Tax Matters

Tax Liens
One troubling aspect of tax practice that CPAs sometimes have to deal with is what to do when the IRS or some other authority attaches a tax lien to a client’s property. The issue is even more complex when the property is in joint name because it involves both federal and state law. Recently the U.S. Supreme Court considered how “tenancy by the entirety,” a form of joint ownership available only to married couples, affects a tax lien.

Don Craft failed to file tax returns from 1979 to 1986. In 1988 the IRS assessed $482,500 in unpaid income taxes against him. It attached a lien to property located in Grand Rapids, Michigan that Don and his wife Sandra Craft owned as tenants by the entirety. After the IRS attached the lien, Don transferred his ownership interest to Sandra for $1. She sold the property and placed half the net proceeds into an escrow account as the IRS required before it would release the lien and allow the sale. The Sixth Circuit Court of Appeals held that the lien did not attach to the property because Don did not have an interest in it separate from his wife’s. The IRS appealed and the Supreme Court granted certiorari, agreeing to hear the case and determine whether a tax lien could attach to property owned as tenancy by the entirety.

Result. For the IRS. Under IRC section 6321, a tax lien may attach to any “property” or “rights to property” a taxpayer owns. Therefore the question before the Court was whether a tenant by the entirety has property or a right to property to which a lien could attach. Although this is a federal-law question, the answer depends on state law. In answering the question it’s necessary to consider property as a bundle of rights and examine how the various types of ownership affect an individual taxpayer’s rights.

By law, tenancy by the entirety can exist only between married persons. Each tenant has a right of survivorship. Under Michigan law a tenant by the entirety has the right to use the property, to exclude others from using it, to share in any income from the property, to receive half the proceeds on sale and to borrow against the property with the other tenant’s consent.

According to the Supreme Court, the fact the Crafts could use the property, receive income from the property and exclude others from it are important rights. By themselves, these rights may be sufficient to be considered a right to property, enabling the IRS to attach a lien. When the right to alienate (borrow against or sell) the property is added to these rights—even if it cannot be done unilaterally—this is sufficient for the Court to decide that each spouse has a right to property. The Court left for another day the effect of the survivorship right on deciding whether a right to property exists. One reason the Court found the other rights sufficient to make this determination is because both tenants had the same rights. If it had held them to be insufficient, the conclusion would be that nobody had a right to the property. The Court pointed out that its own conclusion was not influenced by the fact the state of Michigan reaches the opposite conclusion for state creditors.

Justices Thomas, Stevens and Scalia dissented. However, since most states have similar rights for tenants by the entirety, tax liens will attach to most property owned in this way. For the Craft case, the final answer must await another court’s decision as to whether Mr. Craft’s transfer of his ownership interest in the property to his wife for $1 was fraudulent.

If clients ask CPAs about the effect of different types of ownership on the ability of creditors to attach liens, they should say it appears ownership as tenants by the entirety is ineffective as a means of preventing a federal tax lien from attaching to a property.

United States v. Sandra Craft, 122 Sup. Ct. 1414 (2002).

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

Unreported Tips and FICA
Food service employees generally rely on tips to earn a reasonable wage; they and their employers have special withholding and reporting requirements. IRC section 3121(q) requires that “tips received by an employee in the course of his employment shall be considered remuneration” and “deemed to have been paid by the employer” for purposes of FICA withholding and reporting. Under IRC section 6053 each employee is required to report tip income to his or her employer on a monthly basis. Under Treasury regulations section 31.3402(h)-1 the employer may withhold on the basis of average estimated tips.

In 1991 and 1992, San Francisco’s Fior D’Italia restaurant reported tip income of $247,181 and $220,845 respectively. These amounts were supported by reports from the restaurant’s employees. However, customer credit card slips listed larger tip totals than the amounts the employees reported. Consequently, the IRS calculated and assessed additional FICA taxes.

The IRS used an “aggregate estimation method” to calculate the additional taxes. It computed an average of the tips found on the credit card slips: 14.49% for 1991 and 14.29% for 1992. The IRS multiplied the restaurant’s total receipts by these percentages and subtracted the amounts already reported. It assessed FICA taxes on the difference between the computed and reported amounts.

Fior D’Italia paid part of the taxes and brought a refund suit, arguing that section 3121(q) required that each employee’s tips be determined and individual deficiencies aggregated to determine any underreported amounts. Under that interpretation the IRS would not be allowed to use its aggregate estimation method. The district court ruled for Fior D’Italia, and the Ninth Circuit Court of Appeals affirmed (see “Tax ‘Tips’,” JofA, Feb.02, page 68). The IRS petitioned the U.S. Supreme Court for certiorari. The Court granted it due to differing opinions in the Ninth, Eleventh and federal circuits.

Result. For the IRS. The tax authorities may use aggregate estimation methods to determine the required withholding and reporting amounts. The Supreme Court decided that IRC section 6201, which requires the IRS to make inquiries, determinations and assessments of the tax, allows it to use reasonable methods to estimate taxes due. The Court also ruled the definitional section that used the singular term “employee” does not explicitly require the IRS to make the computations on an individual basis. In addition, IRC sections 446(b) and 6205(a)(1) do not imply an aggregate estimation method could not be used, as the lower courts had argued.

The Court went on to discuss the reasonableness of the aggregate method. It suggested that assessing taxes individually would not have resulted in a better tax computation. Fior D’Italia stipulated it would not challenge the particular IRS calculation as inaccurate, preventing it from presenting evidence that any assessment was inaccurate.

Businesses that must comply with the tip withholding and reporting requirements can take steps to minimize any overstatement of liabilities that might arise from the IRS’s aggregate estimation methods. A restaurant should document

Short-term employees who earn less than $20 in tips.

Employees whose total earnings, including tips, exceed the wage base.

Cash given back to patrons paying with a credit card.

A lower tip percentage paid by cash patrons.

Credit card fees paid out of tips, resulting in lesser net tips to employees.

Although the recordkeeping requirements to support a lower assessment might be substantial, the tax savings could also be quite large.

United States v. Fior D’Italia Inc., Sup. Ct., 89 AFTR2d 2002-2883.

Prepared by Sharon Burnett, CPA, PhD, assistant professor of accounting and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.

Sale of Future Lottery Payments Is Ordinary Income
Lottery winnings generally are taxed as ordinary income in the year a taxpayer receives them. But what happens if the winner sells the right to receive future lottery payments in exchange for a lump sum amount? Is the transaction eligible for capital gains treatment?

In 1991 Mr. and Mrs. Macginnis and their sons were multi-million-dollar winners in the Oregon state lottery. Mr. Macginnis’ share was $9 million, payable in 20 equal annual installments of $450,000. After receiving 5 payments, Macginnis sold his right to receive the remaining 15 payments to a third party for a $3,950,000 lump sum.

Macginnis reported the first 5 payments as ordinary income. Initially he also reported the lump sum in the same way. However, he later filed an amended return treating the lump sum as a capital gain. Based on his amended return, the IRS issued Macginnis a $352,517 refund. It then filed suit to recover the refund plus the costs of bringing the action.

Result. For the IRS. The taxpayer argued the right to the lottery payments was a capital asset under IRC section 1221. However, the district court held that the assignment of the right to receive the remaining payments did not convert the character of the income from ordinary to a gain from the sale of a capital asset. The court said capital gains treatment was not appropriate since no asset had appreciated. Instead, the transaction involved an assignment of an established, noncontingent right to receive future payments of ordinary income. Based on these findings, the court ordered the taxpayer to repay the refund to the IRS.

This ruling would apply to any transfer of a stream of future payments for a lump sum, such as annual lottery payments or a personal injury award settlement made through annual payments. See also Davis, 119 TC No. 1 (2002).

Macginnis, 89 AFTR2d 2002-3028.

Prepared by James Ozello, Esq., Ozello Tax and Legal Consulting, Ringwood, New Jersey.