TAX MATTERS

TAX CASE

ALLOCATING TAX DEFICIENCIES
n specific instances, IRC section 6015 provides relief from joint and several liability imposed on joint tax returns. When a taxpayer qualifies for this relief, it is necessary to allocate the tax deficiency between the taxpayers who filed the joint return. The Tax Court recently examined the methodology for making this allocation.

Ingrid Capehart and Robert J. Capehart filed a joint return for 1994 on which they incorrectly claimed a $37,239 loss on the sale of business property and a $4,183 theft loss. The IRS did not allow these deductions; instead, it determined an $8,225 tax deficiency and levied a $507 accuracy penalty. Ingrid computed her share of the deficiency and penalty and filed for relief under IRC section 6015(c).

Result. For the IRS. Section 6015(c) allows a divorced or separated spouse who previously filed a joint return to calculate his or her deficiency based on the portion of incorrect items the spouse had generated, rather than holding each spouse liable for the entire deficiency under the joint and several liability rule. Both sides agreed that Ingrid qualified for this relief; they disagreed on the actual computation of the tax due from each person.

Ingrid’s share of the deficiency was the total deficiency multiplied by the ratio of her share of the erroneous items to the total amount of such items. To correctly determine her share, she should have allocated the erroneous items—that is, the actual erroneous items plus any recalculated deductions that resulted from them—as if she and Robert were filing separate returns. The inclusion of the erroneous items would have increased the Capeharts’ adjusted gross income and reduced the allowable medical expense deduction. This recalculated deduction was also an erroneous item that should have been allocated equally unless the taxpayer could prove a different allocation is appropriate.

There is an exception to this proportional allocation method that requires reallocating the erroneous item to the taxpayer who received a tax benefit from it. Using the proportional allocation method, Ingrid would have determined her share of the erroneous items was $21,282. If she had filed a separate tax return reporting only her items of income and deduction, her taxable income would have been $14,204. Under the tax-benefit exception, she would have been allocated only $14,204 of the erroneous items (an amount equal to her separate taxable income). The remaining $7,078 of erroneous items ($21,282 – $14,204) would have been allocated to Robert.

The Treasury Department allows taxpayers to use yet another alternative method of allocation but only when there are differing tax rates for the erroneous items. For example, a taxpayer who understates both capital gains and interest income qualifies for a special allocation because a different tax rate applies to each item. The court rejected Ingrid’s alternative method because all erroneous items were subject to the same tax rate.

The accuracy-related penalty is allocated to the spouse whose item generated the penalty. This rule interacts with the tax benefit exception. To calculate the accuracy-related penalty for each party, multiply the tax due after final allocation of the erroneous items by the 20% penalty rate.

The Tax Court accepts the allocation methods prescribed by the tax code and regulations; allocations based on equity arguments fail. Taxpayers should use only the methods detailed in the case study to calculate a spouse’s tax liability under section 6015(c).

Estate of Robert J. Capehart and Ingrid Capehart v. Commissioner, 125 TC no. 10.

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

TOLL PHONE SERVICES NOT SUBJECT TO EXCISE TAX
ecently the District of Columbia Circuit Court of Appeals joined the Sixth and Eleventh Circuits in holding that the federal communications excise tax does not apply to telephone charges calculated solely on a time basis. IRC section 4251 imposes a 3% excise tax on telephone charges based on both the time and the distance of the calls.

When calculating the monthly service charges for the National Railroad Passenger Corporation (Amtrak), the telecommunications company, IBM, considered only one of these factors—the number of minutes the company used. After paying the excise tax, Amtrak filed for a refund. When the IRS did not respond, Amtrak sued in the D.C. district court claiming IRC section 4251 did not apply to telephone charges based on only one variable (in this case, time). When the district court granted summary judgment, the IRS appealed to the D.C. Circuit.

Result. For the taxpayer. In December 2005 the D.C. Circuit held that telephone charges based only on the minutes used were not subject to the communications excise tax.

IRC section 4251 imposes an excise tax on the cost of “toll telephone service,” defined in IRC section 4252(b)(1) as a telephonic communication for which there is “a toll charge which varies in amount with the distance and elapsed transmission time of each individual communication.” The court had to determine whether Congress meant to use the word “and” conjunctively or disjunctively. If a conjunctive interpretation was intended, the tax would be imposed only if the charges were computed based on the time and the distance of the calls. However, a disjunctive interpretation would cause the tax to apply if the charges were based on time or distance.

The IRS argued section 4252 applied to charges for telephone service based either on distance or time. It cited cases in which the Supreme Court decided it was necessary to read the word “and” disjunctively to realize Congress’s intent.

The D.C. Circuit acknowledged that Congress occasionally used the word “and” disjunctively but deemed it did not in this instance. In 1965, when Congress last amended section 4252, AT&T was the only long-distance provider. Congress used the word “and” in the legislation because it mirrored one of AT&T’s calling plans. The court concluded that the legislators used “and” conjunctively as they intended to tax all of the then-existing long-distance plans. Forty years later, AT&T was no longer the sole provider of long-distance services, and many of the new carriers charged customers based only on the number of minutes actually used. The court noted that Congress initially had intended to phase out the excise tax by 1968 and therefore found it unlikely the legislators meant section 4251 to apply to all future long-distance telephone charges. (After several extensions the tax became permanent in 1990.)

The D.C. Circuit disregarded revenue ruling 79-404, which involves only time-based charges. The IRS conceded that the literal language of section 4252 did not include charges based only on time but contended that taxing these charges was consistent with the statute’s intent. The court determined the IRS’s interpretation had enlarged the statute’s unambiguous language. Further, it held that Congress did not implicitly adopt the revenue ruling when it extended the excise tax.

The confusion over section 4252 results from the varied types of modern communications packages. A “plain-meaning” reading of the statute exempts some current rate structures from the excise tax; however, this does not obscure the statute’s legislative intent. Only Congress can amend tax code language to meet current industry practices.

National Railroad Passenger Corp. v. United States, no. 04-5421, CA-DC.

Prepared by Laura Lee Mannino, CPA, LLM, assistant professor of accounting and taxation, St. John’s University, Jamaica, New York.

TAX CASE

IS DISPUTED PARTNERSHIP INCOME TAXABLE?
he claim of right doctrine requires taxpayers who receive disputed income to treat it as taxable income if there are no restrictions on how they can use this money. When there are restrictions—as when the disputed money is in an escrow account—they pay taxes on the disputed amount only when and if they receive the money.

In 1993 Timothy Burke, an attorney and CPA, joined a partnership. In 1996 the partners orally agreed to a new method for dividing partnership income for the years 1996–1998. In 1998 Burke’s partner denied he had consented to the new arrangement. Later that year, the two partners agreed to place all partnership profits (after expenses) into an escrow account until they resolved their differences.

The partnership return for 1998 showed $242,000 of partnership profits; $121,000 appeared on Burke’s schedule K-1. Since he was unable to use the money, Burke did not report it on his individual tax return. The IRS made a deficiency assessment of $41,338. Burke petitioned the Tax Court for relief.

Result. For the IRS. Burke referred to IRC section 703(a), which requires a partnership’s taxable income to be computed in the same manner as an individual’s taxable income, and cited a series of cases in which individuals did not have to report taxable income that had restrictions on the money’s use. He argued that he did not have to report the income until resolution of the dispute because the partnership had deposited the money in an escrow account, which restricted his use of it.

The court disagreed, stating that IRC section 703(a) merely described how a partnership calculates its taxable income before dividing that amount among the partners. Regulations section 1.702-1(a) specifically states that partners must report their individual distributive shares of partnership income even when the amount is not distributed. The court cited a series of cases in which a partner had to report his or her distributive share in the year the partnership reported the income even though the parties contested the amount of each partner’s share. The court further stated that the cases cited by the taxpayer did not apply since none of them involved a partnership or its distributive shares.

It is important to note how the court applied the claim of right doctrine. The partnership had unrestricted use of the receipts—the partners only disputed the division of the money. If the partnership had placed the receipts in an escrow account as the result of a dispute with a third party, under the claim of right doctrine the receipts would not be included in its income until the matter was settled and the partners would need to report income only if the dispute was settled in its favor. In this case, however, “there was nothing conditional or contingent about” the partnership’s income, and therefore each partner had to report his or her distributive share of that income, even though the partnership contested the exact amount of that distributive share.

Timothy Burke v. Commissioner, TC Memo 2005-297.

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