiff to purchase the property * * * [, t]he contract clearly shows that there was no intention on the part of the parties to merge the contract in the deed. A contract for the sale of real estate is merged in the deed only when the latter is intended to be accepted in full performance of the former.”

Likewise, we find that the side letter was an inducing cause that persuaded Mr. Grave to contribute the conservation easement and cash to NAT. Before he even filled out his application to NAT, Mr. Graev emailed NAT asking for its thoughts on the side letter; and after receiving NAT’s assurances that the side letter would not affect the deductibility of his contribution, he specifically requested the side letter. Moreover, after the donation, when NAT recognized that the side letter might be detrimental to Mr. Graev’s tax deductions, NAT offered to rescind the side letter and Mr. Graev did not accept NAT’s offer, indicating that the parties understood the side letter had survived the deed. Accordingly, we find that NAT’s promises in the side letter to return to the easement and cash were enforceable because we find a clear intent evidenced by the parties that the side letter would survive the deed.

3. Nullity

The Graevs appear to argue that NAT’s side letter is a nullity and should be disregarded for tax purposes because it provides for the donor’s potential recovery of the contributions in the event of unwanted tax consequences. In support of this argument the Graevs rely primarily on Commissioner v. Procter, 142 F.2d 824, 827-828 (4th Cir. 1944), rev’g a Memorandum Opinion of this Court. The holding of the Court of Appeals in Procter, however, is inapposite to this case.

In Procter the donors assigned to their children gifts of remainder interests in two trusts, subject to the following clause:

[I]n the event it should be determined by final judgment or order of a competent federal court of last resort that any part of the transfer in trust hereunder is subject to gift tax, it is agreed by all the parties hereto that in that event the excess property hereby transferred which is decreed by such court to be subject to gift tax, shall automatically be deemed not to be included in the conveyance in trust hereunder and shall remain the sole property of * * * [the taxpayer] * * *. [ Id. at 827.]

Under that clause, if the gifts were held by the courts to be taxable, then the gifts would be undone, and the donors would then be not liable for the tax for which the courts had held them liable. The clause purported not only to undo the gifts but also to undo the judicial decision.

The Court of Appeals for the Fourth Circuit held that the clause in Procter was “clearly a condition subsequent and void because contrary to public policy”, id., for three reasons:

(1) Such a clause “has a tendency to discourage the collection of the tax by the public officials charged with its collection”, thereby discouraging efforts to collect the tax. Id.

(2) “[T]he effect of the condition would be to obstruct the administration of justice by requiring the courts to pass upon a moot case”. Id.

(3) “[T]he condition is to the effect that the final judgment of a court is to be held for naught because of the provision of an indenture necessarily before the court when the judgment is rendered.” Id. That is, a final judgment would cause the condition to be operative, but the condition should not be allowed to operate to undo the judgment, since the instrument containing the condition was before the court, and all matters pertaining thereto merged in the judgment. Id. at 827-828.

None of these three reasons would apply to nullify NAT’s side letter:

First, the conditions in NAT’s side letter would not discourage the collection of tax. This Opinion decides that the Graevs are not entitled to charitable contribution deductions (and that there are therefore deficiencies in their income tax), and the return of the contributions to the Graevs would not at all undo or contradict that holding but would instead be consistent with that holding. In order for the condition in the side letter to be triggered, the deductions must be disallowed, and income tax will thereafter be owing whether or not the contribution is returned.

Second, the possibility of the subsequent return of the contributions does not render this case moot. The Graevs claimed deductions; the IRS disallowed them and determined deficiencies of tax; the Graevs challenged that determination, and we must decide the matter. If we had upheld the deductions, the condition in the side letter would never have been met, the gift would be complete, the contribution would be deductible (assuming other qualifications are met), and we would enter decision in favor of the Graevs to overturn the IRS’s deficiency determination. Because instead we disallow the deductions and enter decision in the IRS’s favor, upholding the deficiency determination, the condition in the side letter is triggered and the gift presumably reverts to the donor. However, in this case, unlike Procter, the reversion to the donor would not be inconsistent with the court’s holding — i.e., the tax collector in our case, unlike Proctor, would collect the tax consistent with the judgment even if the condition become operative and the gift were returned to the donor.

Third, although the final judgment in the IRS’s favor would cause the side letter to be operative, the return of the contribution pursuant to the side letter would not operate to undo the judgment, as was the case in Procter. The return would have no effect on the Graevs’ tax liabilities.

Other cases have similarly distinguished Procter and have held that certain tax contingency provisions are not void as against public policy. See Estate of Christiansen v. Commissioner, 130 T.C. 1, 8 n.7, 17-18 (2008) (a clause that “increases the amount donated to charity should the value of the estate be increased”, “would not make us opine on a moot issue [i.e., the value of the estate], and wouldn’t in any way upset the finality of our decision in this case”), aff’d, 586 F.3d 1061 (8th Cir. 2009); Estate of Dickinson v. Commissioner, 63 T.C. 771, 777 (1975) (stating that the “agreement makes no attempt to nullify * * * [the Court’s] determination” (citing Surface Combustion Corp. v. Commissioner, 9 T.C. 631, and O’Brien v. Commissioner, 46 T.C. 583)); Estate of Petter v. Commissioner, T.C. Memo. 2009-280 (“a judgment adjusting the value of each unit will actually trigger a reallocation of the number of units between the trusts and the foundation under the formula clause. So we are not issuing a merely declaratory judgment”), aff’d, 653 F.3d 1012 (9th Cir. 2011).

4. Voluntary removal of the easement

The event that might defeat the contribution to NAT is the “removal” of the easement and the return of the cash pursuant to NAT’s side letter. Even if, as a matter of law, the side letter was not enforceable for any of the reasons the Graevs advance, the question would remain whether, as a matter of fact, in December 2004 there was a non-negligible possibility that the IRS would disallow the Graevs’ contribution deduction and NAT would voluntarily remove the easement. We have found that there was. Mr. Graev evidently concluded that NAT’s promise should be believed; he took deliberate steps to obtain its promise; and his conclusion is evidence of what was likely. NAT made such promises to Mr. Graev and others precisely because it was soliciting contributions from within a community of potential donors, and the ability of such an organization to obtain solicitations might well be undermined if it got a reputation for failing to keep its promises. To decide that there was no non-negligible possibility that NAT would voluntarily extinguish the easement and return the cash would require us to find that, in order to induce Mr. Graev to make his contribution, NAT made cynical promises that it fully intended to break. Our record will not support such a finding; the stipulated evidence simply shows a non-profit organization going about accomplishing its purpose. If we speculate (without evidence) that NAT might have reneged on its promise, or even if we assume that NAT probably would have reneged on its promise, that still leaves us with at least a non-negligible possibility that NAT would have done what it said it would do. That possibility is fatal to the Graevs’ contribution deductions.

III. Conclusion

Thus, on the evidence before us, we find that there was a substantial possibility that the IRS would challenge the Graevs’ easement contribution deductions. We hold that neither State nor Federal law would prevent enforcement of the side letter. And we find that apart from any legal enforceability of the side letter, it reflected what NAT was likely to do in the event of IRS disallowance.

For these reasons, we conclude that at the time of Mr. Graev’s contributions to NAT, the possibility that the IRS would disallow the Graevs’ deductions for the contributions and, as a result, that NAT would “promptly refund * * * [Mr. Grave’s] entire cash endowment contribution and join with * * * [Mr. Graev] to immediately remove the facade conservation easement from the property’s title” (as it promised) was not “so remote as to be negligible”. Accordingly, under 26 C.F.R. sections 1.170A-1(e) and 1.170A-7(a)(3) the deduction relating to the cash contributions is disallowed. Likewise, under 26 C.F.R. sections 1.170A-1(e), 1.170A-7(a)(3), and 1.170A-14(g)(3), the easement contribution deductions are disallowed.

To reflect the foregoing,

An appropriate order will be issued.

FOOTNOTES

1 Unless otherwise indicated, all section references are to the Internal Revenue Code (26 U.S.C.; “the Code”), as amended, and all Rule references are to the Tax Court Rules of Practice and Procedure.

2 In January 2010 the parties entered into a stipulation to be bound, by which they agreed that if in this case the Court decides the conditional gift issue in the Graevs’ favor, the outcome of some the other issues in this case (chiefly, the valuation of the contributed easement) will follow the outcome of a then-pending case. That case was decided in favor of respondent in July 2010, appealed to the U.S. Court of Appeals for the Second Circuit, vacated and remanded, and decided again in favor of respondent in January 2013. See Scheidelman v. Commissioner, T.C. Memo. 2010-151, vacated and remanded, 682 F.3d 189 (2d Cir. 2012), remanded to T.C. Memo. 2013-18. Decision in that case was entered April 12, 2013, and the time to appeal has not yet expired; but we are able to resolve the issue addressed herein without awaiting the resolution of the Scheidelman issues. We do not resolve here the issue of the Graevs’ liability for the penalties, which will be a subject of future proceedings.

3 The burden of proof is generally on the taxpayer, see Rule 142(a)(1), and the submission of a case under Rule 122 does not alter that burden, see Borchers v. Commissioner, 95 T.C. 82, 91 (1990), aff’d, 943 F.2d 22 (8th Cir. 1991). However, the burden of proof can be shifted when the Commissioner’s position implicates “new matter” not in the notice of deficiency, see note 8 below, addressing the Graevs’ contention about supposed “new matter” in this case.

4 For pre-2004 cases involving facade easements, see Richmond v. United States, 699 F. Supp. 578 (E.D. La. 1988) (upholding partial disallowance of contribution deduction where the taxpayer’s valuation of facade easement was found excessive); Satullo v. Commissioner, T.C. Memo. 1993-614 (upholding disallowance of contribution deduction where the facade easement was unenforceable in the year at issue because it had not been recorded, and where a mortgage had not been subordinated to the donee’s interest), aff’d without published opinion, 67 F.3d 314 (11th Cir. 1995); Dorsey v. Commissioner, T.C. Memo. 1990-242 (upholding partial disallowance of contribution deduction where the taxpayer’s valuation of facade easement was found excessive); Griffin v. Commissioner, T.C. Memo. 1989-130 (same), aff’d, 911 F.2d 1124 (5th Cir. 1990); Losch v. Commissioner, T.C. Memo. 1988-230 (same); and Hilborn v. Commissioner, 85 T.C. 677 (1985) (same). For pre-2004 cases involving conservation easements generally, see Strasburg v. Commissioner, T.C. Memo. 2000-94 (upholding partial disallowance of contribution deductions where the deductions claimed exceeded the taxpayer’s pro rata basis in the property and valuation of the easement was found excessive); Fannon v. Commissioner, T.C. Memo. 1986-572 (upholding partial disallowance of contribution deductions where the taxpayer’s valuation of scenic easement was found excessive); Akers v. Commissioner, T.C. Memo. 1984-490, aff’d, 799 F.2d 243 (6th Cir. 1986) (same); and Great N. Nekoosa Corp. v. United States, 38 Fed. Cl. 645, 654 (1997) (holding that conservation easements were not exclusively for conservation purposes when the plaintiffs retained the right to extract sand and gravel).

5 The deed recites that it was executed October 11, 2004, but Mr. Graev’s signature on the deed was notarized on December 16, 2004, and he delivered it to NAT one day later. NAT’s then president, James Kearns, signed the deed on NAT’s behalf on December 28, 2004.

6 26 C.F.R. section 1.170-1(e), Income Tax Regs. (1959), provided:

If as of the date of a gift a transfer for charitable purposes is dependent upon the performance of some act or the happening of a precedent event in order that it might become effective, no deduction is allowable unless the possibility that the charitable transfer will not become effective is so remote as to be negligible. If an interest passes to or is vested in charity on the date of the gift and the interest would be defeated by the performance of some act or the happening of some event, the occurrence of which appeared to have been highly improbable on the date of the gift, the deduction is allowable. The deduction is not allowed in the case of a transfer in trust conveying a present interest in income if by reason of all the conditions and circumstances surrounding the transfer it appears that the charity may not receive the beneficial enjoyment of the interest. * * *

7 26 C.F.R. sec. 81.46(a), Estate Tax Regs. (1949), provided:

If as of the date of decedent’s death the transfer to charity is dependent upon the performance of some act or the happening of a precedent event in order that it might become effective, no deduction is allowable unless the possibility that charity will not take is so remote as to be negligible. If an estate or interest has passed to or is vested in charity at the time of decedent’s death and such right or interest would be defeated by the performance of some act or the happening of some event which appeared to have been highly improbable at the time of decedent’s death, the deduction is allowable.

The current version of this regulation is in 26 C.F.R. sec. 20.2055-2(b)(1), Estate Tax Regs.

8 In his reply brief, Mr. Graev complains that an IRS argument invoking the perpetuity requirement is “new matter” as to which the IRS should bear the burden of proof under Rule 142(a)(1). We do not believe that the burden of proof affects the resolution of this issue, since the material facts are not actually in dispute, and the outcome is the same no matter which party has the burden. See Dagres v. Commissioner, 136 T.C. 263, 279 (2011). More important, however, the argument that the gifts were subject to a subsequent event — an issue plainly stated in the notice of deficiency — is by its nature an argument that the gifts failed to be perpetual. One reason a conservation easement may fail to be a perpetual gift to the donee, and may thus fail to be deductible, is that it is subject to a condition that creates a non-remote possibility that the easement may revert to the donor. See 26 C.F.R. sec. 1.170A-14(g)(3), Income Tax Regs. The issue of perpetuity is not new matter in this case.

9 We do not address the circumstance in which a hyper-cautious donor conditions his gift on non-disallowance where there is no non-negligible possibility of disallowance.

10 The Graevs also cite an IRS private letter ruling. We decline to consider it, in light of section 6110(k)(3), which provides: “(3) Precedential status. — Unless the Secretary otherwise establishes by regulations, a written determination may not be used or cited as precedent.” See Abdel-Fattah v. Commissioner, 134 T.C. 190, 202 (2010); Vons Cos., Inc. v. United States, 51 Fed. Cl. 1, 12 (2001).

11 For the remainder trust issue we cited 26 C.F.R. section 1.170-1(e) (1961) (see note 6 above for the 1959 version which was identical to the 1961 regulation); but the limitations now set forth in 26 C.F.R. sections 1.170A-1(e), 1.170A-7(a)(3), and 1.170A-14(g)(3), Income Tax Regs., are equivalent.

12 In Surface Combustion Corp. v. Commissioner, 9 T.C. 631 (1947), aff’d, 181 F.2d 444 (6th Cir. 1950), we held that a provision in an employee trust allowing an employer to reclaim his contributions to the trust if the contributions were determined to be nondeductible did not prevent the employer from deducting his contributions to the trust since the contingency was in the control of the Commissioner. Surface Combustion did not involve charitable contributions, section 170, nor any regulations with a “so remote as to be negligible” standard.

13 Our Opinion in O’Brien v. Commissioner, 46 T.C. 583, 592 (1966), indicates that the Commissioner also cited — but we distinguished — Jones v. United States, 252 F. Supp. 256 (N.D. Ohio 1966), aff’d in part, rev’d in part, 395 F.2d 938 (6th Cir. 1968), a case not involving a tax-treatment-contingent contribution, in which (as we noted) the District Court held that the possibility that a contribution at issue there would be defeated “was not ‘so remote as to be negligible’ under section 1.170-1(e), Income Tax Regs.” This description of Jones includes our only mention of that regulation in our discussion of this issue in the O’Brien Opinion, and our discussion does not address any relation between the regulation and the tax-treatment-contingent deduction at issue in O’Brien.

14 In this argument the Graevs do not distinguish between the contribution of the easement (which was subject to the statutes that the Graevs cite) and the contribution of the cash (which was not). Reliance on New York real estate principles to argue that the side letter is not enforceable as to the cash contribution is misplaced. Even if the side letter were not enforceable as to the easement, for the reasons the Graevs advance, so that they could not require NAT to “remove” it, the Graevs show no reason that the side letter would not be enforceable so as to require the return of the cash.

15 The legislative history of these provisions suggests that they were included in the statutes so that the conservation easements would satisfy the perpetuity requirement of 26 C.F.R. sec. 170A-14(g). See John C. Partigan, “New York’s Conservation Easement Statute: The Property Interest and Its Real Property and Federal Income Tax Consequences”, 49 Albany L. Rev. 430, 452 n.87 (1985).

16 The Commissioner does not dispute that NAT is a “not-for-profit conservation organization” for purposes of New York’s Environmental Conservation Law.

17 Our holding here is distinguishable from Commissioner v. Simmons, 646 F.3d 6, 10 (D.C. Cir. 2011), aff’g T.C. Memo. 2009-208, which looked at similar abandonment language in an easement deed and concluded “deductions cannot be disallowed based upon the remote possibility * * * [the charity] will abandon the easements.” See also Kaufman v. Shulman, 687 F.3d 21, 28 (1st Cir. 2012), aff’g in part, vacating in part, and remanding in part Kaufman v. Commissioner, 136 T.C. 294 (2011), and 134 T.C. 182 (2010). In Commissioner v. Simmons, 646 F.3d at 10, the Court of Appeals for the D.C. Circuit stated that “the Commissioner has not shown the possibility * * * [the charity] will actually abandon its rights is more than negligible. [The charity] * * * has been holding and monitoring easements in the District of Columbia since 1978, yet the Commissioner points to not a single instance of its having abandoned its right to enforce.” In the instant case, however, NAT gave Mr. Graev an explicit, written promise that it would abandon its rights in the easement if certain events occurred. We find nothing to indicate that NAT did not intend to comply with its written promises.






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