Tax Update Blog: August 2003 Archives

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TAXPAYER APPEALS IRS ATTACK ON S CORPORATION BASIS TRANSFERS

August 28, 2003

A while back we discussed the Tax Court's Oren decision, in which the Tax Court ruled that a shareholder had too little basis to take the losses generated by his S corporation. Shareholders can only deduct their S corporation losses to the extent they have basis in their S corporation stock. This basis is increased by the shareholder's share of corporate income, and by shareholder contributions and loans to the corporation; it is reduced by shareholder withdrawals and corporate losses.

Donald Oren was an owner of multiple S corporations. Mr. Oren borrowed money from one of his S corporations and loaned it to his money-losing S corporations before year-end so he would have enough basis to deduct their losses for the year. While all of the formalities of the year-end transactions were in order, the Tax Court ruled that they lacked "substance" and therefore should be ignored.

Mr. Oren has appealed the decision, and the briefs are available in PDF format. The taxpayer briefs are here and here; the IRS brief is here. Over $5,000,000 in federal taxes are at stake.

The Tax Court's decision makes it hard for taxpayers with multiple S corporations to be sure that they have enough basis for their losses. The taxpayer argues that the IRS wants to add its own "substance" requirement for S corporation basis that is not required by the tax law.

WHAT TO DO?

At least until the Appeals Court (8th Circuit) rules on this case, taxpayers need to be extra careful in executing year-end basis transactions with their S corporations.

Taxpayers using year-end loans to S corporations should try not to fund the loans with borrowings from other S corporations; they should instead use personal funds or actual distributions from the other corporations. They should also avoid circular transactions that cause the cash to end up in the same entity where it started.

Many taxpayers with multiple S corporations will find an S corporation holding company the best answer. The holding company format was not available in the years at issue in Oren. This format puts all S corporation basis in one place, eliminating the need to shift basis around each year from profitable corporations to loss corporations.

Perhaps the 8th Circuit will have a decision in time for 2003 year-end planning. Stay tuned.

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NEW TAX LAW TIP: GET ACTIVE TO TAKE YOUR SECTION 179 DEDUCTION

August 26, 2003

As we mentioned last week, the 2003 tax act increases the maximum Section 179 deduction to $100,000 for 2003, 2004 and 2005. The deduction had been $25,000. This deduction allows taxpayers to immediately deduct expenditures on capital items that they would otherwise have to depreciate over several years.

Unfortunately, a trap awaits some taxpayers who would like this deduction. The section 179 deduction is limited to taxable income from a taxpayer's active trade or business. Any wage income qualifies; K-1 income qualifies if the taxpayer "meaningfully" participates in the business management or operations. Income of passive partners does not qualify; nor does income from pensions, dividends, or interest.

EXAMPLE: Endrun, Inc., an S corporation, purchases $100,000 of assets in 2003. The company is owned equally by Fanny Fastgo, who runs the business; and Larry Livingood, who is retired and who only has interest, dividend and pension income and who has nothing to do with the business. If the company takes a $100,000 Section 179 deduction, Fanny gets a $50,000 deduction. Larry gets no deduction at all; the deduction is carried forward and is available only when he incurs some salary or other active income.

THE MORAL?

A pass-through entity (S corporation or partnership) should make sure its owners can actually use a larger Section 179 deduction before claiming it.

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SEPTEMBER 2003 AFRS ARE OUT

August 26, 2003

The IRS has issued (Rev. Rul. 2003-101) the minimum interest rates for loans made in September 2003:

Short Term (demand loans and loans with terms of 1-3 years): 1.52%
Mid-Term (loans from 3-9 years): 3.43%
Long-Term (over 9 years): 5.08%

Historical AFRs are available on the “Links” page at www.rothcpa.com.

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WE'RE FAMOUS!

August 21, 2003

That is, if you look in the right place and read carefully.

The Tax Update is quoted in today's Wall Street Journal in Tom Herman's Tax Report. If you subscribe to the Online Journal, you can read the article here; look on page D2 if you are a paper subscriber.

The article quotes us on the IRS's liberal policy of granting second 1040 extensions. The quote is drawn from this post.

Now if only they'd link to us...

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THE KEY TO POPULARITY FOR TAX LAWYERS?

August 21, 2003

If I were a tax lawyer, this would have hurt my feelings. I'm sure it doesn't apply to accountants...

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2003 TAX LAW TIP: SECTION 179 DEDUCTION

August 19, 2003

NEW TAX LAW TIP

The recently enacted tax law increases the annual "Section 179 deduction" to a maximum of $100,000 for 2003. The Section 179 deduction enables taxpayers to deduct in the year of purchase the cost of items that would otherwise have to be amortized or deducted.

The new law now applies this deduction to "canned" software. When considering a software purchase, don't forget that this break may now be available. But be careful - the deduction begins to disappear when a company's total purchases of "Section 179 property" exceed $400,000 in a single year.

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WHAT'S MOM WORTH?

August 19, 2003

It's safe to say that few children dream of attaining a Tax Court judgeship. The rare child who is aware that such a creature exists is also advanced enough to know what Judge Learned Hand had to say about the subject of the Tax Court's work:

"The words of such an act as the Internal Revenue Code merely dance before my eyes in a meaningless procession, and leave in my mind only a confused sense of some vitally important, but successfully concealed, meaning which is in my ability to comprehend only after an inordinate expenditure of time.

But it gets even worse. In a recent case, the Tax Court had to tell a family that their mother wasn't nearly as valuable as they had thought.

IS $800,000 PER YEAR RIGHT FOR MOM?

E.J. Harrison and Myra Harrison started a trash hauling business in California in the dark depression year of 1932. It did well enough to provide a jobs for their three sons when Mr. Harrison died in 1991, by which time the business had been incorporated as E.J. Harrison and Sons, Inc. Myra was kept on by her grateful sons. The sons thought quite a bit of their mother, paying her $808,041 in 1995, $764,664 in 1996 (the year she turned 80), and $541,325 in 1997.

Myra worked at the office three days a week. The Tax Court says her work

"...consisted in part of filing and maintaining historic company records. She also looked over proposed trash hauling contracts before signature, and she reviewed bills and signed checks prepared by others in payment of those bills. She was the only officer with authority to sign checks without a countersignature. On occasion, she attended meetings arranged by one or more of her sons with drivers or other employees where her fluency in Spanish was of use. In addition, she met with bankers in connection with her loan guaranties."

She also had a public relations role, representing the corporation at civic events. While many of her contemporaries were on the golf course or at the bridge table, her civic and office work typically took 40 hours or more a week.

SO WHAT'S THE PROBLEM?

Closely-held businesses have battled the IRS over "excessive compensation" since the early days of the tax law. Nowadays this battle is primarily fought by C corporations. The stakes arise because C corporations are taxed twice on their income - first when it is earned, and again when it is recovered by the shareholders through dividends or a sale of the stock. S corporations, in contrast, are only taxed once; shareholders pay tax on the income as it is earned, and may then withdraw the earnings from the company without further tax.

If a C corporation can pays its earnings as deductible wages, it avoids the second tax. The corporation takes a deduction for the payment, eliminating the corporate tax; the executive/shareholder then pays tax on the wages. The IRS has often argued that such payments exceed the "reasonable" value of the employee/shareholder's services, and are therefore really non-deductible dividends. When the IRS wins this argument, the C corporation double tax is preserved.

SO WHAT'S REASONABLE?

The IRS and the company took the argument over Myra's compensation to Tax Court. The battle became a contest of expert witnesses. The IRS expert won. The Tax Court concluded that Myra's duties "...were substantially similar to those of an outside board chair who does not otherwise perform the tasks of a chief executive or chief operating officer..." and that her pay was "... grossly in excess of what companies of a comparable size pay for such services." The Court used board chairs of comparable companies as a yardstick to determine that deductible compensation was $98,000 in 1995, $101,000 in 1996, and 106,000 in 1997.

IS EXCESS COMPENSATION STILL AN ISSUE?

Many companies avoid the excess compensation issue via an S corporation election. The IRS continues to assert the issue against closely-held C corporations. The recent reduction in the tax rate on dividends has lowered the stakes in this battle, but it hasn't eliminated them altogether. The IRS will still normally get to tax corporations at up to 35% on any compensation deemed "excessive." The recipient of the "excess" compensation will then pay the 15% tax on dividends, instead of the 35% rate that applies to wages. This still leaves the IRS 15% ahead on "excess" amounts.

WHAT TO DO?

S corporation status is still a good bet for prosperous corporations looking to avoid double tax. If an S election is impossible or uneconomical, a C corporation can still take steps to preserve its compensation deduction. Basic safety measures include annual review of salary and bonuses according to a formal plan; monitoring the compensation of other similar businesses as a benchmark for compensation; and paying at some amount as dividends. It can be difficult for a prosperous corporation that has never paid dividends to defend an excess compensation case.

With the rate on dividends being lowered to 15%, many senior shareholders may be more willing to take dividends than before. In some cases - particularly during a stretch of low corporate income years - the combined corporate and individual taxes will be lower if dividends are paid instead of wages.

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YOU KNOW YOU'RE HAVING A BAD DAY...

August 18, 2003

...when your home page looks like this.

What was there before, and why was it enjoined? A selection from the injunction gives a flavor of the site's former contents:

Eduardo Rivera prepares, promotes, and sells abusive tax schemes purporting to exempt his customers from federal income taxation. He markets his schemes, which he describes as "legal documentation, educational materials, and workshops to educate, inspire and assist the people in their desire to opt out of the voluntary tax system with the least amount of risk," through his website www.EdRivera.com.

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NO POWER, NO PROBLEM - IRS GRANTS 7-DAY BREAK TO BLACKOUT VICTIMS

August 15, 2003

The IRS announced today (IR-2003-100) that it will extend until August 22 all deadlines from August 15 through August 21 for all taxpayers affected by the Northeast blackout.

The extension covers all returns or payments due from taxpayers who live in the blackout area or keep their tax records there. Taxpayers should write NORTHEAST BLACKOUT” in red ink on the top of any returns using the blackout extension.

This break will come in handy for individuals with extended returns. The announcement also extends the deadline for all other payments and returns due in the next seven days, including payroll tax deposits and corporate tax returns for May 31 fiscal years.

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WHY THIS SECOND EXTENSION BUSINESS, ANYWAY?

August 15, 2003

August 15 is the deadline for extended 1040s. That is, unless you file another extension. While the second extension is not automatic, denials are rare. As a practical matter, second extensions are an exercise in busy work. Other than keeping tax practitioners busy in August, what's the point?

The Treasury Inspector General for Tax Administration (TIGTA) is wondering the same thing. The TIGTA has just issued a report saying the current extension regime not only wastes taxpayer and practitioner time, but it also encourages late payment of taxes.

EXTENDERS AS PROBLEM CHILDREN

The report says problem taxpayers are greatly overrepresented among those of us who extend our returns:

The IRS granted extensions of time to file tax returns to approximately 6.9 million individual taxpayers in CY 1999. Many of these taxpayers subsequently presented the IRS with significant filing and payment compliance problems:

· Approximately 1.3 million taxpayers filed their tax returns after the extension periods had expired.

· An additional 935,000 taxpayers had not filed their tax returns by September 20, 2001 (29 months after the regular April 15, 1999, due date).

· Approximately 2.1 million taxpayers with extensions had failed to pay all of their taxes by the regular April 15 due date.

· Over 700,000 taxpayers with extensions had balance due accounts after filing their returns.

Only 52 percent of the taxpayers with extensions had both paid all of their taxes by April 15 and filed their tax returns by their extended due dates. In contrast, 99 percent of the taxpayers not obtaining extensions had either paid all of their taxes by April 15 or filed their returns by April 15 to report their underpayments.

TOO EASY AND TOO COMPLICATED?

The report says that the extension rules make it too easy to delay paying taxes. If an extension is properly filed, the penaltly for paying less than 90% of your tax due is 1/2% per month. By contrast, the penalty is 10 times larger - 5% per month - if no extension is filed. The report says many taxpayers file the extension just to hang onto the money longer. This gives the taxpayers time to get into financial trouble, making it less likely that the balance due will ever be paid.

While the report says it is too easy to put off paying taxes, the extension procedures themselves are too complicated. They require taxpayers to make a "reasonable estimate" of their tax when they extend, but they provide little guidance as to what a "reasonable estimate" means. The extension requires forms that are not included in the standard package provided to taxpayers. If additional time is needed, the taxpayer has to obtain and file yet another form.

OUTLINE FOR A SIMPLER EXTENSION REGIME

The report outlines steps for a simpler extension regime:

- Replace the "reasonable estimate" requirement with a safe-harbor that avoids penalties when either 90% of current year tax or 100% of prior tax is paid by April 15.

- Provide for a single 6-month extension, replacing the automatic 4-month and optional 2-month extension.

The report also suggests eliminating the need to file an extension form if the safe-harbor payments have been made. This would make the federal rules similar to the current Iowa rules.

GOOD IDEAS, AS FAR AS THEY GO.

These recommendations are sensible. They could be even better if they would also provide that all return-date sensitive deadlines, other than payment dates, be automatically extended by the six-month extension period. This would cover deadlines for SEP and Keogh plan payments; it would also cover automatic accounting method changes and similar items.

WHAT'S NOT TO LIKE?

Practitioners now use the August deadline as a club to get the attention of extended taxpayers who would prefer to not think about their taxes over the summer. These taxpayers might not start to even think about their taxes until, say, October 14, without the August deadline. The problem? That's when some of us do our own returns!

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MORE BEACH READING

August 12, 2003

Reader Phyllis Pearson has a can't-miss book for those of you who already have read Tax Stories. It is ERISA Insights: Voices From the Early Days.

Ah, yes. "Bliss was it in that dawn to be alive,
But to be young was very heaven!"

Or not. Wordsworth might not have exactly been contemplating ERISA when he wrote that...

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TRACK YOUR CHILD TAX CREDIT CHECK ON THE WEB

August 08, 2003

The IRS announces that you can now track the status of your child tax credit check on the web here.

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THE JOYS OF EXTENDING

August 08, 2003

August 15, the first deadline for extended 1040s, looms. Many taxpayers who would rather be sweating on the golf course are instead sweating over their tax records and asking, "why did I do this?"

Some of us, of course, just were too darn busy to get our 1040s done back in April. Others had a much better reason - an extension gives taxpayers more time to fund a pension plan.

Self-employed taxpayers with "SEP" or "Keogh" pension plans have until the extended due date of their returns to make their contributions for the prior year. For example, SEP contributions for 2002 were due on April 15, 2003 for taxpayers who didn't extend, but are due August 15 for extended returns.

CAN I EXTEND AGAIN?

Second extensions, good until October 15, are available via Form 2688. These extensions are not automatic. We have found the IRS generally willing to grant second extensions if they are asked nicely, and if you give them a good reason. While they won't take "I'm too darn busy" as a reason, they are generally understanding when additional time is needed to gather the information required to prepare an accurate return.

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THE 80'S LIVE ON

August 08, 2003

Like any extreme binge, the savings and loan real estate frenzy of the 1980s produced a wicked hangover - one that still gives the government headaches. The headache throbbed yesterday when the U.S. Court of Federal Claims awarded $55 million in damages to a company that took over six failed Texas thrifts for the government.

The Federal Savings and Loan Insurance Corporation (FSLIC) was the government agency that ended up with the insovent thrift institutions. It worked aggressively to get the failed S&Ls into the hands of solvent owners. The FSLIC struck a deal with Centex corporation to take over six sick institutions. The deal had two two key provisions:

-The FSLIC would reimburse Centex for losses incured on the sale of the assets of the dead thrifts, and

- Centex would deduct the losses on its tax returns, splitting the tax benefit with the FSLIC 50-50.

This deal was, in effect, a "double dip" with respect to the losses; the government made the losses good, but also allowed a tax benefit for half of them.

BUYERS REMORSE

After Centex took over the thrifts, Congress had buyer's remorse on the deals worked out by the FSLIC. Being Congress, it thought it could undo the deals. The "Guarini" legislation retroactively disallowed the deduction. Companies like Centex were not pleased with having their acquisitions unilaterally restructured, so they sued.

The Supreme Court settled the main issue in 1996 when it applied the ancient legal principal known as "a deal's a deal." While the goverment could undo the deals, it breached its contracts when it did so, and it had to reimburse the thrift buyers for damages the federal and state tax savings lost when the deductions were legislated away. Litigation for damages continues.

Fortunately for Centex, an employee named Jeff Mason maintained meticulous tax records. The government hired an expert to challenge Mr. Mason's computations - an expert "whose credibility suffered greatly in the court's eyes both from the quality of his written reports and from his in- court presentation."

What do we learn from the case?

1. There are limits to the goverments ability to undo a bad bargain, and
2. A good internal accountant comes in handy - in this case, $55 million handy.

PDF link: Centex Corporation v. United States

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IF YOU DON'T REMIT WITHHOLDING, NO EXCUSE IS GOOD ENOUGH FOR IRS

August 06, 2003

Tax practitioners are adept at finding excuses. The official term for these is "reasonable cause." The phrase shows up 163 times in an electronic search of the tax regulations. A good excuse, er, reasonable cause can avoid penalties for everything from taking a flaky deduction to failing to file a return. It's easy to get the impression that no blunder is beyond retrieval, with a good excuse.

A partner in the development of a Des Moines-area subdivision learned otherwise, the hard way, in a recent case. Faced with severe financial difficulties, the developer failed to remit employment taxes to the IRS while paying other creditors.

The partner told the U.S. District Court for Iowa (Southern District) how alleged chicanery by an associate triggered the financial collapse of the partnership. Judge Vietor was unmoved:

"Paying creditors instead of paying over withoholding taxes with the knowledge that the taxes are due constitutes willfulness as a matter of law. (citation omitted). (The partner) acted willfully and is therefore, as a responsible person, liable under I.R.C. Sec. 6672 for the trust fund penalty as a matter of law."

As a result, the taxpayer ended up about $27,000 poorer. The tax law imposes liability for all employment taxes on all "responsible persons." Every responsible person is potentially liable for all employment taxes, even if there are other responsible persons out there.

The Moral: always pay your employment taxes, even if you have to stiff everyone else.

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BEACH READING

August 05, 2003

Tired of those escapist mysteries or romance novels on the beach? Fret not. Just drop Tax Stories - a behind-the-scenes look at ten landmark tax cases - in your beach bag! The book goes beyond the opinions to introduce you to the characters who litigated the cases that shape our tax lives. Nowhere else will you find an analysis of the development of the Crane holding, through analysis of an unpublished handwritten draft opinion!

If you aren't excited already, consider this comment in a Tax Analysts review of Tax Stories:

"I have no major quarrels with Tax Stories, but I cannot say the book is for everyone. Indeed, its greatest flaw is that its readership is extraordinarily narrow in scope. Yes, there are several tax geeks like myself (and probably you, if you have read this far) who won't be able to put this book down, but who else will venture to read this book?"

We'll loan you our copy when we're done.

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C CORPORATION RATE CUTS ON THE WAY?

August 01, 2003

Will C corporations be finally be invited to the tax rate cut party?

Individuals have enjoyed across-the-board tax rate cuts, as the top personal rate has dropped from 39.6% to 35% since 2000. While C corporations have benefitted from some other tax cuts - especially the bonus depreciation provisions - their top rate has remained stuck at 35%. But the day of C corporation rate cuts may soon be upon us.

GOODBYE, ILLEGAL EXPORT SUBSIDIES

The rate reductions may come courtesy of the World Trade Organization. The WTO ruled some time back that the United States illegally subsidizes exports with the "Extraterritorial Income" (ETI) tax break. The WTO has authorized trade sanctions of up to $4 billion if the break is not repealed. The biggest beneficiaries of the break are large C corporation manufacturers - think Boeing and GE. The corporate rate reductions might be enacted to offset the loss of the ETI break.

There are two competing plans to repeal the ETI and satisfy the WTO. One plan, sponsored by Ways and Means Committee members Phil Crane (R, Ill) and Charles Rangel (D, NY) would reduce the effective tax rate on U.S. manufacturing income to 31.5%.

The competing plan, sponsored by Ways and Means Committee Chairman Thomas (R, CA) and Senator Orrin Hatch (R, UT), would provide a package of breaks, including an eventual reduction in the top rate for all C corporations - not just manufacturers - to 32%. (but see correction below.) The package would also speed up depreciation rates and provide other manufacturer-oriented benefits.

Correction: the 32% rate in the Thomas-Hatch proposal would be phased out for corporate taxable income over $1,000,000, and the 35% rate would continue to apply to taxable income over $10,000,000.

SO ACT NOW AND GET YOUR ILLEGAL SUBSIDY!

Both bills would phase out the ETI, in hopes of avoiding the $4 billion in retaliatory sanctions authorized by the WTO. In the meantime, companies with exports can legally use these illegal subsidies with surprising ease. For companies with annual export sales under $5,000,000, there is no requirement to even have an offshore office or representative. The ETI illegal only for the governement, not for taxpayers (now there's a switch)! And remember: Canada is a foreign country, so your sales there are eligible for the ETI break, while it lasts.

The detailed text of the proposals is here in PDF format:

Crane-Rangel
Thomas-Hatch

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THE FEW, THE PROUD... THE RESEARCHED

August 01, 2003

The IRS "National Research Program" (NRP) is well underway, according to the General Accounting Office. The Congressional oversight agency recently reported that the kinder and gentler replacement to the old "Taxpayer Compliance Measurement Program (TCMP)," remembered by many as the "Audits from Hell" program, is proceeding smoothly.

The "research" of the NRP involves more or less detailed examinations of a sample of taxpayer returns to identify where auditors should concentrate their efforts when looking at 1040s. The NRP is supposed to be less intrusive than the old TCMP, and that appears to be so, at least as it relates to the number of returns examined. The program involves only about 47,000 returns from 2001; of these, only about 42,000 will involve detailed examinations. This is only about half of the size of the last planned TCMP, which was cancelled in the face of objections from Congress.

These 47,000 research subjects represent about 4/100 of 1% of the returns filed for 2001. These "lucky" taxpayers can be excused for failing to appreciate the kinder and gentler nature of the NRP. From what we have seen, the difference between the NRP Audits from Heck and the old "Audits from Hell" is about the same as the difference between extracting two and four wisdom teeth without novocaine.

You can view the GAO report here.

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