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Tax Update Blog: February 2004 Archives

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February 27, 2004

"Revocable trusts" or "living trusts" are a common financial and estate planning device. In these arrangements a taxpayer establishes a trust in which he is trustee and which he can revoke any time. At the death of the taxpayer the assets are disposed of under the trust terms, bypassing probate. The family assets don't become part of the public probate records, and sometimes administative costs of the asset distribution are reduced.

The federal income tax pretty much ignores these "grantor trusts." The grantor hasn't really given up anything, after all -- he can always help himself to the trust assets. The income from the assets is taxed to the grantor as if there were no trust at all.


Iowa had always followed federal rules in taxing trusts. Practitioners were therefore stunned when Department of Revenue examiners strayed from the federal system to deny an Iowa capital gain deduction to taxpayers who held business real estate in their grantor trust.

The capital gain deduction enables taxpayers to avoid Iowa tax on capital gains on the sale of businesses or business real estate if they meet a "10 x 10" requirement - that is, if they have both held the property for 10 years and "materially participated" in the business for 10 years.

A provision of the capital gain deduction law provides that “This capital gain exclusion does not apply to estates and trusts.” Tax practitioners assumed that this rule applied only to non-grantor trusts, which pay taxes on undistributed income. Since grantor trust assets are taxed directly to the owner, it wouldn't make sense for this rule to apply to them.

What makes sense isn't always what gets asserted in a revenue exmination. An examiner told a Mr. and Mrs. Hunter that trusts are trusts, grantor or non-grantor, and the capital gain deduction doesn't apply to trusts. The Hunters paid the tax assessed and filed a protest with the department.


The Department apparently realized that this examination position would upend many years of settled law and hundreds of estate plans. Iowa would, in effect, have to improvise its own system of taxing trusts. Given the numbingly tedious nature of such a task, the Department stepped back from the brink and permitted the capital gain deduction:

"The Tax Review Unit has decided that the reason given for the assessment was incorrect. In this case, there does not appear to be any justification to distinguish between estates and trusts and other flow-through entities, specifically partnerships, limited liability companies, and S corporations...

In instances where the estate or trust has income taxed directly to the individual, the individual may claim the capital gain deduction if he or she meets the necessary requirements."

And calm was restored to the placid ("dull" is such a harsh word) world of trust taxation.

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February 25, 2004

In a ruling that is sure to disappoint Iowans everywhere, a Federal court in California has ruled that Iowa birth doesn't exempt an individual from Federal income taxes.

Neil Alan Scott, a transplanted Iowan living in California, skipped filing returns for a number of years, starting in 1985. He filed returns for 1989 and 1992; on those returns, he eschewed the conventional "single" or "married" filing status and instead filed "Natural born free Citizen/National of Iowa." As the tax return instructions had no rate table for that filing status, he logically assumed that he didn't have any tax due, so he helpfully wrote in "N/A" on all of the lines on his returns.

Even so, the court ruled in favor of the IRS, enabling them to collect the taxes. It does inspire wonder, thought - what is an "Un-natural" born citizen?

If you are interested in detailed reasoning why lame arguments like Mr. Scott's never work, go here.

No link to the Scott decision is available. A Google search of his name does uncover a letter to the editor to the North County Times of California by "Dr. Neil Alan Scott" (scroll down on this link for full letter). One passage convinces us that the letter writer is the same fellow who lost the court case:

"Congress, only, has power to legislate for non-volunteering unprivileged American national private citizens in the 50 states concerning interstate commerce and postal roads. Also, federal government treaties are restricted, such as the U.N. and NAFTA etc., believe it or not, affirmed by the U.S. Supreme Court in 1957's Reid vs. Covert 365 US 1 at 17. But none are so hopelessly enslaved as those who falsely believe they are free,… per von Goethe."

If only he'd have unleashed that devastating argument against the IRS! Oh, wait, he probably did...

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February 24, 2004

Henry J. Aaron, Brookings Institution economist, has a piece in today's Tax Notes (sorry, subscription only) discussing Health Savings Accounts.

He says most discussions of HSAs have missed their real significance:

"For reasons explained at length below, both the claims that HSAs will lower medical cost inflation and the fears that they will undermine coverage are probably overstated. But the larger point is that the appeal of HSAs should not be considered within the confines of company-financed health insurance, but in the larger context of total labor compensation. The principle effect of the new HSA provisions is to break down the distinction between health and pension benefits. Much retirement saving is devoted to paying for health care. HSA balances that remain unused during an employee's working years may be used under extremely favorable terms to pay for health care during retirement, and they may be used on terms identical to those of tax-sheltered savings plans to pay for general consumption. Those options mean that HSAs are just defined contribution pension plans, with particularly advantageous tax treatment and particularly generous rules for withdrawal." (Emphasis in original.)

Aaron says the tax advantages of HSAs are so significant that employer-sponsored HSAs are likely to become widespread - not as a health-care benefit, but as a particularly tax-favored retirement benefit.

See our prior HSA coverage here and here. The BenefitsBlog has a thorough roundup of HSA information here.

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February 23, 2004

While the revelers samba in Rio and party in New Orleans, the economics nerds are partying on the 'net.

This weeks Carnival of the Capitalists is up at the "Forgotten Fronts" website. It covers economic issues that are cropping up in the campaign, including "outsourcing." One post notes that some accountants (not us!) are outsourcing tax return preparation to India, now that the American Institute of Certified Public Accountants has issued outsourcing guidance to its members.


...of zapping your tax return information across the ocean.

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February 22, 2004

Ever wonder how your income rates? Are you one of those "wealthy" taxpayers who pays too much tax (or too little, depending on who you are talking too)? We hope so! Go here to see where your 2001 adjusted gross income ("AGI,") -- taxable income before itemized deductions and personal exemptions -- ranks, compared to the other kids.

Dinosaurian economics blogger Steve Verdon has some commentary based on these statistics. He notes that the top 1% of earners has about 17.5% of total national AGI, but pays just under 34% of all income taxes. He then makes the obvious, but still pertinent, point:

"Now, it should be obvious that when federal taxes are cut then those at the top are going to the majority of the benefit because they pay the majority of the taxes."

Perhaps more interesting is the relatively low levels of income needed to reach the "elite" percentiles. For example, an AGI of $92,754 got you into the top 10% of returns in 2001. That's not at all unusual for a two-earner couple. An AGI of $56,085 put you in the top 25%, and $28,528 got you into the top 50%. When someone says the "rich" should pay more taxes, there's a good chance that "rich" means "you."

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February 20, 2004

An S corporation owner who has his own weblog visited with President Bush this week to talk taxes. Afterwards, the President showed that he knows what an S corporation is, and also touched on Section 179:

Rex Hammock is with us. Last stander. From Nashville, Tennessee. He started his own company...

And he did, and he's got what is called a subchapter S corporation. Many of you know what that means, but for those who don't, it means that you get taxed at the individual income tax level. So when we cut the rates on everybody, not just a few, it helped Rex, made him a little more comfortable in his ability to plan. But more importantly, by raising the level of deductibility for small businesses to $100,000, it provided incentive for him to invest. And so this year, he told me he's going to spend $100,000 on computers, scanners and software to help his employees in his publishing business become more productive...

We always thought presidents paid other people to know what an S corporation is. Maybe he should challenge his eventual opponent to go mano-a-mano with him in a televised tax code death match.

It is good to see that President Bush grasps that lowering individual taxes directly lowers business taxes because so many businesses are S corporations, partnerships and proprietorships. It would be nice if that knowledge were more widespread in policy circles.

(Link via Instapundit)

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February 20, 2004

Marketers have pitched so-called "Pension Rescue" arrangements to well-off Iowans over the past few years. These arrangements promise tax deductions for life insurance purchases and low-tax or no-tax transfers of lots of wealth to the next generation.


In one variant, a taxpayer on a corporate board of directors would set up a "Keogh" profit-sharing plan for her directors fees. The contributions to the plan would be deductible. Additional funding would come from a tax-free rollover of an existing IRA into the Keogh plan. The plan would use its funds to buy life insurance with a "springing cash value" feature; the policy cash surrender value would be reduced to a very low amount by a big "surrender charge" that would disappear all at once at some point in the life of the policy.

Shortly before the expiration of the surrender charge, the plan would transfer the policy to the taxpayer, who would pay tax on the temporarily depressed cash surrender value. The taxpayer would then transfer the policy to her heirs, valuing the transfer at the depressed value for gift tax purposes. Then the surrender charge would disappear and the cash value would "spring" to life, providing large amount of net worth to the next generation.

The "secret" of these plans is the reduced cash surrender value. For many income tax and gift tax purposes, cash surrender value is used to measure the value of an insurance policy. By artificially lowering the cash value, these plans tried to enable the transfers of policies at very low income tax and gift tax cost.


The IRS last week took a series of actions against combinations of qualified retirement plans and life insurance that they considered abusive.

Rev. Proc. 2004-16 says that cash surrender value can only be used to measure the value of life insurance policies distributed from a qualified plan if the value was at least the sum of:

-Premiums paid and dividends credited, reduced by
-actual reasonable mortality charges.

Rev. Proc. 2004-16 is effective February 13, 2004, so there is no "grandfathering" of existing "Pension Rescue" plans. This could lead to some unpleasant income tax and gift tax results.


There are many important tax and financial uses for life insurance. An established insurance broker for a major insurance company can help you use the right insurance tools to meet your financial and tax goals. Beware the out-of-town salesman with a plan that seems too good to be true - it probably is.

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February 20, 2004

Some states offer easy tax-free treatment to those wishing to sell their businesses. If you make good in, say, Nevada, and sell your business to enjoy a life of ease after only a year or two, you pay no state income tax - there isn't one.

In Iowa, you need to be made of sterner stuff.

Iowans who "materially participate" in a business for ten years or more incur no Iowa tax on capital gains on the sale of business assets, or real estate used in the business – but only if they have also “held” the property for 10 years. Taxpayers get this “capital gain deduction” in computing their taxable income. Two recent rulings show how the Iowa Department of Revenue enforces these stern “10 x 10” requirements.



Mr. Hartrick requested a ruling on whether he met the “10 x 10" requirement for deducting capital gain.

The ruling lays out the facts:

Taxpayer materially participated in his business, an S corporation (“A”), for over 20 years. “A” owned the building from which it operated until late 1993, when it burned down. The facility was rebuilt on the same site and was reoccupied by the same business in the spring of 1994. At that time, the owners of “A” set up a separate S corporation (“B”) to buy the building from “A.” The building was rented back to “A.” The taxpayer was a 50% owner in both “A” and “B.” The business building was sold in April 2003.

What a worthy taxpayer: toiling 20 years in the state, stoicly rebuilding after a disastrous fire -- surely the state graced the sale of the building with tax exemption...

Sorry. The Department found that the transfer of the rebuilt property in 1994 to another S corporation with identical ownership started a new holding period, of which only nine years or so had run. No capital gain deduction for you, short-timer!


Mr. McCabe claimed the capital gain deduction on a farm inherited from his mother. The Department initially rejected the deduction, but relented after the taxpayer protested. The Department's response to the protest set our the facts:

The facts of this Protest are that Mr. McCabe’s mother passed away on April 14, 1987 and his father on August 8, 1987. Mr. McCabe inherited a share of farm land from each of his parents. In both parents’ cases, land was deeded in shares to several individuals as tenants in common with the transfer of title occurring from the estate in 1989. In 1990, the same land was deeded to ALMC Farm Inc., an Iowa S corporation. Protester received shares of stock in ALMC in exchange for the land. The transfer to the sub-S does not affect the deduction… In early 1999, ALMC sold the land to Ronald Gehling, an unrelated party.

The statement “the transfer to the sub-S does not affect the deduction” seems out of place in light of the harsh Hartrick result. The only obvious distinction between the Hartrick and McCabe facts is that Mr. Hartrick “sold” land between S corporations, while Mr. Mcabe transferred is shares “in exchange for stock,” apparently in a tax-free transaction.

So tax-free transfers are ok? Well, not necessarily. The Department informally tells us that the McCabe transaction passed muster because all of the farm business was transferred, while the Hartrick taxpayer only transferred the real estate, leaving the rest of the business in the old S corporation. The Department may have approved if an entire trade or business was transferred in Hartrick.


Iowans need to consider whether a business restructuring will reset the 10-year holding period clock. A transfer of a whole business appears safe, at least when it is a tax-free transfer. Taxpayers considering transfers of less than a whole business, even in a tax-free transaction, should consider getting the deal blessed in writing by the Department if they don’t want to restart their 10-year clock. Taxpayers contemplating a taxable transaction before the 10-year clock runs definitely should pause and reconsider.


Taxpayers should be able to know whether they are restarting the 10-year clock without having to ask the Department of Revenue. The Department should adopt a straightforward way of measuring the holding period of business assets. We humbly offer the following suggestions:

-A tax-free incorporation, merger, or corporate division should not restart the holding period.

-A tax-free contribution to or distribution from a partnership, or a tax-free partnership merger or division, should not restart the holding period.

-It should not matter whether an entire business is transferred.

-Death, gifts, or taxable transactions should restart the holding period.

-Transfers between spouses should be disregarded.

With these guidelines, or something similar, taxpayers could arrange their affairs knowing how their transactions will affect their eligibility for the capital gain deduction.

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February 20, 2004

The IRS has issued (Rev. Rul. 2004-25) the minimum interest rates for loans made in March 2004:

Short Term (demand loans and loans with terms of 1-3 years): 1.58%
Mid-Term (loans from 3-9 years): 3.34%
Long-Term (over 9 years): 4.84%

Historical AFRs are available on the “Links” page at

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February 19, 2004

Congress is in no hurry to clean up its own mess, so the IRS has decided to take action.

With the tax season in full swing, the IRS today announced (IR-2004-22) that taxpayers should file their returns as if pending technical corrections to the 2003 tax law related to dividends were already in place. Specifically:

Pass-through entities (S Corporations, Partnerships, estates and trusts) on fiscal years beginning in 2003 may treat dividends received after December 31, 2002 as "qualifying dividends" eligible for the 15% top rate.

Taxpayers who bought stock the day before the ex-dividend date in 2003 will be eligible for the 15% rate on those dividends. This corrects a strange technical glitch.

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February 16, 2004

Economics weblogs "Marginal Revolution" and "Truck and Barter" have been discussing scaling speeding fines to income. Under such a system, a rich speeder pays a higher fine - perhaps because the rich scofflaws won't be deterred otherwise.

Iowa's counties are way ahead of them. According to a series of stories in The Des Moines Register, taxpayers willing to pay more can get their speeding tickets transmogrified into broken taillights, bad mufflers, and so on as needed - at a price - when a speeding ticket might cost the driver his license, or his job.

"Last year, [Cass County Attorney] Barry issued 148 defective-equipment citations that replaced 54 tickets written by police for offenses such as speeding and reckless driving. Those 148 tickets carried fines and fees of roughly $150 each - more than three times the typical penalty for equipment violations - and generated more than $21,000 for the state."

If you are going fast enough, you can plead guilty to equipment violations of a scope that would appear to make speeding impossible, because the car would fall apart:

"To get the tickets dismissed, Sniader sent Barry a sworn statement in which he stated that his car was riddled with broken equipment:

"'The Chevy Monte Carlo that I was driving at that time had a defective muffler, defective windshield wiper, defective tail light, defective back-up lamps, defective horn, defective windshield, defective signal lamps, defective mirrors and defective safety belt.'"

This system is not a pure "ability-to-pay" system, of course - nothing keeps somebody without prior violations from paying the standard $43 fine. It's almost market-based, in a quaintly extortionate way - you can pay more to keep the moving violation off your record if you really need to:

"At the time, Denney had three speeding convictions on his record - all from within the previous 10 months. Under Iowa law, a fourth ticket for failure to yield could have been a serious threat to his driving privileges.

"But Denney hired a lawyer to negotiate a deal, and Cass County Attorney James Barry eventually agreed to convert the ticket to citations for defective brakes and tires, each of which generated $155 in revenue for the county. As part of the deal, Denney agreed to pay for the damages to Johnson's truck, later estimated to be $9,000."

Perhaps this is an argument against consolidating our counties. If we had only 15 or 20 counties, instead of 99, would there be room for such creative ideas? Now the legislature can build on this creativity to solve the Iowa's budget problems. For example, in addition to enhanced alternative fines, Iowa maybe could issue admission coupons to our state's fine gaming facilities to pay for the casino's impending tax refunds by generating additional gambling tax revenue. Iowa, lead the way!

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February 13, 2004

The IRS has launched an assault on the heavily marketed "springing cash value" life insurance arrangements sold to closely-held businesses and self-employed taxpayers for their qualified plans. In four seperate actions, the IRS put such insurance-pension plan arrangements on their list of abusive transactions, set rules to value them, and placed limits on how much life insurance can be held in a plan.

These arrangments have always relied on a willingness of the tax law to be stupid enough to ignore their abusive features - a slender reed, now about gone.

We'll have more later. The BenefitsBlog has links and commentary now.

UPDATE here.

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February 13, 2004

Just in time for Valentines Day, the IRS Commissioner was moved to write "Dear Abby." About love?

Dear Abby:

I read your sound advice to "Addicted to Spending," the woman who racked up thousands of dollars in credit card debt. She said she couldn't sleep at night for fear her husband would divorce her when he found out. You were right that a credit counseling agency can provide valuable assistance, but she needs to be careful which one she selects.

Obviously a raging romantic, Commissioner Everson gushes:

We have stepped up our audits of credit counseling agencies and, where warranted, will revoke their tax exemption.

Dear Abby swoons to the Commissioner's sweet words:

I know my tax dollars are being well spent when the highest collection officer in the land reaches out to help people with money troubles.


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February 13, 2004

The IRS yesterday shut out its prime systems modernization contractor from new projects worth approximately $40 million. The contractor, Computer Science Corporation, recently disclosed that it will miss an April deadline for a critical part of the $15 billion project.

The project has been plagued with overruns and delays from the start.

The General Accounting Office says the program has generated $290 million in cost overruns and more than 83 months of delays on 11 key modernization programs.

The contractor accepted responsibility in testimony before the Ways and Means Committee yesterday. The IRS also has some responsibility; at one point, according to the contractor, the IRS had 1100 change orders in on ongoing projects. The sheer difficulty of upgrading a 1960's tape-based system to a 21st century database has also delayed the project.

You heard me! If those vacuum tubes aren't here in five minutes, we'll get shut out of $40 million in new work!

The AP covers the story here.

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February 12, 2004

For the first time in memory, the IRS is planning to expand Schedule M, the reconciliation of business taxable income to financial statement income. George White of the AICPA has the scoop.

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February 12, 2004

If your S corporation is losing money, you may only deduct your share of the losses on your 1040 to the extent of your basis in the stock, or in loans you have made to the corporation (loan guarantees don't work). The critical element of year-end tax planning for such losses is making sure you have enough basis to use them.

That kind of planning got harder today when the Eighth Circuit Court of Appeals upheld the Tax Court's Oren decision.

Donald Oren and his wife together owend 100% of three S corporations in 1995, 1996 and 1997. Two of the corporations -- Highway Sales and Highway Leasing -- were generating tax losses. Mr. Oren arranged to borrow money and loan it to the money-losing corporations. This technique, called "back-to-back loans," is a standard S corporation planning technique.

Mr. Oren got in trouble by borrowing the money for the back-to-back loans from his family's third S corporation, Dart Transit Company. Mr. Oren loaned the funds borrowed from Dart to Highway Sales and Highway Leasing, taking care to execute notes, transfer checks, and otherwise get the paperwork in order. Highway Sales and Highway Leasing then loaned proceeds of their loan from Mr. Oren to Dart, getting the cash back to where it started.

The Appeals Court agreed with the Tax Court's conclusion that this arrangement failed to create basis that would enable Mr. Oren to deduct his share of the losses from Highway Sales and Highway Leasing.


The courts found that Mr. Oren had no "actual economic outlay" in its loans around the circle. The Eighth Circuit decision says:

"True, Oren and his corporations observed all of the formalities necessary to create legal obligations. The notes were signed; checks were issued and cashed. But there were no arm’s length elements in these transactions. No external parties were involved... one must assume the occurrence of a great number of unlikely facts as a postulate to a circumstance in which Oren would suffer personal economic loss as a result of the lending transactions."


Not satisfied with saying that the loans lacked substance, the courts ran up the score on Mr. Oren. The Eighth Circuit said that even if the loans were respected, the basis created would not be "at-risk" under the Tax Law.

The "at-risk" rules are a relic of the tax-shelter battles of the 1970s. These rules were designed to prevent taxpayers from deducting losses attributable to secured borrowing if the borrower isn't on the hook for the loan if the lender forecloses on the property. The rules treat loans as not "at-risk" if it is "borrowed from a person with an interest in an activity or a related person," or if a transaction "is structured - by whatever method - to remove any realistic possibliity that the taxpayer will suffer an economic loss." Using the same factors that convinced it that the loans lacked substance, the Eighth Circuit decided that there was no such realistic possibility.


Owners of related S corporations now need to be very careful with their year-end basis planning. It's not just enough to make sure the paperwork is in place by year end; you need "substance," whatever that is.

S Corporation holding companies are probably the best way to deal with this problem if you own more than one S corporation. This technique only works if all of the S corporations are owned in identical proportions among all shareholders - for example, it would work if the same individual owned all of the shares of two S corporations. In such a situation, the taxpayer can incorporate a new corporation to serve as a holding company and contribute the shares of the existing corporations to the new corporations. This way there is only a single basis for all of your corporations, and you don't have to worry about shuffling the basis around at the end of the year. This usually can be done tax-free. Unfortunately for Mr. Oren, this technique was only made available starting in 1997.

Distributions and contributions might succeed where back-to-back loans fail. The Eighth Circuit may be hinting at this technique when it says of Mr. Oren:

It should be noted that he would suffer no additional loss (over his previous investments), as a result of the loans, by a simple decline in the value of any of the corporations. He has not increased his total investment in any of the businesses.

If Dart had instead made a cash S corporation distribution to Mr. Oren, and if Mr. Oren had then contributed the cash to the loss corporations, Mr. Oren would probably have gotten his losses. If the loss corporations then had loaned the contributed funds right back to Dart, the transaction might have still failed, but the IRS would have had a tougher argument. If the funds were left in the loss corporations, it's hard to see where the IRS would have been able to challenge the losses.

If you must do back-to-back loans, borrow from a bank or another unrelated party. The tax law is much more willing to respect a transaction if you leave the family out of it.


When you lack enough basis to deduct your S corporation loss, it is deferred, not denied. You can take the loss in any year in which you restore your basis. Mr. Oren now owes over $5 million to the IRS on over $14 million disallowed losses. If he didn't restore his basis since 1995, he now has the opportunity to shelter $14 million in income. He can be pardoned if that doesn't exactly cheer him up.

Prior coverage of the Oren case:

Our comments on the Tax Court decision

We discussed related issues here and here.

For more information on S corporations generally, go here.

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February 10, 2004

Congress and the IRS have become less nit-picky in recent years. It is now fairly easy to make late S corporation elections good, for example. It also used to be impossible to catch a break for taking more than 60 days to roll over an IRA withdrawal; now there are good cause exceptions.

Even so, there are still parts of the tax law where only the right words on a timely-filed form stand between the taxpayer and tax disaster. The Estate of John Clause learned that lesson the hard way in Tax Court yesterday.

Mr. Clause wanted to take advantage of Section 1042 of the Internal Revenue Code. Section 1042 allows taxpayers who sell shares of a C corporation to the company Employee Stock Ownership Plan (ESOP) to avoid current tax on their gain if they reinvest the proceeds in publicly-traded securities, if certain other requirements are met. One of the requirements is an election under Section 1042 on a timely-filed tax return.

Mr. Clause did his part, reinvesting the proceeds. His CPA prepared his return excluding the gain. Unfortunately, the tax returns failed to include an election required under the Section 1042 regulations. The taxpayer failed to convince the Tax Court that "substantial" compliance had been achieved. The judge says:

"Having not literally complied with the election requirements in the statute and the regulation, petitioner argues that he substantially complied with the requirements of section 1042 and should, therefore, receive the benefits of the section because the failure to file the elections was 'purely administrative in nature'. We disagree."

The moral? It's best not to count on the kindness of tax administrators; better to say the magic words demanded by the rules when you file your returns, even if they seem silly. Mr. Clause's heirs will now presumably discuss the additional $395,279 tax on the failed ESOP rollover with the hapless CPA who prepared the return for the rollover year.

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February 06, 2004

From the Iowa Supreme Court opinion striking down the differential tax on casinos:

In the end, we return to the fact that the item taxed—gambling revenue—is identical. The higher tax rate is triggered by the location where such revenues are earned. Yet there is no legitimate purpose supported by fact that justifies treating one gambling enterprise differently than another based on where the gambling takes place, other than an arbitrary decision to favor excursion boats.

With this decision (Racing Association of Central Iowa v. Fitzgerald), the Iowa Court has taken upon itself the obligation to decide whether the purposes of tax laws are "legitimate," or whether distinctions in the law are "arbitrary."

But why would a decision relating to casinos and gamblers affect a prudent, risk-averse Iowa banker? Let's play a little game. We will substitute one of our favorite words - "lending" - for "gambling" in the paragraph quoted above:

In the end, we return to the fact that the item taxed—lending revenue—is identical. The higher tax rate is triggered by the location where such revenues are earned. Yet there is no legitimate purpose supported by fact that justifies treating one lending enterprise differently than another based on where the lending takes place, other than an arbitrary decision to favor...

Iowa banks pay a 5% "franchise tax" for the privelege of doing business in Iowa. The state collected $31,378,000 via the Franchise tax in the 6/30/2002 fiscal year. Credit Unions are exempt from the franchise tax; they instead pay a "monies and credits tax," a form of property tax; the receipts from this tax are so small that they are lumped into a "miscellaneous" category that totaled $1,432,000 for the 6/30/2002 year.

Banks have long chafed over this tax differential; an attempt to subject the largest Iowa credit unions to the franchise tax failed in the last legislative session. With the Racing Association decision, a new approach may be available to address the issue.


No one would suggest that banks simply stop paying franchise tax. Still, the Iowa Court decision sheds new light on how Iowa taxes credit unions vs. banks.

The standard for an "equal protection" violation of the Iowa Constitution now is not whether the legislature can come up with a reason for a tax law distinction; it now must be a reason that four Iowa Supreme Court justices find persuasive. While the distinction between a riverboat and a racetrack may not be decisive, that between a bank and a credit union might be.


The odds remain against the banks here. While the Court has opened the door to reconsideration of many tax law distinctions, if they are swamped with "equal protection" tax cases, they may start to find the legislature's distinctions more rational.

Still, the possibility of an ornery, or very large, bank deciding to bear the costs of a long "equal protection" legal fight might give the state pause. Continuing to treat large credit unions more favorably than banks might, at some point, seem too risky for the legislature.

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February 05, 2004

The "Tax Analysts Live" group blog last had a new post January 27. More posts are required to maintain the Pavlovian response of your readers! Must...have...posts...

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February 04, 2004

Whatever you think about the Iowa Supreme Court's decision yesterday on casino taxes, you can't say that they fear more work. They made sure they will be hearing state tax cases for a long time.

Yesterday the Court decided that there is no "reasonable basis" to tax riverboats differently from racetrack casinos. That opens up a world of dispute in tax cases.

The Court ruled that distinctions between a business that can float across the river or downstream to a different state and a stationary racetrack are unreasonable. As best we can tell, the test for "reasonable" tax rules is what the majority of the Court considers "reasonable" on a given day.

It's easy to find distinctions in the tax law that seem vulnerable under this new outlook.

Apportionment on Pass-through entities: S corporation shareholders get a credit against Iowa tax for their income from sales outside of Iowa; sole proprieters and LLC owners get no such credit, even though their businesses are identical.

Rehabilitation Credits and Economic Develoment Credits: These credits are limited by law to an amount that the legislature has decided the state can afford. Apparently the state's fiscal needs no longer provide a reasonable basis for tax distinctions. How can taxpayers be reasonably treated differently just because the credits appropriated for a fiscal year have been used up?

Sales tax on services: In this day of alternative medicine, how can massage therapists and foot reflexologists reasonably be subjected to sales tax, while doctors are excluded? For that matter, how can the state even consider taxing accounting and engineering services, but not attorney and medical services?


Tax practitioners this year will need to consider these "equal protection" arguments as we do returns. Should we claim Iowa apportionment credits that the statute clearly doesn't allow to partners and proprietors, on the grounds that their K-1 income is not getting "equal protection" to S corporation income?Should we claim unappropriated rehabilition and economic development credits?

Should we amend all of our 2000 returns before April 30 to prevent the statute of limitations from running? Or is the statue of limitations itself an equal protection violation? The Des Moines Register editorial supporting the decision unhelpfully notes that "Such issues will be sorted out in future cases." That's for sure.


The legislature has to make a lot of messy decisions between conflicting good causes, often under severe fiscal pressure and late in the evening. These decisions will now be reviewed for "reasonableness" by the Iowa Supreme Court at their leisure. Given the Governor's expansive use of line-item vetoes and the Iowa Supreme Court's new monopoly on reason, the legislature can be forgiven for feeling that their role is now merely to offer up a menu of policy choices for the reasoned consideration of the other branches of govenment.

UPDATE: House Speaker Tom Rants is not pleased.


Tusk and Talon weighs in, as does the Cornfield Commentary.

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February 03, 2004

Apparently the Iowa Supreme Court doesn't like being bossed.

Even though the U.S. Supreme Court unanimously reversed their initial decision striking down Iowa's tax on racetrack casinos, the Iowa Supremes, under orders to arrive at a new decision "not inconsistent" with the Federal Court's decision, today struck down the casino tax again. The Iowa vote was 5-2. (RACING ASSOCIATION OF CENTRAL IOWA, 2/4/03.)

The Iowa Court used a new analysis to strike down the decision -- an analysis that might have saved the U.S. Court a lot of trouble if they had used it the first time. While the initial ruling said that the same "equal protection" analysis applies to the federal and Iowa constitutions - triggering the Supreme Court's review - today's decision takes a different tack:

"Notwithstanding the broad statement made by this court in its initial opinion that we will apply the same analysis under the state equal protection provision as is applied under the federal Equal Protection Clause, this court has always reserved to itself the ability to employ a different analytical framework under state constitutional provisions."

Based on this analysis, today's decision holds that there is no "reasonable" basis to tax racetracks and riverboats differently; as a result, the different tax rates between the two are unconstitutional and the tracks are due $112 million in refunds, plus interest.

One of the dissenting Iowa justices had this to say:

"The decision of the majority causes great harm to the law, to the concept of federalism, to the doctrine of judicial economy, to the essential reliability of legal principles, and to the balance of power within our government. Perhaps most troubling of all, it also causes a great injustice to the people of Iowa. It is never an easy decision to dissent, but that decision has never been easier than in this case."

Other than that, he liked the decision just fine.

We will leave it to real lawyers to discuss the wisdom of the decision; we will limit ourselves to noting that there is no reasonable basis to tax accounting fees differently from legal fees.


Today's decision.

The U.S. Supreme Court decision (pdf file)

The prior, reversed Iowa Supreme Court decision.

Our not very prescient analysis of the prior Iowa decision. For a more authoritative discussion of the U.S. Supreme Court Decision, go here and scroll down.

UPDATE: Iowa Attorney General may appeal the latest decision.

And a real lawyer (and professor) adds some thoughts. Here's another.

UPDATE II: Now even a layman can tell that the Iowa Supremes got it wrong, because The Des Moines Register editorial page says "Iowa court got it right."

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February 02, 2004

This week's Carnival of The Capitalists is at the weblog with the coolest name, Deinonychus Antirhoppus (it's the name of a dinosaur that is famously on our kindergartner's favorite T-shirt). This week's Carnival covers the ground from Social Security reform to the question: are small-business weblogs good business? (You're reading one now!)

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