Federal Income Taxation
| Publication year | 2017 |
Federal Income Taxation
Robert Beard
Gregory S. Lucas
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In 2016, federal courts in the United States Court of Appeals for the Eleventh Circuit handed down several notable opinions on federal tax issues. This Article surveys four of those opinions involving the collection of foreign taxes pursuant to a tax treaty, the characterization of income from the sale of real estate as capital gains, and self-employment taxes on deferred compensation.1
The Internal Revenue Code (Code)2 provides for different rates of individual income tax for ordinary income earned through business activities and long-term capital gain income. Capital gain is "[i]ncome representing proceeds from the sale or exchange of a capital asset. . . ."3 "Capital asset" is not directly defined in the Code, but does not include "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business."4 Thus, when a taxpayer disposes of some property that has been held for more than a year, the question arises as to whether that property was held for sale as part of the taxpayer's business, or was instead purchased as an investment. In the Eleventh Circuit, determining whether an asset is a capital asset requires
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consideration of seven factors set out in the old United States Court of Appeals for the Fifth Circuit case of United States v. Winthrop.5 These factors include the following:
(1) The nature and purpose of the acquisition of the property and the duration of the ownership; (2) the extent and nature of the taxpayer's efforts to sell the property; (3) the number, extent, continuity and substantiality of the sales; (4) the extent of subdividing, developing, and advertising to increase sales; (5) the use of a business office for the sale of the property; (6) the character and degree of supervision or control exercised by the taxpayer over any representative selling the property; and (7) the time and effort the taxpayer habitually devoted to the sales.6
Although the third Winthrop factor is the "most important,"7 no one factor is determinative.8 This makes the determination of whether an asset is a capital asset necessarily a fact-intensive inquiry.9
Due to the more favorable tax rates applicable to long-term capital gain, individual taxpayers generally will prefer to characterize income as long-term capital gain rather than ordinary income. Because of the highly fact-specific nature of the determination, it is often difficult for a taxpayer to predict if the Internal Revenue Service (IRS) will accept the taxpayer's characterization. The Eleventh Circuit addressed one such failed attempt to characterize the sale of real estate as the sale of a capital asset in Boree v. Commissioner.10
This case originated in a 2002 purchase of 1,892 acres of vacant land located in Baker County, Florida by Glen Forest, LLC (Glen Forest), a tax partnership of Gregory Boree (Boree) and Daniel Dukes (Dukes).11 The purchase price was approximately $3.2 million and was substantially debt-financed. Within a month of the initial purchase, Glen Forest began making occasional sales of portions of the land.12
In 2003, Glen Forest submitted a residential development plan for the property to the Baker County Planning and Zoning Department. The planned residential development of the property would be called West
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Glen Estates, and would contain more than 100 lots, which Glen Forest would develop and sell in stages. Baker County accepted the proposal and rezoned the property, and also granted Glen Forest's request for an exemption from county requirements that Glen Forest complete interior roads prior to selling lots. Soon after, Glen Forest created a homeowners' association for West Glen Estates.13 The association documents referred to Glen Forest as the "developer" and gave it authority to appoint at least one member to the association's board so long as Glen Forest "holds for sale in the ordinary course of business at least five percent (5%) of the acreage in all phases of the property."14 The documents made no distinctions among the lots that made up West Glen Estates.15
After gaining the initial approvals from Baker County and forming the homeowners' association, Glen Forest continued with its efforts to develop West Glen Estates. It applied for environmental permits, created easements for water and utilities, and constructed an unpaved road. Glen Forest did not, however, maintain a sales office or hire a broker to sell lots, although it did place occasional classified advertisements for West Glen Estates in local newspapers. Through these efforts, Glen Forest sold approximately twenty-six lots in 2004.16
Development and selling slowed after a series of land use restrictions were adopted by Baker County in late 2004. These restrictions included moratoria on development along certain roads adjacent to West Glen Estates and on the development of subdivisions containing unpaved roads. It later required that internal subdivision roads be paved, a restriction from which Glen Forest sought, but failed to secure, an exemption. Boree estimated that complying with the paving requirement would cost approximately $7 million. Perhaps because of these new restrictions, Glen Forest sold only eight lots in 2005. Dukes also sold his interest in Glen Forest to Boree in 2005, and Boree's wife replaced Dukes as Glen Forest's second member.17
Faced with the new restrictions, Glen Forest attempted to get Baker County to approve higher-density development in order to help cover the costs of paving the roads. The new development plan would include a commercial zone and a recreational parcel for equestrian and other activities. Although Glen Forest won approval for this plan, Baker County
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also adopted, in early 2006, a requirement that roads leading to subdivisions be paved, which would cost Glen Forest an estimated $4.4 million. Glen Forest sold no lots in 2006.18
Faced with the new paving requirement, Glen Forest turned to a developer, Adrian Development (Adrian), that was planning a development adjacent to West Glen Estates, in an attempt to sell West Glen Estates. An agreement was reached under which Adrian would purchase almost all of the remaining property (over 1,067 acres) for at least $9,000 per acre. The transaction closed in early 2007, and included property in various stages of development.19
The Borees' tax returns had been prepared by the same accounting firm since 1998. Glen Forest's Schedules K-1 for the years 2002 to 2004 reported ordinary losses from the sale of West Glen Estates lots. For the years 2005 to 2007, the costs incurred for the West Glen Estates property were deducted as ordinary and necessary business expenses. As those costs exceeded the Borees' business income, they also claimed ordinary losses in those years. The reporting of these gains, expenses, and losses as ordinary is consistent with the Borees being engaged in the business of developing real estate. However, the gain from the sale of the West Glen Estates property in 2007 was reported as long-term capital gain, rather than as ordinary gain.20 That is consistent with the Borees being real estate investors, rather than developers.
In 2011, the IRS issued the Borees a deficiency notice relating to the characterization of the West Glen Estates income as long-term capital gains rather than ordinary income.21 The IRS determined that the income from the sale should have been reported as ordinary income.22 The IRS also imposed a 20% understatement of income tax penalty on the resulting underpayment.23 The Borees challenged the deficiency notice and penalty in the Tax Court.24
At trial, the Borees contended that West Glen Estates was intended to be held as an investment, and that the sales were made only to service the debt incurred in the original purchase of the land. The Tax Court, however, noted that the evidence contradicted that testimony, and instead supported the IRS's position that the Borees purchased the property to develop in the ordinary course of business. Specifically, the Tax
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Court noted that the Borees engaged in business activities that included the following: (1) subdividing the property; (2) building roads; (3) engaging in zoning activities; (4) presenting Glen Forest as a real estate business to prospective buyers, government bodies, and on their earlier tax returns; and (5) making frequent and substantial sales of property. All of these weighed against treating West Glen Estates as a capital asset under Winthrop. The Tax Court concluded that the Borees were engaged in the business of developing and selling residential real estate, and therefore should have reported the income from the sale of West Glen Estates as ordinary income.25 Thereupon, the Tax Court found that the Borees were liable for $1,784,242 in unpaid taxes arising from that mischaracterization.26
The Tax Court also imposed the 20% penalty for understatement of tax, pursuant to § 6662.27 That section of the Code imposes a penalty for "[a]ny substantial understatement of income tax."28 However, the penalty should not apply to any portion of the underpayment "if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion."29 "Reasonable cause" is determined "on a case-by-case basis, taking into account all pertinent facts and circumstances."30 If the taxpayer relies on the advice of a professional, that reliance must be reasonable and have been made in good faith,31 and the professional must have acted based on "all pertinent facts and circumstances and the law as it relates to those facts and circumstances."32 In applying the § 6662 penalty, the Tax Court did not provide specific reasons for its determination that the Borees had not acted reasonably and in good...
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