Tax Matters

IRC Section 1341—A Reversal
Most taxpayers normally know when and how much income they have earned. In certain cases, a taxpayer has to give back to the original payor an amount it previously reported as income (for example, a refund). In these situations, the taxpayer can claim a deduction for the repayment. If tax rates have remained constant, the income and the deduction will offset each other. If current rates are lower, the deduction will not fully offset the taxes the entity paid previously. Under these circumstances a taxpayer may use IRC section 1341 to calculate the tax due based on the rates in effect when it reported the income. A recent case reexamines the issue and restricts the taxpayers that may use the relief provision.

In 1983 Cinergy Corp., a public utility, increased its rates due to financial difficulties. The higher rates were based on, among other things, current and deferred federal income taxes. In 1988 following an improvement in Cinergy’s financial condition, the government ordered it to refund part of its prior rate collections, specifically the portion for deferred taxes. The deduction for the refund generated a lower savings than the tax the company paid on the original receipts. Cinergy attempted to calculate the tax using section 1341, and the IRS objected. The taxpayer paid the assessed tax and sued for a refund.

Result. For the IRS. Taxpayers may avail themselves of the special computation in section 1341 if they have met three conditions:

The taxpayer included an item in income to which it appeared to have an unrestricted right.

The IRS allowed a deduction in a subsequent year because the taxpayer did not have a right to the item.

The deduction exceeds $3,000.

The government successfully argued Cinergy did not meet the first two requirements.

The IRS said the taxpayer did not meet the first requirement because it had an actual, not an apparent, right to the income it reported. To qualify for section 1341 a taxpayer must have only an apparent right to the income. Cinergy responded that in prior cases the courts had accepted an actual right as falling within the statute’s requirements because the word “appears” does not just refer to an incorrect conclusion. An appeals court found prior cases had conflicting opinions and looked at the legislative history behind section 1341. Based on the review, the court concluded Congress did not intend for taxpayers with an actual right to income to use this provision. Congress had enacted it to help taxpayers that incorrectly reported income under the claim-of-right doctrine only to find out later they did not have a right to the income.

The IRS also argued Cinergy did not meet the second condition because the refund was based on subsequent events rather than on events connected to the original collection and reporting of the income. The court agreed there needed to be a direct nexus between the original reporting of income and its refund. In this case the taxpayer did not demonstrate a connection. The refund was the result of the company’s improved financial condition rather than an item that existed when the rate increase was granted. Having failed two of the three requirements, Cinergy could not use section 1341.

This case reopens the question of whether a taxpayer that reports income based on an actual right to it may use section 1341. This most recent decision concludes actual income does not qualify, although several prior cases allowed it to. Although not at issue, the court’s reasoning suggests it would side with prior courts and deny section 1341 treatment to any income a company received without a claim of right, such as illegally obtained income (for example, embezzled funds). The case also demonstrates the need for a taxpayer to prove a link between the collection of the income in question and its refund. Given the projected future decreases in tax rates, this limitation on the use of section 1341 will be detrimental for some taxpayers in years to come.

Cinergy Corp. v. United States, U.S. Court of Federal Claims, March 2003.

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

Bonuses and Accumulated Earnings Prove Troublesome
Under IRC section 162(a)(1), businesses can deduct bonuses they pay employees as reasonable compensation for services actually rendered in the current or prior years. The courts have generally applied either a single-factor independent-investor or multiple-factor test to determine the deductibility of bonuses. The courts closely scrutinize bonuses when the employee/ owner is the recipient because of the possibility of disguised dividends.

IRC section 531 imposes a penalty tax on corporations that accumulate earnings for the purpose of helping an employee avoid personal income taxes by not distributing them. An excess accumulation is one that goes beyond the company’s reasonable needs. According to tax regulations, a corporation can justify reasonable needs through a specific, definite and feasible plan for its eventual use of the accumulation.

Haffner’s Service Stations is a closely held corporation that sells oil and gas in Massachusetts and New Hampshire. The three principal officers are Haff, his father Emile and his mother Louise. Haff is the president and CEO. The bonuses in question were ones the company had paid to Emile and Louise, who were in their 80s in the years under dispute—1990 to 1992. During this period the company paid Emile and Louise total salaries of $108,575 and bonuses of $2.3 million. Haffner’s allocated a small portion of the bonuses to other family businesses but had deducted the remainder on its tax return. The company has never paid dividends. In addition its retained earnings increased 61% from 1990 to 1992.

In 1996 the IRS notified Haffner’s of an impending deficiency under IRC section 534(b) for excess earnings accumulation. The company responded that it had been accumulating the earnings for a potential stock repurchase based on an adverse ruling in a family lawsuit. The IRS assessed deficiencies for the three years, disallowing the bonuses and imposing the accumulated earnings tax. The Tax Court ruled in favor of the IRS. Haffner’s appealed to the First Circuit Court of Appeals.

Result. For the IRS. The First Circuit agreed with the Tax Court that the bonuses were unreasonable based on a multiple-factor test:

Employee’s qualifications—Emile and Louise had only marginal skills.

Nature, extent and scope of employee’s work—Emile and Louise’s work was not fundamental, substantial or all-encompassing.

Size and complexity of employer’s business—the taxpayer’s business was neither complex nor relatively large.

Comparison of compensation paid with company’s gross and taxable income—the percentages were high, on average 7.69% of gross income and 21.73% of taxable income.

n General economic conditions—the business was not subject to adverse conditions, so the court could not find definitively that Emile and Louise had caused any or all of the company’s success.

Comparison of salaries with distributions to shareholders and retained earnings—Haffner’s has never paid dividends, and the court did not find enough information to determine whether the shareholders had earned a reasonable rate of return excluding their compensation.

Prevailing rates of compensation for comparable positions in comparable companies—the parties did not include information for the court to make a determination on this issue.

Employer’s salary policy for all employees—no employee other than Haff, Emile and Louise had ever received six-figure compensation in one year or a bonus.

Compensation paid in prior years had been deficient—Haffner’s had the wherewithal to pay compensation in prior years if it had wished to, and it was more than a coincidence that Emile and Louise needed money in the bonus years because of the legal fees caused by the family lawsuit.

Absence of a pension plan/profit-sharing plan—Haffner’s had a pension plan, but the court received no information on its participants.

The First Circuit also agreed with the Tax Court that the company’s reasonable need or plan for the accumulated earnings was insufficient. The regulations require a specific, definite plan. One discussion with the taxpayer’s accountant does not constitute a plan. The First Circuit did not find it necessary to rule on the Tax Court’s determination that the family lawsuit was primarily a personal, not a business, problem. The lack of a plan was sufficient. However, the Tax Court said the taxpayers’ reliance on its accountant’s advice concerning each year’s tax return was enough to avoid accuracy-related penalties.

CPAs should be aware that while the courts often look to the single-factor, independent-investor test to determine the reasonableness of bonuses, they may instead use the multiple-factor test when the employee in question controls the company. When a corporation is accumulating earnings, it must carefully document an actual need and a plan. The plan does not have to be formal but should be provable and the result of more than a one-time conversation.

Haffner’s Service Stations v. Commissioner, 91 AFTR2d 2003-1461.

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