Beginning next year, taxpayers will be able to charge their taxes to a major credit card.

As part of its plan to increase electronic filing and payment of taxes (the goal is to receive 80% of all returns by 2007), the IRS entered into agreements with private companies to provide the new service.

"A lot of people will want to pay their taxes with credit cards, and that might increase compliance," said Jamie L. Ward, a CPA with Denman & Co., LLP, Des Moines, Iowa, and a member of the Institute's 1997-98 tax technology committee.

"The IRS will collect more, and that will work in their favor," she said.

Under the new agreement, US Audiotex of San Ramon, California, will process tax credit-card payments by phone. Taxpayers using US Audiotex and filing electronically (by home computer, by Telefile or through a preparer) will be able to charge their taxes with a toll-free phone call.

Taxpayers filing their taxes using Intuit's Turbo Tax or MacInTax software will be able to charge their taxes through NOVUS Services, Inc., of Riverwoods, Illinois. Taxpayers will be able to use any credit card issued by NOVUS to make the charges.

The IRS will not charge taxpayers for the credit card service. However, taxpayers will be assessed a convenience fee by the credit card service providers based on the tax amount charged.

The fees associated with electronic filing may deter some taxpayers, Ward said. "Our firm doesn't do a lot of electronic filing because most of our returns are complex ones."

"The people that do file electronically, however, now pay a fee to do so. They would have to pay an extra fee to use their credit card." The filing fee and the credit card fee together could easily total as much as $100, she said.

"Business-oriented CPA firms are not going to get excited about anything that is on the table now," said C. Eugene Prescott, former chairman of the AICPA's tax technology committee, concerning the new electronic filing services.

Prescott said the services would be an improvement for individuals with simple filings; however, businesses and individuals with more complex filings have little incentive to make the switch to filing electronically.

Required supporting documentation and the need to file some schedules on paper remain a barrier.

Michael E. Mares, immediate past chairman of the AICPA tax executive committee, addressed the difficulties that keep CPAs from embracing electronic tax return filing for most of their clients when he testified before Congress this summer:

• Not all forms can be filed electronically.

• White paper schedules, disclosures and elections cannot be attached electronically.

• The required signature, Form 8453 (Jurat form), disrupts the normal processing of the tax returns in a CPA office.

• The procedures for registration and the annual registration cutoff in early December are less desirable than a rolling acceptance date.

• The registration is cumbersome for firms with multiple offices.

"It boils down to this," Prescott said. "As long as a paper version is necessary, doing both a paper and an electronic return is worse than making multiple copies of a paper return."

In one of the first steps of the overhaul mandated in the Internal Revenue Service Restructuring and Reform Act of 1998, the IRS unveiled a new 27-word mission statement.

Its mission is to "provide America's taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all."

According to IRS Commissioner Charles O. Rossotti, the mission statement reflects the new attitude of the IRS. "Our top priority is putting the interests of the taxpayers first," he said.

A closely held corporation's profitability often is due in large part to the knowledge, skills and entrepreneurship of shareholder-employees. A company's attempts to compensate these employees adequately for their efforts often lead the IRS to challenge the compensation paid as excessive. In such situations, the IRS reclassifies part of the compensation as a dividend, which — unlike wages — is not deductible by the corporation.

With adequate documentation, it is possible for a closely held company to fully compensate shareholder-employees without having part of the payment reclassified as a disguised dividend. The company can apply a five-part test to evaluate the reasonableness of such compensation based on

1. The employee's role in the company.
2. A comparison of the compensation paid with the payments of similar companies.
3. The character and financial condition of the company.
4. Potential conflicts of interest, such as the ability to "disguise" dividends as salary.
5. Internal consistency of compensation throughout the company's ranks.

Dexsil Corp. was formed to manufacture and market a product used in gas chromatography. The number of employees expanded rapidly from 2 to 30. A single shareholder-employee functioned as president, CEO, treasurer and CFO, working between 60 and 65 hours a week. He increased his compensation as the company's sales and profits grew. The IRS persuaded the Tax Court — which used the five factors listed above — that the total compensation paid to him was excessive and therefore a portion represented a dividend. Dexsil appealed.

Result: For the taxpayer. The case was remanded to the Tax Court for further proceedings consistent with the opinion. The taxpayer convinced the Second Circuit Court of Appeals that it should consider additional factors that were either omitted or incorrectly evaluated by the Tax Court. The taxpayer successfully asked the Second Circuit to consider

• A hypothetical or independent investor test. Would an independent investor pay the employee in question the reported salary based on the company's dividend record and return on equity? To the extent an outsider would do so, the compensation is reasonable.

• The existence of a contingent compensation formula. To be valid, such a formula would have had to have been in existence for several years, preferably from the beginning of the employee's term of employment, and result in reasonable compensation over a long period of time. Although the formula can be informal and oral, a fixed compensation policy is easier to prove.

• The many roles performed by the employee. To evaluate an individual's compensation adequately, it is necessary to compare what he or she earns with the pay of individuals in other companies who perform all the jobs the employee in question performed. It is also important to select the right company and employees to serve as benchmarks in applying the five factors.

• Dexsil Corporation v. Commissioner, 98-1 USTC 50, 471; 81 AFTR 2d 2312 (CA-2).

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

Comparing the risks of Roth IRAs versus traditional IRAs means weighing a future unknown benefit against a certain one. Traditional IRAs have immediate tax savings. Roth IRAs, on which taxes are prepaid, may have a future benefit that is less than the prepaid tax.

Specifically, there are three risk factors for Roth IRAs.

The first risk is the possibility that the IRS or federal income taxes may not exist in the future. Although you may be smiling (or, perhaps, even laughing), bear in mind that in June the House passed the Tax Code Termination Act, which would eliminate the current tax code (except for Social Security payroll taxes) on December 31, 2002.

In addition, a grass-roots group of taxpayers called the Citizens for an Alternative Tax System (CATS) is pushing for the Schaefer/Tauzin National Retail Sales Tax Act. This act would replace income tax with a sales tax.

The second risk is the possibility that money received from a Roth IRA distribution might not be subject to tax at all if, when it is combined with other earnings, the total amount of income has not reached a taxable level.

The third risk is the likelihood that the present value of the prepaid tax (the cost) of a Roth IRA may be greater than the present value of the future tax savings (the benefit).

For example, if a 40-year-old invests $2,000 yearly in a Roth IRA for 25 years (assuming a 28% tax bracket), the prepaid tax of $560 per year has a present value of $5,083. Assuming a 10% growth rate, the fund will grow to $146,694 in 25 years.

Still assuming a 28% tax rate, the tax savings with a Roth IRA (if all funds are withdrawn in one lump sum) will equal the $146,694 times 28% to a total savings of $41,074. The present value of $41,074 discounted for 25 years at 10% is $3,791. The net present value of a Roth IRA in this case would be a negative $1,292 ($5,083 cost minus $3,791 savings).

Observation. Clients should know that, unlike a traditional IRA that provides a certain immediate benefit, the benefit of a Roth IRA might be zero. The greatest risk of a Roth IRA, however, is that the present value of the prepaid tax could be greater than the present value of the future tax savings.

—W. Terry Dancer, PhD, associate
professor of accounting, Glen Jones,
JD, assistant professor of law, and
James Washam, PhD, assistant
professor of finance, Arkansas
State University.

What an Improvement!

• In the past, the IRS allowed real estate developers to allocate the cost of common improvements (for example, recreational facilities) among lots in a residential subdivision to expedite their sale. The Tax Court has now extended this allocation principle to commercial real estate developments as well. In Norwest Corp. v. Commissioner, 111 TC no. 5 (1998), the Court stated that "when the basic purpose of property is the enhancement of other properties to induce their sale and such property does not have, in substance, an independent existence" the cost of such improvements can be allocated to the other properties.

Ninety Days Same As Cash

• An accrual basis manufacturer promised to pay retailers a cash rebate if they advertised a discounted product by yearend. In order to get paid, the retailers had to submit claim forms and proof of performance to the manufacturer within 90 days after the year's end. In revenue ruling 98-39, (1998-33 IRB), the IRS ruled that, as long as the manufacturer was able to reasonably estimate the amount of its liability, it could deduct the rebate in the year preceding payment to the retailers. According to the IRS, the liability for payment was determined when the retailers advertised the product and the filing of claim forms was merely an administrative act. The IRS stated, however, that in some cases the claim form may be considered a condition precedent to the accrual.

Deferred Taxes for Deceased

• If a decedent's interest in a closely held business exceeds 35% of the decedent's adjusted gross estate, Internal Revenue Code section 6166 allows the estate to defer taxes for up to 14 years by requiring the IRS to accept a 15-year payment schedule (5 interest-only payments, followed by 10 estate tax payments). This delay often gives the business time to buy out the decedent's interest and avoid a distress sale to outside parties. In a new private letter ruling, the IRS said that a decedent's active participation as a landlord in the management and operations of three real estate rental properties was an interest in a closely held business for purposes of IRC section 6l66 (LTR 9832009).

Thumbs Down on Post-Mortem Disclaimer

• It makes sense for a person who owes a large amount of back taxes to disclaim any possible inheritance. If he or she does not do so, inherited property can be turned over to the government to satisfy any outstanding liens. However, in Drye Family 1995 Trust v. United States, CA-8 (8-17-98), a taxpayer in Arkansas used this post-mortem strategy and lost. The Court ruled that the disclaimer was not effective for the purpose of defeating a federal tax lien. Courts in other states have ruled differently in this area.

IRS Didn't Agree With Couple

• A couple received a letter from the IRS Appeals Office stating that they owed $2,900 for 1993. They mailed in a check for $2,500, writing "'93 full payment of tax liability" on the notation line and back of the check. The IRS cashed the check and issued a deficiency notice for the difference. Seeking to avoid the rest of the payment, the taxpayers petitioned the Tax Court for relief, but lost. According to the Court, the IRS can be bound only by entering into a closing agreement under IRC section 7121 and there was no such agreement in this case. Tom Kelly, et ux., v. Commissioner, TC Memo 1998-266.

—Michael Lynch, CPA, Esq., associate professor of tax
accounting at Bryant College, Smithfield, Rhode Island.