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Tax Matters

The ETA Needs You

The IRS needs tax practitioners' help to meet the aggressive electronic filing goals laid out in the Restructuring and Reform Act of 1998. That was the message Robert E. Barr, IRS assistant commissioner for electronic commerce and chief of the Electronic Tax Administration (ETA), recently delivered to a group of practitioners in New York City.

"We clearly cannot be successful in the ETA without the support of the practitioner community," Barr said.

He explained that professional tax preparers now complete 50% of tax returns. To achieve the goal of having 80% of all returns electronically filed by the year 2007 (as mandated in the 1998 act), the IRS must persuade practitioners to file all their returns electronically.

"The good news is that, although we have challenges ahead, the whole marketplace is moving with tremendous speed toward the new technologies and the ETA is riding that wave," Barr said.

As evidence of the electronic trend, Barr pointed to the statistics for the 1999 tax season.

The IRS received electronically more than 29 million of the total 125 million returns filed. Overall, the number of electronically filed returns in 1999 increased 19%, and the number of returns electronically filed by practitioners increased 20%, over the prior year.

In addition, the IRS collected $1.2 trillion from employers through the Electronic Federal Tax Payment System (EFTPS) for fiscal year 1998, an amount which grew by 18% this year. EFTPS, which now accounts for more than 80% of all federal tax deposits, allows businesses to pay their payroll taxes electronically.

This season's new options and pilot programs were aimed at creating a completely paperless tax return process, Barr said. The most important developments included an expanded electronic payment option and personal identification number (PIN) pilots.

This year, for the first time, the IRS offered taxpayers the option of paying by credit card. Approximately 53,000 tax liabilities were paid using the cards.

The IRS also conducted two PIN pilots aimed at eliminating paper signature forms. It mailed postcards with electronic customer numbers to eight million taxpayers. Approximately eight percent (649,576 filers) used the numbers on their returns this year.

In another pilot, involving 2,493 tax practitioners, taxpayers were allowed to choose a one-time PIN for their 1998 returns. Using the PINs, the practitioners filed 496,119 returns.

What's in store in the year 2000? Barr said the ETA wants to expand payment options by increasing the number of credit card companies that participate in the program. The ETA is also working to increase the number of forms that can be filed electronically.

Another goal is to eventually have taxpayers use digital signatures. In the meantime, however, the ETA plans to increase the number of both individual and practitioner participants in its PIN pilots for the 2000 tax season.

IRS Publishes New Group-Term Life Rates

The IRS published new Table I rates for the taxable portion of group-term life insurance costs. Issued under IRC section 1.79-3, the new rates are used to determine the value of employer-funded group-term life insurance coverage.

Effective for coverage provided on or after July 1, 1999, the updated tables have rates that will result in lower taxable income for employees in all age groups. In addition, the revised table includes a new age bracket for employees who are under 25.

INDIVIDUAL

IRS Gives Broke Taxpayers a Break

Individual taxpayers, who would suffer economic hardship if forced to pay their entire tax liability, can now breathe a sigh of relief. The IRS released temporary and proposed regulations (TD 8829 and IR-1999-64) that allow it to take into account hardship and equity factors in offers in compromise (OIC).

According to Charles O. Rossotti, commissioner of the IRS, the new regulations will help people the IRS has not been able to reach before. However, he warned taxpayers against interpreting the new law as an open invitation to avoid paying taxes.

Rossotti cautioned that the new hardship provisions are meant "only for taxpayers entangled in very severe circumstances," and are "not designed to be a sweeping program for everyone with financial difficulties."

The old regulations permitted the IRS to accept an offer in compromise only on grounds of doubt as to liability, collectibility or both. Taxpayers can still submit offers under the old rules, but now they may receive an OIC settlement even if liability or collectibility is not an issue.

Under the new rules, which went into effect July 21 and will be in force for three years, taxpayers will receive relief if collection of the liability would create economic hardship or if exceptional circumstances exist that would cause collection of the tax liability to be detrimental to voluntary compliance.

The regulations list the following examples of economic hardship:

• The taxpayer is incapable of earning a living because of long-term illness, medical condition or disability.
• The taxpayer has a dependent whose long-term illness requires the taxpayer to use his or her resources for basic living expenses and medical care.
• The taxpayer would not be able to meet basic living expenses if his or her assets were liquidated to pay outstanding tax liabilities.
• The taxpayer is unable to borrow against his or her assets, and seizure and sale of the assets would have sufficiently adverse consequences to make enforced collection unlikely.

In the new regulations, the IRS gives two examples of cases where the new OIC rules would apply (see section 301.7122-IT(b)(4)(iv)).

In the first example, the taxpayer is retired and his only source of income is his pension. His only asset is his retirement account, and the funds in the account are sufficient to pay his tax liability. Liquidation of the account would leave the taxpayer without adequate means to provide for basic living expenses.

In the second example, the taxpayer was hospitalized for a number of years. When he was ill, he could not manage his finances and didn't file any tax returns. The taxpayer's health improved, and he began to file his tax returns. The IRS informed him it had prepared a substitute return for an earlier year. With penalties and interest, the tax bill is now more than three times the original tax liability.

In both these examples, the new rules would allow the taxpayers to obtain OICs from the IRS.

Observation. Taxpayers seeking relief under the new hardship/equity guidelines must submit the new form 656-A in addition to form 656 (the standard OIC form). If the offer is rejected, it will automatically receive an independent administrative review. In addition, the taxpayer has the right to appeal any rejection of an offer in compromise to the IRS Office of Appeals.

The temporary regulations, which are in effect through December 31,1999, require taxpayers to waive the statute of limitations as a condition of the acceptance of an OIC. After January 1, 2000, the IRS will no longer require the waivers, but it will suspend the statute of limitations during the time it is considering an offer.

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

Shareholder Guarantees of Corporate Debt

Many creditors are reluctant to lend money to closely held businesses because of limited liability protection. In many cases a creditor will insist that one or more of the corporation's shareholders personally guarantee the debt. If the company pays a shareholder a fee for providing a guarantee, is the payment deductible?

In 1983, three individuals formed Seminole Thriftway, Inc., to operate a supermarket. The corporation needed additional capital to purchase land and inventory. To persuade a bank to lend the money, the three shareholders personally guaranteed repayment of the debt. In 1985, Seminole hired a general manager who received stock in addition to other compensation. In 1987, the company paid the original shareholders a fee to compensate them for guaranteeing the debt and deducted it on the corporation's tax return. For tax years 1992 to 1994, the IRS denied the deduction by reclassifying the payment as a constructive dividend. The company paid the additional tax and sued for a refund.

Result. For the IRS. The Court of Federal Claims reviewed prior cases and determined that classification of such a payment as either a deductible expense or a constructive dividend is based on five factors.

• The reasonableness of the payment.
• Whether similar corporations pay their shareholders for loan guarantees.
• Whether the shareholders demanded payment for guaranteeing the debt.
• Whether the company pays sufficient dividends; failure to do so implies the payment is a constructive dividend.
• The proportional relationship between the payment and stock ownership.

Because the government sued for summary judgment, the facts were not in dispute. The parties agreed the fees were reasonable and consistent with those paid by other corporations. This focused the decision on the last three factors.

The Seminole shareholders signed guarantees without demanding any compensation. In fact, several years had passed before the company paid them a fee—a circumstance that favored the IRS. Seminole paid no dividends during the years in question although the company was profitable. This implied the payments were a constructive dividend and not a deductible fee. Finally, although the company paid the fee at a time when there was another shareholder who had not guaranteed the debt and who did not receive any compensation, the guarantee was made by all of the shareholders who existed at the time the debt was incurred. Since the payment was proportional to the ownership of the original shareholders, the fee was closer to a constructive dividend. Based on these factors, the court concluded the payment was, in fact, a dividend.

A corporation can pay and deduct a fee to a shareholder for guaranteeing a corporate debt. However, the IRS will review the payment based on the five-factor test. If the shareholder fails to demand a fee before signing the guarantee, the payment is likely to be reclassified as a constructive dividend to the extent the company has undistributed earnings and profits. Payments should be structured so they are not proportional to stock ownership at the time the guarantee is signed. Also, since not all suits will be for summary judgment, taxpayers must be able to demonstrate the fee is reasonable and would have been paid by comparable corporations.

• Seminole Thriftway, Inc. v. United States, U.S. Court of Federal Claims, 1998.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

©1999 AICPA