Tax Matters

Section 1341 Clarified
As a result of unforeseen circumstances, taxpayers may discover they must repay an amount previously collected and included in income. If the tax rates or other items have changed from those that existed in the year the income was reported, the current deduction for the repayment may not completely offset the taxes paid on the prior reported income.

In these cases, the taxpayer should consider whether IRC section 1341 provides relief.

Between 1981 and 1995 Quaker State bought crude oil from independent oil producers. In 1994 these independent producers, including Lazy Oil, brought suit claiming price-fixing against Quaker State and others. In 1995 Quaker State settled the suit for $4.4 million without admitting guilt. Quaker State took advantage of the relief provision contained in section 1341 to calculate the tax result of this payment. Under it a taxpayer may reduce its current year’s tax by the amount of the extra tax paid as a result of having included the item in income in the prior year. (This reduction is in lieu of claiming the payment as an expense.) The IRS objected to Quaker State’s use of section 1341, saying the taxpayer had not met the code requirements for doing so.

Result. For the taxpayer. In its decision the U.S. Court of Federal Claims referred to the following five requirements of section 1341 and then considered whether the taxpayer had met each one:

An item must have been included in income in a prior year.
The inclusion must have occurred because the taxpayer appeared to have an unrestricted right to the income.
A deduction was allowed in the current year.
It was established the taxpayer did not have an unrestricted right to the income.
The deduction exceeded $3,000.

Section 1341(b) denies relief when an included item is from the sale of inventory (inventory exception). The parties agreed that Quaker State had met the fifth requirement. But, they disputed whether the taxpayer had met the other four requirements and whether the inventory exception denied relief. The court discussed each of these requirements in turn.

The first dispute was whether Quaker State had included an item in income in a prior year. The IRS said an understatement of an expense (cost of goods sold) was not the inclusion of an item of income; Quaker State argued it was. The court agreed with the taxpayer, saying that, because Quaker State was a manufacturer, understating its cost of goods sold was the equivalent of including an item in income. Therefore the taxpayer met the first requirement. The second disagreement was whether Quaker State had an appearance of the right to income. The IRS argued Quaker State had an actual right to the income, not just an appearance of the right: The court rejected this position. After reviewing earlier cases and commentary, the court ruled that an actual right to income is within the phrase “apparent right to income.” (Prior courts had split on this.)

The requirement that the taxpayer be entitled to a deduction has two subtests. First, there must be a deduction as the result of the restoration of the income, and, second, the deduction must occur under a code section other than section 1341. The IRS argued there was no restoration of income. The court disagreed, saying restoration does not have to be to the party that made the payment, but only to someone who reported lower income in a prior year. Therefore, this condition was met. The court then stated the payment generated a deduction under section 162, fulfilling this requirement.

The last item considered was whether the payment was the result of Quaker State’s lack of an unrestricted right to keep the income. The court ruled, based on prior cases, the requirement was met because the taxpayer made the payment as a result of a legal obligation. The requirement excluded voluntary payments. A settlement even without an admission of guilt is an involuntary payment. Therefore this requirement was met.

The IRS’s last argument was that the payment fell within the inventory exception. The court concluded, based on prior cases and the regulations, this exception primarily applied to sales returns and allowances. Since the payment was neither, it was not excluded.

This case joins others in which the courts took a very broad view of section 1341. The outcome is due, in part, to the general rule that remedial provisions should be interpreted broadly and all doubts resolved in the taxpayer’s favor. If this trend continues, more companies should be eligible to use the relief provision contained in section 1341.

Pennzoil-Quaker State Co. v. United States, U.S. Court of Federal Claims, 2004 US Claims, Lexis 281.

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

Note Sale: Does It Accelerate Related-Party Interest Deductions?
An accrual-basis taxpayer normally takes deductions for expenses in the year the item accrues. But when the expense accrued by the taxpayer is owed to a related party who uses the cash basis of accounting, IRC section 267(a)(2) delays the deduction for the accrual-basis taxpayer to the year in which the related party includes the amount in gross income, the year of payment. Related parties include certain family members, such as spouses, children, parents and siblings, as well as individuals and corporations in which an individual owns directly or indirectly more than 50% of the stock.

Ronald Moran Cadillac (RMC) was a car dealer franchise operating in California. Prior to 1994 it had borrowed $2,339,929 from its 100% shareholder. The amount of the loans and all accrued interest were recorded on a note on January 1, 1994. The pre-1994 interest of $787,994 had not been deducted by the taxpayer due to the restrictions of IRC section 267(a)(2). On September 20, 1994, the shareholder sold the note and all accrued but unpaid interest to an unrelated third party, resulting in a capital loss of $500,000. On its 1994 federal income tax return, RMC deducted interest of $1,049,657, creating an $810,267 net operating loss (NOL). The IRS disallowed the pre-1994 interest of $787,994, thereby eliminating the NOL. RMC filed a claim for a refund with the U.S. District Court of California, arguing that once the note was sold by its shareholder to an unrelated third party, the restrictions of section 267(a)(2) were no longer in effect. Therefore, it now could deduct the previously disallowed interest of $787,994.

The IRS argued that once section 267(a)(2) disallowed a deduction for an accrued expense for a given tax year, the expense could not be deducted until it was paid. The replacement of the former creditor who was a related party with a new creditor who was not did not accelerate the deduction of the previously disallowed accrued interest. The district court agreed, saying the IRS’s interpretation was supported by the language of the statute, Treasury regulations and congressional intent. RMC appealed the decision to the 9th Circuit Court of Appeals.

Result. For the IRS. The 9th Circuit agreed section 267(a)(2) disallowed a deduction by an accrual basis payor until the tax year in which the payee included the amount as income. RMC acknowledged it had not paid any of the pre-1994 interest of $787,994 to the new creditor; the court ruled RMC, therefore, could deduct that interest only in the year it was paid. RMC argued the IRS had taken an inconsistent position since, in 1994, it had allowed the franchise to deduct the accrued interest for the first eight months of that year when the 100% shareholder held the note, but it had not allowed RMC to deduct the accrued interest for pre-1994 years. The court rejected this argument as well, saying section 267(a)(2) required determination of related-party status be made at the end of the tax year. Since RMC and the new creditor were not related parties at the end of 1994, section 267(a)(2) did not apply to any interest for that year. However, because RMC and its 100% shareholder were related parties at the end of the tax years prior to 1994, section 267(a)(2) did control when the interest for those years should be deducted.

RMC further argued that the sale of the note by its 100% shareholder to the unrelated third party converted the accrued interest prior to 1994 into a new liability, thus permitting the taxpayer to accrue and deduct the entire amount in 1994. The court also rejected this argument. It said once the restrictions of section 267 applied to an accrued expense, they continued to apply until the expense was paid. Therefore, no deduction was allowed until the interest was actually paid. Any acceleration of the deductions of the interest due to the sale of the note would have been contrary to the purpose of section 267.

Ronald Moran Cadillac, Inc. v. United States 385 F3d 1230 (CA-9).

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

Tax Shelter Can Have Business Purpose
The IRS has been developing policies to attack a variety of tax shelters including the contingent liability shelter, in which a high-basis asset is transferred to a new corporation in exchange for stock in an IRC section 351 transaction. The transferred asset is accompanied by a contingent liability—a liability that the transferor has not yet been able to recognize for tax purposes. Consequently, the stock received has a high basis though its value is low because of the contingent liability, and selling it results in a loss. In notice 2001-17 (2001-1 CB 730) the IRS announced it would disallow losses claimed from contingent liability transactions.

Black & Decker created Black & Decker Healthcare Management Inc. (BDHMI) by transferring $561 million to the newly formed corporation. BDHMI assumed a $560 million contingent liability for health care claims; its resulting value was $1 million ($561 million less $560 million). Black & Decker then sold the BDHMI stock for $1 million and claimed a capital loss of $560 million ($1 million less $561 million), which it used to offset capital gains from the sale of three of its businesses. The IRS disallowed the loss. Black & Decker sued for a refund.

Result. For the taxpayer. The District Court of Maryland (Northern Division), issued a summary judgment holding that the BDHMI transaction had economic substance and therefore must be acknowledged. Pointing out that a sham transaction can be ignored for tax purposes as discussed in Hunt (938 F2d 466, 471 (4th Cir. 1991)), the court reiterated the definition of a sham transaction as one designed solely to create tax benefits rather than to serve a legitimate business purpose. In Rice’s Toyota World (752 F2d 89, 90 (4th Cir. 1985)), the court determined that a transaction would be treated as a sham if “the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and the transaction has no economic substance because no reasonable possibility of profit exists.”

Although Black & Decker conceded that tax avoidance was its sole motivation for the transaction, the court held that the second part of the definition was not satisfied, as the transaction did contain economic substance. Because BDHMI assumed the responsibility for the management, servicing and administration of Black & Decker’s health plan, considered and proposed numerous health care cost containment strategies, and maintained salaried employees, the transaction had very real economic implications for participants in Black & Decker’s health plan and should not be treated as a sham transaction.

The IRS’s plan to challenge tax shelters has important implications for all tax-avoidance plans. Although the IRS lost this case, it will continue to aggressively litigate any transaction considered a tax shelter. Still, this case indicates transactions that have economic substance aside from the tax benefits have a good chance of being upheld in the courts.

Black & Decker Corp. v. United States (DC MD 10/20/2004).

Prepared by Ronald R. Hiner, EdD, and Darlene Pulliam, CPA, PhD, professors of accounting at T. Boone Pickens College of Business, West Texas A&M University, Canyon.