Tax Matters

Tax Matters

TAX NEWS

IRS Offers Help on Mutual Fund Expenses

Mutual fund distributors can benefit from the new IRS guidance on how to account for commissions paid on sales of mutual fund B shares.

Revenue procedure 2000-38, which became effective October 2, outlines three methods—the distribution fee period, the five-year and the useful life. All three allow the distributor to capitalize the commissions paid.
Larry Langdon, commissioner of the IRS Large and Mid-Size Business Division, said the revenue procedure is an example of how the division is focusing on working with taxpayers to resolve issues in a quicker, fairer manner.

Distributors who wish to change to one of the three accounting methods must obtain the IRS commissioner’s consent by following the procedures outlined in the new guidance.

The text of the revenue procedure is available on the IRS Web site, www.irs.gov.

TAX BRIEFS

INDIVIDUAL

Depreciation of Lear Jet Is Not a Business Expense

In 1984 Stanley Kurzet sold his business and invested the proceeds in a Lear jet and a timber farm in Oregon. He also owned other business and investment properties and a residence in California. On their joint return, the Kurzets deducted expenses for business travel from California to Oregon, including the costs of operating the jet.

The IRS challenged the deductions, especially the depreciation of the jet, which more than doubled the Kurzets’ deduction. According to the service, these deductions were not ordinary and necessary business expenses under IRC section 162.

The Tax Court agreed with the government and said, “Large transportation expenses (including significant noncash expenses such as depreciation) associated with the Lear jet appear to be out of the ordinary and unnecessary in light of the fact that [Kurzet’s] timber farm was not producing any current income (due to [his] decision to defer cutting any of the timber).”

The Tenth Circuit Court of Appeals held that the Tax Court had erred by including depreciation in the costs of operating the jet. Relying on Noyce v. Commissioner, 97 TC 670 (1991), the Tenth Circuit stated that depreciation should not be considered in assessing whether business expenses are reasonable under IRC section 162. By ignoring depreciation, the court cut the travel expense deductions in half and allowed the entire deduction.

Observation. The Kurzets also argued that the time saved by traveling in their own jet, as opposed to commercial air travel, should be considered in determining whether an expense was reasonable. The Tenth Circuit agreed.

Stanley M. Kurzet v. Commissioner (CA 10, 8-16-2000), 86 AFTR2d, 2000–5166.

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

Deduction for Religious Education Disallowed

Taxpayers who itemize are allowed a deduction for donations to qualifying religious organizations. Often the organization uses part of the money for religious education and indoctrination of its members. When a tax-exempt school offers both religious and secular education, one might assume that a portion of the tuition qualifies as a charitable contribution. But the law clearly states that tuition payments are a personal expense, are considered quid pro quo and are not deductible. In a recent case, the Tax Court held that no portion of the tuition payments to a religious school was deductible.

In Sklar v. Commissioner (TC Memo 2000-118), the taxpayers lived in California where four of their children attended orthodox Jewish day schools. They deducted the tuition paid to Emek Hebrew Academy and Yeshiva Rav Isacsohn Torath Emeth Academy, both tax-exempt organizations under IRC section 501(c)(3). A letter from the schools stated that an estimated 55% of their tuition was for religious education and 45% for secular education. The taxpayers accordingly deducted $13,240 on their 1994 income tax return.

The IRS sent a notice of deficiency disallowing the deduction. The taxpayers claimed their First Amendment rights were being violated and cited Hernandez, a 1989 case that discussed charitable contributions comparable to the tuition payments in question.

In Hernandez v. Commissioner (490 U.S. 680) the U.S. Supreme Court examined the deduction of fees paid to the Church of Scientology for “auditing”—a type of individualized spiritual counseling and training. These payments—the primary source of income for the Church of Scientology—are required of those being trained and, are, therefore, similar to tuition. The Court held the payments were nondeductible because they represented an exchange of money for an economic benefit. The Sklars argued that the dissenting opinion of Justice O’Connor allowed for the deductibility of payments similar to those made for auditing in Hernandez.

The Tax Court, however, stated that the current case had few parallels to the 1989 case and relied, in its opinion, on several other cases that disallowed the deduction of tuition to both parochial and secular entities. Courts have previously determined that tuition payments to a school in exchange for a child’s education are personal and not deductible. Additionally, tax law and the courts recognize that charitable contributions must be made from a “detached and disinterested generosity” or “out of affection, admiration, charity or like impulses.” The required intent is missing when the individual receives something of value, such as tuition, in return for his or her contribution.

In Sklar the court also reviewed an item that all tax professionals should consider. The husband in the case, who was a CPA, had failed to file a timely return, stating that his work load prevented him from filing by the due date. The IRS assessed a penalty. The Tax Court retained the penalty due to the taxpayer’s willful neglect and noted that the reasonable cause requirement was not met.

Observation. Contributions made to qualifying organizations are not always deductible under IRC section 170. Fees required by a charitable organization in return for an economic benefit, including religious services, are disallowed. This includes any donation made in anticipation of a benefit other than the gratification of benevolence. Payments such as those for tuition are always considered personal expenses and are nondeductible. Quid-pro-quo contributions received by charities in excess of $75 must be properly reported to the donor to eliminate possible confusion about deductibility.

—Cynthia Bolt Lee, CPA,
assistant professor of business administration,
the Citadel, Charleston, South Carolina.

TAX CASE

When Giving Advice, Experience Is Key

IRC section 6662 imposes a penalty on taxpayers who underpay their tax as a result of negligence. Before 1989 section 6653 imposed a similar penalty. Taxpayers can usually avoid negligence penalties by showing they relied on professional advice. A recent decision in a case that began nearly 20 years ago, however, illustrates an instance in which such reliance did not eliminate the section 6653 penalty. If a similar situation arose today, would a penalty be imposed under current law?

Addington, Cohn and Sann were attorneys employed by Sann and Howe, which also employed Guy Maxfield as senior tax partner on an “of counsel” basis. In 1981 Maxfield introduced the three attorneys to an investment partnership engaged in plastics recycling, which he had spent 50 to 75 hours investigating. Rather than independently investigating the partnership, the three attorneys invested solely on Maxfield’s advice.

More than 200 tax cases have resulted from plastics recycling partnerships. The courts uniformly have concluded such transactions are shams and denied the claimed tax benefits. Consequently, the IRS denied the three taxpayers the 1981 and 1982 deductions they claimed and assessed negligence penalties. The Tax Court upheld the penalties. The taxpayers appealed the decision based on the argument that they relied on professional advice.

Result. For the IRS. It has long been established that taxpayers may rely on professional advice in preparing their tax returns without fear of a negligence penalty for failure to investigate the tax rules themselves. However, this presupposes that the adviser has the requisite knowledge and experience. The Tax Court held that the adviser in this case had no expertise in the relevant area (plastics recycling) and, therefore, it was unreasonable to rely on his advice. The appeals court concurred.

The case appears to say that an adviser must have experience in the specific industry before taxpayers can rely on his or her advice. This conclusion is offset somewhat by the statement in the appellate decision that the lengthy cautionary language in the offering memoranda and the taxpayers’ own sophistication should have put them on notice that they needed to personally investigate the partnership to avoid a negligence penalty. To complicate matters the district court, in Klein, refused to grant summary judgment for the IRS in another plastics recycling negligence case on the grounds that an adviser does not always need specific industry experience. Depending on the final outcome of these cases, a taxpayer may have to investigate an adviser’s background, knowledge and experience before trusting the advice he or she gives—at least for tax penalty purposes.

Lawrence M. Addington v. Comm., 85 AFTR2d, 2000–496.

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

New Way to Split Your IRA

An owner of a large IRA with multiple beneficiaries usually receives distributions over his or her life and the life expectancy of the oldest beneficiary using the term-certain method. When the owner dies, payments continue over the remaining portion of the original term.

Instead, however, the owner could divide the IRA into a number of separate IRAs via master-to-trustee transfers and name a different beneficiary for each. The payments could be extended over a longer period for the younger beneficiaries. (For more planning tips, see “How to Maximize IRA Accumulations,” page 32.)

Now there’s another option involving less paperwork and less money. In letter ruling 200036047, the IRS allowed a taxpayer to divide his IRA into nine subaccounts, each with its own beneficiary. He then elected to receive distributions over his and each sub-IRA’s beneficiary’s joint life expectancy. Upon his death, payments can be stretched out over the remaining life expectancy of the taxpayer and the life of each of the beneficiaries.

You Can Have More Than One IRA Payment Series

Generally, if an IRA owner receives distributions before age 5912, they are subject to a 10% excise tax under IRC section 720(1). However, this penalty can be avoided if the owner receives a series of substantially equal periodic payments. But, if the owner modifies the series before the later of (1) the close of the five-year period beginning with the date of the first payment or (2) his or her reaching age 5912, the penalty is invoked, plus interest for the deferred period.

In letter ruling 20033048, a 51-year-old IRA owner had been receiving a series of substantially equal periodic payments since 1995. In 2000 the taxpayer wants to receive a lump sum payment equal to seven and a half times the normal annual distribution. Then, in 2001, the taxpayer wants to begin a second series of monthly distributions.

According to the IRS, since the lump sum payment substantially modifies the first series, the lump sum and all prior distributions in that series will be subject to the 10% tax on premature distributions in the year 2000.

However, the service stated that nothing in the code limits a taxpayer to one series of payments. So, as long as the second series begins in calendar year 2001 or thereafter, it will not be subject to the 10% tax.

Ignore What the Form Says

In the past taxpayers whose only capital gains were distributions from a mutual fund that were subject to the 20% maximum tax rate were prohibited from using form 1040A. Starting in the year 2000, these taxpayers can now report such gains on form 1040 A, line 10.

But there’s a problem. Copy B (the taxpayer’s copy) of form 1099-DIV for the year 2000 still states that taxpayers who report capital gains in box 2a of this form must file the long form 1040.

According to the service, taxpayers can ignore this instruction and use the short form 1040A.

The Right Way to Disclose a Gift

In revenue procedure 2000-34 (2000-34 IRB 186) the IRS outlined procedures donors must follow if they fail to adequately disclose gifts on their gift tax returns. If the donor does not adequately disclose the gift, the statute of limitations doesn’t begin to run and the gift can be revalued when computing future gift or estate taxes.

To start the statute of limitations running, the donor must file an amended gift tax return (form 709) with the same service center where the original return was filed. The top of the first page must say “Amended Form 709 for gift(s) made in (year) in accordance with Revenue Procedure 2000-34.”

Regulations section 301.6501 (c)-1(f)(2) sets forth what information must be in each gift tax return to ensure adequate disclosure.

IRS May Have First Dibs on Your Pension

Can the IRS get at your pension before you do? According to the service, the answer is yes. In legal memorandum no. 200032004, a delinquent taxpayer had reached his company’s normal retirement age of 65 but elected not to retire. According to the company’s plan, upon retirement the employee could elect to receive either a lump sum payment or a joint-and-survivor annuity.

As part of its collection efforts, the IRS levied the taxpayer’s assets in the plan under IRC section 6331, but the plan administrator refused to honor the levy. The service concluded that it could levy against the plan but must wait to collect until the taxpayer has an immediate right to receive benefits. Currently, the taxpayer has only a “present right to a future benefit.” The levy was sufficient to reach the right to the benefits. However, the plan administrator isn’t required to honor the levy until the taxpayer retires and becomes entitled to receive the benefits.

In addition, the service commented that since the taxpayer has the right to elect a lump sum payment, the IRS might elect that option on his behalf (assuming the spouse gave her consent).

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