The U.S. Supreme Court vacated a conviction for criminal tax evasion, holding that the taxpayer could argue that distributions he received were a nontaxable return of capital. If they were so characterized, then the taxpayer had no tax deficiency, which is a required element of tax evasion, the court pointed out. In doing so, the court also rejected a 1976 case’s requirement that any such distributions must have been intended as a return of capital when they were made. The Supreme Court remanded the instant case to the Ninth Circuit, which had also decided the earlier case.

Petitioner Michael H. Boulware’s conviction on several counts of criminal tax evasion and filing false income tax returns had been affirmed by the Ninth Circuit (98 AFTR2d 2006-8206). The Ninth Circuit had upheld the government’s contention that monies diverted from Hawaiian Isles Enterprises Inc. (HIE), a closely held corporation of which Boulware was the founder, president and controlling shareholder, were taxable distributions. Boulware sought to introduce evidence that HIE had no earnings and profits during the years in question, and therefore funds he received constituted nontaxable returns of capital. But relying on its own decision in U.S. v. Miller , 39 AFTR2d 77-364, the Ninth Circuit did not allow Boulware to present evidence supporting his return-of-capital theory.

Miller held that a diversion of funds may be deemed a return of capital only if the taxpayer could demonstrate that the distribution, at the time it was made, was intended to be a return of capital and not a constructive dividend. Other circuits had ruled differently on the application of IRC §§ 301 (distributions) and 316(a) (dividends) to informally transferred or diverted corporate funds in criminal tax proceedings. The Supreme Court granted certiorari in Boulware to resolve the split.

The government cited Miller ’s intent requirement and argued that section 301(a)’s requirement that a distribution be made “with respect to stock” obviates any possibility a diversion of funds could qualify as a return of capital. But the latter issue should be determined by the facts of the case, reviewed by a court “familiar with the whole evidentiary record,” the Supreme Court said. In any event, the question was not considered by the Ninth Circuit, it said. As for Miller , the Ninth Circuit erred in requiring contemporaneous intent and only compounded its error with Boulware , the Supreme Court said.

Rather, the Supreme Court viewed as essential to distribution of a dividend its source specified by section 316, earnings and profits. And economic substance, such as the lack of earnings and profits, is the touchstone for characterizing funds received by a shareholder, rather than intent, it said. Since the money could therefore be considered a return of capital, there was no tax deficiency, which the court noted is a required element of criminal tax evasion under IRC § 7201 (the other elements are a willful attempt to evade tax and an affirmative act to that end).

Justice David Souter’s opinion for the unanimous decision quoted Ninth Circuit Judge Sidney R. Thomas, who in a separate opinion concurring with that court’s majority—only because, Thomas said, it was bound by its own decision in Miller—nonetheless deplored that court’s holding that “a defendant may be criminally sanctioned for tax evasion without owing a penny in taxes.”

Boulware v. U.S ., 101 AFTR2d 2008-1065

Prepared by Alice A. Upshaw , CPA, MPA, instructor of accounting, and Darlene Pulliam , CPA, Ph.D., McCray Professor of Business and professor of accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.

In Action on Decision 2008-001, the Service said it would not acquiesce in the Tax Court’s allowance of a taxpayer’s contested valuation of the stock of a closely held corporation following a post-death, tax-free reorganization. The court’s 2006 decision represented a $100 million victory for family owners of privately held Kohler Co., the well-known manufacturer of small engines and plumbing fixtures. The Wisconsin-based company reorganized in 1998, partly to reconsolidate family control by buying out its approximately 4% nonfamily ownership.

The IRS issued deficiency notices and 20% accuracy-related penalties on the two gift returns and one estate return for 1998 of three grandchildren of the 137-year-old company’s founder: Herbert V. Kohler Jr.; the estate of his late brother, Frederic; and their sister, Ruth Kohler. Another deficiency was issued against the gift return of Herbert Kohler’s wife, Natalie Black (who also was the personal representative of Frederic Kohler’s estate). Frederic Kohler died in 1997. His estate chose an alternate valuation date in September 1998 and filed the estate tax return showing a stock value of approximately $47 million. The government valued the stock at $144.5 million.

During the alternate valuation period, the company issued new stock with transfer restrictions and a purchase option in exchange for its old stock. Nonfamily shareholders could not swap their shares but could accept $52,700 cash per share or litigate for a higher price, which some successfully did.

The government contended that the date of Frederic’s death was the proper valuation date but was blocked on procedural grounds from so arguing. It then argued that the valuation should be based on the pre-reorganization stock, citing Treas. Reg. § 20.2032-1(d), which provides that certain property interests that change form during an alternate valuation period by being actually received or disposed of by the estate are to be valued as of the date of death. However, the Tax Court noted that the regulation does not address tax-free reorganizations and found no authority to treat one as a change in form or exchange to be disregarded.

Alternately, the government argued the post-reorganization stock should be valued without regard to the transfer restrictions and purchase option. It pointed to IRC § 2032, which provides that property is valued as of the date it is “distributed, sold, exchanged or otherwise disposed of” during an alternate valuation period. But the Tax Court pointed out that Treas. Reg. § 20.2032-1(c), defining “otherwise disposed of,” specifically excludes tax-free reorganizations.

The court also found fault with the credentials, methods and conclusions of the government’s valuation expert witness, Scott Hakala. On the other hand, the court approved the probity and diligence of the plaintiffs’ two experts, Robert Schweihs and Roger Grabowski.

Not only was the plaintiffs’ valuation more reliable, but they were entitled to shift the burden of proof to the government to show that its valuation was the proper one, the court said. The government said the estate had been uncooperative toward its reasonable requests for documents. But on the whole, the estate did cooperate in good faith, the court said. Although the estate moved to quash a government summons of documents, it readily complied once that motion was denied. Moreover, the motion reflected legitimate concerns by the estate about the relevance of documents sought, given Kohler Co.’s interest in confidentiality of its proprietary information, the court said.

Besides nonacquiescing, the Service also issued proposed regulations (REG- 112196-07) to restrict to “market conditions” post-death events that cause a reduction in estate value during an alternate valuation period.

Herbert V. Kohler Jr. et al. v. Commissioner , TC Memo 2006-152

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

Despite contrary holdings by other circuits, the Fifth Circuit recently held fast to its earlier decision in Cook v. Commissioner to once again overrule an estate’s discounting of an annuity interest and restrict it to the valuation tables prescribed by IRC § 7520.

The decedent in the recent decision, James Bankston, received three annuities in a settlement resulting from injuries he suffered in an automobile accident. Each annuity guaranteed monthly or annual payments for at least 15 years. Under two of the contracts, payments could not be “anticipated, sold, assigned or encumbered.” The third annuity provided that payments were “non-assignable.” Bankston died in 1996 before receiving all of the payments, so his estate’s administratrix, Tincy Anthony, had to estimate their present value for estate tax purposes. The estate initially used the tables but later requested a refund, arguing that the nontransferability clauses provided for an exception to the tables. The IRS and a district court in Louisiana did not agree ( Anthony , 95 AFTR2d 2005-2905), and the estate appealed.

Estates of decedents who die after Dec. 13, 1995, are governed by Treas. Reg. § 20.7520-3(b)(ii), which provides an exception to using the tables when valuing a “restricted beneficial interest,” that is, an annuity subject to “any contingency, power or other restriction.” The estate interpreted “any … other restriction” broadly and argued it encompassed the marketability restrictions. The regulation provides examples where the annuity tables should not be used, such as where an annuity is expected to exhaust the fund before the last possible payment is made, where the trust corpus may be invaded without the beneficiary’s consent, or where the right to receive payments is contingent on the survival of a terminally ill individual. The Fifth Circuit noted that those examples and other language in the regulation concern only restrictions that threaten the receipt of the payment stream, not those that affect the ability of payees or their heirs to transfer their right to the payment stream.

It also applied its 2003 ruling in Cook (92 AFTR2d 2003-7027). In Cook , the Fifth Circuit held that because nonmarketablility was irrelevant to the right to receive a stream of payments, it could be regarded as underlying the valuation tables. Although the decedent in Cook died in 1993, before the regulation took effect, nothing in the regulation countermands that case’s holding, and it remains applicable, the Fifth Circuit said.

Alternatively, the estate argued that the tables produced an “unreasonable and unrealistic” result. The estate’s claimed value was $1,176,810 less than the table value. The Ninth and Second circuits have upheld departure from the tables on those grounds in Shackleford (88 AFTR2d 2001-5658) and Gribauskas (92 AFTR2d 2003-5914), respectively. Compare also the District Court for the Northern District of Ohio’s decision last year in Negron (99 AFTR2d 2007-3127, discussed in “ Tax Matters: Ohio Court Turns the Tables on Annuities ,” JofA , Jan. 08, page 74). However, the Fifth Circuit in Cook and now Anthony holds that since a lack of marketability does not allow an exception from the table, neither does it render the tables’ result unreasonable.      

Anthony, Administratrix of Succession of Bankston v. United States, 101 AFTR2d 2008-983

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

An amendment to IRC § 6214(b) included in the Pension Protection Act of 2006 empowers the Tax Court to apply equitable recoupment to offset overpayments of hospital insurance taxes (the Medicare portion of FICA) against income tax deficiencies, according to the court’s ruling in Menard Inc. v. Commissioner . Although the Tax Court lacks original jurisdiction over deficiency and overpayment claims for Medicare taxes imposed under IRC §§ 3101 and 3111, its power to use equitable recoupment is ancillary to its original jurisdiction over a deficiency redetermination.

In earlier rulings, the court agreed with the IRS that compensation paid by Menard Inc. to President and CEO John Menard, who was also an 89% shareholder, was unreasonable and actually a disguised dividend. The corporation owed an income tax deficiency to the extent that Mr. Menard’s compensation was not deductible as an ordinary business expense. Mr. Menard was assessed personal deficiencies on reimbursed expenses that were found unreasonable and on constructive receipt of interest income on loans he made to the corporation.

The deficiency against the corporation totaled $5,720,334 plus a penalty of $188,295, and Mr. Menard was assessed a deficiency of $921,491 plus a penalty of $184,298. The taxpayers objected to the final computation of tax due, contending the corporation and Mr. Menard were each due a credit of $196,845, the amount of Medicare taxes each paid on the wage income now recharacterized as constructive dividends. By the time rulings were issued in Menard I (TC Memo 2004-207) and Menard II (TC Memo 2005-3), the statute of limitations for filing a refund claim on the overpaid Medicare taxes had expired with respect to both taxpayers

The doctrine of equitable recoupment allows a litigant, under certain circumstances, to avoid the bar of a statutory limitations period. The factors outlined in Estate of Mueller (101 TC 551) require: (1) that the otherwise time-barred overpayment is sought as an offset; (2) the overpayment arises out of the same transaction, item or taxable event as the overpayment before the court; (3) the transaction, item or taxable event has been inconsistently subjected to two taxes; and (4) if the transaction, item or taxable event involves two or more taxpayers, there is sufficient identity of interest between the taxpayers subject to the two taxes that the taxpayers should be treated as one.

The IRS did not dispute the amount of the overpayment or whether the elements of an equitable recoupment claim were present. The court rejected the Service’s contention that the court lacked authority to apply the doctrine. The court said legislative history of the amendment to section 6214(b) showed a clear intent to empower the Tax Court to use equitable recoupment. The Service’s “narrow construction” of the statute would be inconsistent with the policy of preventing “an inequitable windfall to a taxpayer or the Government that would otherwise result from the inconsistent tax treatment of a single transaction, item, or event.”

Menard Inc. v. Commissioner , 130 TC no. 4

Prepared by JofA staff member Jeffrey Gilman , J.D.

In an unrelated development, the IRS provided a safe harbor method for accounting by accrual-method taxpayers for FICA and FUTA tax liabilities incurred by compensation earned at year end and paid in the new year. The recurring-item exception of Treas. Reg. § 1.461- 5(b)(1)(i) will be available to taxpayers under the all-events test, the Service said in Revenue Procedure 2008-25. The method is included as an automatic consent to change of accounting provided under Revenue Procedure 2002-9. Citing Eastman Kodak Co. v. U.S. (37 AFTR2d 76-1200), the Service and Treasury noted that taxpayers may not know at the end of a taxable year whether an employee has reached any applicable payroll tax ceiling by the time the tax is paid, raising a question as to when the corresponding liability is fixed. The method is effective for taxable years ending on or after Dec. 31, 2007.

The final regulations also clarify that each member of an expanded affiliated group—or EAG, defined in IRC § 7874(c)(1)—must separately perform its own allocation of W-2 wages to DPGR before they are aggregated by the EAG. In addition, the regulations provide that to the extent a net operating loss (NOL) is used in the year it was sustained to determine a taxable income limitation under section 199, such NOL is not treated as an NOL carryover or carryback in determining the taxable income limitation in subsequent or previous years.

The regulations, issued as Treasury Decision 9381, took effect Feb. 15, 2008.