New Requirements for 2006 Business Filers • Superseding Return Starts SOL • Innocent
Spouse Relief
 

Editor:
John L. Miller, CPA
Faculty Instructor
Metropolitan Community College
Omaha, NE

Mr. Miller is a member of the AICPA Tax Division’s IRS Practice & Procedures Committee. Mr. Dolan, Mr. Keenan and Ms. Markman are members of that committee. For further information about this column, contact Mr. Miller at johnmillercpa@cox.net.  

New Requirements for Business Filers’ 2006 Returns

When filing 2006 corporate tax returns, many businesses will encounter new IRS requirements that significantly affect how they file. Some filers of Forms 1120, U.S. Corporation Income Tax Return, and 1120S, U.S. Income Tax Return for an S Corporation, will be covered by phase two of a mandatory Service electronic-filing (e-filing) program, while others will wrestle with preparing to file a Schedule M-3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More, for the first time. Even veterans who successfully e-filed last year’s corporate returns and mastered Schedule M-3 will have to adjust to changes in the e-filing transition rules and the requirement to provide additional information with that schedule.

Original Corporate E-File Mandate

Last year, taxpayers with assets of $50 million or more that filed Form 1120 or 1120S, and also filed 250 “other” returns, were required to e-file their corporate income tax forms. (The 250 “other” returns include income, excise and employment taxes, and information returns such as Forms W-2 and 1099.) Taxpayers covered by the mandate used Modernized E-File (MeF), a new IRS filing program, which requires all taxpayers to submit their return data via a single extensible-markup-language (XML)-based electronic transmission.

Many taxpayers found it a challenge to change from traditional return preparation processes to the new e-filing environment. Corporate tax return preparation has always involved retrieving data from multiple sources and systems within a company. Assembling the actual return usually entailed melding data from several separate systems, some derived from return preparation software and some delivered on spreadsheets, Word documents or third-party transaction documents.

The new IRS system requires that all return data (regardless of source) be translated into XML format. Taxpayers may have to modify their internal work processes to ensure that data from their international operations, asset management systems or investment portfolios correctly finds its way into their chosen return preparation software.

Phase one successful: The first phase of the Service’s corporate electronic mandate was deemed a success. Over 500,000 Forms 1120 and 1120S were processed by the MeF system last year, with mandated returns accounting for 14,000 of the total. Much of the initial success can be traced to the IRS’s active engagement of affected taxpayers, return preparers, software vendors and practitioner groups. The AICPA’s IRS Practice & Procedures Committee met regularly with major software vendors and senior Service personnel to identify and address potential problems, leading to a series of transition options that removed obstacles to the e-filing program. Among the most important options were those allowing certain forms to be filed as .pdf documents rather than XML; provided paper or .pdf alternatives for key international forms (Forms 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations; 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business; 5713, International Boycott Report; 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities; and 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships; and their associated schedules); and authorized summary-level data for certain high-volume transactional forms.

Because of some first-year system limits, the IRS also agreed that certain fact patterns would result in a waiver; some corporate forms (Forms 1120-F, U.S. Income Tax Return of a Foreign Corporation; 1120-FSC, U.S. Income Tax Return of a Foreign Sales Corporation; 1120-RIC, U.S. Income Tax Return for Regulated Investment Companies; and 1120-REIT, U.S. Income Tax Return for Real Estate Investment Trusts) were excluded from e-filing.

2006 Return Requirements

For tax year 2006, the mandate expanded to filers of Forms 1120 and 1120S that have assets of $10 million or more and file 250 “other” returns. In October 2006, Large and Mid-Size Business Commissioner Deborah Nolan notified those corporations that, based on the assets reflected on their last return, they were required to e-file under the expanded mandate.

Some taxpayers in this second wave of mandated filers may encounter challenges because of the small size of their tax staffs. In an October 2006 KPMG/Tax Executive Institute survey of tax directors whose corporations filed mandated 2005 returns, 88% said they had incurred either modest or substantial additional compliance costs. Not surprisingly, a majority of the additional expense related to the purchase, training and support costs associated with return-preparation software. For many of those corporations, the costs might have run even higher had their tax departments not had access to in-house technology support for installing and using the software; 86% of the respondents had internal information technology resources to draw on.

The IRS has narrowed the transition options for the second year of the mandate; improvements to both Service systems and commercially available software have reduced the need for some exceptions. For 2006, fewer .pdf forms will be allowed; paper or .pdf alternatives for filing 2005 international forms have been eliminated. A transition option will continue to allow summary data to be entered for certain high-volume transactional forms. Also, in response to privacy concerns expressed by corporate tax directors, the IRS will permit corporate filers to complete Schedule E, Compensation of Officers, without including officers’ names and Social Security numbers; see www.irs.gov/businesses/corporations/article/0,,id=163357,00.html, Section 3.

Another significant change for 2006 returns is that a taxpayer may e-file more than one return. Unlike last year (when only one electronic return per taxpayer was permitted), a taxpayer filing an initial 2006 return and then filing a subsequent (superseding) return before the original or extended due date must now e-file both returns; the same applies for amended returns. (For a discussion of superseding returns, see Keenan, Tax Practice & Procedures, “Superseding Return Filed on Extended Due Date Starts SOL,” p. 236, this issue.)

Waivers: For taxpayers that do not believe they can comply with the e-file mandate, Temp. Regs. Sec. 301.6011-5T provides an opportunity to request a waiver. The taxpayer must demonstrate that either undue hardship or technology issues prevent it from e-filing. The IRS provided detailed instructions for documenting the waiver request in Notice 2005-88. In discussions that preceded the 2005 return filings, the Service predicted that few waivers would be needed or approved, because the transition options would eliminate most significant obstacles. Only 113 waivers were granted for the 2005 tax year, with 48 of those related to entities filing their last required return. The IRS generally did not approve a waiver request if the software purchased or licensed by a taxpayer or preparer did not include all of the features needed to comply with the MeF requirements, taking the position that compliant software is available in the marketplace and taxpayers are expected to obtain it.

Tax Year 2006 Directions for Corporations Required to e-file is an especially useful reference for taxpayers and tax advisers, available at www.irs.gov/businesses/corporations/article/0,,id=163357,00.html. The Service’s website also houses a comprehensive set of continuously updated frequently asked questions. The AICPA’s IRS Practice & Procedures Committee has prepared a presentation that can be downloaded from the AICPA website; visit http://tax.aicpa.org/Resources/Corporations+and+Shareholders/ and click on “AICPA PowerPoint on IRS Mandatory Corporate E-File Program.”

Expanded Schedule M-3 Filing Requirements for 2006 Returns

Schedule M-3 must be filed by corporations and partnerships with $10 million or more in assets, and by certain other partnerships. Filers of Forms 1120-PC, U.S. Property and Casualty Insurance Company Income Tax Return; 1120-L, U.S. Life Insurance Company Income Tax Return; 1120S; and 1065, U.S. Return of Partnership Income, are required to include Schedule M-3 with their 2006 returns. Cooperative associations filing new Form 1120-C, U.S. Income Tax Return for Cooperative Associations, must file a Form 1120, Schedule M-3, if they report total assets of $10 million or more.

Schedule M-3 currently contains a line for entities to report any book-tax difference arising from the cost-of-goods-sold (COGS) deduction. However, in pursuit of more detail on how entities compute the deduction, the IRS created Form 8916-A, Reconciliation of Cost of Goods Sold Reported on Schedule M-3, which requires a breakdown of the COGS deduction (e.g., amounts attributable to cost-flow assumptions; book vs. tax inventory computations; inventory shrinkage accruals; and amounts attributable to Sec. 263A costs). The latter must be further broken down into expense items, such as stock option expense, meals and entertainment expense, deferred compensation and depreciation.

Because many companies do not keep records that separately account for the component parts of the COGS deduction, and may be unaware of the new requirement, affected taxpayers will struggle to prepare the form properly during the next filing season. 

From Michael P. Dolan, Director, IRS Policies & Dispute Resolution, KPMG LLP, Washington, DC

Superseding Return Filed on Extended Due Date Starts SOL

The general statute of limitations (SOL) for assessment found in Sec. 6501 gives the IRS three years to assess tax after a return has been filed, beginning on the date that a valid Federal tax return is deemed filed. A return filed prior to the deadline is deemed filed on the due date. A return filed on extension is deemed filed on the day the Service actually receives the return, provided it is received on or before the extended due date; if the return is received after that date, it is deemed filed on the postmark date.

Sometimes a taxpayer receives an extension to file a Federal tax return, but files before the extended due date. The taxpayer then files a second return, also before the extended due date, changing data reported on the originally filed return. This situation triggers a question—which return constitutes “the return” for assessment SOL purposes?

Effect of a Timely Filed Amended Return

A second tax return filed before the return due date that changes data reported on an original return is commonly referred to as a “superseding” tax return. The seminal case in the area is Haggar Co., 308 US 389 (1940), in which the taxpayer was required to declare the value of stock, for purposes of a now-obsolete capital stock tax, on its “first return.” The taxpayer reported the par value of its stock on a timely filed return, then filed an amended return before the extended due date to declare the stock’s actual value. Noting that the government was not prejudiced and that there was a long-standing administrative practice of accepting timely amended returns in other contexts, the Supreme Court held that “[a] timely amended return is as much a ‘first return’…as a single return filed by the taxpayer.”

Effect of Haggar: The principle underlying the Court’s holding in Haggar has been extended and applied in court decisions and by the IRS in administrative rulings. For example, in National Lead Co., 336 F2d 134 (2d Cir. 1964), the taxpayer elected for tax year 1950 to use the LIFO inventory replacement provision in the 1939 Code; under this provision, the election was irrevocable. Prior to the election deadline, the taxpayer notified the Service that it was revoking the election. The Second Circuit cited Haggar as authority for the proposition that an election can be validly revoked within the time allowed for making it, and held that the taxpayer properly revoked it. The court reasoned that the government was in no way disadvantaged by the result, because the final election was made within the time specified in the law (see also Matheson, 74 TC 836 (1980) (election to deduct disaster loss); Rev. Rul. 56-67 (election to file consolidated return was revocable by filing separate returns before due date); and IRS Letter Rulings 8939054 (consent to revoke election under Section 10202(e)(3)(A) of the Revenue Act of 1987) and 8526074 (consent to revoke Sec. 83(b) election if requested within 30-day period for making such election)).

Superseding Returns and the SOL

In recent Chief Counsel Advice (CCA) 200645019, the IRS concluded that a taxpayer’s superseding tax return filed on the extended due date is the return that starts the assessment SOL.

Facts: On March 15, 2003, the taxpayer timely mailed Form 7004, Application for Automatic 6-Month Extension of Time to File Certain Business Income Tax, Information, and Other Returns, requesting an extension to Sept. 15, 2003 to file Form 1120, U.S. Corporation Income Tax Return. Before that date, the taxpayer filed Forms 1120 and 1139, Corporation Application for Tentative Refund. These forms reflected a tax overpayment and requested a refund. Form 1120 included only basic income tax information and schedules; the taxpayer did not include any of the required Forms 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations.

On Sept. 15, 2003, the taxpayer mailed a second Form 1120 for the 2002 tax year, which included different information from the original return and requested an additional refund on a second Form 1139. The taxpayer attached Forms 5471 to the second Form 1120.

Analysis: The Service first addressed whether the filing of Form 1120 before Sept. 15, 2003 revoked the remaining extension to file granted until that date. Based on Haggar, it concluded that the taxpayer’s filing of a first return before Sept. 15, 2003 did not revoke the remaining extension.

Second, the IRS addressed whether the taxpayer’s original Form 1120 or the superseding one started the three-year assessment SOL. It concluded that the taxpayer’s superseding tax return filed on Sept. 15, 2003 was the valid return for the tax period; thus, the superseding return started the assessment SOL.

Third, the Service addressed whether the Sec. 6038(b) penalty applied to the Forms 5471 attached to the subsequent filing on Sept. 15, 2003, as late-filed information returns. Under Sec. 6038, a U.S. taxpayer that owns a controlling interest in a foreign business entity is required to furnish certain information on Form 5471 with its Federal tax return. Failure to comply subjects the taxpayer to certain penalties under Sec. 6038(b). However, the application to extend the filing deadline of the taxpayer’s return also extended the deadline for Form 5471.

Holding: Because the return filed on Sept. 15, 2003 was the taxpayer’s return for the tax period, the IRS concluded that the Forms 5471 attached to that return were timely filed.

From John Keenan, J.D., Director, Deloitte Tax LLP, Washington, DC

Innocent Spouse Relief

Searching the Internet under “innocent spouse relief” will turn up many organizations, CPAs, attorneys and others offering to assist a taxpayer with an innocent spouse claim. IRS Pub. 971, Innocent Spouse Relief (And Separation of Liability and Equitable Relief), explains the various types of relief, who may qualify and how to apply. Although the current innocent spouse rules under Sec. 6015 have been effective for determining unpaid balances due the IRS as of July 22, 1998 and Federal tax liabilities arising after that date, many cases have recently been decided by the Tax Court and district courts.

In her 2006 annual report, Nina Olson, the National Taxpayer Advocate, included innocent spouse cases as among the most litigated; see National Taxpayer Advocate’s 2006 Annual Report to Congress, at www.irs.gov/advocate/article/0,,id=165806,00.html.

An analysis of recent cases reveals that the Service interprets the rules as narrowly as possible. This is especially true of the “equitable” relief cases using Sec. 6015(f), which Congress intended for cases that do not fit the other two forms of innocent spouse protection: innocent spouse relief and relief by separation of liability.

Taxpayer Losses

The Tax Court has supported the IRS’s rulings against taxpayers in many equitable relief cases, including Madden, TC Memo 2006-4, Motsko, TC Memo 2006-17, and Lopez, TC Memo 2005-36. The Tax Court denied relief even though the taxpayers in the cases might suffer economic hardship.

The Tax Relief and Health Care Act of 2006 (TRAHCA ’06) amended Sec. 6015 specifically to give the Tax Court jurisdiction to review innocent spouse cases claiming equitable relief and to suspend the statute of limitations while such claims are pending. This provision may change the dynamic in some of these cases.

Until the TRAHCA ’06 was passed, Sec. 6015(e) gave taxpayers the option to petition the Tax Court to review denials of innocent spouse relief and relief by separation-of-liability cases, but not equitable relief cases. However, in Capehart, 11/7/06, the Ninth Circuit ruled that the Tax Court properly determined the taxpayer was not eligible for Sec. 6015(b) relief from joint liabilities arising from tax shelter investments, because she played a substantial role in managing the investments in question.

Taxpayer Victories

Partial: Sometimes the taxpayer prevails in part. In Levy, TC Memo 2005-92, the court held that the IRS abused its discretion in denying the taxpayer Sec. 6015(f) equitable relief from joint liabilities for five years of understatements attributable solely to her ex-husband. The court found that although the taxpayer significantly benefited from unpaid liabilities and failed to show that she would suffer economic hardship if not granted relief, she had no knowledge or reason to know, at the time she signed the returns, that her ex-husband would not pay those tax liabilities.

Complete: Sometimes the taxpayer wins outright. In Campbell, TC Memo 2006-24, the court ruled that a nurse/homemaker was entitled to Sec. 6015(b) relief from over $2.8 million of liabilities attributable to her husband’s sham commodities-trading transaction. It was deemed highly inequitable to hold her liable, given her lack of knowledge, lowered standard of living, age and relatively modest assets. The court rejected the Service’s argument that the taxpayer misled by not fully disclosing account ownership.

In DeFore, TC Summ. Op. 2004-162, a husband qualified for innocent spouse relief under Sec. 6015(c), despite having reason to know that his wife had understated her income. Proportionate relief was appropriate, as he was no longer married and did not have actual knowledge when signing the return of any of the items giving rise to the deficiency. Because the tax understatement was attributable entirely to the wife’s omitted income, the entire deficiency was allocated to her.

In Cook, TC Memo 2005-22, the taxpayer qualified for innocent spouse relief under Sec. 6015(c), even though she prepared invoices for the omitted income. She had been subjected to physical and emotional abuse throughout her marriage. The court concluded that she lacked actual knowledge of the unreported income and qualified for relief from joint liability.

Similarly, in Neal, TC Memo 2005-201, the taxpayer was held entitled to Sec. 6015(f) relief from joint liabilities. In McClelland, TC Memo 2005-121, the taxpayer was entitled to Sec. 6015(b) relief from liability for a deficiency arising from her and her husband’s false interest deduction. The court felt it would be inequitable under Sec. 6015(b)(1)(D) to hold her liable, because her husband had caused the false deduction and concealed it from her.

Overwhelming: Sometimes the taxpayer really wins. In Owen, TC Memo 2005-115, and Bulger, TC Memo 2005-147, the Tax Court held that a widowed taxpayer was entitled to reasonable administrative and litigation costs resulting from pursuit of a Sec. 6015(c) allocation claim for partial innocent spouse relief from joint partnership/tax-shelter-related liabilities. The IRS’s position, that the taxpayer did not qualify for allocation because of her alleged knowledge about items giving rise to deficiencies, was not substantially justified. The court held that the Service failed to apply a proper standard for evaluating actual knowledge, and did not investigate or account for the taxpayer’s detailed response indicating her lack of knowledge (which was bolstered by clear evidence that the partnership promoter had deceived all of the investors).

Conclusion

Claims for innocent spouse relief need to be very carefully and fully prepared before being sent to the IRS. The questions in Form 12507, Innocent Spouse Statement, should be used as a guide to determine whether a case has a reasonable chance of success. The answers should be prepared before Form 8857, Request for Innocent Spouse Relief (And Separation of Liability and Equitable Relief), is submitted. Form 12507 should not be submitted until the Service requests it.

From Carol Markman, CPA, Feldman, Meinberg & Co. LLP, Syosset, NY