TC clarifies filing requirements for mark-to-market election.

In L.S. Vines, 126 TC 279 (2006), the Tax Court ruled that a taxpayer who lost over $25 million from trading securities could be allowed an extension to take a Sec. 475(f) election. This election allows a taxpayer to use the mark-to-market (MTM) method, which permits him or her to deduct all trading losses as ordinary in one tax year (instead of as capital losses, limited to $3,000 per tax year).The court found that Vines met the requirement for an extension under Regs. Sec. 301.9100-3, because he acted reasonably and in good faith and the government's interests would not be prejudiced.

The case is significant for two reasons. First, the court held that the government's interests are not always prejudiced when taxpayers file a late election that allows them to limit their tax liability to the amount they would have paid had they been knowledgeable about the tax law. Second, Regs. Sec. 301.9100 provides relief to certain taxpayers needing extensions to file elections. However, the Service has denied most letter ruling requests for MTM-method filing extensions; it believes such extensions permit taxpayers to use hindsight to lower their tax liability, and that relief should be granted only in unusual or compelling circumstances. The Vines court found that filing a late Sec. 475(f) election does not always involve hindsight, and that the IRS has not defined "unusual or compelling circumstances."

Background

The taxpayer was an attorney who won a large class-action lawsuit in 1999. As a result, he reported profits of $18,520,775 in 1999 and $16,966,055 in 2000. Vines subsequently retired from his law firm and started trading securities on Jan. 28, 2000. After technology stocks declined sharply, he incurred losses of $25,196,152 by April 14, 2000, when he stopped actively trading. Because Vines was in the business of trading securities, he was eligible for a Sec. 475(f) election, which would have allowed him to deduct all of his trading losses as ordinary, offsetting the ordinary income provided by his law practice. However, when he filed for an extension to file his 1999 return, his tax preparer did not advise him to file a Sec. 475(f) election.

After discovering that he could elect to use the MTM method, on July 21, 2000, Vines attempted to change his accounting method by filing Form 3115, Application for Change in Accounting Method, a Sec. 475(f) election and a letter explaining why he should be entitled to an extension under Regs. Sec. 301.9100-3(c). He was advised by his accountant and lawyers that he could resume active trading while they requested an IRS ruling; thus, on July 26, 2000, he resumed his trading activities. On Oct. 27, 2000, he submitted a ruling request seeking extension relief to make a Sec. 475(f) election under Regs. Sec. 301.9100-3(c); the Service denied the request on Dec. 5, 2001. Thus, Vines could deduct only $3,000 of capital losses for 2000, under Sec. 1221(b), even though his reported losses totaled $26,768,761.

See. 475(f) Election and Regs. Sec. 301.9100-3 Relief

A Sec. 475(f) election is permitted to taxpayers whose primary business is selling securities. Generally, the taxpayer must file the election with his or her return for the tax year immediately preceding the election year. If the taxpayer files for an extension, the Sec. 475(f) election must be filed at the same time. Once the appropriately filed election is approved by the Service, the taxpayer can use MTM rules for recognizing gains and losses. Sec. 475(d) (3)(A)(i) provides that ordinary income or loss treatment is accorded for any sale or disposition of securities by securities traders; taxpayers who qualify for the election can carry back the losses to offset income from prior years. Thus, the carryback provision was applicable. to Vines, who had net profits of $18,520,775 in 1999 from his law practice.

Relief requirements: Regs. Sec. 301. 9100-3 provides guidance (and relief) for extensions not considered automatic. Because Vines did not apply for a Sec. 475(f) election when he filed his automatic extension in April 2000, Regs. Sec. 301.9100-3 required him to demonstrate that he acted reasonably and in good faith and that the late election would not prejudice the government's interests. To show that he or she acted reasonably and in good faith, a taxpayer must meet one of the five general criteria outlined in Regs. Sec. 301.9100-3(b)(1) and must not be deemed not to have acted reasonably and in good faith. Under Regs. Sec. 301.9100-3(b)(1), the taxpayer must have:

1. Requested relief before the Service discovers the failure to meet the regulatory election;

2. Failed to make the election because of intervening events beyond the taxpayer's control;

3. Failed to make the election, because after exercising reasonable diligence (taking into account the taxpayer's experience and the complexity of the return issue), the taxpayer was unaware of the need for the election;

4. Reasonably relied on IRS written advice; or

5. Reasonably relied on a qualified tax professional, including one employed by the taxpayer, and the tax professional failed to make, or advise the taxpayer to make, the election.

The Tax Court found that Vines met three of the above provisions. He met #1 when he requested relief on July 21, 2000, before the IRS discovered that he had not made the election. Also, he acted with "reasonable diligence" (#3), because he immediately hired a law firm (and a new accountant) to file the election on learning about Sec. 475(f). The taxpayer met #5, because he had relied on the advice of a professional tax accountant. His original accountant had over 30 years of experience in tax accounting, previously held several leadership positions within his field and had extensive knowledge of the taxpayer's trading activities and losses. Thus, Vines (and subsequently, the Tax Court) had no reason to question the accountant's credentials as a qualified tax professional. The court held that Vines certainly satisfied at least one of the five general criteria.

The final requirement for acting reasonably and in good faith is that the taxpayer must not be deemed not to have acted reasonably and in good faith. Regs. Sec. 301.9100-3(b)(3) provides the following three requirements; if the taxpayer meets any of them, the IRS can assert that he or she did not act reasonably and in good faith:

1. Seeks to alter a return position for which an accuracy-related penalty has been or could be imposed under Sec. 6662 at the time the taxpayer requests relief (taking into account any qualified amended return filed within the meaning of Regs. Sec. 1.6664-2(c)(3)) and the new position requires or permits a regulatory election for which relief is requested;

2. Was informed in all material respects of the required election and related tax consequences, but chose not to file the election; or

3. Uses hindsight in requesting relief. If specific facts have changed since the due date for making the election that make the election advantageous to the taxpayer, the IRS will not ordinarily grant relief. In such a case, it will grant relief only when the taxpayer provides strong proof that the decision to seek relief did not involve hindsight.

Analysis: The Tax Court found that the first two provisions did not apply. The Service argued that Vines had the benefit of hindsight (#3), noting that if a hypothetical taxpayer had gains, he or she would not make a Sec. 475(f) election, because those gains would have to be realized under the MTM rules. Vines argued that, had he been aware of the Sec. 475(f) election, he would have made it. In addition, he noted that he stopped trading on April 14, 2000 and his losses were exactly the same on two important dates: the date he learned about the election (June 4, 2000) and the date by which he should have made the election (April 17, 2000).

Decision: The Tax Court ruled for the taxpayer, noting that Regs. Sec. 301.9100-3(b)(iii) states, "[i]f specific facts have changed since the due date for making the election that make the election advantageous to the taxpayer, the IRS will not ordinarily grant relief: Allowing the late election did not give Vines any advantage not available to him on the day the election should have been filed.

Regs. Sec. 301.9100-3(c) also states that relief will not be granted if the government's interests would be prejudiced by granting relief. The IRS argued that Vines should have been denied extension relief because it would lower his tax liability, thus making such relief prejudicial. However, the Tax Court ruled that the government's interests were not prejudiced, because "granting petitioner an extension of time to file his section 475(f) election does not result in petitioner's having a lower tax liability than he would have had if he had timely filed the election." Further, the court held that Regs. Sec. 301.9100-3(c)(2) allows the finding of "unusual and compelling circumstances" to defeat the presumption of prejudice. Finding that the IRS has not defined unusual and compelling circumstances in the regulations, the Tax Court decided that the taxpayer's circumstances were both unusual and compelling; thus, the government's interests could not be presumed to be prejudiced. Instead, allowing Vines to make the late election precisely fulfilled the purpose of Regs. Sec. 301.9100 relief." "to permit taxpayers that are in reasonable compliance with the tax laws to minimize their tax liability by collecting from them only the amount of tax they would have paid if they had been fully informed and well advised."

Implications

Even though the Vines decision was taxpayer-favorable, not all taxpayers will be able to obtain extension relief for late MTM elections. Already, Vines has been cited in Kazim Z. Acar, ND CA, 8/16/06. However, the district court ruled against the taxpayer, because he missed the filing deadline by three years, continued to accrue losses over a three-year period and could not prove he met any of the five general criteria outlined in Kegs. Sec. 301.9100-3(b)(1).The taxpayer admitted that he wanted to make the late election to reduce his taxes, and argued that Regs. Sec. 301.9100 relief was justified because he had been unaware of the MTM election. The different outcomes in the two cases reveal the important implications of Vines.

First, the taxpayer must be able to establish that he or she has met at least one of the five general requirements outlined in Regs. Sec. 301.9100-3(b)(1), thereby demonstrating that he or she acted reasonably and in good faith. Second, the taxpayer must act quickly to establish reasonable diligence and to minimize any tax differences between the election deadline date and the date the late election is actually filed. The Vines case was unusual. The taxpayer stopped trading a few days before the election filing date and did not resume trading until after he filed the election. Thus, his tax liability did not increase or decrease with the late filing of his MTM election and the IRS could not argue successfully that he used hindsight in making the election after the deadline.

Unfortunately, most taxpayers who miss the election filing deadline will probably keep trading securities before they discover the MTM election is available; thus, their losses or gains may increase or decrease before they file their elections. Taxpayers in this situation cannot assume a similar outcome as Vines. However, the Tax Court's language indicates dissatisfaction with the IRS's approach to granting relief in MTM cases. If the court did not find that allowing the large amount of losses Vines deducted as ordinary to be prejudicial to the government's interests, it should be safe to conclude that cases involving losses are not automatically prejudiced.

Further, the court did not rule on other possible hindsight scenarios. For example, suppose that Vines had kept trading, but after April 17, 2000 and before he filed his election on July 21, 2000, he made profitable trades, thus reducing the losses he could deduct as ordinary. Would the court have ruled against him? Perhaps not. The IRS is supposed to apply the relief rules in a manner that promotes fairness and efficiency. The decision in Vines indicates that the Tax Court found that strict adherence to the filing deadline may not promote justice but, instead, may be an unreasonable requirement that is unsupported by tax law.

FROM GEORGE SCHMELZLE, PH.D., ASSOCIATE PROFESSOR OF ACCOUNTING, MISSOURI STATE UNIVERSITY, SPRINGFIELD, MO, AND CARL E. KELLER, JR., PH.D., CPA, ASSISTANT PROFESSOR OF ACCOUNTING, INDIANA UNIVERSITY--PURDUE UNIVERSITY AT FORT WAYNE, FORT WAYNE, IN (NEITHER AFFILIATED WITH GRANT THORNTON LLP)