This week the tax court quoted Abraham Lincoln, decided the difference between a tax and a penalty, and declined to ease the definition of an easement.
In 144 T.C. No. 8 (Maines), the taxpayer owned an S corporation and a partnership. These “pass-through” businesses qualified for tax credits from the state of New York. The credits were passed from the businesses to the taxpayer, who used them on his New York personal income tax return to reduce his individual income tax liability and receive any refundable portion.
For 2005 part of the refundable credits offset half of the taxpayer’s state income tax liability. For 2006 and 2007, nonrefundable credits offset the taxpayer’s entire state income tax liability. By combining these with other credits not at issue, for tax years 2005-2007 the taxpayer paid no state income taxes and received refunds from the state of New York.
The IRS said the excess refundable state tax credits were taxable income under federal law. The taxpayer disagreed.
The taxpayer said New York calls these payments “credits” and that New York says these “credits” are “overpayments” of state income tax. Therefore, the IRS is bound by the state’s description. The IRS said if this were true, a state could undermine federal tax law simply by including certain descriptive language in its statute.
What do you think the court decided?
The Court’s Decision
In 144 T.C. No. 9 (El), the taxpayer failed to report a taxable distribution from a retirement plan (among other issues). The IRS assessed a 10% “additional tax” under code section 72(t), “10-percent additional tax on early distributions from qualified retirement plans.” You may know of this section as the amount assessed for early withdrawal from retirement plans when you’re under age 59-1/2 and no exception applies.
The question before the court was whether the section 72(t) additional tax is a “tax” or a “penalty, addition to tax, or additional amount.” What difference does it make?
In 1998, when congress reformed the IRS (Internal Revenue Service Restructuring and Reform Act of 1998), part of the reform was intended to relieve taxpayers from being “guilty until proven innocent.” The act added section 7491(c) to the internal revenue code. This section says that when the IRS seeks to impose a penalty against an individual, the IRS must first find and provide some evidence that demonstrates the IRS’s position is correct.
In this case, neither the taxpayer nor the IRS provided evidence of the taxpayer’s age at the time of the distribution. If the 10% “additional tax” is a penalty, the IRS would have to provide the evidence.
What would you say is the right terminology for the 10% amount assessed under section 72(t)?
THE COURT’S DECISION
In T.C. Memo. 2015-43 (Balsam Mountain Investments, LLC) , the question was whether a conservation easement was a “qualified real property interest” and therefore eligible for a charitable contribution deduction.
In 2003 the taxpayer, a partnership, granted a perpetual conservation easement to an unrelated nonprofit corporation on a 22-acre parcel of land. For the next five years the taxpayer had the right to change the boundaries of the restricted area. The taxpayer’s right to change the boundaries was subject to certain conditions, including that the total area restricted by the easement had to remain 22 acres and that at least 95% of the original 22-acre parcel had to remain within the boundaries of the restricted area.
The IRS said that by retaining those rights, the taxpayer did not meet the requirements of internal revenue code section 170(h)(2)(C) . That section defines a “qualified real property interest” as “a restriction (granted in perpetuity) on the use which may be made of the real property.”
What do you think? Does the taxpayer’s right to change the boundaries of the restricted area fall within the definition of a qualified real property interest in the code section?
THE COURT’S DECISION
Editorial note: This anecdote existed before Lincoln; he may have used it as an illustration, substituting cow or pig for dog, though the expression was not original with him.
We have to side with the Commissioner (and Lincoln) on this one: “Calling the tail a leg would not make it a leg.” Our precedents establish that a particular label given to a legal relationship or transaction under state law is not necessarily controlling for federal tax purposes. Federal tax law looks instead to the substance (rather than the form) of the legal interests and relationships established by state law.
The taxpayer has a legal interest in the credits New York law entitles him to. Those credits were paid to the taxpayer and nothing we say undermines New York’s decision to make them. But federal tax law has its own say in how to characterize those payments under the code. The credits are transfers from New York to the taxpayer–subsidies essentially.
First, section 72(t) calls the exaction that it imposes a “tax” and not a “penalty”, “addition to tax”, or “additional amount.”
Second, several provisions in the code expressly refer to the additional tax under section 72(t) using the unmodified term “tax.” See secs. 26(b)(2), 401(k)(8)(D), (m)(7)(A), 414(w)(1)(B), 877A(g)(6).
Third, section 72(t) is in subtitle A, chapter 1 of the Code. Subtitle A bears the descriptive title “Income Taxes”, and chapter 1 bears the descriptive title “Normal Taxes and Surtaxes.” Chapter 1 provides for several income taxes, and additional income taxes are provided for elsewhere in subtitle A. By contrast, most penalties and additions to tax are in subtitle F, chapter 68 of the Code.
Because the section 72(t) additional tax is a “tax” and not a “penalty, addition to tax, or additional amount” within the meaning of section 7491(c), the burden of production with respect to the additional tax remains on the taxpayer.
We hold that the easement is not a “qualified real property interest” of the type described in section 170(h)(2)(C). Belk v. Commissioner, 140 T.C. 1, 10-11 (2013), supplemented by T.C. Memo. 2013-154, aff’d, 774 F.3d 221 (4th Cir.2014), held that a conservation easement is not a “qualified real property interest” of the type described in section 170(h)(2)(C) if the easement agreement permits the grantor to change what property is subject to the easement.
This is because an interest in real property is a “qualified real property interest” of the type described in section 170(h)(2)(C) only if it is an interest in an identifiable, specific piece of real property.
The easement granted by the taxpayer permitted it to change the boundaries of the “Conservation Area.” Therefore, the easement is not an interest in an identifiable, specific piece of real property. Under Belk, the easement is not a “qualified real property interest” of the type described in section 170(h)(2)(C).