From The Courts — Recent Developments, August 2011

VIEW IN PDF:  Tax News & Comment — August 2011

The Supreme Court, in an unanimous opinion, held that a medical resident whose normal work schedule requires him to perform services 40 or more hours per week, is not a “student” for purposes of IRC § 3121(b), and therefore not within the statutory exception for FICA withholding.  Mayo Foundation For Medical Education v. United States, No. 09-837 (2011).

[The Federal Insurance Contributions Act (FICA) requires employees and employers to pay taxes on all “wages.” FICA defines “employment” as “any service performed . . . by an employee for the person employing him,” but excludes from taxation any “service performed in the employ of . . . A school, college or university . . . If such service is performed by a student who is enrolled and regularly attending classes [at the school]. IRC § 3121(b)(1).

Since 1951, the Treasury Department had construed the student exception to exempt from taxation students who work for their schools “as an incident to and for the purpose of pursuing a course of study.” 16 Fed.
Reg. 12474. In 2004, the Treasury Department issued regulations providing that the services of a full time employee normally scheduled to work 40 or more hours per week “are not incident to and for the purpose of pursuing a course of study.” Treas. Regs § 31.3121(b)(10)-2(d)(3)(iii). The regulations stated that the analysis was not affected by “the fact that the services . . . may have an educational, instructional, or training aspect. Id.

Mayo paid the FICA tax, and filed suit for refund in District Court claiming that the rule was invalid. The District Court granted summary judgment for Mayo, finding that the regulation was inconsistent with the unambiguous words of the statute. However, the Eighth Circuit reversed, finding that the regulation was a permissible interpretation of an ambiguous statute. The Supreme Court granted Certiorari and, in an opinion by Chief Justice Roberts, affirmed the decision of the Eighth Circuit.]

The Court began its analysis by noting that the regulation in question provides that an employee’s service is “incident” to his studies only when “[t]he educational aspect of the relationship between the employer and the employee, as compared to the service aspect of the relationship, [is] predominant.” Treas. Reg. § 31.3121(b)(10)-2(d)(3)(i).

The Court cited to Chevron U.S.A. v. National Resources Defense Counsel, Inc., 467 U.S. 837 (1984), in finding relevant the inquiry as to whether Congress had “directly addressed the precise question at issue.” The Court found that Congress had not, since the statute does not define the term “student,” and does not address the question of whether medical students are subject to FICA.

The Court found unpersuasive Mayo’s argument that the dictionary definition of “student” as one “who engages in ‘study’ by applying the mind ‘to the acquisition of learning, whether by means of books, observations, or experiment’ plainly encompasses residents, since a “full-time professor taking evening classes” could fall within the exemption.

Moreover, the Court was unimpressed with the view of the District Court that an employee be deemed a ‘student’ as long as the educational aspect of his service “predominates over the service aspect of the relationship with his employer,” dryly observing that “[w]e do not think it possible to glean so much from the little that § 3121 provides.” The Court concluded that neither the plain terms of the statute, nor the District Court’s interpretation of the exemption “speak[s] with the precision necessary to say definitively whether [the statute] applies to medical students.”

The Court then to cited Chevron with approval:

Chevron recognized that the power of an administrative agency to administer a congressionally created . . . program necessarily requires the formulation of policy and the making of rules to fill any gap left, implicitly or explicitly, by Congress.

The regulations at issue were promulgated pursuant to the “explicit” authorization granted to the Treasury by Congress to “prescribe all needful rules and regulations for the enforcement of” the Internal Revenue Code. IRC § 7805(a). Finding that Treasury had issued the full time employee rule only after notice-and-comment procedures, the rule “merits Chevron deference.” Long Island Care at Home, Ltd., v. Coke, 551 U.S. 158, 173-174 (2007).

The Court then addressed Mayo’s argument that the Treasury Department’s conclusion that residents who work more than 40 hours per week “categorically cannot satisfy” the student exemption.

The Court first found “perfectly sensible” the Treasury Department’s method of distinguishing between workers who study and students who work was by “[f]ocusing on hours an individual works and the hours he spends in studies.” The approach, the Court noted, avoids “wasteful litigation and needless uncertainty” and, as Treasury observed, “improves administrability.”

The Court then observed that taxing residents under FICA would “further the purpose of the Social Security Act . . . and import a breadth of coverage.” Although Mayo contended that medical residents have not yet “begun their working lives because they are not fully trained,” Treasury had not acted “irrationally” in concluding that “these doctors — ‘who work long hours, serve as highly skilled professionals, and typically share some or all of the terms of employment of career employees’ — are the kind of workers that Congress intended to both contribute to and benefit from the Social Security system. 69 Fed. Reg. 8608.” As a coup de grace, the Court, citing Bingler v. Johnson, 394 U.S. 741, 752 (1969) for the proposition that “exemptions from taxation are to be narrowly construed.”

Recognizing the value medical residents impart to society, Chief Justice Roberts concluded the opinion by observing:

We do not doubt that Mayo’s residents are engaged in a valuable educational pursuit or that they are students of their craft. The question whether they are “students” for purposes of §3121, however, is a different matter. Because it is one to which Congress has not directly spoken, and because the Treasury Department’s rule is a reasonable construction of what Congress has said, the judgment of the Court of Appeals must be affirmed.

                     *     *     *

The IRS has advanced many theories to challenge the gift and estate tax savings occasioned by the use of family entities and grantor trusts in estate planning. Most arguments have been unsuccessful. However, the IRS discovered a potent weapon in IRC § 2036(a), which provides that the value of the gross estate includes the value of all property to the extent the decedent has made a transfer but has retained (i) the possession or enjoyment of, or the right to income from, the property, or (ii) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.

The IRS has been successful in arguing that IRC § 2036(a) requires the inclusion in the decedent’s estate of (i) partnership assets if the decedent continued to derive benefits from the partnership, or of (ii) trust assets, if the decedent continued to receive distributions. The IRS has been most successful where the transactions with not imbued with a sufficient quantum of non-tax objectives, or the economics of the transaction were questionable, most often because the transferor had not retained sufficient assets to live according to his accustomed standard without receiving partnership (or trust) distributions.

The Ninth Circuit recently affirmed a decision of the Tax Court which found that the decedent’s retention of benefits in property transferred to a partnership resulted in the failure of the transfer to constitute a bona fide sale for full and adequate consideration. Estate of Jorgensen v. Com’r, No. 09-73250 (5/11/11). On appeal, the Estate did not contest that the decedent had retained some of the benefits of the transferred property, but argued that the benefits retained were de minimis.  The Ninth Circuit disagreed, remarking:

We do not find it de minimis that decedent personally wrote over $90,000 in checks on the accounts post-transfer, and the partnerships paid over $200,000 of her personal estate taxes from partnership funds.  See Strangi v. Com’r, 417 F.3d 468, 477 (5th Cir. 2005) (post-death payment of funeral expenses and debts from partnership funds indicative of implicit agreement that transferor would retain enjoyment of property); see also Bigelow, 503 F.3d at 966 (noting payment of funeral expenses by partnership as supporting reasonable inference decedent had implied agreement she could access funds as needed.

            *     *     *

By Rebecca K. Richards

The Court of Appeals for the District of Columbia Circuit in Intermountain Insurance Service of Vail, LLC v. Com’r, reversed the Tax Court and upheld an IRS regulation that considered an overstatement of basis as an “omission of gross income” for the purpose of triggering the extended six-year statute of limitations provided for in Internal Revenue Code sections 6501(e)(1)(A) and 6229(c)(2). 2011 WL 2451011 (D.C. Cir. June 21, 2011),

[In general, under IRC § 6501(a), the IRS has three years to make an adjustment to the amount of gross income reported by a taxpayer. However, IRC § 6501(e)(1)(A) extends the statute of limitations to six years when the taxpayer “omits from gross income an amount properly includible therein which is in excess of 25 percent of gross income stated in the return.” IRC § 6229(c)(2) provides for an extended six-year statute of limitations under a similar statutory scheme for partnerships.

On its 1999 income tax return, Intermountain reported a loss on the sale of assets. On September 14, 2006, nearly six years later, the IRS issued a deficiency alleging that Intermountain had realized a gain of approximately $2 million on its 1999 sale of assets. The IRS alleged that Intermountain had overstated its basis and, therefore, understated its gross income.

In response, Intermountain filed a motion for summary judgment in the Tax Court, arguing that the adjustment was not timely since it was not within the  three-year statute of limitations. In opposition, the Commissioner argued that the adjustment was timely because the 1999 return contained an “omission from gross income,” thus triggering the extended six-year statute of limitations provided for in §§ 6501(e)(1)(A) and 6229(c)(2).]

In reliance on the Supreme Court decision in Colony, Inc. v. Com’r, 357 U.S. 29 (1958), the Tax Court granted summary judgment to Intermountain and held that an overstatement of basis did not constitute an “omission from gross income” for the purpose of IRC §§ 6501(e)(1)(A) or 6229(c)(2). The Supreme Court held in Colony that basis overstatements did not constitute “omissions from gross income” for the purpose of the predecessor to IRC § 6501(e)(1)(A). The Tax Court found Colony to be controlling authority and ruled that the extended statute of limitations did not apply.

Shortly thereafter, the IRS issued regulations contradicting the Tax Court’s ruling. The regulation stated that the phrase, “omits from gross income,” in IRC §§ 6501(e)(1)(A) and 6229(c)(2) generally included overstatements of basis. The Commissioner then moved the Tax Court for reconsideration. The Tax Court denied the motion, finding the regulation inapplicable because it had not become effective until after the three-year statute of limitations had expired. The Commissioner then appealed to the Court of Appeals for the District of Columbia Circuit.

The issue posed to the Court of Appeals was whether to afford deference to the IRS regulation interpreting IRC §§ 6501(e)(1)(A) and 6229(c)(2)  as including basis overstatements in the definition of “omission from gross income.” The Court found that IRC § 6501(e)(1)(A) was indeed ambiguous because “neither the section’s structure nor its legislative history nor the context in which it was passed” clearly resolved the question of whether an overstatement of basis constituted an omission from gross income. Intermountain, 2011 WL 2451011 at *12.

In performing the Chevron analysis, i.e., whether the regulation is a reasonable interpretation of the statute, the Court found “nothing unreasonable” in the IRS regulation interpreting “omits from gross income” as including overstatements of basis. Accordingly, the Court found that the regulation was entitled to deference.

Legislative regulations interpret statutes that expressly delegate the authority to promulgate regulations. Interpretative regulations are less authoritative and are used primarily to interpret the Code. The regulations at issue in Intermountain were interpretative regulations. Intermountain illustrates the high level of judicial deference that is afforded to agency regulations under Chevron.

Deferring to agency regulations is in seeming opposition to the long-standing concept of staré decisis (judicial obligation to respect precedents established by prior cases). However, with administrative agencies such as the IRS, the Supreme Court has stated that some flexibility may be desirable: “To engage in informed rulemaking, [the agency] must consider varying interpretations and the wisdom of its policy on a continuing basis.” Chevron, 467 U.S. at 863-64.

 [Rebecca is entering her third year at Hofstra Law School, where she is at the top of her class. Rebecca is Senior Articles Editor for the Journal of International Business and Law. She expects to graduate in May, 2012. Rebecca is completing a productive seven-month internship at the office.]

           *     *     *

The Tax Appeals Tribunal has affirmed a Determination of the Division of Tax Appeals which found that a Connecticut domiciliary who commuted to Manhattan as an investment manager was subject to New York State personal income tax on income from all sources, and not merely their New York source income,  under Tax Law § 601 as a “resident individual” solely by reason of ownership of a summer house near Amagansett which was sporadically used. In the Matter of John and Laura Barker, DTA No. 822324.

Tax Law § 605(b)(1) includes in the definition of a “resident individual” a person “who is not domiciled in this state but maintains a permanent place of abode in this state and spends in the aggregate more than one hundred and eighty-three days of the taxable year in this state. . .”  The taxpayer conceded that he spent more than the required 183 days in New York.  At issue was whether the summer house constituted a “permanent place of abode” for the purpose of Section 605(b)(1).  Administrative Law Judge Joseph Pinto, after a hearing at the Division of Tax Appeals found that it did, and upheld a $1.056 million deficiency (consisting of tax, interest and penalties) resulting from a three-year audit beginning in 2002.

On appeal, the taxpayer argued that the ALJ has misconstrued the “permanent place of abode” analysis and had incorrectly found the summer house not to be a “camp or cottage”.  The Tax Appeals Tribunal began its analysis by noting that only the regulations (and not the statute) defines the term “permanent place of abode.”  Under 20 NYCRR 105.20(e), the term was defined as “a dwelling place permanently maintained by the taxpayer. . . [but not] a mere camp or cottege.”

The taxpayer argued that the vacation home was not a permanent place of abode, citing an earlier case which it interpreted as establishing a “subjective standard” providing that the permanence “must encompass the physical aspects of the dwelling place as well as the individual’s relationship to the place.”  The Tribunal dismissed this argument, stating that the holding stood only for the proposition that a permanent place of abode may be found even where the taxpayer bears no legal right to the property.

The Tribunal rejected the taxpayer’s argument that the subjective use of the summer house was determinative, stating that “[it] is well settled that a dwelling is a permanent place of abode where, as it is here, the residence is objectively suitable for year round living and the taxpayer maintains dominion and control over the building.” The only positive note for the taxpayer in the case is that the Tribunal remanded the matter to the ALJ for a supplemental determination as to whether the petitioners had established reasonable cause for abatement of the $221,086 in penalties.

The upshot of this case is that working in New York will be enough to subject all of a person’s income to New York income tax if the person owns a vacation home in New York, without regard to whether the home is used.  The ruling may well discourage nonresidents from owning a summer home in New York.

The interpretation of the regulations by the Division of Tax Appeals and the Tax Appeals Tribunal is not without legitimate disagreement. The phrase in the regulations which excludes a “mere camp or cottage, which is suitable and used only for vacations” taken literally certainly justifies those  Tribunals’ view that the exception is inapplicable. However, one is left with the distinct impression when reading the first sentence of the regulation, that the phrase “a dwelling place permanently maintained by the taxpayer” is not satisfied where the taxpayer owns summer home in which the taxpayer does not spend much time since, at least with respect to the taxpayer, it is not the taxpayer’s “dwelling place.”

Furthermore, where the words of the statute are clear, there is need to consult the regulations. Admittedly, in the case, the statute failed to define the term “permanent place of abode.” However, the interpretation of the regulation by the Tribunals seems to contract the statute, since the statutory phrase “permanent place of abode” cannot seemingly be satisfied by a taxpayer who does not reside in that abode.

For example, assume that the statute taxes “dogs”. The regulations define the term “dogs” as “including  cats.” Clearly a cat is not a dog, yet under the regulations cats are taxed. The regulations contradict the statute. Should a deficiency attempting to impose tax on a cat be upheld? This analogy is not intended to suggest that the case in issue presented such a stark situation. However, the analogy is fair.

Although it will be too late for this taxpayer, should the legislature feels that the result is not what it intended, it could revise the statute or regulations. Whether or not this is the result the legislature intended, one suspects that Albany may not act. Therefore, commuters who own vacation residences in New York should be aware that they must report all of their income, from whatever source, on their New York State income tax return.

            *     *     *

The Tax Appeals Tribunal, affirming a determination of the Administrative Law Judge, has found that Madigascar has no right to claim a refund for transfer tax paid in connection with the sale of its New York City mission.  In the Matter of The Republic of Madigascar, DTS Nos. 822357 and 822358.

There was no dispute that the condominium housed the “premises of the mission” under the Vienna Convention on Diplomatic Relations of 1961. Accordingly, Madigascar was exempt from liability for transfer tax. However, as part of the negotiations for the sale of the mission, Madigascar agreed to pay half of the transfer tax. Normally, the transfer tax is the responsibility of the seller. The problem with the arrangement was that Madigascar paid the tax on behalf of the purchaser. Tax Law § 1404[b] provides that while the grantor is generally responsible for the payment of transfer tax, where the grantor is exempt, the liability for payment of the tax shifts to the grantee.

In finding “no remedy” under the Tax Law for Madigascar, the Tribunal observed:

[T]he State of New York did not impose any tax liability upon petitioner in this case. . . Petitioner’s obligation to pay resulted from volunteering to do so as part of its contractual agreements. . .The Vienna Convention does not affect petitioner’s liability under the Tax Law since it was the terms of the parties’ contracts that resulted in petitioner paying the transfer tax at issue.

*      *     *

In general, expenses paid during the taxable year for medical care of the taxpayer or a dependent not compensated for by insurance or otherwise may be deducted to the extent those expenses exceed 7.5 percent of AGI under IRC § 213. The term “medical care” includes “amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, and amounts paid for qualified long-term care services.” Long term care expenses are deductible if a physician has determined that the taxpayer is “chronically ill.”

The Tax Court, in Estate of Baral v. Com’r, No. 3618; 7/5/2011, found that payments made to caregivers were deductible as itemized medical expenses (subject to the 7.5 percent AGI limitation) since a physician had determined that the taxpayer, who suffered from dementia, was chronically ill. Although the payments were not made to medical personnel, they were nevertheless deductible as “medical expenses” since a physician had found the services necessary due to the taxpayer’s dementia, and had recommended 24-hour care.

A contrary result was reached by the Tax Court in Estate of Olivio v. Com’r, (No. 15428-07; 7/11/2011).  In Olivio, a child provided long-term care for nine years, and claimed as a debt of his mother’s estate $1.24 million, representing the value of the services allegedly provided by him pursuant to an oral agreement with his mother. he Tax Court found that services provided by family members are presumed to be without remuneration in the absence of a written agreement.

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