A husband and wife were married for more than 20 years. The wife paid the bills, handled the banking and controlled the family’s finances. The husband rarely wrote a check.

Early in their marriage, the wife was convicted of a felony after embezzling from her employer. However, she subsequently obtained employment in a small Oregon town as a clerk, and, over the years, worked her way up to financial director for the town.

The wife was known as a compulsive shopper who often spent up to $1,000 on clothes for her daughters during a shopping spree. She also made improvements to their home and bought herself and her daughters new cars.

The wife again was convicted of embezzlement. This time, she had taken $225,000 from the town. Moreover, the money had not been included on the couple’s joint federal income tax return.

After their divorce became final, the husband filed for innocent spouse relief under IRC section 6015(c). However, such relief is not available to a spouse who had actual knowledge of the item giving rise to the deficiency. The IRS argued that the husband was not innocent because he failed to prove lack of knowledge. According to the IRS, he should have been aware of the embezzlement because of the home improvements, the amount of money in the joint family checking accounts and the shopping sprees.

The Tax Court, however, sided with the husband. According to the court, the IRS had to prove the husband had actual subjective knowledge of the embezzlement income and satisfy this burden of proof by a preponderance of evidence. Merely showing what a reasonably prudent person would be expected to know did not meet this burden (Culver v. Commissioner, 116 TC no. 15).

It’s All in the Family

Several family members owned a corporation, but none of them had a controlling interest. The corporation made several interest-free loans to various partnerships. All the partners were family members, but some partners were not shareholders of the corporation.

The IRS said that under IRC section 7872, the corporation should have reported the forgone interest as taxable income on its federal return and the same amount should have been reported as dividend income by the shareholder-partners.

The corporation argued that IRC section 7872 only applied to sole or controlling shareholders, and that, even if the imputed interest rules did apply, they should apply only to the extent the shareholder-partners benefited from the loan. In other words, since the shareholders owned only part of the partnerships, then they should be taxed only on a portion of the imputed income.

The Tenth Circuit Court of Appeals affirmed the Tax Court and held that IRC section 7872 applied to any below-market interest loan, direct or indirect, between a corporation and any of its shareholders. According to the Tenth Circuit, the imputed interest rules apply when a corporation makes loans to entities owned partially by its shareholders and partially by their family members who aren’t shareholders. This holds true even if none of the corporate shareholders has a controlling interest in the entity. The court reasoned that if nonfamily members had owned significant interests in the borrowing entities, the corporation probably wouldn’t have made the loans. Therefore, the corporation and its shareholders had to report as income the forgone interest on the entire amount of the loan (Roundtree Cotton Co. v. Commissioner, 87 AFTR2d 2001-718 (CA 10, 3-29-01)).

Too Bad Golf School Wasn’t Just About Golf

A taxpayer was a self-employed golf instructor. He enrolled himself at the Golf Academy of the South, an accredited two-year business school that offered some golf-related courses. Graduates could transfer their credits to other institutions and earn a bachelor’s degree in another two years. On his federal income tax return, the taxpayer listed his trade or business as “golf instructor” and deducted his tuition as a business expense on schedule C.

Under Treasury regulations section 1.162-5, tuition paid for courses that maintain or improve a taxpayer’s skills in his or her current trade or profession is a deductible business expense. But if the courses also qualify a taxpayer for a new trade or business, the tuition is not deductible. In this case, the taxpayer argued that the coursework maintained or improved his skills as a golf instructor. The IRS denied the deduction because the courses qualified the taxpayer for a new trade or business.

The Tax Court sided with the government and held that because the courses could be used toward an undergraduate degree and would qualify the taxpayer for a variety of new trades and businesses, the tuition was not deductible (Fields v. Commissioner, TC Summary Opinion 2001-35).

Just the Real Tip Income, Please

Tips are subject to FICA taxes just as if they had been wages paid by the employer. Each month, employees are required to report their tips on form 3070. The employer then reports to the IRS gross sales, charged tips and employee-reported tips on form 8027.

A restaurant employed waiters, bartenders, busboys and others whose earnings partially comprised tips. The IRS assessed the restaurant for additional FICA taxes on unreported tip income. To arrive at the amount owed, the service computed an average tip percentage based upon credit card sales and multiplied this percentage by the gross receipts.

The district court held that the government had exceeded its authority by estimating the tip income. The Ninth Circuit Court of Appeals affirmed the district court, holding that the IRS should not have calculated and assessed unreported FICA tips by estimating the amount of the tips. According to the court, Congress authorized the IRS to use estimates in assessing income taxes but no such authority existed with respect to FICA taxes. Instead, there should have been an employee-by-employee determination of taxable tips. The court’s opinion made it clear that the IRS could not use an aggregate approach to estimate an employer’s FICA liability (Fior D’Italia v. United States, no. 99-16021 (9th Cir., 3-7-01)).

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