TAX MATTERS

TAX BRIEFS

CORPORATIONS AND PARTNERSHIPS TO TELL MORE ABOUT OWNERSHIP
The IRS issued proposed revisions to Form 1120, U.S. Corporation Income Tax Return, and Form 1065, U.S. Return of Partnership Income, that would ask for more ownership information. Corporations would be required to identify individuals who own at least 50% of the voting power of all classes of the corporation’s stock entitled to vote and entities holding at least 10% of voting power. The reporting corporation also would have to identify other foreign or domestic corporations, partnerships or trusts in which it owns at least 10% of voting stock or interest, as well as any disregarded entity it owns. Partnerships would list entities having a 10% or greater ownership interest in them directly or indirectly, along with entities in which the partnership owns at least a 10% interest. In addition, corporations with more than $10 million in assets would be asked about transfers of interest, cost-sharing arrangements and changes in accounting methods. Pending the results of comments received in August and September, the IRS plans to have the revised forms and related schedules ready for tax years ending on or after Dec. 31, 2008.

GOVERNMENT EMPLOYMENT TAX DELINQUENCIES IMPROVED
The IRS has improved its coordination among offices to collect approximately $45 million in delinquent payroll taxes owed by federal government units, plus that owed by state and local governments, the Treasury Inspector General for Tax Administration reported. The report followed a 2002 TIGTA audit finding that more than 12,000 government entities at all levels were delinquent in reporting or paying employment taxes. TIGTA said then that the IRS Tax Exempt and Government Entities Division, which contains the Federal, State and Local Governments office, lacked an effective agreement with the Small Business/Self-Employed (SB/SE) Division, which is responsible for collecting delinquent employment taxes, including those of governmental entities. Since then, a working group between the divisions and special unit established by SB/SE to address federal government agencies has helped, TIGTA said. Still, TIGTA said, the IRS should take additional steps to identify and address reasons for the delinquencies, strengthen case controls and develop strategies for dealing with federal fiscal constraints upon paying prior-year debts from current-year appropriations.

AICPA ASSESSES FORM 990 REDESIGN
The AICPA proposed a list of suggestions for the IRS to mitigate what the Institute considers increased burdens that will result from the new draft of Form 990, Return of Organization Exempt From Income Tax.

The AICPA’s 990 Task Force said the changes improve transparency of reporting, aiding in performance assessment and oversight. The panel is concerned, however, that rushing implementation of the changes will impose significant costs on taxpayers and the IRS and may deter taxpayers’ efforts to improve the overall quality of tax reporting.

The panel recommends the IRS add an executive summary to highlight key information and give users at least a year to implement changes after the reporting requirements have been finalized and published.

The AICPA’s recommendations to accommodate successful implementation of the redesigned Form 990 include:

Timely communication with Form 990 users throughout the development process.
Development and testing of systems to process new reported information, including strategizing on alternatives to improve enforcement effectiveness.
Communication of reporting requirements to software developers.
Seeking feedback from other regulatory agencies on the changes.
Educating reporting organizations and their advisers on the changes to give them time to implement internal reporting changes.

The AICPA also recommends changes to enhance clarity and consistency in compensation reporting.

The AICPA’s letter to the IRS commenting on the redesigned Form 990 is available at www.irs.gov/pub/irs-tege/redesignedform990comments_aicpa.pdf or http://tax.aicpa.org/.

TAX CASE

SON OF BOSS GOES INTO OVERTIME
As a general rule, the statute of limitations on income tax returns is three years, extended to six years under section 6501 for a substantial omission of gross income. Courts in recent tax shelter litigation involving overstatement of basis have declined to apply the longer period. However, a recent district court decision in Florida extended the statute in a “Son of BOSS” basis dispute.

Nelson Jefferson was the majority owner of Florida Electronic Supply Inc. (FES), an S corporation. To sell his low-basis stock, he engaged in a tax shelter the IRS has labeled “Son of BOSS”—a variation on an earlier scheme known as Bond and Options Sales Strategy. In simple terms, these transactions use a new partnership, a contingent liability and a section 754 election to create an increase in basis to eliminate gain.

In November 1998, Jefferson formed Brandon Ridge Partners and Brandon Ridge Inc., an S corporation. He contributed to the partnership his FES stock and the $3.2 million proceeds of a short sale of Treasury securities, along with an obligation to cover the sale. The partnership in turn contributed an interest in nearly all its assets to Brandon Ridge Inc., which Jefferson claimed allowed the partnership to increase its basis by $3.2 million. Then the partnership sold the FES shares to a third party for $3.3 million, on which it claimed only a $31,000 gain on its 1998 return, which it filed in September 1999. Jefferson filed his individual return that October.

In February 2006, the IRS adjusted the gain to $3.2 million. (An earlier summons to the now-defunct law firm of Jenkins & Gilchrist allowed the Service to meet the six-year limit.) Jefferson argued that the three-year statute of limitations barred the adjustment, pointing out that the Tax Court in Bakersfield Energy Partners and Court of Federal Claims in Grapevine Imports had ruled in taxpayers’ favor on this issue this year (see “You Say Omit, I Say Understate,” JofA, Sept. 07, page 83). In these cases, the courts based their opinions on the Supreme Court’s decision in Colony Inc. v. Commissioner that the extended period requires an omission of gross income, and that a basis overstatement is not an omission.

In the current case, the district court ruled in favor of the IRS based on three factors: First, the language in section 6501 has been changed since the 1958 Colony decision to apply only to sales of goods or services by a business, the court said. Second, the court noted that section 6501 refers to an income amount for income tax, versus an item for estate and gift tax. It reasoned that since increased basis leading to understated income is part of the amount of reported income, the extended statute could apply. Third, the court addressed Jefferson’s alternate argument that the stock sale was adequately disclosed and thus the three-year period should apply. But in this case, neither the partnership nor the individual return disclosed the contingent liability—the completion of the short sale—which was the real reason for the adjustment, the court said.

The court’s conclusion puts taxpayers on notice that adequate disclosure of a tax planning (shelter) transaction will include every aspect of the transaction and not just its general code provisions. If other courts follow this part of the decision, taxpayers may want to increase their disclosures.

Brandon Ridge Partners v. U.S., 100 AFTR2d 2007-5347

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

EMBEZZLEMENT NO EXCUSE
The Third Circuit recently affirmed a district court’s opinion holding a corporation liable for payroll taxes embezzled by its payroll agent.

Pediatric Affiliates PA of New Jersey (Pediatric) hired PAL Data Processing Inc. (PAL) to handle its payroll needs. PAL’s founder, Menachem Hirsch, would routinely send Pediatric a tax form that accurately calculated Pediatric’s payroll taxes, and Pediatric would remit the funds to PAL. However, Hirsch would send only part of the payments to the IRS, keeping the rest. Hirsch engaged in the same procedures with more than 50 clients, embezzling more than $2 million. Pediatric learned of Hirsch’s misappropriation in 2002, when it received IRS notification that it underpaid its payroll taxes for 1999 and 2000. Hirsch subsequently pleaded guilty to wire fraud and tax evasion and received monetary penalties and 37 months in prison. Pediatric also brought suit against PAL and Hirsch for fraud and won a $1.2 million judgment.

Meanwhile, the IRS initiated a levy against Pediatric’s assets for the deficiency. Pediatric claimed it was not liable for the deficiency or interest because it had paid the correct amount to PAL. A federal district court in New Jersey held for the IRS, and Pediatric appealed.

The Third Circuit cited the Supreme Court case of U.S. v. Boyle for the well-established principle that reliance on a third party does not excuse a taxpayer of its obligations. In addition, a taxpayer signs Form 8655, Reporting Agent Authorization, which states that the agency arrangement “does not relieve [it], as the taxpayer, of the responsibility to ensure that all tax returns are filed and that all deposits and payments are made.”

Pediatric argued that under the doctrine of judicial estoppel the IRS could not both charge Hirsch with tax evasion and enforce payment against Pediatric. Also, Pediatric argued that a holding for the IRS would force Pediatric to pay the taxes twice. The Third Circuit stated that judicial estoppel was not applicable in such circumstances and noted that although Pediatric may have been obligated to pay the taxes twice, the IRS would receive them only once. Furthermore, the court said Pediatric had received an alternate remedy in the lawsuit judgment.

Finally, Pediatric argued that the doctrine of equitable estoppel prevented the IRS’s collection of the deficiency. The argument was based on an oral representation by an IRS appeals officer during administrative proceedings that Pediatric should not be held responsible for money stolen by Hirsch. Finding no written evidence of these statements or detrimental reliance on the statements by Pediatric, the court held the doctrine to be inapplicable.

Pediatric Affiliates v. U.S., 99 AFTR2d 2007-2240

Prepared by Laura Lee Mannino, CPA, LL.M., assistant professor of accounting and taxation, St. John’s University, Jamaica, N.Y.

TAX CASE

HORSES, HOUSES AND A PROFIT MOTIVE
Taxpayers who deduct as business expenses what the IRS might regard as spending on an unrelated hobby generally run a distinct risk of an underpayment assessment. In one recent case, however, the Tax Court accepted that two seemingly dissimilar undertakings could be treated as a single activity for purposes of the section 183 hobby loss rules.

A Florida woman, Tracey Topping, used her prominence as an equestrian to build a business designing horse barns and home interiors for wealthy acquaintances and new contacts on the Palm Beach-area horse show circuit. For the first six years of operations, her combined equestrian and design activities showed a profit of nearly $1 million. However, the Service said Topping’s equestrian activities, which by themselves produced a net loss, were a hobby unrelated to her design work. Thus, it said, her horse show contest winnings and any gains from selling horses had to be reported as “other income” on her 1040, and related expenses claimed as miscellaneous itemized deductions subject to the 2% of adjusted gross income floor. This determination would have cost her more than $250,000 in deficiencies for tax years 1999 through 2001.

The Tax Court, however, determined the two undertakings were a single activity because Topping treated them as an integrated business based on her equestrian activities, which significantly benefited her design business. The court noted more than 90% of Topping’s client base came from her equestrian contacts. In response to a subsequent IRS argument that the equestrian activities were nondeductible personal expenses, the court also agreed with Topping that her expenses associated with the equestrian-related portion of the business were ordinary, necessary and reasonable in amount as a cost of supporting and building up the interior design business.

The court distinguished Topping’s enterprise from several cases cited by the IRS in which erstwhile business expenses were held to be hobbies: A real estate lawyer’s polo playing did not materially benefit his practice (De Mendoza v. Commissioner, TC Memo 1994-314), nor did a CPA’s yachting, even though he flew a flag from his boat bearing the numerals “1040” (Henry v. Commissioner, 36 TC 879).

Tracey L. Topping v. Commissioner, TC Memo 2007-92

Prepared by Steven C. Thompson,CPA, Ph.D., McCoy Professor of Business, Texas State University, San Marcos, Texas.

TAX CASE

WORK PRODUCT STANDS UP TO IRS SUMMONS
The decision in United States v. Textron gives taxpayers a boost in efforts to protect tax workpapers from an IRS summons, although the Service’s Chief Counsel Donald Korb cautions the victory “may be short-lived.” The U.S. District Court in Rhode Island said the work product privilege applied to the corporate conglomerate’s workpapers even though the documents were previously disclosed to an independent auditor. The government also failed to show “substantial need” for the documents to defeat the work product privilege.

The IRS sought to enforce a summons issued pursuant to IRC § 7602 to force Textron to produce workpapers for an audit of the tax years 1998–2001. The audit focused on nine “sale-in, lease-out” (SILO) transactions, which the IRS has classified as listed transactions engaged in for the purpose of tax avoidance, pursuant to Treas. Reg. § 1.6011-4(b)(2). Textron argued, in part, that the information was privileged.

The workpapers contained the opinions of Textron’s attorneys and accountants regarding the estimated hazards of litigation percentages and their calculations of tax reserve amounts. The court concluded the workpapers were subject to the attorney-client privilege and the tax practitioner privilege of IRC § 7525(a)(1), but Textron waived those privileges when it disclosed the documents to an independent auditor, Ernst & Young. The court still denied the government’s motion because the workpapers were protected by the work product privilege.

The workpapers fell within the work product rule described by the Supreme Court in Hickman v. Taylor, 329 U.S. 495 (1947), and codified in Federal Rule of Civil Procedure 26(b)(3). The court said the materials contained the “mental impressions, conclusions, opinions, or legal theories of an attorney or other representative of a party concerning the litigation,” and the materials were created “because of” anticipated litigation. Textron would not have created the papers had it not anticipated a dispute, the court said. The court noted that the “because of” test adopted by the First Circuit is less restrictive than some other circuits, which require that anticipation of litigation be the “primary purpose” the materials were created for work product privilege to attach.

Disclosure to the independent auditor did not waive the work product privilege because Ernst & Young did not have an adversarial relationship with the taxpayer and had a professional obligation under AICPA Code of Professional Conduct section 301 not to disclose confidential information without the consent of the client, in this case Textron. Furthermore, the court said, the determination of Textron’s tax liability must be based on factual information, none of which would be found in the requested workpapers.

IRS Chief Counsel Korb said “nothing in the decision undermines the IRS policy of seeking tax accrual workpapers when appropriate.” The records are “produced in the ordinary course of business for non-litigation purposes,” he said, essentially to conform with SEC regulations, and are not protected by the work product privilege.

Future litigation in this area could determine whether the public disclosure of workpapers on tax positions required by FASB Interpretation no. 48 waives the work product privilege. The years contested in Textron predate FIN 48, which applies to periods beginning after Dec. 15, 2006.

U.S. v. Textron Inc., 100 AFTR2d 2007-5221

Prepared by JofA staff member Jeffrey Gilman, J.D.