TAX MATTERS

TAX CASE

UNDERSTANDING CLOSING AGREEMENTS
hen an IRS audit identifies deficiencies in a tax return, the taxpayer may be asked to sign a closing agreement. There are two types of closing agreements. The first—contained on Form 866, Agreement as to Final Determination of Tax Liability—establishes the final tax liability. The other, contained on Form 906, Closing Agreement on Final Determination Covering Specific Matters, makes a determination on only those items specifically listed on the form. Other items still can be adjusted by the IRS in subsequent actions. These agreements are binding on both sides absent fraud, malfeasance or misrepresentation of material fact.

In a form 866 closing agreement, a deficiency notice is not necessary. Both sides agree to a final liability and, therefore, there is no need to provide an opportunity for the taxpayer to request a court review. With form 906, all unstated items are left open for future review. If the IRS adjusts any of these items, the taxpayer has the right to request court review. Therefore, the IRS must issue a deficiency notice before attempting to collect.

Bernhard Manko was a 99% partner in Comco. The IRS audited the partnership returns for 1987 to 1991 and reached an agreement with Manko and the other partners on necessary adjustments. Since the adjustments affected Manko’s individual return, he agreed to an indefinite extension of the time for assessment of additional tax. After agreeing to the partnership adjustments, Manko signed a form 906 closing agreement. Although the partnership items were settled, the IRS used this form because it wanted to retain the right to make other adjustments to Manko’s individual return. The IRS then examined the individual return and issued an Income Tax Examination Changes form reflecting both partnership and individual adjustments. It assessed the extra tax shown on the change form without issuing a deficiency notice. According to the IRS, Manko owed $10.763 million for 1988 and $2.644 million for 1989. From 1996 through 2000 the IRS sent five additional change forms adjusting the amounts due for 1988 and 1989. In 2003 Manko terminated his consent to extend the assessment deadline. The IRS issued a final notice of intent to levy. At a hearing, the taxpayer argued that the levy should not proceed since he had not received a deficiency notice. In 2004 the IRS ruled that the levy could be implemented. The taxpayer petitioned the court for a determination.

Result. For the taxpayer. Usually a deficiency notice must be issued before the IRS can assess a deficiency, but Manko had signed a form 906 closing agreement and the IRS argued that the closing agreement waived the necessity of issuing such a notice. The Tax Court disagreed.

A deficiency notice allows the taxpayer the right to petition the Tax Court to review the assessment. (The notice is not necessary if the assessment is based solely on a mathematical or clerical error or if the taxpayer waives the restrictions on assessment.)

As this case demonstrates, taxpayers need to know which form is being used and which items are still in dispute to preserve their right to contest these items. The Tax Court acknowledged that when form 906 is used, the IRS must issue a deficiency notice. However, according to the regulations, taxpayers don’t have the right to challenge any item listed on the form. Items subject to challenge are settled and not open to review. Any other item is covered by the normal rules for tax disputes.

Bernhard F. Manko v. Commissioner, 126 TC no. 9.

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

TAX CASE

MEDICAL REIMBURSEMENT PLAN FOR EMPLOYEE-SPOUSE
mployees can exclude reimbursement they receive from their employers for medical expenses—and employers can deduct payments made to employees—only under certain conditions. There must be a bona fide employer-employee relationship and a proper plan, even if unwritten, that conforms to IRS guidelines for medical reimbursement plans. And covered employees must know about or have notice of the plan. The IRS looks even more closely when the employer and employee are husband and wife.

Maureen Speltz was a licensed day care provider who operated a sole proprietorship in Minnesota. Her husband, who also had a full-time job, was her only part-time employee. Mrs. Speltz established a medical reimbursement plan for her employee-husband with the help of a tax adviser. An employment contract specified his duties and minimum work requirements to qualify for the plan. Mrs. Speltz deposited his salary, which was used to reimburse him for health insurance premiums and any uninsured medical costs, into a flexible spending account.

In the years 2000 and 2001 Mrs. Speltz deducted the reimbursements on her schedule C as a business expense and the couple excluded the payments on their joint tax returns. The IRS disallowed the deductions and assessed a deficiency. The taxpayers petitioned the Tax Court for relief.

Result. For the taxpayer. The IRS argued that the couple could not exclude the reimbursements to the husband because no proper plan existed. And, even if it did, the husband was not a bona fide employee and the plan was not sufficiently available to him. The service further contended Mrs. Speltz could not deduct the amounts on her schedule C since they were not business expenses. The Tax Court rejected all of these arguments.

First, the court found that a proper plan existed. Mrs. Speltz had prepared a document that explained employees were eligible to receive up to $6,500 a year in medical expense reimbursements and specified the number of hours they must work to receive them. The Tax Court concluded the employee-husband knew of the plan because he had signed a document stating his annual compensation consisted entirely of medical reimbursements up to the $6,500 limit. In addition, during the years in question, he had submitted claims for reimbursement under the plan.

The court also said Mr. Speltz was a bona fide employee because Mrs. Speltz could control his work activities—the “fundamental” test used to determine whether an employer-employee relationship exists. In addition the court held that Mr. Speltz performed activities essential to operating the day care business. Thus his salary was compensation for work he had actually performed and it did not result from his spousal relationship.

The Tax Court also found that payments for personal services are ordinary and necessary business expenses; the taxpayers in this case had to demonstrate only that the payments were reasonable. To ascertain this the court used a log maintained by Mrs. Speltz and divided her husband’s total compensation by his total work hours. It then held the payments were reasonable because his hourly rate was much less than the salary she would have had to pay to another employee.

This case demonstrates how a sole proprietorship can both obtain tax benefits and provide health benefits for family members. It also illustrates the importance of carefully researching the issue and implementing a well-documented plan.

Peter F. and Maureen L. Speltz v. Commissioner, TC Summary Opinion 2006-23.

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

TAX CASE

FAMILY LIMITED PARTNERSHIP TRANSFERS WERE INDIRECT GIFTS OF STOCK
RC section 2501 imposes a tax on the transfer of property by gift during a taxable year. IRC section 2511 says this tax applies whether the gift is direct or indirect or the transfer is in trust or otherwise. The gifted property is valued as of the date of transfer under IRC section 2512(a). The step transaction doctrine, which determines whether separate transactions, regardless of their overall purpose, should be treated as an integrated set of transactions for tax purposes, also applies to such transfers.

During 1998 and 1999 Mark and Michele Senda formed two family limited partnerships to which they transferred a total of 46,977 shares of MCI WorldCom stock worth approximately $3.5 million. The Sendas then gave substantial interests (90% and 67.2%, respectively) in the limited partnerships as gifts to their three children. The IRS contended that, based on the step transaction doctrine, the Sendas had made indirect gifts of stock to their children; the Sendas claimed they had made gifts of the partnership interests. The IRS valued the stock at its fair market value of $2.75 million. The Sendas valued the partnership interests at $0.7 million after subtracting discounts for lack of marketability and minority interests and the annual gift tax exclusion for each child. The Tax Court agreed with the IRS, and the Sendas appealed to the Eighth Circuit Court of Appeals.

Result. For the IRS. The Sendas made five different arguments to the Eighth Circuit, but the appeals court spent time only on the second, quickly disposing of the other four. The couple’s second argument was that the court had erred in determining the timing of the stock and partnership interest transfers. The Sendas claimed they had transferred the stock to the partnerships before they transferred the partnership interests to the children. As evidence they pointed to various documents: gift-tax returns, the partnerships’ income-tax returns and certificates of ownership and two letters faxed to their tax advisers concerning what were the most tax-advantageous percentages of partnership interests that could be given to the children. With the exception of faxed letters, all the documents were executed after the transfer dates listed on the tax returns. Both the Tax Court and the Eighth Circuit ruled that these after-the-fact documents were unreliable in establishing the sequence of events.

The courts next looked at the faxed letters, one dated the same day as the transfer of stock to the first partnership and the other dated two days after the transfer to the second. The second letter was not helpful to the Sendas’ argument as on their return they said they had transferred the partnership interest the same day as the second stock transfer. In his testimony Mark Senda undermined his own argument by acknowledging his business practice was to execute documents and transactions as of a certain date, not necessarily the actual date of the transaction.

The appeals court agreed with the Tax Court that “at best, the transactions were integrated (as asserted by the IRS) and simultaneous.” This is a classic application of the step transaction doctrine.

Both courts expressed concern that the Sendas’ primary focus as seen in the evidence was what were the most tax-advantaged percentages they could give the children. No purpose was presented for the family limited partnerships other than tax minimization.

Family limited partnerships have been used both successfully and unsuccessfully in the gift and estate tax area to transfer property among family members. The decision in this case illustrates that tax avoidance strategies that have no nontax purpose are likely to be ignored by both the IRS and the courts. Family limited partnerships, in and of themselves, are not a sanctioned loophole in the tax code and should not be treated as such by taxpayers or tax advisers.

Mark W. and Michele Senda v. Commissioner, 97 AFTR2d 2006–419.

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

TAX CASE

INTEREST OWED TO A RELATED FOREIGN ENTITY
hen a taxpayer owes interest to a related foreign entity that is exempt by treaty, Treasury regulations section 1.267(a)-3 requires that the taxpayer use the cash method. The Seventh Circuit Court of Appeals affirmed the validity of this regulation.

Using an acquisition company, Schneider SA, a French corporation, acquired Square D, an accrual taxpayer, in 1991. The acquisition company borrowed $328 million from Schneider for this purpose. After completing the acquisition, Schneider owned 100% of Square D’s stock and Square D had to repay the loan.

Schneider SA was not required to include the interest accrued in its taxable income for U.S. federal income tax purposes. Square D deducted the interest accruals on its 1991 and 1992 federal income tax returns, rather than on its return for 1996, the year it paid the interest. The IRS determined a tax deficiency for 1991 and 1992. Square D, claiming that the IRS’s position was a flawed interpretation of the regulation, argued that the interest deductions for the two years were legitimate. The Tax Court had previously ruled the regulation invalid (Tate & Lyle I, 103 TC 656 (1994)), but the Third Circuit Court of Appeals reversed this holding (Tate & Lyle, 87 F3d 99 (1996)). In a 10–6 ruling, the Tax Court then abandoned its prior ruling and held that regulations section 1.267(a)(3) was valid. Square D appealed the decision.

Result. For the IRS. Square D argued that because Schneider SA did not have to include the interest accrual in income, the matching requirement of regulations section 1.267(a)-3 was invalid because it was inconsistent with IRC section 267(a).

Relying on Chevron (467 US 837), the Seventh Circuit first looked at the plain meaning of the tax code and regulations; it next examined the reasonableness of the IRS’s interpretation of the statute. Then, following the Third Circuit’s decision in Tate & Lyle I, the Seventh Circuit upheld the validity of regulations section 1.267(a)(3).

The court also held that Congress intended to allow the IRS to determine the method of deduction. Thus, if a U.S. taxpayer makes an interest payment to a related foreign person who is exempt from taxation by treaty, the taxpayer will be required to use the cash method with respect to the interest payments.

Square D Company and Subsidiaries v. Commissioner, 97 AFTR2d 2006-508 (CA7).

Prepared by Michael H. Brown, CPA, PhD, assistant professor of accounting, Tabor School of Business, Millikin University, Decatur, Ill.