Washington Hotline – November 24, 2020


National Tax Security Awareness Week

In IR-2020-259, the Internal Revenue Service announced that November 30 to December 4, 2020 will be the Annual National Tax Security Awareness Week. Each year, the IRS highlights the best methods for protecting individuals or businesses from identity theft and other security risks.

IRS Commissioner Chuck Rettig stated, “As the holiday season and tax season approach, everyone should remember to take basic steps to protect themselves. With more taxpayers and tax preparers working remotely, identity thieves are trying to use COVID-19 to scare and scam people out of their identities or money. All of us must be on guard and use the strongest security measures we can. The goal of National Tax Security Awareness Week is to remind people about important steps they can take to protect themselves and their tax information.”

As the COVID-19 pandemic continues, the IRS is receiving reports on many variations of prior scams. The National Tax Security Awareness Week is an educational program to encourage individuals, businesses and tax professionals to take steps to reduce identity theft.

The IRS has created multiple YouTube videos with information on data security. Go to IRS.gov and search for “Easy Steps to Protect Your Computer and Phone” and “Avoid Phishing Emails.”

Each day of National Tax Security Awareness Week will highlight a specific area of data security.

Day One: Personal and Financial Information – Individuals should use security software on computers and phones. The software should be set to automatically update no less than once each day. You should be on alert to avoid email phishing scams related to COVID-19 or Economic Impact Payments. All accounts should be protected with strong passwords. If you have the option, use two-factor authentication. Avoid use of public Wi-Fi in shopping malls and other similar locations.

Day Two: Multi-factor Authentication – Most tax software providers permit multi-factor authentication. This option is also available from your bank or financial services firm. Multi-factor authentication requires a second verification code, often sent to your mobile phone. It is paired with your password to increase protection for your online accounts.

Day Three: Identity Protection PIN – In January of 2021, taxpayers will be permitted to join the IRS IP PIN program. This IP PIN is a six-digit code known by you and the IRS. It will be available on IRS.gov/IPPIN. The IP PIN provides added protection for your Social Security number on your tax return. You should not share your IP PIN with anyone except your tax preparer.

Day Four: Business Protection – Most of the attacks by fraudsters involve businesses with fewer than 100 employees. You should follow sound business data practices and security measures. Your tax software accounts should use two-factor authentication. With COVID-19, many employees are working remotely. All remote employees should have access through a Virtual Private Network (VPN). If you are a tax professional, you should have a written data security plan. Your employees should be knowledgeable about phishing and phone scams, fake client scams and COVID-19 scams. Tax professionals must have a data security and data theft recovery plan.

Editor’s Note: As COVID-19 numbers increase with cold weather, there will be a new round of identity theft scams. Individuals and businesses should take prudent steps to increase security and avoid identity theft this winter.

Pre-Bubble Easement Valuation Upheld

In Kumar Rajagopalan et ux. et al. v. Commissioner; No. 21394-11; No. 21575-11; T.C. Memo. 2020-159, the Tax Court upheld the taxpayer valuation on a conservation easement granted at the peak of the 2006 real estate market.

S. S. Mountain, LLC (“SS Mountain”) was formed in 2004 in North Carolina. Kumar Rajagopalan and former NFL star Warren Sapp were LLC members. SS Mountain purchased 120 acres in Hayward County, North Carolina. The LLC members considered two options – creating a residential subdivision of 37 lots or a plan with 12 lots and open space.

They decided to create 12 lots and grant a conservation easement on the balance of the property. On November 28, 2006, SS Mountain granted a conservation easement on 89.378 acres to the North American Land Trust (NALT). The development required further construction for roads and utilities.

Prior to the easement grant, four lots were sold for $750,000 dollars and a bank loan for $5 million was obtained. The remaining lots had similar estimated values. Defendant Sapp purchased an additional lot on September 21, 2007 for $1.1 million. Qualified appraiser Dave Roberts valued the easement using a “before and after” method.

The real estate market declined substantially after 2007 and the value of the properties decreased. SS Mountain reported a contribution deduction of $4,879,000 and attached the qualified appraisal to its 2006 Form 1065, U.S. Return of Partnership Income. SS Mountain issued Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc. As LLC members, Kumar deducted $190,000 and Sapp deducted $2.1 million. The IRS denied both deductions and issued deficiencies and penalties under Section 6662(a).

A “qualified conservation contribution” is “a contribution of a qualified real property interest to a qualified organization, exclusively for conservation purposes.” See Section 170(h)(1). The Mountain LLC conservation easement deed permitted modification of certain restrictions, so long as these changes did not impact the conservation easement. The court permitted these restrictions.

The valuation contest was a battle between taxpayer’s appraiser George P. Galphin, Jr. and the IRS appraiser Richard Marchitelli. Galphin completed a “before and after “valuation. With a before value of $4,150,000 and an after value of $1,250,000, his easement value was $2,900,000.

Marchitelli claimed a before value of $1,280,000, an after value of $560,000 and a resulting conservation easement value of $720,000.

At trial, taxpayers urged the court to uphold the initial $4,879,000 easement value.

The Tax Court noted that valuation often is determined through comparable properties. However, this property had a “recent and reliable and therefore relevant, transactional history.” The property had been acquired for approximately $3 million in 2004 and 2005. There were four lots sold for $750,000 each. The bank loaned SS Mountain $5 million secured by the 12 lots based on an independent appraisal that determined the lots were each worth $750,000. Finally, following donation of the easement, taxpayer Sapp purchased a lot for $1.1 million and obtained a $900,000 bank loan.

The valuation by the bank and by the Hayward County property tax records supports an $8 million value based on these transactions. See Reg.1.170A-14(h)(3)(ii).

Based on this valuation, the court stated, “We conclude that the amounts claimed by the Kumars and the Sapps were reasonable.” Based on sales of comparable lots and a price per acre, the Tax Court continued, “One comes up with a value that makes the deduction claimed by SS Mountain, and that flowed through to the Kumars and the Sapps entirely reasonable – if reasonable only because we have to look at it from within the market bubble that existed at the time.”

The court noted, “The Kumars and Sapps benefit from timing their donation at what turned out to be very nearly the frothiest point on a local real-estate bubble that was even bubblier than it was in most parts of the nation. In valuing that donation, they get the benefit of the bubble, even as the Commissioner would get the benefit of its bursting a couple years later.”

The Tax Court judge quoted the adage “bulls make money, bears make money, but pigs get slaughtered.” Because the claim value was “subhyperporcine,” the deduction was approved and the penalties were denied.

Final Separate Trade or Business UBTI Regulations

On November 19, 2020, the IRS published T.D. 9933. This is a pre-release version of the final regulations on Section 512(b)(12) that require each unrelated trade or business to calculate unrelated business taxable income (UBTI) under a separate share rule. The final version of the regulations will be subsequently published in the Federal Register.

North American Industry Classification System (NAICS) – The unrelated separate trades or businesses must be categorized using two digits of the NAICS code. These two digits must correctly describe the type of business. If a business sells goods online and in a physical location, the code should reflect the activities in the physical location.

The final regulations permit a change of an NAICS code. The changed code in essence terminates the first business activity and creates a new business. An organization with multiple separate share entities will allocate deductions under a reasonable basis between the respective trades or businesses. See Reg. 1.512(a)-1(c).

Net Operating Losses (NOLs) – Generally, net operating losses (NOL) must be allocated to the respective unrelated trades or businesses. If there are pre-2018 NOLs, the regulation preamble states, “For example, the final regulations further clarify that an exempt organization may allocate all of its pre-2018 NOLs to one of its separate unrelated trades or businesses or it may allocate its pre-2018 NOLs ratably among its separate unrelated trades or businesses, whichever results in the greater utilization of the post-2017 NOLs in that taxable year.”

The post-2017 NOLs will be allocated to specific trades or businesses. If a trade or business is terminated, an NOL with respect to that entity is suspended. It may be used if that trade or business is opened again in a future year.

Investments – The nonprofit’s investments are aggregated as a separate unrelated trade or business. Investments in qualified partnerships will be separately categorized in some cases. A qualified partnership interest (QPI) will be designated by the nonprofit. There is a 20% capital interest threshold and a participation test that applies to qualified partnership interests.

Applicable Federal Rate of 0.6% for December – Rev. Rul. 2020-26; 2020-50 IRB 1 (16 November 2020)

The IRS has announced the Applicable Federal Rate (AFR) for December of 2020. The AFR under Section 7520 for the month of December is 0.6%. The rates for November of 0.4% or October of 0.4% also may be used. The highest AFR is beneficial for charitable deductions of remainder interests. The lowest AFR is best for lead trusts and life estate reserved agreements. With a gift annuity, if the annuitant desires greater tax-free payments the lowest AFR is preferable. During 2020, pooled income funds in existence less than three tax years must use a 2.2% deemed rate of return.