Federal tax update

Legislation

H.R. 3594, the Installment Tax Correction Act of 2000, repealed retroactively the prohibition on installment sales by accrual basis taxpayers.

H.R. 4577, the Consolidated Appropriations Act of 2000, extended the Medical Savings Account program through 2002 and the District of Columbia Homebuyer Tax Credit through 2003 and modified a number of empowerment zone provisions, including an expansion of the added Section 179 deduction to $35,000 in 2002 and an increase in the exclusion on sale of qualifying small business stock to 60 percent upon enactment.

Regulations

Final Regulations Under Code Section 125 expand the circumstances under which a cafeteria plan election may be changed during the year, most significantly to increase contributions or to drop coverage upon an increase in the cost of a qualified benefit or upon the offering of a new benefit package under the plan.

Proposed Regulations Under Code Section 401 make significant changes to existing interpretations of the minimum distribution rules, most significantly creating a uniform table to compute the minimum distribution based on an assumed designated beneficiary who is ten years younger (the minimum distribution will be less only if a spouse more than ten years younger is the designated beneficiary); after the account holder's death, the remaining account balance is paid out over the life expectancy of a designated beneficiary (if none, over the life expectancy of the account holder upon death after the required beginning date or by the end of the fifth following year upon death before the required beginning date).

Proposed Regulations Under Code Section 460, which would take effect only when finalized, provide that a successor entity following a corporate formation, reorganization or conversion to or from an S corporation "steps into the shoes" of the predecessor entity such that the old taxpayer's obligation to account for the contract terminates on the transaction date and is assumed by the new taxpayer who would continue to use the same method of accounting; the contract would be considered constructively completed in the case of all other transactions.

Final Regulations Under Code Section 467 remove the $2 million minimum for application of the anti-abuse rule on rental arrangements retroactive to agreements entered into on or after July 19, 1999; the anti-abuse rule allows IRS to apply a constant rental accrual where tax avoidance is a principal purpose for providing increasing or decreasing rent.

Proposed Regulations Under Section 643 would recognize a trustee's allocation of capital gains to income not only if required by the terms of the trust and applicable state law but also if made under a discretionary power that is exercised in a reasonable and consistent manner.

Final Regulations Under Code Section 6015 provide that a return will not be considered as a joint return and the spouse may not be considered liable if the return was signed under duress.

Final Regulations Under Code Section 6212 provide that a taxpayer's "last known address" is the address maintained by the United States Postal Service in its database until either the taxpayer files and the IRS properly processes a Federal tax return (not an extension per Revenue Procedure 2001-18) with a different address or the taxpayer provides the IRS with "clear and concise" notification of a change of address.

Final Regulations Under Code Section 7502 follow a 1999 Second Circuit Court of Appeals decision in Weissbart and accept the postmark date as the filing date on late filed original income tax returns for purpose of the statute of limitations on refunds.

Final Regulations Under Code Section 7508 provide for extensions of pension plan, IRA and rollover deadlines for servicemen in a combat zone or for individuals affected by a presidentially declared disaster area.

Cases

In Benci-Woodward v. Commissioner, 121 S.Ct. 855, the U.S. Supreme Court by denying certiorari let stand a Ninth Circuit Court of Appeals decision requiring the recipient of taxable damages to report the gross proceeds and to deduct the attorney's portion as a miscellaneous itemized deduction; the First and Federal Circuit Courts of Appeal as well as the Tax Court are in accord while the Fifth, Sixth and Eleventh Circuit Courts of Appeal take the opposite position.

In Baldwin v. Commissioner, TC Memo 2000-- 306, payments by a state to the spouse of a recipient of workers' compensation to care for the disabled worker were determined not to be tax free but were treated as compensation for services.

In Daya v. Commissioner, TC Memo 2000-360, the Tax Court denied a deduction for mortgage interest paid by two sons living with parents who were unable to make the mortgage payment holding that the living arrangement was insufficient to support a deduction in the absence of an ownership interest.

In Zipkin v. United States, 86 AFTR2d 2000-- 5571, a Minnesota Federal District Court allowed a taxpayer with $646,000 of construction costs related to special features required by a medical condition to deduct the costs in excess of the enhanced value of the property in the year when the home first becomes habitable rather than as they were incurred, claiming that the difference between the actual cost of construction and the fair market value of the home could not be determined until completion.

In Geary v. Commissioner, 235 F.3d 1207, the Ninth Circuit Court of Appeals agreed with the Tax Court that petition circulation and signature collection expenses incurred by a San Francisco police officer to place on the ballot a proposition allowing him to continue teaming up with a ventriloquist's dummy called "Officer O'Smarty" were not deductible as employee business expenses but were nondeductible amounts incurred with an attempt to influence the general public.

In Gregg v. United States, 2000 WL 33122690, an Oregon Federal District Court determined that the test for material participation by a limited liability company member involved in management is the same test as for a general partner in a partnership rather than the narrower test for a limited partner; however, the Court determined that the number of hours of participation in an activity during a short year may not be annualized.

In St. Charles Investment Company v. United States, 232 F.3d 773, the Tenth Circuit Court of Appeals reversed the Tax Court and allowed an S corporation to pass through suspended passive activity losses to its shareholders that had arisen during C corporation years.

In Taylor v. Commissioner, Summary Opinion 2000-17, the Tax Court determined that a taxpayer's principal residence for purpose of eligibility for the exclusion remained in New Jersey where he spent the preponderance of his time although his domicile had shifted to Florida as evidenced by his future plans and by where he voted.

In Suhr v. Commissioner, TC Memo 2001-28, the Tax Court determined that a wife who was required to turn over one-half of the proceeds from sale of an asset was subject to tax on the entire proceeds where title to the asset was solely in her name notwithstanding that the asset was marital property.

In In Re Hinckley, 256 B.R. 814, a Florida Bankruptcy Court permitted a wife, whose husband had a master of laws degree in taxation, to qualify under the innocent spouse rule and to avoid joint liability for pension income that he believed was non-taxable; she testified that he became belligerent "like a rabid dog" and also threatened to kill himself if she would not sign the tax returns.

In Smith v. Commissioner, TC Memo 2000-353, the Tax Court determined that a flooring installer did not need to use accrual accounting although he showed inventories on his balance sheet, because the product was determined to be incident to the service; as the result of this decision and the earlier case of RACMP Enterprises, Inc., IRS announced in Chief Counsel Memorandum 2001-10 that it will not challenge contractors' use of cash basis accounting pending further study unless the business would otherwise be required to use accrual basis accounting.

In Catalano v. Commissioner, 2001 WL 125748, the Ninth Circuit Court of Appeals agreed with the Tax Court that an individual who received income from his 100 percent owned S Corporation for the lease of three boats for entertaining clients had to report the income notwithstanding the disallowance of the corporate deduction as a "facility used in connection with entertainment."

In Gitlitz v. Commissioner, 121 S.Ct. 701, the U.S. Supreme Court determined that the forgiven debt of an S Corporation which is excluded from gross income by virtue of its insolvency at the time of the debt discharge still increases the basis of shareholders in their stock and allows them to deduct previously unusable losses which they were carrying forward due to the lack of basis.

In Flor D'Italia, Inc. v. United States, 2000 WL 33207169, the Ninth Circuit Court of Appeals agreed with a California Federal District Court and, in contrast with the Federal Circuit, determined that the IRS may not use aggregate estimates of employee tips to determine a restaurant's FICA tax liability but must make an employee-by-employee determination.

In Estate of Cranor v. Commissioner, TC Memo 2001-27, the Tax Court ruled that a Tax Court Petition sent by Federal Express properly addressed except that the box "Hold Saturday" was improperly checked causing the envelope to be held for 13 days prior to its return to sender was timely filed.

In Neely v. Commissioner, 116 TC No. 8, the Tax Court determined that the general three-year statute of limitations for IRS to commence an action against a business for improper classification of workers as independent contractors is not extended on account of fraud even though the workers were paid in cash; the fraud treatment was avoided because the owner had instructed his office manager to see that Forms 1099 were issued to the workers notwithstanding the cash arrangement.

In Mesa Oil, Inc. v. United States, 2000 WL 1745280, a Colorado Federal District Court applying collection due process rules remanded a taxpayer appeal to the Internal Revenue Service with directions that the matter be assigned to a new Appeals Officer where the original Officer gave no statement of facts, no legal analysis and no explanation of how or why the proposed levy balanced the need for collection with the interests of the taxpayer.

In Herreras v. United States, 257 B.R. 1, a California Federal District Court reversed the Bankruptcy Court and held that an IRS lien attaches to an attorney's work in progress on personal injury cases.

In Malkin v. United States, No. 00-6083, the Second Circuit Court of Appeals agreed with a New York Federal District Court that IRS could produce computer generated transcripts and testimony in support of the transcripts to show that a taxpayer consented to an extension of the statute of limitations where IRS could not produce the waiver because the administrative file was destroyed.

In Shrenker v. United States, 2001 WL 118510, a New York Bankruptcy Court followed an earlier decision of a Pennsylvania Federal District Court which held that the preparation of a substitute return by IRS precludes a subsequent bankruptcy even when the taxpayer ultimately files the tax return, at least when the subsequent return is without purpose.

In United States v. Weiss, 86 AFTR2d 2000-7130, a Pennsylvania Federal District Court disagreed with a prior Bankruptcy Court decision, finding that an attorney who financed a wedding and honeymoon, purchased a new home and two cars and lent money to others willfully attempted to defeat or evade his tax obligations.

In Haesloop v. United States, 86 AFTR2d 2000-- 6380, a New York Bankruptcy Court denied an attorney a discharge from income taxes in bankruptcy where the attorney paid no estimated taxes, filed his returns late, maintained two homes, drove a luxury car, borrowed for his daughter's education and paid off his wife's tax liability.

Revenue Rulings, Procedures and Notices

In Revenue Procedure 2001-10, IRS created an automatic conversion procedure for businesses with a three-year average of gross receipts under $1 million wishing to use the cash method of accounting and dropped the conformity requirement for financial statements.

In Notice 2001-7, IRS delayed application of the Proposed Regulations under Code Section 6045(f) relating to the reporting of payments to attorneys but indicated that payors may continue to rely upon the Proposed Regulations as a "safe harbor" until the effective date of final regulations.

In Notice 2001-10, the Internal Revenue Service provided "interim" guidance on the taxation of split dollar life insurance, allowing the employer to consistently choose whether any employer payment shall be considered as a loan to the employee (which would typically be a compensation-related below market loan) or as compensation to the employee, in which case the employee will normally report income under new tables for the cost of current life insurance protection plus additional income equal to any dividends made to the employee; the Notice contemplates that further guidance may tax the employee prospectively on the rise in the cash surrender value of the life insurance contract.

In Information Release 2001-23, IRS indicated that innocent spouse claimants fearing domestic abuse should write the term "Potential Domestic Abuse Case" at the top of Form 8857 in order to minimize the release of information to the other spouse.

In Action on Decision 2001-02, the Internal Revenue Service non-acquiesced in Vinick v. United States in which the First Circuit held that a responsible person for purpose of the Trust Fund Recovery Penalty must possess actual and exercised authority over financial matters.

In Chief Counsel Advice 2001-14, IRS stated its position that the bankruptcy discharge exempts the debtor from personal obligation to pay tax liability but does not prohibit collection under tax liens remaining attached after bankruptcy such as upon exempt property.

Letter Rulings

In Letter Ruling 200050032, IRS determined that a limited liability company member who contributes real property subject to a mortgage to the LLC which by agreement will become primarily liable on the mortgage still includes the entire liability in his basis (as opposed to a shared basis among all of the LLC members) where he executes a continuing guarantee of payment as opposed to a continuing guarantee of collection so that the creditor can proceed directly against the LLC member.

In Letter Ruling 200050046, IRS determined that a proportionate reduction in payment amounts following a transfer of a portion of an IRA balance to a spouse incident to divorce where the transferor spouse was already taking "substantially equal periodic payments" does not trigger the 10 percent penalty for premature distribution; the transferee spouse was not required to conform to the other spouse's payment scheme.

In Letter Ruling 200107019, IRS permitted plaintiffs in a lawsuit to transfer their rights to punitive damages to a charity prior to final judgment in order to avoid taxation of the damages; however, IRS determined that the contingent attorneys fees on the punitive damages would remain taxable to the plaintiffs.

In Letter Ruling 200109018, IRS determined that a partnership holding legal title for the equitable individual owners to avoid state intangible personal property tax was not an eligible S Corporation Shareholder; however, IRS granted relief as an "inadvertently ineffective election."

by

David S. De Jong

Stein Sperling Bennett De Jong et al

Rockville, MD

Copyright American Association of Attorney-Certified Public Accountants 2001
Provided by ProQuest Information and Learning Company. All rights Reserved