Tax Update Blog: June 2004 Archives

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WHY DIDN'T THE COMMITTEE REPORTS MENTION THIS?

June 29, 2004

From the TaxProf Blog:

   Anthony Infanti (Pittsburgh) has published 
   The Internal Revenue Code as Sodomy Statute, 
   44 Santa Clara L. Rev. 763 (2004).

Taxpayers who have had bad experiences with IRS examiners might agree.

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DES MOINES LUNCHTIME RATES 9.8 TODAY

June 25, 2004

The Belin Quartet plays a Schubert program this afternoon at Nollen Plaza in Des Moines

72 degrees, almost no wind, sunny - a perfect downtown lunchtime.

Looking west towards Capitol Square.

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'STEVE MARTIN' DEFENSE FAILS TO AVOID PENALTIES

June 24, 2004

A classic Steve Martin skit has the comedian explaining how to avoid paying taxes on a million dollars: say "I forgot." The Tax Court today didn't buy a version of that defense with respect to $105,000 of salary income omitted from a return.

Michael Sullivan apparently neglected to provide his tax preparer for 2000 a W-2 for $105,000 from a new employer. The IRS caught it and assessed Mr. Sullivan $39,519 in tax and an "accuracy-related penalty" of $2,314. Mr. Sullivan tried to get the Tax Court to lift the penalty. The judge declined:

   Taxpayers have a duty to read a return and
   to make sure all items are included. (citations 
   omitted) At trial, Mr. Sullivan agreed with 
   this point. The omission of the CEMAX 
   Form W-2 resulted in petitioners' failure to 
   include almost one-third of their income on 
   their original return. Petitioners' failure to 
   carefully review their return was not 
   reasonable.

Link: Sullivan v. Comm., T.C. Summary Opinion 2004-83

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TREASURY GOES AFTER VIRGIN ISLAND TAX SCHEMES

June 24, 2004

The Treasury today warned taxpayers against tax schemes involving the Virgin Islands and other U.S. Possessions:

   The notice describes a form of arrangement
   that has been promoted and that involves 
   running a taxpayer's salary or business 
   income through a U.S. Virgin Islands entity 
   such as a limited partnership.  The notice
   warns, however, that these questionable 
   positions may also be promoted through 
   other forms of arrangements and with 
   respect to U.S. possessions other than the 
   U.S. Virgin Islands.

Notice 2004-45, which was issued separately today by the IRS, describes a typical version - a version very similar to one that we have seen marketed.

Under these deals, a taxpayer pretends to quit his job to move to the U.S. Virgin Islands. The taxpayer then invests in a Virgin Islands partnership, which contracts with the employer that the taxpayer pretended to leave to do the employee's work. The taxpayer then works for the "former" employer through the partenrship.

The partnership then claims a U.S.V.I. economic development credit that eliminates 90% of the tax, and the partner pays tax on only 10% of his income.

The fatal flaw of these deals is that they require the IRS to be almost willfully stupid, and to believe that, say, an investment banker who offices in Chicago is really is a Virgin Islands resident. What one might call "anectotal evidence" indicates a lot of folks have given this a whirl, so it will be interesting to watch it play out.

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MAULING THE ETI REPEAL BILLS

June 24, 2004

Tax professor (and BNA portfolio author) Jack Maule has done some thinking on the ETI repeal bills headed to conference.

This quote from his article reflects its tone:

   "People ask me why I can be so cynical and sarcastic."

Our most recent coverage of the ETI repeal bills can be found here.

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IRS ISSUES PUBLICATION ON FRAUDULENT TRUSTS

June 24, 2004

The IRS has just released Publication 2193, "Should Your Financial Portfolio Include Too Good to Be True Trusts?" (pdf format link) The publication warns against trusts promising to reduce or eliminate your taxes while leaving you with use of the trust funds.

The publication has warning signs of bad trusts:

   -A promise to reduce or eliminate income 
   and self-employment tax. 
   -Deductions for personal expenses paid by 
   the trust. 
   -Depreciation deductions on an owner's 
   personal residence and furnishings. 
   -High fees for trust packages, to be offset 
   by promised tax benefits. 
   -Use of back-dated documents. 
   -Unjustified replacement of trustee. 
   -Lack of an independent trustee. 
   -Use of post office boxes for trust addresses. 
   -Use of terms such as pure trust, 
   constitutional trust, sovereign trust or 
   unincorporated business organization.

There are additional indicators of bad trusts that the publication omits:

   -The trustee insists the trust be funded
   only with small-denomination unmarked bills.
   -The trust promoter will only meet you in
   remote wooded settings.
   -You can only enter the trustee's office if
   you know the current password.
   -The trustee's tax attorney produces a tax
   opinion consisting entirely of the word 
   "whatever."
   -The trustee wears on orange jumpsuit.
   -The trustee will waive his fee if you help him
   reclaim the $23 million dollars in the Royal 
   Bank of Nigeria left by his late deposed 
   father.

Remember, you heard it here first.

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LITERALISM CARRIES THE DAY FOR TAXPAYERS IN FOUR DEBT FORGIVENESS CASES

June 22, 2004

Sometimes the tax law means just what it says.

Debt forgiveness is taxable to the forgiven debtor under general tax principles. Courts found ways to overcome these general principles over the years, particularly for taxpayers who were bankrupt or insolvent. Congress has gradually replaced the case law with a statutory scheme to govern when debt cancellation is taxable.

One of the most important exclusions for cancellation of debt (COD) from income is found in Code Sec. 108(a)(1)(A), which excludes from income debt cancellation when "the discharge occurs in a title 11 case..." Title 11 is the federal bankruptcy code.

Four Tax Court cases issued today show that...

...IT DOESN'T HAVE TO BE YOUR BANKRUPTCY!

In 1988 Northcliff Associates, a Maryland general partnership, filed for Chapter 11 protection while it attempted to reorganize its debts. This had to be scary for general partner Chester L. Price, who was on the hook for, in round numbers, $1,850,000 in partnership debt.

The bankruptcy trustee negotiated a deal with Mr. Price and the other general partners. In exchange for cash payments, the creditors forgave the partners their liability for partnership debt. Mr. Price bought out his liability for $25,000.

BANKRUPTCY, OR JUST INSOLVENCY?

The partners didnt report their debt forgiveness on their tax returns on the grounds that the discharge occurred "in a title 11 case." The IRS disagreed on the grounds that it was the partnership's bankruptcy case, not the partners'. The IRS said that the partners could exclude the debt forgiveness only to the extent it rendeded them solvent, as provided by Code Sec. 108(a)(1)(B). This would have given Mr. Price $456,864 of taxable income.

The Tax Court sided with the partners:

   For purposes of section 108, a “title 11 case”
   is defined as “a case under title 11 of the 
   United States Code (relating to bankruptcy),
   but only if the taxpayer is under the 
   jurisdiction of the court in such case and 
   the discharge of indebtedness is granted by
   the court or is pursuant to a plan approved 
   by the court.” Sec. 108(d)(2).

   The partnership’s chapter 11 bankruptcy was 
   a case under title 11 of the United States 
   Code. See 11 U.S.C. ch. 11 (2000). 
   Pursuant to its December 19, 1995, order, 
   the bankruptcy court discharged and released
   petitioner from all liability to the trustee, the
   bank, and all other creditors that might have
   claims arising from or relating to the 
   partnership, petitioner’s status as a general
   partner in the partnership, and the April 9, 
   1985, personal guaranty agreement. In the 
   same order, the bankruptcy court explicitly 
   asserted its jurisdiction over petitioner for
   this purpose. Giving due regard to principles 
   of judicial comity, we discern no reason to 
   second-guess the bankruptcy court’s 
   assertion of jurisdiction over petitioner in the
   partnership’s chapter 11 bankruptcy case.

In other words, as long as your debt is forgiven in a Title 11 case, it doesn't have to be your Title 11 case to qualify for the exclusion, according to the Tax Court. The Court reached the same result in four cases released today involving the partnership.

It will be interesting to see whether the IRS chooses to appeal the cases. In Gitlitz v. Commissioner, another case involving taxation of debt forgiveness, the Supreme Court took the statute literally to arrive at an odd result with the effect of giving bonus deductions to taxpayers with debt forgiveness income. The Court said it wasn't their job to fix Congressional drafting errors. Congress later rewrote the statute. There is no evidence the courts have abandoned what one might call an Amelia Bedelia approach to statutory construction.

Links:

Chester L. Price, T.C. Memo. 2004-149.

Jose Gracia and Nancy Gracia, T.C. Memo. 2004-147

Ralph J. and Joan B. Mirarchi, T.C. Memo. 2004-148

Estate of Jose Martinez, Deceased, Patrick G. Martinez, Personal Representative, T.C. Memo. 2004-150

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HSA QUALIFICATION ALLOWED DESPITE STATE LAWS AGAINST QUALIFYING HIGH-DEDUCTIBLE INSURANCE

June 22, 2004

Taxpayers wanting to set up Health Savings Accounts have faced a roadblock in some states. The tax law requires taxpayers to have high-deductible health insurance to qualify for an HSA. Such high-deductible plans are illegal in some states (we believe this is true in New York, for instance).

The IRS yesterday announced (Notice 2004-43) that it will allow taxpayers to set up and fund HSAs until 2006 even if state laws prevent them from purchasing qualifying health insurance:

   Several states currently require that health 
   plans provide certain benefits without regard
   to a deductible or with a deductible below 
   the minimum annual deductible requirements
   of section 223(c)(2) (e.g., first-dollar coverage
   or coverage with a low deductible). These 
   health plans are not HDHPs under section 
   223(c)(2) and individuals covered under these
   health plans are not eligible to contribute to 
   HSAs. Because of the short period between
   the enactment of HSAs and the effective 
   date of section 223, these states have had 
   insufficient time to modify their laws to 
   conform to the standards of section 223. 
   Thus, it is appropriate to provide transition 
   relief that treats HDHPs as qualifying under 
   section 223(c)(2) when the sole reason the 
   plans are not HDHPs is because of 
   state-mandated benefits. During the 
   transition period, otherwise eligible individuals 
   covered under these plans will be treated 
   as eligible individuals for purposes of section 
   223(c)(1) and may contribute to an HSA.

IS THIS PART OF A TREND?

This is the second waiver of the high-deductible health plan requirements (see Notice 2004-25), and it may not be the last one. Now that the IRS has set a precedent of waiving the HDHP rules, it may find it hard to resist another waiver when the current one runs out in 2006.

Various state rules require coverage with lower deductibles for certain conditions. For example, Kansas until recently required that mental and nervous conditions be covered for 100 percent of the first $100 of expenses, 80 percent of the next $100, and 50 percent of the next $1,640. Such provisions were enacted because they had a political constituency. To avoid confronting interest groups, legislators are likely to instead pressure Treasury to extend the Notice 2004-43 waiver. The slogans are easy to imagine: "The IRS wants to take our high-risk mentally ill off their medications!"

While such requirements are well meaning, they limit consumer choice and probably raise the cost of insurance. We hope that the Treasury hasn't inadvertently undercut the expansion of high-deductible health insurance options with this waiver.

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TAX EFFECTS OF DISASTER DECLARATION

June 21, 2004

62 Iowa counties were declared a "Presidential Disaster Area" as a result of storms and flooding. Taxpayers in these counties have an automatic extension until July 26 to file any original or extended returns, and to income tax payments, due May 19 through July 25, 2004

The automatic extension doesn't apply to information returns, such as 1099 or W-2 forms, or to employment and excise tax deposits.

Iowa counties in the disaster area are Adair, Adams, Allamakee, Audubon, Benton, Black Hawk, Boone, Bremer, Buchanan, Buena Vista, Butler, Calhoun, Carroll, Cass, Cedar, Cerro Gordo, Chickasaw, Clay, Clayton, Clinton, Dallas, Delaware, Dubuque, Fayette, Floyd, Franklin, Fremont, Greene, Grundy, Guthrie, Hancock, Hardin, Howard, Humboldt, Iowa, Jackson, Jasper, Johnson, Jones, Kossuth, Linn, Madison, Marshall, Mills, Mitchell, Montgomery, Page, Palo Alto, Pocahontas, Polk, Pottawattamie, Poweshiek, Sac, Shelby, Story, Tama, Warren, Webster, Winnebago, Winneshiek, Worth and Wright.

The IRS has more on disaster tax relief here.

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A $ 2 MILLION TAX BILL NOT A DELUSION FOR TAX PROTESTER SCHIFF

June 18, 2004

A federal court in Las Vegas has found long-time tax protester Irwin A. Schiff liable for over $2 million in tax, interest and penalties on income taxes from 1979 to 1985, according to a Justice Department announcement.

Mr. Schiff tried a novel defense against civil fraud penalties, according to the DOJ press release:

   Schiff maintained that he should be excused
   from the imposition of civil fraud penalties 
   because he allegedly has recently been 
   diagnosed as suffering from a “chronic and 
   severe delusional disorder” that resulted in 
   his irrational and incorrect beliefs pertaining 
   to the federal income tax system.

The "chronic" part was right, for sure. His How Anyone Can Stop Paying Income Taxes came out in 1982, and he has written at least five other books on the same theme. His tax life reached a state of high irony when his royalties from How Anyone Can Stop Paying Income Taxes were attached by the IRS.

But if he was delusional, it was only in believing that defense might work; the court declined to accept that defense. Two alternative strategies come to mind for Mr. Schiff:

- move to the Sixth Circuit, which seems more accepting of diminished-capacity tax protesters, or

- buy another book.

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ON TO CONFERENCE

June 17, 2004

House passes its ETI repeal bill.

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GOOD THING THERE WASN'T A FIRE

June 17, 2004

The historic Edna M. Griffin Building is showing its age today.

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IRS ANNOUNCES JULY 2004 APPLICABLE FEDERAL RATES

June 17, 2004

The IRS has issued (Rev. Rul. 2004-66) the minimum interest rates for loans made in July 2004:

-Short Term (demand loans and loans with terms of 1-3 years): 2.26%
-Mid-Term (loans from 3-9 years): 4.11%
-Long-Term (over 9 years): 5.34%

Historical AFRs are available here and via the “Links” page at www.rothcpa.com.

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IOWA SUPREME COURT STRIKES DOWN ITEM VETO - AND IOWA VALUES FUND

June 16, 2004

The Iowa Supreme Court today struck down Governor Vilsack's controversial 2003 item veto of tax cuts in the Iowa Values Fund legislation.

The decision doesn't reinstate the tax cuts. To the apparent surprise of everyone involved, the Court said that no part of the package was lawfully enacted. This apparently strikes down the Iowa Values Fund. The state now finds itself in an awkward situation, having already spent millions of Iowa Values Fund dollars.

What happens next? Who knows? It should be fun to watch.

Links:

The Iowa Supreme Court Decision

Summary of the Decision

UPDATE: Here is a discussion of the decision by a real lawyer (thanks to State29 for the tip).

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GRASSLEY: ETI REPEAL BILL TO BE COMPLETED IN AUGUST OR SEPTEMBER

June 16, 2004

Charles Grassley, Chairman of the Senate Finance Committee, yesterday told reporters that he expects a Senate-House conference to complete work on the repeal of the Extraterritorial Income Exclusion ("ETI") in August or September.

The longer it takes the taxwriters to come to an agreement, the you have to get a new sport-utility vehicle qualifying for the $100,000 "Section 179" deduction. The Section 179 deduction allows taxpayers to deduct the cost of equipment in the year of purchase, instead of over a period of years through depreciation deductions. The Senate bill would reduce the $100,000 ceiling to $25,000 for SUVs placed in service after the President signs the bills into law. The House bill lacks the SUV provision.

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TREASURY WITHDRAWS CASH BALANCE PLAN REGULATIONS

June 15, 2004

The Treasury today announced that it is withdrawing Proposed Regulations on cash balance plans. The Treasury press release says:

   The regulations are being withdrawn to 
   provide Congress an opportunity to review 
   and consider a legislative proposal on cash
   balance plans that was included in the 
   Administration's Budget for Fiscal Year 2005.
   The legislative proposal would require a five-
   year "hold harmless" period for current 
   employees following a cash balance 
   conversion, would ban benefit "wear-away" 
   after a cash balance conversion, and would 
   clarify the legal status of cash balance plans 
   and other hybrid plans.

The BenefitsBlog covers a new District Court case upholding a conversion of a defined benefit plan to a cash balance arrangement; she also has some background on the controversy surrounding cash balance plans.

UPDATE: More here.

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JUSTICE DEPARTMENT GOES AFTER 'AUDIT DEFENSE NETWORK.'

June 15, 2004

The Justice Department announced last that it has won an injunction against the "National Audit Defense Network." The Justice Department says that the NADN is a scam that has cost the government $324 million in tax revenues so far:

   According to court papers, NADN charges 
   customers $2,495 to make sham website 
   modifications, but also adds a sham $7,980 
   promissory note as part of the ostensible 
   purchase price to artificially raise the total 
   cost to $10,475. NADN allegedly tells 
   prospective purchasers that they can use 
   that inflated cost to claim a $5,000 ADA 
   income-tax credit and a $5,475 business 
   tax deduction, thereby reducing their taxes 
   by more than double the $2,495 they paid 
   for the “modifications.” 

Will the Justice Department be a match for the NADN "Technical Dream Team"? The dream will become a nightmare for the NADN's "estimated 100,000 customers" when the IRS gets the NADN customer list.

(Note: erroneous link and date on original post corrected.)

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WAYS AND MEANS APPROVES ETI REPEAL; QUICK HOUSE PASSAGE EXPECTED

June 15, 2004

Brushing aside Treasury concerns, House taxwriters last night approved their bill to repeal the Extraterritorial Income Exclusion (ETI). The bill would repeal the ETI and provide a lower tax rate for C corporation manufacturing income.

The bill is also freighted with a large number of provisions that appear, at least to the untrained eye, to be unrelated to international trade. These include a $10 billion program for tobacco growers and a repeal of an excise tax on tackle boxes.

The bill is considered a "must-pass" piece of legislation because trade sanctions imposed by the World Trade Organization will remain in effect until the ETI is repealed.

UNUSUAL TASTE IN FRAGRANCES

Ranking Ways and Means Committee Democrat Charles Rangel says the bill is a piece of stinky business. Quoth Tax Analysts: "I want the bill to reach the floor as soon as possible because it stinks to high heaven."

Chairman Bill Thomas apparently thinks the bill smells ok: "This bill minimizes double taxation and simplifies complex international tax law. By doing so it levels the playing field for American businesses competing in a worldwide economy and encourages them to keep jobs in the United States."

Whatever the fragrance, the bill is expected to pass the House quickly. It will then have to be reconciled in conference with the ETI repeal already passed by the Senate. As the Senate bill is very different, the conference may be difficult.

Prior coverage:

HOUSE ETI REPEAL TAKING SHAPE

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JUST WHEN THE PARTY IS GETTING GOOD...

June 12, 2004

...some guy always wants to take away the keg. Greg Jenner, tax policy chief for the Treasury Department, is saying that some of the features in the "must pass" extraterritorial income exclusion (ETI) repeal bill might make for less than ideal tax policy:

“These bills would cause a sea change in the way that we tax business income, and it’s a change that I don’t think is for the better,” Jenner told an AICPA gathering.

Tax Analysts reports:

   Although he said he understands Congress’s 
   desire to help the manufacturing industry, 
   Jenner cautioned that differentiating between 
   types of income could give tax administrators 
   real headaches. Because the bills offer tax cuts
   for manufacturing income, Jenner argued, 
   they give businesses incentives to do all they 
   can to characterize income as manufacturing 
   and deductions as nonmanufacturing. 

For example, maybe accounting firms would say they have two divisions: one that "manufactures" pretty bound copies of audit reports and tax returns; and a related "service" business (with all the deductions) that supports the "manufacturing" profit center. Works for us. This clearly wouldn't work under either ETI repeal bill, but there will be a lot of calls that would be more difficult.

Whether the administration will actually attempt to change these bills seems doubtful at this stage of the legislative process, but Mr. Jenner's comments won't make it any easier for Senator Grassley and House Ways and Means Chairman Thomas to agree on a final ETI bill.

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RONALD REAGAN, 1911-2004

June 11, 2004

October 22, 1986: President Reagan signs the Tax Reform Act of 1986.

The Tax Prof Blog has a roundup of opinions on President Reagan's lasting impact on the tax law.

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WHAT PART OF '60 DAYS' DON'T YOU UNDERSTAND?

June 11, 2004

One of the hazards of a professional education may be the temptation to be too clever. Consider the case of James Dirks, a research attorney employed by the California court system.

Mr. Dirk had the winning bid on a house that was up for auction. He withdrew money from IRA accounts to pay for the house. He knew that the tax law allows such withdrawals to be tax-free if they are put back in an IRA within 60 days. He withdrew $118,000 from the IRAs on January 19, 2000; he planned to restore the funds to the IRA when he closed on a mortgage for the new house. The 60-day grace period was to expire March 19, 2000.

The mortgage didn't close until April 3, 2000. On April 4, Mr. Dirk put $118,000 back into his IRAs. Even though the 60-day period had expired, he didn't report the IRA withdrawals as taxable income on his 2000 return.

"SUBSTANTIAL" COMPLIANCE?

This is where Mr. Dirks may have gotten too clever. He told the Tax Court that even though he missed the 60-day deadline, he really met it under the “equitable doctrine of substantial compliance.” (That would have come in handy when we got home at 1 a.m. after telling our parents we'd be in by 10.)

Unfortunately for Mr. Dirks, the Tax Court doesn't seem to believe in equitable doctrine. The judge quoted another court:

   All fixed deadlines seem harsh because all 
   can be missed by a whisker--by a day, or
   for that matter by an hour or a minute. They 
   are arbitrary by nature. * * * The legal 
   system lives on fixed deadlines; their 
   occasional harshness is redeemed by the 
   clarity which they impart to legal obligation.
   * * * There is no general judicial power to 
   relieve from deadlines fixed by legislatures.

                              (Citations omitted)

ANOTHER PITFALL OF PROFESSIONAL TRAINING

The IRS assessed Mr. Dirks "substantial understatement" penalties of $8,819 for failing to report the $118,000 in IRA income. The law allows the penalties to be waived if the taxpayer acts "reasonably and in good faith" to comply with the tax law. Here the Tax Court held Mr. Dirks's professional background against him:

   We disagree with petitioner’s argument that 
   he acted reasonably and in good faith with
   respect to the subject matter of the 
   deficiency. Petitioner is a seasoned attorney 
   who filed his 2000 tax return with the 
   knowledge and understanding of the
   relevant provisions of section 408. The fact 
   that he may have intended earnestly to 
   meet the 60-day rule did not excuse him
   from not reporting the withdrawals as income 
   when he failed to meet that rule.  Nor do we 
   believe that reasonableness and good faith
   may be found in petitioner’s litigating 
   position that he substantially complied with 
   the 60-day rule by paying the amount of 
   withdrawals into the second IRA 
   contemporaneously with the closing of his 
   escrow.

AN EXPENSIVE SOURCE OF FUNDS

Considering only federal taxes and penalties, Mr. Dirks will pay $52,916 for the use of $118,000 for 76 days. That works out to an effective interest rate of 215.37%.

The moral? There are at least two:

- IRAs can be an expensive source of interim financing, and
- 60 days means 60 days.

Link: James Dirks vs. Commissioner, T.C. Memo. 2004-138 (pdf format)

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TIME FOR DR. TROWBRIDGE TO STOP DIGGING?

June 10, 2004

The Fifth Circuit Court of Appeals has spanked Dr. John Trowbridge, a tax-protesting physician, with a $6,000 penalty for filing a "frivolous" appeal. The appeal, which asserted that the taxpayer wasn't a "taxpayer" and which “objects to the use of Federal Reserve Notes to discharge debts,” was an attempt to overturn a Tax Court decision imposing a $25,000 fine for similar foolish arguments.

We can look forward to seeing more litigation from Dr. Trowbridge; he may well be planning further futile litigation to keep the IRS from collecting the $31,000 in fines and the $989,877 in back taxes, interest and penalties imposed by the Tax Court in two separate decisions.

Dr. Trowbridge was one of the first taxpayers ever to get the full $25,000 penalty for frivolity from the Tax Court. Now that he has also been penalized by the Fifth Circuit, he probably has done about all he can to annoy the courts, at least for these tax years.

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HOUSE ETI MARKUP DELAYED

June 10, 2004

Tax Analysts reports that the Ways and Means markup of Chaiman Thomas's ETI repeal bill, scheduled for today, has been moved to June 14.

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NEW REVENUE RULING ADDRESSES EMPLOYER-PAID DISABILITY

June 09, 2004

The IRS today published Rev. Rul. 2004-55 on how proceeds of employer-paid disability insurance are taxed. The ruling's conclusions are what you might expect:

-If the employee receives the insurance benefit tax-free, the benefits are taxable, but

-If the employee has elected to be taxed on the employer's premium payments, the proceeds are tax free.

The ruling covers long-term and short-term plans.

Key text:

   HOLDING
   Under the Amended Plan, long-term disability
   benefits received by an employee who has 
   irrevocably elected, prior to the beginning of 
   the plan year, to have the coverage paid by
   the Employer on an after-tax basis for the 
   plan year in which the employee becomes 
   disabled are attributable solely to after-tax 
   employee contributions and are excludable
   from the employee's gross income under 
   Sec. 104(a)(3).

   Under the Amended Plan, long-term disability
   benefits received by an employee whose 
   coverage is paid by the Employer on a 
   pre-tax basis for the plan year in which 
   the employee becomes disabled are 
   attributable solely to pre-tax Employer 
   contributions and are includible in the 
   employee's gross income under 
   Sec. 105(a).

UPDATE: Reader "Chad" makes an important point in the comment below.

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HOUSE ETI REPEAL TAKING SHAPE

June 09, 2004

The tax break for car donations isn't dead yet.

The Senate has approved a bill that would limit the charitable deduction for donated motor vehicles to the sales price received by the charity when it sells the car. The car donation provision is part of a "must-pass" bill that would repeal the "extraterritorial income exclusion" ("ETI"). The World Trade Organization has imposed trade penalties on US goods that will remain in effect until the ETI is repealed.

The House Ways and Means Committee plans to work on its version of the "must-pass" Extraterritorial Income exclusion (ETI) repeal tomorrow, with a goal of passage by the full House next week. While Ways and Means Chairman Bill Thomas has put together a draft that may have enough support to get through the House, his bill may have a rocky reception in the Senate. His much more lenient car donation provision will be just one of many sticking points when Mr. Thomas meets with his Senate counterpart, Charles Grassley, to reconcile the bills.

A DIFFERENT APPROACH - MANUFACTURING BREAK FOR C CORPORATIONS ONLY

The ETI deduction is a favorite of large U.S. exporters. Both bills try to make up the loss of the deduction by providing other tax breaks to manufacturers. The two bills take very different approaches.

The Senate bill provides a special deduction for income from production activities, including manufacturing, construction and farming, for all taxpayers involved in such activities. The large Senate bill includes many other tax provisions, and is fully "paid for" by a package of anti-tax shelter provisions and loophole closers.

The House bill, by contrast, provides a reduced tax rate on production income to C corporations only, paired with a package international tax rule changes. To placate S corporations and partnerships, the House bill eases certain S corporation qualification rules and provides a number of other tax breaks, including extension of the $100,000 Section 179 deduction limitation an additional two years. The House bill also has revenue raisers, but they come $34 billion short of paying for the bill's tax breaks.

OTHER HOUSE, SENATE DIFFERENCES

In addition to confining the producer tax benefit to C corporations, there are a number of other significant differences in the house bill:

S CORPORATION PROVISIONS. The House bill includes 16 S corporation provisions, including

-a provision to make it possible for taxpayers owning bank stock in an IRA to get the stock out of the IRA so the bank can become an S corporation.

-An increase in the the maximum number of S corporation shareholders to 100 (75 under current law);

-Treatment of families as a single shareholder for purposes of counting shareholders.

AMT RELIEF. Current law excludes C corporations with gross receipts up to $7.5 million from alternative minimum tax. The House bill would raise the threshold to $20 million.

SALES TAX DEDUCTION. The House bill would permit taxpayers to elect to deduct state and local sales taxes instead of income taxes. Non-business sales taxes are non-deductible under current law.

TAX SHELTERS. In the words of Senator Grassley, "The Senate bill is very, very aggressive on closing of corporate loopholes and shelters whereas the House is very timid on that"

CAR DONATIONS. While the Senate bill limits the deduction for donated vehicles to their subsequent sales price, the House bill instead stiffens the appraisal requirements for vehicle donations.

Both bills have many other provisions unrelated to international trade to help secure support that are not consistent between the bills. When added to the different approaches the bills take to ETI repeal, Chairmen Thomas and Grassley have their work cut out for them. Tax Analysts quotes Senator Grassley as predicting a "very tough conference."

LINKS

The full text of the Chairman's Mark of HR 4520 (pdf format).

Ways and Means Summary of HR 4520 (pdf format).

Text of Senate Version of ETI repeal (S 1637).

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IN OTHER NEWS, BEER FOUND POPULAR AMONG STUDENTS, DRINKERS

June 08, 2004

Tax Notes headline: "Some Forms 1099 Erroneous This Year, Study Finds"

The headline doesn't quite do justice to the story, which reports that 9.5% of 1099s from investment houses had errors in 2003, based on a survey by the Securities Industry Association. While the story isn't quite clear on this, it appears that this compares to a normal error rate of about 7.5%. This would be about a 27% increase over the normal error rate.

The higher error rate is unsurprising, considering the mid-year change in dividend rules that took effect in 2003.

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CASINO CASE FINALLY DIES

June 07, 2004

It's dead.

The Iowa casino tax case (Fitgerald vs. Racing Association of Central Iowa), died today when the U.S. Supreme Court declined to take the opportunity to overturn the Iowa Supreme Court again.

The U.S. Supremes unanimously overturned the Iowa court last year, holding that the U.S. Constitution permits taxing casinos at higher rates than riverboats. The Iowa court had said that the U.S. "equal protection" standards governed under the Iowa constitution, so that settled that, so it seemed. The case was sent back to Iowa for rehearing, but that seemed to be just a formality.

Then the Iowa court reaffirmed its own original decision, saying that federal law governs Iowa constitutional law, except when it doesn't.

The legislature and the casinos worked out a compromise after the last Iowa court decision under which the casinos relinquished their rights to the tax refund permitted by the Iowa court; this may have caused the U.S. Court to lose interest.

Prior coverage:

IF RACETRACK = RIVERBOAT, DOES BANK = CREDIT UNION?

WHAT IS IOWA'S TAX LAW? WHO KNOWS?

TAKE THAT, U.S. SUPREME COURT: IOWA SUPREME COURT STRIKES DOWN CASINO TAX

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THE CEDARPUNDIT IS DEAD. LONG LIVE STATE 29!

June 04, 2004

After an extended hiatus where he ate nothing but the raw flesh of deer taken in Johnson County with his bare hands, the enigmatic man of mystery CedarPundit has returned as State 29!

We think.

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IRS OVERPAYMENT AND UNDERPAYMENT INTEREST RATES DROP

June 02, 2004

The IRS announced that interest rates for refunds and underpayments for the third quarter of 2004 will drop by a full percentage point (IR 2004-76). The new rates:

   -4 percent for overpayments [3 percent 
   for corporation overpayments];
   -4 percent for underpayments;
   -6 percent for large corporate underpayments
   -an additional 1.5 percent for the portion of 
   a corporate overpayment exceeding $10,000.

Rev. Rul. 2004-56 (pdf file) has a table of historical underpayment and overpayment rates.

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WHEN IS DAY TRADING A BUSINESS?

June 02, 2004

Frank Chen got caught up in the day-trading frenzy of the late 1990s. After making 12 trades in January 1999, he geared up to 133 trades in February and 145 in March. Sometime in April he apparently began to reconsider this financial strategy, as he only made 25 trades that month. The $84,794 in trading losses he was to report on his 1999 return may have had something to do with this decision. In May he was down to four trades, and he made no trades at all in June.

When he filed his return, he claimed that he was a stock "trader." Stock traders can fully deduct their capital losses as ordinary losses; lesser mortals, being mere investors, can only deduct capital losses to the extent of their capital gains, plus $3,000. Unused losses carry forward indefinitely.

WHAT MAKES A TRADER?

The Tax Court, in considering Mr. Chen's 1999 tax return, said that there are two hurdles to cross to become a trader:

1. You must buy and sell frequently enough to try "to catch the swings in the daily market movements." The court said Mr. Chen met this test in February and March, 1999.

2. The trading activity must be "regular, frequent and continuous." The court said Mr. Chen failed to clear this hurdle:

   In the cases in which taxpayers have been
   held to be traders in securities, the number 
   and frequency of transactions indicated that
   they were engaged in market transactions 
   almost daily for a substantial and continuous 
   period, generally exceeding a single taxable 
   year; and those activities constituted the 
   taxpayers’ sole or primary income-producing
   activity.  Conversely, where, as in this case,
   (1) the taxpayer’s daily trading activities 
   covered only a portion of a single taxable 
   year, and (2) securities trading was not the 
   sole or even primary activity in which the 
   taxpayer engaged for the production of 
   income, trader status was denied.  Daily 
   trading in securities for only a quarter of a
   single taxable year is reasonably 
   characterized as “sporadic” rather than 
   “frequent, regular, and continuous”, and, 
   therefore, insufficient to achieve trader 
   status.

                            (citations omitted.)

Mr. Chen would have had to continue his trading into 2000 to get to the tax treatment he desired. Considering that he lost $84,000 in less than 3 months of heavy trading, that might have been an expensive tax accomplishment.

Trader status is, perversely, only a tax advantage if you are unsuccessful. Traders with gains don't qualify for reduced capital gain rates.

Still, Mr. Chen can work through his losses at the rate of $3,000 per year on future returns. Assuming no more capital gains, he will use the last of them on his 2027 tax return.

Link: Frank Chen v. Commissioner, T.C. Memo. 2004-132 (pdf file).

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