Taxpayers participating in these listed transactions must disclose such participation to the Service by Jan. 15. Failure to disclose can result in severe penalties—up to $100,000 for individuals and $200,000 for corporations.

Ruling 2007-65 aims at situations where cash-value life insurance is purchased on owner-employees and other key employees, while only term insurance is offered to the rank and file. These are sold as 419(e), 419A(f)(6), and 419 plans. Other arrangements described by the ruling may also be listed transactions. A business in such an arrangement cannot deduct premiums paid for cash-value life insurance.

A CPA who is approached by a client about one of these arrangements must exercise the utmost degree of caution, and not only on behalf of the client. The severe penalties noted above can also be applied to preparers of returns that fail to properly disclose listed transactions.

Prepared by Lance Wallach, CLU, ChFC, CIMC, of Plainview, N.Y., a writer and speaker on voluntary employees’ beneficiary associations and other employee benefits.

In U.S. v. Roxworthy, 98 AFTR2d 2006-5964 (2006), the Sixth Circuit joined four other circuits in adopting the “because of” test as the standard for determining whether documents were prepared “in anticipation of litigation,” a critical element of the work product privilege. Courts applying the test have examined (1) whether a document was created because of a party’s subjective anticipation of litigation, as contrasted with an ordinary business purpose, and (2) whether that subjective anticipation of litigation was objectively reasonable. Therefore, circumstances surrounding a document’s creation are pivotal in determining whether it may be withheld.

Courts also have said a document can be created both for use in the ordinary course of business and in anticipation of litigation without losing its work product privilege. For example, attorneys’ work resulting from participation in audits “to deal with issues of statutory interpretation or case law” ( U.S. v. Frederick , 83 AFTR2d 99-1870) may invoke the attorney-client privilege where the lawyer’s analysis would not have been performed had the possibility of litigation with the IRS not been anticipated—as opposed to an accounting function that “would have been created in essentially similar form irrespective of the litigation” ( U.S. v. Adlman , 81 AFTR2d 98-820).

The purpose of the work product privilege is to prevent a potential adversary, such as the IRS, from gaining an unfair advantage by obtaining documents prepared by the opposing party or its counsel in anticipation of litigation that may reveal the party’s strategy or its own assessment of the strengths and weaknesses of its case.

Prepared by Laura Jean Kreissl , Ph.D., assistant professor of accounting, and Darlene Pulliam , CPA, Ph.D., professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.

John Dunkin, a Los Angeles Police Department officer, and his wife, Julie, divorced in 1997. The divorce court awarded Julie half of John’s pension, based on California’s community property laws. Although he was eligible to retire and receive benefits, John decided to continue working. Consequently, the court ordered John to pay Julie the present value of her share of the pension, which the court determined to be $25,511 a year. He paid her the sum in 2000 from his wages and deducted it from his federal taxable income as alimony. The Service argued that he was subject to income taxes on that amount. The Tax Court ruled for Dunkin, and the government appealed.

The Ninth Circuit noted that under IRC § 71, for a payment to qualify as alimony, it must cease at the recipient’s death. In this case, the payments were to continue to Julie’s estate if she died while John remained employed by the Police Department. Therefore, it could not be alimony.

One member of the three-judge panel, in a dissenting opinion, noted that if Dunkin had retired, the portion of the pension paid to his wife would have been taxable to her. The majority’s holding “defies reason, not to mention fairness,” wrote the dissenting judge, Stephen Reinhardt, who proposed the question be addressed by the California Supreme Court.

In the meantime, in negotiating divorce settlements, it is important to consider state property rights, pension vesting and expected retirement dates to avoid unexpected tax outcomes.

Commissioner v. John Michael Dunkin , 100 AFTR2d 2007-5870

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

Under section 71, cash payments made under a divorce or separation agreement are considered deductible alimony if they are made to an ex-spouse not living in the same household with the payor and are not designated as child support. In addition, the payor must not be liable to make payments after the death of the payee spouse (a continuing payment liability) or payments in their place (substitute payment liability).

Neil Proctor, an active member of the U.S. Navy, and Liza Holdman were divorced in 1993. The divorce decree required Proctor at retirement to pay Holdman 25% of his naval retirement pay under the USFSPA. When Proctor retired from the Navy in 2000, he did not make any payments to Holdman; however, he was compelled under a 2001 court order to do so. In 2002, Proctor paid Holdman $3,387, which he deducted as alimony on his 2002 federal tax return. The IRS disallowed the deduction, and Proctor petitioned the Tax Court for relief.

The IRS argued the payments did not qualify as alimony because they were a property settlement. The Tax Court disagreed. IRC § 71(b)(1)(B) does permit a divorce agreement to specify that certain payments are not alimony, the court stated. But the Proctor-Holdman agreement contained no such statement; thus, the payments would be deductible alimony if the other requirements of § 71(b)(1) were satisfied. Since the divorce agreement required Proctor to make cash payments to Holdman, who was not a member of the same household, the payments would be alimony if they would terminate upon her death. Under the USFSPA, the retirement payments would stop upon the death of either Proctor or Holdman, whichever occurred first, so Proctor was not liable for any payments after Holdman’s death. Also, under the USFSPA, Holdman had no rights in the retirement pay that she could sell, assign or transfer. Therefore, the court concluded, the payments were alimony.

Neil Jerome Proctor v. Commissioner , 129 TC No. 12

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

The Eleventh Circuit vacated and remanded the decision of a Florida district court in United States v. Mount Sinai Medical Center , which had held that payments to medical residents were not exempt from FICA (for the earlier decision, see “ Tax Matters,” JofA, May 05, page 106).

FICA, which supports the Social Security Trust Fund, imposes tax on the wages of employees and creates an equivalent liability for employers. Section 3121(b)(10), however, provides an exception for “service[s] performed in the employ of…a school, college, or university…if such service is performed by a student who is enrolled and regularly attending classes at such school, college, or university.” This exemption prompted Mount Sinai Medical Center of Florida Inc. to obtain a refund of approximately $2.5 million in FICA taxes paid and withheld from medical residents participating in the hospital’s Graduate Medical Education Program (GMEP). The IRS then sued to recover the refund, claiming it was paid in error. Based on the legislative history of § 3121 and a factually similar case in the Sixth Circuit, the district court held that the student exemption did not apply to medical residents and held for the IRS.

On appeal, however, the Eleventh Circuit found that the district court’s reliance on Congress’ enactment and then repeal of an exception for medical interns was misplaced, as the current statute is unambiguous. It also refused to follow the Eighth Circuit, which has held that medical residents always fall within the student exemption. Rather, the Eleventh Circuit adopted the position of a federal district court in United States v. Mayo Foundation, which calls for a case-by-case analysis of whether the employer (1) qualifies as a “school, college or university” and (2) whether the employees qualify as students. If both tests are satisfied, the student exemption should apply, the Eleventh Circuit said.

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

Carol Negron was the executrix of two estates whose decedents had won the Ohio Super Lotto jackpot prize. Both winners died in 2001 after receiving 11 of 26 annual payments of $256,410 each. Each estate elected to receive a lump-sum distribution of the remaining 15 payments for $2.27 million. The IRS determined values from the tables of $2.66 million for one decedent and $2.77 million for the other. But Negron contended the tables do not reflect a discount appropriate to Ohio lottery proceeds’ being nontransferable and therefore not marketable. The government argued the tables do include such a discount.

The Ninth Circuit in Shackleford , 88 AFTR2d 2001-5658, has upheld a departure from the tables, as has the Second Circuit, overruling the Tax Court in Gribauskas , 92 AFTR2d 2003-5914. The Fifth Circuit, on the other hand, has concluded that lottery annuity payments are properly valued by the tables (Cook, 92 AFTR2d 2003-7027), as have district courts in Massachusetts, (Donovan, 95 AFTR2d 2005-2131), Louisiana (Anthony , 95 AFTR2d 2005-2905) and elsewhere.

Although the Fifth Circuit ruled against the taxpayer in Cook , the Ohio district court drew from that opinion a two-part test based on principles already well-established by 1962 (Weller , 38 TC 790): Estates may propose an alternative valuation when (1) the value ascribed by the tables is unrealistic and unreasonable, and (2) a more reasonable and realistic means by which to determine a fair market value is available. Negron, the Ohio court said, had satisfied the first prong of the test, and it gave her an opportunity to demonstrate the second.

Negron v. United States , 99 AFTR2d 2007-3127

Prepared by Melanie J. Earles , CPA, DBA, professor of accounting, Tennessee Tech University, Cookeville, Tenn.

The IRS is requesting comments on a proposal to revamp how taxpayers may obtain the Service’s consent to change their method of accounting for tax purposes. Notice 2007-88 describes a “standard consent process” that would become the exclusive method not only for changes currently eligible for automatic consent but other changes not specifically requiring what would be called “specific consent” or “letter ruling consent.” Comments are requested by Jan. 18. The IRS said it will conduct a pilot program before issuing definitive guidance or implementing any permanent changes.

After delaying for one year new documentation requirements of IRC section 409A concerning nonqualified deferred compensation plans, the Service also extended transition relief for most other provisions until 2009. Notice 2007-86 providing the transition relief supersedes or modifies several provisions contained in Notice 2007-78. It does not affect, however, the latter notice’s guidance concerning predetermined cash-out features or restrictions on certain trusts and other arrangements.