Criminal conviction of corporate officers for misconduct is not enough to allow shareholders to claim a theft loss, the Tax Court ruled.

In cases where a shareholder’s stock becomes worthless due to corporate theft, it would generally be advantageous to treat relatively small losses as capital losses (due to the 10% of AGI floor for theft losses) and larger losses as casualty/theft losses, because a casualty/theft loss is a deduction against ordinary income and recouped more quickly.

A WorldCom Group employee, Mehdi Taghadoss, purchased stock and exercised options through an independent 401(k) and employee stock purchase plan. After WorldCom’s top officials were charged with fraud, the firm filed for bankruptcy in July 2002. (Ex-CEO Bernard Ebbers was convicted of fraud and sentenced to 25 years in prison in July 2005.) A reorganization plan approved in October 2003 provided, inter alia, that Taghadoss’ interests would be canceled when WorldCom emerged from bankruptcy. Taghadoss filed his 2003 tax return claiming a casualty or theft loss of $1,344,863, then received a statement valuing his 31,083 shares at $677. WorldCom emerged from bankruptcy in April 2004. The IRS disallowed the loss for 2003, and Taghadoss sued.

For a casualty loss, the Tax Court noted that Taghadoss did not suffer physical damage to his property, as required in Furer v. Commissioner (TC Memo 1993- 165, aff’d without opinion, 74 AFTR2d 94-6019 (9th Cir. 1994)). In assessing a theft loss, the court relied on cases defining theft consistently with laws of the taxpayer’s state of residence. In Virginia, where Taghadoss lived, theft requires an intention to permanently deprive another of his or her property. Thus, WorldCom officials’ filing of false statements with the SEC was not theft, the court held. Taghadoss bought the securities through independent plans and brokers, none of whom were alleged to have stolen from Taghadoss. The court discounted several internal WorldCom memos stating “that everything is fine,” because Taghadoss did not show a direct causal connection between the memos and his stock purchases.

The court also dismissed Taghadoss’ argument that he could claim a theft loss as a shareholder for a theft against the corporation, stating that this would be allowed only if the corporation were a device to defraud its investors.

Further, since Taghadoss’ holdings were not worthless in 2003, no loss was allowed for that tax year under section 165(g) and Treas. Reg. § 1.165-5(f). The court found that Taghadoss had abandoned his securities when they were canceled in April 2004 without action on his part. Had this happened today, Treas. Reg. § 1.165-5(i)(1), effective for securities abandoned after March 12, 2008, allows that they may be treated as if sold for zero dollars on the last day of the tax year.

Mehdi Taghadoss v. Commissioner, TC Summary Opinion 2008-44

By Valrie Chambers, CPA, Ph.D., associate professor of accounting, and Brian Elzweig, J.D., LL.M., assistant professor of business law, both of Texas A&M University–Corpus Christi.

The Tax Court ruled, contrary to the IRS’s argument, that the step transaction doctrine did not apply where gifts of interests in a family limited partnership (FLP) were made only six days after the funding of the partnership with stock. However, the court also partially denied the taxpayers’ discounts for lack of control and marketability of those interests.

FLPs are often used for estate tax planning and reduction and asset protection. But they need to establish a significant nontax reason for transfers of assets to them and operate in a businesslike manner (see “FLPs That Flop,” JofA, April 08, page 72).

Thomas H. and Kim D.L. Holman transferred more than 70,000 shares of stock in Thomas’ then-employer, computer maker Dell Inc., to an FLP on Nov. 2, 1999. On Nov. 8, 1999, they made gifts of FLP interests to an account established for the benefit of their minor children and reduced the value of the interests by 14.25% for minority interest and by 35% for lack of marketability. The gifting program continued through 2001. The partnership could be dissolved only by written consent of all partners for the next 50 years and allowed limited partners (the children) to withdraw or assign their interests only by prior written consent of all partners.

The IRS, citing the step transaction doctrine, treated the 1999 transaction as an indirect gift of the stock. It assessed deficiencies of more than $232,000 for the three years. The court, however, concluded that even in the six days between the funding of the FLP and the gifts the assets were exposed to real economic risk from a potential market decline, because of the relative volatility of Dell shares. “We draw no bright lines,” the court said, although in a footnote, it added it might look less favorably on more stable assets, such as long-term government bonds or preferred stock.

The taxpayers fared less well in arguing for valuation discounts for transfer restrictions. Under section 2703(a), a transfer restriction is disregarded for purposes of the gift tax unless it meets the three requirements of section 2703(b). The court found that the FLP did not meet the first two requirements because it was not a bona fide business arrangement and was designed to transfer assets within the family at less than full and adequate consideration. Consequently, the court said, it did not need to determine the third factor, whether the restrictions were comparable to those of a similar arrangement entered into by persons in an arm’s-length transaction.

The government abandoned its initial reliance on section 2704(b) to disregard liquidation restrictions and instead provided its own, lower, discounts, which the court generally favored over the plaintiffs’. For lack of control, the court accepted both experts’ approach of comparing a basket of closed-end investment funds’ ratio of share price to pro rata net average value. For the three gift dates at issue, the court accepted discounts of 11.32%, 14.34% and 4.63%, respectively. As for the lack-of-marketability discount, the court found the plaintiffs’ figure was little more than “a guess.” Under the terms of the partnership agreement, any would-be buyer would have to persuade all the partners to admit him or her as a substitute partner—a prospect so uncertain that the partnership interests might as well be incapable of being valued for that purpose, the court said. Still, the court accepted the government’s figure of 12.5%, based on a comparison made by both experts to private placement discounts of stock subject to disposition restrictions of SEC Rule 144

Thomas H. Holman Jr. v. Commissioner, 130 TC no. 12

By Bob Jennings, CPA/CITP, president of Jennings Advisory Group LLC, Clarksville, Ind.

The Tax Court required an auto parts remanufacturer to include in income charges it normally waived in exchange for used parts from its customers. In so ruling, the court underscored that where a taxpayer’s accounting method does not clearly reflect income, the government can require it to use a different method.

Jeffrey, Bruce and Donald Bigler owned BBB Industries, an accrual-method S corporation that rebuilt alternators and starters. When the company sold a part, the bill consisted of a unit price and a core price. The customer paid the unit price, plus (rarely) the core amount or (usually) traded for equivalent credit a used part, which BBB would then remanufacture. BBB reported as taxable income the unit price but not the core price, which it accounted for on its balance sheet as a liability or deferred income, depending on when it was credited and the used part received.

Under the accrual method, income is reported when all events have occurred that fix the right to receive the income, and its amount can be determined with reasonable accuracy (the “all-events” test). Generally, it is met on the earliest of the date payment is received, the date payment becomes due, or the date economic performance takes place. The government used its authority under IRC § 446(b) to declare that BBB’s method of accounting under the all-events test did not clearly reflect income and that the core amount must be reported when and in the amount billed. It assessed deficiencies for 2002 on Jeffrey, Bruce and Donald Bigler’s returns of $236,286, $237,523 and $506,443, respectively.

According to the court, the income accrued when the bills were sent, because the company had the right to collect the full amount. The fact that a future credit could be issued or that historically the company rarely collected cash for the core was immaterial. Nor was the court persuaded by BBB’s arguments it should be allowed to deduct cores credited but not yet received, or that the core amount exceeded the cores’ fair market value. The court compared the case to others where allowances for merchandise returns or deposits for returnable containers have been held to be taxable income when billed.

The government attempted to impose an accuracy-related penalty under section 6662(a). The court found, however, that the taxpayers were not liable for it because they acted with reasonable cause and in good faith. It noted the Biglers had kept detailed records and followed GAAP and industry standards.

Jeffrey M. Bigler v. Commissioner, TC Memo 2008-133

By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accountancy and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

The Tax Court rejected an attempt by credit card issuer Capital One to retroactively defer its recognition of income from fees for late payments of card balances. Capital One sought to do so by taking advantage of a law change allowing such payments to be characterized as changes to original issue discount (OID). OID, the excess of an obligation’s stated redemption price at maturity over its issue price, generally must be recognized as income or deducted by an issuer ratably over the life of the obligation. The government said the treatment might have been available to Capital One, but not without IRS consent to a change in accounting method, as required under section 446(e). The court agreed.

From 1995 through 1999, Capital One recognized late fees as income at the time they were charged to the cardholders. In 1997, the Taxpayer Relief Act (TRA) added IRC § 1272(a)(6)(C)(iii), which requires taxpayers to treat certain credit card receivables as creating or increasing OID on the pool of credit card loans related to the receivables.

One of the taxpayer’s subsidiaries attached Form 3115, Application for Change in Accounting Method, to its 1998 consolidated return, requesting a change in its method of accounting based on the provisions of section 1272(a)(6)(C)(iii). However, this form did not specify a change in accounting for late fees. The taxpayer continued to report late fees in current income in 1998 and 1999. In 2000, it began reporting late-fee income as an increase in OID.

The IRS issued notices of deficiency for 1997, 1998 and 1999. Capital One filed a petition with the Tax Court challenging the deficiencies. In an amended petition, it also sought to treat its late-fee income as an increase in OID in 1998 and 1999, which would reduce its taxable income by $425 million for the two years. The court found that the taxpayer’s application for a change in accounting method was not clearly indicative of the requested change.

The taxpayer relied on a provision of the TRA that provided that a change in accounting method to comply with the act could be “treated as made with the consent of the Secretary of the Treasury.” The court, however, observed that this provision was not codified. Even if it had been, the court said, the taxpayer would still have been required to follow applicable procedures to implement even such a required change in method. The consent requirement, the court noted, is intended to maintain consistency in the tax accounting method used, promote administrative simplicity for the IRS, and avoid volatility stemming from changes in revenue recognition.

The taxpayer also argued it was not dealing with a material item and thus not changing an accounting method. The court found, however, that the change did affect a material item, as defined by Treas. Reg. § 1.446-1(e)(2)(ii)(a).

Capital One Financial Corp. and Subsidiaries v. Commissioner, 130 TC no. 11

By Gerald P. Weinstein, CPA, Ph.D., professor and chair of accountancy, and Robert Bloom, Ph.D., professor and Wasmer Fellow in Accountancy, both of John Carroll University, University Heights, Ohio.

The Tax Court held that a taxpayer had to recapture the majority of his prior-year section 179 deduction since he failed to show that the business use of his GMC Suburban remained above 50% in the following tax year. His testimony of the business use of the vehicle, although considered credible by the court, did not satisfy the substantiation requirements of section 274(d) related to listed property.

Code § 179 permits taxpayers to immediately expense all or part of the cost of listed property (autos, computers, cell phones, video equipment, etc.) if the property is used more than 50% in a trade or business during the year it is placed in service. If, in a subsequent tax year, the business use of the property drops to 50% or less, some of the deduction must be recaptured. The recapture amount is the difference between the section 179 amount deducted and the amount of deprecation that would have been allowed under the Alternative Depreciation System (ADS) for the years when the business use exceeded 50%. The recapture potential ceases after the normal recovery period has elapsed—six years in the case of automobiles. Section 274(d) requires taxpayers to maintain sufficient records and documentary evidence to determine each element of an expenditure. The records must have the same reliability as a contemporaneous record.

In 2002, Michael Birdsill, a California resident, started a broadcast engineering consulting business in which he drove his 1998 GMC Suburban to radio towers to gather information. He deducted depreciation of $26,396 related to the use of the vehicle. In 2003, Birdsill also deducted $11,968 under section 179 on a 1993 Ford F-250 pickup truck that he placed into service in that year, reporting 8,110 miles of business and total use. He claimed no expenses on the Suburban in 2003 and reported a net loss of approximately $21,000 from his business. In 2006, the IRS sent Birdsill a deficiency notice for tax year 2003, claiming he was required to report $23,756 of depreciation recapture related to the Suburban—the difference between his 2002 section 179 deduction and the $2,640 (10% of $26,396) depreciation that would have been allowed under the ADS. Birdsill petitioned the Tax Court for relief.

Birdsill testified that in 2003 he used the Ford for 75% of his total business miles and the Suburban for the other 25%, and that both vehicles were used more than 50% for business. These amounts were estimates by Birdsill, as he had not kept any records to support his business use of the Suburban in 2003. Since he had not satisfied the substantiation requirements of section 274(d), the court held that Birdsill had not established that his business use of the Suburban continued to exceed 50% in 2003; thus he had to include the recapture amount in his 2003 taxable income. The court also rejected Birdsill’s argument that the deficiency notice should be voided because the recapture issue was brought up in retaliation for his filing an appeal. The court could find no evidence of IRS wrongdoing and stated that even in cases where the taxpayer’s constitutional rights had been violated, the deficiency notice had not been voided by the court.

This case illustrates the importance of continuing to use listed property predominantly for business purposes and substantiating that use throughout the normal recovery period after a section 179 amount has been claimed.

Michael R. and Melanie J. Birdsill v. Commissioner, TC Summary Opinion 2008-55

By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.

©2008 AICPA

The Tax Court held that the IRS abused its discretion in denying a stay-at-home mom’s request for innocent spouse relief because it did not consider all of the relevant factors. Chrystina Nihiser filed for relief after her husband stopped paying their taxes due to financial problems with his business. Although she had known the couple would most likely fail to pay the taxes shown on the returns she signed, the Tax Court found other factors weighed in her favor, resulting in relief from a tax liability for tax years 1996–2001 of close to $250,000.

Nihiser married Kevin Connelly in 1980 and stopped working as a schoolteacher when she gave birth to their daughter in 1988. They lived in California. Connolly supported the family with his law practice and controlled all of the finances, keeping his income and expenses hidden from Nihiser. In 1993, Connolly began filing their joint returns, which he had Nihiser sign on the due date, without paying the taxes due. In 1999, Connelly presented Nihiser with divorce papers but never filed them. Although the couple began living in separate rooms of the same apartment, they continued to file joint returns for the next two years. Ultimately, Connelly was imprisoned for stealing from his clients, and Nihiser returned to full-time teaching.

Although the IRS did not begin any actions against the couple, Nihiser initiated innocent spouse proceedings. Because the tax liability was neither an understatement nor a deficiency, Nihiser was limited to filing under section 6015(f), which calls for relief if, taking into account all the facts and circumstances, it would be inequitable to hold her liable. The court looked to the balancing test of Revenue Procedure 2000-15 (since superseded by Rev. Proc. 2003- 61) to examine whether the IRS abused its discretion by denying Nihiser relief and, if so, to determine the appropriate relief.

Four of the eight factors were in contest, each raising new questions for the court:

(1) The requesting spouse is divorced, legally separated or living apart from the nonrequesting spouse. The court held that the couple’s living apart, albeit within the same household, weighed in favor of relief.

(2) The requesting spouse would suffer economic hardship if forced to pay the tax liability. It was unclear whether this determination should be based on when relief was requested (when Nihiser was working only part time), during appeals (when she was working full time) or at trial (when her wages were being garnisheed to pay a state tax debt). Because remand is not an option in innocent spouse cases, the Tax Court based the determination on the trial record rather than just the administrative record. In so ruling, the court cited a line of prior decisions including Ewing (118 TC 494, rev’d on other grounds, 97 AFTR2d 2006-1224 (9th Cir. 2006); see also “Tax Matters: Innocent Spouse Relief Reversed,” JofA, Aug. 06, page 74); Robinette (123 TC 85); and the more recent Porter (130 TC no. 10).

(3) The requesting spouse was abused by the nonrequesting spouse. Such abuse need not rise to the level of duress to favor relief. Describing this as an “underdeveloped area,” the court referred to factors of psychological abuse cited in domesticrelations law, such as drug use, threats of suicide, possessive behavior and degrading language, all of which were substantiated by Nihiser’s administrative record.

(4) Whether the requesting spouse knew or had reason to know of the liability. This factor weighed against relief.

Other factors conceded by the government as favoring Nihiser were (1) that the tax liability was attributable to the other spouse and (2) she received no significant benefit from the underpayment. Thus, the court said, five factors favored relief and one weighed against it. The remaining two factors were considered neutral or irrelevant: (1) the requesting spouse subsequently complied in good faith with federal tax laws and (2) the nonrequesting spouse was not under a legal obligation pursuant to a divorce decree or agreement to pay the outstanding liability.

Knowledge of the liability generally is an “extremely strong” factor but can be outweighed by other considerations in “limited situations,” the court said, quoting the revenue procedure. Since Nihiser’s ability to act on her knowledge was restricted by abuse that included her husband’s hiding the broader state of the family’s finances, this, the court said, was such a situation.

Nihiser v. Commissioner, TC Memo 2008-135

By Laura Lee Mannino, CPA, LL.M., assistant professor of accounting and taxation, St. John’s University, Jamaica, N.Y.

The IRS modified its final rules regarding the disclosure of a taxpayer’s Social Security number to a tax return preparer located outside the U.S. to allow disclosure under specified circumstances. Previously, the rules had generally required U.S. preparers to redact SSNs from tax return forms and other information transmitted to a foreign preparer.

The IRS decided, however, that if both domestic and foreign preparers’ programs and procedures adequately protect the numbers and other confidential information against unauthorized access or other misuse, redaction is not necessary. Treasury Decision 9409, which modifies TD 9375, was accompanied by Revenue Procedure 2008-35, which in turn supersedes Rev. Proc. 2008-12. Prop. Treas. Reg. § 301.7216-3 and Temp. Treas. Reg. § 301.7216-3T, both issued as part of the recent Treasury decision, allow the disclosure where a taxpayer gives consent and the U.S. preparer verifies “adequate data protection safeguards” are in place. They also clarify that the general prohibition against disclosure pertains only to the 1040 series of forms.

With Revenue Ruling 2008-29, the IRS analyzed nine scenarios for applying withholding rules to commissions, severance pay and other forms of supplemental wages under IRC § 3402, including proper application of the aggregate versus optional flat-rate methods. The guidance supersedes revenue rulings 67-131 and 66-294.

A district court upheld the IRS’s denial of deductions by two large banks from a sale in, lease out (SILO) transaction, continuing a string of victories by the Service against the one-time promoted shelter. The opinion by the court for the Northern District of Ohio against KeyCorp and PNC Financial Services Group cited the decision a month earlier by the Fourth Circuit regarding a lease in, lease out (LILO) strategy employed by another bank, BB&T (101 AFTR2d 2008-1933, “ Tax Matters: LILO Comes Up One Leg Short,” JofA, Aug. 08, page 84).

The IRS moved as long ago as 1996 to deny tax benefits of LILOs, which the plaintiffs in the instant case had participated in until 1999, when the IRS issued Revenue Ruling 99-14 designating them as abusive shelters. “One might have thought that banks would step away from similar transactions,” the court said. Instead, AWG Leasing Trust, a partnership of the two banks, paid $423 million in 1999 to purchase a German waste incineration facility, with a long-term leaseback provision and repurchase option granted to the seller. The court upheld the Service’s $88 million tax deficiency for tax years 1999–2003. Congress outlawed SILOs in 2004, but many previous deals remain in effect, the court said. The case is AWG Leasing Trust v. U.S. (101 AFTR2d 2008-2397).

Along with final regulations adopting automatic six-month filing extensions for certain returns, the IRS proposed reducing the extension to five months for partnerships and other pass-through entities. The shorter period is intended to better enable owners to receive Schedules K-1 and other information returns in time to prepare their individual returns by the extended due date. A transitional rule retains the six-month automatic extension for returns due before Jan. 1, 2009. The IRS is seeking public comment by Sept. 29 on any taxpayer burden imposed by the five-month provision. See REG- 115457-08 and Treasury Decision 9407.

Following the U.S. Supreme Court’s refusal to hear an appeal attacking the validity of “check-the-box” provisions, a district court has similarly denied a legal challenge to the default business entity classification. The plaintiff in the more recent decision, L&L Holding Co. LLC v. U.S. (101 AFTR2d 2008-2081), contested an employment tax collection action, just as in the earlier case, Littriello v. U.S. (99 AFTR2d 2007-2210; “Tax Matters: Check-the-Box Regulations Are Valid,” JofA, July 08, page 86). The Supreme Court in February allowed the Sixth Circuit’s decision against the taxpayer in Littriello to stand.

Subsequently, the District Court for the Western District of Louisiana likewise ruled that the check-the-box regulations are valid when applied to an LLC as an employer for purposes of employment taxes. L&L was the sole owner of Gonzales Home Health Care LLC, which had not made an election to be taxed as a corporation under the check-the- box rules and so by default was a disregarded entity.

Because of Gonzales’ unpaid employment taxes, the IRS filed a lien against L&L. L&L argued that because it did not meet the statutory definition of “employer” under IRC § 3401, the check-the-box regulations’ requirement that it be treated as the employer conflicted with the Code’s plain language.

Citing Littriello, as well as McNamee v. Department of the Treasury (99 AFTR2d 2007-2871), decided a year earlier by the Second Circuit, the district court denied there was any conflict, since the regulations do not define “employer” but prescribe treatment for all tax purposes, including employment taxes. Neither does the Code define LLCs, so their tax treatment is covered only by the regulations, the court said.