TAX MATTERS

TAX BRIEFS

CIRCULAR 230 REVISIONS FINALIZED
The Treasury Department issued final regulations amending a number of Circular 230 standards, including sections on conflicts of interest, contingent fees, conduct for which practitioners may be sanctioned and publicity of disciplinary hearings. Most of the changes became effective upon their issuance on Sept. 26.

The final regulations concerning conflicts of interest continue to allow clients to waive otherwise lawful conflicts, but the requirements have been tightened. Each affected client must waive the conflict and give informed consent, confirmed in writing within 30 days.

Although several commentators had criticized a proposal to curtail the use of contingent fees, the Treasury Department attempted to strike a balance on this issue. The final regulations allow contingent fees for services rendered in connection with an IRS examination of (1) original returns or (2) amended returns and refund claims filed within 120 days of a notice of examination or written challenge by the IRS. Contingent fees also are allowed for interest and penalty analyses and for services in connection with a judicial proceeding. These provisions apply to fee arrangements entered into after March 26, 2008.

Several commentators had questioned the appropriateness of making a practitioner’s willful failure to sign a tax return a sanctionable offense under section 10.50. In response, the Treasury Department included a reasonable-cause exception.

The final regulations also made a concession to concerns about public disclosure of pending disciplinary proceedings. Reports and decisions will be made publicly available only after a final decision of an administrative law judge or appellate authority. Proposed regulations would have opened all hearings, reports, evidence and decisions to the public.

The final regulations did not update Circular 230 to correspond to amendments to IRC section 6694 passed by Congress last spring that raised the standard for preparers from a realistic possibility an undisclosed position would be sustained upon examination to a reasonable belief that the position would “more likely than not” be sustained. But the Treasury Department reserved subsections of section 10.34 and issued proposed regulations for that purpose.

TIGTA: HOBBY LOSS RULE HOBBLED
The Office of the Assistant Secretary of the Treasury for Tax Policy will propose legislative changes to IRC section 183 to strengthen and clarify the hobby loss rule. The office agreed to do so at the urging recently of the Treasury Inspector General for Tax Administration, which faulted the statute’s language in part for what TIGTA said was probable widespread abuse. Treasury also will highlight the topic in messages to practitioner organizations.

Although violations of the hobby loss rule probably account for a sizable portion of the estimated $30 billion a year in unpaid taxes resulting from improper deductions, exemptions and credits, the IRS is unable to gauge the extent of the problem or effectively target compliance efforts, TIGTA said in the report.

About 1.5 million taxpayers claimed net losses on Schedule C that reduced their income from other sources in each of four consecutive years (2002–2005)—possible evidence of improper deductions, TIGTA said. Nearly three-quarters of those taxpayers (73%) were assisted by tax practitioners, the report noted.

Among the hurdles the IRS faces in improving compliance is the hobby loss rule itself, as codified in IRC section 183 and corresponding regulations, TIGTA said. The section prohibits claiming a net loss from an activity that isn’t a trade, business or income-producing activity—in other words, a hobby. Regulations require only the “objective” of making a profit; a better requirement would be a “reasonable expectation” of profitability, TIGTA said.

TAX CASE

NO THEFT LOSS FOR “PHANTOM” INCOME
The section 165 theft loss deduction seldom benefits taxpayers to the extent they think it should. This can be especially true if the thief is their investment manager and they discover only belatedly they’ve been paying taxes on investment income that never existed.

Between 1992 and 2000, Michael and Anita Kaplan transferred approximately $5.7 million to Reed Slatkin, an investment adviser and money manager in California. He reported to them that their investment earned $519,157 from 1992 through 1996 and $3,617,953 from 1997 through 1999. The Kaplans reported this income on their tax returns and paid tax on it. Slatkin, however, was running a Ponzi scheme, for which he pleaded guilty in 2002 to 15 felony counts. A year earlier, Slatkin filed for bankruptcy, and the trustee notified the Kaplans and other creditors that they could expect approximately a 21% recovery.

The government agreed to refund taxes the Kaplans paid on the “phantom” income for years still within the statute of limitations—1997 through 1999. The Kaplans then filed a refund claim on their 2001 return stemming from a theft loss deduction under section 165(a) equal to their investment, fictitious income and taxes paid on that income for 1992 through 1996. The claim was denied, and the issue went to district court in Tampa, Fla.

Based on Slatkin’s guilty plea, there was no question that a theft loss existed. The question was the appropriate year for it to be reported—according to regulation 1.165-1(b), the first year in which the Kaplans no longer had any reasonable chance of recovery (see “‘Reasonable Certainty’ for a Theft Loss Deduction,” JofA, Oct. 07, page 74). This is determined based on foresight and not hindsight, and in 2001, the court ruled, the Kaplans did have a chance of recovery, as estimated by the bankruptcy trustee.

The court next considered a theft loss for the phantom income. The government’s position, adopted by the court, was that since there was no proof that the income existed, there could not have been a theft. As for the taxes, they could not be considered a theft either, the court concluded. The proper approach would be to file amended returns. But if, as in this case, the statute of limitations has run, the taxpayer is out of luck.

It is critical that taxpayers determine the credentials and honesty of any cash manager before transferring money. Theft loss deductions, even when allowed, will not restore taxpayers to their pre-theft position.

Michael and Anita Kaplan v. U.S., 100 AFTR2d 2007-5674

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

INDIANAPOLIS POWER & LIGHT TRIPS CIRCUITS
In a split decision, the Third Circuit Court of Appeals required a grocer to include in gross income a payment characterized as a loan from a supplier. The loan could be forgiven if the grocer, Karns Prime and Fancy Foods Ltd. of Harrisburg, Pa., purchased a certain volume of goods. But because Karns had no unconditional obligation to repay the proceeds when it executed the purchase agreement, the loan was more in the nature of an advance rebate, the majority opinion said.

The court thus reached an opposite conclusion from the Ninth Circuit earlier in Westpac Pacific Foods v. Commissioner, a ruling the IRS agreed to follow this summer (see “Tax Matters,” JofA, Dec. 06, page 80, and Sept. 07, page 86). That case involved payments explicitly designated as advance rebates to grocers from a supplier. Both courts based their decisions on a 17-year-old Supreme Court ruling that customer security deposits held by an electric utility were not income.

To raise capital, Karns asked its principal supplier, Super Rite Foods Inc., for a loan. In 1999, in exchange for $1.5 million from Super Rite, Karns executed a promissory note and supply agreement. Karns could either repay the loan in six annual installments of $250,000 each or purchase at least $16 million worth of product each year to have that year’s installment forgiven. For the first three years of the agreement, Karns exceeded the minimum purchase amounts, and those years’ payments were forgiven. The company included $250,000 as income on its returns for tax years 2001 and 2002.

In 2003, however, the IRS issued a deficiency notice of $486,355 for tax year 2000, claiming that since Karns had no unconditional obligation to repay the $1.5 million, the entire amount was income when received. Karns petitioned the Tax Court, lost and appealed.

The Third Circuit contrasted Karns’ loan from customers’ security deposits on electric service that were the subject of the Supreme Court’s 1990 ruling in Commissioner v. Indianapolis Power & Light Co., 65 AFTR 2d 90-394 (110 S.Ct. 589). In that case, the court held that the deposits were not income, since customers could demand repayment when they discontinued their electrical service. But unlike the utility, Karns alone could control whether it could keep the money, simply by meeting the required terms, the Third Circuit said.

The majority opinion, after saying the loan could be considered an advance rebate, disagreed with the Ninth Circuit in Westpac, in which that court said an advance rebate could be considered a loan. Specifically, the Third Circuit faulted the Ninth Circuit’s application of Indianapolis Power, saying it ignored the Supreme Court’s discussion of when a deposit would be income: in situations where “so long as the recipient fulfills the terms of the bargain, the money is its to keep.”

One judge of the Third Circuit’s panel of three, in a dissenting opinion, emphasized provisions in Karns’ supply agreement that she said gave Super Rite “immense latitude” to cancel the agreement, allowing Karns no advance guarantee the loan would be forgiven and hence little control over keeping its proceeds.

The situation was left unclear, however, given Rev. Proc. 2007-53, issued by the IRS in response to the Westpac ruling but before the decision in Karns. In it, the IRS said it would follow Westpac and established a method for accrual taxpayers to recognize advance trade discount payments as a reduction in cost of inventory.

Karns Prime & Fancy Food Ltd. v. Commissioner, 100 AFTR 2d 2007-5267

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.

TAX CASE

TAX COURT TO RULE ON SEX CHANGE
The U.S. Tax Court in Boston is reviewing whether expenses of a sex-change operation are deductible.

Rhiannon G. O’Donnabhain, born anatomically male, was diagnosed by her psychotherapist in 1996 with gender identification disorder (GID), which she says caused her extreme discomfort since childhood. In 1997, O’Donnabhain began taking feminizing hormones and presenting herself as a female. She also changed her legal name. In 2001, after her psychotherapist, psychologist and surgeon recommended gender reassignment surgery, O’Donnabhain underwent the procedure and reported finally feeling a sense of comfort with her body.

She claimed a medical expense deduction for all costs relating to her surgery on her 2001 income tax return. The IRS disallowed the deduction and issued a notice of deficiency, ruling that the surgery was cosmetic and elective. Cosmetic surgery, defined as intended to improve appearance rather than to promote bodily functions or prevent or treat illness or disease, typically is not a deductible medical expense under IRC § 213. An exception is made for surgery to correct a congenital disfigurement or one caused by an injury or disease.

The case has provoked debate whether gender reassignment surgery is necessary to correct what O’Donnabhain argues is a medically recognized mental disorder. The IRS’s argument is outlined in Chief Counsel Memorandum 200603025.

The Tax Court heard arguments in July and August and is expected to rule in early 2008.

Prepared by Jean T. Wells, CPA, J.D., assistant professor of accounting and KPMG Professor in Residence, Howard University, Washington, D.C., and Gwendolyn McFadden-Wade, CPA, J.D., LL.M., associate professor of accounting, N.C. A&T State University, Greensboro, N.C.

TAX CASE

A POINT OF NO RETURN
Is filing of a return required for a conviction of false return preparation? A recent case held it was not.

Linda Borden of Florida was convicted by a federal jury in March 2007 of 27 counts of preparing or presenting false or fraudulent returns under IRC section 7206(2). However, she asked the court to enter an acquittal with respect to one of those counts relating to a return prepared for a client, Brian White. Borden delivered the return to White, but he decided not to file it because he believed it to be incorrect. After his wife accidentally mailed it to the IRS, White contacted the IRS and requested that the return not be processed, and the IRS acquiesced.

Borden argued that section 7206 requires filing of a false return, and since the IRS had not processed White’s return, she could not be guilty of the offense. The government pointed out that section 7206(2) mentions “preparation or presentation” of a false return but doesn’t specifically require that it be filed. The court agreed, basing its decision on the plain language of the statute. The presentation, or filing, of a fraudulent return is a separate crime from its preparation.

Borden is appealable to the Eleventh Circuit, which has not spoken on this issue. In reaching its decision, the district court referred to a dissenting opinion in a Ninth Circuit case, U.S. v. Dahlstrom, 52 AFTR2d 83-5836, in which the majority held that filing is required for conviction. The district court noted, along with the dissent in Dahlstrom, that the decisions relied on by the majority in that case dealt with when the statute of limitations begins to run, not the question at hand.

Additionally, the Florida court noted that if filing was a prerequisite to the crime of false preparation, offenders could not be convicted as a result of undercover operations. Finding this result inconsistent with Congress’ intent, the court held that a preparer commits the crime of fraudulent preparation once the return is delivered to the client with the belief that the client will file it, whether or not the return is ultimately filed.

U.S. v. Borden, 99 AFTR2d 2007-2243

Prepared by Laura Lee Mannino, CPA, LL.M., assistant professor of accounting and taxation, St. John’s University, Jamaica, N.Y.

TAX CASE

A MOOT POINT (AND A HALF) FOR EXXON
When it comes to overpayment interest due them, most taxpayers probably wouldn’t quibble too much over a difference of 1.5 percentage points, especially if that margin applied only to compounding of previously earned interest. But Exxon Mobil isn’t most taxpayers. For it, that fraction was worth $140 million, for which it litigated but lost. At issue was whether a 1995 reduction in interest rates on corporate overpayments exceeding $10,000 should apply to previously accrued interest as well as outstanding overpayments.

Before 1995, overpayment interest for corporations was the federal short-term rate plus 2 percentage points. That year, section 6621 was amended to reduce the corporate rate to 0.5 percentage points above the federal short-term rate for any portion of an overpayment exceeding $10,000.

Exxon Mobil timely filed all its corporate returns for 1979 through 1985, on which it overpaid $567 million. The IRS refunded the sum in July 2005, plus interest calculated at the reduced rate from Jan. 1, 1995, on both the overpaid amounts and the $491 million in interest accrued before 1995. Exxon Mobil petitioned the Tax Court for an additional $140 million in interest, saying under the language of the amended statute, the rate reduction applied only to overpayments. The interest on the interest, Exxon Mobil said, should continue to accrue at the original rate. The motion was denied, and Exxon Mobil appealed. In affirming the Tax Court, the Fifth Circuit refused to bifurcate interest in the manner suggested by Exxon Mobil. Accordingly, the 0.5 percentage point increase over the federal short-term rate called for in section 6621 is used to compound pre-1995 interest.

Exxon Mobil Corp. v. Commissioner, 99 AFTR2d 2007-2145

Prepared by Laura Lee Mannino.