The Multi-Professional Organization Allocation Task Force (which includes members of the AICPA, the American Bankers Association, the American College of Trust and Estate Counsel and several bar associations) recently submitted a proposal to Congress advocating changes in the application of the generation-skipping transfer (GST) tax exemption.

The proposed changes would help taxpayers and their advisers fully make use of the GST exemption.

In the proposal we are trying to increase fairness and equity by simplifying what is an extremely complex area of the law, said Lloyd Leva Plaine, a partner at the law firm of Sutherland, Asbill & Brennan LLP, Washington, D.C., and a member of the task force.

People are trying to use the $1 million generation-skipping transfer exemption that they are allowed by law, she said, but the usage is being unnecessarily restricted by the complexity of the exemption allocation rules.

The GST tax, enacted by Congress in 1986, imposes the maximum gift and estate tax rate (55%) on transfers to beneficiaries more than one generation removed from that of the benefactor. The law, however, allows every individual a $1 million GST exemption. The exemption may be allocated to any property subject to estate or gift tax.

The GST exemption is automatically allocated in direct gifts from grandparents to grandchildren, unless the transfer is made through a trust, in which case the exemption must be elected.

In most cases people just miss the allocation, said John H. Gardner, chairman of the AICPA trust, estate and gift tax committee.

The task force proposal attempts to remedy the GST tax-exemption dilemma through the following recommendations:

• Extending the automatic exemption allocation rule to GST-type trusts.

• Providing statutory authority for the IRS to grant 9100 relief to taxpayers for late allocation.

• Confirming that substantial compliance provisions cover allocations evident from the return and other documents.

• Extending the predeceased parent exception to provide for retroactive allocation of the GST exemption for unnatural order of death when the transferor is still alive.

• Providing a trust-severance rule to cover various situations, including unexpected order of death and when there is an inclusion ratio between zero and one.

This proposal would extend the automatic allocation of the GST exemption to trusts and situations where one rationally would want it to be made, making the GST exemption more user-friendly and more accessible to taxpayers, Plaine said.

Charles O. Rossotti, commissioner of the IRS, recently announced the appointment of W. Val Oveson, a member of the AICPA state and local taxation committee, to the enhanced national taxpayer advocate position.

Having the reputation of an innovative and effective administrator, Oveson expects to play a major role on the management team that will push for modernization and customer service improvements at the IRS in accordance with the provisions of the IRS Restructuring and Reform Act of 1998.

Oveson, chairman of the Utah State Tax Commission since 1993 and Utahs former lieutenant governor for two terms, described his new job as being the manager of information between taxpayers and tax legislators.

He said he will focus on three main areas in his new role.

1. Listening to taxpayers to determine the areas of tax administration that cause problems. He will use the IRS Problem Resolution Program (PRP) to collect anecdotal and statistical information and rely heavily on the new citizen advocacy panels (CAP) to gather information.

   Another way to get the taxpayers point of view will be communicating with groups that represent tax practitioners such as the AICPA, Oveson said.

2. Communicating taxpayers complaints within the IRS and developing solutions to those problems.

3. Reporting to Congress on the taxpayer problems found, what the IRS is doing to correct them and the legislative action needed (if any) to resolve the problems.

   Oveson said that, as the national taxpayer advocate, he will play a big part in reshaping how the IRS deals with taxpayers. The position, formerly called the taxpayer advocate, has had more than a name change, he said. It now has more authority within the IRS, an increased staff allocation and an enhanced reporting relationship to Congress.

   The national taxpayer advocate plays a very prominent role in the restructuring movement, Oveson said. The new position will enhance the restructuring and not diminish it.

IRS Commissioner Charles O. Rossotti reached beyond the circle of IRS insiders when he created the agencys new management team .

These changes are part of our effort to place the right people in the right jobs to help move us toward the creation of a new, taxpayer-focused IRS, said Rossotti about the appointments.

Management Team
National Taxpayer Advocate W. Val Oveson, chairman of the Utah State Tax Commission.

Deputy Commissioner (Modernization) John LaFaver, secretary of the Kansas Department of Revenue.

Deputy Commissioner (Operations) Robert Wenzel, IRS chief operations officer since April 1998.

Chief Information Officer Paul J. Cosgrave, whose experience includes 25 years in the information technology industry.

Deputy Chief of Management and Finance Lynda Willis, GAO director of tax policy and administration issues.

Chief Financial Officer Donna H. Cunninghame, CFO of the Corporation for National Service.

National Director of Education Ronald P. Sanders, executive director of George Washington Universitys Center for Excellence in Municipal Management.

If a taxpayer wants to exchange business or investment property tax-free under the IRC section 1031 like-kind exchange rules, when must he or she receive the replacement property? Section 1031 establishes two conditions a taxpayer must meet to qualify a transaction as a deferred like-kind exchange:

1. The replacement property must be identified within 45 days.

2. The taxpayer must receive the replacement property by the earlier of the due date of his or her tax return (including extensions) or 180 days after the transfer.

Orville Christensen owned business property which he transferred to a facilitator (someone who is paid to arrange a like-kind exchange) on December 22, 1988, as the first step in a tax-free, deferred like-kind exchange. Christensen identified the replacement properties on February 3, 1989. He received those properties from the facilitator between April 25 and June 20, 1989. While Christensen met the first condition for a section 1031 exchange, he and the IRS disagreed over whether he met the second. He appealed the IRS decision.

Result: For the IRS. The Ninth Circuit Court of Appeals rejected the taxpayers claim that, because of the availability of an automatic extension to file his tax return, the due date should include the extension period even if the taxpayer did not request an extension. According to the court, the IRC is clear. It says the property must be received no later than the due date of a return, including extensions. That can only mean extensions that are actually granted.

Christensen argued that he had substantially complied with the requirement. He contended that, by filing his return on the actual due date, he had provided the IRS with the information it needed. Therefore, he substantially complied with the requirements in section 1031. The Ninth Circuit rejected the argument that filing a return is substantially equivalent to an extension.

If the taxpayers return is due prior to 180 days after the property transfer in question, he or she must apply for a filing extension in order to have the entire 180 days to obtain the replacement property. The courts will reject all arguments that the extension is not necessary or that the taxpayer substantially complied with all requirements. If it turns out the property is not received on time, the sale will usually qualify for installment treatment, allowing the taxpayer to report the gain in the year the property is received rather than in the year of the original transfer.

• Orville Christensen v. Commissioner, 98-1, USTC 50, 352 (Ninth Circuit Court of Appeals).

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

The alternative minimum tax (AMT) is a parallel tax system (calculated separately from regular taxes) designed to ensure that wealthy taxpayers with substantial tax preference items are subject to some income tax liability. A recent Tax Court case, however, indicates that the AMT can be applied even in the absence of the tax loopholes.

In Klaassen v. Commissioner, TC Memo 1998-241, the court decided that the AMT could be applied to large families of modest income with no real tax preference items except personal exemptions. This case shows that, because the AMT is not indexed for inflation, unwary middle-class taxpayers, whom Congress never intended to be subject to this tax, are now getting caught in its web.

The Klaassens were members of the Reformed Presbyterian Church of North America. They believed that a large family was a blessing and they opposed birth control and abortion measures. On their joint 1994 itemized return, the Klaassens reported adjusted gross income of $83,056; claimed 12 personal and dependency (10 children) exemptions; and deducted $4,767 in medical and dental expenses and $3,264 in state and local taxes.

Upon audit, the IRS determined that the Klaassens were subject to the AMT, despite the fact that they had no tax preference items for regular income tax purposes.

Following the letter of the law as outlined in form 6251, the IRS adjusted the Klaassens personal exemptions downward, disallowed their deduction for state and local taxes and limited their medical deductions to 10% of adjusted gross income instead of the 7.5% allowed for regular tax purposes. It then calculated their AMT taxable income at $68,832, substantially higher than the $34,092 of regular taxable income the Klaassens had reported on the form 1040.

The Klaassens did not challenge the IRS calculations. Instead, they argued that Congress did not intend for the AMT to have this effect on large families and that the AMT violated their religious freedom to have a large family.

The court disagreed. Leaving no room for interpretation, it concluded that, even though tax preference items were the reason for the AMTs creation, their existence is not required for the AMT to apply.

Observation: There is a large group of taxpayers who, although by no means rich, are falling victim to the AMT. CPAs must be aware that clients with modest incomes and itemized deductions for state and local income taxes, real estate taxes, home equity loans, medical expenses and miscellaneous itemized deductions (subject to the 2% test) are prime candidates for the AMT. Taxpayers claiming the new Hope scholarship credit and the Lifetime Learning credit (which are not included in the AMT calculation) may also find themselves caught in the AMT trap.

This case illustrates the need to index the AMT brackets and exemption amounts; to allow regular tax credits against the AMT; to allow more itemized deductions in calculating AMT; and to exempt from the AMT families with regular tax-adjusted gross income under a stated income level. If these changes are not made, it is estimated that, in the next 10 years, nearly 10 times more taxpayers will become subject to this tax.

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

Company Safe on Home-Expense Deductions

• To encourage employee transfers, a computer manufacturer engaged the services of a relocation company to buy relocated employees residences. A transferred employee could then buy a replacement home before the old residence was sold. In Amdahl Corp. v. Commissioner , 108 TC no. 24 (1997), the corporation was allowed to deduct any losses and expenses related to such sales as ordinary and necessary business expenses. The IRS had argued that such losses were capital losses and could be offset only against capital gains (see revenue ruling 82-204, 1982-2 CB 192). The court disagreed because the relocated employee retained legal title to the residence and remained legally responsible for the mortgage and real estate tax payments until a sale to a third party took place.

No Looking Back

• In accordance with the Taxpayer Relief Act of 1997, the IRS issued final regulations (TD 8775) effective July 2, 1998, that allow manufacturers and construction contractors with long-term contracts subject to the look-back methodand completed in tax years ending after August 5, 1997to elect not to apply that method in de minimis cases. To make the election, a manufacturer or contractor simply attaches the statement to a return (including extensions) that is filed on time and writes on the statement Notification of Election Under Section 460(b)(6). In the final regulations, the choice not to apply the look-back method automatically revokes an election under regulations section 1.460-6(e) to use the delayed reapplication method.

Ad Designs Currently Deductible

• RJR Nabisco, Inc., spent $1.8 million to develop graphic designs for its cigarette products. The IRS said these costs had to be capitalized because they resulted in goodwill or indefinite future benefits. The IRS argued that there is a difference between the costs of developing advertising campaigns and the cost of executing those campaigns by producing a specific piece of advertising. The court held that RJR Nabisco could currently deduct the costs of the graphic designs as an advertising expense under regulations section 162 even though those costs might produce long-term benefits. RJR Nabisco Inc., et al. v. Commissioner , TC Memo 1998-252.

Pay for Your Own Mistakes

• The IRS has issued procedures to follow when a taxpayers refund is erroneously deposited in another account. According to the IRS, if a bank improperly deposits the money to the wrong account, through no fault of the IRS, the government does not have to pay the bank. The bank must recover the erroneous deposits from the account owner. However, if the IRS caused the mistake, the refund must still be issued to the proper taxpayer and the IRS must rectify its own error.

Research Credit Test Tested

• In Norwest Corporation v. Commissioner , 110 TC no. 34 (June 29, 1998), the court, in a case of first impression, closely examined the seven tests that must be satisfied in order to obtain the qualified research credit under regulations section 41 for internal-use software. The court held that the three tests for internal-use software set forth in the conference report accompanying the Tax Reform Act of 1986 require a higher threshold of technical advancement than that for other fields of research.

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