Tuesday, May 31, 2011

Federal Interest Rates to Remain the Same in the Third Quarter

The IRS has announced that interest rates for the quarter beginning July 1, 2011 (third quarter), will remain the same as in the second quarter. The rates remain at: 4% for overpayments (3% in the case of a corporation); 4% for underpayments; 6% for large corporate underpayments; and 1.5% for the portion of a corporate overpayment exceeding $10,000 [Rev Rul 2011-12, 2011-26 IRB; IR 2011-53].

Federal and State Taxing Authorities Offering Employment Tax Relief to Taxpayers in Storm-Ravaged Areas

The IRS and several state taxing authorities are offering employment tax relief to taxpayers in Alabama, Arkansas, Georgia, Kentucky, Mississippi, Missouri, North Carolina, Oklahoma, South Carolina, and Tennessee, who were impacted by recent storms that ripped through these states.

Here are some of the latest developments:

Alabama. Federal tax relief is available to victims of severe storms, tornadoes, and associated flooding that began on April 15, 2011 in 42 Alabama counties. The IRS will waive the failure-to-deposit penalty for employment tax deposits due after April 14 and before May 3, 2011, as long as the deposits were made by May 2, 2011. Affected taxpayers also have until June 30, 2011 to file their first quarter Form 941 [IRS Notice AL/TN-2011-26AL, 4/29/11].

The Alabama Department of Revenue (DOR) is giving affected taxpayers until June 30, 2011, to file their withholding tax returns that would otherwise have been due between April 15, 2011, and June 29, 2011. The tax relief includes the waiver of late filing and payment penalties. However, there is no provision in Alabama tax law that provides for the waiver of interest [DOR News Release, State Filing Extensions Granted to Alabama Storm Victims, 5/5/11; Order of the Commissioner of Revenue, 5/4/11].

Arkansas. Federal tax relief is available to victims of severe storms, tornadoes, and associated flooding that began on April 23, 2011 in 26 Arkansas counties. The IRS will waive the failure-to-deposit penalty for employment tax deposits due after April 22 and before May 10, 2011, as long as the deposits were made by May 9, 2011. Affected taxpayers also have until June 30, 2011 to file their first quarter Form 941 [IRS Notice OK-2011-08, 5/3/11].

Georgia. Federal tax relief is available to victims of severe storms, tornadoes, straight-line winds, and associated flooding that began on April 27, 2011 in 25 Georgia counties. The IRS will waive the failure-to-deposit penalty for employment tax deposits due after April 26 and before May 13, 2011, as long as the deposits were made by May 12, 2011. Affected taxpayers also have until June 30, 2011 to file their first quarter Form 941 [IRS Notice ATL 2011-36, 5/2/11].

Georgia is giving taxpayers who reside in or have a principal place of business in the disaster area until June 30, 2011, to file returns, make tax payments and perform other time-sensitive acts that were originally due after April 26, 2011 and before June 30, 2011. The relief is also available to taxpayers who are not located in the disaster area if their records are maintained in the disaster area [Georgia Department of Revenue Extends Relief to April Severe Storm and Tornado Victims, 5/5/11].

Kentucky. Federal tax relief is available to victims of severe storms, tornadoes, and associated flooding that began on April 22, 2011 in 11 Kentucky counties. The IRS will waive the failure-to-deposit penalty for employment tax deposits due after April 21 and before May 10, 2011, as long as the deposits were made by May 9, 2011. Affected taxpayers also have until June 30, 2011 to file their first quarter Form 941 [IRS Notice, 5/20/11].

Mississippi. Federal tax relief is available to victims of severe storms, tornadoes, straight-line winds, and associated flooding that began on April 15, 2011 in 29 counties. The IRS will waive the failure-to-deposit penalty for employment tax deposits due after April 14 and before May 3, 2011, as long as the deposits were made by May 2, 2011. Affected taxpayers also have until June 30, 2011 to file their first quarter Form 941 [IRS Notice LA/MS-2011-19, 5/2/11].

Mississippi is offering the same tax relief that is being offered by the IRS. The Mississippi relief applies to tax returns and payments with an original or extended due date that falls after April 14, 2011 and before June 30, 2011. The Mississippi Department of Revenue (DOR) will abate interest and any late filing/late payment penalties that would otherwise apply [DOR Notice, Mississippi Severe Storm and Flooding Disaster Relief, 5/2/11].

Federal tax relief is also available to victims of flooding that began on May 3, 2011 in 14 counties. The IRS will waive the failure-to-deposit penalty for employment tax deposits due after May 2 and before May 19, 2011, as long as the deposits were made by May 18, 2011 [IRS Notice LA/MS-2011-23, 5/12/11].

Missouri. Federal tax relief is available to victims of severe storms, tornadoes, straight-line winds, and associated flooding that began on April 19, 2011 in 15 Missouri counties. The IRS will waive the failure-to-deposit penalty for employment tax deposits due after April 18 and before May 5, 2011, as long as the deposits were made by May 4, 2011. Affected taxpayers also have until June 30, 2011 to file their first quarter Form 941 [IRS Notice KS/MO 2011-18, 5/10/11].

North Carolina. Federal tax relief is available to victims of severe storms, tornadoes, and flooding that began on April 16, 2011 in 19 counties. The IRS will waive the failure-to-deposit penalty for employment tax deposits due after April 15 and before May 3, 2011, as long as the deposits were made by May 2, 2011. Affected taxpayers also have until June 30, 2011 to file their first quarter Form 941 [IRS Notice NC-2011-20, 4/20/11].

Oklahoma. Federal tax relief is available to victims of severe storms, tornadoes, and associated flooding that began on April 14, 2011 in Atoka County. The IRS will waive the failure-to-deposit penalty for employment tax deposits due after April 13 and before April 30, 2011, as long as the deposits were made by April 29, 2011. Affected taxpayers also have until June 30, 2011 to file their first quarter Form 941 [IRS Notice OK-2011-07, 4/25/11].

South Carolina. The South Carolina Department of Revenue (DOR) has announced that it will follow the various IRS information releases that postpone certain deadlines until June 30, 2011, for affected taxpayers who live in or have a business in Alabama, Arkansas, Georgia, Mississippi, North Carolina, Oklahoma, and Tennessee. The postponement applies to the deadline for filing tax returns, making tax payments, and other time-sensitive acts [South Carolina Information Letter 11-7, 05/04/2011].

Tennessee. Federal tax relief is available to victims of severe storms, tornadoes, straight-line winds, and associated flooding that began on April 19, 2011 in the following counties: Dyer, Lake, Obion, Shelby, and Stewart. The IRS will waive the failure-to-deposit penalty for employment tax deposits due after April 18 and before May 5, 2011, as long as the deposits were made by May 4, 2011. Affected taxpayers also have until June 30, 2011 to file their first quarter Form 941 [IRS Notice AL/TN-2011-30TN, 5/10/11].

Federal tax relief is also available to victims of severe storms, tornadoes, straight-line winds, and associated flooding that began on April 25, 2011 in the following counties: Bledsoe, Bradley, Cocke, Greene, Hamilton, Johnson, McMinn, Monroe, Rhea, and Washington. The IRS will waive the failure-to-deposit penalty for employment tax deposits due after April 24 and before May 11, 2011, as long as the deposits were made by May 10, 2011. Affected taxpayers also have until June 30, 2011 to file their first quarter Form 941 [IRS Notice AL/TN-2011-27TN, 5/2/11].

Ruling Roundup

New rulings have been issued on the trust fund recovery penalty, donning and doffing of protective equipment, employment tax levies, and garnishments.

Trust fund recovery penalty. A federal district court has rejected an individual's attempt to set off one trust fund recovery penalty by another time-barred overpaid one because the penalties in the assessments were made against totally separate entities [U.S. v. Dieter H. Klohn, DC FL, 107 AFTR 2d ¶ 2011-809, 5/6/11].

Donning and doffing of protective equipment. A federal district court has ruled that workers at a beef processing plant should not be compensated for the time they spent putting on and taking off (donning and doffing) protective equipment [Martinez v. Cargill Meat Solutions Corp., DC NE, Dkt. No. 4:09CV3079, 4/12/11].

29 USC 203(o) of the Fair Labor Standards Act (FLSA) states that for purposes of determining employee working hours, the “time spent changing clothes or washing at the beginning or end of each workday” is not counted as time worked if it is “excluded by the express terms of, or by custom or practice under, a bona fide collective-bargaining agreement.” The court said that the protective equipment at issue (frocks, hair nets, ear plugs, hard hats, rubber or cotton gloves, and boots) qualified as “clothes” under 29 USC 203(o). It was undisputed that a collective bargaining agreement excluded this activity from compensation.

Employment tax levies. In most instances before the IRS can issue a tax levy, it must provide the taxpayer with notice and an opportunity for an administrative collection due process (CDP) hearing, and for judicial review. However, Code Sec. 6330(f), effective for levies served after Sept. 21, 2007, allows the IRS to issue an employment tax levy without first giving the taxpayer a pre-levy CDP notice, if the levy is a “disqualified employment tax levy” (DETL). Code Sec. 6330(h) defines a DETL as a levy to collect the employment tax liability of a taxpayer (or predecessor) who requested a CDP hearing for unpaid employment taxes in the two-year period prior to the beginning of the taxable period for which the levy is served.

The IRS has now issued a program manager technical advice (PMTA) that includes a test to determine whether a business is a predecessor business for purposes of these rules. The PMTA includes examples to support the rules. The PMTA notes that the purpose behind requiring a prior CDP hearing within two years is to ensure that a taxpayer has had a recent opportunity to resolve the collection of its employment tax liabilities in a CDP hearing. Accordingly, to be exempt from this requirement, a taxpayer must have a sufficient identity with the predecessor such that the CDP hearing given to the predecessor may be imputed to the taxpayer [Program Manager Technical Advice 2011-11].

Garnishments. In U.S. v. Dover, DC TN, 107 AFTR 2d 2011-1882, 4/18/11, a federal district court ruled that the federal government may garnish a taxpayer's Roth IRA to help satisfy a criminal restitution debt because a Roth IRA is not exempt from federal tax levy under Code Sec. 6334.

New Online Resource Center for Form I-9

The U.S. Citizenship and Immigration Services (USCIS) has launched I-9 Central, which is a new, free online resource center that provides simple one-click access to resources, tips, and guidance to properly complete Form I-9, Employee Eligibility Verification, and better understand the Form I-9 process [USCIS website, News Releases, USCIS Launches I-9 Central on USCIS.gov, 5/13/11].

An employer must complete a Form I-9 for all newly-hired employees to verify their identity and authorization to work in the United States.

I-9 Central includes information on employer and employee rights and responsibilities. It has step-by-step instructions for completing the form, and information on acceptable documents for establishing identity and employment authorization. It also includes a discussion of common mistakes to avoid when completing the form, guidance on how to correct errors, and answers to employers' recent questions about the Form I-9 process.

Can salaried employees who are exempt from overtime also receive standby pay? If so, are they entitled to overtime if they return to work during off hours?

The employees may receive standby pay. You can pay them overtime if they are required to return to work, but you are not required to do so.

29 CFR 541.604(a) allows an employer to provide an exempt employee with additional compensation without losing the exemption or violating the salary basis requirement, if the employment arrangement also includes a guarantee of at least the minimum weekly required amount paid on a salary basis. Thus, for example, an exempt employee guaranteed at least $455 each week paid on a salary basis may also receive a 1% commission on sales as additional compensation.

29 CFR 541.604(a) also states that the additional compensation may be paid on any basis without jeopardizing the employee's exempt status (e.g., flat sum, bonus payment, straight-time hourly amount, time and one-half, or any other basis). This compensation may include paid time off.

It is important to note that neither standby pay nor overtime pay is required under the Fair Labor Standards Act (FLSA) for exempt employees.

You should also make sure to check state overtime laws, if you decide to pay the employees overtime. State laws may supersede federal laws governing overtime if the state law is more advantageous to the employee.

New Bill Would Give States More Flexibility in Using Federal Unemployment Funds

On May 11, the House Ways and Means Committee approved H.R. 1745, the “Jobs, Opportunity, Benefits, and Services Act of 2011” (JOBS Act). The bill would give states more flexibility in how they use their remaining $31 billion in federal unemployment funds for this year. Under current law, the money must be used to pay unemployment benefits. Under the JOBS Act, states could use the money for: (1) regular or extended unemployment benefits; (2) preventing unemployment tax hikes; (3) paying interest or principal on federal unemployment loans; or (4) promoting job creation and hiring through the use of reemployment services, including wage subsidies.

Some opponents of the bill feel that the legislation could damage the economy recovery if less unemployment benefits are provided to the long-term unemployed. A few states have already enacted legislation that reduces the maximum time period in which claimants may receive benefits.

The bill will be sent to the House floor for consideration. A parallel bill has been introduced in the Senate (S. 904).

IRS Eases Backup Withholding Requirements for Third Party Network Transactions

The IRS has issued a notice that provides interim guidance to third party settlement organizations on backup withholding requirements under Code Sec. 3406 and its accompanying regulations [Notice 2011-42, 2011-23 IRB].

Code Sec. 3406(a)(1) requires certain payors to deduct backup withholding from a “reportable payment,” regardless of any threshold amount otherwise applicable to such payment, if the payee fails to furnish its taxpayer identification number (TIN) or furnishes an incorrect TIN to the payor. A “reportable payment” includes any payment card transaction and any third party network transaction.

Code Sec. 6050W requires information returns to be filed by certain payors with respect to payments made in settlement of payment card transactions and third party payment network transactions. Payments made in settlement of third party network transactions, however, are only required to be reported if the amount to be reported exceeds $20,000, and the aggregate number of transactions exceeds 200 for any payee within a calendar year.

A third party settlement organization (TPSO) is defined in Code Sec. 6050W(b)(3) as “the central organization which has the contractual obligation to make payment to participating payees of third party network transactions.”

The new notice states that a payment made by a TPSO is a reportable payment potentially subject to Code Sec. 3406 backup withholding only if the payee has received payment from that TPSO in more than 200 transactions within a calendar year. The relief provided in Notice 2011-42, 2011-23 IRB, doesn't apply to payment card transactions. Payments made in settlement of payment card transactions do not have a de minimis transaction threshold with respect to the Code Sec. 3406 backup withholding rules.

The regulations under Code Sec. 3406 will be amended to reflect this guidance.

OCSE Revises Child Support Income Withholding Order Form

The Office of Child Support Enforcement (OCSE) has finalized a new version of the Income Withholding for Support (IWO) Form [OCSE Action Transmittal AT-11-05, 5/16/11].

An IWO form is used by state and tribal agencies to transmit child support withholding orders and notices to employers and other debtors using standardized formats prescribed by the Secretary of Health and Human Services.

The new version of the form includes the following changes:

Shading has been eliminated from sections of the form that caused problems when the form was faxed.

The note on page one of the form has been reworded to say that if an employer receives an IWO form from someone other than a state or tribal child support agency, the employer should attach a copy of the underlying order to the IWO form.

The remittance identifier has been moved to page one of the form above the case and order identifier to ensure that employers/income withholders will use the identifier when submitting payments.

A checkbox has been added on page two of the form for employers to indicate that the IWO is being returned because it either does not direct payments to the State Disbursement Unit (SDU), or the IWO is irregular.

The employment termination section of the form has been expanded to allow employers to note that there has been a change in the employee's income status.

The form instructions have been updated to include guidance on when to reject and return invalid IWOs.

Employers must reject a new IWO issued after May 30, 2011, that is not directed to the SDU as required under federal law, and return it to the sender. With respect to IWOs issued before May 31, 2011 that the employer has already processed and that are not directed to the SDU, the employer should contact the state child support enforcement (CSE) agency in the state that issued the underlying support order to request a revised IWO form directing payment to the SDU. Effective May 31, 2012, an employer must reject an income withholding document that was not issued on an approved Office of Management and Budget form.

The OCSE is advising states, tribes, and others to begin using the new form immediately. States that require additional time to implement the new IWO form may honor previous versions of the forms until May 31, 2012.

Information Return Extension Requests Can No Longer Be Filed on Paper if Filing on Behalf of Multiple Taxpayers

The IRS has issued a May 2011 version of Form 8809, Application for Extension of Time To File Information Returns. The form is used to request an extension of time to file any of the following forms: W-2, W-2G, 1042-S, 1097, 1098, 1099, 3921, 3922, 5498, and 8027. The form can now only be filed on paper if the request is for one filer. Previously, the form could be filed on paper by payers/transmitters requesting extensions of time to file information returns for 10 or fewer payers. Form 8809 can also be filed: (1) by completing a fill-in Form 8809 online through the FIRE (Filing Information Returns Electronically) system; or (2) electronically through the FIRE system in a file formatted according to the specifications in IRS Publication 1220.

IRS Having Problems Processing Form 941, Schedule R

The IRS told participants during the May 12 payroll industry conference call that it is having some problems processing Form 941, Schedule R, Allocation Schedule for Aggregate Form 941 Filers.

Schedule R is used by “Form 2678 agents” to file an aggregate return on behalf of multiple taxpayers. An agent files Form 2678, Employer/Payer Appointment of Agent, to receive permission to file an aggregate return for all of his or her clients under the agent's EIN. A “Form 2678 agent” assumes joint liability with the employer for the employer's Social Security, Medicare, and federal income tax withholding responsibilities.

There are seven columns on Schedule R that agents must complete to allocate information on Form 941 to each of their clients. The IRS notes that some agents are submitting a spreadsheet with this information, rather than submitting the Schedule R itself. The spreadsheet has the same columns as Schedule R, but the agents are squeezing as much information onto a page as they can. In this situation, the IRS must re-type the information, which is not only time-consuming, but it can also lead to more errors. The IRS is advising agents to only submit information that conforms to the format of Schedule R (i.e., not to add lines, create spreadsheets, etc.).

IRS Issues New Version of Amended Form 941 Return

There is now a January 2011 version of Form 941-X, Adjusted Employer's Quarterly Federal Tax Return or Claim for Refund, and the Form 941-X instructions, on the IRS website. The form was last revised in September 2010.

Unreported tips. A new line has been added to Form 941-X (Part 3, line 11) to report any FICA tax corrections to the amounts reported on Form 941, line 7c (for quarters ending before 2011), or line 5e (for quarters ending after 2010), from an IRS “Section 3121(q) Notice and Demand” letter.

Daniel Lauer, Program Manager for the IRS National Tip Compliance Program, discussed the “Section 3121(q) Notice and Demand” letter during the May 12 payroll industry conference call. He pointed out that an employer will not have to report anything on this line of Form 941 (or Form 941-X) unless the employer has been contacted by the IRS about unreported tip income. Lauer said that this usually happens in three situations: (1) The IRS has conducted an audit of the employer and found that the employer failed to report some tips. (2) The IRS has uncovered some unreported tips using a new tip compliance program that it launched last year. (3) An IRS audit of an employee uncovered some unreported tips that the employer also failed to report.

A “Section 3121(q) Notice and Demand” letter instructs the employer to include the FICA taxes shown in the notice and demand letter on the employer's next Form 941. Lauer said that an employer will not be subject to any interest charges or deposit penalties if it properly reports the taxes as instructed in the notice and demand letter, and remits the tax due with its Form 941, or if it timely makes a deposit in accordance with the instructions in the letter. The letter will be issued well before the end of the quarter. The deposit needs to be made before the end of the quarter to avoid penalties. Corrections to the amounts reported on Form 941 are reported on Form 941-X.

Payroll tax exemption in the HIRE Act. The new version of Form 941-X notes that the lines for the payroll tax exemption in the HIRE Act (Part 3, lines 12a-12c) should only be completed for corrections to quarters ending after March 31, 2010, and before Jan. 1, 2011, since the payroll tax exemption in the HIRE Act can no longer be claimed after Dec. 31, 2010.

Advance earned income credit. The new version of Form 941-X also notes that corrections to the advance earned income credit (Part 3, line 18) should only be made for quarters ending before Jan. 1, 2011, since the advance earned income credit was repealed beginning in 2011.

IRS Announces Health Savings Account Limitations for 2012

Some annual contribution limits for health savings accounts (HSAs) are increasing in 2012 [Rev Proc 2011-32, 2011-22 IRB].

Eligible individuals may, subject to statutory limits, make deductible contributions to an HSA. Employers, as well as other persons (e.g., family members), may also contribute on behalf of an eligible individual. Employer contributions generally are treated as employer-provided coverage for medical expenses under an accident or health plan and are excludable from income. In general, a person is an “eligible individual” if he or she is covered under a high deductible health plan (HDHP) and is not covered under any other health plan that is not a high deductible plan, unless the other coverage is permitted insurance (e.g., for worker's compensation, a specified disease or illness, or insurance providing a fixed payment for hospitalization).

For calendar year 2012, an HDHP is a health plan with: (1) an annual deductible of at least $1,200 for individual coverage, or $2,400 for family coverage (these figures are unchanged from 2011); and (2) maximum out-of-pocket expenses of $6,050 for individual coverage, ($5,950 in 2011) or $12,100 for family coverage ($11,900 in 2011).

For 2012, the maximum annual contribution to an HSA is $3,100 for self-only coverage ($3,050 in 2011) and $6,250 for family coverage ($6,150 in 2011).

IRS Has No Current Plans to Increase Standard Mileage Rates

The IRS stated during the May 12 payroll industry conference call that it has no current plans to increase the standard mileage rate of 51 cents per mile for business miles driven, despite the current high gasoline prices. Ligeia Donis, Assistant Branch Chief, IRS Office of Chief Counsel, gave two reasons for this. First of all, there is always the possibility that gas prices could decline. Second, the IRS had received some feedback from employers that the change was difficult to implement when it adjusted the standard mileage rate in the middle of 2008.

An employer that requires employees to supply their own autos may currently reimburse them at a rate that doesn't exceed 51 cents per mile for employment-connected business, and the reimbursement will be treated as a tax-free accountable plan reimbursement. The employee must substantiate the time, place, business purpose, and mileage of each trip. Additionally, an employee's personal use of lower-priced company autos during 2011 may be valued at 51 cents per mile if the conditions specified in Reg. §1.61-21(e)(1) are met.

Employers Will Not Be Penalized if FUTA Surtax is Retroactively Reinstated

Unless Congress takes action soon, the federal unemployment tax rate (FUTA) will decrease by 0.2%, effective July 1, 2011. That is because the 0.2% FUTA surtax is scheduled to expire on June 30. The surtax is part of the 6.2% gross unemployment tax rate that employers pay on the first $7,000 of wages paid annually to each employee (6% permanent tax rate, 0.2% temporary surtax). The surtax has been in effect in every year since 1976, when it was enacted by Congress on a temporary basis. Unless new legislation is enacted, the FUTA tax rate, before consideration of state unemployment tax credits, will drop to 6.0%, effective July 1, 2011.

On the May 12 payroll industry conference call, the IRS was asked about the surtax. Sherry Saucerman, IRS Tax Analyst, noted that the IRS has no control over whether Congress enacts legislation to extend the surtax. She pointed out that the federal unemployment tax return (Form 940) is filed on an annual basis (due January 31 of each year). So it is possible that even if legislation is not enacted before July 1 to extend the surtax, it could be enacted prior to January 31 of next year, and be applied retroactively to July 1. The IRS was then asked how an employer would compute its upcoming quarterly FUTA tax deposits, which must be paid by all employers whose FUTA tax is more than $500 for the calendar year, if the legislation was to be applied retroactively. Shelley Dockstader, National Account Manager in IRS Electronic Tax Administration, replied that the IRS would have some mechanism in place under which an employer would not be assessed deposit penalties if it computed its third and fourth quarter unemployment tax deposits at a 6.0% rate, and legislation was enacted after the fourth quarter of this year that retroactively reinstated the surtax.

Observation: As of today, the surtax extension hasn't surfaced yet in Congress, although a proposal in the President's fiscal year 2012 budget would keep the 0.2% FUTA surtax in effect on a permanent basis. Another budget proposal would raise the annual FUTA wage base from $7,000 to $15,000 per worker, beginning in 2014. Federal unemployment tax rates would be lowered under this proposal, so employers' FUTA liability would not increase.

Social Security Wage Base Expected to Increase in 2012

The Social Security Administration's Office of the Chief Actuary (OCA) is projecting that the Social Security wage base will increase by at least $3,500 in 2012. It has been $106,800 since 2009. The projection was included as part of the annual report to Congress by the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance (OASDI) Trust Fund programs. Projections were made through 2020 [The 2011 OASDI Trustees Annual Report].

The SSA provides three kinds of forecasts for Social Security wage bases (intermediate, low cost, and high cost). The SSA intermediate forecasts through 2020 are as follows:

2012 — $110,700
2013 — $114,900
2014 — $120,000
2015 — $125,400
2016 — $130,800
2017 — $135,900
2018 — $141,300
2019 — $146,700
2020 — $153,300

The Social Security wage base is also projected to be $110,700 in 2012 under the low cost forecast. It would be $110,400 under the high cost forecast. The Social Security wage base would reach $159,900 in 2020 under the high cost forecast.

Actual annual increases to the wage base are announced in October of the preceding year and are based on then-current economic conditions. As a result, the OCA's forecasts, especially the longer-range ones, are subject to change. Last year, the OCA correctly projected that the Social Security wage base would remain at $106,800 in 2011.

Other issues raised in SSA's report. In addition to projecting increased wage bases, the SSA also provided general conclusions and observations regarding the long-term viability of the Social Security program. Based on a number of factors, notably including the aging of the “baby boomer” population and the increase in life expectancy, the SSA projected that Social Security should be able to fully pay scheduled benefits until the trust funds are exhausted in 2036. (Last year's report projected that the funds would be exhausted in 2037.) After 2036, the amount of non-interest income is projected to cover approximately 77% of the cost of Social Security.

The report includes two alternatives for keeping the Social Security program solvent in the long-term—namely, increasing taxes or reducing benefits. The scheduled benefits could be paid for by raising payroll taxes beginning in 2036, initially from 15.3% to 16.4% and slowly increasing the rate after that to approximately 16.9%. Alternatively, benefits could be reduced to match the scheduled tax rates, starting with a 23% reduction in 2036 and gradually increasing after that to a 26% reduction.

Thursday, May 26, 2011


Revenue Procedure 2011-34 provides late election relief in certain situations for real estate professionals who failed to timely file the election to aggregate their rental real estate interests.

Revenue Procedure 2011-34 will be published in Internal Revenue Bulletin 2011-24 on June 13, 2011.

IRS Now Accepting Applications For Tax Counseling For The Elderly And Volunteer Income Tax Assistance

IRS announced on May 23 that it is now accepting applications for the Tax Counseling for the Elderly (TCE) and Volunteer Income Tax Assistance (VITA) grant programs. (IR-2011-56) The application deadline is June 30. “Previous grant recipients will have the option to apply for up to three years of annual funding which would reduce the amount of paperwork they must complete over the three-year period,” IRS said. In 2011, IRS awarded $6.1 million to 31 TCE grantees and $12 million to 179 VITA grantees. Through April 10, the two grant programs filed more than 2 million returns at almost 9,000 sites. As described by IRS, the TCE program provides free tax counseling and return preparation to persons age 60 or older. It also gives training and technical assistance to its volunteers. VITA provides services to underserved populations in hard-to-reach urban and non-urban areas. Additional information, including application forms, can be found at http://www.irs.gov/individuals/article/0,,id=184243,00.html.

Document Entitled “Background And Selected Issues Related To The U.S. International Tax System And Systems That Exempt Foreign Business Income” Published

The Joint Committee on Taxation has published a document entitled “Background and Selected Issues Related to the U.S. International Tax System and Systems That Exempt Foreign Business Income.” (JCX-31-11) The document is divided into three sections: (1) Present Law: Worldwide Taxation and Deferral of Active Business Income; (2) Territorial System; and (3) Territorial Systems of Selected Countries. The countries discussed in the third section include Australia, Canada, France, Germany, Japan, Netherlands, Spain, Switzerland, and the United Kingdom. The document is located at http://www.jct.gov/publications.html.

3,700 Recovery Act Contract And Grant Recipients Owe An Estimated $750 Million

A minimum of 3,700 American Recovery and Reinvestment Act (Recovery Act) contract and grant recipients owed an estimated $750 million in “known unpaid federal taxes” as of Sept. 30, 2009, the Government Accountability Office (GAO) said in a report released on May 24. (GAO-11-485) They received more than $24 billion in Recovery Act funds and represent approximately 5% of the contractors and grant recipients, GAO said. The delinquent parties include prime recipients, subrecipients and vendors. The Recovery Act, which was enacted in February 2009, appropriated $275 billion to be distributed for federal contracts, grants and loans. As of Mar. 25, 2011, $191 billion had been paid out. “Federal law does not prohibit the awarding of contracts or grants to entities because they owe federal taxes and does not permit IRS to disclose taxpayer information, including unpaid federal taxes, to federal agencies unless the taxpayer consents,” GAO said. “The estimated amount of known unpaid federal taxes is likely understated because IRS databases do not include amounts owed by recipients who have not filed tax returns or understated their taxable income and for which IRS has not assessed tax amounts due,” GAO added. The failure to remit payroll taxes is one of the common causes of the tax delinquencies. The report can be found at http://www.gao.gov/new.items/d11485.pdf.

IRS Unable To Verify Whether Individuals Claiming Residential Energy Credits Are Entitled To Them

IRS is unable to verify whether individuals claiming Residential Energy Credits are entitled to them at the time their tax returns are processed, the Treasury Inspector General for Tax Administration (TIGTA) said in an audit released on May 18. (Audit Report No. 2011-41-038) According to TIGTA, some 6.8 million individuals claimed $5.8 billion in Residential Energy Credits on tax year 2009 tax returns processed through Dec. 31, 2010. The agency “does not require individuals to provide any third-party documentation supporting the purchase of qualifying home improvement products and/or costs associated with making energy efficiency improvements and whether these qualified purchases and/or improvements were made to their principal residence,” the audit said. Using a statistically valid sample of 150 tax returns, TIGTA was unable to confirm home ownership for 45 (or 30%) of the taxpayers. Home ownership is required to claim Residential Energy Credits. Auditors also identified 362 ineligible individuals who were allowed to erroneously claim $404,578 in Residential Energy Credits on their tax returns. “These individuals were allowed to erroneously claim these credits because the IRS did not develop a process to identify prisoners or individuals under the age needed to enter into a contract to purchase a residence,” the audit said. It noted that the agency has data that could have been used to identify these erroneous deductions. TIGTA included in its recommendations that a revision be made to Form 5695, Residential Energy Credits, to request specific information to establish that key eligibility requirements are met. The report can be found at http://www.treasury.gov/tigta/auditreports/2011reports/201141038fr.pdf.

IRS Has New Location On Its Website That Addresses Collection Procedures For Taxpayers Who File And/Or Pay Late

IRS has a new location on its website that addresses collection procedures for taxpayers who file and/or pay late. The page provides detailed information that is grouped under the following subject headings: the collection process and taxpayer rights; what a taxpayer should do if he or she cannot file or pay by the due date; what a taxpayer should do if IRS requests financial information to determine how much the taxpayer can pay; payment options that are available if a taxpayer cannot pay in full; what IRS can do if a taxpayer will not pay or file; and ways a taxpayer can prevent future tax liabilities. The new IRS collection procedures page is located at http://www.irs.gov/businesses/small/article/0,,id=238176,00.html.

IRS Promoting Importance For Tax Professionals To Attend The 2011 IRS Nationwide Tax Forums

IRS is heavily promoting the importance for tax professionals to attend one of the events scheduled as part of the 2011 IRS Nationwide Tax Forums. (Special Edition Tax Tip 2011-03) As described by the agency, the tax forums are three-day events presented by IRS experts and partner organizations that offer up-to-date information on federal and state tax issues. Those who register early will receive a significant discount on the registration fee. The early registration period closes two weeks prior to each forum. Forums will be held in the following cities on the dates indicated: Atlanta, June 28-30; Orlando, July 12-14; Dallas, July 26-28; San Jose, Aug. 9-11; Las Vegas, Aug. 16-18; and National Harbor, MD (Washington, DC area), Aug. 30- Sept. 1. Attendance at one of the forums carries benefits for enrolled agents, certified public accountants, certified financial planners and other tax professionals, IRS said. These benefits include the opportunity to receive up to 18 continuing education credits, access to 40 separate seminars and workshops on relevant tax topics, and the chance to sign up to become an Authorized IRS e-file Provider. “Tax professionals attending a forum can bring their toughest unresolved case to meet with IRS personnel who may be able to help,” IRS stressed. Complete details and registration are available at http://www.irstaxforum.com/index.

Republican Senators Ask IRS To Explain Reported Gift Tax Probe Of 501(C)(4) Contributors

On May 18, six Republicans on the Senate Finance Committee wrote IRS Commissioner Shulman and asked him to explain IRS's reported examination of donors who made transfers to Code Sec. 501(c)(4) organizations without paying a gift tax. The six Republicans are Orrin Hatch, Ranking Member, Jon Kyl (R-AZ), Pat Roberts (R-KS), John Cornyn (R-TX), John Thune (R-SD) and Richard Burr (R-NC).

The letter characterizes the applicability of gift taxes to Code Sec. 501(c)(4) contributions as ambiguous, declares that, historically, IRS has deliberately opted against vigorous enforcement of the gift tax on such contributions, and questions whether IRS's reported enforcement initiative is politically motivated (i.e., initiated at the behest of the Administration). The letter says “enforcement of gift taxes on contributions to 501(c)(4) organizations engaged in public policy debate runs an unacceptable risk of chilling political speech, which receives the highest level of constitutional protection under the First Amendment.”

The letter requests Commissioner Shulman to release names of individuals inside and outside of IRS involved in the decision to pursue the issue and related correspondence, as well as any analysis generated or obtained by IRS regarding the First Amendment implications of applying the gift tax to Code Sec. 501(c)(4) contributions. It does not, however, request an analysis of the gift tax issues involved.

Bill Cutting Tax Benefits For Big Oil Companies Fails To Advance In Senate; Backers Will Look For Another Venue

On May 17, Senate Democrats failed to gain the 60 votes necessary to move to consideration of S. 490, the “Close Big Oil Tax Loopholes Act.” The motion to proceed to the bill failed by a vote of 52 to 48. The bill would have cut targeted tax breaks for major integrated oil companies (as defined in section Code Sec. 167(h)(5)(B)) and used the savings to reduce the deficit. The bill's backers were undeterred by the defeat and said they'll look for another venue to advance the bill. Before the vote on the motion to proceed to the bill, Senate Majority Leader Harry Reid (D-NV) said, “I am confident that before we finish our budget negotiations here, in anticipation of raising the debt ceiling, that [the Close Big Oil Tax Loopholes Act] would be part of it.”

Senate Bill Aims to Stem Pre-Retirement 401(K) “Leakage.”

On May 19, Senators Herb Kohl (D-WI) and Mike Enzi (R-WY) introduced legislation to help ensure that retirement savings in defined contribution plans last throughout retirement. The bill, called the “Savings Enhancement by Alleviating Leakage in 401(k) Savings Act of 2011” (the SEAL Act), was introduced following a hearing on the topic that Kohl held as Chairman of the Senate Special Committee on Aging. The SEAL Act aims to stem the phenomenon of more and more Americans using retirement accounts as rainy day funds by taking out withdrawals and loans from their employer-sponsored 401(k)s and then being unable to pay themselves back (commonly called 401(k) “leakage”). The bill's sponsors cited a recent study finding that about 28% of active participants in defined contribution plans had an outstanding loan.

The bill would:

... Extend the rollover period for plan loan amounts, to help terminated workers who often face the tough choice between defaulting on an outstanding loan and incurring tax penalties or immediately repaying the entire outstanding loan balance. Effective for transfers made after the enactment date, the SEAL Act would allow such taxpayers to avoid tax and penalties by contributing the amount outstanding on their loans (the qualified plan loan offset amount) to an IRA by the time they file their taxes for the year in which the amount is treated as a distribution from a qualified employer plan. “Paying back a loan after just losing your job can be difficult so our bill would give people more time to pay themselves back,” Kohl said.

... Direct IRS to modify the hardship distribution regs, within a year after the enactment date, to allow 401(k) participants to continue to make elective contributions during the six months following a hardship withdrawal. Current regs bar elective contributions for the six-month period after an employee receives a hardship withdrawal from a 401(k) plan. Also, IRS is to make other modifications necessary to carry out the purposes of Code Sec. 401(k)(2)(B)(i)(IV) (relating to hardship distributions).

... Modify the plan loan rules so that the overall number of loans that participants can take would be limited to three at a time, effective for loans made after the date which is one year after the enactment date.

... Ban plan loans that are made through a credit card or any other similar arrangement, effective for plan years beginning after the date which is 60 days after the enactment date. The bill's sponsors say that such 401(k) debit cards promote “leakage,“ and often accrue large fees in the process.

Small Business Health Relief Act Would Repeal Parts of 2010 Health Reform Legislation

On May 23, Senate Republican Whip Jon Kyl (R-AZ) introduced the “Small Business Health Relief Act of 2011,” describing it as a bill to repeal “onerous provisions of ObamaCare that raise the price of health insurance and that especially hurt small businesses.” The reference to ObamaCare is to the health reform legislation signed into law last year, namely the Patient Protection and Affordable Care Act (PPACA, P.L. 111-148) and the Health Care and Education Reconciliation Act of 2010 (Reconciliation Act, P.L. 111-152).

Among other changes, the “Small Business Health Relief Act of 2011” would:

... Repeal the following sections of PPACA (and associated Code provisions): Sec. 1513, dealing with shared responsibility for employers, i.e., imposing under certain circumstances a penalty on large employers not providing certain levels of health coverage (Code Sec. 4980H); Sec. 1514, requiring employer reporting of health insurance coverage (Code Sec. 6056, and Code Sec. 6724(d)); and Sec. 10106(e), (f) and (g) (which carry changes to Code Sec. 4980H).

... Provide that health savings accounts under Code Sec. 223, be treated as essential health benefits under Sec. 1302 of PPACA.

... Repeal Sec. 9003 of PPACA, which provides that, beginning after 2010, the cost of over-the-counter medicines can't be reimbursed with excludible income through a health flexible spending arrangement (FSA), health reimbursement account (HRA), health savings account (HSA), or Archer MSA, unless the medicine is prescribed by a doctor or is insulin.

... Repeal Secs. 9005 and 10902 of PPACA and Sec. 1403 of the Reconciliation Act, imposing a $2,500 annual cap after 2012 on health FSA benefits in a cafeteria plan (Code Sec. 125(i)).

... Broaden the grandfathered health plan coverage rules in Sec. 1251 of PPACA.

House Passes Airport and Airway Extension Act

On May 23, the House of Representatives by voice vote approved H.R. 1893, the “Airport and Airway Extension Act of 2011, Part II.” Among other things, the bill would amend the Code to extend through June 30, 2011, increased excise taxes on aviation fuels, the excise tax on air transportation of persons and property, and the expenditure authority for the Airport and Airway Trust Fund. It also would increase the authorization of appropriations for the nine-month period beginning on Oct. 1, 2010, for airport planning and development and noise compatibility planning projects.

Are Vineyards And Orchards Eligible For Expensing Under Code Sec. 179?

Code Sec. 179 expensing has become a potent tax saver, thanks to current law's $500,000 deduction ceiling. So it should come as no surprise that taxpayers and their advisers are on the lookout for assets that potentially qualify as Code Sec. 179 property eligible for expensing. One such class of property is vineyards and orchards. IRS has published an Audit Techniques Guide (ATG) turning a thumbs down on expensing for such property, but its conclusion appears to be based on prior law. A more recent ATG leaves the door open to a better result. This Practice Alert presents the case for treating vineyards and orchards as Code Sec. 179 property and covers IRS's current “conflicted” guidance as well.

Background. Under Code Sec. 179, a taxpayer, other than an estate, a trust, or certain noncorporate lessors, can elect to deduct as an expense, rather than to depreciate, up to a specified amount of the cost of qualifying new or used tangible personal property placed in service during the tax year in the taxpayer's trade or business. The maximum annual expensing amount generally is reduced dollar-for-dollar by the amount of Code Sec. 179 property placed in service during the tax year in excess of a specified investment ceiling. The amount eligible to be expensed for a tax year can't exceed the taxable income derived from the taxpayer's active conduct of a trade or business. And any amount that is not allowed as a deduction because of the taxable income limitation may be carried forward to succeeding tax years.

For tax years beginning in 2010 or 2011: (1) the dollar limitation on the expense deduction is $500,000; and (2) the investment-based reduction in the dollar limitation starts to take effect when property placed in service in a tax year exceeds $2,000,000 (beginning-of-phaseout amount). Amounts ineligible for expensing due to excess investments in expensing-eligible property can't be carried forward and expensed in a subsequent year. Rather, they can only be recovered through depreciation. For tax years beginning in 2012, the maximum expensing amount under Code Sec. 179 is $125,000 and the investment-based phaseout amount is $500,000. The $125,000/$500,000 amounts will be indexed for inflation. However, for tax years beginning after 2012, the maximum expensing amount drops to $25,000 and the investment-based phaseout amount drops to $200,000. (Code Sec. 179(b))

In general, property is eligible for Code Sec. 179 expensing if it is:

... tangible property that's Code Sec. 1245 property depreciated under the MACRS rules of Code Sec. 168, regardless of its depreciation recovery period;

... for any tax year beginning in 2010 or 2011, up to $250,000 of qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property); and

... off-the-shelf computer software, if placed in service in a tax year beginning before 2013. (Code Sec. 179(d)(1))

Eligibility of vineyards and orchards for expensing. Back in '67, IRS ruled in Rev Rul 67-51, 1967-1 CB 68, that fruit orchards or groves don't qualify for Code Sec. 179 treatment. However, when that ruling was issued, former Code Sec. 179 defined section 179 property as tangible personal property of a character subject to the allowance for depreciation under Code Sec. 167, bought for use in a trade or business or for income production, and with a useful life of 6 years or more. (Code Sec. 179(d) before amend by §202(a), P.L. 97-34) The '67 ruling also cited to Reg. §1.179-3(b), which provided in part that tangible personal property did not include land. IRS reasoned in the ruling that because “trees are part and parcel of the land in which they are rooted,” trees of a fruit orchard or grove bought and held for production of income were not tangible personal property for Code Sec. 179 purposes.

In a Farmers ATG originally published several years ago, but last reviewed or updated on Mar. 16, 2011, IRS again says that trees or vines do not qualify under Code Sec. 179, citing to the '67 ruling.

Time for a rewrite? The definition of section 179 property has undergone a major transformation since the '67 ruling was written. Now, such property (other than certain software) is defined as tangible property to which Code Sec. 168 applies (i.e., it is depreciable), which is section 1245 property (as defined in Code Sec. 1245(a)(3)), and which is acquired by purchase for use in the active conduct of a trade or business. In turn, Code Sec. 1245(a)(3) provides that section 1245 property is any property subject to the depreciation allowance under Code Sec. 167 and which falls into one of six classes, the first of which is personal property (Code Sec. 1245(a)(3)(A)), and the second of which (Code Sec. 1245(a)(3)(B)), in relevant part, is other property (not including a building or its structural components) whose basis has been reduced by depreciation, amortization or the deductions that are treated as amortization under Code Sec. 1245(a)(2), during a period in which the property was used as an integral part of manufacturing, production or extraction.

Vineyards and orchards acquired by purchase for use in the active conduct of a trade or business are depreciable. Thus, the question of whether vineyards or orchards are Code Sec. 179 property comes down to whether they may be treated as “other property” used as an integral part of manufacturing, production, or extraction under Code Sec. 1245(a)(3)(B).

Investment credit rules hold the key. Reg. §1.1245-3(c)(2) provides in part that the terms used in Code Sec. 1245(1)(3)(B) (to the extent discussed above) have the same meaning as when used in Reg. §1.48-1(a), relating to the definition of investment credit property before repeal by P.L. 101-508. Under Reg. §1.48-1(a), the term “section 38 property” means “property (1) with respect to which depreciation (or amortization in lieu of depreciation) is allowable to the taxpayer, (2) which has an estimated useful life of 3 years or more, and (3) which is (i) tangible personal property,” and “(ii) other tangible property (not including a building and its structural components) but only if such other property is used as an integral part of manufacturing, production, or extraction....” And under Reg. §1.48-1(d)(2), for purposes of Reg. §1.48-1(a), the terms “manufacturing”, “production”, and “extraction” include the “cultivation of the soil, the raising of livestock, and the mining of minerals.... Thus, section 38 property would include, for example, property used as an integral part of the... cultivation of orchards, gardens, or nurseries....” Finally, Rev Rul 67-51 specifically says that trees of fruit orchards or groves purchased and held for the production of income qualify as “other tangible property” for former Code Sec. 48(a)(1)(B) purposes and Reg. §1.48-1(d). Thus, under former Code Sec. 48—and therefore by extension under current Code Sec. 1245(a)(3)(B) —farming is a production activity and vineyards as well as orchards qualify as “other property.” And if vineyards and orchards qualify as Code Sec. 1245(a)(3) property, then they are eligible for expensing under Code Sec. 179.

Possible change of heart at IRS? IRS's “Wine Industry Audit Technique Guide,” last reviewed or updated on May 10, 2011, carries the following information about the expensing issue:

In Kimmelman vs. Commissioner, 72 TC 294 (1979), it was held that grapevines are not “tangible personal property” within the meaning of I.R.C. §179(d). Prior to 1981, I.R.C. §179(d)(1), in part, defined I.R.C. §179 property as tangible, personal property, of a character subject to depreciation under I.R.C. §167, used in a trade or business, with a useful life of 6 years or more.

Current tax services [not RIA's Federal Tax Coordinator] reference pre-1981 cites to maintain that vines do not qualify as Section 179 property. Section 179 was amended in 1981 and the definition of qualifying property was substantially changed. The definition now references I.R.C. §1245(a)(3), to include (in part) any property of a character subject to the allowance for depreciation in §167, and is used as an integral part of manufacturing, production, or extraction. Certain practitioners are taking the position that this new definition includes vineyards and are taking I.R.C. §179 deductions.

Observation: The Vineyard Audit Techniques Guide doesn't say it agrees with this position, but it doesn't disagree with it, either. Thus, at worst, it's an open issue as far as IRS is concerned. At best, it may signal that IRS is reconsidering its view on whether orchards and vineyards are expensing-eligible under Code Sec. 179.

New Auditor Guidance On Timber Casualty Losses

IRS has published new guidance for its examiners on auditing of timber casualty losses, characterized by IRS as a “significant compliance risk” in an earlier Field Directive. The guidance consists of a new Audit Techniques Guide (ATG) providing IRS examiners with the tools they need to audit returns showing timber casualty losses.

Background. A deduction for a casualty loss incurred in a trade or business or a transaction entered into for profit generally can't exceed the lesser of (1) the reduction in the property's value, or (2) its adjusted basis. However, if the property is totally destroyed and its fair market value before the casualty is less than its adjusted basis, the full adjusted basis is deductible. (Reg. §1.165-7(b)(1)) A business or investment casualty loss must be determined by reference to the “single identifiable property” (SIP) damaged or destroyed. (Reg. §1.165-7(b)(2)(i))

IRS's original rulings position was that the SIP damaged or destroyed by casualty is the quantity of timber—the units (board feet, log scale, cords, or other units) of wood in standing trees that are available and suitable for exploitation and use by forest industries—rendered unfit for use by casualty. The SIP was the quantity of timber destroyed by the casualty and a casualty loss was triggered only by total destruction of the timber. However, following several contrary court decisions, IRS, in Rev Rul 99-56, 1999-51 IRB, revoked the earlier rulings, held that the SIP was the entire depletion block, and acknowledged that partial damage may be sufficient for claiming a casualty loss.

In general, a “depletion block” is an account for timber basis that may be defined as an operational unit or a logging unit, or may be established by geographical or political boundaries or logical management areas. Once the SIP is identified, the casualty loss is determined by reference to that specific property unit. The amount deductible is the lesser of the diminution in fair market value (of the SIP) or the adjusted basis (of the SIP).

Illustration: Corp A has a 200,000-acre block of timber with a fair market value of $300 million and a basis of $10 million. The block is the area into which it aggregated its timber for depletion purposes, i.e., its depletion block. A storm destroys 20% of the trees, and the block's fair market value is reduced to $240 million. Under Rev Rul 99-56, Corp A may claim a casualty loss deduction equal to its entire $10 million basis in the timber, even though 80% of the trees in the timber block are undamaged.

An earlier Field Directive on timber casualty losses provides a simplified method for “assessing whether IRS resource allocation is feasible when determining the issue of timber casualty losses.”

To “effectively utilize” IRS resources in the classification and examination of a forestry industry taxpayer, the Field Directive provides a simplified method for “assessing whether IRS resource allocation is feasible when determining the issue of timber casualty losses.” When reviewing the taxpayer data, if the values claimed by a taxpayer are less than the values computed under these simplified method, “resources would not need to be expended” (i.e., IRS will allow the claimed loss). The simplified method includes an adjustment related to size of the timber block, that is, any allowable loss is reduced if the block size is 100,000 acres or more.

New timber ATG. The new Timber Casualty Loss ATG provides IRS examiners with the tools they need to audit returns showing timber casualty losses. It summarizes the following consequences associated with using a depletion block as the SIP:

(1) It permits the “borrowing of basis” from non-damaged units within the block (see illustration above), but at a price, namely that both the basis limit and the loss in value must be determined with reference to the same property unit. Thus, the selection of the depletion block as the SIP means that the valuation requirement changes from a valuation of damaged timber units (cords, board feet), which is fairly easy to determine, to a valuation of the entire depletion block, which could potentially include hundreds of thousands of acres and is difficult to value.

(2) Valuing a depletion block may be prohibitively expensive and, as a result, taxpayers often use a variety of short-cut techniques which are often flawed.

(3) The larger the depletion block (SIP), the more the taxpayer is able to “borrow basis,” but the less the damaged volume contributes to the value of the property unit as a whole. Thus, small volume losses, as part of a large SIP, may reflect little or no loss in overall value when the required “before and after” valuation is properly performed.

(4) The depletion block size may not be accurate and may have been “re-engineered” to take advantage of the simplified method in the Field Directive (discussed above). If the examiner determines that the taxpayer's blocks should be disregarded, the examiner should determine the taxpayer's correct blocks with respect to the most appropriate divisions. This determination should take into account the historical timber accounting records, as well as the geographic and political boundaries and any blocks that the taxpayer has customarily used for management purposes.

(5) Declining timber markets, such as those experienced since 2000, may adversely impact a taxpayer's ability to recover basis and put pressure on improper (excessive) valuations. For example, if a timber property were acquired in '99 (at peak prices) and experienced a casualty event in 2002, when timber values were at depressed levels, the aggregate basis of the property may be significantly higher than its value, particularly if the property were valued as a unitary whole (in a depressed market). Thus, there is more tax incentive to inflate values to recover more of the basis.

The ATG carries a detailed discussion of various timber valuation method, provides detailed examples, and cautions examiners to, among other things, look out for improper valuation methods, failure to document tax basis, inflation in the diminution in fair market value on account of the timber loss, and mistaken aggregation of the basis of the land (which is not allowable in computing a timber loss deduction) with the basis of the timber. It also tells examiners to determine whether the taxpayer has conducted a salvage of the damaged timber, or is attempting to claim a nondeductible loss from diseases or insects (only losses from fire, storm, hurricane, etc., qualify).

References: For single identifiable property for casualty loss purposes, see FTC 2d/FIN ¶M-1827; United States Tax Reporter ¶1654.304; TaxDesk ¶368,025; TG ¶16961.

No Gifts Triggered By Trust Transfers To Resolve Family Discord

PLR 201119003

IRS has privately ruled that transactions between a marital trust and a decedent's children from his first marriage to resolve discord between his surviving spouse and her stepchildren won't trigger gifts and won't result in a deemed transfer of the remainder interest in the marital trust.

Facts. Decedent and Spouse 1 established Family Trust, a revocable trust. After the death of Spouse 1 and Decedent's remarriage to Spouse 2, Decedent amended and restated Family Trust. Upon Decedent's death, Family Trust became irrevocable. Decedent was survived by Spouse 2, Child 1, Child 2, grandchildren and great-grandchildren. Spouse 1 was the mother of Child 1 and Child 2.

Spouse 2 and Trustee (together, Trustees) serve as co-trustees of Family Trust as well as the trusts created thereunder upon the death of Decedent.

Along with cash and securities, Marital Trust was funded with ownership interests in entities holding commercial real estate. In nineteen of these entities, Marital Trust held only a partial interest, with the balance of ownership held or shared by Child 1, Child 2, and/or a trust for the benefit of Child 1. At the time of Decedent's death, Child 1 served as a manager, managing member, or general partner of at least eight of these entities.

More than 2 years after Decedent's death, Child 1 and Child 2 filed a petition in state court for an accounting by the Family Trust. Trustees filed a petition to establish ownership interests of Marital Trust in certain entities. Eventually, the parties negotiated a settlement agreement (Agreement).

Under the terms of Agreement, Marital Trust will purchase, at fair market value (FMV), the interests of the other parties in certain named entities so that Marital Trust will own an interest of 100% in these entities. Likewise, Child 1 and Child 2 will purchase, at FMV, Marital Trust's interest in certain named entities so that Child 1 and Child 2 and any trust for the benefit of Child 1 will own an interest of 100% in these entities. After these purchases, the entities previously-owned partially by Marital Trust and partially by Child 1, Child 2, and/or a trust for the benefit of Child 1 will be either wholly owned by Marital Trust or wholly owned by Child 1, Child 2, and/or a trust for the benefit of Child 1. To the extent there is any difference in the aggregate FMV of the Marital Trust purchases and the Child 1 and Child 2 purchases, an equalizing payment will be made. FMV will be determined impartially, by two commercial appraisers selected by a retired judge (collectively, “FMV exchange”).

Marital deduction background. Qualified terminable interest property (QTIP) qualifies for the estate tax marital deduction under Code Sec. 2056(b)(7). To qualify as QTIP, the decedent's spouse must get a qualifying income interest for life, an irrevocable election must be made, and other requirements must be met.

The QTIP is included in the donee spouse's estate on her death. (Code Sec. 2044) However, transfer tax is accelerated if the spouse makes a gift of her income interest. Under Code Sec. 2519, if a spouse makes a gift of any portion of her qualifying income interest in the QTIP trust, she is deemed to make a transfer of the entire value of the remainder. In addition, the transfer of the income interest itself is subject to gift tax under general principles. (Reg. §25.2519-1(a))

The conversion of QTIP into other property in which the donee spouse has a qualifying income interest for life is not treated as a disposition of the qualifying income interest. Thus, the sale and reinvestment of assets of a trust holding QTIP is not a disposition of the qualifying income interest, provided that the donee spouse continues to have a qualifying income interest for life in the trust after the sale and reinvestment. Similarly, the sale of real property in which the spouse possesses a legal life estate, followed by the transfer of the proceeds into a QTIP trust, or by the reinvestment of the proceeds in income producing property in which the donee spouse has a qualifying income interest for life, is not considered a disposition of the qualifying income interest. On the other hand, the sale of QTIP followed by the payment to the donee spouse of a portion of the proceeds equal to the value of the donee spouse's income interest, is considered a disposition of the qualifying income interest. (Reg. §25.2519-1(f))

Gift tax background. The gift tax is imposed on the transfer of money or other property by gift. (Code Sec. 2501(a))

The gift tax applies whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. (Code Sec. 2511) The gift tax does not apply to a transfer for full and adequate consideration in money or money's worth. (Reg. §25.2511-1(g)(1))

Where property is transferred for less than an adequate and full consideration in money or money's worth, then the amount by which the value of the property transferred exceeds the value of the consideration received is considered a gift. (Code Sec. 2512) Transfers reached by the gift tax include sales, exchanges, and other dispositions of property for a consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money's worth of the consideration received. However, a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm's length, and free from any donative intent), is considered as made for an adequate consideration in money or money's worth. (Reg. §25.2512-8)

Favorable rulings. IRS observed that the FMV exchange process was the product of a court-ordered mediation proceeding presided over by a retired judge. The mediation proceeding was ordered to resolve the ongoing and, at times, contentious dispute between Trustees, Child 1, and Child 2 regarding (1) the administration of Family Trust and Marital Trust, (2) Marital Trust's management rights over certain properties, and (3) Marital Trust's ownership interest in entities owned partially by Marital Trust, Child 1, Child 2, and a trust for the benefit of Child 1.

IRS concluded that the FMV exchange procedures were the result of a bona fide adversarial proceeding and arms-length negotiations. Therefore, to the extent the payments made and received in the FMV exchange process are distributed in accordance with each party's respective ownership interest, as properly determined under applicable local law, IRS concluded that the transfers occurring pursuant to the FMV exchange will be made for adequate and full consideration in money or money's worth and will not be subject to the gift tax.

IRS further found that, upon the conclusion of the FMV exchange process, Spouse 2 will continue to possess a qualifying income interest for life in the assets of Marital Trust and Spouse 2's right to income will not be diminished or relinquished. Thus, it concluded that, under Reg. §25.2519-1(f), the sale and purchase of ownership interests in various entities held by Marital Trust and the payment or receipt of an equalizing payment pursuant to the FMV exchange process won't be treated as a disposition of a qualifying income interest life under Code Sec. 2519.

Observation: There is often the potential for disputes when an individual leaves property to a second spouse and children of his prior marriage. The individual's estate plan should be designed to minimize such potential disputes. However, if they should arise and involve facts similar to those in the ruling, the parties should consider employing a process similar to that used in the ruling. It may operate to settle the dispute in a satisfactory manner without adverse gift tax costs.

References: For gifts of income interests in QTIPs, see FTC 2d/FIN ¶Q-6315; United States Tax Reporter Estate & Gift ¶25,194; TaxDesk ¶736,016.

Returns Altered By CPA Without Clients' Knowledge Weren't Valid

Program Manager Technical Advice 2011-013

In Program Manager Technical Advice (PMTA), IRS has determined that a purported return on which a return preparer increased the amount of the taxpayer's claimed charitable deduction without the taxpayer's knowledge was a nullity because it was unknown to and unverified by the taxpayer.

Background. In Beard v. Com., (CA 6 6/24/1986) 58 AFTR 2d 86-5290, the Sixth Circuit, affirming the Tax Court, held that for a document to constitute a valid return, it must:

... contain sufficient data to calculate tax liability;

... purport to be a return;

... represent an honest and reasonable attempt to satisfy the requirements of the tax law; and

... be executed under penalty of perjury.

Observation: The above four-part analysis is commonly known as the “substantial compliance” standard or the Beard formulation.

Facts. A certified public accountant (CPA) prepared approximately 700 individual income tax returns for tax year 2002, of which approximately 450 were filed electronically. CPA initially prepared the returns with the information provided by the taxpayer and printed a copy of that return to give to the taxpayer, but then increased the charitable contribution amount without the taxpayer's knowledge in order to increase the amount of the refund.

Additionally, CPA established a refund anticipation loan (RAL) account at a financial institution for that taxpayer, also without the taxpayer's knowledge, that allowed CPA to issue a bank check before the refund was received from IRS. CPA provided the taxpayer with a bank check for the amount of the refund shown on the original tax return, less his $50 preparation fee. The excess refund attributable to the inflated charitable deduction was put into CPA's checking account.

In some cases, IRS froze certain taxpayers' refunds, and the financial institution demanded that they repay the refund amounts. Some taxpayers paid the amount of the check they received, while others paid the entire amount, including the fraudulent portion that CPA received without their knowledge.

CPA also reported fraudulent business expenses for several taxpayers. According to IRS, these fraudulent expenses appeared to have been claimed with their knowledge.

Issues. The questions presented to IRS included:

(1) whether a return on which CPA claimed an inflated charitable contribution without the taxpayer's knowledge is a nullity;

(2) if the return is a nullity, but the taxpayer received a RAL for the correct amount of his refund (less preparation fees), whether the taxpayer will receive another refund when the true return is filed;

(3) whether a return on which CPA claimed an inflated charitable contribution without the taxpayer's knowledge, but also claimed fraudulent business expenses with the taxpayer's knowledge, is a nullity; and

(4) whether affected taxpayers should file new or amended returns.

Conclusion. IRS determined that since the return that was signed and verified by the taxpayer was not the document that was actually sent to IRS, and the taxpayer was unaware of the inflated charitable contribution expenses added by the return preparer, he didn't execute his return under penalties of perjury. Thus, the signature requirement wasn't met, and the document doesn't constitute a return. The result is the same for returns on which fraudulent business expenses were also claimed with the taxpayer's knowledge.

IRS noted that since no return was filed, no accuracy-related or civil fraud penalties could be imposed against the taxpayer. However, criminal fraud penalties under Code Sec. 7206 could potentially apply.

If the taxpayer in fact received a RAL in the correct amount, then there is no overpayment, and IRS thus won't issue a second refund when the taxpayer's true return is filed. However, where the refund was frozen by IRS, and the taxpayer sent the amount of the refund to the financial institution, the taxpayer has overpaid his taxes and IRS should send the correct amount of the refund directly to the taxpayer.

Finally, IRS determined that since the fraudulently altered returns were nullities, affected taxpayers are treated as if no return has been filed. Therefore, taxpayers whose returns were fraudulently altered shouldn't file a Form 1040X. Instead, they should file an accurate Form 1040 (or 1040 series return), and the Criminal Investigation or Small Business/Self-Employed Division should use that information to correct the taxpayers' Master Accounts.

References: For the requirement that a taxpayer execute a return under penalty of perjury, see FTC 2d/FIN ¶S-1401; United States Tax Reporter ¶60,614; TaxDesk ¶570,100 et seq.; TG ¶1960.

Treasury Official Calls For Permanently Reinstating Build America Bonds

In a blog post titled “The Case for Bringing Back BABs,” Treasry Acting Assistant Secretary for Economic Policy John Bellows touted the successes of the Build America Bonds (BABs) program, citing findings of a recent Treasury report that the program saved participating state and local governments billions of dollars in borrowing costs and helped spur job creation. Although BABs expired at the end of 2010, President Obama proposed making the program permanent at a 28% subsidy rate, and four bills have been introduced in Congress to extend the program.

Background. Code Sec. 54AA, which was added to the Code by the American Recovery and Reinvestment Act of 2009 (Recovery Act, P.L. 111-5), permitted state and local government issuers to elect to treat otherwise tax-exempt bonds issued to finance capital projects as taxable BABs. These bonds must have been issued before Jan. 1, 2011. A taxpayer that held a BAB on an interest payment date in the tax year was allowed a nonrefundable credit equal to 35% of the interest payable by the issuer on that date. The credit was allowed against regular tax and alternative minimum tax (AMT), and was treated as taxable interest under Code Sec. 54AA(a). For certain “qualified” BABs, in lieu of the holder's credit, the issuer could elect a “direct payment” option and claim a refundable credit from IRS equal to 35%.

Treasury analysis. The Treasury report stated that throughout the existence of the BABs program, there were 2,275 separate BABs issued that provided over $181 billion for new public capital infrastructure projects. BABs issuers saved an estimated $20 billion in borrowing costs, which exceeds the net cost of the program to the federal government. The report estimates that, as compared to traditional tax-exempt bonds, the average BABs issuer saved 84 basis points (or.84%) on interest costs for 30-year bonds, and also had significant interest savings for bonds with shorter maturities.

According to the report, BABs are more efficient than tax-exempt bonds at delivering a federal subsidy for state and local government borrowing since every dollar goes to the issuer, whereas with tax-exempt bonds, the Federal revenue cost of tax exemption often exceeds the benefits achieved by the State and local governments. Additionally, the tax compliance framework for BABs is also more administrable than tax-exempt bonds.

Obama's proposal. In the President's FY 2012 budget proposals, released on February 14, Obama proposed reinstating and expanding the BABs program at a 28% subsidy level rate. The proposal would also expand the eligible uses for BABs to also include:

... current re-fundings of prior public capital project financings for interest cost savings where the prior bonds are repaid within 90 days of issuance of the current refunding bonds;

... short-term governmental working capital financings for governmental operating expenses, subject to a 13-month maturity limitation; and

... financing for Code Sec. 501(c)(3) nonprofit entities (i.e., hospitals and universities).

According to Bellows, Obama's proposal would provide a sustainable and revenue-neutral funding option for state and local governments to continue financing infrastructure projects.

Other proposals. Four bills have been introduced in Congress to extend the BABs program:

... H.R. 11, the “Build America Bonds to Create Jobs Now Act of 2011,” introduced on Feb. 10, 2011, would extend the program through 2012 with a 32% rate in 2011 and 31% in 2012;

... H.R. 736, the “Build America Bonds Extension for Rural and Urban Transportation and Highways” (BABE RUTH) Act of 2011, introduced on Feb. 16, 2011, would extend the program through 2014 with a 32% rate in 2011 and 30% thereafter;

... H.R. 747, the “Build America Bonds Extension Act of 2011,” also introduced in Feb. 16, 2011, would extend the program through 2012 at a 28% rate; and

... H.R. 992, the “Building America Jobs Act of 2011,” introduced Mar. 10, 2011, with similar terms to H.R. 11.

All of the above bills were referred to the House Committee on Ways and Means.

Infrastructure funding. On May 17, the Senate Finance Committee held a hearing on financing 21st century infrastructure. A document prepared by the Joint Committee on Taxation in connection with the hearing provides an overview of mechanisms available to supplement bonds issued by State and local governments. Although the report focused largely on infrastructure trust funds and tax-exempt financing for transportation infrastructure, it also provided a description of the currently expired BABs program. BABs have also been addressed in recent testimony on infrastructure funding. Thus, it's possible that BABs (or a similar program) could re-surface in an infrastructure funding bill.

Bottom line. It remains to be seen whether the BABs program will be made permanent or temporarily extended, or if it's simply gone for good. But the Treasury's current spotlight on BABs shows that, regardless of the fact that BABs have expired, this tax-favored financing mechanicsm has yet to go away.

References: For BABs, see FTC 2d/FIN ¶L-15600 et seq.; United States Tax Reporter ¶54AA4; TaxDesk ¶382,155; TG ¶15128.

Tax Court Admits Administrative Record From Remand Hearing Into Evidence

Hoyle, (2011) 136 TC No. 22

In a supplemental opinion, and over various objections raised by the taxpayers, the Tax Court has determined that the administrative records from a remanded Appeals Office hearing can be admitted into evidence. It also determined that IRS properly refiled its notice of federal tax lien while the suit was pending.

Background. Code Sec. 6320(a)(1) requires IRS to give a taxpayer written notice of the filing of a tax lien on his property. The notice must inform him of the right to request a hearing in IRS's Appeals Office. (Code Sec. 6320(a)(3)(B), Code Sec. 6320(b)(1))

At the hearing, the taxpayer may raise any relevant issues including appropriate spousal defenses, challenges to the appropriateness of collection actions, and collection alternatives. (Code Sec. 6330(c)(2)(A)) However, the taxpayer may challenge the underlying tax liability only if he did not receive a statutory notice of deficiency for the tax liability and did not otherwise have an opportunity to dispute the tax liability. (Code Sec. 6330(c)(2)(B))

In addition to considering issues raised by the taxpayer under Code Sec. 6330(c)(2), the Appeals officer must verify that the requirements of any applicable law or administrative procedure have been met. (Code Sec. 6330(c)(1), Code Sec. 6330(c)(3)) Where the validity of the underlying tax liability is properly in issue, the Tax Court will review the matter de novo (i.e., a fresh review). Otherwise, the Tax Court will review IRS's determination for abuse of discretion. (Sego, (2000) 114 TC 604, Goza, (2000) 114 TC 176)

Under Code Sec. 6321, a tax lien arises in favor of the U.S. upon a taxpayer's failure to pay after a demand for payment has been made. The lien covers all property and rights to property belonging to the person, and it arises when the tax is assessed and continues until the underlying liability is satisfied or otherwise becomes unenforceable.

In order for a notice of lien to remain in force, the IRS must refile the notice within the required refiling period. (Reg. §301.6323(g)-1(a)(1)) The required refiling period is a one-year period ending 30 days after ten years has expired from the date of tax assessment, and a one-year period ending with the expiration of ten years after the last refiling period closes. (Code Sec. 6323(g)(3); Reg. §301.6323(g)-1(c))

However, neither the failure to refile before the expiration of the refiling period, nor the release of the lien, shall alter or impair any right of the U.S. to property or its proceeds that is the subject of a levy or judicial proceeding commenced prior to the end of the refiling period or the release of the lien, except to the extent that a person acquires an interest in the property for adequate consideration after the commencement of the proceeding and does not have notice of, and is not bound by, the outcome of the proceeding. (Reg. §301.6323(g)-1(a)(3)(i))

Facts. In '96, IRS assessed a deficiency for the joint return filed for '93 by Martin Hoyle and his wife. In 2002, it issued them a Notice of Federal Tax Lien Filing and Your Right to a Hearing Under IRC 6320 with respect to their unpaid tax liability for '93. The NFTL stated that unless it was refiled by Sept. 25, 2006, it would operate as a certificate of release of lien. The Hoyles timely submitted a Form 12153, Request for a Collection Due Process Hearing. They raised their underlying tax liability and questioned whether offsetting overpayments were properly reflected in the lien amount.

By letter dated Dec. 9, 2003, IRS's Appeals officer informed the Hoyles that they were precluded from raising the underlying tax liability because they had a previous opportunity to dispute the underlying tax. By letter dated Mar. 31, 2004, IRS sent them a notice of determination upholding the filing of a Federal tax lien. On Apr. 30, 2004, they filed with the Tax Court a timely petition for review of IRS's determination.

In Hoyle I, (2008) 131 TC 197, the Court was faced with these issues: (1) Whether the Hoyles could raise the issue of whether a notice of deficiency for their '93 tax year was mailed to them; (2) if they could raise that issue, whether IRS's Appeals officer properly verified that the notice was sent; and (3) if the Appeals officer did not properly verify that the notice was sent, whether the Tax Court should review the underlying tax liability de novo.

After concluding that it had jurisdiction to review whether IRS's Appeals officer verified that a notice of deficiency was sent to the Hoyles preceding the assessment, the Court held that if no notice of deficiency was mailed, it would not review the underlying tax liability de novo. That's because, if no notice of deficiency was mailed, the assessment of the '93 tax liability would be invalid, the lien would be improper, and collection could not proceed. However, it was unclear what the Appeals officer relied on to verify that the assessment was preceded by a duly mailed notice of deficiency. Consequently, the Tax Court sent the case back to the Appeals Office to clarify the record as to the basis for the Appeals officer's verification that all requirements of applicable law were met.

Intervening events. The settlement officer who was assigned the case following Hoyle I determined, with IRS's counsel, to give the Hoyles a face-to-face conference to determine whether the notice of deficiency was sent to their last-known address, whether the assessment was valid, and whether they could challenge the underlying ability based on not receiving the deficiency notice. IRS's counsel then reviewed the settlement officer's supplemental notice of determination to ensure that all issues that the Court required to be addressed in fact were.

On Feb. 19, 2009, the settlement officer discovered that the refiling date stated on the original NFTL had passed. Accordingly, on Mar. 3, 2009, IRS filed Form 12474-A, Revocation of Certificate of Release of Federal Tax Lien, then subsequently filed the NFTL for the '93 tax year.

Issues in Hoyle II. In Hoyle II, (2011), 136 TC No. 22, the Tax Court considered: (i) whether IRS's proposed supplemental stipulation of facts and exhibits, including the administrative record of the remand hearing and a certified mail list showing the mailing of the original deficiency notice to the Hoyles' representative, could be admitted into evidence; and (ii) whether IRS could refile its NFTL during the pendency of these proceedings.

Supplemental opinion. The Tax Court held that the administrative record on remand was in fact admissible to show the information that was available to the Appeals Office during its administrative consideration of the case. The Court reasoned that a hearing on remand is intended to supplement the original Code Sec. 6320 hearing. A taxpayer is only entitled to a single Code Sec. 6320 hearing for the tax year to which the unpaid liability relates, and when a case is remanded to Appeals, the supplemental determination is accordingly what the Court reviews.

The Court rejected the Hoyles' argument that the administrative record on remand was inadmissible because it raised matters not considered at the original hearing, noting that the settlement officer was specifically ordered to consider whether a notice of deficiency was property sent to the Hoyles. The administrative record on remand contained much evidence relevant to the determination, and to the Court's review of it, such as the certified mail list. Consequently, so long as the administrative record on remand was authenticated, it was admissible.

The Court also rejected the Hoyles' claim that the settlement officer and IRS counsel had improper ex parte contact. Rather, their conversations were solely procedural, ministerial, or administrative. The Hoyles' final objection, that the administrative record on remand lacked trustworthiness and thus constituted inadmissible hearsay, also failed. The Court noted that its consideration of this record was for the limited purpose of establishing what information was available to Appeals in preparing the supplemental notice of determination, not the truth of such information.

Finally, the Tax Court determined that, contrary to the Hoyles' argument, IRS was permitted to refile its lien. The '93 tax was assessed on Aug. 26, '96, and the Hoyles timely requested an administrative review of the original NFTL, which stated that it would operate as a certificate of release unless it was refiled by Sept. 25, 2006. Under Reg. §301.6323(g)-1(a)(3)(i), even though the NFTL wasn't refiled during the refiling period, it nonetheless remained effective because the underlying property was the subject matter of a suit to which the government was a party that was filed before that period expired. Further, since no final decision on the '93 tax had been issued, the period of limitations on collection remained suspended. Thus, IRS's filing of a revocation of certificate of release of federal tax lien and refiling of the NFTL were proper.

References: For collection due process hearings with regard to liens, see FTC 2d/FIN ¶V-6000; United States Tax Reporter ¶63,204; TaxDesk ¶911,002; TG ¶71971. For collection due process hearings with regard to levies, see FTC 2d/FIN ¶V-5255; United States Tax Reporter ¶63,304; TaxDesk ¶902,505; TG ¶71945.

Corp. Denied Deduction For Unsubstantiated “Management Fees” Paid To Related Entity

Weekend Warriors Trailers, Inc., et al, TC Memo 2011-105

The Tax Court has determined that the fees paid from a recreational trailer manufacturing corporation to a commonly controlled S corporation under a management agreement weren't deductible business expenses. It also upheld IRS's partial disallowance of the manufacturing corporation's depreciation deductions claimed for an airplane and a boat and determined that below-market loans to the corporation's sole shareholder resulted in forgone interest income to the corporation and constructive dividends to the shareholder.

Background on business deductions. Code Sec. 162 allows a deduction for the ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. “Ordinary” means an expense that is a common and accepted practice in the field of business while “necessary” means an expense that is appropriate and helpful in carrying on the trade or business.

Expenses for entertainment and listed property are subject to strict substantiation requirements under Code Sec. 274(d). Listed property includes passenger autos and most other property used as a means of transportation, such as boats or airplanes. (Code Sec. 280F(d)(4)(A)(ii)) Further, under Code Sec. 274(d), no depreciation deduction is allowed under Code Sec. 167 or Code Sec. 168 for any listed property unless the strict substantiation requirements are met.

Code Sec. 168(k) allows a bonus first-year depreciation allowance for “qualified property” in the first year that the property is placed in service for use in a trade or business. Under Code Sec. 168(k)(2)(A)(ii), the “original use” of the property must begin with the taxpayer. During 2002, the bonus depreciation was 30% of the adjusted basis of the qualified property. (Under current law, a taxpayer can write off 100% of the cost of qualified property placed in service after Sept. 8, 2010 and before Jan. 1, 2012.)

Background on below-market loans. Under Code Sec. 7872, loans between parties that lack either an interest rate, or a rate that reflects market conditions, must be recharacterized to reflect the reality of the underlying transaction. As a result, the borrower is treated as having received a gift, dividend, or other type of payment depending on the situation.

Facts. Mark Warmoth is a lifelong off-road vehicle enthusiast who, after working for a major recreational vehicle (RV) manufacturer for 14 years, started his own business in '88 manufacturing a unique recreational travel trailer that he designed to transport off-road vehicles to the desert. The business was incorporated in '95 as “Weekend Warrior Trailers,” and eventually elected S corporation status in 2003. Warmoth was the sole shareholder of Weekend Warrior from its incorporation until 2009, and he was the chief executive officer (CEO) and president during the years at issue.

Weekend Warrior's restructuring. In 2002, Warmoth hired a financial planner to prepare an overall plan for him and advise him on how to handle the company's rapid growth. The financial planner, together with a team of advisors, recommended creating a corporation called “Leading Edge,” an S corporation.

On Dec. 28, 2002, Weekend Warrior and Leading Edge entered into a management agreement under which Leading Edge agreed to provide design, personnel (by transferring Weekend Warrior employees to Leading Edge and leasing them back), and management services. Weekend Warrior paid millions in management fees to Leading Edge from 2002 to 2004. Leading Edge also paid a portion of Warmoth's and top managers' wages and made several loans to Weekend Warrior. Warmoth initially received 10,000 shares of Leading Edge stock, for which he was supposed to (but didn't) pay $20,000, and he was the only member of the board of directors until early 2003.

Leading Edge was inactive after Dec. 31, 2004, and Weekend Warrior later ceased operations in July 2008.

Other transactions. In 2001, Warmoth and Weekend Warrior purchased a river boat that was to be used on the Colorado River where Warmoth owned a house and frequently entertained. No contemporaneous log was maintained regarding the business use of the boat.

In 2002, Weekend Warrior purchased an airplane. No contemporaneous mileage log was kept to record the purpose of any of the flights.

For years 2002 through 2004, Weekend Warrior made a number of loans to Warmoth.

Parties' reporting positions. From 2002 through 2004, Weekend Warrior claimed “management fee” deductions of over $4 million each year. It also claimed employee leasing fees in 2003 and 2004 of $13 and $14 million, respectively. (These were unchallenged by IRS.)

With regard to the airplane, Weekend Warrior claimed total depreciation deductions of $234,667 in 2002, $160,000 of which represented bonus depreciation, and $170,667 in depreciation for 2003 and 2004.

For 2002 through 2004, Weekend Warrior claimed $30,661, $21,897, and $21,897 in depreciation for the boat.

Leading Edge included the management and employee leasing fees in income for 2002 through 2004. It also reported small amounts of “other” income in 2003 and 2004, along with $176,495 of investment income in 2004.

Weekend Warrior reported on its Schedule Ls for 2002 through 2004 shareholder loans of approximately $1.2, $2, and $3.4 million per year. Warmoth was the only shareholder at that time.

IRS position. IRS disallowed most of Weekend Warrior's 2002 management fee deduction and recalculated it under Code Sec. 482 arms-length principles, added forgone interest to its income under Code Sec. 7872, disallowed depreciation and other deductions, made other adjustments, and imposed a Code Sec. 6662(h) 40% penalty. Similar adjustments were made for 2003 and 2004. These adjustments flowed through to Warmoth as Weekend Warrior's sole shareholder.

IRS also determined that Warmoth received a $41,343 dividend in 2002 and was subject to penalty under Code Sec. 6662(a).

Tax Court largely sides with IRS. The Tax Court concluded that the management fees weren't deductible under Code Sec. 162. The record contained scant evidence showing what services were performed or any other details of the parties' relationship, leaving the Court unable to determine whether the fees were reasonable and necessary.

The Court then determined that Weekend Warrior failed to establish business use of the airplane above the amounts allowed by IRS, and accordingly upheld IRS's partial disallowance of the depreciation deductions claimed in 2003 and 2004.

Weekend Warrior's Code Sec. 168(k) additional first-year depreciation deduction for the airplane was also denied. Even if Weekend Warrior had satisfied the Code Sec. 274(d) requirements, it wouldn't have been entitled to a Code Sec. 168(k) deduction because the airplane wasn't new when Weekend Warrior acquired it.

IRS's determination to disallow in full the depreciation deductions claimed in regard to the boat was also upheld for lack of substantiation.

The Tax Court upheld IRS's determinations regarding the below-market interest loans and their tax consequences for 2002 and 2003. However, the Court redetermined the amount of shareholder loans for 2004 based on indications in Weekend Warrior's general ledgers that there were loans and advances to other companies and individuals in addition to Warmoth.

Penalties imposed. The Tax Court, noting that IRS abandoned its prior assertion of Code Sec. 6662(h) 's 40% penalty against Weekend Warrior, found that IRS met its burden of production that Warmoth and Weekend Warrior acted negligently. IRS also satisfied its burden regarding the substantial understatement penalty for Weekend Warrior in 2002 and Warmoth in 2003 and 2004.

References: For ordinary and necessary business expenses, see FTC 2d/FIN ¶L-1200; United States Tax Reporter ¶1624; TaxDesk ¶255,500; TG ¶16003. For heightened substantiation requirements applicable to listed property, etc., see FTC 2d/FIN ¶L-4600; United States Tax Reporter ¶2744.10; TaxDesk ¶295,311; TG ¶17852. For below-market loans, see FTC 2d/FIN ¶J-6014; United States Tax Reporter ¶78,724; TaxDesk ¶319,504; TG ¶18587.

IRS Must Produce Redacted Returns Of Employees In “Rental Payment” Classification Case

D.O. Creasman Electronics, Inc. v. U.S., (DC NC 05/10/2011) 107 AFTR 2d ¶2011-826

In a case involving whether “rental payments” made to an electronics company's employees for the use of their trucks and tools are wages subject to federal employment taxes, a district court has granted in part the company's motion to compel IRS to disclose the employees' tax returns in order to determine whether the employees paid taxes on the payments. The court decided that although disclosing the entire contents of the returns was unnecessary, disclosure of redacted returns was appropriate.

Background on withholding. Withholding applies to “wages,” as defined by Code Sec. 3401(a). Subject to certain exceptions, this includes all remuneration for services performed by an employee for his employer, including the cash value of all remuneration paid in any medium other than cash. (Reg. §31.3402(a)-1(c)) However, certain payments, such as those for travel, transportation, or other reimbursements, if properly substantiated, can be excluded from the employee's income and not subject to withholding.

Under Code Sec. 3402(d), if an employer that fails to deduct and withhold the tax can show that the income tax was paid by the employee, the tax won't be collected from the employer. However, the employer may still be liable for penalties for the failure to deduct and withhold.

Background on disclosure of return information. In general, under F.R.Civ.P. 26(b), parties are entitled to discovery of any non-privileged matter relevant to any claim or defense. However, subject to exceptions, the government is generally prohibited from disclosing tax returns under Code Sec. 6103(a). One such exception is Code Sec. 6103(h)(4)(B), which provides that a return may be disclosed in a federal judicial proceeding pertaining to tax administration if the treatment of an item reflected on such return is directly related to the resolution of an issue in the proceeding.

Facts. D.O. Creasman Electronics, Inc. (Creasman) hires individuals known as “cable splicers” to install and splice cable lines in order to build and expand cable networks. The cable splicers are paid for the work they perform based on either hourly or unit rates. Creasman doesn't provide the cable splicers with tools or transportation, but instead provides them with rental payments in exchange for the use of their trucks and tools.

Creasman reported the rental payments that it made to cable splicers for use of their trucks and tools as miscellaneous income, not wages. IRS, however, determined that the payments were wages subject to employment taxes and assessed the taxes and penalties. Creasman disagreed, claiming that the rental payments were made in accordance with standard industry practice.

Creasman filed a refund suit, alleging that it has overpaid other taxes at various times, but that IRS has refused to refund these overpayments and instead applied them against its improper assessment. IRS counterclaimed for over $500,000 that Creasman allegedly failed to withhold from the cable splicers' wages.

Creasman served its “First Request for Production of Documents” on the government seeking copies of the individuals' tax returns for the 2004 and 2005 tax years. It argued that the entire return was necessary in order to determine whether the employees reported the rental payments as income, which in turn would potentially reduce its liability under Code Sec. 3402(d).

The government objected, asserting that it should disclose only a summary chart of the relevant return information or redacted copies of the returns. Creasman filed a motion to compel production.

Partial production ordered. The district court determined that the disclosure of redacted returns was appropriate in this case. It noted that, as the parties agreed, the information contained in the returns was subject to disclosure under Code Sec. 6103(h)(4)(B) because it directly related to Creasman's tax liability under Code Sec. 3402(d). It then evaluated the scope and manner of the disclosure, weighing the individuals' right to privacy against Creasman's right to discovery, and ultimately concluded that the government should redact the personal taxpayer information and disclose the returns.

The government was instructed to, in addition to marking the returns as “confidential,” redact all identifying information, including social security numbers, of the taxpayers and their spouses and/or dependents. Further, the production was specifically limited to returns of individuals that Creasman employed as cable splicers.

References: For unwithheld tax paid by an employee, see FTC 2d/FIN ¶J-9001.1; United States Tax Reporter ¶34,024.07. For types of remuneration subject to withholding, see FTC 2d/FIN ¶H-4332; United States Tax Reporter ¶34,014.03; TaxDesk ¶532,005; TG ¶9205.