tax matters

Tax Matters

TAX NEWS

IRS Issues P(T)INs to Preparers

Beginning this year, tax practitioners can use alternative numbers called PTINs on the individual tax returns they prepare for clients instead of their own Social Security numbers. The IRS is providing this option in response to practitioners’ concerns about privacy and possible misuse of their Social Security numbers by anyone who has access to prepared returns.

The 9-digit PTIN will begin with the letter “P.” Form W-7P, Application for Preparer Tax Identification Number, can be obtained from the IRS’s Web site (www.irs.ustreas.gov) or by calling its toll-free forms hot line—800-829-3676.

States get in the act

Most states are allowing tax preparers to use the IRS-issued PTIN numbers on state tax returns. However, thirteen states do not recognize the PTINs; of them, 11 do not require preparers to enter their Social Security numbers on state returns. Arizona and Tennessee are the only states that require practitioners to use their Social Security numbers on state tax returns, but will not permit them to use the PTINs.

—Jay A. Scheidlinger, CPA, Esq., a tax practitioner with Israeloff, Trattner & Co., Valley Stream, New York.

State	Allows federal PTINs	Reason	State	Allows federal PTINs	Reason
Alabama	Yes		Montana	Yes
Alaska	Yes		Nebraska	N/A	Social Security number not required
Arizona	No		Nevada	N/A	Social Security number not required
Arkansas	Yes		New Hampshire	Yes
California	Yes		New Jersey	Yes
Colorado	Yes		New Mexico	Yes
Connecticut	Yes		New York	Yes
Delaware	Yes		North Carolina	Yes
Florida	Yes		North Dakota	Yes
Georgia	Yes		Ohio	Yes
Hawaii	Yes		Oklahoma	N/A	Social Security number not required
Idaho	Yes		Oregon	N/A	Social Security number not required
Illinois	Yes		Pennsylvania	Yes
Indiana	Yes		Rhode Island	Yes
Iowa	Yes		South Carolina	Yes
Kansas	N/A	Social Security number not required	South Dakota	Yes
Kentucky	Yes		Tennessee	Yes
Louisiana	Yes		Texas	N/A	Social Security number not required
Maine	Yes		Utah	Yes
Maryland	N/A	Social Security number not required	Vermont	Yes
Massachusetts	Yes		Virginia	Yes
Michigan	Yes		Washington	N/A	Social Security number not required
Minnesota	Yes		West Virginia	N/A	Social Security number not required
Mississippi	Yes		Wisconsin	N/A	Social Security number not required
Missouri	Yes		Wyoming	N/A	Social Security number not required

Note: PTINs are allowed in the District of Columbia.

TAX BRIEFS

INDIVIDUAL

Early Retirees Can Enjoy COLAs

In the past, if a taxpayer took a distribution from a traditional IRA account before he or she reached age 59 1/2, the withdrawal was generally subject to a 10% penalty. Under IRC section 72(t)(2)(A)(iv), however, IRA account owners who retire early can avoid this penalty by electing to receive their distributions in a series of equal periodic payments.

To take advantage of this provision, taxpayers must determine an annual payment amount at the time of retirement. When choosing an annual payment, taxpayers should take into account their current IRA balance, the projected future earnings the account will generate and their life expectancy.

In PLR 199943050, a 50-year-old taxpayer took early retirement, rolled over his corporate pension into an IRA and began taking equal periodic payments. After a few years, the IRA doubled in size because the stock market outperformed his prior expectations. The taxpayer asked the IRS if it was possible to modify his payment plan by adding an annual 4% cost-of-living adjustment (COLA) and by including a one-time “catch-up” amount. The IRS denied the request. It held the taxpayer could not modify the annual payment without triggering the 10% penalty for premature distributions.

Observation. There are ways early retirees can make their IRA payments keep pace with the market and not incur the 10% penalty. In 1995 the IRS privately ruled that IRA owners under age 591/2 could withdraw funds from the account with a built-in 3% annual cost-of-living adjustment as long as they had specified the COLA amount up front (PLR 199536031).

In addition, three methods are available for determining substantially equal payments. CPAs should know that one of these methods, the term-certain method, allows taxpayers to receive higher payments each year if they expect substantial future earnings from their IRA investments.

Under this method, the taxpayer’s IRA account balance at the time of retirement is divided by his or her remaining life expectancy. For example, assume at retirement the taxpayer has $600,000 in his or her IRA and a life expectancy of 30 years. The first-year distribution would be $20,000. If the stock market performed well, and the account balance grew to $660,000 the following year, the second-year distribution would be $22,759 [$660,000 (30–1)]. If the account balance for year three grew to $740,000, the distribution that year would be $26,429 [$740,000 (30–2)]. If the taxpayer’s investments continued to grow, this trend would continue and he or she would avoid the 10% penalty.

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

SPECIAL REPORT

What CPAs Should Know About School Tuition Organizations

On October 4, 1999, the U.S. Supreme Court let stand a ruling by the Arizona Supreme Court that supports the constitutionality of school tuition organizations—tax-exempt entities that provide scholarships to students. The ruling, which answered the question of whether these organizations violate the separation between church and state, silenced critics. Supporters say the Court’s action will spur the formation of such organizations in other states.

That predicted boom would give CPAs opportunities to provide audit and attest services to the organizations. Taxpayers, parents and scholarship recipients would gain valuable assurance if CPAs provided independent audits of these privately run nonprofit entities. In addition, CPAs would be able to give tax advice to individual clients who make donations to school tuition organizations.

Requirements

Since 1998 Arizona taxpayers have been allowed a dollar-for-dollar state tax credit up to $500 for donations to school tuition organizations. Under IRC section 501(c)(3), these organizations are required to

Provide scholarships to students in amounts up to but not exceeding the cost of tuition at a qualified private school.
Allocate at least 90% of their annual revenue for scholarships.
Not limit the availability of scholarships to students from only one school.
Allow scholarship recipients to attend any qualified school of their parents’ choice.

Arizona legislators defined a “qualified school” as a private school that doesn’t discriminate on the basis of race, color, sex, handicap, family status or national origin. However, section 501(c)(3) does permit private schools to discriminate on the basis of religion. Therefore, parochial schools would meet the requirements.

Taxpayers can use the $500 tax credit to reduce their state tax liability. If a taxpayer does not owe any state taxes, however, contributing to school tuition organizations will not result in a refund.

A carryover provision allows unused credits to be carried forward for five consecutive taxable years to offset future income tax liability. In addition, contributions to school tuition organizations qualify as charitable deductions for federal income tax purposes.

Separation of church and state

Whether education assistance programs that include parochial schools violate the principle of separation of church and state has long been a subject of debate. As recent court decisions show, neutrality is the key in determining the constitutionality of such programs.

The statement “Congress shall make no law respecting an establishment of religion” in the U.S. Constitution is known as the “establishment clause” and forms the basis for separation of church and state.

A statute does not violate the Constitution if (1) it serves a secular purpose, (2) its principal or primary effect neither advances nor inhibits religion and (3) it does not foster an excessive government entanglement with religion. Therefore, the support of private schools, in itself, is not unconstitutional. The Supreme Court has tried to steer a course of “constitutional neutrality.”

The clearest tenet of the establishment clause is that the state cannot give preference to one religious denomination over another. This emphasis on neutrality is apparent in a recent line of Supreme Court cases upholding a variety of educational assistance programs. For example, the Court ruled that it was legal for public school teachers to provide remedial education to disadvantaged children in parochial schools.

In another case, the Court ruled it was legal for Washington state to provide financial assistance to a blind student attending a private Christian college. In the upcoming term, the justices have agreed to hear a case to decide whether Louisiana can continue to use taxpayer money from a federal block grant to provide computers, software and library books to religious schools.

Vouchers

Scholarship grants from school tuition organizations and school vouchers are similar in that parents can choose which private schools they wish their children to attend. Although Florida, Ohio and Wisconsin all currently are experimenting with vouchers, confusion over their use in Cleveland captured national attention.

On the first day of school, Solomon Oliver, Jr., a U.S. district court judge in Ohio, issued an injunction halting the voucher program until a trial could determine whether vouchers violated the constitutional separation of church and state. The Ohio program covered up to $2,500 in tuition costs per child for poor families. The judge subsequently allowed more than 3,000 students to re-enroll in the pilot school voucher program in Cleveland, but refused to permit a new group of nearly 600 children to enter the program. In December, the federal district court in Cleveland ruled the city’s school voucher program was unconstitutional; however, the program will continue pending the state’s appeal of the decision.

Florida’s program also is controversial in that it grades public schools and provides vouchers only to students from schools that don’t make the grade. Under Governor Jeb Bush’s A-Plus Plan for Education, students in failing public schools—schools graded “F” two times in a four-year period—can apply for scholarships to the private school of their choice. A public school gets an “F” if the majority of its students fail to meet minimum performance standards on the state’s reading, math and writing exams.

Wisconsin’s program requires the state to pay the education costs of low-income Milwaukee parents who want to send their children to private schools. Under the Milwaukee Parent Choice Program, parents can select a private school and receive a state voucher for up to $5,000 a year per child to cover the expenses.

Explosive growth

Why should CPAs be interested in school tuition organizations? In Arizona in 1998, these organizations received $1,815,799 from 4,246 contributors. With the U.S. Supreme Court decision last fall that upheld the constitutionality of school tuition programs, challenges to them have been exhausted. As a result, the Arizona Department of Revenue estimates the tax-credit school tuition program could provide private schools with $75 million a year.

In addition, nearly half the states are considering providing similar public financial support for religious and other private schools. Proponents and opponents agree it may be only a matter of time before the Supreme Court hears a case that directly focuses on the issue of private school funding.

Independence is crucial

CPAs should be in the forefront, providing much-needed expertise to this new and expanding program. School tuition organizations must be autonomous: CPAs can and should play an important role in assuring their continued autonomy by providing a level of assurance that only an independent audit can give. In addition, CPAs need to know about the tax implications of school tuition organizations so they can advise their clients about them.

—Lawrence C. Mohrweis, CPA, PhD, associate professor of accounting at Northern Arizona University, Flagstaff.

TAX CASES

Deducting Retirement Plan Expenses

IRC section 404 limits the amount of retirement plan contributions an employer can deduct. It is unclear, however, whether IRC section 404 also limits deductions for plan-related expenses.

Sklar, Greensteen & Scheer, PC, a professional services corporation, established a retirement plan, hiring a representative of Prudential-Bache Securities to manage some of the investments. The corporation became dissatisfied with the investment results and filed a complaint with the American Arbitration Association. Over the four years the complaint was litigated, Sklar, Greensteen & Scheer paid and deducted the related expenses. The IRS denied the deduction on the grounds that only recurring expenses are deductible, based on revenue ruling 86-142. The company appealed the decision.

Result. For the taxpayer. The Tax Court first determined whether the expense payments were contributions under section 404. The plan document said the corporation could pay plan expenses, but if it did not, the plan would pay them. Since the plan made payment by the corporation an option, the court concluded that the payment was not an actual or constructive contribution under section 404 and, therefore, IRC section 162 governed deductibility of the expenses. Since nonrecurring expenses are deductible under section 162 if they are ordinary and necessary, Sklar, Greensteen & Scheer could deduct the litigation expenses.

The court noted—although not directly on point—that if the plan had said all expenses were to be provided for by contribution, then the payments would be considered contributions and their deductibility limited by section 404. However, the Tax Court said, the nonrecurring nature of the item did not affect the section 404 limits, as the IRS had argued. Revenue ruling 86-142 was, according to the court, an incorrect interpretation of the regulations under section 404 and would not be followed by the court.

Based on this case, it appears a corporation can maximize its deduction and the funds available to employees at retirement by not having plan expenses provided for by contributions. In all cases, the expenses must meet the ordinary requirements. The fact the expenses are nonrecurring should be ignored in determining their deductibility.

Sklar, Greensteen, & Sheer, PC v. Commissioner, 113 TC no. 9.

—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

Pick a Better Test

In a decision that reversed a Tax Court ruling, the Seventh Circuit Court of Appeals held that the salary a closely held corporation paid to its majority owner and CEO was reasonable. The owner and CEO was the company’s chief sales and marketing person, head of research and development and principal investor. In 1993 and 1994, the company paid him $1.3 million and $1 million, respectively. The Tax Court used a multifactor test and determined that a reasonable salary to the owner and CEO would have been $900,000 for 1993 and $700,000 for 1994.

The circuit court rejected the Tax Court’s seven-part test. It said the vague nature of the test allowed for arbitrary decisions. In its ruling, the circuit court applied the “independent investor” test. Under that test, a CEO’s salary is presumed reasonable if the company’s investors receive a higher rate of return than they had reason to expect (Commissioner v. Exacto Spring Corp., 7th Cir. 11-16-99).

Returned to Sender

The IRS is attempting to locate more than 100,000 taxpayers whose 1998 refund checks, totaling $72 million, couldn’t be delivered because of incorrect names and addresses. Taxpayers still waiting for their 1998 refund should call the IRS’s toll-free assistance number at 800-829-1040 (IR-1999-91).

Agents Are Not Invited

An informant calls the IRS Criminal Division and offers to disclose tax and nontax criminal violations by a taxpayer. A meeting is set up with the informant and a U.S. district attorney to discuss the possible criminal nontax violations. Can an IRS special agent be present at the meeting?

“Absent a compelling reason,” IRS special agents shouldn’t be present at such meetings. Their presence might imply there was an unauthorized disclosure of return information, and IRC section 6103 prohibits such disclosures (ILM 199945002).

Online or Offline: To the IRS It’s the Same

Increasingly stockbrokers are trading on the Internet. Does the Internet Tax Freedom Act (PL 105-277) eliminate or change brokers’ reporting obligations merely because the sales are executed online?

In Service Center Advice (SCA 199945043), the IRS concluded that reporting requirements for Internet traders were the same as for non-Internet traders. Both must file form 1099 and complete an information return following each transaction.

Who’s the Boss?

A police officer worked at several off-duty jobs. His police department coordinated the jobs, but the off-duty employers paid him. His off-duty employers also had the authority to hire and fire him.

The officer claimed he wasn’t subject to self-employment taxes because he was an employee of the police department even while working his off-duty jobs. He argued that he was always subject to the police department’s control.

The Tax Court disagreed and ruled the officer was an independent contractor. It held that his off-duty income constituted self-employment income (Commissioner v. Tracey Lee Milian, TC Memo, 1999–366).

IRS Helps in Search for Missing Children

The IRS teamed with the National Center for Missing and Exploited Children (NCMEC) to expand the distribution of photos of lost, abducted and runaway children. The service will print the pictures of missing children on 1999 tax instruction booklets and other IRS publications. Information about the children and NCMEC’s 24-hour, toll-free hot line number will be printed with the photos (IR–1999–85).

Paper or Plastic?

The IRS has given taxpayers more opportunities to pay with plastic. This year individual taxpayers can use their credit cards to pay the balance due on their 1999 returns, pay a projected balance due when requesting an automatic extension of time to file a 1999 return and make estimated tax payments for 2000. In addition, they will no longer be required to file forms 4868 and 1040-ES.

The pay-by-phone system will allow taxpayers to use American Express, Discover or MasterCard. This phone option, which started January 14, will be available for estimated tax payments on March 1, 2000.

Also, all individuals who file electronically—including those using TeleFile, the file-by-phone system—can choose to have the balance due debited directly from their bank accounts (IR–1999–87).

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