Tax Matters

Computing the Accumulated
Earnings Tax
As the difference between ordinary income tax rates and capital gains tax rates increases, corporations have sought to minimize dividend payments to shareholders with the objective of helping them secure capital gains taxed at a lower rate. To prevent companies from doing this, Congress adopted the excess accumulated earnings tax provision of IRC section 535. Recently the Tax Court had an opportunity to consider the computation of this penalty tax.

Metro Leasing and Development Corp. filed its 1995 tax return showing a liability of $2,674, which it paid in March 1996. The IRS audited Metro’s return and after modifying the company’s deductions for officers’ salaries, determined it had not paid enough tax. It also found Metro was subject to the accumulated earnings penalty tax. Metro disagreed and filed suit in Tax Court. The company paid the disputed amount but continued its suit. The Tax Court held for the IRS on both the compensation and accumulated earnings tax issues. It required the parties to compute the new tax liability based on the corporation’s holdings under the court’s rule 155. The parties disagreed on the correct tax computation and instituted the current case to determine the right amount.

Result. For the IRS. The base for the accumulated earnings penalty is accumulated taxable income. A corporation determines this amount by adjusting its taxable income for “economic items” to better reflect how much cash it has available to make dividend distributions. The adjustments include a deduction for federal income taxes paid; charitable contributions and any net operating losses are added back. Metro disagreed with the IRS computation of the income tax deduction. The company had sold property in 1995, reporting the gain on the installment method. Metro argued the full tax liability on the gain was a current deduction even though part of the tax had been postponed until the company collected the remainder of the sales price.

The taxpayer based its argument on section 535(b)(1), which says a deduction is permitted for federal income taxes accrued during the year. The court agreed with the IRS that the taxpayer’s interpretation was incorrect. Accrued means tax actually payable based on reported income, not tax based on income a corporation would include if it reported all items of income and deductions under the accrual method. Therefore, in computing its accrued tax, Metro would include only the current year’s reported installment income.

The second issue in dispute was the contested deficiency the taxpayer paid. Metro argued the amount was deductible in arriving at its accumulated taxable income. It cited J.H. Rutter Rex Manufacturing Co. v. Commissioner in which the Fifth Circuit Court of Appeals reversed the Tax Court and held that paid deficiencies were deductible even though contested. The IRS argued that a contested liability is nondeductible regardless of payment. The Tax Court decided not to follow Rutter Rex. While the law allows a deduction for accrued taxes, a contested liability is not accrued because it does not meet the requirements of the all-events test for current recognition. Therefore Metro could not deduct these taxes even though it paid them.

This decision clarifies that the deduction for federal income tax is based on the tax accrued on the income a taxpayer reports under its accounting method. It also reopens a controversy about contested liability. Future litigation will be needed to settle the issue.

Metro Leasing and Development Corp. v. Commissioner 119 TC no. 2.

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

Tax-Exempt Bonds for
Religious Institution
Don’t Violate Constitution
Under IRC section 103 taxpayers may exclude from gross income interest on so-called private activity bonds that also qualify under IRC section 141, which includes the private loan financing test. To meet this test a government unit must issue the bonds. The availability of tax-exempt financing to religious institutions depends on whether the government unit—by issuing the bonds—violates the establishment clause of the First Amendment to the U.S. Constitution: “Congress shall make no law respecting an establishment of religion….”

In 1991 the Industrial Development Board of Nashville (IDB) and the Metropolitan Government of Nashville (Metro) approved a $15 million tax-exempt bond issue for David Lipscomb University, a liberal-arts institution affiliated with the Churches of Christ. The school used the bond proceeds to build new facilities and renovate existing ones. Lipscomb is an IRC section 501(c)(3) organization, and the bonds met all the requirements to be considered tax-exempt private activity bonds.

Five Nashville-area taxpayers sued the IDB and Metro on the grounds that, by issuing the bonds, the government advanced religion in violation of the First Amendment. The taxpayers argued Lipscomb was so intensely religious that any type of aid to the school would have this effect as there was no way to separate the university from religion. The district court found for the taxpayers and issued a permanent injunction prohibiting the IDB and Metro from selling the bonds. The IDB and Metro appealed to the Sixth Circuit Court of Appeals.

Result. For IDB and Metro. The Sixth Circuit reversed the district court’s orders and found in favor of the two government entities. The court held that, since they were in no way responsible for repaying the bonds (even in the case of default) and issued them for many other profit and nonprofit entities, their issuing the bonds was at most an indirect benefit. The court said the only impact on taxpayers was the potential loss of tax revenue—an indirect benefit to the university too small to consider.

Courts have decided similar cases based on how much an educational institution promotes religion to its faculty and students. The Sixth Circuit agreed Lipscomb was intensely religious but decided that issuing bonds was a general benefit religious entities should be allowed, much as they receive police and fire department protection and are exempt from tax. Further, the court felt the IDB and Metro “no more endorsed Lipscomb University than it did Wal-Mart in issuing industrial revenue bonds.”

CPAs with clients that are religious education institutions could advise them to seek out tax-exempt bonds to finance only expenditures that would give some type of economic benefit to the community, such as construction expenditures. Lipscomb did sign a statement that it would not use the bond proceeds to directly benefit religious endeavors. Thus, building a new chapel probably would not be acceptable, but constructing a new gymnasium would. Accountants should recommend some caution since of the three judges deciding this case, one strongly dissented.

Steele v. Nashville Industrial Development Board, 6th Cir., 8/14/02.

Prepared by Sharon Burnett, CPA, PhD, assistant professor of accounting and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.