internal_revenue_service department of the treasury index number number release date washington dc person to contact telephone number refer reply to cc dom p si 1-plr-118019-99 date date legend portfolio trust fund fund fund fund co-administrator advisor state declaration date plr-118019-99 date date date this letter responds to your submission of date together with subsequent correspondence in which you requested certain rulings under sec_704 sec_721 sec_851 and sec_7704 of the internal_revenue_code facts portfolio is a series of trust which was organized as a business_trust under the laws of state pursuant to the declaration of trust the trust is registered as an open- end management investment_company under the investment_company act of act portfolio is a separate business_trust under the laws of state which recognize that separate trusts established under a single instrument with common trustees are independent legal entities portfolio is registered as a series_fund an open-end management investment_company under the act portfolio is classified as a partnership under sec_301_7701-3 of the procedure and administration regulations co-administrator is a co-administrator of portfolio portfolio serves as an investment vehicle for fund fund fund and fund the funds each fund is a series in a business_trust or business corporation that is an open-end management investment_company under the act each fund invests substantially_all of its assets available for investment in portfolio and has the same investment objective as portfolio each fund is treated as a corporation for federal_income_tax purposes and has elected or will elect to be taxed as a regulated_investment_company ric under part i of subchapter_m of chapter of subtitle a of the code each fund intends to be operated in a manner which would permit it to continue to qualify as a ric on date co-administrator became a partner in portfolio in exchange for cash and fund became a partner in portfolio in exchange for securities and other assets with a fair_market_value of dollar_figurea on date fund became a partner in portfolio in exchange for cash on date fund became a partner in portfolio in exchange for cash on date fund became a partner in portfolio in exchange for cash plr-118019-99 beneficial interests in portfolio are issued solely in private_placement transactions that do not involve any public offering within the meaning of sec_4 of the securities act of as amended act portfolio will not register its shares under the act because shares in portfolio may be issued solely in private_placement transactions that do not involve any public offering within the meaning of sec_4 of the act investments in portfolio only may be made by investment companies or certain other entities that are accredited investors within the meaning of regulation d under the act the interest of each partner in portfolio is limited to the net assets of portfolio and does not extend to the assets of any other investment vehicles of trust portfolio has not invested in any of trust’s other investment vehicles nor are any of trust’s other investment vehicles invested in portfolio except as required by sec_704 and sec_1_704-1 each partner will be allocated a pro_rata share of partnership income gain loss deduction and credit in accordance with the regulations under sec_704 each partner’s initial capital_account balance will be the amount of money and the fair_market_value of the property contributed to portfolio by the partner under sec_1_704-1 portfolio will revalue its investment portfolio to fair_market_value as of the close of each day portfolio will adjust each partner’s capital_account to reflect the partner’s share of the net change in the value of its portfolio of securities from the close of the prior day to the close of the current day portfolio intends to qualify as a securities_partnership under sec_1_704-3 the number of partners in portfolio will be limited to or fewer calculated pursuant to sec_1_7704-1 portfolio has made the following additional representations each of the funds has contributed or will contribute either solely cash and or a portfolio of stocks and securities that meets the diversification requirements of sec_368 and sec_1_351-1 for purposes of this test government securities are not included within the meaning of securities under sec_368 but are included within the meaning of total assets in sec_368 cash contributed by co-administrator and each fund has been and will be used only to carry on the normal operating and investment activities of portfolio normal operating activities would include payment of partnership level expenses and periodic withdrawals of partnership capital normal investment activities would consist only of investments that are consistent with the portfolio holding itself out to investors as a money market fund which is a type of investment fund that seeks to provide investors with a high level of income while preserving capital and liquidity by investing in high quality short-term investments plr-118019-99 for purposes of determining the required_distribution under sec_4982 each fund will account for its share of partnership items of income gain loss and deduction as they are taken into account by portfolio as required by revrul_94_40 the organization of portfolio was done in a manner to enable it to be classified as a partnership and was not done to enable a partner that is a ric to make distributions that would be prohibited under revrul_89_81 had the ric invested directly in the assets of portfolio portfolio intends to invest its assets in a manner that will allow each fund that invests in portfolio to meet the requirements specified for rics in sec_851 law and analysis ruling portfolio and funds have requested a ruling that portfolio will not be a publicly_traded_partnership within the meaning of sec_7704 sec_7704 provides that a publicly_traded_partnership is treated as a corporation sec_7704 and sec_1_7704-1 provide that for purposes of sec_7704 the term publicly_traded_partnership means any partnership if interests in the partnership are traded on an established_securities_market or readily_tradable on a secondary market or the substantial equivalent thereof sec_1_7704-1 provides that interests in a partnership are readily_tradable on a secondary market or the substantial equivalent thereof if taking into account all of the facts and circumstances the partners are readily able to buy sell or exchange their partnership interests in a manner that is comparable economically to trading on an established_securities_market sec_1_7704-1 provides that interests in a partnership are not readily_tradable on a secondary market or the substantial equivalent thereof for purposes of sec_7704 if i all interests in the partnership were issued in a transaction or transactions that was not required to be registered under the act and ii the partnership does not have more than partners at any time during the taxable_year sec_1_7704-1 provides that for purposes of sec_1_7704-1 a person owning an interest in a partnership grantor_trust or s_corporation flow-through_entity that owns directly or through other flow-through entities an interest in the partnership is treated as a partner in the partnership only if i substantially_all of the value of the beneficial owner’s interest in the flow-through_entity is attributable to the flow-through entity’s interest direct or indirect in the partnership and ii a principal purpose of the plr-118019-99 use of the tiered arrangement is to permit the partnership to satisfy the 100-partner limitation of sec_1_7704-1 portfolio has represented that the number of partners in portfolio will be limited to or fewer calculated pursuant to sec_1_7704-1 no interest in portfolio has been or will be issued in a transaction or transactions required to be registered under the act accordingly portfolio will not be a publicly_traded_partnership within the meaning of sec_7704 ruling portfolio and funds have requested rulings that the transfers of property to portfolio by the funds would not be transfers to an investment_company within the meaning of sec_351 and sec_1_351-1 if portfolio were incorporated sec_721 a provides that neither a partner nor a partnership will recognize gain_or_loss on a contribution of assets to a partnership in exchange for a partnership_interest sec_721 provides that subsection a shall not apply to gain realized on a transfer of property to a partnership which would be treated as an investment_company within the meaning of sec_351 if the partnership were incorporated sec_351 a provides that no gain_or_loss will be recognized if one or more persons transfers property to a corporation solely in exchange for stock_or_securities in the corporation and immediately_after_the_exchange the transferors control the transferee corporation sec_351 provides that sec_351 will not apply to a transfer of property to an investment_company sec_1_351-1 provides that a transfer to an investment_company will occur when i the transfer results directly or indirectly in diversification of the transferors' interests and ii the transferee is a regulated_investment_company ric real_estate_investment_trust reit or a corporation more than percent of the value of whose assets excluding cash and non-convertible debt obligations from consideration are held for investment and are readily marketable stocks or securities or interests in rics or reits sec_1002 of the taxpayer_relief_act_of_1997 pub_l_no 111_stat_788 the act amends sec_351 for transfers after date in taxable years ending after such date subject_to certain transitional relief provisions sec_1002 of the act is intended to expand the types of assets considered in determining whether a transfer is to a transferee described in sec_1_351-1 to include certain assets in addition to readily marketable stocks or securities and interests in rics or reits however the act is not in intended to alter the requirement of sec_1_351-1 that a transfer of property will be considered to be a transfer to an investment_company under sec_351 only if the transfer results directly or indirectly in diversification of the plr-118019-99 transferors’ interests see s rep no 105th cong 1st sess h_r rep no 105th cong 1st sess h_r rep no 105th cong 1st sess sec_1_351-1 provides that a transfer ordinarily results in diversification of the transferors’ interests if two or more persons transfer nonidentical assets to a corporation in the exchange it further provides that if a transfer is part of a plan to achieve diversification without recognition of gain such as a plan which contemplates a subsequent transfer however delayed of the corporate assets or of the stock_or_securities received in the earlier exchange to an investment_company in a transaction purporting to qualify for nonrecognition treatment the original transfer will be treated as resulting in diversification revrul_87_9 1987_1_cb_133 provides that a transfer to a corporation of shares of corporation y stock by one transferor and a transfer of cash by another transferor will be treated as a transfer of nonidentical assets under sec_1_351-1 sec_1_351-1 provides that a transfer of stocks and securities will not be treated as resulting in a diversification of the transferors' interests if each transferor transfers a diversified portfolio of stocks and securities and a portfolio of stocks and securities is considered to be diversified if it satisfies the and 50-percent tests of sec_368 applying the relevant provisions of sec_368 except that government securities are included in total assets for purposes of the denominator of the and 50-percent tests unless acquired to meet the and 50-percent tests but are not treated as securities of an issuer for purpose of the numerator of the and 50-percent tests an investment_company is diversified within the meaning of sec_368 if not more than percent of the value of its assets is invested in the stock and securities of any one issuer and not more than percent of the value of its total assets is invested in the stock and securities of five or fewer issuers after applying the law to the facts submitted and representations made we conclude that the transfers of property to portfolio by the funds would not be transfers to an investment_company within the meaning of sec_351 and sec_1_351-1 if portfolio were incorporated provided that these are the only transfers to portfolio except for transfers solely of cash and or a diversified portfolio of stocks and securities however we express no opinion about whether subsequent transfers of stock and securities to portfolio by any transferor will affect the tax consequences of the original transfers ruling portfolio and funds have requested a ruling that a fund holding a beneficial_interest in portfolio is deemed to own a proportionate share of each of the assets and earn a proportionate share of partnership income in portfolio attributable to that share plr-118019-99 for purposes of determining whether the fund satisfies the requirements of sec_851 and sec_851 of the code sec_851 defines a ric in part as a domestic_corporation registered under the act as a management company sec_851 limits the definition of a ric to a corporation meeting certain election gross_income and diversification requirements sec_851 of the code provides that to qualify as a ric percent of a corporation's gross_income must be derived from dividends interest payments_with_respect_to_securities_loans as defined in sec_512 gains from the sale_or_other_disposition of stocks securities foreign_currencies or other income derived with respect to the business of investing in such stocks securities or currencies sec_851 of the code requires that to qualify as a ric at the close of each quarter of the taxable_year at least percent of the value of a corporation's total assets must be represented by cash and cash items including receivables government securities securities of other rics and other_securities generally limited in respect of one issuer to an amount not greater in value than percent of the value of the total assets of the corporation and to not more than percent of the outstanding_voting_securities_of_such_issuer sec_851 of the code provides that to qualify as a ric not more than percent of the corporation's total assets may be invested in the securities other than government securities and securities of other rics of any one issuer or two or more issuers that the corporation controls and which are determined under regulations to be engaged in the same or similar trades_or_businesses or related trades_or_businesses sec_702 of the code provides that the character of items stated in sec_702 that are included in a partner's_distributive_share shall be determined as if such items were realized directly from the source from which realized by the partnership or incurred in the same manner as incurred by the partnership sec_702 provides that where it is necessary to determine the amount or character of the gross_income of a partner such amount shall include his distributive_share of the gross_income of the partnership section n of the technical_and_miscellaneous_revenue_act_of_1988 added a sentence to the flush language of sec_851 of the code that states that income derived from a partnership or trust shall be treated as satisfying the percent test of sec_851 only to the extent that such income is attributable to items of income of the partnership or trust which would be described in sec_851 if earned directly by the ric the legislative_history of that sentence indicates that it was intended to clarify the plr-118019-99 general_rule used to characterize items of income gain loss deduction or credit includible in a partner’s distributive_share as applied to rics that are partners it therefore explains the relationship of sec_702 to the percent test under sec_851 see s rep no 100th cong 2d sess under subchapter_k of the code a partnership is considered to be either an aggregate of its members or a separate_entity under the aggregate approach each partner is treated as an owner of an undivided_interest in partnership assets and operations the entity_theory provides that the partnership is a separate_entity in which partners have no direct interest in partnership assets and operations see s rep no 83d cong 2d sess and h_r rep no 83d cong 2d sess in order for the funds to qualify as rics under the diversification tests of sec_851 of the code the aggregate approach will have to be applied to each fund’s partnership_interest in portfolio as an aggregate each fund will be able to take into account its share of the individual items of income and assets of portfolio revrul_75_62 1975_1_cb_188 concerns a life_insurance_company that contributed cash to a partnership in exchange for a percent interest in the partnership the partnership held real_estate as its principal asset for the taxable_year in question sec_805 of the code required life_insurance_companies to value their assets each taxable_year for this purpose sec_805 required that shares of stock and real_estate be valued at their fair market values and that other assets be valued at their adjusted_basis the issue presented in the ruling is whether for purposes of sec_805 the life_insurance company's interest in the partnership is considered to be an investment in the real_estate held by the partnership an aggregate approach or an investment in other_property an entity approach revrul_75_62 holds that the partnership_interest held by the life_insurance_company must be accounted for as other_property for purposes of sec_805 the ruling cites sec_705 and sec_741 of the code both of which generally treat an interest in a partnership as an interest in an entity as evidence of an intent in subchapter_k to take the entity approach in questions concerning the nature of an interest in a partnership the ruling states that the legislative_history of sec_805 does not indicate that application of the entity approach to the facts of the ruling is inappropriate and that there is no compelling reason to take the aggregate approach the flush language of sec_851 and its legislative_history indicate that here unlike the situation described in revrul_75_62 congress intended that an aggregate approach be taken in determining the nature of the partnership interests held by the funds the flush language of sec_851 mandates an aggregate approach in applying the percent gross_income_test of sec_851 to rics that hold partnership interests it would be anomalous to suggest that congress intended that a ric's interest in a plr-118019-99 partnership be viewed as a direct investment in the partnership’s assets for purposes of the sec_851 test but not be viewed as a direct investment in those assets for purposes of the tests set out in inter alia sec_851 the tax treatment accorded real_estate_investment_trusts reits lends further support to applying the aggregate approach to the present case reits were created to provide an investment vehicle similar to the ric for small investors to invest in real_estate and real_estate mortgages see h_r rep no 86th cong 2d sess like rics reits are subject_to restrictions on the type of assets they can hold if they want to retain the benefits accorded them under subchapter_m for example under sec_856 of the code at least percent of the gross_income of a reit must be derived from any or all of nine sources including rents_from_real_property interest on obligations secured_by mortgages gain from the sale or disposition of real_property and income and gain derived from foreclosure_property reits and rics also have similar distribution and holding_period requirements sec_1_856-3 of the income_tax regulations provides that in the case of a real_estate_investment_trust which is a partner in a partnership as defined in sec_7701 and the regulations thereunder the trust will be deemed to own its proportionate share of each of the assets of the partnership and will be deemed to be entitled to the income of the partnership attributable to such share for purposes of sec_856 the interest of a partner in a partnership's assets shall be determined in accordance with his capital interest in the partnership the character of the various assets in the hands of the partnership and items of gross_income of the partnership shall retain the same character in the hands of the partners for all purposes of sec_856 thus for example if the trust owns a 30-percent capital interest in a partnership which owns a piece of rental property the trust will be treated as owning percent of such property and as being entitled to percent of the rent derived from the property by the partnership similarly if the partnership holds any property primarily_for_sale_to_customers in the ordinary course of its trade_or_business the trust will be treated as holding its proportionate share of such property primarily for such purpose also for example where a partnership sells real_property or a_trust sells its interest in a partnership which owns real_property any gross_income realized from such sale to the extent that it is attributable to the real_property shall be deemed gross_income from the sale or disposition of real_property held for either the period that the partnership has held the real_property or the period that the trust was a member of the partnership whichever is shorter thus the regulations adopt the language of the aggregate look-through approach in determining how a reit should account for its partnership interests for purposes of all of the income and asset qualification tests under sec_856 of the code plr-118019-99 the legislative purpose underlying the creation of both rics and reits was to provide small investors a means of pooling their resources to invest in a particular type of assets without the imposition of the corporate_income_tax the qualification tests are similar for each therefore although the ric regulations do not specifically address the issue herein it is appropriate to adopt an approach for rics that parallels that set forth for reits each of the funds as a partner in portfolio will be deemed to own a proportionate share of the assets of portfolio and will be deemed to be entitled to the income of portfolio attributable to such share for purposes of determining whether the fund satisfies the requirements of sec_851 and sec_851 for purposes of these sections the interest of a fund in portfolio shall be determined in accordance with the fund's capital interest in portfolio ruling portfolio and funds have requested a ruling that portfolio’s method of aggregating gains and losses from qualified_financial_assets for the purpose of making reverse sec_704 allocations is reasonable within the meaning of sec_1_704-3 sec_704 provides that income gain loss and deduction with respect to property contributed to the partnership by a partner is shared among the partners so as to take account of the variation between the basis of the property to the partnership and its fair_market_value at the time of contribution sec_1_704-3 states that the purpose of sec_704 is to prevent the shifting of tax consequences among partners with respect to precontribution gain_or_loss under sec_704 a partnership must allocate income gain loss and deductions with respect to property contributed by a partner to the partnership so as to take into account any variation between the adjusted tax basis of the property and its fair_market_value at the time of the contribution this allocation must be made using a reasonable method that is consistent with the purpose of sec_704 sec_1_704-3 provides that the principles of sec_1_704-3 apply to allocations with respect to property for which differences between book_value and adjusted tax basis are created when a partnership revalues partnership property under sec_1_704-1 reverse sec_704 allocations a partnership that makes allocations with respect to revalued property must use a reasonable method that is consistent with the purposes of sec_704 and c sec_1_704-3 indicates that sec_704 generally applies on a property-by- property basis therefore in determining whether there is a disparity between adjusted tax basis and fair_market_value the built-in gains and built-in losses on items of contributed or revalued property generally cannot be aggregated plr-118019-99 sec_1_704-3 sets forth a special rule allowing certain securities partnerships to make reverse sec_704 allocations on an aggregate basis specifically sec_1_704-3 provides that for purposes of making reverse sec_704 allocations a securities_partnership may aggregate gains and losses from qualified_financial_assets using any reasonable approach that is consistent with the purposes of sec_704 once a partnership adopts an aggregate approach the partnership must apply the same aggregate approach to all of its qualified_financial_assets for all taxable years in which the partnership qualifies as a securities_partnership sec_1_704-3 defines a securities_partnership as a partnership that is either a management company or an investment_partnership and that makes all of its book allocations in proportion to the partners’ relative book capital accounts except for reasonable special allocations to a partner that provides management services or investment advisory services to the partnership under sec_1_704-3 a partnership is a management company if it is registered as a management company under the act sec_1_704-3 defines qualified_financial_assets as any personal_property including stock that is actively_traded as defined in sec_1_1092_d_-1 defining actively_traded property for purposes of the straddle rules for a management company qualified_financial_assets also include the following even if not actively_traded shares of stock in a corporation notes bonds debentures or other evidences of indebtedness interest rate currency or equity notional_principal_contracts evidences of an interest in or derivative financial instruments in any security currency or commodity including any option forward or futures_contract or short position or any similar financial_instrument sec_1_704-3 and e v describe two approaches to making aggregate reverse sec_704 allocations that are generally reasonable -- the partial netting approach and the full netting approach however sec_1_704-3 provides that other approaches may be reasonable in appropriate circumstances sec_1_704-3 provides that an allocation method or combination of methods is not reasonable if the contribution of property or event that results in reverse sec_704 allocations and the corresponding allocation of tax items with respect to the property are made with a view to shifting the tax consequence of built-in_gain or loss among the partners in a manner that substantially reduces the present_value of the partners' aggregate tax_liability furthermore sec_1_704-3 provides that the character and other tax_attributes of gain_or_loss allocated to the partners under an aggregate approach must a preserve the tax_attributes of each item of gain_or_loss realized by the partnership b be determined under an approach that is consistently applied and c not be determined with a view to reducing substantially the present_value of the partners' plr-118019-99 aggregate tax_liability portfolio has represented that its allocations have complied and will comply with sec_1_704-3 portfolio has elected to use an aggregate method for making reverse sec_704 allocations under the method adopted portfolio has established two revaluation accounts for each partner -- an unrealized_gain account urga and an unrealized_loss account urla each time portfolio restates its capital accounts to reflect a revaluation of its assets portfolio credits each partner's urga with the partner's share of the change in unrealized gains since the last capital_account restatement by the partnership similarly portfolio credits each partner's urla with the partner's share of the change in unrealized losses since the last partnership restatement after portfolio makes the book adjustments it allocates tax gains and tax losses for securities sold since portfolio's last capital_account restatement tax gain is allocated among the partners in accordance with the relative balances in the partners' urgas tax loss is allocated among the partners in accordance with the relative balances in the partners' urlas portfolio then reduces each partner's urga and urla by the amount of tax gain and loss allocated to that partner after applying the relevant law to the information and representations submitted we rule that portfolio’s method of making reverse sec_704 allocations is a reasonable method within the meaning of sec_1_704-3 provided that a contribution or revaluation of property and the corresponding allocation of tax items with respect to the property are not made with a view to shifting the tax consequences of built-in_gain or loss among the partnership in a manner that substantially reduces the present_value of the partners' aggregate tax_liability ruling portfolio and funds also have requested permission to aggregate built-in gains and losses from qualified_financial_assets contributed to portfolio with built-in gains and losses from revaluations of qualified_financial_assets held by portfolio for the purpose of making sec_704 and reverse sec_704 allocations the aggregation rule_of sec_1_704-3 applies only to reverse sec_704 allocations therefore a securities_partnership using an aggregate approach must generally account for any built-in_gain or loss from contributed_property separately the preamble to sec_1_704-3 explains that the final regulations do not authorize aggregation of built-in gains and losses from contributed_property with built-in gains and losses from revaluations because this type of aggregation can lead to substantial distortions in the character and timing of income and loss recognized by contributing partners t d 1995_1_cb_120 however the preamble also recognizes that there may be instances in which the likelihood of character and timing distortions is minimal and the burden of making sec_704 allocations separate from reverse sec_704 plr-118019-99 allocations is great consequently sec_1 e iii authorizes the commissioner to permit by published guidance or letter_ruling aggregation of qualified_financial_assets for purposes of making sec_704 allocations in the same manner as that described in sec_1_704-3 in this case portfolio’s burden of making sec_704 allocations separate from reverse sec_704 allocations is represented to be substantial in addition the likelihood that this type of aggregation could be abused by portfolio and its partners is minimal it is represented that fund fund and fund each is a publicly_offered_regulated_investment_company as defined in sec_67 and sec_1_67-2t a qualified contributor and upon commencement of operations fund also will be a qualified contributor after applying the relevant law to the facts presented and the representations made we conclude that portfolio may aggregate built-in gains and losses from qualified_financial_assets contributed to portfolio by fund with built-in gains and losses from revaluations of qualified_financial_assets held by portfolio for purposes of making sec_704 and reverse sec_704 allocations provided that a contribution or revaluation of property and the corresponding allocation of tax items with respect to the property are not made with a view to shifting the tax consequences of built-in_gain or loss among the partners in a manner that substantially reduces the present_value of the partners' aggregate tax_liability and that each of the partners other than co- administrator is a qualified contributor ruling portfolio and funds also have requested permission to use portfolio’s method for making sec_704 allocations including reverse allocations for qualified contributors that become partners in portfolio it is anticipated that qualified contributors may become partners in portfolio in the future these new partners may contribute securities with built-in_gain or loss to portfolio but only securities consistent with portfolio’s investment objective after applying the relevant law to the information and representations submitted we rule that portfolio’s method of making sec_704 allocations including reverse allocations for new partners who invest in portfolio is a reasonable method within the meaning of sec_1_704-3 and is permitted by the commissioner under sec_1_704-3 provided that i a contribution or revaluation of property and the corresponding allocation of tax items with respect to the property are not made with a view to shifting the tax consequences of built-in_gain or loss among the partnership in a manner that substantially reduces the present_value of the partners' aggregate tax_liability ii the partner is registered as an open-end management company under the act and is a qualified contributor and iii to the extent portfolio relies on this plr-118019-99 ruling with respect to the contribution portfolio will document any such contribution on its tax_return filed subsequent to the contribution except as specifically ruled upon above we express no opinion on the federal tax consequences of the transactions described above under any other provisions of the code and regulations or about the tax treatment of any conditions existing at the time of or effects resulting from the transaction s that are not specifically covered by the above rulings rulings four through six are limited to allocations of gain_or_loss from the sale_or_other_disposition of qualified_financial_assets made under sec_704 sec_704 and sec_1_704-3 specifically no opinion is expressed concerning i whether any fund qualifies as a ric that is taxable under subchapter_m part i of the code ii allocations of items other than items of gain_or_loss from the sale_or_other_disposition of qualified_financial_assets or iii the aggregation of built-in gains and losses from qualified_financial_assets contributed to portfolio by any partner other than the funds and future new partners that qualify as qualified contributors in addition portfolio must maintain sufficient records to enable it and its partners to comply with sec_704 and sec_737 this ruling is directed only to the taxpayer s requesting it sec_6110 of the code 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 fund and fund 3’s second authorized representative signed david r haglund sincerely david r haglund senior technician reviewer branch office of the assistant chief_counsel passthroughs and special industries enclosures copy of this letter copy for sec_6110 purposes


t c memo united_states tax_court bruce david cohen petitioner v commissioner of internal revenue respondent docket no filed date respondent determined deficiencies and additions to tax for petitioner’s and taxable years held petitioner’s sole_proprietorship earned net_income as redetermined herein for each of the years involved in this case held further petitioner recognized capital_gain from the sale of stock in the amounts of dollar_figure and dollar_figure in and respectively held further petitioner’s filing_status for was married filing separate held further petitioner is entitled only to the standard_deduction in held further petitioner is liable for the sec_6651 i r c addition_to_tax for failure timely to file income_tax returns for each of the years at issue -- - held further petitioner is liable for the sec_6654 i r c addition_to_tax for failure to pay estimated_tax for each of the years under consideration bruce david cohen pro_se miles d friedman for respondent memorandum findings_of_fact and opinion nims judge respondent determined the following deficiencies and additions to tax with respect to petitioner’s federal income taxes taxable_income tax additions to tax_year deficiency sec_6651 a sec_6654 dollar_figure dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number big_number after concessions the issues remaining for decision are whether petitioner’s sole_proprietorship earned net_income in the amounts asserted by respondent for each of the years involved in this case whether petitioner recognized capital_gain from the sale of stock in and in the amounts asserted by respondent whether petitioner’s filing_status was single or married filing separate in whether petitioner is entitled to only the standard_deduction or instead to itemized_deductions in whether petitioner is liable for the sec_6651 a addition_to_tax for failure timely to file income_tax returns for each of the years at issue and whether petitioner is liable for the sec_6654 addition_to_tax for failure to pay estimated_tax for each of the years involved additional adjustments to petitioner’s self-employment taxes and deduction for self-employment taxes are computational in nature and will be resolved by our holdings on the foregoing issues unless otherwise indicated all section references are to sections of the internal_revenue_code in effect for the years at issue and all rule references are to the tax_court rules_of_practice and procedure to facilitate disposition of the foregoing issues we shall first make general findings_of_fact and then combine our findings and opinion with respect to each issue i general findings_of_fact some of the facts have been stipulated and are so found the stipulations of the parties with accompanying exhibits are - incorporated herein by this reference at the time the petition was filed in this case petitioner resided in dana point california from through petitioner operated a sole_proprietorship under the name of dana point bicycle sport bicycle sport bicycle sport was an independent bicycle retail store engaged primarily in the business of selling new bicycles and bicycle-related products to consumers and of repairing bicycles petitioner failed to timely file federal_income_tax returns or to pay any estimated_taxes for the years at issue as a result a revenue_agent with the internal_revenue_service darrell cavender contacted petitioner in in an attempt to secure the delinquent returns when petitioner failed to submit the requested returns notices of deficiency based on records obtained from third parties were issued to petitioner for the subject years on date thereafter on date petitioner filed tax returns for all years through the information provided on such returns and additional financial materials obtained respondent concluded that the amounts for which petitioner was determined to be liable should be reduced at initial hearings in this case on march and respondent communicated to the court the following revised amounts in dispute taxable_income tax additions year deficiency to tax dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure respondent also informed petitioner at the hearings that further adjustments would be made if petitioner demonstrated nontaxable sources of income and or business_expenses in excess of those underlying respondent’s revised computations provided evidence of a cost_basis in property generating capital_gains or substantiated certain amounts claimed as itemized_deductions petitioner did not do so and respondent’s position regarding petitioner’s tax_liabilities remained substantially unchanged at the time of trial on date petitioner appeared and testified at trial but did not provide any further documentation relating to his financial affairs subsequent to the proceedings respondent filed a posttrial brief petitioner did not il net_income from proprietorship the income of a sole_proprietorship must be included in calculating the income and tax_liabilities of the individual owning the business sec_61 the net_profit_or_loss of - - such an enterprise is generally computed on schedule c profit or loss from business by subtracting cost_of_goods_sold and ordinary and necessary business_expenses from the gross_receipts of the venture for the years at issue respondent calculated petitioner’s net_income from bicycle sport through a combination of accepting in whole or in part figures reported on petitioner’s late-filed returns and of employing indirect methods to supply missing or additional data taxpayers are required to maintain records sufficient to establish the existence and amount of all items reported on the tax_return including both income and deductions therefrom sec_6001 65_tc_87 affd 540_f2d_821 5th cir sec_1_6001-1 income_tax regs in absence of books_and_records adequate to determine a taxpayer’s proper tax_liability the commissioner is authorized to reconstruct income by any reasonable method which will clearly reflect income sec_446 360_us_446 116_f3d_1309 9th cir 92_tc_661 as a general_rule the commissioner’s determinations are presumed correct and the taxpayer bears the burden of proving error therein rule a cf sec_7491 generally effective with respect to examinations commencing after date however the court_of_appeals for the ninth circuit to which - appeal in the instant case would normally lie has indicated that before the presumption of correctness will attach in an unreported income case the determination must be supported by at least a minimal factual predicate or foundation of substantive evidence linking the taxpayer to income-generating activity or to the receipt of funds palmer v irs supra pincite3 see also 774_f2d_932 9th cir petzoldt v commissioner supra pincite here the record clearly links petitioner to an income- producing activity bicycle sport even according to petitioner’s own returns generated substantial gross_sales in each of the years at issue accordingly respondent’s reconstructions of the business’s profits to the extent they reveal unreported income are supported by the requisite factual predicate for placing the burden to show otherwise upon petitioner a on the schedule c attached to petitioner’s form_1040 u s individual_income_tax_return gross_receipts from bicycle sport are shown as dollar_figure after deductions petitioner reported a net_loss from his business of dollar_figure respondent accepted and the parties stipulated that gross_sales in were dollar_figure however because petitioner provided no records substantiating his claimed expenditures respondent used industry - - statistics to reconstruct expenses in this endeavor respondent relied on a financial survey prepared by the national bicycle dealers association entitled the cost of doing business for independent bicycle retailers the survey found that for the average independent bicycle retailer with total revenue of between dollar_figure and dollar_figure in and the owner of the business took a total salary or draws of percent of total revenues and the shop had a net financial income of percent of total revenues the parties then stipulated that in the average independent bicycle retailer with total revenue in the dollar_figure to dollar_figure range also had owner salary or draws of percent and net financial income of percent of total revenues based on these percentages respondent computed bicycle sport’s net profit for tax purposes to be dollar_figure this number comprises owner draws of dollar_figure x dollar_figure a nondeductible outlay in this context and net financial income of dollar_figure x dollar_figure stated differently the survey showed that the average bicycle retailer earned net_income for tax purposes of percent of sales percent percent and incurred deductible or offsetting expenditures of percent percent -- percent of sales accordingly here bicycle --- - sport was determined to have net_income of dollar_figure after subtracting expenses of dollar_figure x dollar_figure from the stipulated gross_sales petitioner has offered no concrete evidence to establish either that his business diverged from that of the average bicycle retailer or that he incurred specific costs in excess of those taken into account by respondent’s method of reconstruction rather petitioner has offered testimony tangential at best regarding his standard of living on the premise that my standard of living did not has not never has reflected the amount of income that they alleged either originally or now he has also relied on unsupported assertions that his business operated at a loss such as that in the following brief colloquy the court all right you went for years without making any money is that what you’re saying mr cohen yes sir absolutely in these circumstances we conclude that respondent has employed a reasonable method for reconstructing petitioner’s schedule c income for and that petitioner has failed to carry his burden of showing such method to be in error as the court_of_appeals for the ninth circuit has expressly stated courts have long held that the irs may rationally use statistics to reconstruct income where taxpayers fail to offer accurate -- - records palmer v irs f 3d pincite petitioner must report business income from bicycle sport of dollar_figure for the taxable_year b and for the and taxable years the schedules c submitted by petitioner reflected gross_sales from bicycle sport of dollar_figure dollar_figure and dollar_figure respectively after offsets and deductions petitioner reported a net_loss of dollar_figure in a net profit of dollar_figure in and a net_loss of dollar_figure in petitioner has at no time provided books_and_records to document the calculation of these amounts with respect to these years respondent was able to obtain the financial records necessary to perform a bank_deposits analysis the use of the bank_deposits method for computing unreported income has long been sanctioned by the courts 281_f2d_100 9th cir affg tcmemo_1958_94 102_tc_632 96_tc_858 affd 959_f2d_16 2d cir underlying this method is the principle that bank_deposits constitute prima facie evidence of income clayton v commissioner supra pincite dileo v commissioner supra pincite 87_tc_74 a bank_deposits analysis must generally encompass the following a totaling of bank_deposits the elimination from such total of any amounts derived from duplicative transfers or nontaxable sources of which the commissioner has knowledge the further reduction of the adjusted total by any deductible or offsetting expenditures of which the commissioner is aware clayton v commissioner supra pincite dileo v commissioner supra pincite as previously indicated the burden here rests on petitioner to show error in respondent’s analysis either by proving a nontaxable source for deposits or by substantiating allowable expenditures rule a clayton v commissioner supra pincite 64_tc_651 affd 566_f2d_2 6th cir in some circumstances eg fraud cases the commissioner may be expected to investigate leads of nontaxable sources that are reasonably susceptible of being checked 348_us_121 see also 74_tc_44 affd 663_f2d_527 5th cir however this lead-check rule has been held inapplicable where the taxpayer bears the burden_of_proof or where purported leads are vague and unsupported by any evidence tunnell v commissioner supra pincite during petitioner maintained a single business bank account in the name of bicycle sport at the dana niguel bank a second business bank account was opened in the name of bicycle sport on date at monarch bank after a period of inactivity the dana niguel bank account was closed on date with a final withdrawal of dollar_figure using records for these accounts respondent determined petitioner’s net_income from bicycle sport as follows total deposits dollar_figure dollar_figure dollar_figure less transfers dollar_figure dollar_figure dollar_figure subtotal dollar_figure dollar_figure dollar_figure less checks debits dollar_figure dollar_figure dollar_figure subtotal dollar_figure -21 dollar_figure -dollar_figure plus owner draws dollar_figure dollar_figure dollar_figure subtotal dollar_figure dollar_figure dollar_figure plus additional draws dollar_figure dollar_figure dollar_figure subtotal dollar_figure dollar_figure dollar_figure less gifts loans etc dollar_figure dollar_figure dollar_figure net_income dollar_figure dollar_figure dollar_figure we consider the sustainability of respondent’s analysis first by addressing whether petitioner has shown entitlement to further offsetting or deductible expenditures and second by deciding whether petitioner has proven nontaxable sources for the deposits in the bicycle sport accounts in performing the above calculations respondent treated as deductible business_expenses all checks drawn on the bicycle sport accounts except for those determined to be owner draws for the majority of these sums characterized as nondeductible draws the record contains copies of checks which are made payable to petitioner have the word draw written in the space for description and specify a check amount in round hundred- dollar increments petitioner does not dispute that these and similar checks totaled dollar_figure dollar_figure and dollar_figure for and respectively however for december of no copies of the checks drawn on bicycle sport’s account were made available to respondent because the bank statements for december showed two checks in even amounts similar to those identified as draws respondent concluded that these too represented nondeductible draws of an additional dollar_figure petitioner has offered no evidence establishing that the amounts treated as draws should in fact be characterized as deductible expenditures rather petitioner’s testimony at trial seems to indicate that these sums were in fact owner draws but that petitioner holds a misguided interpretation of the income_tax consequences thereof for instance the discussion set forth below illustrates petitioner’s apparent position mr cohen i’m saying that some of those came-- some of that came from--as a draw on equity which i’m legally entitled to do as a nontaxable event if i have that money that i’ve put into the business then i’m allowed to take that back out and not declare that as--that doesn’t have to necessarily be a taxable_event mr cohen not only that but i’m saying that some of the money that i started the business with if i started the business with x number of dollars i’m allowed to draw that x number of dollars out without it being income the court well that’s your version you can draw it out but it’s subject_to income_tax the business has to pay-- the court i mean you don’t just arbitrarily draw money out of a business account and say well thi sec_1s equity i don’t have to worry about the tax due on it you can’t--that’s just not the way things operate given this testimony we have no basis on which to conclude that the amounts treated as draws in respondent’s bank_deposits analysis represent deductible expenditures petitioner has not so much as alleged any specific business_expenses that were omitted from respondent’s calculations hence petitioner has failed to prove his entitlement to any reduction in the net business income determined by respondent on account of additional costs incurred by bicycle sport we next turn to whether such net_income should be decreased to reflect nontaxable sources for the funds deposited in the bicycle sport accounts on several occasions during the examination and at trial petitioner alluded to potential nontaxable sources in the form of inheritances gifts and loans from family members anda friend anthony turley however none of these receipts have been substantiated the minimal record -- - which relates thereto is vague as to both timing and amount mr cavender inguired during the examination of petitioner’s parents regarding alleged loans and or gifts but petitioner’s parents could not recall when or how much was remitted to petitioner mr turley likewise admitted that he was unsure of the dates when any particular loans were made when questioned at trial regarding a claimed inheritance from his grandmother petitioner indicated that the funds were used at least in part to buy a condominium similarly an alleged loan from petitioner’s sisters was linked to the purchase of a home significantly petitioner never asserted that these nontaxable sums were deposited in bicycle sport’s accounts we conclude that petitioner has not proven any of the deposits into the bicycle sport accounts other than the single transfer identified by respondent to be attributable to nontaxable sources we also note for the sake of completeness and because the parties have made assertions with respect thereto that this record reveals no reasonably definitive leads which respondent failed to check we hold that petitioner must report business income from his sole_proprietorship in the amounts of dollar_figure dollar_figure and dollar_figure for the years and respectively in accordance with respondent’s bank_deposits analysis c and for the and taxable years the schedules c submitted by petitioner reported gross_sales in the respective amounts of dollar_figure and dollar_figure after reduction for costs and expenses bicycle sport was shown as having earned a net profit of dollar_figure in and dollar_figure in respondent has accepted these figures as representing petitioner’s net business income for such years due in part to a lack of complete records for performance of a bank_deposits analysis since petitioner has never specifically addressed these years in his generalized arguments to the court we likewise hold petitioner to the amounts stated on his own returns til capital_gain as a general_rule a taxpayer is required on the disposition of property to report as capital_gain the excess of the amount_realized on disposition over his or her adjusted_basis in the property sec_1001 on petitioner’s and returns he reported capital_gain from the sale of stock in the amounts of dollar_figure and dollar_figure respectively the attached schedules d capital_gains_and_losses each show a sales_price equal to the full amount reported as gain and neither reflect nor deduct therefrom any cost or other basis at trial however petitioner seemed to contend albeit rather obliquely that he was entitled to offset his reported gains by some amount other - than a zero basis nonetheless he did not offer any specific figures in his testimony and did not produce any documentation regarding how when or at what prices he obtained the shares thus absent any data in the record which would support a recalculation of petitioner’s capital_gains we hold petitioner to the dollar_figure and dollar_figure figures stated on his returns iv filing_status the filing_status of an individual for income_tax purposes is determined as of the close of the taxable_year sec_7703 a in applying this rule however an individual legally_separated from his or her spouse will not be considered as married sec_7703 here there appears to be a dispute between the parties regarding whether petitioner’s filing_status for should be single or married filing separate the parties have stipulated that petitioner was married on date that he and his wife separated on date and that the couple did not file joint returns in or accordingly respondent has acknowledged on brief that petitioner’s filing_status was single for tax years prior to in addition the parties have stipulated that petitioner’s filing_status was married filing separate in and it is respondent’s position that married filing separate is the appropriate status for as well petitioner on the other hand has refused to agree to a stipulation to such effect yet -- - he has also declined to provide any argument whatsoever related to his filing_status and relationship with his wife therefore since there is no evidence in the record that petitioner and his wife were separated before january of we hold that petitioner’s status for is married filing separate v standard_deduction or itemized_deductions an individual who does not elect to itemize his or her deductions is entitled to the standard_deduction specified for his or her filing_status sec_63 and c petitioner did not elect to itemize on his or returns and respondent does not disagree with such treatment for and petitioner claimed itemized_deductions of dollar_figure dollar_figure and dollar_figure respectively attributable solely to alleged home mortgage interest because respondent has conceded that petitioner is entitled to deduct the interest reported for and subject_to computational statutory limits thereon only the deductions remain at issue respondent asserts that petitioner has not substantiated his interest payments for and once again the record is devoid of any evidence provided by petitioner on this matter we sustain respondent’s position in affording petitioner only the standard_deduction for - - vi sec_6651 addition_to_tax sec_6651 imposes an addition_to_tax for delinquency in filing returns and provides in relevant part as follows sec_6651 fatlure to file tax_return or to pay tax a addition to the tax --in case of failure- to file any return required under authority of subchapter_a of chapter on the date prescribed therefor determined with regard to any extension of time for filing unless it is shown that such failure is due to reasonable_cause and not due to willful neglect there shall be added to the amount_required_to_be_shown_as_tax on such return percent of the amount of such tax if the failure is for not more than month with an additional percent for each additional month or fraction thereof during which such failure continues not exceeding percent in the aggregate the supreme court has characterized the foregoing section as imposing a civil penalty to ensure timely filing of tax returns and as placing on the taxpayer the heavy burden of proving both that the failure did not result from ‘willful neglect ’ and that the failure was ‘due to reasonable cause’ in order to escape the penalty 469_us_241 willful neglect denotes a conscious intentional failure or reckless indifference id reasonable_cause correlates to ordinary business care and prudence id pincite n sec_301_6651-1 proced admin regs - sec_6012 a further delineates that an individual is required to file a tax_return for any year in which his or her gross_income exceeds the sum of the applicable exemption_amount and standard_deduction for such taxpayer in this context gross_income includes gross_income derived from business sec_61 which in turn is defined as total sales less the cost_of_goods_sold plus certain other items sec_1_61-3 income_tax regs business_expenses as distinct from cost_of_goods_sold are not subtracted in ascertaining gross business income id here petitioner did not file tax returns for and until october of such returns were untimely by a large margin see sec_6072 furthermore the returns even as filed reflect substantial gross_income derived from bicycle sport and thus clearly place petitioner over the filing threshold petitioner however has fallen far short of establishing reasonable_cause for his repeated failure_to_file timely tax returns other than vague references to loss of records and perhaps the misguided belief that he owed no taxes petitioner has not offered any explanation for his delinquency we therefore hold that petitioner is liable for the sec_6651 addition_to_tax for each of the taxable years at issue - vii sec_6654 addition_to_tax sec_6654 provides for an addition_to_tax in the case of any underpayment of estimated_tax by an individual where payments of tax through either withholding or the making of estimated quarterly tax_payments do not equal the percentage of total liability required under the statute imposition of the addition is automatic and mandatory unless one of the statutory exceptions enumerated in sec_6654 is shown by the taxpayer to apply sec_6654 a - e g 75_tc_1 since petitioner paid no estimated_taxes and has offered no evidence indicating any of the exceptions to be applicable here we sustain respondent on this issue for each of the taxable years under consideration to reflect the foregoing and the parties’ concessions decision will be entered under rule


t c memo united_states tax_court horace e mccann petitioner v commissioner of internal revenue respondent docket no filed date horace e mccann pro_se horace crump for respondent memorandum opinion powell special_trial_judge this case was assigned pursuant to the provisions of sec_7443a and rule sec_180 sec_181 and sec_182 by notice_of_deficiency dated date respondent determined a deficiency in petitioner's federal_income_tax and an accuracy-related_penalty pursuant to sec_6662 in section references are to the internal_revenue_code in effect for the year in issue rule references are to the tax_court rules_of_practice and procedure the respective amounts of dollar_figure and dollar_figure at the time the petition was filed petitioner resided in birmingham alabama the issues are whether petitioner is entitled to deductions in amounts greater than those allowed by respondent for charitable_contributions employee business_expenses and other miscellaneous deductions and liable for an accuracy- related penalty for negligence under sec_6662 the facts may be summarized as follows petitioner is an employee of the occupational safety and health administration osha on schedule a of petitioner's federal_income_tax return petitioner claimed deductions for the following charitable_contributions miscellaneous employee business_expenses other miscellaneous deductions dollar_figure big_number big_number upon examination respondent disallowed portions of the claimed deductions as follows allowed disallowed charitable_contributions dollar_figure miscellaneous employee business_expenses big_number other miscellaneous deductions dollar_figure big_number big_number the primary difficulty with this case is that although petitioner prepared his return for he cannot identify with any specificity items of contributions or expenses he claimed he had no documentation with regard to the disallowed amounts furthermore his testimony was unclear and often evasive charitable_contributions petitioner testified that he made cash contributions in the amount of dollar_figure to various but unspecified churches and charitable organizations petitioner has the burden of establishing that respondent's determination is incorrect in whole or in part and he has not carried that burden rule respondent's determination is sustained employee business_expenses petitioner claims that the disputed employee business_expenses arise from three areas education and training expenses cost of a printer for his computer and cost of safety shoes with regard to the training and eduction expenses petitioner contends that he incurred expenses in learning how to operate computers he has no records showing the date or amounts of these alleged expenses petitioner submitted a receipt in the amount of dollar_figure for the cost of a computer printer according to petitioner he uses a computer and printer in his employment petitioner concedes however that the printer was located at his home and that he was not required to buy the computer or printer as a condition of his employment the printer is so-called listed_property as defined by sec_280f and accordingly no deduction is allowable under sec_280f petitioner also submitted a receipt in the amount of dollar_figure for safety shoes that he testified are required for his job we will allow petitioner a deduction in this amount as an employee_business_expense to the extent that the amount exceeds the limitation contained in sec_67 other miscellaneous deductions of the dollar_figure at issue in this category the parties agree that petitioner paid dollar_figure in legal expenses during legal expenses are deductible under sec_162 or sec_212 if they are ordinary and necessary expenses_incurred in a trade_or_business_expenses incurred for the management_conservation_or_maintenance_of_property_held_for_the_production_of_income or expenses_incurred with respect to federal income taxes personal expenses are not deductible sec_262 petitioner contends that dollar_figure was incurred in connection with a suit concerning his federal income taxes whether a legal expense is deductible under sec_162 or sec_212 depends on the origin and nature of the expense 372_us_39 it appears from an order of the circuit_court of tuscaloosa county alabama filed date that petitioner's former wife brought an action against petitioner to recover from petitioner various amounts including monies withheld from the former wife's income_tax refund by the internal_revenue_service for payment of taxes due from petitioner which petitioner was ordered to pay under paragraph of the final decree of divorce entered on date the action therefore had nothing to do with any dispute concerning petitioner and the internal_revenue_service over petitioner's tax_liability but rather arose from a debt between petitioner and his former wife that in turn arose out of the divorce proceedings as such the legal expenses_incurred were clearly personal and are nondeductible united_states v gilmore supra the remainder of the miscellaneous deductions in dispute dollar_figure are more nebulous petitioner appears to argue that at least part of this amount was for other legal expenses including his former wife's attorney's_fees incurred in connection with the litigation described above for the same reason these expenses are not deductible petitioner also contends that a part of this amount was incurred in purchasing or depreciating a computer petitioner however offers no substantiation for this expense moreover it appears that similar to the printer discussed infra sec_280f prohibits any deduction in sum except for the allowance of dollar_figure for safety shoes respondent's determination is sustained with respect to the deficiency respondent also determined that petitioner was liable for an accuracy-related_penalty for negligence in the preparation and filing of his return sec_6662 imposes a penalty in the amount of percent on any underpayment to which the section applies sec_6662 applies to underpayments due to negligence sec_6662 negligence is the failure to make a reasonable attempt to comply with the law sec_6662 petitioner has not established that he used reasonable care in preparing his return indeed all of the deductions except for the safety shoes are clearly not deductible thus the entire deficiency as redetermined is attributable to negligence respondent's determination with respect to the penalty under sec_6662 is sustained decision will be entered for respondent


internal_revenue_service number release date index number ------------------------------------- -------------------------------------------------- ------------------- ----------------------------- in re -------------------------------------------------- ------------------- ----------------------------- ----------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact -------------------- id no ------------- telephone number --------------------- refer reply to cc ita b5 plr-128522-06 date date this is in reference to a form_1128 application to adopt change or retain a dear ------------- tax_year submitted on behalf of the above-named taxpayer requesting permission to change its annual_accounting_period for federal_income_tax purposes from a taxable_year ending august to a taxable_year ending december effective for the tax_year beginning date and ending date the taxpayer has requested that the form_1128 be considered timely filed under the authority contained in sec_301_9100-3 of the procedure and administration regulations the taxpayer's form_1128 requesting a change in accounting_period to a tax_year ending date was due on or before date but was not timely filed however the form and the request for discretionary administrative relief were filed within days of such due_date the information furnished shows that the taxpayer intended to make the change and to file form_1128 on a timely basis due to an error or misunderstanding however the form was not timely filed the error was not due to any lack of due diligence or prompt action on the part of taxpayer sec_1_442-1 of the income_tax regulations provides that in order to secure the commissioner's consent to a change in annual_accounting_period the taxpayer must file an application on form_1128 with the commissioner within such time and in such manner as is provided in administrative procedures published by the commissioner but for a timely filing the taxpayer’s form_1128 would be subject_to the automatic consent procedures of revproc_2002_37 2002_1_cb_1030 and due on or before the due_date including extensions of the return of tax required for the short_period date sec_301_9100-3 of the regulations provides that requests for extensions of based on the facts and information submitted and the representations made it is plr-128522-06 time for regulatory elections that do not meet the requirements of sec_301_9100-2 automatic extensions such as the instant case must be made under the rules of sec_301_9100-3 requests for relief subject_to sec_301_9100-3 will be granted when the taxpayer provides evidence to establish that the taxpayer acted reasonably and in good_faith and that the granting of relief will not prejudice the interests of the government held that the taxpayer has acted reasonably and in good_faith and that the granting of relief will not prejudice the interests of the government accordingly the requirements of the regulations for the granting of relief have been satisfied in this case and taxpayer's late-filed form_1128 requesting permission to change to a tax_year ending december effective for the tax_year beginning date is considered timely filed furnished by the taxpayer and is limited to the filing of form_1128 except as specifically addressed herein no opinion is expressed regarding the tax treatment of the subject transaction under the provisions of any other sections of the code or regulations that may be applicable thereto this office has not verified any of the material submitted in support of the requested ruling verification of factual information representations and other data is within the examination jurisdiction of the taxpayer's irs industry director the ruling contained in this letter is based upon facts and representations a copy of this letter_ruling and taxpayer's form_1128 are being forwarded to the service_center where the taxpayer files its federal_income_tax returns with instructions that the form_1128 be considered timely filed and processed in accordance with established procedures under revproc_2002_37 this ruling is directed only to the taxpayer that requested it sec_6110 of the internal_revenue_code provides that it may not be used or cited as precedent sincerely yours s george f wright george f wright senior technician reviewer branch office of associate chief_counsel income_tax accounting enclosures copy of this letter copy for sec_6110 purposes


internal_revenue_service department of the treasury index number washington dc number release date person to contact telephone number refer reply to cc dom p si 03-plr-115865-99 date date legend taxpayer month taxable_year taxable_year dear this letter responds to a letter dated date written on behalf of taxpayer requesting relief under sec_1362 of the internal_revenue_code from taxpayer’s invalid s_corporation_election facts according to the information submitted taxpayer is a domestic_corporation that in month elected s_corporation status under sec_1362 taxpayer filed timely returns as an s_corporation for taxable_year sec_1 and from the time taxpayer elected s_corporation status until present two of taxpayer’s shareholders have been non-resident aliens nras at the time of taxpayer’s election taxpayer was unaware that non-resident aliens could not be shareholders of an s_corporation taxpayer requests sec_1362 relief for its invalid sec_1362 election toward that plr-115865-99 end taxpayer proposes the following remedial measures the nra shareholders will transfer their stock to x who is an eligible shareholder taxpayer will amend its year and year returns to allocate x all income that was allocated to the nra shareholders the nra shareholders represent that they will transfer their shares of taxpayer to x and x represents that it will amend its returns for year sec_1 and to take into account the income that was allocated to the nra shareholders discussion sec_1361 provides that the term s_corporation means with respect to any taxable_year a small_business_corporation for which an election under sec_1362 is in effect for such year sec_1361 provides that a domestic_corporation cannot be a small_business_corporation if the corporation has a nra as a shareholder because taxpayer had nras as shareholders when taxpayer elected under sec_1362 taxpayer was not a small_business_corporation in month as such taxpayer was not eligible to elect under sec_1362 and the election was ineffective sec_1362 provides that if an election under sec_1362 by any corporation was not effective for the taxable_year for which made the secretary determines that the circumstances resulting in such ineffectiveness were inadvertent no later than a reasonable period of time after discovery of the circumstances resulting in such ineffectiveness steps were taken so that the corporation is a small_business_corporation and the corporation and each person who was a shareholder in the corporation at any time during the period specified pursuant to sec_1362 agrees to make such adjustments consistent with the treatment of the corporation as an s_corporation as may be required by the secretary with respect to such period then nonwithstanding the circumstances resulting in such ineffectiveness such corporation shall be treated as an s_corporation during the period specified by the secretary conclusion after applying the relevant law and regulations to the representations made we conclude as follows notwithstanding the ineffectiveness of taxpayer’s s_corporation_election because of taxpayer’s failure to comply with sec_1361 taxpayer will be treated as an s_corporation from the time of the election and thereafter provided the election was otherwise effective and was not terminated under sec_1362 this ruling is conditioned on the following the nra shareholders must transfer all their shares in taxpayer to x from the time of taxpayer’s election and thereafter x must in determining its federal_income_tax liability take into account the nra shareholders’ pro_rata share of the separately and nonseparately computed items of taxpayer as provided in sec_1366 make any adjustments to stock basis as provided in plr-115865-99 sec_1367 and take into account any distributions made by taxpayer as provided in sec_1368 if taxpayer the nra shareholders or x fail to comply with these conditions this ruling will be null and void except as specifically ruled above we express no opinion concerning the federal tax consequences of the transactions described above under any other provision of the code this letter is issued only to the taxpayer who requested it under sec_6110 it may be used or cited as precedent pursuant to a power_of_attorney on file with this office a copy of this letter will be sent to taxpayer’s authorized representative taxpayer should attach a copy of this letter to its next federal_income_tax return we enclose a copy for that purpose sincerely yours jeff erickson assistant to the branch chief branch office of the assistant chief_counsel passthroughs and special industries encl copy for sec_6110 purposes


internal_revenue_service national_office technical_advice_memorandum date third party communication none date of communication not applicable number release date index uil no case-mis no territory manager ----------------------- ------------------------------ --------------------------------- tam-159330-04 cc ita b02 taxpayer's name taxpayer's address taxpayer's identification no year s involved date of conference --------------------------------------------------------- -------------------- ------------------------------ ---------------------------------------------- -------------------------------------------------------- --------------------------- legend taxpayer x y z date date date date a b c d e f --------------------------------------------------------- ----------------------------- ------------------------------------------------------------- ------------------------ ---------------------- -------------------------- ------------------------- ---------------------- -------- --------------- -------------- ---- ---- -------------- tam-159330-04 issue s whether the costs of terminating a merger paid_by taxpayer are deductible either as ordinary and necessary business_expenses under sec_162 of the internal_revenue_code or as an abandonment_loss under sec_165 or whether the costs must be capitalized under sec_263 conclusion s the termination expenses are nondeductible capital expenditures that must be capitalized under sec_263 facts taxpayer is a corporation in the ------ production industry three years prior to the taxable_year at issue x another corporation in the------- production industry began acquiring taxpayer stock x subsequently contacted taxpayer about a potential combination of the corporations but taxpayer declined to pursue the merger possibility because of antitrust and political concerns in the year before the taxable_year at issue a syndicate of investors expressed an interest in a leveraged buy-out lbo of taxpayer taxpayer’s managers were receptive to the lbo because of the depressed value of taxpayer’s stock they also recognized that taxpayer had little in the way of takeover defenses and that an acquisition of taxpayer at a large premium was possible the investors formed y to acquire taxpayer and negotiations between the parties ensued on date y and taxpayer entered into a merger agreement y merger agreement whereby y would purchase all of taxpayer’s stock at a dollars per share followed by a merger of y into taxpayer with taxpayer as the surviving corporation the y merger agreement provided that under certain circumstances taxpayer would be permitted to terminate the agreement and in some cases taxpayer would be required to pay y a termination fee of b dollars and to reimburse up to c dollars y’s out-of-pocket fees and expenses_incurred in connection with the merger termination expenses the y merger agreement provided that taxpayer could terminate the agreement if ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------ ---------------------------------------------------------------------------------------------------- ------- tam-159330-04 ------------------------------------------------------------------------------------------------------------ --------------- if the merger with y had been consummated taxpayer would have become a privately held corporation operating under the direction of taxpayer’s senior management the acquisition by y was seen as an attempt to keep taxpayer from falling into the hands of outsiders on date x made an unsolicited offer to acquire all of the outstanding shares of taxpayer stock through a tax-free merger x proposed to exchange d dollars worth of x common_stock for each outstanding share of taxpayer stock because taxpayer’s management did not wish for x to acquire taxpayer contact was made with z to encourage z to bid on taxpayer on date z announced an offer to acquire all outstanding common_stock of taxpayer through a part cash part stock transaction in a letter from z to taxpayer z indicated the following reasons among others favoring the proposed transaction the proposal avoids significant regulatory risk and attendant uncertainties unlike a merger with x the resulting company would be the world’s leading supplier of ------ products in that industry taxpayer and z offer complementary products operations and philosophies the letter also indicated that the companies would combine only in ways that create strength and that they do not anticipate any significant reduction in employment levels subsequently x and z actively engaged in bidding to acquire taxpayer on date taxpayer ultimately accepted the tender offer from z under which z agreed to acquire all of the outstanding shares of taxpayer in exchange for e dollars of value in cash and z common_stock z merger agreement under the z merger agreement each party made certain representations and warranties taxpayer warranted that the y merger agreement had been terminated in accordance with its terms and that taxpayer is obligated to pay b and c dollars to y for the termination expenses the z merger agreement provided that a breach by taxpayer of any representation warranty covenant or agreement in the z merger agreement that was not curable and that represented a material adverse effect represented grounds for z to terminate the z merger agreement z agreed to advance funds to taxpayer to pay the termination expenses to y repayable by taxpayer if under certain circumstances the z merger agreement was not completed taxpayer terminated the y merger agreement z paid the termination expenses to y and taxpayer signed a promissory note note in the amount of b and c dollars with a stated_interest rate payable on demand to z tam-159330-04 -----------------------------------------------------------------z described the merger as more than the sum of its two parts z indicated that it expected to triple its revenue and that the merger was generating synergies and broadening the customer base of the combined companies taxpayer deducted the termination expenses in cost_of_goods_sold on its federal_income_tax return for the taxable_year at issue no liability was recorded for tax or financial purposes by taxpayer for the note and no payments of principal or interest thereon have been made by taxpayer z accounted for the payment of the termination expenses as a contribution of capital to taxpayer taxpayer also deducted f dollars for legal expenses_incurred to terminate the y merger agreement law and analysis general background the ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying on any trade_or_business are generally deductible under sec_162 a deduction is also generally allowable for any loss sustained during the taxable_year and not_compensated_for_by_insurance_or_otherwise related to abandoned plans for mergers sec_165 sec_1_165-2 revrul_73_580 1973_2_cb_86 sec_161 and sec_261 however provide in part that the allowance of deductions under sec_162 and sec_165 are subject_to sec_263 sec_263 disallows deductions for a ny amount_paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate sec_263 reflects the basic principle that a capital_expenditure may not be deducted from current income 418_us_1 in 503_us_79 the supreme court considered the nature of capital expenditures the court rejected the taxpayer’s argument that the creation or enhancement of an asset is a prerequisite to capitalization but instead looked at the nature of the benefits realized by the taxpayer the court recognized that the presence of an ensuing benefit that may have some future aspect is not controlling in determining whether an expense represents a capital_expenditure citing 403_us_345 and that the mere presence of an incidental future benefit may not warrant capitalization but the court emphasized that a taxpayer’s realization of benefits beyond the year in which the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization u s pincite the court also indicated that the ‘decisive distinctions’ between current expenses and capital expenditures ‘are those of degree and not of kind ’ and that because each case tam-159330-04 turns on its special facts the cases sometimes appear difficult to harmonize u s pincite citations omitted corporate merger expenses generally the expenses_incurred for the purpose of changing the corporate structure for the benefit of future operations are capital expenditures indopco inc v commissioner u s pincite 326_f2d_712 8th cir cert_denied 379_us_832 in indopco the supreme court considered whether costs incurred by the taxpayer in a reverse subsidiary cash_merger in which the taxpayer became a wholly-owned subsidiary of the acquiring_corporation were nondeductible capital expenditures the court found that the merger produced significant benefits to the taxpayer that extended beyond the tax_year in question and therefore the expenditures were not deductible under sec_162 u s pincite in particular the court pointed out representations in the record that the taxpayer would benefit greatly from the acquiring corporation’s enormous resources some synergy may exist with the acquiring_corporation because of the nature of its operations and its strong consumer products orientation because it was now a wholly owned subsidiary the taxpayer was no longer subject_to substantial_shareholder relations expenses and the taxpayer was allowed in the interests of administrative convenience and simplicity to reduce the number of authorized shares in a e st119_f3d_482 7th cir the taxpayer faced with a hostile takeover incurred expenses adopting antitakeover measures but the taxpayer eventually accepted the tender offer the court focused on the taxpayer’s concerns about the proposed takeover the suitor had no capital marketing or research_and_development the suitor intended to abandon the taxpayer’s long-term strategic business plans to find that the taxpayer was defending against an unwanted acquisition in an effort to maintain and protect an established business f 3d pincite the court determined the costs were incurred to frustrate not facilitate the merger with the hostile suitor and to preserve the status quo not to produce future_benefits in 171_br_603 s d ohio the taxpayers entered into merger agreements with white knights to stave off tender offers from a hostile suitor but despite the taxpayers’ efforts the suitor acquired the taxpayers and the taxpayers paid break-up fees to the white knights the court found that unlike the merger in indopco the taxpayers’ mergers did not create synergy especially because the suitor had no experience in the taxpayers’ field but rather the fees were paid as a result of unsuccessful attempts to defend the business from the hostile suitor the internal_revenue_service and the department of the treasury have issued capitalization_rules at sec_1_263_a_-5 of the income_tax regulations that specifically apply to merger termination_payments however the regulations are effective only with respect to amounts paid_or_incurred on or after date and do not apply in this case tam-159330-04 and therefore the fees were deductible business_expenses the court also found in the alternative that because the taxpayers did not voluntarily terminate the proposed mergers in order to engage in more favorable mergers the break-up fees were deductible as losses sustained with respect to an abandoned transaction in 224_f3d_874 8th cir the court phrasing the issue as turning on the origin of the claim doctrine considered the tax treatment of employees who as part of their duties as directors of the employer performed services indirectly and incidentally related to a corporate acquisition the court stated that in applying the origin of the claim doctrine the ultimate question is whether the expense is directly related to the transaction that provides the long term benefit in 116_tc_211 the court in a reviewed opinion determined that the entrance and exit fees paid to the f d i c by the taxpayer upon its acquisition of a failed savings and loan association in a conversion_transaction did not provide significant future_benefits in arriving at this conclusion the court focused narrowly on the nature of benefits arising from the payments standing alone the court explicitly declined to determine whether the fees should be capitalized in connection with the taxpayer’s acquisition of another financial_institution t c pincite cancellation of unfavorable contracts cases involving the deductibility of payments to cancel contracts have looked at the nature of the benefit received by the termination generally the cancellation of a contract does not in and of itself require capitalization of the cancellation payment although the payor enjoys the general benefit of disposing of an unfavorable and burdensome contract and is able to enter into a more favorable contract these general benefits standing alone do not require capitalization see 237_f2d_901 7th cir 137_f2d_745 3d cir there are also situations in which a cancellation payment is made specifically to acquire a new benefit but the cancellation is not connected closely enough to the benefit to require capitalization in the 36_tc_255 the court allowed the taxpayer to deduct a prepayment penalty incurred in paying off existing debt in order to acquire a loan from a new lender similarly in revrul_73_146 1973_1_cb_61 a corporation’s payments to cancel pre-existing stock_options as a condition of a merger agreement were not required to be capitalized the origin of the claim doctrine as originally developed requires a factfinder to determine the tax_attributes of legal expenses by looking at the matter being litigated rather than at the indirect consequences of the expenses see 372_us_39 see also 397_us_572 although the cost of stock appraisal standing alone may be a deductible expense the appraisal litigation expenses at issue originated in the acquisition of a capital_asset and therefore must be capitalized reflecting the general_rule that the nature and character of a payment depends on the transaction from which it originated the doctrine has been invoked in situations not involving litigation expenses as in wells fargo tam-159330-04 however where the cancellation payment is more closely linked to the acquisition of a long-term benefit courts have treated the payment as a capital_expenditure for example in 111_tc_231 a lessee was required to capitalize a lease_cancellation_payment made in order to enter into a more favorable lease with the same lessor see also basin electric power cooperative v commissioner tcmemo_2004_109 similarly lessors have been required to capitalize lease and license cancellation payments made to reacquire possession of the property see 63_tc_414 52_tc_850 in 273_fsupp_229 d s c aff’d 393_f2d_494 4th cir the taxpayer bottling companies in order to acquire soft-drink syrup directly from the soft-drink company and avoid the middleman’s mark-up paid the soft-drink company’s expenses of acquiring and liquidating the middleman the taxpayers deducted the expenses as paid solely to eliminate burdensome and onerous contracts however the court viewed the payment as made pursuant to an overall plan to improve taxpayer’s profits through the acquisition of a more favorable contract to acquire the syrup the benefits of which could reasonably be expected to continue for an indefinite period discussion in determining whether payment of the termination expenses is a capital_expenditure or a deductible business_expense the inquiry must focus on the nature of the benefits realized by taxpayer upon entering into the z merger agreement and whether the y merger agreement was terminated and the termination expenses were paid to achieve that benefit although the termination expense provisions of the y merger agreement were in some respects provided as a defensive maneuver against an unfavorable merger the termination expenses were not paid as a result of a failed defense - rather they were paid to acquire a significant future benefit clearly the z merger agreement provided long-term benefits to taxpayer taxpayer had initially entered into the y merger agreement because taxpayer’s managers believed the merger would be advantageous particularly with respect to fending off a combination with x but the z proposal offered additional significant future_benefits as in indopco the z merger agreement was entered into at least in part because of anticipated synergies between the two companies z’s annual report emphasized the benefits expected to be achieved as a result of the merger-- the z proposal was at no point considered to be a hostile tender offer threatening taxpayer’s business as was the case in a e staley mfg co and federated dep’t stores inc the termination expenses were not paid pursuant to an arrangement to fend off suitors in order to maintain the status quo rather taxpayer pursued and welcomed the z merger agreement tam-159330-04 payment of the termination expenses will be treated as a capital_expenditure made to achieve the benefit inherent in the z merger agreement if it is directly related to the agreement see wells fargo co in this case taxpayer and z contemplated that taxpayer would cancel the y merger agreement in order to enter into the z merger agreement - it was a condition of the merger further the termination provision in the y merger agreement specified that taxpayer could terminate the agreement and would be required to pay the termination expenses in order to enter into a binding written_agreement concerning a superior proposal otherwise taxpayer’s board_of directors was required in the absence of mutual consent breach or other specified conditions to recommend that shareholders approve of the y merger agreement accordingly the y merger agreement was terminated and the termination expenses were paid specifically to enter into the z merger agreement these facts are significantly different from those found in the shaker boulevard co discussed above where expenses_incurred to cancel an existing contract were not found to be closely related to the new contract the facts are also different from those in federated dep’t stores inc where the court found that the terminated merger was a separate transaction from the subsequent merger the payment of the termination expenses bears a direct relationship to the z merger agreement the y merger agreement was entered into because taxpayer’s board_of directors determined that it would be in the best interest of taxpayer and its shareholders unlike capitol indemnity ins co and cassatt but more like darlington-hartsville coca-cola bottling co u s bancorp v commissioner rodeway inns and peerless weighing vending machine corp taxpayer terminated the y merger agreement and paid the termination expenses specifically to acquire a benefit the synergies promised by the z merger agreement that absent termination would not be available because taxpayer’s payment of the termination expenses is directly related to the z merger agreement and because the z merger agreement confers significant future_benefits upon taxpayer payment of the termination expenses is a capital_expenditure the termination expenses therefore are not deductible expenses but rather they must be capitalized under sec_263 caveat s a copy of this technical_advice_memorandum is to be given to the taxpayer sec_6110 provides that it may not be used or cited as precedent