TAX MATTERS

INCOME AND DEDUCTIONS, THEFT LOSS

A NOT-SO-SPEEDY RECOVERY
The Court of Federal Claims applied rules on theft loss subject to recovery in a holding that recognized a deduction later than it was initially claimed by a taxpayer but, for a portion of the loss, sooner than the IRS had allowed.

Casualty and theft losses are deductible under IRC § 165 to the extent not reimbursed by insurance. These recoveries can take place years after the loss. Consequently, the proper year in which to deduct the loss can be an issue.

A former Detroit television station owner, Aben Johnson, purchased $83.5 million of gems and jewelry from Palm Beach, Fla., jeweler Jack Hasson during the early and mid-1990s. In 1997 Johnson discovered that the gems were worth only $5.4 million and the remainder of his money had been stolen. Johnson deducted a $58.16 million theft loss ($78.16 million loss less a $20 million estimated recovery) on his 1998 tax return. The government objected and the court agreed that he was not yet entitled to the deduction because he was pursuing litigation to recover some or all of his loss. During extensive discovery, Johnson found that Hasson had transferred most of his assets to bank accounts in the names of various associates, some of them overseas. By the end of 1998, Johnson had located approximately $45,240,000 in assets.

In a criminal proceeding, Hasson was found guilty of wire fraud and other charges, and in 2001 that court ordered him to pay Johnson restitution. According to trial testimony, among the purportedly rare diamonds Hasson sold Johnson was one for $1.5 million that Hasson represented as having once belonged to actress Carole Lombard but was actually a $141 cubic zirconium. Also testifying as fellow victims were golfers Jack Nicklaus and Greg Norman. Johnson recovered approximately $1,404,000 through 2001. After 2001, he recovered an additional $37.9 million, the largest amount ($20,346,000) from a Paris bank account in 2005.

In the tax dispute, Johnson argued he was entitled to a theft loss in 1998 or 2001, while the government contended the loss was deductible in 2005.

The Code and regulations state that casualty and theft losses are deductible in the year sustained. Because theft losses are not always immediately obvious, the regulations define the year a theft is sustained as when it is discovered (see also "Maximize Tax Benefits Under IRC Section 165," JofA, April 05, page 72). However, no portion of the loss for which there is a reasonable prospect of recovery is deductible. Losses awaiting recovery are deductible when it can be ascertained with reasonable certainty whether reimbursement will be received (see "Reasonable Certainty’ for a Theft Loss Deduction," JofA, Oct. 07, page 74).

In 1998, Johnson had a reasonable prospect of recovery. He could not deduct any loss, however, until the amount he could recover was reasonably certain, the court said in a 2006 partial ruling for the government. Because under Treas. Reg. § 1.165-1(d)(2) the "reasonable prospect" standard applies only to the year of discovery of the loss, a taxpayer may deduct in that year an amount for which there is no reasonable prospect of recovery. This is a different standard from a reasonable certainty of recovery, the court said, which required that Johnson provide an objective "verifiable determination" of the amount, such as by settlement, adjudication or abandonment of claims—not, as Johnson provided, a rough estimate, particularly one that subsequent developments demonstrated had been too pessimistic.

However, in a subsequent ruling in January 2008, neither did Johnson have to wait until 2005 to deduct any amount of the loss, as argued by the government, because the regulations do not require final recovery. By 2001, a clearly identifiable set of claims had been sufficiently resolved to permit a theft loss of $37.2 million in that year.

Aben E. and Joan G. Johnson v. U.S., 101 AFTR2d 2008-523 and 99 AFTR2d 2007-328

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

S CORPORATIONS, DISTRIBUTIONS

CONTESTED BUYOUT DOESN’T BAR GAIN
The Ninth Circuit Court of Appeals affirmed the Tax Court’s decision that a cash-method shareholder’s forced buyout triggers gain recognition in the year that the buyout payment is received, even if the shareholder continues to dispute the buyout in court. Additionally, the shareholder must recognize any interest income from investment of the buyout funds as taxable in the year it is received.

Glenn Hightower and Daniel O’Dowd were each 50% co-owners of Green Hills Software Inc., an S corporation. Their relations with each other deteriorated until 1998, when O’Dowd triggered a dispute-resolution provision in the shareholder agreement. It provided for binding arbitration and that either party could force a buyout of the other’s stock based on a formula price. Hightower was unable to raise the funds to buy out O’Dowd’s shares, so he was forced to sell his shares to O’Dowd. Hightower received the buyout check in 2000, deposited it in an interest-bearing account and sought to have the sale set aside in court. By 2003, Hightower had lost in state court and had exhausted all appeal opportunities. Meanwhile, he had not reported his pass-through distributive share of Green Hills’ 2000 income, any of the gain from the forced buyout payment or the interest received from its invested proceeds.

The courts dismissed Hightower’s contention that the gain escaped tax under the claim-of-right doctrine until 2003. The doctrine requires that a payment be included in income only in the year it is received by the taxpayer without restriction as to its disposition. The courts said the doctrine did not apply because there was no restriction on Hightower’s disposition of the buyout funds and that he was under no fixed legal obligation to repay the buyout funds to another party at some future date. His decision to save the funds did not change his tax obligation. Interest income from the invested buyout funds was taxable upon receipt. Additionally, the rulings dismissed Hightower’s claim that the pass-through income was not taxable in 2000 because of his restricted management role from 1998 to 2000.

Recently, the Supreme Court denied certiorari in a similar case, Burke v. Commissioner, 99 AFTR2d 2007-2637 (see also “Tax Matters: Is Disputed Partnership Income Taxable?” JofA, May 06, page 82). In Burke, the First Circuit determined that a partner must pay income tax on his share of a partnership’s income that had been placed in escrow due to a lawsuit.

Glenn Hightower v. Commissioner, 101 AFTR2d 2008-470

Prepared by Bob Thomas, Ph.D., assistant professor 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.

RULEMAKING AUTHORITY

THIRD CIRCUIT SILENCES NATIONAL MUFFLER, PUMPS CHEVRON DEFERENCE
The Third Circuit Court of Appeals recently upheld the validity of Treas. Reg. § 1.882-4(a)(3)(i), which disallows deductions by a foreign corporation that fails to file a U.S. tax return within 18 months of the normal due date. When assessing the validity of the regulation, the Third Circuit applied the Chevron standard and found the language of IRC § 882(c)(2) to be ambiguous and that the related regulation was a reasonable interpretation of that language.

Some Treasury regulations, known as "legislative," are issued under specific authority granted by Congress in a Code provision with language such as, "The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section." Other regulations, known as "interpretive," are issued under the general authority granted in section 7805(a) to fill in gaps in the Code. Courts may invalidate a regulation that exceeds the secretary’s authority to issue it.

In 1979, in National Muffler Dealers Association v. U.S., 43 AFTR2d 79-828 (440 U.S. 472), the Supreme Court outlined six factors for assessing the validity of a regulation: whether the regulation is a substantially contemporaneous construction of the Code, its evolution, how long it has been in effect, the reliance placed on it, its consistency with other interpretations, and the scrutiny it received when Congress re-enacted the related Code section. In 1984 the Supreme Court in Chevron USA Inc. v. Natural Resources Defense Council Inc. (467 U.S. 837) established a two-step analysis: Is the statute unambiguous, and does it directly address the issue? If yes, the plain meaning of the Code should be followed. If not, is the regulation a permissible interpretation of the Code?

Swallows Holdings Ltd., a foreign corporation, owned real estate in California. From 1993 to 1996, the property generated rental income, but the company did not file tax returns for those years until 1999, outside the 18-month filing window allowed by the regulation for deductions. On its late returns, Swallows Holdings deducted its expenses, which the IRS disallowed.

Swallows Holdings asked the Tax Court to invalidate the regulation, claiming IRC § 882(c)(2) contains no explicit time requirement for filing a return in order to deduct expenses. It argued the plain language of section 882(c)(2) only requires a return to be filed in the “manner” prescribed under that subtitle. Furthermore, court decisions from the 1930s and 1940s—before the 1990 issuance of Treas. Reg. § 1.882-4(a)(3)(i)—had generally held that the term “manner” did not mean “time and manner.” In a split decision, the Tax Court ruled the regulation invalid, based on the unambiguous language of section 882(c)(2), and applied the National Muffler factors while examining prior cases, Code re-enactments and the development of the regulation. The majority also stated that a Chevron analysis would have produced the same result and is simply a practical restatement of the National Muffler factors. The court further stated the secretary was attempting “to resurrect a failed litigating position through the issuance of interpretive regulations.”

On appeal, the Third Circuit held that the National Muffler factors are not necessarily consistent with the two-prong test of Chevron. Swallows Holdings argued that interpretative regulations should not be examined under Chevron, but the court, quoting U.S. v. Mead Corp. (533 U.S. 218), said the Chevron standard should be used if “Congress would expect the agency to speak with the force of law.” Since the regulation was open to public comment before it was issued, the court ruled, the regulation had the force of law, thus making it subject to the Chevron standard. The court found the term “manner” used in section 882(c)(2) to be ambiguous and that the regulation was a reasonable interpretation of the statute.

This case illustrates how confusing the legal landscape surrounding the validity of regulations can be. The Tax Court found section 882(c)(2) unambiguous, while the Third Circuit found it ambiguous. The Tax Court believes Chevron is a restatement of National Muffler, but the Third Circuit treats them as different tests. Tax Court Judge Mark V. Holmes’ dissenting opinion in the case listed the circuits’ varied positions on the standards for analyzing the validity of general authority regulations and described the problem those differences create for the Tax Court. It appears as if this case may have raised as many questions as it answered.

Swallows Holdings Ltd. v. Commissioner, 101 AFTR2d 2008-876

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

GIFTS AND ESTATES

ALL IN THE FAMILY?
The Tax Court recently held that a note does not constitute a qualified family-owned business interest (QFOBI) for purposes of IRC § 2057, which allows an estate to deduct up to $675,000 from its value for estate tax purposes. To qualify for the deduction, the value of the QFOBI at the time of death must exceed half the value of the adjusted gross estate. This 50% liquidity test, found in section 2057(b)(1)(C), was at issue in Estates of Duane and Lois Farnam v. Commissioner.

The Farnams, of Minnesota, operated a family business of automobile parts sales as Farnam Genuine Parts Inc. To fund the company’s operation, the couple loaned it money over several years in return for unsecured promissory notes. Duane Farnam died in 2001 and Lois Farnam in 2003. Both their estate tax returns claimed deductions for QFOBIs, which the IRS disallowed in 2005.

The issue before the court was whether the notes constituted interests for purposes of the 50% liquidity test. Section 2057(e)(3) defines family ownership in the case of a corporation in terms of the amount of stock held by family members or, in the case of a partnership, capital interest. The decedents’ estates argued that section 2057(e)(3) applies only to determining whether an entity is family-owned and noted that the definition of a QFOBI in paragraph 2057(e)(1) does not similarly specify an equity or capital interest.

The Tax Court, however, agreed with the IRS that the QFOBI definition should be read as limited by the terms of the family ownership test. It would be “illogical to divorce the equity ownership requirements” of the latter from the former, the court said. The court thus held that the loans did not constitute QFOBIs and upheld the resulting deficiencies of $763,131 for the estate of Duane Farnam and nearly $1.5 million for that of Lois Farnam.         

Estates of Duane and Lois Farnam v. Commissioner, 130 TC 2

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

CHARITABLE TRUSTS

NEW SPLIT-INTEREST RETURN FORM
The IRS recently issued a revised Form 5227, Split-Interest Trust Information Return, for use in preparing returns for tax years beginning on or after Jan. 1, 2007. Among its numerous changes, the most significant are:

Charitable split-interest trusts are no longer required to file Form 1041-A, Trust Accumulation of Charitable Amounts, sections of which are now incorporated in Form 5227.

Form 5227 is now open to public inspection.

Failure to file or late filing subjects trusts and/or trustees to new penalties and higher existing ones.

The Pension Protection Act amended IRC § 6034 to allow the IRS to merge forms 5227 and 1041-A for charitable remainder trusts, charitable lead trusts and pooled income funds. Sections of Form 1041-A related to distributions of income and principal to charitable organizations are now incorporated into Form 5227.

IRC § 6104(b) now requires that Form 5227 be open to public inspection, except for information related to noncharitable trust beneficiaries, which has been moved to a new Schedule A that is not open to public inspection. Note that Form 1041-A also was subject to a similar public-inspection requirement, although the requirement was not disclosed on the face of the return. The procedural rules related to public inspection are found at Treas. Reg. § 301.6104(b)-1(d). To inspect a return, the petitioner must submit a written request to the IRS that must include the name of the trust, the trustee’s address, the type of return and the year for which the return was filed.

IRC § 6652(c)(2)(C) generally imposes a failure-to-file penalty on split-interest trusts unless the failure is due to reasonable cause. The penalty is imposed on the trust for failure to timely file a return, file a complete return or to furnish correct information. The Pension Protection Act altered the penalties for failure to file Form 5227 as follows:

The penalty for failure to file is $20 for each day the failure continues, with a maximum of $10,000 for any one return. This represents an increase from the penalty previously assessed for Form 1041-A of $10 for each day, with a maximum of $5,000 for any one return.

A new “super penalty” has been added for larger charitable split-interest trusts. Such trusts with gross income greater than $250,000 are now subject to a penalty of $100 for each day the failure continues, with a maximum of $50,000 for any one return.

The IRS may make a written demand with a deadline for filing the delinquent return or furnishing information. If the trustee fails to comply by the specified date, the trustee will be charged a penalty of $10 for each day the failure continues, with a maximum of $5,000 for any one return.

If the trustee required to file the return knowingly fails to do so, the same penalty that is imposed on the trust will also be imposed on such trustee. Also, penalties for filing a false or fraudulent return apply.

Prepared by Ted Batson, CPA, MBA, CFP, executive vice president, Renaissance, Indianapolis, and member of the AICPA Trust Accounting Income Task Force.

The applicability of the $1,000 specific deduction found at IRC § 512(b)(12) in computing the unrelated business taxable income of a charitable remainder trust.

The requirement to include the unrelated business income in the appropriate income category, notwithstanding the fact that it is subject to a 100% excise tax.

The requirement to pay the excise tax from trust corpus.

The excise tax is to be reported on the appropriate form—currently Form 4720, Return of Certain Excise Taxes Under Chapters 41 and 42 of the Internal Revenue Code.

The proposed regulations are proposed to be effective for taxable years beginning after Dec. 31, 2006. Comments on REG-127391-07 are requested by May 6.

Prepared by Ted Batson, CPA, MBA, CFP.