TAX MATTERS

TAX BRIEF

ON THE LINE FOR A PHONE TAX REFUND?
re your clients using the standard formula for their refund of federal excise tax (FET) on long-distance phone service? The IRS made it easy: Just compare the FET rates on phone bills for April and September 2006—before and after phone companies quit collecting the tax on anything other than local service—and multiply the difference by the total spent on phone bills for the 41 months the refund covers.

Maybe that’s a little too easy, say consultants offering “FET recovery” services. For many enterprises, the actual excise tax paid is more than double the amount the formula allows, says John Manickam of Wingspread Business Support Services of Raleigh, N.C. (www.wingspreadbss.com). Details are available in The Handbook for Telecommunication Federal Excise Tax Refund, by Manickam and Michael S. Plude, CPA, which is available for $65.99 as a book or download from www.fet-refundhandbook.com. Telecommunications expense management companies also offer the service. Although the refund can be claimed only on 2006 returns, businesses that used the formula may find it worthwhile to file an amended return with actual tax paid, Manickam said.

TAX CASE

LOAN PREMIUM NOT LIABILITY
any taxpayers have been able to reduce their taxes in transactions involving contingent liabilities, leading Congress to change subchapter C and the Treasury Department to change the regulations under IRC section 752. In July 2006, a district court reviewed the definition of a liability and Treasury’s ability to make regulations retroactive and ruled in favor of the taxpayer.

St. Croix Ventures and Rogue Ventures, single-member LLCs, each borrowed $41.7 million from a bank at 17.97% interest. They each received the principal and a $25 million “loan premium” in exchange for the above-market interest rate. The loans required interest for seven years and repayment of principal at the end of the period. The LLCs agreed to pay a declining penalty if they repaid the loans early. Each LLC invested its total amount, $66.7 million, in Klamath LLC and Kinabalu LLC, respectively, for 90% partnership interests. The partnerships assumed the debt. Several months later, St. Croix and Rogue withdrew from the partnerships. The partnerships repaid the debt and distributed cash to the LLCs. The IRS classified the $25 million loan premium as a liability; the taxpayer disagreed.

Result. The court first decided whether the loan premium was a liability for purposes of IRC section 752. At the time of this transaction, in 2000, the regulation did not define a liability. Prior cases—Helmer v. Commissioner and Long v. Commissioner—held that contingent liabilities are not liabilities for purposes of section 752. A contingent liability is one that is not fixed; it does not become a liability until it becomes fixed or liquidated. Since the loan premium was not repayable unless the loan was prepaid, and that event was not certain to occur, the loan premium was contingent and not a liability.

The government also argued the contingent amounts had to be classified as liabilities to maintain the equality of inside and outside basis. The court acknowledged that much of partnership taxation is designed to maintain this equality. However, it does not always exist. In fact, the government has argued against equality when it was in its interest to do so. Therefore, the court rejected the need for equality when a disparity served the taxpayer’s interest.

The final issue was whether Treasury Regulation section 1.752-6, issued June 24, 2003, could be applied retroactively to affect the outcome of the case. Regulations are not generally applied retroactively, but they can be. Before examining the general rules for retroactive regulations, the court said the level of deference accorded an interpretive regulation was less than for a statutory regulation. Since the court ruled the regulation was interpretive, it considered the general rules for retroactive regulations. The court listed four items that affected the decision: (1) whether the taxpayer was reasonable in relying on prior law or policy; (2) whether Congress implicitly approved the prior law by re-enactment of relevant code sections; (3) whether retroactive application would cause equal taxpayers to be taxed differently; and (4) whether retroactive application would result in a harsh outcome. The court concluded that factors 1, 2 and 4 favored the taxpayer and 3 was neutral and denied retroactive application of the regulation.

In May 2005, the Treasury Department issued final regulation section 1.752-7, which approaches contingent obligations differently than the regulation in question in this case and the approach taken for corporate taxpayers. This case is still relevant for the definition of liabilities and the retroactivity of regulations.

Klamath Strategic Investment Fund LLC v. United States, 440 F. Supp.2d 608; 98 AFTR2d 2006-5495 (DC Tex., 2006).

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

TAX CASE

PERSONAL LOAN GUARANTEE NOT BASIS
osses from an S corporation flow through to its shareholders, who can deduct them on their individual tax returns as long as they have sufficient basis to absorb them. Economic outlays such as capital contributions and loans by a shareholder to an S corporation will increase a shareholder’s basis. Generally, loan guarantees, pledges of collateral and other forms of indirect borrowing are not considered economic outlays. The Eleventh Circuit Court of Appeals created an exception in Selfe v. U.S., 778 F.2d 769, in which a taxpayer borrowed money and later loaned that money to her newly formed S corporation. The corporation then assumed her liability for the loan, but the bank required the taxpayer to personally guarantee its repayment. The court permitted a basis increase because of the loan guarantee, since the substance of the transaction showed she was the primary obligator on the loan.

Last year, the Sixth Circuit refused to apply the Selfe exception to a case in which the taxpayer cosigned on the loan but the bank never sought payment from him.

William Maloof was the sole shareholder of Level Propane, Petroleum & Gases Co., which borrowed $4 million from a bank. Maloof personally guaranteed the loans by pledging all of his stock in it and other S corporations and a $1 million insurance policy on his life. Level Propane defaulted on the loan and was forced into bankruptcy, but the bank did not demand payment. From 1990 to 2000, Level Propane sustained large losses. Maloof increased his basis by $4 million because of the loan guarantee and then deducted the losses on his individual return. The IRS took the position that no increase in basis was warranted, disallowed the losses and assessed a tax deficiency against him. Maloof petitioned the Tax Court.

Maloof argued that his personal guarantee of the loan and the pledging of his stock and insurance policy constituted economic outlays that increased his basis. The Tax Court rejected this argument, stating the bank never sought his personal assets for repayment of the loan. The taxpayer also argued he had an economic outlay because he incurred a “cost” when he lost control of the corporation. No evidence was presented supporting any loss of control, nor was any evidence offered that measured a cost related to that loss. Finally, the taxpayer argued that, in substance, he had borrowed the money and in turn transferred it to the corporation and that the holding in Selfe should be followed. The court ruled the Selfe holding did not apply because Maloof never personally borrowed any money and the bank never sought any payments from him (see “Tax Matters,” JofA, Mar.06, pages 78–79). Maloof appealed to the Sixth Circuit.

Result. For the IRS. The appeals court said Maloof’s basis could be increased if the corporation was indebted to him or if he had incurred a cost evidenced by an economic outlay. The loan agreement clearly showed the corporation as the borrower, and the corporation would be indebted to him only if he used personal assets to pay the corporate loan. Even though the taxpayer cosigned the loan, the bank never sought his assets for repayment. Based on this, the court concluded Maloof never incurred any type of economic outlay.

This decision marks another defeat for taxpayers attempting to increase their S corporation’s stock basis with a loan guarantee. It should also be noted that if the taxpayer had shown that the loan was his, the interest payments made by the corporation to the bank on his behalf would be constructive dividends. He still would have had some additional tax liability.

William H. Maloof v. Commissioner, 456 F.3d 645.

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

TAX CASE

FULL DEDUCTION ON MEAL REIMBURSEMENTS
nder IRC section 274(n), employers generally may deduct only half their reimbursements to employees for meals and entertainment. But employee-leaseback arrangements—notably in the trucking industry—have mapped a route through the section’s several exceptions.

Many smaller trucking carriers use a professional employer organization (PEO) to reduce their costs. One PEO, Transport Labor Contract/Leasing (TLC), in 2004 had 5,563 driver-employees leased to 453 trucking company clients. TLC paid per diem reimbursements to its drivers and billed its trucking company clients for these amounts. In 2004 the Tax Court said TLC was subject to the 50% limitation because it, rather than the trucking companies, was the “common-law employer.” Although the trucking companies made recommendations on which drivers to hire, the Tax Court noted that TLC screened and eliminated some candidates and retained the right to lease a driver to any of its trucking clients. TLC appealed to the Eighth Circuit.

Result. For the taxpayer. If the reimbursement is wages, the 50% limitation is on the employee, but the limit shifts to the employer for expense reimbursements. However, an employer can escape the limit if the payments qualify under the IRC section 274(e)(3) exception, because they are “paid or received by one person…under a reimbursement or other expense allowance arrangement with another person other than an employer.” The appeals court said TLC qualified for this exception because it was the employer performing services for a “person other than an employer” under a proper reimbursement arrangement.

The Eighth Circuit also said it did not disagree with the Tax Court’s decision in Beech Trucking, 118 T.C. 428 (2002), in which the Tax Court applied the limitation to a trucking company that was the common-law employer. But when a PEO is the employer, it should qualify for the exception if it can substantiate a “reimbursement or other expense allowance arrangement” as defined by 1.62-2(c) through (f) of the Treasury Regulations. The trucking company, not the PEO, actually bore the expense and thus should be subject to the limitation, the appeals court said.

If the PEO is the common-law employer, it can escape the limitation by qualifying for the section 274(e)(3) exception. And if the PEO is not the employer, it also should escape, because the limit will be applied to the trucking company, as in Beech. The only way for a trucking company to escape the limit under the Eighth Circuit’s approach is to argue that the PEO is the common-law employer and that the reimbursement arrangement or accounting does not qualify under the regulations.

Transport Labor Contract/Leasing Inc., 98 AFTR 2d 2006-6143.

Prepared by R. Dan Fesler, CPA (inactive), CIA, CMA, professor of accounting, and Larry Maples, CPA (inactive), Alumni Professor of Accounting, Tennessee Technological University, Cookeville, Tenn.