Tax Matters

Tax Matters

TAX NEWS

Donating Excess Inventory to Charity

CPAs may want to remind clients with excess inventory that they can earn a federal tax deduction when the product is donated to charity. Corporations with a fiscal year ending December 31 should be urged to check their inventory levels now. Clients that have difficulty finding an organization to take their product can contact the nonprofit National Association for the Exchange of Industrial Resources at 800-289-4551. The organization will send them a free guide to the donation process.

Last Known Address Program Delayed

Last year the IRS announced that, effective May 1, 2000, a new program would allow it to update taxpayers’ addresses using the U.S. Postal Service’s national change of address (NCOA) database. Previously a taxpayer’s “last known address,” although not defined by statute or regulation, had been determined by case law to be the address that appeared on the taxpayer’s most recently filed and properly processed return. Furthermore, the IRS issued proposed regulations to reflect this new definition. But in announcement 2000–49, the IRS said it would delay the program’s start because it could not complete by May all the steps necessary to implement the regulations. The service did not give a new start date.

Tip Compliance Programs Widened

The IRS expanded its voluntary tip compliance programs from the food and beverage, gaming and hairstyling industries to all those in which tipping is customary (announcements 2000-19 and 2000-23; notice 2000-21). In exchange for an employer’s or employee’s participation, the IRS agrees to refrain from tip examination.

Employers may participate in either the Tip Rate Determination Agreement (TRDA) or the Tip Reporting Alternative Commitment (TRAC). Under a TRDA, the IRS and the employer determine the amount of tips that employees receive and the amount they should report to the IRS. Under a TRAC, the employer agrees to educate employees about tip income requirements and to establish tip reporting procedures.

TAX CASE

Expensing Corporate Activities

One of the most difficult questions a company faces is whether it must capitalize an expenditure or whether it can deduct it. Minor variations in the facts can greatly affect the answer to the question.

American Stores Co., a corporation that filed consolidated tax returns, owned and operated a large number of food and drug stores. The company made a tender offer to acquire 100% of the stock of a competitor, Lucky Stores. It notified the Federal Trade Commission of its intention, as required by law. The FTC required the taxpayer to hold the target company separate until it reached an agreement with the commission on certain divestitures. The parties reached an agreement and the FTC issued a final consent to the Lucky Stores acquisition.

The following month the state of California obtained a temporary restraining order requiring American Stores to continue to hold Lucky Stores separate. American incurred significant legal fees relating to the FTC proceedings. It capitalized these fees on its tax return. American Stores also incurred $1,074,867 in legal fees in 1988 and $2,666,045 in 1989 in connection with the California litigation. The company capitalized these amounts for book purposes but deducted them for tax purposes. The IRS issued a notice of deficiency requiring the company to capitalize the fees.

Result. For the IRS. The government argued the expenditures were capitalizable under Indopco. Specifically, it argued that the expenditures were not ordinary and necessary expenses of carrying on a business. Rather, they were part of the cost of acquiring a capital asset.

American Stores responded that in numerous cases the courts allowed a company to deduct expenditures incurred to defend its business and policies. Since it had received FTC approval for the acquisition, the company felt it was defending its business against a challenge by the state of California. The Tax Court acknowledged that while similar expenses were deductible in some cases, an expediture that was deductible in one context may have to be capitalized in another. Therefore, in making its decision, it looked at the context in which the questioned expenditures arose.

The court applied the origin-of-the-claim doctrine to determine the deductibility of the expenditures. Under this doctrine, an expenditure’s origin and not its purpose determines the tax treatment. In this case, the origin was an antitrust suit to prevent the company from acquiring stock or assets that would lessen competition or create a monopoly. Therefore, the origin of the suit was acquisition of a capital asset. The fact that title had already passed was immaterial. The companies had not yet actually merged. They had been held separate as a consequence of California’s “hold separate” order. That meant the expenditures were not made by a single business to defend its decisions. Because the origin was the acquisition of an asset, the expenditures should have been capitalized for tax purposes and not deducted.

In reciting the facts of the case, the Tax Court noted that the company accounted for the acquisition as a purchase, not a pooling, and capitalized the expenditures for book purposes. It did so because the purchase method of accounting treats the expenditures as liabilities of the target company assumed by the acquiring company. As the court did not mention these facts in the opinion, it’s impossible to know what impact they had on its thinking. However, the accounting treatment’s classification of these expenditures as part of the acquisition and not as ordinary expenses of a unified business may have helped the court reach its decision. In any event, taxpayers need to be able to prove they are entitled to a deduction and not rely on the fact that such expenditures are generally deductible by similar taxpayers.

American Stores Co. v. Commissioner, 114 TC no. 27.

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

LINE ITEMS

Black Tie Not An Option: Appeals Are Informal

The 1998 IRS Restructuring and Reform Act contained a taxpayers bill of rights. one provision expanded taxpayers’ due-process protections when dealing with collection matters: IRC section 6330 gives taxpayers the right to a “collection due-process” hearing in the IRS appeals office before a levy can be issued.

In Davis v. Commissioner, 115 TC no. 4 (2000), a taxpayer timely requested an appeals hearing, but his additional request to subpoena witnesses and documents was denied.

According to the Tax Court, hearings at the appeals level historically have been informal. The court could find nothing in IRC section 6330 or the legislative history of the 1998 act that suggested that Congress intended to change the informal nature of these hearings.

Error on 1999 Form 1040 PC May Trigger IRS Letter

Some taxpayers that used the form 1040 PC format to report their 1999 capital gains have received letters from the IRS saying they owe additional taxes.

These taxpayers received capital gain distributions from a mutual fund that were subject to the maximum tax rate of 20%. If the taxpayers included these distributions on line 13 of form 1040 and checked the accompanying box, they did not have to file schedule D.

However, form 1040 PC, as originally issued, did not include this box. So if a taxpayer used old return preparation software to report 1999 capital gains, he or she may have gotten a letter.

The IRS has said that it has no idea about how many taxpayers may be affected. If you or your client received a letter, you should either submit the information the service is requesting or file an amended return and treat the distribution as a long-term capital gain.

No Deduction for Homeowners’ Association Loan

The IRS ruled that an individual may not deduct the interest a homeowners’ association paid on a loan obtained to restore one of the common elements in the community. The regular and special homeowners’ assessments, a deed of trust on the common area and the homeowners’ dues secured the loan. One homeowner felt that since he was being assessed to pay off the loan he should be allowed to deduct the interest as qualified residence interest under IRC section 163(h)(2).

In LTR 200029018, the IRS said that because the homeowner’s principal residence wasn’t collateral for the loan and he had not undertaken any personal obligation on it, the interest deduction was denied.

No Summons Required for a Preparer

In a legal memorandum, the service said that an IRS employee—conducting an earned-income-credit due-diligence audit of a return preparer—does not have to provide a summons to the preparer to examine any documents that may be relevant or material to the inquiry of the preparer’s potential liability under IRC section 6695(g).

The service also advised that the preparer couldn’t refuse to provide the information based on the tax advice privilege under IRC section 7525. According to the memorandum, the attorney-client privilege under IRC section 7525 pertains to tax advice only and not to return preparation advice (LTR 200029008).

When an IRA Transfer Isn’t a Transfer

Under IRC section 408(d)(6), the transfer of an individual’s interest in an IRA to his spouse or former spouse under a divorce or separation instrument is not a taxable event. However, in order for it to be tax-free, the transfer must actually go to the spouse or former spouse.

In Jones v. Commissioner, TC Memo 2000-219, the taxpayer owned an IRA, which he gave to his wife in a divorce settlement agreement. However, instead of changing the account to his wife’s name or transferring the funds to her IRA, he had a check issued to himself for the entire account balance, which he endorsed over to his wife.

The IRS said that the check amount was currently taxable to the husband plus a 10% penalty for early withdrawal because he transferred cash and not the IRA to his wife.

The Tax Court agreed with the service and ruled that the endorsement of the check was not a transfer of his interest in the IRA because his interest was extinguished when he withdrew the funds.

Mixing Apples and Dentistry

A dentist and his wife operated a dental practice. They also maintained an apple orchard. The dentist recommended that his patients eat apples, and he and his wife sold their apples to the patients. On their federal income tax return, the couple attempted to offset the losses from the apple orchard against earnings from the dental practice.

The IRS stated that the apple orchard lacked a genuine profit motive, and the Ninth Circuit Court of Appeals agreed. According to the court, the apple orchard and the dental practice were separate activities, which could not be aggregated. The loss relating to the apple orchard was denied because IRC section 183 limits the deductibility of business activity losses to for-profit activities (Zdun v. Commissioner, CA-9; July 5, 2000).

An IRA of Her Own

A couple filed for divorce and, as part of the settlement, the husband agreed to give a portion of his IRA to his former spouse. According to IRC section 408(d)(6), this trustee-to-trustee transfer is tax-free. The husband, although he was under 5912 years old, had already begun receiving substantially equal periodic payments without incurring penalties.

The former wife asked whether she would have to continue to withdraw substantially equal periodic payments from the IRA. The IRS said that since the IRA was now hers, she was not required to continue the withdrawals (PLR 200027060).

Couple Charged With Filing False Returns and Fraud

A pharmacist was president, sole shareholder and an employee of a company that operated two pharmacies. His wife kept the books for the company. However, an independent accounting firm prepared the corporate tax returns and the couple’s individual returns.

To record the company’s cash receipts and disbursements, the accounting firm gave the couple worksheets, which included a column for personal cash withdrawals.

The couple failed to record substantial amounts of personal cash payments. They did not disclose these unrecorded withdrawals to the accounting firm.

An IRS auditor was unable to reconcile the worksheets to the bank statements. So the audit was expanded to include the couple’s joint tax returns.

The couple were indicted and convicted of two violations of IRC section 7206(1) for filing false income tax returns. They conceded the unreported income issue, but contested the additional taxes for fraud and substantial understatement of tax.

The Tax Court found clear and convincing evidence of fraud on the couple’s part because they (1) understated their income, (2) maintained inadequate records, (3) gave implausible or inconsistent explanations and (4) had an intent to mislead (Philip E. Parsons v. Commissioner, TC Memo 2000-205).

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