TAX MATTERS

TAX CASE

REFINING THE DEFINITION OF A CAPITAL ASSET
ection 1221 of the tax code broadly defines a capital asset. Over time the courts have attempted to narrow that definition and eliminate confusion. Recently a Third Circuit Court of Appeals ruling brought further clarification.

In June 1991 George and Angeline Lattera purchased a Pennsylvania lottery ticket for $1 and won $9,595,326. In September 1999 they received court approval to sell the rights to the remaining 17 annual payments of $369,051 for $3,372,342. They reported this transaction as a long-term capital gain. The IRS reclassified it as ordinary income and assessed a $660,784 deficiency. The taxpayers petitioned the Tax Court to eliminate the deficiency; the court sided with the IRS. The couple then appealed to the Third Circuit.

Result. For the IRS. Both the Tax Court and the Ninth Circuit Court of Appeals have ruled that the sale of lottery winnings generates ordinary income. Because of the harsh criticism of these decisions, the Third Circuit reexamined the issue to clarify what property qualifies as a capital asset.

In Hort and Lake, the Supreme Court narrowed the definition of capital asset by establishing the “substitute for ordinary income” exception. Under this exception, the sale of property that generates a receipt which is a substitute for future ordinary income is not a sale of a capital asset. It has been suggested that the Supreme Court’s 1988 decision in Arkansas Best rejected this exception. Although most courts do not fully discuss the exemption’s limits or reconcile differences in prior decisions, they find that the exception survived the Arkansas Best holding.

In the current case, the Third Circuit provided an analytical framework for addressing this issue. According to the appeals court, certain assets (stocks, bonds and options) are clearly capital and others (interest and rent) are unmistakably ordinary income. When disputes arise, a court should consider the nature of the property. If the property more closely resembles a capital asset, it is capital; if it more closely resembles ordinary income property, it is ordinary income.

If the property does not closely resemble either extreme, then the court should determine whether the transaction created a horizontal or a vertical carve-out. A horizontal carve-out, which disposes of only part of the taxpayer’s interest in the property, generates ordinary income. In a vertical carve-out, which disposes of all of the taxpayer’s remaining rights in the property, the court must determine whether the taxpayer disposed of a right to future income that had previously been earned—which generates ordinary income—or a right to earn future income—which creates capital gains.

A winning lottery ticket does not closely resemble either capital or ordinary income. Therefore, the court examined the type of carve-out the transaction created. The taxpayers sold all the remaining installments of their winnings; thus, they created a vertical carve-out. Since the purchaser receives the installments automatically, the taxpayers sold a right to future income. When they sold the remaining installments, the taxpayers received ordinary income.

The Third Circuit’s approach, which is new, attempts to reconcile all of the major cases. If other courts adopt this approach, taxpayers will need to change their analysis of disputed property and present different arguments to support their capital asset treatment.

George Lattera v. Commissioner, 437 F3d 399 (CA-3).

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

CO-OP REAL ESTATE TAXES NOT DEDUCTIBLE FOR AMT
axpayers generally can deduct expenditures they incur directly, but not expenditures paid by others on their behalf. IRC section 216, however, allows tenant-stockholders to deduct a proportionate share of real estate taxes paid by a cooperative housing corporation (co-op). Ostrow v. Commissioner addressed the deductibility of these taxes when computing a tenant-shareholder’s alternative minimum tax (AMT) liability.

The Ostrows, who were subject to AMT, deducted real estate taxes paid by the co-op on their joint return; the IRS disallowed the deduction. The couple argued that since the section 216 deduction had not been specifically disallowed, it was permitted in computing the AMT. The Tax Court disagreed, saying a tenant-shareholder’s share of the co-op’s real estate taxes was not deductible for purposes of determining the AMT. The taxpayers appealed to the Second Circuit Court of Appeals.

Result. For the IRS. IRC section 164(a)(1) allows taxpayers to deduct real property taxes paid or accrued during the taxable year. In the case of a co-op, this section permits the corporation to deduct real estate taxes it pays relating to the houses or apartment building it owns. IRC section 216 expands section 164 to reach tenant-stockholders of co-ops. Specifically, section 216(a)(1) allows a tenant-stockholder to deduct his or her proportionate share of the real estate taxes the co-op can deduct under section 164.

Taxpayers are required to pay a minimum amount of taxes, referred to as the AMT, pursuant to IRC section 55. Some deductions allowed for regular tax purposes are disallowed in the computation of AMT; one such item is taxes. IRC section 56(b)(1)(A)(ii) disallows the deduction for any “taxes described in” section 164(a). However, section 56 does not specifically provide that a deduction allowed under section 216 is disallowed in computing a taxpayer’s AMT.

The issue before the court—one not previously heard by the Second Circuit or any other court of appeals—was whether the deduction for real property taxes permitted by section 216 had been disallowed for AMT purposes. The taxpayers argued that since the adjustments for AMT had not expressly included section 216, the deduction was permitted. They cited other IRC provisions that list sections 164 and 216 separately to prove that Congress had specifically included section 216 when it intended for another provision to apply to it.

The IRS argued that the section 216 deduction was disallowed for AMT purposes because it related to a tax described in section 164(a). It also said the language of section 56 did not disallow deductions for real property taxes provided by a particular section. Rather, the IRS argued, the phrase “taxes described in” caused all real property taxes to be disallowed, regardless of which section permitted the deduction for regular tax purposes. Section 164 allows a deduction for state and local real property taxes, and section 216 explicitly incorporates section 164. The only distinction is that the section 216 taxes are paid by the co-op rather than directly by the taxpayer. Thus, because the section 216 deduction in this case related to a tax described in section 164(a), it was disallowed for AMT purposes.

The Second Circuit agreed with the IRS and affirmed the Tax Court’s decision. In disallowing the deduction, the court reviewed the history of section 216. Prior to 1942, the courts had held that tenant-stockholders could not take deductions for taxes paid by a co-op. However, in an effort to treat them the same as homeowners, Congress added a provision to the tax code specifically allowing tenant-shareholders to deduct such taxes. The Senate Finance Committee report said the purpose of the new deduction was “to place the tenant stockholders of a cooperative apartment in the same position as the owner of a dwelling house so far as deductions for interest and taxes are concerned.” Accordingly, Congress intended for taxpayers to deduct real estate taxes whether they paid the taxes directly or indirectly through a co-op. However, taxpayers who pay real estate taxes indirectly should not receive benefits denied to those who pay taxes directly. Allowing tenant-shareholders to deduct real estate taxes for AMT purposes would do just that and is not consistent with the stated purpose of section 216. Consequently, no taxpayer can deduct real estate taxes for AMT purposes—whether the taxes are paid directly or indirectly.

Ostrow v. Commissioner, Docket no. 05-0261, CA-2.

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

TAX CASE

WHEN IS A LIABILITY A LIABILITY?
o deduct an accrued expense, an accrual-basis taxpayer must satisfy an all-events test. The test has two prongs: Does the liability exist and, if so, can it be measured with reasonable accuracy? Legally a liability exists when it is final, fixed and absolute; that is, when the last event creating it has occurred and economic performance has occurred.

During 1984 and 1985, Chrysler Corp. sold vehicles covered under a company warranty as well as by the Uniform Commercial Code and the Magnuson-Moss Act. On its 1984 and 1985 tax returns, Chrysler deducted the estimated amount of possible future warranty claims related to vehicles sold in those years. The IRS disallowed the deductions and assessed the company a deficiency. Chrysler petitioned the Tax Court for relief, arguing that due to the warranty statutes the sale of the vehicles to its dealers was the last event that “fixed” its liability.

Chrysler cited United States v. Hughes Properties, Inc., 473 US 593, where a casino accrued a deduction for future slot machine payouts when a state law required the casino to pay out a set percentage of the amounts put into the machines. The Supreme Court held that the last event that created the casino’s liability was the placing of the last coin into the slot machines at the end of the year. Chrysler argued that in this case any statutory liability fixed the liability and thus satisfied the first prong of the all-events test.

The government cited United States v. General Dynamics Corp., 481 US 239, in which the Supreme Court disallowed a deduction for the estimated costs of employee medical expenses under a medical reimbursement plan. In that case the last event fixing General Dynamic’s liability was when the employees filed proper claims with the company—not when the employees received medical care. Agreeing with the IRS, the Tax Court found that Chrysler’s situation was similar to the General Dynamics case. The company appealed the case to the Sixth Circuit Court of Appeals.

Result. For the IRS. Both parties cited the same cases. The Sixth Circuit examined what a taxpayer must do in order to “establish liability with sufficient certainty.” It held that although a statute imposing an obligation may be sufficient to establish an absolute liability, it is not necessarily sufficient. The court also held that Chrysler’s warranty liability was contingent; to fix a liability a customer actually had to submit a warranty claim. Furthermore, a taxpayer may not deduct estimated expenses even though they are statistically certain.

This case illustrates the difference between the recognition of a liability and the related deduction for tax purposes on the one hand and the recognition of a liability and the related expense under generally accepted accounting principles (GAAP) on the other. GAAP requires only the existence of a present obligation resulting in the probable transfer of assets or the providing of services in the future as a result of a past transaction or event.

Chrysler Corporation v. Commissioner, 436 F3d 644 (CA-6).

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