TAX MATTERS

TAX BRIEFS

IRS ISSUES GUIDANCE ON MONETARY PENALTIES
he IRS published guidance in Notice 2007-39 to outline how it will wield its new statutory authority to impose monetary penalties on taxpayer representatives for violations of Circular 230.

The amendment to 31 USC §330 empowers the Service to levy monetary penalties for violations occurring after Oct. 22, 2004. The penalty may be imposed on practitioners who are incompetent or disreputable, fail to comply with Circular 230 or, with intent to defraud, willfully and knowingly mislead or threaten a current or potential client. The amount of the penalty cannot exceed the gross income derived, or expected to be derived, from the conduct resulting in the penalty. If the offending practitioner acted on behalf of an employer, the IRS may impose a separate penalty against the employer if it knew, or reasonably should have known, of the conduct.

In determining the amount of a penalty, the IRS will consider the level of culpability of the practitioner, firm or other entity; whether the practitioner, firm or other entity violated a duty owed to a current or prospective client; the actual or potential injury caused by the prohibited conduct; and any aggravating or mitigating factors.

The monetary penalties may be imposed in addition to any suspension, disbarment or censure of the practitioner.

The Service is seeking comments by Aug. 13 on how to apply the penalty. Comments may be e-mailed to Notice.Comments@irscounsel.treas.gov.

LOOK TO AUDIT BOTTOM LINE, SAYS IRS
xperience from its expanded number of audits of corporate returns will allow the IRS to work smarter in the future, the agency said, as it acknowledged spending more time on audits that came up empty of additional tax. The IRS rebutted a report in April by a research organization associated with Syracuse University that showed the percentage of large corporations audited—those with assets of $250 million or more—declined to 35% in 2006 from 44% in 2005, as did additional tax recommended as a result (http://trac.syr.edu/tracirs). From 1996 to 2006, “nonproductive” audit hours more than tripled, said the research group, the Transactional Records Access Clearinghouse.

Audit-derived assessments, however, were up, the IRS said. Not only did the number of large corporate audits increase by 50% from fiscal 2003 to 2006, but revenues recommended from them doubled, from $13 billion to more than $26 billion.

“Any discussion about ‘no change rates’ is not complete without looking at the bottom line,” the IRS said, adding that even audits that don’t bring in more dollars can yield lessons for greater productivity by examiners going forward.

BILLS TARGET CONTRACTOR SCOFFLAWS; FED WORKERS DELINQUENT
.S. Rep. Ed Towns, D-N.Y., in April introduced the Contractor Tax Enforcement Act, HR 1870, to bar federal tax debtors from contracting with the government. Another bill, introduced by Brad Ellsworth, D-Ind., would require contractors to certify they don’t owe a federal tax debt. The proposed legislation followed by a few days a Government Accountability Office report to a House Oversight and Government Reform subcommittee chaired by Towns. The GAO found in a continuing investigation of tax cheating by federal contractors that of 122 contractors owing tax that the agency selected for closer scrutiny, all had engaged in abusive or criminal nonpayment. One contractor that owed more than $18 million in tax provided health care services to the departments of Veterans Affairs and Health and Human Services. Owners of several of the businesses also owned vacation homes, boats or luxury vehicles or spent hundreds of thousands of dollars on gambling, the GAO said. Earlier, the GAO determined some 63,000 federal contractors collectively owed about $7.6 billion in taxes.

Because tax returns are confidential, federal procurement officials must rely on voluntary disclosure or public records to identify tax debtors, the GAO said. The Office of Management and Budget in March published proposed new rules requiring contractors to certify they have not been convicted of tax-law violations or been notified they owe delinquent taxes.

How tax compliant are federal employees? In its annual Federal Employee/Retiree Delinquency Initiative (FERDI) report, the IRS said that as of last October, 283,852 federal employees and retirees owed more than $2.1 billion in back taxes, not including installment agreements, a delinquency rate of 3.1%. More than 10,200 workers and retirees of the Department of Veterans Affairs’ nearly 240,000 total head count owed $82.7 million, a 4.26% delinquency rate. Another 7,370 Veterans Affairs employees and retirees owed $39 million in installment plans. More than 1.2% of the Department of the Treasury’s workers and retirees owed taxes without an installment plan, for a total of $7.26 million. Of the Tax Court’s 208 employees and retirees, 10, or 4.8%, were delinquent. The FERDI tally showed an improvement from 2005, when the overall rate was 3.3%. Federal workers and retirees generally pay their taxes more conscientiously than the rest of the population, the IRS said, but it urged federal agency leaders to stress compliance.

TAX CASE

DISALLOWED INDEMNITY DEDUCTION BLUES
rom time to time, corporate officers and shareholders agree to indemnify their corporations for certain expenses and losses. The taxpayer would prefer to claim an ordinary loss deduction instead of a capital loss or, worse, a nondeductible payment. The Sixth Circuit Court of Appeals recently denied such a claim.

Isaac Tigrett II was in the business of developing and promoting restaurant and entertainment venues. After founding and building the Hard Rock Café chain, he developed the House of Blues concept. As CEO of HOB Entertainment Inc., Tigrett sought in 1996 to open a temporary House of Blues at the Olympic Games in Atlanta. The corporate board initially was not in favor, until Tigrett promised to indemnify the corporation for up to $5 million of any losses. The House of Blues opened but was shut down for 41/2 days after the bombing of Centennial Olympic Park by Eric Rudolph. The corporation lost $10 million, and Tigrett paid the $5 million. The district and appellate courts upheld the government’s position that the payment was designed to generate a future benefit of an initial public offering of HOB stock and denied it as an ordinary loss or expense.

The Sixth Circuit looked at the guarantee and payment as a single transaction and regarded Tigrett’s concern for his business reputation as a capital asset for which payments to preserve and protect were nondeductible. Also, the payment was not “ordinary” within the meaning of trade or business expenses in section 162, the court said. Tigrett argued alternatively for a loss under section 165(c). This argument also failed, since the U.S. Supreme Court has held that voluntary payments of another’s loss are gratuities, not debts or losses [Putnam v. Commissioner, 50 AFTR 502 (1956)]. They are either a contribution to the capital of the corporation or a capitalized payment to protect an individual’s business reputation, the court said. It is extremely doubtful that any future taxpayer will be able to obtain an ordinary loss for a similar indemnity agreement.

Isaac B. Tigrett II v. U.S., 99 AFTR 2d 2007-501.

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

NO GAIN, SOME PAIN FOR ANOTHER LOTTERY WINNER
The Second Circuit Court of Appeals joined other courts holding that a taxpayer’s sale of rights to future installments of lottery winnings is ordinary income and not capital gain.

Shirley Prebola won $17.5 million in the New York State Lottery. The winnings were to be paid in 26 annual installments. Prebola reported the first three payments as ordinary income. She then sold her rights to the remaining payments for a lump sum of $7.1 million and reported that amount as a long-term capital gain. The IRS disagreed and issued a notice of deficiency for $1.31 million. The Tax Court (TC Memo 2005-261) held for the IRS.

On appeal, Prebola pointed to the broad definition of “capital asset” in section 1221 and market forces outside her control, such as variable interest rates, that determined the value of the right to the future payments. The circuit court, however, agreed with the Tax Court and relied on the long-standing doctrine developed by the Supreme Court holding that, with few exceptions, a lump-sum payment received in exchange for what would otherwise be a stream of ordinary income payments is treated as ordinary income and not capital gain.

The Third, Ninth and Tenth circuits have also ruled for the IRS in similar recent cases.

Shirley Prebola v. Commissioner, 99 AFTR 2d 2007-1660.

Prepared by Ryan H. Pace, M.Tax, J.D., LL.M., assistant professor of accounting, Goddard School of Business and Economics, Weber State University, Ogden, Utah.