Tax Matters

Collecting Attorney Fees From the IRS
Recently a district court in New Jersey reviewed the rules and requirements in the tax code under which taxpayers can collect a reasonable reimbursement for attorney fees they pay to litigate tax cases they win.

Daniel Scheingold, John Orem and Edward Trueblood were officers of IE Inc. and Street Holding Co. Both entities failed to remit withheld payroll taxes to the IRS. The government assessed penalties of $1,883,307.95 and $172,679.85 against Scheingold as a responsible party at each of the two corporations. He made a $10,000 qualified offer to settle his liability, which the government rejected. At trial the court found Orem and Trueblood to be responsible parties and liable for the unpaid taxes. Scheingold, found innocent, instituted a suit against the IRS for reimbursement of his legal fees, which were in excess of the statutory limit of $125 per hour.

Result. For the taxpayer. Under IRC section 7430, in certain cases taxpayers are entitled to reimbursement of reasonable litigation costs and attorney fees. To be eligible, taxpayers must be the prevailing party in litigation against the government. There is an important exception: No reimbursement is due if the government can establish its litigation position was substantially justified. After reviewing the testimony and evidence in this case, the court found the government’s position was substantially justified. Normally this would have been the end. However, there is an exception to the substantial justification rule. If the taxpayer had made a qualified offer the government rejected and the final outcome (judgment) is equal to or less than the offer, then the taxpayer is treated as the prevailing party and entitled to reimbursement. Even though the offer in this case was only $10,000, it was reasonable given the taxpayer’s circumstances; therefore he was entitled to reimbursement.

Section 7430(g) defines a qualified offer as one made in writing during the qualified offer period that specifies the offer amount, is designated as qualified and remains open for the required time. The qualified offer period starts with receipt of the first letter stating the deficiency and ends 30 days before the case is set for trial. The offer must stay open until it is rejected, the trial begins or 90 days has elapsed, whichever is earliest. Because Scheingold’s offer met all of these conditions, he was entitled to reasonable costs and attorney fees.

The maximum stated rate for such fees is $125 per hour, though the rate can be higher in limited cases. The U.S. Supreme Court in Pierce v. Underwood interpreted the rule allowing higher fees as one where the defendant shows the attorney is qualified for the proceeding in a specialized sense beyond simple legal knowledge. There is a split among the circuit courts of appeal as to the correct interpretation of the Supreme Court decision. The Seventh, Ninth and Eleventh circuits interpret the rule as allowing higher fees if the attorney has specialized expertise in a particular area of law. The Fourth, Fifth and D.C. circuits require expertise outside of American law. The Third Circuit has not ruled definitively. The district court chose to side with the Seventh, Ninth and Eleventh circuits. Scheingold’s attorney’s skill in tax investigation and assessment litigation and his background as a special agent for the IRS provided him with the expertise to justify a higher hourly rate.

This case points out for CPAs the split in the circuits about fees in excess of the statutory rate as well as the special rules for qualified offers.

United States v. Scheingold, Orem and Trueblood, 293 FSupp2d 447, 2004-1 USTC 50, 116.

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

What Constitutes a Responsible Person?
IRC section 6672 imposes a penalty equal to the total amount of any federal payroll (trust fund) tax any person willfully evades, fails to collect or does not account for and pays over. In view of the section’s scope, the courts broadly interpret “any person” to include officers, employees, partners and others with responsibility for the financial affairs of the business. In interpreting this section, the courts focus on two key elements that drive the penalty: the determination of who is a “responsible person” and whether or not he or she acted willfully. CPAs must properly advise employers and clients about the implications of section 6672.

A recent college graduate, Christopher Lyon was president, secretary-treasurer and sole director of the North Branch Coal Co. from January 1996 until North Branch ceased operations in spring 1997. He received a salary and commission based on the amount of coal the company mined. North Branch’s bylaws stipulated the president was responsible for supervising its affairs and “shall sign or counter-sign all contracts and other instruments of the corporation.”

In March 1999 the IRS assessed Lyon for more than $338,000 in trust fund taxes North Branch owed. After making a $500 payment, Lyon sued for a partial refund in a U.S. district court, asserting he was not the responsible party under section 6672. Following cross-motions, the district court granted summary judgment to Lyon after concluding he lacked actual authority and thus was not a responsible party. The IRS appealed.

Result. For the IRS. Christopher Lyon claimed he had assumed the various roles in the corporation at his father’s direction. The father testified his son had lacked authority over general decision making and management of the company and actually had spent little time on corporate affairs. He did, however, deliver payrolls; accept the resignation of and reappoint a vice-president; sign the corporate annual reports and tax returns, including payroll returns; and execute various documents, including a credit agreement with a bank. Christopher Lyon also had been authorized to conduct all of North Branch’s banking business. Lyon said he had signed documents when and where he was told to do so, without reading them. Accompanied by an accountant, he had met on several occasions with an IRS agent who explained the penalty and enforcement provisions of section 6672. After promising to pay the taxes, Lyon reneged, asserting his father was willing to accept the blame.

In reviewing previous decisions, the court noted the major element in determining a responsible person was whether that individual had the statutorily imposed duty to make the payments. Title alone was not sufficient; the determination had to be based on substance over form. The court formulated a list of factors to apply to an individual to judge whether the substance was sufficient to create the responsibility. These factors included officer title, payroll control, payables control, financial operations responsibility, check signatory power and its actual use, and hiring and firing ability.

In applying the factors, the court concluded Lyon had actual authority. Thus, the onus was on him to demonstrate he had been prevented from exercising that authority. Although Lyon’s father had controlled the operations of the corporation, the younger Lyon had held “all the legal cards” and could have paid the taxes had he chosen to do so. The fact that he might have been fired for such action did not make him any less responsible.

Turning to the question of “willfulness,” the court observed the issue turned on whether the individual knew the payments were not being made. Since Lyon had met with the IRS and knew the liability existed and the corporation had paid other creditors during the period in question instead of the government, the court concluded Lyon’s failure to pay was willful.

Lyon v. Commissioner, CA-4, 2003-2 USTC 50,554.

Prepared by William J. Cenker, CPA, PhD, KPMG Professor of Accountancy, and Robert Bloom, PhD, professor of accountancy, John Carroll University, Cleveland.

Deemed Substantiation of Business Travel Expenses
IRC section 162(a)(2) permits taxpayers a deduction for business travel expenses such as lodging, meals and other incidental costs while away from home. IRC section 274(n) limits the deduction for meal and beverage expenses to 50% of the amount incurred. And section 274(d) requires strict substantiation of all travel expenses. In lieu of substantiating actual expenses, however, in certain circumstances taxpayers may determine the deductible amount by electing to use the “deemed-substantiation” methods in revenue procedure 96-64.

Continental Express Inc., a long-haul trucking company, reimbursed its drivers 9 cents a mile to cover expenses such as parking, lodging, showers, laundry, linens and Federal Express charges. The drivers could spend the per diem amount at their own discretion. The average amount the company paid to the drivers under the per diem plan for the years in question was less than the federal meals and incidental expense (M&IE) rate.

Revenue procedure 96-64 says 40% of a per diem paid for lodging, meals and incidental expenses is treated as having been paid for food and beverages when the amount is less than the federal rate. Since the drivers sometimes used part of the per diem for lodging, Continental treated 40% of the 9 cents a mile (3.6 cents) as paid for meals and beverages and 60% (5.4 cents) as paid for other items. This resulted in a deduction for the company of 7.2 cents a mile (50% of 3.6 cents, plus 5.4 cents).

Of this amount the IRS disallowed 2.7 cents a mile based on another sentence in the revenue procedure: It says when a per diem is paid only for meals and incidental expenses, the amount treated as paid for food and beverages is the lesser of the actual per diem or the federal M&IE rate. The IRS, therefore, applied the 50% limitation to the entire 9 cents a mile per diem, allowing a deduction of only 4.5 cents a mile. Over the three-year period in question, the disallowed deductions amounted to approximately $2,800,000. The taxpayer petitioned the Tax Court for relief.

Result. For the IRS. It argued that revenue procedure 96-64 clearly says a taxpayer’s per diem allowance is considered paid only for M&IE when calculated in the same manner as the drivers’ compensation. In this case Continental also paid its drivers on a per mile basis. Since the company’s per diem was treated as being paid only for M&IE, the revenue procedure required the smaller of the per diem paid or the federal M&IE rate be treated as paid for food and beverages. Also, since the average amount Continental paid per day was less than the federal per diem rate, the entire amount should have been considered paid for food and beverages subject to the 50% limitation. The Tax Court agreed.

Continental argued revenue procedure 96-64 was invalid because the tax treatment of the expenses had been computed without regard to their actual nature. The Tax Court agreed with Continental that the deduction under revenue procedure 96-64 did not necessarily match the actual expenses. The court held that the taxpayer had two options: It could have substantiated the actual expenses following the requirements of revenue procedure 96-64 or it could have followed the revenue procedure’s deemed-substantiation rules. Since those rules are elective and the taxpayer avoids having to substantiate actual expenses, Continental must take the bad with the good—the permitted deduction does not necessarily represent the actual expense.

The company also attempted to persuade the court it should be allowed additional deductions: Continental provided testimony at the trial estimating its drivers’ nonmeal travel expenses in an attempt to deduct them under the Cohan rule. The court found the company had provided reasonable estimates of the actual expenses but rejected this attempt as well. Since Continental did not follow the substantiation requirements of the regulations under section 274(d), it was not entitled to any deductions related to those expenses.

Certain deductions have strict substantiation rules. This case illustrates for CPAs the importance of following such rules. It also points out that when deemed-substantiation rules are provided the IRS and the courts will interpret them strictly.

C.A. Boyd v. Commissioner, 122 TC no. 18.

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

Valid Transfers Excluded From Gross Estate
Under IRC section 2036(a) and Treasury regulations section 20.2036-1(a) there are two exceptions that prevent transfers from being included in a decedent’s gross estate. First, if a transfer is a bona fide sale for adequate and full consideration, it is not part of the gross estate. Second, the transfer also can avoid inclusion if the decedent did not retain possession, enjoyment or rights to the transferred property or the right to designate who would possess or enjoy the property.

In 1991 Ruth Kimbell transferred the bulk of her estate to a revocable living trust. In January 1998 the trust and Mrs. Kimbell’s son David and his wife formed a limited liability corporation (LLC) with the trust holding a 50% interest. David was the LLC’s sole manager. Later that month, the trust and the LLC formed a limited partnership (LP) to which the trust contributed $2.5 million, receiving a 99% limited partnership interest. The LLC contributed $25,000 and received a 1% general partnership interest. At the LP’s inception, approximately 11% of the assets were working interests in oil and gas properties.

On March 25, 1998, Mrs. Kimbell died, leaving a will. In December her estate filed a federal estate tax return claiming a 49% discount on the value of Mrs. Kimbell’s interests in the LP and LLC based on lack of control and marketability of the LP. The IRS subsequently audited the Kimbell estate, determining that the transfers to the LP and LLC were subject to section 2036(a) and that the value of the assets transferred should be included in the gross estate. The estate paid the additional tax and filed for a refund. A district court agreed with the IRS determination and the estate appealed the decision to the Fifth Circuit Court of Appeals.

Result. For the taxpayer. The Fifth Circuit first determined the transfer to the LP (by far the larger and more important) was for full and adequate consideration. To reach this conclusion, the court focused on three main points: (1) the trust and LLC received partnership interests proportionate to the assets each contributed; (2) the partnership accounts were properly credited; and (3) the partnership agreement required distributions on termination or liquidation according to the partner’s capital balances.

The Fifth Circuit then determined the transfer to the LP was a bona fide sale based on four factors: (1) Mrs. Kimbell had had sufficient assets outside the partnership to support her personal needs; (2) all partnership formalities were satisfied and the transferred assets were actually assigned to the partnership; (3) most of the assets transferred did require active management; and (4) non-tax-objective business reasons existed for the transfer to a partnership that the trust could not satisfy. (Perhaps the most compelling reason was that the LP provided personal legal protection for Mrs. Kimbell from possible environmental issues related to the working oil and gas interests.)

The bona fide sale determination was particularly important since the district court had decided transfers between related parties by definition could not be bona fide sales. The Fifth Circuit rejected this argument and said that while related party transactions should be scrutinized at a higher level than those between unrelated parties, related party status should not automatically disallow the transaction.

The Fifth Circuit thus decided the transfer to the LP met the first exception of section 2036(a) and the assets were not included in Mrs. Kimbell’s gross estate. The court then turned its focus to the transfer from the trust to the LLC. It decided the second exception to section 2036(a) applied since Mrs. Kimbell only had a 50% interest in the LLC and David Kimbell had sole management powers. Therefore, Mrs. Kimbell had not retained the right to enjoy or designate who would enjoy the LLC property. The Fifth Circuit remanded to the district court the determination of whether Mrs. Kimbell’s interest in the LP was an assignee or limited partner interest for valuation purposes.

Based on the outcome of this important case, CPAs should make clients doing estate planning aware of the two exceptions under section 2036(a) and its regulations and emphasize the IRS and the courts probably will ask these questions about property transfers:

Was the transfer for full and adequate consideration, based on the three main points mentioned earlier?

Was the transfer a bona fide sale based on the four factors described above?

If the answer to either question was no, did the transferor give up all rights of possession, enjoyment or ownership of the assets as well as the right to designate who would possess or enjoy the transferred property?

Kimbell v. United States, 93 AFTR2d 2004-2400, 05/20/2004.

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