TAX MATTERS

TAX CASE

BEATING THE CLOCK ON REFUNDS
ost taxpayers know when to file their annual tax return. But they may be less sure of how much time they have to claim a refund. Three decisions last year may help clarify the rules.

In the first, Wachovia Bank was trustee for the George C. Nunamann Trust, which was created in 1984 and became a charitable trust in 1991. Although Wachovia was then no longer obligated to file returns or pay taxes, it mistakenly continued to do so through 2001. In 2003, Wachovia realized its error and filed for refunds for 1997 and 1998 totaling more than $111,000. Citing the three-year statute of limitations in IRC section 6511(a), the IRS denied the claims. A district court granted summary judgment for Wachovia. The IRS appealed (see “Tax Matters,” JofA, Dec.06, page 82).

In the second case, home-products company Electrolux claimed a special exception to section 6511(a) in subsection (d)(2)(A), which allows refunds arising from a net capital loss carryback that are claimed within three years from the time for filing a return for the tax year in which the loss occurred. Electrolux’s former parent company, White Consolidated Industries Inc. (WCI), had sustained a $53.8 million capital loss in 1994. WCI carried the loss back to 1993 and forward through 1998. In 1999, the IRS allowed refunds stemming from all the years except 1995, saying that WCI’s Dec. 31, 1999, amended return was too late by 31/2 months. Electrolux, as successor-in-interest to WCI, sought a refund of more than $1.45 million for 1995 and filed a complaint in the U.S. Court of Federal Claims.

In the third case, Richard Stevens was named executor of the Gloria S. Keesey Stevens estate. In November 1998, he filed a request for an extension of time to file a return and included a payment of $162,109. He was given until May 16, 1999. Before the extended due date and several times after it, Stevens called the IRS and requested further extensions, noting that the estate was entitled to a significant refund. He was told he could extend the due date. On July 30, 2002, he filed the return, requesting a refund of $65,481. The refund was denied as being past the due date. Stevens filed an action in the U.S. District Court for Northern California.

Results. Against Wachovia and Electrolux but for Stevens.

Wachovia argued that it came under the general six-year statute of limitations for civil actions against the United States in 28 U.S.C. § 2401, outside the tax code. The Eleventh Circuit Court of Appeals said the three-year limit of section 6511(a) applied instead, interpreting “in respect of which tax the taxpayer is required to file a return” to mean a tax return generally.

In Electrolux, the court held that the special rule applied only to the carryback years, not a carryforward one. In Stevens, the court held that Stevens’ telephone conversations were informal but valid requests and he was entitled to the refund.

These cases underscore that refund claims filed beyond the prescribed deadlines will be narrowly construed. The one exception is informal extension requests, although taxpayers must be able to prove they made them.

Wachovia Bank v. U.S., 98 AFTR2d 2006-5111 (CA-11).
Electrolux Holdings, Inc. v. U.S., 97 AFTR2d 2006-3123.
Richard O. Stevens v. U.S., 98 AFTR2d 2006-5184.

Prepared by Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

TAX CASE

IRS SCORES VICTORY OVER ALLEGED TAX SHELTER
he Second Circuit Court of Appeals overturned the TIFD III-E Inc./Castle Harbour decision (see “Tax Matters,” JofA, June05, page 93), a win for the IRS in its battle against tax shelters. The court ruled that the mere existence of a business purpose of a partnership does not preclude a conclusion that its primary purpose was tax avoidance. It also said Dutch banks with which TIFD III-E entered a partnership agreement had no meaningful stake in the partnership’s success and thus should not have been considered equity partners.

TIFD III-E was a wholly owned subsidiary of General Electric Capital Corp. (GECC), which in turn was a commercial-aircraft-leasing subsidiary of General Electric Co. To reduce its risks, GECC formed Castle Harbour, a limited liability company to which it contributed aircraft. Castle Harbour was owned by TIFD III-E and two other GE subsidiaries. TIFD III-E and the subsidiaries sold interests in Castle Harbour to Dutch banks. Under the arrangement, 98% of Castle Harbour’s operating income was allocated to the Dutch banks; consequently, the same percentage of net book income (operating income reduced by expenses including depreciation) was allocated to the banks, representing their actual income from the Castle Harbour investment.

All the aircraft in Castle Harbour, however, already had been fully depreciated for tax purposes. Accordingly, the taxable income allocated to the Dutch banks was greater than their book allocation by the amount of book depreciation for that year. The Dutch banks, however, did not pay U.S. income taxes. Thus, by allocating such a large percentage of the income from fully tax-depreciated aircraft to the Dutch banks, GECC avoided an enormous tax burden while, at the same time, shifting very little book income.

The IRS reallocated Castle Harbour’s income to GECC, attributing $310 million of additional income to TIFD III-E that resulted in an additional tax liability of $62 million. TIFD III-E filed a complaint in U.S. District Court for Connecticut to recover $62 million it had deposited with the IRS to satisfy the tax liability. The district court found that the Castle Harbour transaction was “economically real,” undertaken, at least in part, for a nontax business purpose; it resulted in the creation of a true partnership with all participants holding valid partnership interests; and the income from the transaction was properly allocated among the partners under section 704(b) and regulations section 1.704-1. Thus, the court ordered the IRS to refund the $62 million plus interest. The IRS appealed to the Second Circuit.

Result. For the IRS. The Second Circuit judges determined the lower court failed to consider the appropriate tests of law. The test used by the Supreme Court in IRS v. Culbertson, 337 U.S. 733, 742, requires an examination of the nature of an interest based on a realistic appraisal of the totality of the circumstances. That test requires that “all of the facts—the agreement, the conduct of the parties in execution of its provision, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent” be used to determine the purpose of a partnership.

The Second Circuit also said the district court should have determined whether the purported partnership interest had the prevailing character of debt or equity as discussed in O’Hare v. Commissioner, 641 F.2d 83. The error here was that the district court accepted “at face value artificial constructs of the partnership agreement without examining all the circumstances to determine whether powers granted to the taxpayer effectively negated the apparent interests of the banks,” the Second Circuit said.

TIFD III-E Inc. v. U.S., 98 AFTR2d 2006-5616 (CA-2).

Prepared by Matt Stampfli, CPA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., professor of accounting, both of the College of Business, West Texas A&M University, Canyon.

TAX CASE

VALUE GIFTS ON THE DATE GIVEN
he Fifth Circuit reaffirmed that under IRC section 2512, a gift’s value is determined on the date it is given. The court also decided that a discount used to determine the present value of a previously transferred interest was allowable if it was the amount a willing buyer would require to cover any additional taxes under section 2035.

Charles T. McCord Jr. and his wife, Mary, along with their four sons, established McCord Interest Ltd. (MIL), a Texas limited partnership. The couple received all the class A limited partnership interest in MIL and 82% of the class B limited partnership interest, for a total contribution of $12.3 million.

On Jan. 12, 1996, the McCords gave all their class B limited partnership interest to two charities, their sons and each son’s generation-skipping trust by executing an assignment agreement. The gifts were in dollar amounts of the net fair market value of MIL and not stated in percentages of interest. An independent appraiser determined the value on the date of the gift as $89,505 for each 1% of class B limited partnership interest. In March 1996, all the recipients signed a confirmation agreement, which translated the dollar value of the gifts into percentages of interest.

The McCords timely filed a 1996 gift tax return that reflected the appraiser’s value of their gifts. They took annual exclusions of $60,000 each and charitable contribution deductions of $209,173 each. In addition, they reduced the value of their gifts by the amount of the gift tax payable for gifts to the nonexempt donees, which reflected the fact that the donees assumed the payment. They also deducted the actuarially determined present value of the nonexempt donees’ liability (which the donees had agreed to pay) for any additional estate taxes if one or both taxpayers died within three years of the gift, based on section 2035.

The IRS issued a deficiency to both taxpayers, saying the McCords understated the gifts’ fair market value and should not have taken the discount for the nonexempt donees’ potential liability under section 2035. The McCords contested the deficiencies in the U.S. Tax Court. The Tax Court initially found in favor of the taxpayers on all issues, then two years later, in what the Fifth Circuit would later call an unusual proceeding that employed a “novel methodology,” the Tax Court reversed its earlier decision.

Result. For the taxpayers. The Fifth Circuit reversed and remanded the case, saying the Tax Court majority erred in relying on the recipients’ agreement, since it came two months after the gift and the donors were not a party to it. The appellate court also determined the value of the gifts was properly discounted because:

The transfer tax rate on the date of the gift would be of interest to a willing buyer for discount purposes. Section 7520 provides the interest rates.

A willing-buyer/willing-seller test would allow a discount for potential additional federal estate taxes if one or both of the taxpayers died within three years of the gift and it is sufficiently determinable to be taken into account.

Succession of McCord Jr. v. Commissioner, 98 AFTR2d 2006-6147 (8/22/2006).

Prepared by Gary D. Rider, J.D., instructor of business, and Darlene Pulliam, CPA, Ph.D., professor of accounting, both of the College of Business, West Texas A&M University, Canyon.