Amdahl Corp., 108 TC 507 (1997), involved costs incurred by an employer in buying and selling the homes of employees it was relocating. The Tax Court held that those costs were employee benefits deductible as ordinary business expenses. Subsequent to that decision, IRS employment tax examiners nationwide began insisting that such costs were taxable to employees, and subject to employment taxes.
In Rev. Rul. 2005-74, 2005-2 CB 1153, the Service rejected its examiners’ reliance on Amdahl in the most common relocation home purchase programs, holding that in such programs ownership is transferred from the employee to the employer, through a relocation company acting as the employer’s agent, in a bona fide sale. The ruling holds that in those fact situations the employer’s expenses associated with the purchase and sale are not taxable to the employee as wages, and provides helpful guidance as to procedures that will avoid taxability of the expenses to the employee.
The ruling also includes a separate fact pattern in which the employee is treated as retaining ownership until a final sale to a third-party, with the employer’s expenses treated as taxable to the employee. This will help employers structure their programs to avoid taxability.
Structuring home disposal programs so that two sales occur and costs are not taxable as wages will again bring into question whether the costs are deductible as ordinary losses or business expenses, or are to be treated as giving rise to a capital loss. As discussed more fully below, the author believes there are sound arguments that the IRS position that the costs give rise to capital losses is wrong, and should not be followed. Moreover, even if some costs are considered capital, the cost advantage of avoiding employment taxes and related tax assistance to employees ordinarily will outweigh any cost disadvantage from capital loss treatment1. Properly structured relocation home purchase programs also save certain costs, and further important policy goals of employee relocation.
Home Purchase Programs
When an employer relocates a homeowner employee, one of the most significant issues—and the single most important cost—is disposal of the employee’s home in the old location. The home must be sold (very few employees elect to, or can afford to, hold on to the home in the old location). Most employers choose to absorb the costs of the sale as part of their relocation program. The program chosen to effectuate the sale can have very significant cost and tax ramifications, however.
The employer can simply leave the employee to sell his or her own house, and reimburse the employee for the costs. In the relocation industry, this method is called “direct reimbursement.” The result, however, is taxability of all such reimbursements to the employee2. Such payments then are subject to withholding and other payroll taxes, as well.
To avoid the unfavorable tax result of direct reimbursement, and also to ameliorate the duplicate housing costs and loss of productivity encountered when the employee is still involved with selling the old house after moving to the new location, employers have developed programs in which they will buy the home from the employee. These programs generally are called “home purchase programs” in the relocation industry, and there are several variations.
Regardless of structure, however, if a program results in two bona fide, independent sales, one from employee to employer (or more commonly, from employee to a relocation management company operating on the employer’s behalf), and a second from that buyer to an unrelated outside buyer, most of the costs are not taxable to the employee3.
Employers, of course, must accept the risks and burdens of ownership, which may result in significant additional costs (for example, carrying costs during the period of employer ownership, repairs, insurance, etc.). But those additional costs operate to a large extent as a substitute for duplicated housing or temporary living costs the employee would have incurred while trying to sell the home, which most employers would subsidize4.
The employer also could suffer a loss due to decline in value of the home during the employer’s ownership, particularly in down markets such as the current one. Nevertheless, this risk is ameliorated somewhat by the relocation appraisal process, which includes a forecasting element that, if done correctly, generally should result in the employer’s offering the employee about what the house will in fact eventually sell for5. The risk of loss on sale also is ameliorated by programs in which the employee markets the home and identifies a potential buyer before the employer buys the home. The latter type of program is in virtually universal use by employers and, as discussed later, is accepted by the IRS in Rev. Rul. 2005-74 as not giving rise to any taxable wages to the employee.
Even if some additional costs are incurred in carrying the employee’s home until sale to a third-party, home purchase programs generally result in substantial savings to the employer over simply reimbursing the employee’s costs of the employee’s own sale, primarily because most employers also would “gross-up” the reimbursements to save the employee from additional tax costs. The following examples may help to explain this dynamic.
EXAMPLE: A relocation management company (RMC) operating on behalf of the employer buys an employee’s house for $300,000, and sells it for the same $300,000 to an unrelated buyer. Costs of purchase and sale, including a standard real estate broker commission on the sale and any fee to the RMC, will be around 10 percent of the sale price, or $30,0006.
The employee has been relieved of all the costs of disposing of the home, and nets the full $300,000 sale price just as if the employee had incurred the costs and been reimbursed for them. As noted, however, if the employer had reimbursed the costs, the reimbursement would have been taxable to the employee, reducing the benefit of the reimbursement by the tax liability incurred.
Most employers who absorb employee costs of homesale would also absorb the additional tax costs to the employee resulting from inclusion of disposal costs in the employee’s income by “grossing-up” (tax protecting) the costs. The expense of doing so, however, is very high. For example, if the $30,000 of expenses incurred are taxable to an employee in the 25 percent federal tax bracket and a 5 percent state bracket, with the 1.45 percent employee portion of Medicare the employee’s effective tax rate on the reimbursement is 31.45 percent. To fully tax protect the employee would cost the employer about $13,7707.
In addition, if the $30,000 is included in the employee’s taxable income, the employer will owe an additional 1.45 percent as the employer’s share of Medicare. In the example, this amount is $635 ($30,000 plus $13,770 times 1.45 percent). The total cost of taxability is, therefore, $14,405.
This cost can be much, much higher for employees in higher tax brackets with expensive homes.
EXAMPLE: An employee is in the 35 percent federal income tax bracket and a 5 percent state income tax bracket, rather than the 25 percent federal bracket assumed in the earlier example. The gross-up percentage would be about 70.8 percent instead of 45.9 percent. If the employee’s home is worth $1 million, and expenses run 12 percent the total additional disposal cost due to taxability, including gross-up, is $87,932.
These are costs that are avoided in a properly structured relocation home purchase program. That is, in the first example it will cost the employer an additional $14,405 to reimburse the employee for homesale costs over what it would have cost to purchase the home from the employee and sell it, and in the second example, $87,932. This tax-cost dynamic is a primary driver for adoption of employee home purchase programs by employers.
Such programs are also adopted to insure that the employee moves promptly and efficiently to the new job location, and arrives there free of the stress of dealing with a home in the former location. Employers believe that productivity on the new job is adversely affected by the time and attention that must be devoted to maintaining and disposing of a home in the old job location. Moreover, as noted, if the employee still owns a house in the old location, the employee will incur additional temporary living or duplicate housing costs in the new location, which the employer will likely subsidize or pay in full. But without relief from employment taxes and gross-up on the home purchase and sale costs incurred, the programs would be decidedly uneconomic for employers to maintain.
The 2005 Ruling
Issued on November 30, 2005, Rev. Rul. 2005-74 was actively sought by Worldwide ERC® on behalf of its members and the industry. Although it has been stated that the ruling is, in effect, an “acquiescence” in Amdahl8, Rev. Rul 2005-74 in fact has the effect of limiting the scope of that case to situations both the IRS and the relocation industry would agree do not result in a bona fide sale between employee and employer.
Properly read, the ruling directly contradicts three of the four primary factors recited by the tax court to support its position in Amdahl. It also contradicts positions that had been taken by IRS field personnel in dozens of employment tax audits nationwide and establishes that costs incurred in the most prevalent types of home purchase programs (which are based on industry standards in place for many years) are not taxable to employees.
The ruling describes three detailed fact patterns, called Situations 1, 2, and 3 in the ruling.
An employer enters into an agreement with an RMC under which the RMC will purchase homes of relocating employees. The employer is responsible for all costs incurred by the RMC, and for any losses sustained. The employer also is entitled to all proceeds on the sale of the home by the RMC, and to any gain on that sale.
The RMC determines a purchase price for the employee’s home by averaging two appraisals done by appraisers chosen by the employee from a list maintained by the RMC. The RMC then offers to purchase the home for that price. If the employee accepts, the sale contract requires the employee to vacate the home and deliver possession to the RMC within a specified time. The contract of sale is not contingent or dependent in any way on the RMC’s entering into a subsequent contract to sell the home, or on any other aspect of the RMC’s subsequent sale of the home.
The settlement date is the later of the date of the contract of sale or the date the employee vacates the home. On the settlement date, the RMC becomes contractually obligated for all expenses, costs, risks, and losses associated with the home (including real property taxes and any outstanding mortgages). The RMC also becomes entitled to sole possession of the home. In addition, it also must pay to the employee all of the employee’s equity in the home (the purchase price less outstanding debt, liens, and normal prorations of such items as taxes). After the settlement, the RMC holds itself out as the owner of the property, and deals with third parties such as mortgage holders, insurance companies, real estate brokers, and others, in its own name.
The employee delivers to the RMC a deed to the property executed by the employee as grantor, but with the grantee’s name left blank (called a “blank deed” in both the ruling and the relocation industry). The RMC can either enter its own name in the deed as grantee and record it, or enter the name of the party to whom it ultimately sells the home as grantee9.
The RMC ultimately sells the home to an unrelated buyer at a slight loss, which is paid for by the employer, along with all of the RMC’s other costs of purchase and sale, such as a real estate sales commission, and a fee for its services. The RMC inserts the buyer’s name in the blank deed to convey legal title to the buyer.
The basic facts are the same as in situation 1, except that in addition to receiving an offer to purchase from the RMC, the employee is allowed to list the home with a real estate broker and market it to other buyers (an “amended value option”). The listing agreement, however, includes an “exclusion clause” under which the real estate broker will not earn a commission if the home is sold to the RMC.
If the employee receives an offer for the home from an outside buyer, the employee does not sign a contract with that buyer, or accept any down payment or earnest money. Rather, the employee turns over the offer to the RMC. If the RMC determines that the offer is bona fide, and exceeds its own offer for the home, the RMC amends its offer to the employee to match the outside offer.
If the employee accepts the RMC’s amended offer, the procedures that follow are the same as in situation 1. The RMC enters into its own listing agreement, and attempts to sell the home, either to the outside buyer who made the offer or another buyer. Nothing about that sale or potential sale, however, affects the employee. At settlement between the employee and RMC, the employee is entitled to his or her equity based on the RMC’s amended offer without regard to whether the RMC is able to enter into or close an outside sale.
As in situation 1, a blank deed is used to transfer title.
The facts describe a purported “amended value option” that has three key differences from situation 2.
- The RMC is not required to amend its offer to the higher amount offered by an outside buyer “unless and until” the RMC is able to enter into a sales contract with that outside buyer.
- The employee is involved in the RMC’s sale to the outside buyer by retaining the right to approve or reject offers or counteroffers between the RMC and outside buyer.
- The employee gets the proceeds of the outside sale representing the higher amended value only if and when the outside sale closes. That is, payment of full equity to the employee depends on whether the outside sale actually closes.
Holdings and Rationale
The issue addressed by Rev. Rul 2005-74 is whether the transactions in situations 1, 2, and 3 involve two separate sales of the home, one from employee to employer and a second from the employer to a third-party buyer. IRS cites the familiar principle that whether a sale occurs is a question of fact, and depends on the transfer of the benefits and burdens of ownership. The ruling goes on to recite the eight factors relied on by the Tax Court in Grodt & McKay Realty, Inc., 77 TC 1221 (1981), which also were relied on by the court in Amdahl. Those factors are:
- Whether legal title passes.
- How the parties treat the transaction.
- Whether an equity was acquired in the property.
- Whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments.
- Whether the right of possession is vested in the purchaser.
- Which party pays the property taxes.
- Which party bears the risk of loss or damage to the property.
- Which party receives the profits from the operation and sale of the property.
In analyzing these factors, the IRS initially holds that delivery of a blank deed satisfies the first of Grodt & McKay factors, citing Reg. 1.6045-4(r), Example 2. Use of the blank deed was one of the principal factors relied on by the Amdahl court in finding no sale to the employer or RMC. Furthermore, in most of the many audits in which the author has been involved, use of the blank deed had been erroneously adopted by IRS employment tax examiners and field lawyers as a conclusive factor to find that no sale occurred.
The Service goes on to find that in situation 1, there are two separate sales, based on the following:
- The delivery of the deed.
- The RMC’s obligation to pay the purchase price.
- The RMC’s acquisition of all the employee’s interest and equity on settlement.
- The contract of purchase and sale.
- The RMC’s subsequent actions in dealing with the home as its own.
- The RMC’s sole responsibility after settlement for the risks and costs of ownership.
- The RMC’s sole right to possession.
- The lack of any connection between the employee’s sale to the RMC and the latter’s subsequent sale to an outside buyer.
- The RMC’s right to any profit earned on that sale.
As a result, none of the costs are treated as taxable compensation to the employee. That is, the expenses of purchase and sale incurred by the employer, through the RMC, are not taxable wages.
Applying the analysis to situation 2, IRS finds that two separate sales also occurred. The Service notes that in addition to the factors cited in analyzing situation 1, the sale to the RMC is not contingent in any respect on the RMC’s sale to either the buyer identified by the employee’s marketing or any other buyer, and that the RMC is specifically identified as the seller in the contract of sale to the ultimate buyer.
In contrast, in situation 3 the Service holds that there is only one sale, from the employee to the ultimate buyer, and that the employer, through the RMC, did not acquire beneficial ownership. The IRS relies on two facts:
- The employee’s sale to the RMC was contingent on the latter’s sale to the ultimate buyer, including the employee’s entitlement to proceeds at the higher amended price.
- The employee retained the right to negotiate offers or counteroffers between the RMC and the outside buyer, thus retaining the right to obtain the benefit of a higher price that should have belonged to the RMC.
In situation 3, since the employee is the real seller, the expenses incurred by the employer are taxable compensation under Section 61(a)(1), and wages includable on the W-2 subject to withholding and payroll taxes.
In all three situations, Rev. Rul. 2005-74 notes that the RMC is acting as the agent of the employer. In situations 1 and 2, the Service holds that it was the employer (and not the RMC) that had the benefits and burdens of ownership. Consequently, it was the employer that was treated as the true buyer and seller of the homes in situations 1 and 2. In situation 3, however, the ruling holds that the agent RMC simply facilitated, on the employer’s behalf, the employee’s own sale. It was the employer that was the true payer of wages in situation 3, even though its name did not appear on any of the purchase and sale documents.
Effect on Employer Home Purchase Programs
In its description of the programs in situations 1 and 2, the IRS essentially tracks the program descriptions for “appraised value” and “amended value” sales that were promulgated by Worldwide ERC® more than 20 years ago, and have been widely followed in the relocation industry and by employers nationwide. The Service’s analysis of the amended value program in situation 2 tracks longstanding relocation industry standards for such transactions embodied in “The 11 Key Elements of an Amended Value Option,” also developed by Worldwide ERC® in 198510.
Consequently, the effect of Rev. Rul. 2005-74 is to confirm that programs followed by a great number of employers nationwide do not result in taxable wages to employees. Moreover, the ruling includes a very detailed recitation of facts that will allow employers for the first time to be assured that the procedures they are following will be accepted by the IRS.
The ruling also states specifically that its conclusions with respect to situations 1 and 2 “apply to circumstances involving substantially similar relocation service programs,” which should provide protection for procedures that are not precisely the same as those situations but are similar in effect11. Basically, IRS has held that procedures clearly organized and documented as a sale between employee and employer, and resulting in the employer’s bearing the costs, risks, burdens, and benefits of the property, will be respected as transferring ownership to the employer in a bona fide sale.
Rev. Rule 2005-74 will go far to end confusion generated by the Tax Court’s poorly reasoned opinion in Amdahl, discussed more fully below. IRS employment tax personnel in the field had been citing Amdahl to hold expenses of relocation home purchase programs taxable virtually without regard to the procedures being followed by the employer, in many cases relying exclusively on the use of the blank deed as a disqualifying feature. Rev. Rul. 2005-74 makes clear that programs conforming to standards common nationwide are not taxable, with or without use of the blank deed, and many open audits have already been resolved in favor of taxpayers, both in Examination and Appeals.
As noted earlier, the opinion in Amdahl generated some eight years of audit controversy. It is ironic that it did so on an issue—the employment tax consequences of the expenses involved—that was not even present in the case itself.
In Amdahl, the issue was the character of the deduction the employer may take for the expenses it incurs in buying and selling employee homes. The IRS has long taken the position that the expenses incurred give rise to a capital loss, deductible only against capital gains12. In the author’s experience, however, companies engaging in such programs generally have not followed that position, arguing that the homes are not capital assets, but property held for sale in the ordinary course of their trade or business under Section 1221(a)(1). Prior to Amdahl, the issue had never reached litigation.
The Amdahl Corporation maintained a relocation home purchase program that it operated through RMCs. The program permitted either a purchase by the RMC based in an appraised value, with subsequent marketing and sale by the RMC, or an assigned sale, under which the employee hired a real estate broker and marketed the home. In the assigned sale program, if the employee found an acceptable buyer, the employee signed a contract to sell the home to that buyer. The employee then assigned that contract to the RMC for closing, but did not receive the assigned sale amount unless and until the sale contract closed. If the contract did not close, the employee was permitted to continue marketing the house seeking another buyer. In either type of purchase and sale, a blank deed was used to pass title to the ultimate buyer.
During the years at issue (1983-1986), Amdahl engaged in 176 homesale transactions, of which about 74 percent were regular, appraised value sales, and 26 percent were assigned sales.
Amdahl had deducted the costs as ordinary and necessary business expenses. The IRS contended that Amdahl had acquired capital assets, and that the costs gave rise to a capital loss. Amdahl argued that the houses it acquired were not capital assets, citing Section 1221(a)(1). Amdahl also argued in the alternative that its programs did not result in a purchase and sale of an asset at all. Rather, it merely assisted the employees’ own sales, and bore the expenses. As such, the expenses were employee benefits, deductible under Section 162(a).
The latter argument, if accepted, leads directly to a conclusion that the expenses were taxable to the employees as wages. Amdahl had not included the amounts in the employees’ wages. The employment tax years were closed for further assessment, however, and the employment tax consequences of the expenses at issue were never raised by the parties or considered by the Tax Court13. Indeed, there is no indication from the opinion or from the briefs of the parties that the court ever was informed or understood that there were collateral consequences to a decision that no sale to the employer or RMC occurred.
The Tax Court based its decision on the ownership issue, and did not reach or discuss the issue under Section 1221. It granted Amdahl ordinary deductions on the ground that the expenses were employee benefits, similar to moving expenses. In doing so, it cited as the “most significant” factors “the relocating employees’ retention of legal title, the intent of the parties, the executory nature of the contracts of sales, and the employees’ receiving any profits from the sale to third-parties.”14
Rev. Rul. 2005-74 should be read as effectively rejecting three of these four factors:
- As noted earlier, the ruling specifically accepts use of the blank deed (retention by the employee of recorded title until the employer’s sale is completed) as consistent with a sale to the employer.
- The Tax Court’s focus on intent was based primarily on its conclusion that Amdahl’s real intention was not to purchase property but to “subsidize the costs of employees’ transfers.” In contrast, Rev. Rul. 2005-74 declares that “[w]hile the reason [the employer] acquires the benefits and burdens of ownership of the home is to facilitate [the employee’s] relocation, this motivation is not incompatible with the concluding that [employer] acquired the property.” That is, if the procedures followed result in a purchase, the purchase will be respected as such even if the reason for it is to absorb the costs of relocating the employee.
- The ruling must be interpreted as making clear that there is no relevance to the executory nature of the contracts of sale. All contracts for sale of real property are by their nature “executory” until settlement, and the contracts between the employee and the RMC described in situations 1 and 2 of Rev. Rul. 2005-74 are no different. In this respect they also are not distiguishable from the contracts at issue in Amdahl. The contracts in both situations 1 and 2 of the ruling and Amdahl represent a binding obligation to complete a purchase once the conditions in the contract are satisfied, but are “executory” until settlement, when the change of ownership actually occurs. The Tax Court’s reliance on the “executory nature of the contracts of sales” is, therefore, of no continuing force as an impediment to treating relocation home purchases as bona fide sales.
In addition to the major factors discussed above, other factors relied on by the Tax Court in Amdahl also are effectively dismissed by Rev. Rul. 2005-74. These include the fact that because the RMC does not take and record title, or pay off the mortgage until its sale to an outside buyer, the employee remains legally liable for the mortgage and real property taxes until the sale to an outside buyer takes place and the deed is recorded. The same is true in situations 1 and 2 of Rev. Rul. 2005-74, which notes specifically that the RMC may take ownership “subject to” the mortgage, rather than formally assuming it or paying it off immediately. The ruling makes clear that this is not inconsistent with a completed sale, since the employer, through the RMC, assumes contractual liability for these payments under the purchase contract from the employee, just as it did in Amdahl.
Similarly, in its analysis the Tax Court asserted that the RMC did not pay the full value of the properties (because it did not immediately pay off mortgages); that the RMC was not interested in long-term appreciation, but only with quick sales even below the appraised value; that the employer-taxpayer viewed the costs as an expense of conducting its business and not as an investment in real estate; that Amdahl would receive a refund of its equity payment if the employee defaulted on his or her contract of sale to the RMC; that Amdahl’s control over the residences was for purposes of security and not an evidence of ownership; and that Amdahl’s risk of loss was small in comparison to its primary motives to relocate the employees. All of these rationales for denying sale treatment are absent from the analysis in Rev. Rul. 2005-74, even though all of them also would be present in situations 1 and 2 of the ruling. As a result, none of these factors should be considered relevant to resolution of the issue, notwithstanding their emphasis in the Amdahl opinion.
Consequently, although Rev. Rul. 2005-74 says that the IRS will follow Amdahl in circumstances involving relocation programs that are substantially similar to those in that opinion, the effect of the ruling essentially is to limit those circumstances to ones in which the employee is entitled to the profit from the employer’s sale, to so-called “assigned sales,” and to programs in which the disqualifying factors in situation 3 of the ruling are present15. All other factors cited in Amdahl are either considered irrelevant under the analysis of situations 1 and 2 in the ruling, as discussed above, or are simply not present in modern programs.
The employer home purchase programs that are in use today are almost universally within the ruling and not within Amdahl16. Consequently, both employers and IRS examiners can cease worrying about Amdahl, and concentrate on compliance with procedures that are spelled out in Rev. Rul. 2005-74.
The Deduction Issue
As noted at the beginning of this article, relocation home purchase programs correctly organized and operated result in the employer’s purchase and then sale of an asset, the employee’s house, which avoids employment taxes and gross-up costs, but calls into question the character of the deduction the employer gets for those costs17.
Returning to the first example given earlier, the facts of which are fairly typical, the employer saves about $14,405 in employment tax and gross-up costs by purchasing the employee’s home rather than simply reimbursing the employee for the employee’s own costs of sale.
The IRS, however, will cite Rev. Rul. 82-204, 1982-2 CB 192, and contend that the costs give rise to a capital loss. Such losses for a corporation are deductible only against capital gain18. Most corporations have little or no capital gain in a typical year, and may lose the benefit of the deduction unless they can carry it back three years or ahead five to offset such gain recognized in other years19. This dynamic has led some commentators to recommend that employers organize their relocation home purchase programs to follow Amdahl and not Rev. Rul. 2005-7420. This analysis, however, ignores the additional employment tax and gross-up cost that would be incurred. It also fails to account for the weakness of the IRS capital loss deduction position, and the computation of the capital loss, which as discussed below would never include all of the expenses incurred.
Flaws in Rev. Rul. 82-204
Section 1221 defines a “capital asset” as any property held by the taxpayer (whether or not connected with the taxpayer’s trade or business), but excludes property falling within certain enumerated exceptions. Section 1221(a)(1) excludes “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”
The exception is intended to “differentiate between the ‘profits and losses arising from the everyday operation of a business’… and ‘the realization of appreciation in value accrued over a substantial period of time’…”21 An employer’s expenses of its home purchase program should be regarded as directly attributable to its regular business operations. Certainly, these activities do not in any way involve the holding of assets for appreciation over time, since the homes are invariably sold at a net loss after expenses and are held only so long as it takes to dispose of them. The buying and selling of the homes is, rather, an integral part of an employer’s hiring and deployment of personnel, which is a critical and necessary part of every employer’s business operations. Employers do not hold the houses for investment.
The case law under Section 1221(a)(1) (formerly Section 1221(1) but essentially unchanged since the 1939 code except for being renumbered), stands for the proposition that the assets involved need not be a part of the taxpayer’s regular inventory, or sold to the taxpayer’s customers in that business, or held as part of a separate business22.
Moreover, the fact that the employer does not ordinarily profit from its sales of homes is not relevant for purposes of Section 1221(a)(1).23 Rather, as the cited cases demonstrate, if the employer is regularly engaged in the sale of real estate as a necessary or desirable adjunct of its regular business, the properties ordinarily will be determined to be held for sale in the ordinary course of that trade or business. Indeed, if an employer was regularly making profits on its sales of employee homes, the IRS would in all probability take the position that the gains were ordinary under the authorities cited above24.
In determining whether a taxpayer’s activities with respect to property (particularly real property) indicate that the taxpayer is holding the property primarily for sale, the courts have applied several factors. These include:
- The frequency, number, and continuity of sales.
- Improvements or other activities to make the properties more marketable.
- The extent of sales activity.
- The length of the holding period for the property.
- The substantiality of the income derived.
- The nature of the taxpayer’s business.
- The taxpayer’s purpose in acquiring and holding the property.
- The listing of property for sale directly or through brokers25.
The typical employer’s relocation home purchase program would easily meet these criteria. It is regularly carried on, and involves frequent sales over many years. The RMCs employ real estate brokers to list, advertise, and sell the properties, and the properties are in fact advertised and listed for sale. The RMCs and their real estate brokers are authorized to make necessary improvements to facilitate sale, and frequently do so. The properties are held only as long as it takes to find a buyer. The employer has no investment motive for holding the properties; its entire motivation is to purchase the house in order to relocate the employee, and then dispose of it as quickly as possible.
In short, the employer is holding these properties for sale to customers in the ordinary course of its regular business. The purchases and sales are integrally connected to that business, and do not result from any investment motivation.
Rev. Rul. 82-204 is simply incorrect. It includes no discussion of any of the analysis or authorities above. Although the ruling states that the homes are not within any of the statutory exceptions to capital asset treatment, it cites no authority whatsoever for that conclusion, and does not explain why the houses are not considered property held for sale in the ordinary course26. The case law discussed above is contrary to the conclusion in Rev. Rul. 82-204, and the author is aware of no cases involving the same or analogous facts supporting that conclusion.
IRS sometimes cites Azar Nut Company, 94 TC 455 (1990), aff’d 931 F.2d 314, (CA-5, 1991), as supporting Rev. Rul. 82-204, but that case is not on point. In Azar Nut the employer had only one purchase and sale of an employee home, no active relocation program, and argued only that the house was “real property used in the taxpayer’s trade or business” within the meaning of what is now Section 1221(a)(2). Whether or not the home was property held for sale in the ordinary course within Section 1221(a)(1) was never briefed, argued, or decided by either the Tax Court or court of appeals. The case is simply not relevant precedent.
Some Costs Are Ordinary, Regardless
In a typical relocation home purchase program, some of the costs the employer incurs are for carrying the property, not for purchasing or selling it. These costs would include, for example, mortgage interest (deductible under Section 163), real estate taxes (deductible under Section 164), and repairs, utilities, maintenance, and insurance (deductible under Section 162 even though the asset is a capital asset—see for example Regs. 1.162-1 and 162-4). These amounts are fully deductible for a business taxpayer even if the asset to which they relate is a capital asset. The same is true of fees paid to the RMC, which is being paid to manage and conduct the employer’s relocation program27.
Consequently, even if the IRS successfully litigated the position it takes in Rev. Rul. 82-204, some of the costs would still be ordinary deductions. The amount would vary, of course, with the holding period for the houses, and ordinarily would be smaller than the combination of acquisition and disposal costs. Nevertheless, regardless of the amount of the deductible costs, the scope of the capital loss issue is not as broad as commentators typically assume.
It Pays to Dispute the Issue
As noted, the Service has been taking its capital loss position for 25 years now, but no cases except Amdahl and E.&J. Gallo Winery have reached litigation, and no case has actually addressed the Section 1221 issue. That is not because taxpayers follow Rev. Rul. 82-20428. Rather, in the author’s experience, it is the product of two circumstances.
One is that the issue is simply not raised in many income tax audits of corporations, although this may begin to change after Rev. Rul. 2005-74. The second is that when the issue is raised, it is typically settled, either at the Examination or Appeals level, generally with each side conceding some of the dollars at issue. This is particularly true of cases that reach Appeals, where the appeals officer is allowed to consider the hazards of litigation, which as demonstrated above are considerable for the IRS.
Although a taxpayer operating a relocation home purchase program conforming to situations 1 and 2 of Rev. Rul. 2005-74 should not assume that it will avoid the capital loss issue, the fact remains that the capital loss issue does not cost a taxpayer as much as might be assumed, and in addition the taxpayer always will save money by disputing it (unless, of course, the taxpayer has available capital gains against which to offset the capital loss deduction).
In contrast, the cost of avoiding the capital loss issue by organizing a home purchase program so that it does not conform to situations 1 or 2 of Rev. Rul. 2005-74 is substantial and unavoidable. That cost in most cases will exceed the cost of not following the IRS capital loss deduction position, even if the Service is completely sustained on its position. Moreover, as shown in the two earlier examples, the cost of failing to conform to situations 1 or 2 of Rev. Rul 2005-74, and not achieving a bona fide transfer of ownership between employee and employer, escalates for employees in higher income tax brackets with more expensive homes.
To illustrate the cost comparison, consider again the two examples given earlier. In the first example, as noted, following Amdahl and not the fact patterns of situations 1 or 2 of Rev. Rul. 2005-74 will cost an additional $14,405 in employment taxes and gross-up expenses. The cost could have been avoided by purchasing and selling the house as in Situations 1 or 2 or Rev. Rul. 2005-74. It was incurred to assure an ordinary deduction for the $30,000 of home disposal costs. At a 35 percent corporate tax rate, the deduction of $30,000 is worth $10,500. Of course, the extra $14,405 is also deductible, so that the total deduction is $15,542 ($44,405 x 35 percent). Although this might make it seem that incurring the extra cost to insure ordinary deductions is a net winner, that is almost assuredly not the case, given the unlikelihood of losing the entire deduction in a dispute with the IRS. Further, depending on the mix of costs that are deductible in any event versus acquisition/disposal costs, any modest cost advantage sought to be obtained by assuring full deductibility ordinarily will not materialize even if one assumes the IRS could sustain its capital loss position in its entirety.
The cost disadvantage of following Amdahl and not conforming to situations 1 or 2 of Rev. Rul 2005-74 is clearer in the second example. Taxability of the expenses, as noted, will cost the employer $87,932. Guaranteed full deductibility of the underlying $120,000 of home disposal costs is worth at most $42,000 at the 35 percent corporate tax rate. Although the extra $87,932 also is deductible, the total cost saving of the deduction achieved is just $72,776 ($207,932 x 35 percent). In this example, it cost an extra $15,156 just to avoid a possible dispute on the character of the deduction. In the author’s experience, variations on the second example, in which accepting employment taxes and gross-up in exchange for guaranteed full deductibility of costs, are the norm rather than the exception.
Relocation home disposal programs organized so that the employer is treated as having purchased and sold the employee’s home save money, notwithstanding IRS attempts to characterize some of the expenses as capital. They also further important policy goals of employee relocation programs. No employer should willingly seek to follow the Tax Court’s decision in Amdahl.
Rev. Rul. 2005-74 is a welcome and carefully considered articulation by the IRS of the programs and procedures it will accept as resulting in bona fide purchases of employee homes by employers, with the beneficial results described above. It should, and no doubt will, be followed by most employers, who will save significant dollars while continuing to argue that their costs give rise to ordinary deductions.
Peter K. Scott is tax counsel for Worldwide ERC®, Arlington, Virginia. He can be reached at +1 703 893 8566 or e-mail firstname.lastname@example.org.
1. A recent article recommends that in order to obtain ordinary deductions employers structure their home purchase programs to follow Amdahl Corp., 108 TC 507 (1997), rather than structuring their transactions to result in bona fide sales to the employer under Rev. Rul. 2005-74. This analysis ignores the employment tax consequences of doing so, and is contrary to the practice of every company that maintains a relocation home purchase program. See Harmon and Kulsrud, “Treatment of Homes Purchased by Employers in Employee Relocation Situations—IRS Provides Guidance,” 84 Taxes No. 5 (November 2006), page 29, at 32. Indeed, if employers followed the recommendation made by those authors, there would be little reason to operate home purchase programs at all. Rather, an employer simply could reimburse the employee’s costs of disposing of the home, which would have the same tax consequences as the authors’ recommendation, without the significant risks and burdens assumed with purchase of a home.
2. Section 82; Reg. 1.82-1(a); Pederson, 46 TC 155 (1966); Ferebee, 39 TC 801 (1963).
3. Rev. Rul. 2005-74; Rev. Rul. 72-339, 1972-2 CB 31; Karsten, TCM 1975-202. See also Reg. 1.82-1(a)(5). An exception to the principle that costs are not taxable holds that costs actually incurred on the sale from employee to employer that are seller costs under local law or custom (for example, transfer taxes in some jurisdictions) and that are paid by the employer are taxable to the employee. In practice, few such costs are incurred. With few exceptions, the sale from employee to employer is done without incurring any costs, and all costs of sale are incurred on the later sale by the employer to an unrelated buyer.
4. It is a general rule of thumb that carrying costs (which would include interest on a mortgage, taxes, insurance, utilities, and maintenance) will average around 1 percent to 1.5 percent of the home value per month. Therefore, if one assumes a $300,000 home, carrying costs ordinarily might be around $4,000 per month. If the employee still owned the house, the employee would usually be incurring somewhat comparable costs. If the employee also has purchased a home in the new location (most employers would provide some sort of equity advance or interest-free bridge loan to make this possible), the employee will be incurring those same costs in two places. Alternatively, the employee may be in temporary housing in the new location, the costs of which will also be substantial. In either event, the cost to the employer to defray one set of those costs usually would not differ greatly from its own costs to carry the home in the departure location after a purchase from the employee. Further, unlike its own carrying costs, the costs to subsidize duplicate housing are taxable to the employee and, therefore, bring into question whether the employer also should pay all or a portion of the additional tax liability the employee incurs.
5. The relocation appraisal is not a determination of static value, but seeks to determine an “anticipated sales price” assuming a sale within the normal marketing period for similar homes in the particular market. It does so in part by applying a forecasting adjustment based on an assessment of the direction of the market over the marketing period, increases or decreases in the number of similar properties for sale, and other factors. The goal is to determine what the house actually will sell for in, say, 90 days if that is the time the appraiser determines that it ordinarily will take to sell that type of home in the particular locality.
6. Inasmuch as fees to RMCs are generally quite modest, and most companies also would pay an RMC a similar fee for assisting the employee to conduct the employee’s own sale, it is assumed for purposes of the examples in this article that the costs of purchase and disposal are roughly the same as if the employee had simply sold the house personally and had been reimbursed. That is, the employer does not incur substantial additional costs over what it would have reimbursed to the employee. Carrying costs incurred are usually for relatively short periods. As discussed in note 4, supra, if substantial carrying costs are incurred during a period of employer ownership, they are roughly offset by these costs of temporary living or duplicate housing costs for the employee that the employer has avoided, reimbursement of which also would have been taxable to the employee.
7. Since the tax protection payment is itself taxable, a reciprocal formula must be used to calculate the total reimbursement required. The most common formula is expressed as the total effective tax rate (here, 31.45 percent) divided by (1 minus the total effective tax rate) times the amount of reimbursement. In the example, this yields .3145/1-.3145 = .459, x $30,000 = $13,770. Note that this example assumes that the employee has already maxed out his or her FICA threshold. If not, the gross-up amount would be higher.
8. See Harmon and Kulsrud, supra note 1, page 32.
9. Use of the blank deed is a longstanding practice in employee relocation home purchase programs, and is an important cost-saving technique. A majority of states impose either a transfer tax, a recording fee, or both on real estate transactions. These costs can be substantial. Taking and recording a deed, and then conveying ownership with a second deed, results in an extra set of transfer taxes or recording fees (as well as raising questions about whether the first such cost should be taxable to the employee). The blank deed enables the employer to pass title directly from the employee to the ultimate buyer. In most states a sale unaccompanied by a recorded deed is not subject to transfer tax or recording fee. Consequently, use of the blank deed avoids conveyance costs on the sale from employee to employer, as well as significantly simplifying the transactions administratively.
10. Both the standard definitions and the “11 Key Elements” were developed by the Worldwide ERC® Law and Government Relations Committee in 1985, and are available to ERC members on its website at www.erc.org. These documents were made available to the IRS Office of Chief Counsel as part of its consideration that led to issuance of Rev. Rul. 2005-74.
11 For example, a widely employed home purchase method called a “buyer value option” (BVO) in the relocation industry follows precisely the procedures cited with approval in the analysis in Rev. Rul. 2005-74, but does not include an initial appraisal and offer, basing the purchase price from the employee entirely on offers received by the employee during marketing of the home. The author believes that such programs should be considered within the favorable holding in situation 2. Audit experience since publication of the ruling has been inconclusive with respect to such programs, but favorable in several instances and unfavorable in others.
12 Rev. Rul. 82-204, 1982-2 CB 192.
13. In a Claims Court refund case pending after Amdahl was decided, which also involved the capital versus ordinary deduction issue, the Justice Department filed a counterclaim demanding additional employment taxes after the taxpayer based its argument on the Amdahl decision: E.&J. Gallo Winery, Docket No. 97-297-T. The case was settled in 2000, and no opinion was filed.
14. In the Amdahl program, the court found as a fact that even in the appraised value purchases, if Amdahl made a profit on its subsequent sale the profit was given to the employee. Although such a profit would almost never occur, passing any profit on the employer’s own sale back to the employee has long been recognized in the relocation industry as inconsistent with the full assumption of the benefits and burdens of ownership by the employer, and is a feature not found in modern programs.
15. The relocation industry has for many years agreed that “assigned sales,” in which the employee actually enters into a sale contract with an outside buyer, result in the expenses of sale being taxable to the employee when paid by the employer. Such programs are almost nonexistent today. Recall that Amdahl dealt with tax periods more than 20 years ago.
16. Harmon and Kulsrud, supra note 1, state that the IRS has not provided any guidance on the 74 percent of sales in Amdahl that were “regular” sales. To the contrary, these transactions are classic “appraised value” sales described in situation 1 of Rev. Rul. 2005-74, and provided that there is no “profit passback” to the employee (which, as pointed out in note 14, supra, is never provided in modern programs), the expenses clearly are not taxable to the employees.
17. An exception might be home purchase programs in which the RMC charges a large fixed-fee per home (for example, 12 percent of the sale price), in return for which the RMC itself assumes all the costs, risks, and burdens of ownership. IRS has informally held that in such a program the RMC, not the employer, is the owner, and it would follow that the employer is entitled to ordinary deductions for the fees. See Ltr. Rul. 9244027.
18. Sections 165(f) and 1211(a).
19. See Sections 1212(a)(1)(A) and (B).
20. Harmon and Kulsrud, supra note 1, page 32; Raby and Raby, “Tax Problems With Home Purchases When Relocating Employees,” Tax Notes, 12/19/05, page 1551.
21. Malat v. Riddell, 383 U.S. 569, (1966) (citations omitted).
22. See Guardian Industries Corp., 97 TC 308 (1991) (sale of waste products from the taxpayer’s photo-finishing business); Black, 45 BTA 204 (1941), acq. (regular sales of real estate are by definition sales to “customers” without regard to taxpayer’s regular business); Girard Trust Corn Exchange Bank, 22 TC 1343 (1954), acq. (foreclosed homes were property held for sale in the ordinary course of taxpayer’s banking business); Rev. Rul. 74-159, 1974-1 CB 232 (same facts as Girard).
23. Girard Trust Corn Exchange Bank, supra note 23; Lawyer’s Title Co. of Missouri, 14 TC 1221 (1950), acq. (title insurance company acquired and sold real estate in an uncompleted project, incurred losses).
24. That is the approach the Service took (albeit under different facts) in Guardian Industries, supra note 23.
25. See, for example, Gault, 332 f.2d 94 (CA-2, 1964).
26. Worldwide ERC® approached the Office of Chief Counsel in both 1983 and 1989-90 seeking a reversal of Rev. Rul. 82-204, which was based on GCM 36361, 8/6/75, in which the facts indicated very few sales, no substantial sales efforts or improvements, and no significant time or activity devoted to the program. The Service, however, declined to do so. It is the author’s belief that despite the weakness of its position in Rev. Rul. 82-204, the Service has always instinctively resisted blessing both nontaxability of the costs to the employees and an ordinary deduction for those costs. Prior to the decision in Arkansas Best Corp., 485 U.S. 212 (1988), the Service also was concerned that the holding in Corn Products Refining Co., 350 U.S. 46 (1955), would be extended to relocation properties. In any event, Rev. Rul. 82-204 is now unlikely to be reversed unless taxpayers prevail in litigation. Many employers, however, also have sound arguments that the Ruling is distinguishable on its facts, if their programs involve many sales, substantial activity, improvements to the homes, and personnel devoted to the program.
27 In the author’s experience, IRS agents and appeals officers readily agree that carrying costs are ordinary deductions. Consequently, companies always should be prepared to separate and substantiate the program costs that are devoted to carrying the houses, as opposed to acquiring or disposing of them. These costs should be excluded before negotiating a settlement concerning the acquisition/disposal costs.
28 Most companies with which the author is familiar simply report the costs as ordinary deductions, declining to follow Rev. Rul. 82-204. Although a Revenue Ruling is a “rule” for purposes of penalties for intentional disregard of a rule or Regulation, these companies typically take the position that disclosure is not required because the position has a realistic possibility of being sustained on the merits. See Reg. 1.6662-3(b)(2). Similarly, the position is supported by substantial authority for purposes of the penalty for substantial understatement, and no disclosure is generally thought to be necessary. See Reg. 1.6662-4(a).