TAX MATTERS

TAX CASE

RESTRICTIONS ON THE RIGHT OF OFFSET
ost businesses assume they can apply the right of offset to net a receivable and payable. Recently the Federal Circuit Court of Appeals limited the government’s right of offset.

Although Pacific Gas and Electric (PG&E) filed its 1982 tax return on time, it subsequently filed an amended return requesting a refund. In 1988 the government found PG&E was entitled to a refund plus interest but incorrectly calculated the amount of interest due. PG&E later filed another refund claim for 1982 based on carrybacks from 1984. The government agreed with the claim but offset (reduced) the refund by $3.37 million, the amount of excess interest the government had erroneously included earlier. PG&E filed a suit in the Court of Federal Claims for the full refund without offset. The lower court had allowed the offset even though it acknowledged the government was time-barred from suing to collect the overpaid interest. PG&E appealed.

Result. For the taxpayer. Basing its finding on Lewis v. Reynolds, the Court of Federal Claims stated that refunds are limited to the actual overpayment of tax. To calculate the overpayment the taxpayer must redetermine the entire tax even if the year is closed. Therefore PG&E redetermined its 1982 tax return liability. Subsequent cases also allowed the government to reduce refunds by a time-barred deficiency (that is, a deficiency the government cannot collect because the tax year is closed). The Federal Circuit Court of Appeals, which considered PG&E’s appeal, found that these cases “stand for the proposition that the government may offset against a tax refund claim any additional amounts the taxpayer owes with respect to the tax shown on the return even though the statute of limitations would bar assessing the additional amount owed.” The appellate court distinguished Lewis and its progeny, which apply to cases involving assessable amounts such as tax deficiencies, tax penalties and deficiency interest, from this case. In PG&E, the government tried to offset overpaid interest, a nonassessable amount, rather than assessable tax from the year at issue.

Computing the interest due on a deficiency or refund requires complex calculations. If the government overpays interest on a refund for a closed year, it may not recover the amount by offset against a refund due from that year.

Pacific Gas and Electric Co. v. United States, Fed. Cir., 417 F3d 1375 (2005).

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

CAN ESTATE REDUCE IRAs' VALUE FOR TAX PURPOSE?
gross estate includes the fair market value of all of the decedent’s property. IRAs are part of the gross estate, but beneficiaries of inherited IRAs do not report taxable income until after they receive distributions. The tax code classifies these items as “income in respect of a decedent” (IRD); both the decedent’s estate and the beneficiary must pay tax. However, the beneficiary can deduct the amount of taxes the decedent’s estate pays on the IRD.

On February 16, 2000, when Doris Kahn died, she owned two IRAs with a combined value of $2,620,410. On its tax return the estate reduced the IRAs’ value by the amount of tax the beneficiary would owe when he or she received distributions and valued the IRAs at $2,219,637. That amount, the estate argued, was the IRAs’ fair market value—the amount a willing buyer would pay and a willing seller would accept in an arm’s length transaction—as a buyer would consider future tax liability before determining a price. The IRS disagreed and assessed the estate a deficiency. The estate petitioned the Tax Court for relief.

Result. For the IRS. The estate argued that in prior cases courts considered the property’s fair market value. One court allowed a reduction in the fair market value of stock in a closely held corporation because a buyer would consider the corporation’s built-in tax liability of its appreciated assets before making an offer. Another court permitted a reduction in the fair market value of stock with resale restrictions because buyers would consider the future burden of such restrictions in any offer. A third court said a potential purchaser would consider clean-up costs before buying contaminated land. The estate argued that the court should apply the same logic to IRAs because a buyer would base any offer on the anticipated tax burden.

The Tax Court distinguished these earlier situations from an IRA. In the former the willing buyer/seller test applied directly to the property; in the latter it applied to the assets underlying the IRA. In addition the buyer of such assets does not assume the tax burden; the beneficiary retains responsibility for any future taxes. Further, because the underlying assets are already fully marketable, the potential buyer does not assume additional burdens if he or she decides to sell them.

This case distinguishes the valuation of IRAs from other property interests. The court’s ruling—that a discount should not be allowed when determining the value of an IRA—is similar to Estate of Smith v. United States (300 FSupp2d 474, affd. 391 F3d 612 (5th Cir. 2004)), which held that the estate should not discount the value of the decedent’s retirement account to offset the beneficiary’s future tax liability.

Estate of Doris F. Kahn v. Commissioner, 125 TC no. 11.

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

TAX CASE

DIVIDENDS-RECEIVED DEDUCTION FROM PORTFOLIO STOCK
ne of Congress’s goals is preventing taxpayers from taking undue advantage of the tax rules. To that end it passed IRC section 246A, which prevents corporations from claiming a dividends-received deduction against dividends from stock purchased using debt that generates an interest expense deduction.

To make its insurance subsidiary a leader in the field, OBH Inc. (formerly Berkshire Hathaway) borrowed $750 million in four separate transactions. The company deposited these loans in the subsidiary’s bank account, which contained all the subsidiary’s other funds. The subsidiary then used this account to purchase stocks and bonds.

During its investigation, the IRS “traced” the company’s borrowed funds to several of its dividend-paying stock purchases and then invoked section 246A to reduce the corporation’s dividends-received deduction. The taxpayer objected to the “tracing.”

Result. For the taxpayer. Section 246A limits the dividends-received deduction for “portfolio stock” when there is related “portfolio indebtedness.” Portfolio stock includes any stock owned by a corporation unless the corporation owns at least 50% of its outstanding stock; both sides agreed the dividend-paying stock at issue was portfolio stock.

“Portfolio indebtedness” refers to indebtedness that is directly attributable to an investment in portfolio stock. The tax code does not define “directly attributable.” In the Congressional Record, however, the phrase describes a direct relationship between the debt and the stock purchase—the company either incurs the debt to purchase the stock or the debt is directly traceable to the stock purchase.

OBH said the first of these tests did not apply as it had borrowed the funds to expand its insurance subsidiary. The government claimed the subsidiary was adequately capitalized and, therefore, that OBH had borrowed the money to buy stock. The district court rejected the government’s argument. Because, in this case, there was no evidence of a prearranged plan, the court accepted OBH’s claim that it had borrowed the money simply to expand its insurance subsidiary.

Since the government failed to prove the debt was incurred to purchase the stock as required by the first test, it argued that the borrowed funds were directly traceable to the stock purchase as required by the second. The government supported its “indirect” tracing approach by arguing that cash is fungible. The court found, however, that Congress had rejected the fungibility-of-cash doctrine when it used the “directly traceable” language in the legislation rather than an allocation formula.

Further, both the Congressional Record and the sole revenue ruling on point illustrate the provision with examples in which the taxpayer uses the actual borrowed funds to acquire the stock. In addition the taxpayer’s expert demonstrated that the company did not have to use the borrowing solely to purchase stock; it could have used the money to purchase many other items. Based on this evidence, the court held that these funds were not directly traceable to the purchases.

This decision clarifies the scope of section 246A. For this section to apply, either the company must incur the borrowing to buy the stock or the purchase must be directly traceable to the borrowing. If the taxpayer demonstrates a business reason for the debt and shows the corporation did not use the funds for purchase, the borrowing should fall outside the section’s provision.

OBH, Inc. v. United States, DC Neb. 2005, U.S. Dist. LEXIS 29382.

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