TAX MATTERS

TAX CASE

CLEAR REFLECTION OF INCOME
s a general rule taxpayers have the right to select their method of accounting—but this right is restricted by the requirement that the selected method clearly reflect income. Recently, the Seventh Circuit Court of Appeals remanded a case to the Tax Court to redetermine the method the taxpayer selected.

JP Morgan Chase, successor to First National Bank of Chicago, engaged in interest rate swaps. These are complex financial transactions that require two parties to pay each other interest based on various factors. Chase reported the income from these swaps based on its financial accounting method. The IRS objected and assessed a deficiency based on its own method. The Tax Court rejected both methods and imposed a third. JP Morgan Chase appealed.

Result. JP Morgan Chase’s method was incorrect. The case was remanded for the Tax Court to reconsider the IRS method.

IRC section 446(a) requires taxpayers to compute their taxable income based on the accounting methods used in their books and records. Under section 446(b), the IRS can impose a different method if a taxpayer’s selected method does not clearly reflect income. The fact that the taxpayer’s method is based on GAAP does not mean it clearly reflects income. These general rules concerning selection of accounting methods give way to specifically designated methods in the tax code.

One such designated method is the mark-to-market method, which must be used by dealers in financial instruments. Since interest rate swaps are financial instruments, JP Morgan Chase was required to use this special method. If the taxpayer’s computation under a mandated method is incorrect, it is treated as a method that does not clearly reflect income and the IRS has the right to mandate the computation under section 446(b).

When the IRS imposes a method under section 446(b), it is entitled to significant deference—in fact, according to the Court of Appeals, taxpayers must follow the IRS’s method unless it is “clearly unlawful” or “plainly arbitrary.” The fact that the imposed method may not be the most accurate method to calculate income is not sufficient for rejecting it.

In this case, the method used by JP Morgan Chase was unacceptable since the IRS showed that it did not clearly reflect income. It is up to the taxpayer to prove that the IRS method was unlawful or arbitrary. The court has the power to impose a different method only if the taxpayer meets this burden. Given this very high hurdle, it is likely the IRS’s method will be imposed.

JP Morgan Chase & Co. v. Commissioner, 2006 US App Lexis 20430 CA-7.

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

EARLY DISTRIBUTIONS FROM INHERITED IRAs
axpayers who inherit individual retirement accounts (IRAs) pay no income tax if they directly roll over the funds into IRAs in their own names. Generally, if the taxpayer receives distributions directly from the inherited IRA, the distributions are taxed, but the 10% penalty tax on premature withdrawals does not apply, even if the beneficiary is under the age of 591/2.

In June 1998, upon the death of Ray Campbell, his wife Charlotte inherited an IRA with a balance of $1,010,988. In July 1998 Mrs. Campbell directly rolled over the entire amount to her IRA. She subsequently remarried, becoming Charlotte Gee.

In 2002, at the age of 55, Mrs. Gee received a $977,888 distribution from her IRA. She and her husband reported the amount as income on their 2002 joint federal income tax return but did not include the 10% penalty tax, even though form 1099-R indicated the distribution was subject to it. On their return the taxpayers stated the wrong code had been entered on the 1099-R; the distribution was from Ray Campbell’s IRA, and thus was exempt from the penalty tax. The IRS assessed a deficiency equal to the 10% penalty; the taxpayers petitioned the Tax Court for relief.

Result. For the IRS. The taxpayers stated that although there was a direct rollover from Ray’s IRA into Charlotte’s, she made no additional contributions to the account and never redesignated it as her own. Therefore, the money retained its character as an amount received by a beneficiary from an inherited IRA and the distribution was made to a beneficiary on account of a death. Thus the distribution was not subject to the 10% penalty tax.

The Tax Court agreed with the IRS that the distribution was not due to the death of her former husband and was not made to her as a beneficiary of his IRA. Although she never actually had redesignated the inherited IRA as her own, it became hers when she chose to have the funds rolled over into her IRA. Once that rollover took place, the only way for her to avoid the 10% penalty for a premature distribution was to qualify for one of the other exceptions listed under IRC section 72(t).

This case illustrates that taxpayers under the age of 591/2 who inherit an IRA must make a decision. They can roll over the balance into their own IRA and pay no tax, in which case distributions from that IRA before age 591/2 will be subject to the 10% penalty unless one of the other exceptions applies. Or they can receive the entire balance or periodic distributions from the inherited IRA, pay tax on those amounts and avoid the 10% penalty. As the Tax Court noted in this case, taxpayers “cannot have it both ways”—they can’t avoid the tax by rolling over the inherited IRA and, later, when premature distributions are received, claim they were due to a death to avoid the 10% penalty tax.

Charlotte and Charles T. Gee v. Commissioner, 127 TC no. 1.

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

TAX CASE

TAXING DAMAGES FOR EMOTIONAL DISTRESS
he Court of Appeals for the District of Columbia on Dec. 22, 2006, vacated its judgment from four months earlier in Murphy, Marrita v. IRS in which the court held that a lawsuit award for emotional distress was not taxable. The government had petitioned for an en banc hearing. Instead, a panel indicated it will rehear the case, with oral arguments set for April 23.

The Internal Revenue Code imposes tax on all income regardless of its source, unless the income is specifically excluded. One such exclusion provided by IRC section 104(a)(2) is for damages received on account of physical injuries. Since not specifically excluded by section 104, damages that do not relate to physical injuries, such as those paid for emotional distress, typically are included in a taxpayer’s income and are subject to tax.

Marrita Murphy challenged the constitutionality of taxing damages for nonphysical injuries. Murphy worked for the New York Air National Guard (NYANG). When she complained to state authorities that a NYANG airbase contained environmental hazards, NYANG retaliated by blacklisting her and giving poor recommendations to potential new employers. Because these acts were violations of the whistle-blower statutes, NYANG was ordered to pay the taxpayer damages in the amount of $70,000: $45,000 on account of her emotional distress or mental anguish and $25,000 for the injury to her professional reputation.

Murphy originally included the full amount of the damages in her gross income and paid the appropriate taxes, but she later filed an amended return claiming a refund based on the exclusion in section 104(a)(2) regarding damages received “on account of personal physical injuries or physical sickness.” After the IRS denied the claim, she filed a lawsuit in district court.

The taxpayer first argued that the damages she received should be excluded under section 104 because she suffered from physical manifestations of her emotional injury. In the alternative, Murphy argued that damages paid with regard to nonphysical injuries are not “income” as the term has been defined by the U.S. Supreme Court. The district court ruled for the IRS, and Murphy appealed to the Court of Appeals for the District of Columbia.

Result. For the taxpayer initially, although the D.C. Circuit vacated the judgment and will rehear the case. The Internal Revenue Code was amended in 1996 to provide that emotional distress is not treated as a physical injury or physical sickness for purposes of section 104; as a result all damages other than those for physical injury fall within the general inclusion rule of section 61.

Murphy submitted evidence that as a result of NYANG’s conduct she suffered from bruxism, a stress-related condition that caused her to grind her teeth, resulting in permanent damage to her teeth. However, the D.C. Circuit found that although she suffered from physical injuries, the damages she received were not awarded on account of such injuries, and therefore section 104 was not applicable.

Murphy alternatively argued that the damages were not income within the 16th Amendment, and therefore could not be subject to tax. The Supreme Court defined income in 1955 in Glenshaw Glass as gains and “accessions to wealth,” and it has long been recognized that a return of capital falls outside this definition of income. Murphy argued that the damages she received, which compensated her for the loss of her emotional well-being and reputation, were a return of human capital and therefore not income. She contended that the Supreme Court alluded to the notion of human capital in Glenshaw Glass, where it distinguished taxable punitive damages from damages for personal injury; the latter, it held, are compensatory in nature and therefore not taxable income. Since Glenshaw Glass did not differentiate between physical and nonphysical damages, Murphy argued, the Supreme Court intended that all damages for personal injury be excluded from income.

The IRS’s rebuttal to this argument distinguished human capital from financial capital. Financial capital has a basis, such that when it is sold there is income to the extent that the amount realized exceeds the taxpayer’s basis. The IRS argued that since people don’t pay for their reputation or emotional well-being, there is no basis and therefore the entire amount received constitutes income.

The D.C. Circuit used an “in lieu of” analysis and held that the damages were not income. If a taxpayer receives damages in lieu of something that is normally subject to tax, such as wages, then the damages would be taxed. However, the taxpayer’s emotional well-being and reputation were not taxable, and therefore neither are the damages she received as a result of her losses. In addition, based on a review of the legislation that implemented Congress’ taxing power provided in the 16th Amendment, particularly the original exclusion for personal injury damages, the court found that the framers of the 16th Amendment would not have construed compensatory damages for nonphysical injuries to be income. Accordingly, the court held that the taxpayer’s damages for emotional distress and loss of reputation did not constitute income within the Constitution and the IRC, and any application of section 104(a)(2) that subjects such payments to taxation is unconstitutional.

Murphy, Marrita v. Internal Revenue Service, D.C. Circuit 05-5139 (8/22/06).

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