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NewsNotes

Lesli S. Laffie, J.D., LL.M.

Debt Relief as Dividend • Frivolous Tax Arguments • QSSTs • Exempt Bond Kit • What Is an Unforeseen Circumstance?

Court Decisions

Debt Relief as Dividend

In Gary D. Combrink, 117 TC No. 8 (2001), the IRS properly recharacterized as a stock redemption a sole shareholder's transfer of stock to a related corporation for debt relief; thus, the shareholder received a taxable dividend under Sec. 301. The transaction qualified as a redemption because the taxpayer controlled both corporations under Sec. 304(a)(1) before and after the transfer, either directly or through Sec. 318(a) attribution rules. Moreover, the release from liability he received from the acquiring corporation constituted Sec. 317 property.

However, part of the loan the acquiring corporation gave the taxpayer was invested in the transferring corporation and, thus, qualified for Sec. 351 gain-nonrecognition treatment under the exception to Sec. 304(a). Nevertheless, the remaining portion of the loan the taxpayer made to the transferring corporation was not initially characterized by the parties as paid-in capital; thus, the debt relief he received for the stock did not fall within the exception to Sec. 304(a).

Further, the redemption was properly treated as a dividend distribution taxable as ordinary income, rather than as a sale or exchange taxable as capital gain. The taxpayer was the sole shareholder of the transferring corporation both before and after the redemption. Thus, he was not entitled to relief under Sec. 302; the deemed stock dividend was taxable as ordinary income under Sec. 301 to the extent of the acquiring corporation's earnings and profits (E&P). Because the taxpayer did not introduce evidence as to the corporation's E&P, the dividend was fully taxable as ordinary income.

From the IRS

Frivolous Tax Arguments

According to IR-2001-73, the IRS has published a legal summary, The Truth About Frivolous Tax Arguments, to address false arguments about the legality of not paying taxes or filing returns. In the summary, the IRS Chief Counsel examines the most frequently raised frivolous tax arguments and provides a digest of the law and relevant legal decisions involving such claims.

The IRS asserts that the most common frivolous arguments fall into six categories, but: filing a return and paying taxes are not voluntary; the meaning of income is not in doubt; the definitions of terms such as "taxpayer" are not in doubt; the Sixteenth Amendment allows a Federal income tax; no legal flaws invalidate the IRS or tax forms; and trusts do not provide a way to avoid filing returns or paying taxes. Courts may impose a delay penalty against taxpayers whose arguments they deem frivolous.

The summary is available on the IRS Website at www.irs.gov and www.treas.gov/irs/ci/index.htm .

Regulations

QSSTs

A new proposed regulation provides guidance on qualified subchapter S trust (QSST) elections for testamentary trusts under Sec. 1361. The proposal incorporates changes made to Sec. 1361 by the Small Business Job Protection Act of 1996 (SBJPA) to provide that a testamentary trust could be a permitted S shareholder for two years. Also, a former qualified subpart E trust would be a permitted shareholder for two years, whether or not the entire corpus was included in the deemed owner's gross estate.

The proposed regulation would eliminate the special rules for determining whether trusts consisting of community property qualify for the two-year period. Prior to the law change, testamentary trusts and former qualified subpart E trusts could be shareholders for only 60 days.

Additionally, the proposal refers to electing small business trusts (ESBTs), which were added by the SBJPA, and provides that certain former qualified subpart E trusts and testamentary trusts could continue as S shareholders after the end of the two-year period by becoming ESBTs. Further, the regulation reflects law changes (1) allowing certain exempt organizations to be S shareholders for post-1997 tax years and (2) increasing the number of permissible S shareholders from 35 to 75.

The proposed regulation also would clarify that a current income beneficiary of a testamentary trust that meets the requirements could make a QSST election at any time during the two-year period in which the trust is a permitted shareholder or the 16-day-and-two-month period beginning on the date after the two-year period ends. Under this provision, a testamentary trust would continue as a permitted shareholder after the end of the two-year period by becoming an electing QSST. Once the trust becomes an electing QSST, the beneficiary would be treated as the shareholder as of the QSST election's effective date.

Interested parties have until Nov. 23, 2001, to submit comments and requests for a public hearing on the proposed regulation to:

Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Room 5226
Attn: CC:IT&A:RU (REG-106431-01)
Washington, DC 20044

Comments may also be submitted electronically by selecting the "Tax Regs" option on the IRS's homepage, at www.irs.gov.

Technology

Exempt Bond Kit

The IRS recently posted an exempt bond tax kit and miscellaneous training materials to its Tax-Exempt Bond Community Website. The Website was launched recently to provide information for the IRS's customer base that invests in the $1.5 trillion exempt bond industry.

The tax kit includes information returns, election forms and instructions for filing exempt bond forms. Also posted are sections of the Internal Revenue Manual relevant to return processing and examinations and links to several bond-related revenue procedures.

Basic and advanced student texts are available in the Website's miscellaneous training materials section. Coursework is organized in instructional modules that start with an introduction to the municipal exempt bond market. Additional modules cover the various types of exempt bonds, events that can affect exempt status and audit techniques. Advanced instructional modules include computations of bond yield, investment valuations and guidelines for the application of the appropriate regulatory guidance.

To access the Tax-Exempt Bond Community page on the IRS Website, from www.irs.gov, click on "Tax Info for Business" and "Tax Exempt Bonds."

What Is an "Unforeseen Circumstance"?

by Norman S. Solomon, CPA, LL.M.

Member, AICPA Tax Division's Individual Taxation Technical Resource Panel

The Taxpayer Relief Act of 1997 (TRA '97) changed the taxation of gain realized on the sale of a personal residence. Under prior law, certain taxpayers age 55 and older could exclude $125,000 from the reportable capital gain realized on a residence sale. The TRA '97 enactment of Sec. 121 allowed taxpayers of any age to exclude up to $250,000 per taxpayer ($500,000 on a joint return) every two years, if they met certain conditions. Basically, a taxpayer must own and occupy a personal residence for at least two years during the five-year period preceding the sale.

Sec. 121(c) allows taxpayers to obtain partial relief when the home has not been owned and occupied for two years, if the sale is due to a change in employment, health reasons or "unforeseen circumstances." That provision anticipates that guidance will be found in regulations. Prop. Regs. Sec. 1.121-3(a) states that the definition of unforeseen circumstances will appear in several places, such as "forms, instructions, or other appropriate guidance including regulations and letter rulings."

The IRS held hearings in January 2001 to allow interested parties to comment on the proposed regulations. The AICPA, American Bar Association and others made presentations suggesting that unforeseen circumstances include the following: (1) health or change of employment of a member of the taxpayer's household; (2) changes in family circumstances; (3) unique circumstances of newlyweds who own separate houses and may not be able to meet the use tests; (4) sales caused by divorce or the break-up of a family relationship; (5) death of a co-owner or occupant; (6) changes in financial circumstances; (7) disability; and (8) changes in the use of the home. IRS personnel have indicated that they will give serious consideration to each proposal.

The IRS recently issued a worksheet in Pub. 918, Drafts of Worksheets in IRS Publications, p. 6, taken from Pub. 523, Sale of Personal Residence, that does not refer to unforeseen circumstances. Rather, it is consistent with the following language from Pub. 523 for 2000:

Unforeseen circumstances. The IRS has not issued regulations defining unforeseen circumstances. You cannot claim an exclusion based on unforeseen circumstances until the IRS issues final regulations or other appropriate guidance.

The Pub. 918 worksheet and IRS position in Pub. 523 have frustrated many practitioners; there does not appear to be any way to report a reduced gain exclusion based on unforeseen circumstances until final regulations are issued. The proposed regulations contain an effective date "for sales or exchanges that occur on or after the date they are published as final regulations in the Federal Register." Nevertheless, informal discussions with IRS personnel have yielded the impression that positions taken on returns filed before (and amended returns filed after) the issuance of final regulations will be respected.

Once final regulations are issued, the situation will greatly improve. (The IRS has tentatively scheduled issuance during October 2001, but IRS personnel have expressed doubt whether this goal will be achieved.)

Practitioners must use their best judgment in determining whether a fact pattern will constitute a qualified unforeseen circumstance before the final regulations are issued. Because claiming a reduced exclusion before that time violates IRS instructions, tax advisers should clearly disclose additional details of the circumstances. Some practitioners may want to wait until after the final regulations are published to claim the exclusion, although this most likely will result in the payment of current taxes and the need for an amended return.