Tax Matters

IRS Unveils Initiative to Solve Processing Problems

The IRS announced that, beginning with the 2001 filing season, taxpayers will be able to check off a box on form 1040 and designate a paid individual tax return preparer to resolve processing-related issues. IR 2000–23 says the designee will be able to speak directly to IRS customer service representatives to resolve issues. The preparer’s authority will be limited to matters arising during the processing of a specific return, such as math error notices and information about payments and refunds. Currently, practitioners (attorneys, CPAs and enrolled agents) and other paid preparers need a power of attorney (form 2848) in order to discuss any tax return problems with the service.

According to the IRS, approximately 8 million pieces of correspondence regarding processing problems are sent out annually to taxpayers during tax season. With the introduction of the “checkbox initiative,” it expects it can resolve 90% of these issues through telephone contact with the paid preparers.

This new system does not eliminate the need for a taxpayer to sign form 2848. A power of attorney will still be required for examination matters, underreported income, appeals and collection notices.

In the future, the IRS hopes to expand the program to cover taxpayers—whether small business owners or the poor, elderly or non-English-speaking—who now rely on relatives to prepare their returns.

—Michael Lynch, Esq., professor of tax accounting
at Bryant College, Smithfield, Rhode Island.

INDIVIDUAL

Shareholder Allowed Deduction for S Corp. Debt Loss

Generally, shareholders of Subchapter S corporations are able to use their distributive share of losses to offset income from other sources to the extent of their basis in stock and debt in the company under IRC section 1366(d)(1). With respect to debt loss, the IRS and the courts historically have held that the indebtedness must be directly between the shareholder and the S corporation in order to be deductible. There are numerous cases where borrowings by an S corporation from a bank do not qualify as a deduction even if the shareholder has personally guaranteed the loan. Similarly, shareholders have been denied deductions for losses where the indebtedness was owed by the S corporation to another entity controlled by the same shareholder.

In Culnen v. Commissioner, TC Memo 2000–139, the Tax Court found an S corporation to be directly indebted to a shareholder even though the funds had been advanced from another corporation that was owned by the shareholder.

The shareholder owned an interest in two corporations, one which was not profitable (Loss Corp.) and another which was (Income Corp.). In order to fund the operations of Loss Corp., the taxpayer instructed Income Corp. to remit funds to, or pay expenses on behalf of, Loss Corp. In all cases, these amounts were recorded on the books of Income Corp. as a loan to the shareholder and recorded on the books of Loss Corp. as a loan from the shareholder. The books of Loss Corp. also recorded interest due to the shareholder for the “loaned” amounts. On his individual income tax return, the shareholder deducted his Loss Corp. losses. He considered the transactions between the two corporations as direct loans between himself—as the common shareholder—and each of the corporations, thereby establishing his basis in these loans under IRC section 1366(d)(1).

The IRS challenged the shareholder’s position and sought to disallow the loss deductions on his return on the grounds that he had not incurred any actual economic outlay due to the direct flow of funds between the two corporations. Presumably, had Income Corp. actually distributed the funds to the shareholder who then contributed or loaned the funds to Loss Corp., the IRS would not have challenged his loss deduction.

The Tax Court disagreed with the IRS assertion that the mere form of a transaction results in a loss disallowance. The court focused on the testimony of the taxpayer, his bookkeeper and outside accountants to corroborate the fact that, for all purposes, these transfers were considered to be on behalf of the shareholder and at no time was there an intention to create an equity or debt interest by Income Corp. in Loss Corp.

Observation: While Culnen is good news for taxpayers and CPAs, it highlights the distinction between the actions of a corporation on its own behalf and those of an agent for the shareholder. To obtain the tax treatment of the former, CPAs should suggest that clients observe the formalities of such an arrangement—that is, recording the amounts consistently as loans, use of promissory notes with interest and, ideally, actual cash transfers to and from the shareholder.

—Vinay Navani, CPA, tax manager,
Wilkin & Guttenplan, PC, East Brunswick, New Jersey.

BUSINESS/INDUSTRY

Size Matters to the IRS

The size of the automobile you buy for business use matters to the IRS. In fact, there is a tax benefit to purchasing a heavier, less fuel-efficient automobile. The annual depreciation deduction for most automobiles used in a trade and business is subject to the limited luxury automobile rules (LLAR), which limit the amount of depreciation that can be taken annually on a luxury automobile under the modified accelerated cost recovery system (MACRS) rules. The normal MACRS life for an automobile is five years, but since the amount of LLAR limits the annual deduction, the depreciable life of the vehicle is extended. If the taxpayer purchases a $20,000 automobile subject to LLAR, it must be depreciated over eight years, which is longer than most drivers keep their business vehicles.

However, heavier automobiles are not subject to LLAR. A $20,000 automobile, whose gross vehicle weight is more than 6,000 pounds, for example, can be depreciated over its expected five-year life. The IRS, however, limits the taxpayer to only a half-year’s depreciation in the year of purchase and a half-year’s depreciation in the sixth year. The tax benefits of purchasing the larger vehicle thus are clear (see exhibit below). For example, in 1999, the difference between the depreciation that could have been taken if a $20,000 automobile was subject to LLAR or not was almost $1,000.

To further complicate the calculation, in the year of purchase, the taxpayer can elect to take a first-year accelerated deduction under section 179, Election to Expense. This election must be taken in the year the automobile is purchased, and it allows the taxpayer to deduct $19,200 of a $20,000 automobile that first year. The taxpayer then deducts the balance ($800) of the cost of the automobile over the remaining five-and-one-half-year life of the automobile as allowed by MACRS. Even though the annual deduction is very small, it must be stretched over the entire life of the automobile.

The depreciation calculations under the three plans are illustrated in the exhibit below.

Since most taxpayers want to enjoy the tax advantages of accelerated depreciation and do not keep automobiles for eight years, they may be better off purchasing vehicles not subject to LLAR.

Tax practitioners should advise clients of the benefits of purchasing heavy vehicles for business use. Many sport utility vehicles (SUVs), vans and large trucks meet the weight requirements. For example, the lightest Chevy/GMC Suburban weighs 6,800 pounds and may go to a beefy 8,600 pounds depending on the options selected. Some vehicles may or may not meet the weight limit. For example, the Chevy Astro/GMC Safari Van ranges from 5,600 pounds to 6,100 pounds depending on the options. Automobile weights can be obtained from the manufacturer or dealer selling the vehicle.

—Marc I. Lebow, CPA, PhD, and
P. Michael McLain, CPA, DBA,
assistant professors of accounting at
Hampton University School of Business,
Hampton, Virginia.

INDIVIDUAL

Aggregating Your Rental Activity? Be Sure to Tell the IRS

As a general rule, passive activity losses can offset only passive income and cannot be used to reduce active or portfolio income. Also, tax credits derived from passive activity can offset only taxes incurred from passive income. Any loss or credit that is disallowed becomes suspended and is treated as a deduction or credit allocable to such activity in the next taxable year.

IRC section 469 (c)(2) says any real estate rental activity automatically is treated as a passive item unless the taxpayer qualifies as a real estate professional. The Revenue Reconciliation Act of 1993 allows real estate professionals, who spend the majority of their time engaged in real estate activities, to avoid the passive loss limitations. To be eligible, a taxpayer must materially participate in the business, perform more than 750 hours of service per year in the real estate activity and be able to demonstrate that more than half of the personal services he or she performs during the year are for real property trades or businesses.

These rules apply as if each real estate rental activity is a separate business. However, IRC section 469(c)(7)(A) allows a qualifying real estate professional to elect to treat all such activities as one. Such an election not only eases the burden of meeting the material participation tests but also allows the taxpayer to currently offset the losses from one rental activity against the income of another and then offset the remaining loss against non-passive-activity income.

In Kosonen v. Commissioner, TC Memo 2000-107, an airline pilot owned seven residential rental properties. Altogether he had 877 combined hours of service in 1994 and 977 hours in 1995. He filed his 1994 and 1995 returns and reported his combined rental losses on line 42 of schedule E, where real estate professionals report the net income or loss from all rental activities in which they materially participated under the passive activity loss rules. Kosonen then reported a combined loss on line 17 of form 1040 and used the loss to offset his other income to arrive at his adjusted gross income.

In 1996, Kosonen did the same thing, except he also attached a statement indicating that he qualified as a real estate professional and elected to treat all his rental real estate activities as one activity.

The IRS agreed that Kosonen would have been considered to have materially participated in his real estate activities in 1994 and 1995 if they had been treated as one. However, since no formal election was filed prior to 1996, the service treated each property separately. Therefore, Kosonen no longer passed the material participation test, and the IRS disallowed the offset against the nonpassive income.

The Tax Court sided with the IRS, ruling that since Kosonen didn’t affirmatively elect to aggregate his real estate rental activities in order to treat them as one activity under the passive activity loss rules, his losses for the seven separate activities were suspended and thus could not be used to offset his non-passive-activity income.

Observation: CPAs should be aware that regulations section 1.469-9(g)(3) requires the taxpayer to file the aggregation election with his or her original income tax return for the year the election is made. The regulation states that once the taxpayer makes such an election, it applies for that year and for all future years during which he or she qualifies as a real estate professional.

—Michael Lynch, Esq., professor of tax accounting at
Bryant College, Smithfield, Rhode Island.

Stock Redemption and Divorce Revisited

When negotiating a divorce settlement, the issue of how to separate ownership of a couple’s closely held business can cause significant problems. One option is for the corporation to redeem the stock owned by either of the spouses. The taxation of such a transaction, however, has been the subject of several court decisions. The latest decision has not definitively settled the issue.

William and Carol Read owned all the stock of Mulberry Motor Parts, Inc. (MMP). During their divorce negotiations, the couple decided William should own 100% of MMP and Carol should receive $838,724 (her stock’s fair market value) of which $200,000 would be payable in cash and the rest in a note bearing 9% interest.

The divorce decree said William was to purchase Carol’s stock or—at his option—have MMP or its ESOP purchase it. William elected to have the corporation purchase the stock. Carol reported no gain on the redemption even though her basis in the stock was zero. William also reported no income from the transaction. The IRS treated the redemption as a sale on Carol’s tax return, creating a taxable gain, and as a constructive dividend (taxed as a dividend even though no cash was received) on William’s return. It also denied the corporation an interest deduction. The IRS left it to the courts to decide which of the two outcomes was correct.

Result. For Carol and against William. Carol had argued that the redemption of her stock was a transfer incident to a divorce and nontaxable under IRC section 1041. William had argued that he should not be charged with a constructive dividend because the redemption did not fulfill a primary and unconditional personal obligation to buy the stock. A divided Tax Court ruled William had received a constructive dividend, saying his argument applied the wrong standard. The unconditional obligation standard does not apply. The appropriate standard was whether the transfer was to a third party on behalf of the former spouse. If the transfer was on William’s behalf, it would be recast as a nontaxable transfer to him followed by his transfer of the stock to the corporation—resulting in a taxable constructive dividend. If the transfer was not on William’s behalf, it was a redemption from Carol that would be taxable as a sale.

The temporary regulations under section 1041 provide that a transfer is on behalf of a former spouse if it is

• Required by the divorce decree.

• Pursuant to a request by the former spouse.

• Ratified by the former spouse.

According to the Tax Court, the stock redemption in this case qualified under the first two options since the divorce decree said the husband would purchase the stock or designate the corporation as the buyer. The result is that Carol received the cash and the note without any tax consequences whereas William had to report these items as a constructive dividend. The Tax Court also held that MMP was not entitled to deduct the interest it paid on the note to Carol.

As a result of the court’s decision, William ended up with a significant tax liability. Based on prior precedent, this could have been avoided if the divorce decree had specified MMP was required to redeem the stock. If the decree also had required William to guarantee payment or to be secondarily responsible for acquiring the stock, the outcome would have been less certain.

Carol M. Read, et al. v. Commissioner, 114 TC no. 2.

Prepared by Edward J. Schnee, CPA, PhD,
Joe Lane Professor of Accounting and director,
MTA program, Culverhouse School of Accountancy,
University of Alabama, Tuscaloosa.